BHC

Bank Holding Company
Supervision
Manual
Division of Banking Supervision and Regulation

Bank Holding Company
Supervision
Manual

Prepared by:
Board of Governors of the Federal Reserve System
Send comments to:

Director, Division of Banking Supervision
and Regulation
Copies of this manual may be obtained from:

Publications Services
Mail Stop 127
Board of Governors of the Federal Reserve System
Washington, D.C. 20551
For price information, please call 202-452-3244.
Bank Holding Company Supervision Manual
Supplement 51January 2017
This supplement reflects decisions of the Board a bank holding company (BHC), savings and
of Governors, new and revised statutory and loan holding company (SLHC), and any other
regulatory provisions, supervisory guidance, and company that controls an insured depository
instructions that the Division of Supervision and institution but that is not a BHC or SLHC, such
Regulation has issued since the publication of as the parent company of an industrial loan
the July 2016 supplement. company); (iii) any company that is treated as a
BHC for purposes of section 8(a) of the Interna-
tional Banking Act of 1978 (for example, any
SUMMARY OF CHANGES foreign bank operating a branch or agency in the
United States); and (iv) any affiliate or subsidi-
ary of any of the foregoing (for example, a
Section 2126.5 brokerdealer subsidiary of a BHC). (Refer to
SR-16-18.)
Section 2126.5, Procedures for a Banking En-
tity to Request an Extended Transition Period
for Illiquid Funds, is a new section that pro- Section 3140.0
vides applicable banking entities with informa-
tion on the procedures for submitting a request This section, Section 4(c)(8) of the BHC Act
for an extended transition period for a hedge (Leasing Personal or Real Property), has been
fund or private equity fund that qualifies as an revised to include a brief summary of a June 10,
illiquid fund pursuant to section 13 of the Bank 2016, Board order (FRB Order no. 2016-07)
Holding Company Act of 1956 (BHC Act), also that approved a notice by a foreign bank holding
known as the Volcker rule. Under the statute, a company and its foreign wholly owned subsidi-
banking entity must apply to the Board for an ary bank to engage in permissible nonbanking
extended transition period for an illiquid fund activities under section 4(c)(8) of the BHC Act
regardless of the banking entitys primary finan- and section 225.24 of the Boards Regulation Y.
cial regulatory agency. The term banking en- The nonbanking activities include railcar leas-
tity is defined by statute to include, with lim- ing and the provision of certain railcar fleet
ited exceptions: (i) any insured depository management services pursuant to sections
institution (IDI) (as defined in section 3 of the 225.28(b)(3) and 225.21(a)(2) of Regulation Y.
Federal Deposit Insurance Act (12 U.S.C. 1813)); The corresponding table of Laws, Regulations,
(ii) any company that controls an IDI (including Interpretations, and Orders has been amended to
include the order.
BHC Supervision Manual January 2017

Page 1
Bank Holding Company Supervision Manual Supplement 51January 2017
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, pages 56, 1010.0 Table of Contents, pages 56,
pages 6.16.2 pages 6.16.2
2000 Table of Contents, pages 1718, 2000 Table of Contents, pages 1718,
pages 18.118.2 pages 18.118.2
2126.5, pages 13
3000 Table of Contents, pages 78 3000 Table of Contents, pages 78

3140.0, pages 14, 4.1 3140.0, pages 14, 4.1
pages 1112 pages 1112

Page 2
Supplement 50July 2016
This supplement reflects decisions of the Board Section 4070.1
of Governors, new and revised statutory and
regulatory provisions, supervisory guidance, and Section 4070.1, Rating...Risk Management Pro-
instructions that the Division of Banking Super- cesses and Internal Controls of BHCs... is par-
vision and Regulation has issued since the pub- tially superseded as the result of the issuance of
lication of the January 2016 supplement. SR-16-11, Supervisory Guidance for Assess-
ing Risk Management at Supervised Institutions
with Total Consolidated Assets Less than $50
SUMMARY OF CHANGES
Billion. With the issuance of SR-16-11, SR-
95-51 (section 4070.1) is applicable only to
bank holding companies and state member banks
Section 1050.2
having $50 billion or more in total assets.
Section 1050.2, Guidance for the Consolidated
Supervision of Regional Bank Holding Compa-
nies, is revised (beginning at subsection Section 4071.0
1050.2.5) to include guidance for regional bank-
ing organizations based on SR-16-4, Relying Section 4071.0, Supervisory Guidance for As-
on the Work of the Regulators of Subsidiary sessing Risk Management at Supervised Institu-
Insured Depository Institution(s) of Bank Hold- tions with Total Consolidated Assets Less than
ing Companies and Savings and Loan Holding $50 Billion, is a new section that reaffirms the
Companies with Total Consolidated Assets of Federal Reserves long-standing supervisory ap-
Less than $50 Billion. The letter was issued by proach that emphasizes the importance of pru-
the Federal Reserve to explain its expectations dent risk management. This sections guidance
for its examiners reliance on the work of the and SR-16-11, Supervisory Guidance for As-
regulators of insured depository institution sub- sessing Risk Management at Supervised Institu-
sidiaries of these holding companies. The letter tions with Total Consolidated Assets Less Than
presents a tailored supervisory approach for $50 Billion, outlines core risk categories and
regional banking organizations, which are defined risk-management principles. This supervisory
as companies with total consolidated assets of guidance reflects updates to, and partially super-
between $10 billion and $50 billion. sedes, SR-95-51, Rating the Adequacy of Risk
Management and Internal Controls at State Mem-
ber Banks and Bank Holding Companies. The
guidance in SR-16-11 provides clarifications on,
Section 4066.0
and distinguishes supervisory expectations for,
Section 4066.0, Consolidated (Funding and the roles and responsibilities of the board of
Liquidity Risk Management), is amended at directors and senior management. The risk-
subsection 4066.0.2 to include Appendix B - management expectations within this guidance
Interagency Guidance on Funds Transfer Pric- are applicable to all supervised institutions with
ing Related to Funding and Contingent Liquid- total consolidated assets of less than $50 billion,
ity Risks, issued March 1, 2016. The guidance including bank holding companies, state mem-
was issued to address weaknesses observed in ber banks, savings and loan holding companies,
some large financial institutions funds transfer and foreign banking organizations with total
pricing practices related to funding risk (includ- combined U.S. assets of less than $50 billion.
ing interest rate and liquidity components) and The guidance also applies to insurance and com-
contingent liquidity risk. (Refer to SR-16-03 mercial savings and loan holding companies
and to the March 1, 2016, attachment to the with total consolidated assets of less than $50
interagency guidance, Illustrative Funds Trans- billion.
fer Pricing Methodologies.)
BHC Supervision Manual July 2016

Page 1
Bank Holding Company Supervision Manual Supplement 50July 2016
Substantive changes that are included in SR- 3. Additional risk-management concepts are
16-11 (when compared to SR-95-51) are: included:
a. Information systems should consist of a
1. Certain major risk categories are modified. consolidated and integrated view of risks.
a. Compliance risk is a separate core risk; b. The board of directors should approve
b. Reputation risk is not considered a core significant policies to establish risk toler-
risk ances for the institutions activities.
c. Risk definitions that are revised:
i. Operational risk is the risk resulting
from inadequate or failed internal pro- Section 5000.0
cesses, people, and systems or from
external events. Section 5000.0, BHC Inspection Program (Gen-
ii. Market risk includes commodity prices eral), is revised at subsection 5000.0.4.3.05 to
iii. Legal risk includes legal sanctions provide additional guidance on the supervisory
approach to be used for holding companies with
2. The responsibilities of the board of directors total consolidated assets of $10 billion or less.
versus senior management are separated across The guidance pertains to relying on the work of
all risk-management components. insured depository institution (IDI) regulators
a. Senior management is responsible for risk for community banking organizations. Examin-
identification. ers are to rely substantially on the findings of
b. Senior management is responsible for the the IDI regulator in evaluating the overall condi-
establishment and maintenance of effec- tion of the holding company. Reserve Bank
tive information systems. reviews are to evaluate the condition, perfor-
c. Both the board of directors and senior mance, and prospects of a subsidiary IDI based
management are responsible for an effec- on the conclusion of the IDI regulator and are
tive system of internal controls. not to duplicate the IDI regulators work. (Refer
to SR-16-4.)

Page 2
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, page 12.1 1010.0 Table of Contents, page 12.1
1050.2, pages 14 1050.2, pages 14, 4.1

page 17 pages 1719
2124.0, pages 34 2124.0, pages 34
2124.01, pages 910 2124.01, pages 910

3070.0, pages 34 3070.0, pages 34
4000 Table of Contents, pages 58 4000 Table of Contents, pages 5-8
4066.0, pages 111 4066.0, pages 116

4070.1, pages 16 4070.1, pages 16
4071.0, pages 16
5000.0, pages 16 5000.0, pages 16

6000.0 Index, pages 2122 6000.0 Index, pages 2122

Page 3
This supplement reflects decisions of the Board section that discusses Federal Reserve supervi-
of Governors, new and revised statutory and sory concerns and issues regarding the establish-
regulatory provisions, supervisory guidance, and ment of arrangements by some bank and sav-
instructions that the Division of Banking Super- ings and loan holding companies (collectively,
vision and Regulation has issued since the pub- holding companies) to protect the financial
lication of the July 2015 supplement. investments made by shareholders (collectively,
shareholder protection arrangements). There
has been an increase in interest by some holding
SUMMARY OF CHANGES
companies to benefit certain shareholders, en-
hance short-term investor returns, and/or pro-
Section 2060.1 vide a distinct disincentive for investors to ac-
quire or increase ownership in a holding
Section 2060.1, Audit (Management Informa-
companys common stock and other capital
tion Systems), is revised (beginning at subsec-
instruments. Such shareholder protection arrange-
tion 2060.1.8) to include an Overview and Ap-
ments raise concerns because they could have
pendix AInteragency Advisory on External
negative implications on a holding companys
Audits of Internationally Active U. S. Financial
capital or financial position, limit a holding
Institutions. The federal banking agencies1 (the
companys financial flexibility and capital rais-
agencies) issued the advisory to communicate
ing capacity, or otherwise impair a holding com-
their support for the principles and expectations
panys ability to raise additional capital in the
that are set forth in Parts 1 and 2, respectively,
future. These arrangements impede the ability
of the Basle Committee on Banking Supervision
of a holding company to serve as a source of
(the BCBS) March 2014 guidance on External
strength to its insured depository institutions
audits of banks.
subsidiaries and are considered unsafe and un-
The agencies acknowledge that the existing
sound. A holding company, regardless of its
standards and practices in the United States are
asset size, should be aware that the Federal
broadly consistent with the BCBS external audit
Reserve may object to a shareholder protection
guidance. Because of the legal and regulatory
arrangement based on the facts and circum-
framework in the United Sates, certain differ-
stances and the features of the particular arrange-
ences exist between the standards and practices
ment. Examples of shareholder protection ar-
followed in the United States and the principles
rangements that have raised supervisory issues
and expectations in the BCBS external audit
are discussed. (Refer to SR-15-15.)
guidance. These differences are addressed in
this advisory, which also describes the agencies
supervisory expectations for U. S. financial insti-
tutions within the scope of the advisory for Section 4061.0
incorporating the principles and expectations in
the BCBS external audit guidance into their Section 4061.0, Consolidated Capital (Capital
practices. The advisory also outlines examiner Planning), is revised for amendments to Regu-
responsibilities related to these supervisory ex- lation Y, 12 C.F.R. 225.8 Capital Planning.
pectations. The rule was amended to limit the ability of a
The BCBS external audit guidance is in- bank holding company with $50 billion or more
tended for internationally active banks, which, in total consolidated assets to make capital dis-
the agencies defined in the advisory (Refer to tributions under the rule if the bank holding
SR-16-2 and its attachment.) companys net capital issuances are less than
the amount indicated in its capital plan. The tier
1 common capital ratio requirement was removed,
Section 2093.0 and certain mandatory capital action assump-
tions were modified. (Refer to 79 Fed. Reg.
Section 2093.0, Control and Ownership (Share- 64040 (October 27, 2014) and 80 Fed. Reg.
holder Protection Arrangements) is a new 75424 (December 2, 2015)).
1. The Board of Governors of the Federal Reserve System,

the Office of the Comptroller of the Currency, and the Federal BHC Supervision Manual January 2016
Deposit Insurance Corporation. Page 1
Section 4060.7 for Large and Noncomplex Firms, The Federal

Reserves guidance explains its supervisory ex-
Section 4060.7, Consolidated Capital (Assess- pectations for capital planning at large and non-
ing Capital Adequacy and Risk at Large Bank- complex bank holding companies and interme-
ing Organizations and Others with Complex diate holding companies of foreign banking
Risk Profiles) is deleted. The section was de- organizations, consistent with the broad supervi-
rived from SR-99-18, superseded by SR-15-18 sory expectations set forth in SR-12-17/CA-12-
and SR-15-19, both issued on December 18, 14, Consolidated Supervision Framework for
2015. Large Financial Institutions. This guidance ap-
plies to U.S. bank holding companies and inter-
mediate holding companies of foreign banking
Section 4063.0
organizations that have total consolidated assets
Section 4063.0, Federal Reserve Supervisory of at least $50 billion but less than $250 billion,
Assessment of Capital Planning and Positions have consolidated total on-balance sheet foreign
for LISCC Firms and Large and Complex Firms, exposure of less than $10 billion, and are not
is a new section consisting of Federal Reserve otherwise subject to the Federal Reserves LISIC
guidance that was issued to explain its expecta- framework (referred to as a Large and Non-
tions for capital planning at Large Institution complex Firm). Refer to SR-15-19 and its
Supervision Coordinating Committee (LISCC) attachment.
firms and large and complex bank holding com-
panies and intermediate holding companies of
foreign banking organizations. This guidance is Section 4080.0
consistent with the broad supervisory expecta-
tions set forth in SR-12-17/CA-12-14, Consoli- Section 4080.0, Federal Reserve System Bank
dated Supervision Framework for Large Finan- Holding Company Surveillance Program, is
cial Institutions. It sets forth the Federal revised to discuss the Federal Reserves revision
Reserves core capital planning expectations for of its safety-and-soundness surveillance pro-
LISCC and large and complex firms. Several gram (the Surveillance Program) for top-tier
appendices are included that detail supervisory bank holding companies and savings and loan
expectations on a firms capital planning pro- holding companies (HCs). The revised program
cesses. The new guidance largely consolidates includes a new early warning model for HCs,
the Federal Reserves existing capital planning the Holding Company Statistical Assessment
guidance. of Bank Risk or HC-SABR model. It deploys
The expectations for LISCC Firms and Large risk identification algorithms (Outlier Metrics)
and Complex Firms are higher than the expecta- and other surveillance products to process finan-
tions for Large and Noncomplex Firms. Within cial and economic data and generate forward-
the group of firms subject to this guidance, the looking, actionable intelligence on HCs that will
Federal Reserve has significantly heightened provide examiners and other supervisory staff
expectations for the LISCC Firms. This guid- with early signals by which to monitor risk-
ance sets forth only minimum expectations, and taking. Results are used to assess exposures,
LISCC Firms are consistently expected to exceed outlooks, and possible compliance shortcom-
those minimum standards and have the most ings, with the goal of calibrating supervisory
sophisticated, comprehensive, and robust capital resources to risk. The Surveillance Programs
planning practices for all of their portfolios and objectives, structure, and maintenance are dis-
activities. Refer to SR-15-18 and its attachment. cussed along with additional information on the
metrics, procedures, and write-up requirements
used to monitor HCs. The program also distrib-
Section 4065.0 utes surveillance results across the Federal
Reserves supervision function. (Refer to
Section 4065.0, Federal Reserve Supervisory SR-15-16 and its attachment.)
Assessment of Capital Planning And Positions

Page 2
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, pages 36, 6.16.2 1010.0 Table of Contents, pages 36, 6.16.2
page 12.1 page 12.1
1050.1, pages 1112 1050.1, pages 1112
1050.2, pages 910 1050.2, pages 910
2000 Table of Contents, pages 912, 12.112.3 2000 Table of Contents, pages 912, 12.112.3
2010.2, pages 12 2010.2, pages 12

pages 56 pages 56
2060.1, pages 111 2060.1, pages 114
2093.0, pages 12
2124.01, pages 12 2124.01, pages 12
2128.06, pages 34 2128.06, pages 34
2500.0, pages 12 2500.0, pages 12
3111.0, pages 15 3111.0, pages 15
3130.1, pages 12 3130.1, pages 12, 2.1

4020.3, pages 12 4020.3, pages 12
4060.7, pages 17
4061.0, pages 13 4061.0, pages 13

4063.0, pages 123
4065.0, pages 116

4080.0, pages 15 4080.0, pages 13

Page 3
This supplement reflects decisions of the Board 2128.03.3.3) to delete a footnote reference to
of Governors, new and revised statutory and SR letter 05-13 and its attachment, Interagency
regulatory provisions, supervisory guidance, and Guidance on the Eligibility of Asset-Backed
instructions that the Division of Banking Super- Commercial Paper Program Liquidity Facilities
vision and Regulation has issued since the pub- and the Resulting Risk-Based Capital Treat-
lication of the January 2015 supplement. ment, which is superseded by SR letter 15-6
Interagency Frequently Asked Questions on
the Regulatory Capital Rule.
SUMMARY OF CHANGES
Section 2010.2 Section 2500.0

Section 2010.2, Supervision of Subsidiaries This section, Supervision of Savings and Loan
(Loan Administration and Lending Standards), Holding Companies was revised to include a
is revised (subsection 2010.2.4.1.9) to remove a reference to SR letter 14-9, Incorporation of
footnote reference to SR letter 02-16, Inter- Federal Reserve Policies into the Savings and
agency Questions and Answers on Capital Treat- Loan Holding Company Supervision Program,
ment of Recourse, Direct Credit Substitutes and which provides a listing of supervisory guidance
Residual Interests in Asset Securitizations, which documents (SR letters) that were issued prior to
is superseded by SR letter 15-6, Interagency July 21, 2011. The Federal Reserve has deter-
Frequently Asked Questions (FAQs) on the Regu- mined that these SR letters are applicable to
latory Capital Rule. savings and loan holding companies.
Section 2090.2
Section 3070.3
Section 2090.2, Control and Ownership (BHC
Formations), has been revised to include the This section, Section 4(c)(8) of the BHC Act
Boards April 9, 2015, approval of its Small (Non-Traditional MortgagesAssociated Risks),
Bank Holding Company and Savings and Loan is revised to delete a footnote reference to SR
Holding Company Policy Statement (effective letter 02-16, Interagency Questions and An-
May 15, 2015). This policy statement expands swers on Capital Treatment of Recourse, Direct
the applicability of the former policy statement Credit Substitutes, and Residual Interests in
to include savings and loan holding companies Asset Securitizations, and its attachment, which
(SLHCs). The policy applies to those bank hold- is superseded by SR letter 15-6 Interagency
ing companies (BHCs) and certain SLHCs that Frequently Asked Questions on the Regulatory
have consolidated assets of less than $1 billion. Capital Rule. Refer to subsection 3070.3.2.5.
Previously, the policy only applied to BHCs Secondary Market Activity.
having consolidated assets of less than $500
million.
Section 3111.0
Section 2128.03 This section, Section 4(c)(8) of the BHC Act

(Acquisition of Savings Associations) includes
Section 2128.03, Credit-Supported and Asset- (subsection 3111.0.3) reference corrections to
Backed Commercial Paper (Risk Management listed Board orders that authorized the acquisi-
and Internal Controls) is revised (subsection tion of savings associations.

Page 1
FILING INSTRUCTIONS
Remove Insert
2000 Table of Contents, pages 12.112.2 2000 Table of Contents, pages 12.112.2
2010.2, pages 12, 2.1 2010.2, pages 12, 2.1

2090.2, pages 16 2090.2, pages 15
2128.03, pages 18 2128.03, pages 18
2500.0, pages 12 2500.0, pages 12
3070.3, pages 16 3070.3, pages 16
3111.0, pages 34 3111.0, pages 34

pages 58 pages 58

Page 2
regulatory provisions, supervisory guidance, and This section, Risk-Focused Supervision for
instructions that the Division of Banking Super- Large Complex Banking Organizations, was
vision and Regulation has issued since the pub- revised to (1) include 10 additional risk-focused
lication of the July 2014 supplement. SR letters to the listing in appendix A and
(2) remove two inactive letters from this list.
SUMMARY OF CHANGES
Section 3110.0
Sections 1050.0, 1050.1, 1050.2, 3900.0,
and 4070.0 This section, Section 4 (c)(8) of the BHC Act
(Industrial Banking) was revised to amend the
These sections have been revised to refer to beginning discussion and to include statutory
SR-12-17/CA-12/14, Consolidated Supervision and regulatory citations and a current Board
Framework for Large Financial Institutions, order reference within section 3110.0.4.
which superseded SR-99-15, Risk-Focused Su-
pervision of Large Complex Banking Organiza-
tions. Section 3111.0
Section 2010.2 This section, Section 4(c)(8) of the BHC Act
(Acquisition of Savings Associations) was re-
Section 2010.2, Supervision of Subsidiaries vised to include a Dodd-Frank Act provision
(Loan Administration and Lending Standards), pertaining to a bank holding companys applica-
is revised to include a new subsection 2010.2.6, tion to acquire an insured depository institution
Guidance on Private Student Loans with Gradu- when it is located in a home state other than the
ated Payment Terms of Origination. The guid- home state of the bank holding company. See
ance provides principles that financial institu- subsection 3111.0.2.5. In addition, subsection
tions should consider in their policies and 3111.0.3 lists additional Board orders that have
procedures for originating these loans. Financial authorized the acquisition of savings associa-
institutions should prudently underwrite their tions.
private student loans in a manner consistent
with safe and sound lending practices. Financial
institutions should also comply with all applica- Section 4069.0
ble federal and state consumer laws and regula-
tions, including providing disclosures that clearly This new section, Dodd-Frank Act Company
communicate the timing and the amount of pay- Run Stress Testing for Banking Organizations
ments to facilitate borrower understanding of with Total Consolidated Assets of $1050 Bil-
loan terms and features. Refer to SR-15-2/CA- lion, provides guidance on the supervisory
15-1. expectations for the Dodd-Frank Wall Street
Reform and Consumer Protection Act stress test
Section 2124.0 practices for these companies and offers addi-
tional details about methodologies that should
This section was revised to include a footnote be employed. Refer to SR-14-3 and the 2014
reference to SR-14-4, Examiner Loan Sam- interagency Supervisory Guidance on Imple-
pling Requirements for State Member Bank and menting Dodd-Frank Act Company-Run Stress
Credit Extending Nonbank Subsidiaries of Bank- Tests for Banking Organizations with Total Con-
ing Organizations with $10$50 Billion in Total solidated Assets of More Than $10 Billion but
Consolidated Assets. The guidance in SR-14-4 Less than $50 Billion (see 79 Fed. Reg. 14153,
clarifies the expectations for the assessment of March 13, 2014).
material retail credit portfolios for these institu-
tions. The guidance in SR-14-4 superseded SR-
94-13, Loan Review Requirements for On-Site
Examinations, but only for these banking orga-
nizations. (For the SR-14-4 guidance, refer to BHC Supervision Manual January 2015
subsection 2010.2.11, appendix I.) Page 1
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, page 12.1 1010.0 Table of Contents, page 12.1
1050.0, pages 18 1050.0, pages 18
1050.1, pages 14 1050.1, pages 14, 4.1
1050.2, pages 14 1050.2, pages 14
2000 Table of Contents, pages 12, 2.1 2000 Table of Contents, pages 12, 2.1
2010.2, pages 12, 2.1 2010.2, pages 12, 2.1

pages 2728 pages 2728, 28.128.2
2124.0, pages 17 2124.0, pages 17
2124.01, pages 12 2124.01, pages 12

pages 1920, 20.1 pages 1920, 20.120.2
3110.0, pages 12 3110.0, pages 13
3111.0, pages 15 3111.0, pages 15
3900.0, pages 17 3900.0, pages 17
4069.0, pages 14
4070.0, pages 18 4070.0, pages 18

Page 2
regulatory provisions, supervisory guidance, and This revised section, Taxes (Consolidated Tax
instructions that the Division of Banking Super- Filing) includes a June 13, 2014, Interagency
vision and Regulation has issued since the pub- Addendum to the 1998 Interagency Policy
lication of the January 2014 supplement. Statement on Income Tax Allocation in a Hold-
ing Company Structure (Addendum). The fed-
eral banking agencies1 (Agencies) announced
SUMMARY OF CHANGES the Addendums issuance to ensure that insured
depository institutions (IDIs) in a consolidated
Section 2010.2 group maintain an appropriate relationship re-
garding the payment of taxes and treatment of
The section, Supervision of Subsidiaries (Loan tax refunds. The Addendum is to ensure that tax
Administration and Lending Standards), is re- allocation agreements expressly acknowledge an
vised to include Appendix I Examiner Loan agency relationship between a holding com-
Sampling Requirements For Credit-Extending pany2 and its IDI subsidiary to protect the IDIs
Nonbank Subsidiaries of BHCs with $10-50 ownership rights in tax refunds. State member
Billion in Total Consolidated Assets. The sub- banks and holding companies should implement
section sets forth the loan sampling expectations the guidance as soon as reasonably possible,
that apply to the Federal Reserves inspection of which the Agencies expect would not be later
credit-extending nonbank subsidiaries of bank than October 31, 2014. The Addendum clarifies
holding companies (BHCs). Examiners will also and supplements but does not replace the 1998
have the flexibility, depending upon the struc- Interagency Policy Statement. (Refer to SR-14-6
ture and size of a nonbank subsidiary, to utilize and its attachment.)
the guidance so that its applicable to a smaller
BHC with credit-extending nonbank subsidi-
aries having total assets below $10 billion. Refer Section 2124.05
to SR-14-4 and its attachment.
This section, Consolidated Supervision Frame-
work for Large Financial Institutions is revised
Section 2020.1 to include Appendix B Managing Foreign
Exchange Settlement Risks for Physically Settled
This section, Intercompany Transactions (Trans- Securities. (See SR-13-24 and its February
actions Between Member Banks and Their Af- 2013 attachment.) This guidance sets forth seven
filiates Sections 23A and 23B of the Federal principles or guidelines for managing foreign
Reserve Act) is revised to discuss statutory exchange transaction settlement risks. The Fed-
amendments to these sections of the Federal eral Reserve supports these principles as part of
Reserve Act resulting from the Dodd-Frank Act. its continuing effort to promote the global finan-
One amendment involved the definition of an cial systems ability to withstand severe market
affiliate, with regard to an investment fund disruptions. Institutions covered by SR-13-24
when an insured depository institution (IDI) or should apply the seven guidelines to their for-
one of its affiliates is an investment adviser. eign exchange activities with the stated clarifica-
Also, the definition of covered transactions tions regarding application of the guidance in
was revised to include the credit exposure result- the United States.
ing for derivative and securities lending and
borrowing transactions between the IDI and its
affiliates. In addition, the Dodd- Frank Act
removed the quantitative 10 percent exemption
limit between financial subsidiaries of an IDI. 1. The Board of Governors of the Federal Reserve System,
The retained earnings of a financial subsidiary Federal Deposit Insurance Corporation, and the Office of the
Comptroller of the Currency.
are to be included as part of the IDIs invest- 2. For the purpose of this guidance, the term, holding
ment. The amendments were effective on July company refers to a bank holding company or a savings and
21, 2012. (See sections 608(a)(1)(A), loan holding company.
608(a)(1)(B), and 609(a) of the Dodd-Frank
Act.) A few additional or revised inspection BHC Supervision Manual July 2014
objectives and procedures are included. Page 1
Section 3070.0 on the periodic on- and off-site inspections that

assess the safety and soundness of supervised
This revised section, Section 4(c)(8) of the BHCs and SLHCs (referred to as holding com-
BHC Act (Mortgage Banking), includes a brief panies). The guidance updates the minimum
discussion of the December 13, 2013, Inter- inspection frequency and scope requirements
agency Statement on Supervisory Approach for for supervised holding companies with total
Qualified and Non-Qualified Mortgage Loans consolidated assets of $10 billion or less to
that was issued to clarify the safety-and-
soundness expectations and Community Rein- conform inspection frequency and scope re-
vestment Act (CRA) considerations for regu- quirements for SLHCs with total consolidated
lated institutions engaged in residential mortgage assets of $10 billion or less to those applicable
lending. The section references the Consumer to BHCs of the same size;
Financial Protection Bureaus (CFPB) Ability- clarify the scoping requirements for targeted
to-Repay and Qualified Mortgage Standards Rule inspections conducted at BHCs and SLHCs
that was issued on January 10, 2013 (effective with total consolidated assets between $1 bil-
on January 10, 2014). Institutions may issue lion and $10 billion; and
qualified mortgages or non-qualified mortgages, modify the requirement for targeted inspec-
based on their business strategies and risk appe- tions for 3, 4, and 5-rated BHCs with
tites. Refer to SR-13-20 and its attachment. total consolidated assets between $1 billion
and $10 billion.
Section 4080.1 Except for the addition of SLHCs, the inspec-

tion scope and frequency expectations for hold-
This section, Surveillance Program for Small ing companies with less than $1 billion in total
Holding Companies, is modified to reflect consolidated assets have not changed.
changes to the small holding company surveil- These frequency and scope requirements vary
lance program. The surveillance program for depending on whether a holding company has
holding companies under $1 billion in total con- been designated complex, with more compli-
solidated assets includes both BHCs and SLHCs. cated holding companies subject to more fre-
(Refer to SR-13-21.) quent and in-depth review. If needed for super-
visory purposes, Reserve Banks may inspect a
holding company with greater frequency and
Section 5000.0 scope than described in this guidance. (Refer to
SR-13-21 and its attachment.)
This section, BHC Inspection Program (Gen-
eral) is revised to include supervisory guidance

Page 2
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, pages 12 1010.0 Table of Contents, pages 12

pages 56, 6.16.2 pages 56, 6.16.2
page 12.1 page 12.1
2000 Table of Contents, pages 12 2000 Table of Contents, pages 12, 2.1
pages 4.14.4 pages 4.14.4
2010.2, pages 12, 2.1 2010.2, pages 12, 2.1
2020.1, pages 139 2020.1, pages 140
2070.0, pages 16 2070.0, pages 18
2124.05, pages 18 2124.05, pages 19
3070.0, pages 12, 2.1 3070.0, pages 12, 2.1
pages 56 pages 56, 6.1
4080.1, page 1 4080.1, page 1
5000.0, pages 120 5000.0, pages 125
pages 78 pages 78

Page 3
regulatory provisions, supervisory guidance, and This section, Consolidated Supervision Frame-
instructions that the Division of Banking Super- work for Large Financial Institutions, includes
vision and Regulation has issued since the pub- an appendix, the December 20, 2013, guidance
lication of the July 2013 supplement. of SR-13-23, Risk Transfer Considerations
When Assessing Capital Adequacy
Supplemental Guidance on Consolidated Super-
SUMMARY OF CHANGES vision Framework for Large Financial Institu-
tions (Refer to SR-12-17/CA-12-14). The
additional guidance centers on how certain risk
Section 2010.2 transfer transactions affect assessments of capi-
tal adequacy at large financial institutions. It
The section, Supervision of Subsidiaries (Loan provides clarification on supervisory expecta-
Administration and Lending Standards), is tions when assessing a firms capital adequacy
revised to supplement the March 23, 2013, in certain circumstances when the risk-based
Interagency Guidance on Leveraged Lending capital framework may not fully capture the
with inspection objectives, inspection proce- residual risks of a transaction.
dures, and an internal control questionnaire for
leveraged lending. The section provides guid-
ance about the risk-management expectations Section 2124.3
for leveraged loans as well as examiner guid-
ance for the review of such loans. Refer to This new section, Managing Outsourcing Risk
SR-13-3 and its attachment. consists of the December 5, 2013, Federal Reserve
Guidance on Managing Outsourcing Risk
that was issued to assist financial institutions1 in
Section 2020.1 understanding and managing the risks associ-
ated with outsourcing a bank activity to a ser-
This section, Intercompany Transactions (Trans- vice provider to perform that activity. The guid-
actions Between Member Banks and Their ance addresses the characteristics, governance,
AffiliatesSections 23A and 23B of the Fed- and operational effectiveness of a financial insti-
eral Reserve Act) is revised to indicate that tutions service provider risk- management pro-
violations of sections 23A and 23B of the Fed- gram for outsourced activities beyond tradi-
eral Reserve Act or Regulation W should be tional core bank processing and information
brought to managements attention. They may technology services. The guidance applies to all
be discussed in the inspection report as Other service provider relationships regardless of the
Matters and referred to the banks primary type of activity that is outsourced. See SR-13-
supervisor. In this regard, there are some revised 19/CA-13-21 and its attachment.
inspection objectives and inspection procedures.
Section 5010.15
Section 2060.05
This section, Procedures for Inspection Report
This section consists of the 2003 interagency PreparationViolations is revised to provide
guidance, Policy Statement on the Internal clarifying instructions on the reporting of viola-
Audit Function and its Outsourcing. The sections or apparent violations in the inspection
tion includes new and revised inspection objec- report. The Violations section or page should
tives and inspection procedures for both the include all BHC and nonbank subsidiary viola-
2003 guidance and the January 23, 2013, Fed-
eral Reserve policy statement that supplements
the 2003 interagency guidance. Refer to SR- 1. For purposes of this guidance, financial institutions
refers to state member banks, bank and savings and loan
03-5 and SR 13-1/CA 13-1 and section 2060.07. holding companies (including their nonbank subsidiaries),
and U.S. operations of foreign banking organizations.

Page 1
tions of the Federal Reserve Act (the act), Regu- banks. If the banks primary regulator has not
lation Y, and other applicable statutes and regu- cited a violation of Section 23A and 23B of the
lations. Section 23A and 23B violations of the act, apparent violations should be noted in the
act should only be included if they have been Other Matters section or page of the inspec-
cited by the primary regulator of the subsidiary tion report.
FILING INSTRUCTIONS
Remove Insert
1010.0 General Table of Contents, pages 36 1010.0 General Table of Contents, pages 36
pages 1518, 18.118.2 pages 1518, 18.118.2
2010.2, pages 12, 2.1 2010.2, pages 12, 2.1
2020.0, pages 12 2020.0, pages 12
2020.1, pages 12 2020.1, pages 12
2060.05, pages 12 2060.05, pages 12
2124.05, pages 16 2124.05, pages 18
2124.3, pages 18
5000.0, pages 1920 5000.0, pages 1920

5010.15, page 1 5010.15, page 1
5010.35, pages 13 5010.35, pages 13
5020.2, pages 12 5020.2, pages 12

Page 2
regulatory provisions, supervisory guidance, and This new section, Supplemental Policy State-
instructions that the Division of Banking Super- ment on the Internal Audit Function and its
vision and Regulation has issued since the pub- Outsourcing, consists of the January 23, 2013,
lication of the January 2013 supplement. Federal Reserve policy statement that supple-
ments the 2003 interagency guidance, which is
in section 2060.05 of this manual. (See SR-
SUMMARY OF CHANGES 13-1/CA-13-1.)
Section 2010.2
Section 2500.0
The Supervision of Subsidiaries (Loan Admin-
istration and Lending Standards) section is This section on Supervision of Savings and
revised to include the 2013 leveraged lending Loan Holding Companies was revised to clarify
guidance, which replaced the 2001 Interagency the manner in which Federal Reserve examiners
Guidance on Leveraged Financing. This guid- communicate supervisory findings to banking
ance describes expectations for the sound risk organizations and institutions supervised by the
management of leveraged lending activities, Federal Reserve. It discusses the examiners use
including why institutions need to develop of the standardized terms, Matters Requiring
Immediate Attention and Matters Requiring
Transactions structured to reflect a sound busi- Attention. (Refer to SR-13-13/CA-13-10 and
ness premise, an appropriate capital structure, its attachment.)
and reasonable cash flow and balance sheet
leverage;
A definition of leveraged lending that facili- Section 5000.0
tates consistent application across all business
lines; This section, BHC Inspection Program
Well-defined underwriting standards that, General, is updated to discuss the Federal
among other things, define acceptable lever- Reserves adoption of a flexible, letter-format
age levels and describe amortization expecta- report in lieu of the standard, longer-form re-
tions for senior and subordinate debt; port. The report communicates the findings of
A credit limit and concentration framework on-site safety-and-soundness inspections of com-
consistent with the institutions risk appetite; munity banking organizations1 that result in
Sound management information systems that composite supervisory ratings of 4 or 5.
enable management to identify, aggregate, and Examiners may use the letter-format report pro-
monitor leveraged exposures and comply with vided that all mandatory and any applicable
policy across all business lines; optional information is included in the report.
Strong pipeline management policies and pro- (See SR-13-10.)
cedures that, among other things, provide for The section also clarifies the manner in which
real-time information on exposures and limits, Federal Reserve examiners communicate
and exceptions to the timing of expected dis- supervisory findings to banking organizations
tributions and approved hold levels; and and institutions supervised by the Federal
Guidelines for conducting periodic portfolio Reserve. The guidance discusses the Federal
and pipeline stress tests to quantify the poten- Reserves use of standard language for
tial impact of economic and market condi- examination/inspection findings with regard to
tions on the institutions asset quality, earn- Matters Requiring Immediate Attention
ings, liquidity, and capital. (MRIAs) and Matters Requiring Attention
(MRAs), reaffirming their definitions, includ-
This guidance should be consistent with the
size and risk profile of an institutions lever- 1. Community banking organizations include state mem-
aged activities relative to its assets, earnings, ber banks, bank holding companies, and savings and loan
liquidity, and capital. Institutions that originate holding companies with assets of $10 billion or less.
or sponsor leveraged transactions should
consider the entire guidance. See SR-13-3 and BHC Supervision Manual July 2013
its attachment. Page 1
ing their use by safety-and-soundness and to community holding companies rated compos-
consumer compliance examiners when com- ite 4 or 5, for which the Federal Reserve
municating supervisory findings to banking has adopted a flexible, letter-format report in
organizations. The use of the term, Observa- lieu of the standard, longer-form report. (Refer
tions is discontinued. (Refer to SR-13-13/CA- to SR-13-10.)
13-10 and its attachment.)
The section, in addition, is revised to further
clarify the 60-calendar-days completion stan- Section 5010.4
dard for examination and inspection reports for
community banking organizations, clarifying This section, Procedures for Inspection Report
the close date for examinations or inspec- Preparation (Core Page 1-Examiners Com-
tions. (See SR-13-14.) ments; Matters Requiring Special Board Atten-
tion), was amended to incorporate a reference
to the guidance found in SR-13-13/CA-13-10,
Section 5010.1 Communication of Supervisory Findings,
which clarified the Federal Reserves use of
The Procedures for Inspection Report Prepara- standardized terminology and definitions for
tion (General Instructions...) section has been MRIAs and MRAs.
revised to include a new subsection that applies
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, pages 36, 6.1 1010.0 Table of Contents, pages 36, 6.16.2
pages 712, 12.112.2 pages 712, 12.112.3
2010.2, pages 12, 2.1 2010.2, pages 12, 2.1
pages 916 pages 916, 16.116.4
2060.07, pages 110
2500.0, pages 12 2500.0, pages 12
5000.0, pages 12 5000.0, pages 12
pages 1316 pages 1314, 14.114.2, 1516
page 19 pages 1920
5010.1, pages 13 5010.1, pages 14
5010.4, pages 12 5010.4, pages 12

pages 769 pages 770

Page 2
regulatory provisions, supervisory guidance, and This section is updated for the various types of
instructions that the Division of Banking Super- formal supervisory actionscorrective actions
vision and Regulation has issued since the pub- (i.e., cease and desist orders (including placing
lication of the July 2012 supplement. limits on the activities or functions of an IDI or
institution-affiliated party)), written agreements,
suspensions (also removals and prohibitions),
nonbank activity terminations, violations of orders
SUMMARY OF CHANGES and written agreements, civil-money penalties
(revised penalty amounts), etc.
The cease-and-desist order discussion has
Section 2010.0 been expanded to include what an order may
require from a BHC or person, and it provides a
The Supervision of Subsidiaries section discussion of the nature of affirmative actions
includes a revision of the Federal Deposit Insur- by a BHC or person that may need to be taken to
ance Act (FDIA) to require bank holding com- restore a BHC to a safe and sound condition.
panies (BHCs) and savings and loan holding The prohibition and removal discussion has
companies to act as a source of strength to their been expanded to detail what entities or indi-
depository institution subsidiaries. See section viduals that the Board may take action against.
38A of the FDIA and section 616(d) of the It also discusses the prohibition against any
Dodd-Frank Act. individual that has been convicted of a crime
involving dishonesty, breach of trust, or money
laundering from serving, participating in, or
Section 2050.0 owning or controlling a BHC, bank or nonbank
subsidiary, or any affiliate thereof without the
This section on Extensions of Credit to BHC prior approval of the Federal Deposit Insurance
Officials was revised for amendments to the Corporation (FDIC), or in certain cases, the
Federal Reserve Act (FRA) regarding insider Board of Governors of the Federal Reserve Sys-
lending. The definition of extension of credit tem. The discussion on indemnifications and
was revised to include an insured depository payments includes a detailed discussion of the
institution (IDI)s credit exposure to a person provisions of section 18(k) of the FDIA and the
arising from a derivatives transaction, repur- FDICs regulation on indemnification agree-
chase agreement, reverse repurchase agreement, ments and payments. The definition of a prohib-
securities lending transaction, or securities bor- ited indemnification payment is included.
rowing transaction. See the FRA, section
22(h)(9)(D)(i), as amended by the Dodd-Frank
Act, section 614(a). Section 2124.05
The FDIA was amended to prohibit the pur-
chase or sale of assets between an IDI and an Effective January 2013, this new section pro-
executive officer, director, or principal share- vides the Consolidated Supervision Frame-
holder of the IDI and any related interest of such work for Large Financial Institutions, which
person unless the transaction is on market terms. supersedes the guidance found in inactive SR-99-
In addition, if the asset purchase or sale repre- 15, Risk-Focused Supervision of Large Com-
sents more than 10 percent of the IDIs capital plex Banking Organizations (former manual
stock and surplus, the transaction must be ap- section 2124.04). On December 17, 2012, the
proved by the majority of the board of directors Federal Reserve set forth a new framework for
of the IDI who do not have an interest in the the consolidated supervision of large financial
transaction. See the Dodd-Frank Act, section institutions. The framework strengthens tradi-
615(1). tional microprudential supervision and regula-
tion to enhance the safety and soundness of
individual firms. In addition, it incorporates
macroprudential considerations to reduce poten-

Page 1
tial threats to the stability of the financial system state that depository institutions can no longer
and to provide insights into financial market rely solely on reports from external credit report-
trends. The consolidated supervision framework ing agencies when making a determination as to
has two primary objectives: the quality and permissibility of an investment
in accordance with the Office of the Controllers
Enhancing resiliency of a firm to lower the (OCCs) Rule (12 C.F.R. 1).
probability of its failure or inability to serve
as a financial intermediary.
Each firm is expected to ensure that the con-
Section 2126.2
solidated organization (or the combined U.S. This is a new section on Investing in Securities
operations in the case of foreign banking orga- Without Reliance on Ratings of Nationally Rec-
nizations) and its core business lines can sur- ognized Statistical Rating Organizations
vive under a broad range of internal or exter- (NRSROs). State member banks were advised
nal stresses. This requires financial resilience on November 15, 2012, that, effective January
by providing sufficient capital and liquidity, 1, 2013, they may no longer rely solely on credit
and operational resilience to maintain effec- ratings issued by NRSROs (i.e., external credit
tive corporate governance, risk management, ratings) to determine whether a particular secu-
and recovery planning. rity is an investment security that is permis-
sible for investment. Under the regulations of
Reducing the impact on the financial system the OCCs rule (12 C.F.R. 1), securities may
and the broader economy in the event of a qualify for investment by national banks only if
firms failure or material weakness. they are determined by the bank to be invest-
Each firm is expected to ensure the sustain- ment grade and not predominantly speculative
ability of its critical operations and banking in nature.2 (See SR-12-15 and its attachment,
offices1 under a broad range of internal or OCC Guidance on Due Diligence Require-
external stresses. This requires, among other ments in Determining Whether Securities are
things, effective resolution planning that ad- Eligible for Investment.) Institutions may per-
dresses the complexity and the interconnectiv- form due diligence by maintaining and updating
ity of the firms operations. internal credit-rating reports and assessments,
The framework is being implemented in a which can be supplemented by reports from
multi-stage approach. (See SR-12-17 / CA-12- external credit-rating services.
14)
2. Under the FRA (12 USC 335) and the Federal Reserves
Regulation H (12 C.F.R. 208.21), state member banks are
subject to the same limitations and conditions with respect to
Section 2126.1 the purchasing, selling, underwriting, and holding of invest-
ment securities and stock as national banks under the National
Banking Act (12 U.S.C. 24 (Seventh)). When investing in
This section, Investment Securities and End- securities, state member banks must comply with the provi-
User Derivatives Activities, was amended to sions of the National Banking Act and the OCC regulations in
12 C.F.R. 1. In addition to this federal requirement, a state
1. Banking offices are defined as U.S. depository institu- member bank may purchase, sell, underwrite, or hold securi-
tion subsidiaries, as well as the U.S. branches and agencies of ties and stock only to the extent permitted under applicable
foreign banking organizations. state law.
FILING INSTRUCTIONS
Remove Insert
pages 1718
2010.0, pages 13 2010.0, pages 14

Page 2
Remove Insert
2050.0, pages 16, 6.1 2050.0, pages 16, 6.1
2070.0, pages 34 2070.0, pages 34

2110.0, pages 18 2110.0, pages 18
2124.04, pages 14
2124.05, pages 16
2126.1, pages 16 2126.1, pages 16
2126.2, pages 16
3130.1, pages 34 3130.1, pages 34
pages 910 pages 910
3130.4, pages 34 3130.4, pages 34
4060.8, pages 34 4060.8, pages 34
pages 78 pages 78
5010.10, pages 16 5010.10, pages 16
5010.29, page 1 5010.29, page 1
5010.31, page 1 5010.31, page 1
6000.0 Subject Index, pages 12 6000.0 Subject Index, pages 12

Page 3
regulatory provisions, supervisory guidance, and This new section, ALLL Estimation Practices
instructions that the Division of Banking Super- for Loans Secured by Junior Liens, provides
vision and Regulation has issued since the pub- the January 31, 2012, Interagency Supervisory
lication of the January 2012 supplement. Guidance on Allowance for Loan and Lease
Losses Estimation Practices for Loans and Lines
of Credit Secured by Junior Liens on 14 Fam-
ily Residential Properties. Institutions should
SUMMARY OF CHANGES consider all credit-quality indicators for junior-
lien loans and lines of credit (collectively, junior
liens). Generally, this information should include
Section 1040.0 the delinquency status of senior liens associated
with the institutions junior liens and whether
The section, Bank Holding Company Exami- the senior liens have been modified. Institutions
nation and Inspection Authority, has been revised should ensure that during the allowance for loan
to discuss the Federal Reserves (FR) current and lease losses estimation process sufficient
authority to conduct bank holding company information is gathered to adequately assess the
(BHC) inspections under section 5(c) of the probable loss incurred within junior-lien
BHC Act (12 U.S.C. 1844(c) and 12 U.S.C. portfolios.
5361(a)(c)). The section also is revised to Institutions with significant holdings of junior
include provisions of the Dodd-Frank Wall Street liens should gather and analyze data on the
Reform and Consumer Protection Act of 2010 associated senior-lien loans they own or service.
(Dodd-Frank Act). The Dodd-Frank Act removes When an institution does not own or service the
the enforcement provisions of section 10A of associated senior-lien loans, it should use rea-
the BHC Act that limited the FRs rulemaking sonably available tools to determine the pay-
and enforcement authority over functionally regu- ment status of the senior-lien loans. Such tools
lated subsidiaries. Previously, the FR was only include obtaining credit reports or data from
able to take enforcement actions against a func- third-party services to assist in matching an
tionally regulated subsidiary when its actions institutions junior liens with its associated senior
posed a threat to the safety and soundness of a liens. Inspection objectives and procedures are
depository institution affiliate. provided. See SR-12-3 and its attachment.
The FR, to the fullest extent possible, is to
rely on reports of examination of any subsidiary
depository institution or functionally regulated
subsidiary made by the primary financial regula-
Section 3000.0
tory agency. Also, the FR should notify, consult, This section, Introduction to BHC Nonbanking
and work with the primary financial regulatory and FHC Activities was revised for an amend-
agency for examination activities, information ment made under section 604(e) of the Dodd-
requests, and required reporting while avoiding Frank Act (see section 4(j)(2)(A) of the BHC
duplication and increased burden on the institu- Act or 12 U.S.C. 1843(j)(2)(A)). The Board is
tion. With regard to its supervision of a nonbank required to apply a balancing test in connec-
financial company, the FR is to rely on (1) reports tion with a notice filed by a BHC to engage in a
and other supervisory information provided to nonbanking activity. The Board must consider
other federal and state regulatory agencies, whether the performance of the activity by the
(2) externally audited financial statements, company can reasonably be expected to pro-
(3) information that is otherwise available from duce benefits to the public, such as greater con-
federal and state regulatory agencies, and venience, increased competition or gains in effi-
(4) information that is required to be reported ciency that outweigh possible adverse effects,
publicly. such as undue concentration of resources,
decreased or unfair competition, conflicts of
interest, or unsound banking practices. The
amendment added another adverse factor to

Page 1
considerwhether the performance of the non- Section 3980.0

bank activity by a BHC would pose a risk to the
stability of the U.S. banking or financial system. This new section, Establishment of an Interme-
diate Holding Company, discusses the Boards
authority under section 167 of the Dodd-Frank
Section 3032.0 Act (12 U.S.C. 5667). If a nonbank financial
company supervised by the FR conducts activi-
This new section presents the Federal Reserves ties other than those determined to be financial
April 5, 2012, policy statement, Policy State- in nature or incidental thereto under section 4(k)
ment on Rental of Residential Other Real Estate of the BHC Act (12 U.S.C. 1843(k)), the Board
Owned (OREO) Properties. The policy state- is authorized to require the company to establish
ment reminds banking organizations and exam- and conduct all or a portion of those activities
iners that the Federal Reserves regulations and that are financial in nature or incidental thereto
policies permit the rental of OREO properties as in or through an intermediate holding company.
part of an orderly disposition strategy within The intermediate holding company must be
statutory and regulatory limits. Banking organi- established in accordance with the Boards regu-
zations may rent one- to four-family residential lation no later than 90 days (or other longer
OREO properties without having to demonstrate appropriate time) after the date on which the
continuous active marketing of the properties, Board notifies the nonbank financial company
provided that suitable policies and procedures of the determination.
are followed. The Board must require a nonbank financial
The policy statement describes key risk- company to establish an intermediate holding
management considerations for banking organi- company, if it makes a determination that the
zations that engage in the rental of residential establishment of such an intermediate holding
OREO. The policy statement also establishes company is necessary to
specific supervisory expectations for banking
organizations that undertake large-scale residen- appropriately supervise activities that are deter-
tial OREO rentals, which generally encom- mined to be financial in nature or incidental
passes 50 properties or more available for rent. thereto; or
See SR-12-5/CA-12-3 and its attachment. Also ensure that supervision by the Board does not
see SR-12-10/CA-12-9, Questions and Answers extend to the commercial activities of the
for Federal Reserve-Regulated Institutions Re- nonbank financial company.
lated to the Management of Other Real Estate
Owned (OREO).
FILING INSTRUCTIONS
Remove Insert
1010.0 Table of Contents, pages 36, 6.1 1010.0 Table of Contents, pages 36, 6.1
1040.0, pages 12 1040.0, pages 12
2010.11, pages 118 2010.11, pages 118

2020.1, pages 1314 2020.1, pages 1314
2020.5, pages 14 2020.5, pages 14

2065.4, pages 12 2065.4, pages 12, 2.1
2065.5, pages 15

Page 2
Remove Insert
2080.4, page 1 2080.4, page 1

2124.01, pages 12 2124.01, pages 12
2124.4, pages 12, 2.1 2124.4, pages 12
pages 58 pages 58
page 25 page 25
3000.0, pages 12 3000.0, pages 12, 2.1
3032.0, pages 14
3980.0, page 1
5000.0, pages 12 5000.0, pages 12

pages 56 pages 56
pages 910 pages 910
6000.0 Alphabetical Subject Index, pages 169 6000.0 Alphabetical Subject Index, pages 169

Page 3
This supplement reflects decisions of the Board supervisory cycle for holding companies of vary-
of Governors, new and revised statutory and ing size and complexity, see SR-11-11 and its
regulatory provisions, and new and revised attachments.
supervisory guidance and instructions issued by
the Division of Banking Supervision and Regu-
lation since the publication of the July 2011 Section 4061.0
supplement.
This new section on Consolidated Capital (Capi-
tal Planning) summarizes amendments to Regu-
SUMMARY OF CHANGES lation Y that require BHCs with $50 billion or
more (large BHCs) of total consolidated assets
Section 2500.0 to develop and submit annual capital plans to
the Federal Reserve. These BHCs are required
This new section, Supervision of Savings and to obtain approval from the Federal Reserve
Loan Holding Companies describes the super- under certain circumstances before making a
visory approach for savings and loan holding capital distribution. The section generally dis-
companies (SLHCs) the Board will use during cusses significant provisions of the rules
the first supervisory cycle.1 The condition, per- amendments.
formance, and activities of SLHCs will be assessed The large U.S. BHCs should have credible
on a consolidated basis in a manner that is capital plans that show sufficient capital to lend
consistent with the Boards established risk- to households and businesses, even under ad-
based supervisory approach for bank holding verse conditions. Each year, boards of directors
companies (BHCs). For specific information of large BHCs will be required to review and
about the supervisory approach during the first approve the capital plans before submitting them
to the Federal Reserve. The rule was effective
1. The first supervisory cycle for an SLHC is the period of
on December 30, 2011. See the Boards Novem-
time between July 21, 2011, and the close of the first required ber 22, 2011, press release, 76 Fed. Reg. 74631
inspection. (December 1, 2011), and 12 C.F.R. 225.8.
FILING INSTRUCTIONS
Remove Insert
page 12.1 page 12.1
2000 Table of Contents, page 25 2000 Table of Contents, page 25
2500.0, pages 12
4061.0, pages 13
6000.0 Alphabetical Subject Index, pages 768 6000.0 Alphabetical Subject Index, pages 769

Page 1
Foreword
Section 1000.0
The Bank Holding Company Supervision risk profile of the holding company. Sources of
Manual has been prepared by Federal Reserve information for the risk assessment include prior
supervision personnel to provide guidance to bank and BHC inspection reports and workpa-
examiners as they conduct on-site inspections of pers, surveillance program reports, and regula-
bank holding companies (BHCs) and their non- tory reports. In addition, other relevant supervi-
bank subsidiaries. The manual is a compilation sory materials derived from within the Federal
of formalized procedures and Board supervisory Reserve System or other federal and state bank-
policies that supervision and inspection person- ing supervisors, as well as from other respon-
nel should follow. The manual includes new sible regulatory agencies (for example, the
concepts and keeps pace with the ever-changing Securities and Exchange Commission and state
industry. An integral part of the Federal Reserves insurance authorities) are used. Other sources
overall program to supervise banking organiza- for the risk assessment may include the banking
tions operating under a holding company struc- organizations publicly available reports, such
ture, the manual enhances the staffs ability to as annual and other periodic reports and infor-
implement the Boards inspection and monitor- mational releases; strategic plans and budgets;
ing efforts. internal management reports; information pack-
The manual is designed to provide guidance ages for the board of directors; correspondence;
to examination and supervision personnel. It the board of directors executive and audit com-
should not be considered a legal reference. mittee minutes; internal audit workpapers and
Questions concerning the applicability of and reports; and stock-analysis reports. The activi-
compliance with federal laws and regulations ties, transactions, and identified areas having
should be referred to appropriate legal counsel. the most significant risks, inadequate risk-
The Federal Reserve System conducts risk management processes, or rudimentary internal
assessments and a full-scope inspection pro- controls will represent the banking organiza-
gram for BHCs. At a minimum, full-scope tions highest risks. The risk-assessment process
inspections should include sufficient procedures culminates in a formalized and structured super-
to reach an informed judgment on the assigned visory strategy, which examination staff will
ratings for the factors included in the bank hold- follow when conducting an inspection.
ing company RFI/C(D) rating system. The pro- The banking organizations highest risks are
cedures of a full-scope inspection focus in part expected to undergo the most rigorous scrutiny,
on assessing the types and extent of risks to analysis, and transaction testing by examiners
which a BHC and its subsidiaries are exposed. and supervisors. Transaction testing is a reliable
Some of these types of risks include credit, and essential inspection technique for assessing
market, liquidity, operational, legal, and reputa- the banking organizations condition and verify-
tional risks. Inspections also focus on evaluating ing its adherence to internal policies, proce-
the organizations policies and procedures for dures, and controls. Transaction testing alone,
identifying, managing, and controlling such risk however, is not sufficient for ensuring safe and
exposures and on determining whether the man- sound operations in a highly dynamic banking
agement and directors are actively involved in environment. The changing nature of financial
the oversight of the organizations risk- instruments and markets allows institutions to
management program. To determine whether rapidly reposition their portfolio risk exposures.
the organizations policies and procedures for To ensure that banking organizations have sys-
risk management are fully effective and being tems in place to identify, measure, monitor, and
followed, inspections or reviews also generally control their changing risk exposures, inspec-
include transaction and compliance testing tions further focus on evaluating the banking
The inspection process commences with a organizations risk-management processes. These
preliminary risk assessment. The risk assess- risk-management evaluations determine the
ment highlights the strengths and weaknesses of extent to which the banking organizations man-
the holding company and is the basis for deter- agement processes can be relied on.
mining the procedures to be conducted during The full-scope inspection may be conducted
an inspection. Risk assessments identify the at a point in time or through a series of targeted
organizations principal business activities and or limited-scope reviews conducted on an ongo-
the types and quantities of risks associated with ing or continuous basis for the largest and most
the activities (including those conducted off-
balance-sheet). The quality of management and BHC Supervision Manual July 2005
the control of risks are factored into the initial Page 1
Foreword 1000.0
complex banking organizations. Irrespective of away from a federally insured subsidiary to a

the duration of the inspection, planned supervi- holding company affiliate.
sory activities should be coordinated well in The competency of BHC management in over-
advance with other responsible bank, thrift, and seeing the banking organizations business
functional regulators in order to avoid duplica- activities, risk management, and financial condi-
tion of effort and to minimize burden on the tion is also evaluated. The FHC and BHC
banking organization. Supervisory findings of inspection process provides a vehicle for a com-
inspections should be communicated to the bank- prehensive assessment of the effectiveness of
ing organizations management or boards of management, resulting in a more open and
directors, as well as to the banking organiza- informed dialogue between management and
tions other bank supervisors and functional representatives of the Federal Reserve.
regulators, when relevant. In summary, the inspection process is intended
An inspection also measures the financial to increase the flow of information to the Fed-
strength of a BHC or financial holding company eral Reserve System concerning the soundness
(FHC) and focuses on financial indices of both of FHCs and BHCs. This information will per-
the consolidated entity and its component parts. mit the Federal Reserve to encourage sound
In addition to the analysis of risk, the other banking practices and to take appropriate super-
principal indices appraised are quality of assets, visory action when warranted.
earnings, capital adequacy, cash flow and liquid- This manual is updated periodically to reflect
ity, and the competency of management. An current supervisory policy and procedures and
inspection or supervisory program should also changing practices within the industry. The
assess the banking organizations program for manual is also available on the Boards public
transactions between insured subsidiaries and web site at www.federalreserve.gov/boarddocs/
affiliates. The basic objective of this assessment supmanual/. We solicit the input and contribu-
is to determine the impact or consequences of tion of all supervisory staff and others in refin-
transactions between the parent holding coming and modifying its contents. Please address
pany or its nonbanking subsidiaries and the all correspondence to the Director of Banking
insured subsidiaries. Of particular importance is Supervision and Regulation, Board of Gover-
whether intercompany transactions result in a nors of the Federal Reserve System, Washing-
diversion of income (or income opportunity) ton, DC 20551.

Page 2
General Table of Contents
Bank Holding Company Supervision Manual 1010.0
This general table of contents lists the major section heads for each part of the manual:
1000 Foreword, Contents, Preface, Use of the Manual
2000 Supervisory Policy and Issues
3000 Nonbanking Activities
4000 Financial Analysis
5000 BHC Inspection Program
6000 Alphabetical Subject Index
A detailed table of contents, which lists the subheads within each major section, precedes parts
2000 through 5000.
Tabs Sections Title
1000 FOREWORD, CONTENTS, PREFACE,

MANUAL USE
1000.0 Foreword
1010.0 Table of Contents
1020.0 Preface
1030.0 Use of the Manual
1040.0 Bank Holding Company Examination and Inspection

Authority
1050.0 Consolidated Supervision of Bank Holding Companies

and the Combined U.S. Operations of Foreign Banking
Organizations
1050.1 Guidance for the Consolidated Supervision of Domestic

Bank Holding Companies that are Large Complex
Banking Organizations
1050.2 Guidance for the Consolidated Supervision of Regional

Bank Holding Companies
2000 SUPERVISORY POLICY AND ISSUES
2000.0 Introduction to Topics for Supervisory Review
2010.0 Supervision of Subsidiaries
2010.1 Funding Policies
2010.2 Loan Administration
2010.3 Investments
2010.4 Consolidated Planning Process

Page 1
General Table of Contents Section 1010.0
Tabs Sections Title
2010.5 Environmental Liability
2010.6 Financial Institution Subsidiary Retail Sales

of Nondeposit Investment Products
2010.7 Reserved
2010.8 Sharing of Facilities and Staff by Banking

Organizations
2010.9 Required Absences from Sensitive Positions
2010.10 Internal Loan Review

2010.11 Private-Banking Functions and Activities
2010.12 Fees Involving Investments of Fiduciary Assets in

Mutual Funds and Potential Conflicts Interest
2010.13 Establishing Accounts for Foreign Governments

Embassies, and Political Figures
2020.0 Intercompany TransactionsIntroduction
2020.1 Intercompany Transactions Between Affiliates

Sections 23A and 23B of the Federal Reserve Act
2020.2 Loan ParticipationsIntercompany Transactions
2020.3 Sale and Transfer of Assets
2020.4 Compensating Balances
2020.5 Dividends
2020.6 Management and Service Fees
2020.7 Transfer of Low-Quality Loans or Other Assets
2020.8 Reserved
2020.9 Split-Dollar Life Insurance
2030.0 Grandfather RightsRetention and Expansion of

Activities
2040.0 Commitments to the Federal Reserve
2050.0 Extensions of Credit to BHC Officials
2060.0 Management Information Systems

Page 2
Tabs Sections Title
2060.05 Policy Statement on the Internal Audit Function

and Its Outsourcing
2060.07 Supplemental Policy Statement on the Internal Audit

Function and Its Outsourcing
2060.1 Audit
2060.2 Budget
2060.3 Records and Statements
2060.4 Structure and Reporting
2060.5 Insurance
2065.1 Accounting, Reporting, and Disclosure Issues

Nonaccrual Loans and Restructured Debt
2065.2 Determining an Adequate Level for the Allowance for

Loan and Lease Losses
2065.3 Maintenance of an Adequate Allowance for Loan and Lease

Losses
2065.4 ALLL Methodologies and Documentation
2065.5 ALLL Estimation Practices for Loans Secured by

Junior Liens
2068.0 Sound Incentive Compensation Policies
2070.0 TaxesConsolidated Tax Filing
2080.0 FundingIntroduction
2080.05 Bank Holding Company Funding and Liquidity
2080.1 Commercial Paper and Other Short-Term Uninsured

Debt Obligations and Securities
2080.2 Long-Term Debt
2080.3 Equity
2080.4 Retention of Earnings
2080.5 Pension Funding and Employee Stock Option Plans
2080.6 Bank Holding Company Funding from Sweep Accounts
2090.0 Control and OwnershipGeneral

Page 3
Tabs Sections Title
2090.05 Qualified Family Partnerships
2090.1 Change in Control
2090.2 BHC Formations
2090.3 Treasury Stock Redemptions
2090.4 Policy Statements on Equity Investments in Banks

and BHCs
2090.5 Acquisitions of Bank Shares Through Fiduciary
Accounts
2090.6 Divestiture Control Determinants
2090.7 Nonbank Banks
2090.8 Liability for Commonly Controlled Depository

Institutions
2091.0 Reserved
2092.0
2093.0 Control and OwnershipShareholder Protection Arrangements
2100.0 International Banking Activities
2110.0 Formal Corrective Actions
2120.0 Foreign Corrupt Practices Act and Federal Election

Campaign Act
2122.0 Internal Credit-Risk Ratings at Large Banking

Organizations
2124.0 Risk-Focused Safety-and-Soundness Inspections
2124.01 Risk-Focused Supervisory Framework for Large

Complex Banking Organizations
2124.02 Reserved
2124.04
2124.05 Consolidated Supervision Framework for Large
Financial Institutions
2124.07 Compliance Risk-Management Programs and Oversight

at Large Banking Organizations with Complex
Compliance Profiles
2124.1 Assessment of Information Technology in Risk-

Focused Supervision

Page 4
Tabs Sections Title
2124.2 Reserved
2124.3 Managing Outsourcing Risk
2124.4 Information Security Standards
2124.5 Identity Theft Red Flags and Address Discrepancies
2125.0 Trading Activities of Banking Organizations

Risk Management and Internal Controls
2126.0 Model Risk Management
2126.1 Investment Securities and End-User Derivatives

Activities
2126.2 Investing in Securities without Reliance on Ratings

of Nationally Recognized Statistical Rating
Organizations
2126.3 Counterparty Credit Risk Management Systems
2126.5 Procedures for a Banking Entity to Request an Extended

Transition Period for Illiquid Funds
2127.0 Interest-Rate RiskRisk Management and Internal
Controls
2128.0 Structured NotesRisk Management and Internal Controls
2128.01 Reserved
2128.02 Asset Securitization
2128.03 Credit-Supported and Asset-Backed Commercial Paper
2128.04 Implicit Recourse Provided to Asset Securitizations
2128.05 Securitization Covenants Linked to Supervisory Actions

or Thresholds
2128.06 Valuation of Retained Interests and Risk Management

of Securitization Activities
2128.07 Reserved
2128.08 Subprime Lending
2128.09 Elevated-Risk Complex Structured Finance Activities
2129.0 Credit DerivativesRisk Management and Internal

Controls

Page 5
Tabs Sections Title
2129.05 Risk and Capital ManagementSecondary-Market

Credit Activities
2130.0 Futures, Forward, and Option Contracts
2140.0 Securities Lending
2150.0 Repurchase Transactions
2160.0 Recognition and Control of Exposure to Risk
2170.0 Purchase and Sale of Loans Guaranteed by the U.S.

Government
2175.0 Sale of Uninsured Annuities
2178.0 Support of Bank-Affiliated Investment Funds
2180.0 Securities Activities in Overseas Markets
2187.0 Violations of Federal Reserve Margin Regulations

Resulting from Free-Riding Schemes
2220.3 Note Issuance and Revolving Underwriting Credit Facilities
2231.0 Real Estate Appraisals and Evaluations
2240.0 Guidelines for the Review and Classification of

Troubled Real Estate Loans
2241.0 Retail-Credit Classification
2250.0 Domestic and Other Reports to Be Submitted

to the Federal Reserve
2260.0 Venture Capital
2500.0 Supervision of Savings and Loan Holding Companies
3000 NONBANKING ACTIVITIES
3000.0 Introduction to BHC Nonbanking and FHC Activities
3001.0 Section 2(c) of the BHC ActSavings Bank Subsidiaries

of BHCs Engaging in Nonbanking Activities
3005.0 Section 2(c)(2)(F) of the BHC ActCredit Card Bank

Exemption from the Definition of a Bank
3010.0 Section 4(c)(i) and (ii) of the BHC ActExemptions

from Prohibitions on Acquiring Nonbank Interests

Page 6
Tabs Sections Title
3020.0 Section 4(c)(1) of the BHC ActInvestment in Companies

Whose Activities Are Incidental to Banking
3030.0 Section 4(c)(2) and (3) of the BHC ActAcquisition

of DPC Shares, Assets, or, Real Estate
3032.0 Rental of Other Real Estate Owned Residential Property

3040.0 Section 4(c)(4) of the BHC ActInterests in
Nonbanking Organizations
3050.0 Section 4(c)(5) of the BHC ActInvestments Under

Section 5136 of the Revised Statutes
3060.0 Section 4(c)(6) and (7) of the BHC ActOwnership

of Shares in Any Nonbank Company of
5 Percent or Less
3070.0 Section 4(c)(8) of the BHC ActMortgage Banking
3070.3 Non-Traditional MortgagesAssociated Risks

Derivative Commitments to Originate and Sell
Mortgage Loans
3072.0 Section 4(c)(8) of the BHC ActActivities Related to
Extending Credit
3072.8 Real Estate Settlement Services
3073.0 Section 4(c)(8) of the BHC ActEducation-Financing

Activities
3080.0 Section 4(c)(8) of the BHC ActServicing Loans
3084.0 Section 4(c)(8) of the BHC ActAsset-Management,

Asset-Servicing, and Collection Activities
3090.0 Section 4(c)(8) of the BHC ActReceivables
3090.1 Factoring
3090.2 Accounts Receivable Financing
3100.0 Section 4(c)(8) of the BHC ActConsumer Finance
3104.0 Section 4(c)(8) of the BHC ActAcquiring Debt in Default
3105.0 Section 4(c)(8) of the BHC ActCredit Card Authorization

and Lost/Stolen Credit Card Reporting Services
3107.0 Section 4(c)(8) of the BHC ActStand-Alone Inventory
Inspection Services

Page 6.1
Tabs Sections Title
3110.0 Section 4(c)(8) of the BHC ActIndustrial Banking
3111.0 Section 4(c)(8) of the BHC ActAcquisition

of Savings Associations
3120.0 Section 4(c)(8) of the BHC ActTrust Services
3130.0 Section 4(c)(8) of the BHC ActGeneral Financial

and Investment Advisory Activities
3130.1 Investment or Financial Advisers
3130.2 Reserved
3130.3 Advice on Mergers and Similar Corporate Structurings,

Capital Structurings, and Financing Transactions

Page 6.2
Tabs Sections Title
3130.4 Informational, Statistical Forecasting, and Advisory

Services for Transactions in Foreign Exchange
and Swaps, Commodities, and Derivative Instruments
3130.5 Providing Educational Courses and Instructional Materials
for Consumers on Individual Financial Management
Matters
3130.6 Tax-Planning and Tax-Preparation Services
3140.0 Section 4(c)(8) of the BHC ActLeasing Personal

or Real Property
3150.0 Section 4(c)(8) of the BHC ActCommunity Welfare
Projects
3160.0 Section 4(c)(8) of the BHC ActEDP Servicing

Company
3160.1 EDP ServicingNetwork for the Processing and

Transmission of Medical Payment Data
3160.2 Electronic Benefit Transfer, Stored-Value-Card,

and Electronic Data Interchange Services
3160.3 Data Processing Activities: Obtaining Travelers Checks

and Postage Stamps Using an ATM Card and Terminal
3160.4 Providing Data Processing for ATM Distribution of Tickets,

Gift Certificates, Telephone Cards, and Other Documents
3160.5 Engage in Transmitting Money
3165.1 Support ServicesPrinting and Selling MICR-Encoded

Items
3170.0 Section 4(c)(8) of the BHC ActInsurance Agency

Activities of Bank Holding Companies
3180.0 Section 4(c)(8) of the BHC ActInsurance

Underwriters
3190.0 Section 4(c)(8) of the BHC ActCourier Services
3200.0 Section 4(c)(8) of the BHC ActManagement

Consulting and Counseling
3202.0 Section 4(c)(8) of the BHC ActEmployee Benefits

Consulting Services
3204.0 Section 4(c)(8) of the BHC ActCareer Counseling
BHC Supervision Manual June 2004

Page 7
Tabs Sections Title
3210.0 Section 4(c)(8) of the BHC ActMoney Orders,

Savings Bonds, and Travelers Checks
3210.1 Payment Instruments
3220.0 Section 4(c)(8) of the BHC ActArranging

Commercial Real Estate Equity Financing
3230.0 Section 4(c)(8) of the BHC ActAgency Transaction

Services for Customer Investments (Securities
Brokerage)
3230.05 Securities Brokerage (Board Decisions)
3230.1 Securities Brokerage in Combination with

Investment Advisory Services
3230.2 Securities Brokerage with Discretionary Investment

Management and Investment Advisory Services
3230.3 Offering Full Brokerage Services for Bank-Ineligible

Securities
3230.4 Private-Placement and Riskless-Principal Activities
3230.5 Acting as a Municipal Securities Brokers Broker
3230.6 Acting as a Conduit in Securities Borrowing and Lending
3240.0 Section 4(c)(8) of the BHC ActUnderwriting and

Dealing in U.S. Obligations, Municipal Securities,
and Money Market Instruments
3250.0 Section 4(c)(8) of the BHC ActAgency

Transactional Services (Futures Commission
Merchants and Futures Brokerage)
3251.0 4(c)(8) Agency Transactional ServicesFCM Board

Orders
3255.0 Section 4(c)(8) of the BHC ActAgency Transactional

Services for Customer Investments
3260.0 Section 4(c)(8) of the BHC ActInvestment Transactions

as Principal
3270.0 Section 4(c)(8) of the BHC ActReal Estate and

Personal Property Appraising
3320.0 Section 4(c)(8) of the BHC ActCheck-Guaranty

and Check-Verification Services

Page 8
Tab Sections Title
3330.0 Section 4(c)(8) of the BHC ActOperating a

Collection Agency
3340.0 Section 4(c)(8) of the BHC ActOperating a Credit

Bureau
3500.0 Tie-In Considerations of the BHC Act
3510.0 Sections 4(c)(9) and 2(h) of the BHC Act

Nonbanking Activities of Foreign Banking
Organizations
3520.0 Section 4(c)(10) of the BHC ActGrandfather

Exemption from Section 4 for BHCs Which
Are Banks
3530.0 Section 4(c)(11) of the BHC ActAuthorization for

BHCs to Reorganize Share Ownership Held on the
Basis of Any Section 4 Exemption
3540.0 Section 4(c)(12) of the BHC ActTen-Year

Exemption from Section 4 of the BHC Act
3550.0 Section 4(c)(13) of the BHC ActInternational

3560.0 Section 4(c)(14) of the BHC ActExport Trading

Companies
3600.0 Permissible Activities by Board Order
3600.1 Operating a Pool Reserve Plan
3600.2 Reserved for future use

3600.4
3600.5 Engaging in Banking Activities via Foreign Branches
3600.6 Operating a Securities Exchange
3600.7 Acting as a Certification Authority for Digital Signatures
3600.8 Private Limited Investment Partnerships

3600.12
3600.13 FCM Activities

3600.16
3600.17 Insurance Activities

Page 9
Tab Sections Title

3600.20
3600.21 Underwriting and Dealing
3600.23 Issuance and Sale of Mortgage-Backed Securities

Guaranteed by GNMA
3600.24 Sales-Tax Refund Agent and Cashing U.S. Dollar

Payroll Checks
3600.25 Providing Government Services
3600.26 Real Estate Settlement through a Permissible Title

Insurance Agency
3600.27 Providing Administrative and Certain Other Services

to Mutual Funds
3600.28 Developing Broader Marketing Plans and Advertising

and Sales Literature for Mutual Funds
3600.29 Providing Employment Histories to Third Parties
3600.30 Real Estate Title Abstracting
3610.1 Section 4(c)(8) of the BHC ActBoard Staff Legal

InterpretationFinancing Customers Commodity
Purchase and Forward Sales
3610.2 Section 4(c)(8) of the BHC ActBoard Legal Staff
InterpretationCertain Volumetric-Production-
Payment Transactions Involving Physical
Commodities
3700.0 Impermissible Activities
3700.1 Land Investment and Development
3700.3 Real Estate Brokerage and Syndication
3700.4 General Management Consulting
3700.5 Property Management
3700.6 Travel Agencies
3700.7 Providing Credit Ratings on Bonds, Preferred Stock,

and Commercial Paper

Page 10
Tab Sections Title
3700.8 Acting as a Specialist in Foreign-Currency Options on

a Securities Exchange
3700.9 Design and Assembly of Hardware for Processing

or Transmission of Banking and Economic Data
3700.10 Armored Car Services
3700.11 Computer Output Microfilm Service
3700.12 Clearing Securities Options and Other Financial

Instruments for the Accounts of Professional
Floor Traders
3900.0 Section 4(k) of the BHC ActFinancial Holding

Companies
3901.0 U.S. Bank Holding Companies Operating as Financial

Holding Companies
3903.0 Foreign Banks Operating as Financial Holding

Companies
3905.0 Permissible Activities for FHCs
3906.0 Disease Management and Mail-Order Pharmacy Activities
3907.0 Merchant Banking
3909.0 Supervisory Guidance on Equity Investment and Merchant

Banking Activities
3910.0 Acting as a Finder
3912.0 To Acquire, Manage, and Operate Defined Benefit

Pension Plans in the United Kingdom (Section 4(k)
of the BHC Act)
3920.0 Limited Physical-Commodity-Trading Activities
3950.0 Insurance Sales Activities and Consumer Protection

in Sales of Insurance
3980.0 Establishment of an Intermediate Holding Company
4000 FINANCIAL ANALYSIS
4000.0 Financial FactorsIntroduction
4010.0 Parent Only: Debt-Servicing CapacityCash Flow
4010.1 Leverage

Page 11
Tab Sections Title
4010.2 Liquidity
4020.0 Banks
4020.1 Banks: Capital
4020.2 Banks: Asset Quality

4020.3 Banks: Earnings
4020.4 Banks: Liquidity
4020.5 Banks: Summary Analysis
4020.6 Reserved
4020.8
4020.9 Supervision Standards for De Novo State Member
Banks of Bank Holding Companies
4030.0 Nonbanks
4030.1 Nonbanks: Credit ExtendingClassifications
4030.2 Nonbanks: Credit ExtendingEarnings
4030.3 Nonbanks: Credit ExtendingLeverage
4030.4 Nonbanks: Credit ExtendingReserves
4040.0 Nonbanks: Noncredit Extending
4050.0 Nonbanks: Noncredit ExtendingService Charters
4060.0 ConsolidatedEarnings
4060.1 Consolidated: Asset Quality
4060.2 Reserved
4060.3 Consolidated CapitalExaminers Guidelines for

Assessing the Capital Adequacy of BHCs
4060.4 Consolidated CapitalLeverage Measure
4060.5 Capital AdequacyAdvanced Approaches
4060.6 Reserved
4060.7 Assessing Capital Adequacy and Risk at Large Banking

Organizations and Others with Complex Risk Profiles
4060.8 Consolidated Risk-Based CapitalDirect-Credit

Substitutes Extended to ABCP Programs

Page 12
Tabs Sections Title
4060.9 Consolidated Capital Planning ProcessesPayment of

Dividends, Stock Redemptions, and Stock
Repurchases at Bank Holding Companies
4061.0 Consolidated CapitalCapital Planning
4062.0 Reserved
4063.0 Federal Reserve Supervisory Assessment of Capital

Planning and Positions for LISCC Firms and Large and
Complex Firms
4064.0 Reserved
4065.0 Federal Reserve Supervisory Assessment of Capital

Planning and Positions for Large and Noncomplex Firms
4066.0 ConsolidatedFunding and Liquidity Risk Management
4069.0 Dodd-Frank Act Company-Run Stress Testing for

Banking Organizations with Total Consolidated
Assets of $1050 Billion
4070.0 BHC Rating System
4070.1 Rating Risk-Management Processes and Internal Controls

of BHCs Having $50 Billion or More in Total Assets
4070.2 Reserved
4070.3 Revising Supervisory Ratings
4070.4 Reserved
4070.5 Nondisclosure of Supervisory Ratings
4071.0 Supervisory Guidance for Assessing Risk Management at

Supervised Institutions With Total Consolidated Assets
Less than $50 Billion
4080.0 Federal Reserve System BHC Surveillance Program
4080.1 Surveillance Program for Small Holding Companies
4090.0 Country Risk
5000 BHC INSPECTION PROGRAM
5000.0 BHC Inspection ProgramGeneral
5010.0 Procedures for Inspection Report Preparation

Inspection Report References
5010.1 General Instructions to FR 1225

Page 12.1
Tabs Sections Title
5010.2 Cover
5010.3 Page iTable of Contents
5010.4 Core Page 1Examiners Comments and Matters

Requiring Special Board Attention
5010.5 Core Page 2Scope of Inspection and Abbreviations
5010.6 Core Page 3Analysis of Financial Factors
5010.7 Core Page 4Audit Program
5010.8 Appendix Page 5Parent Company Comparative

Balance Sheet
5010.9 Appendix Page 6Comparative Statement of Income

and Expenses (Parent)
5010.10 Appendix Page 7Consolidated Classified and

Special Mention Assets
5010.11 Appendix Page 8Consolidated Comparative Balance

Sheet
5010.12 Appendix Page 9Comparative Consolidated

Statement of Income and Expenses
5010.13 Capital Structure
5010.14 PagePolicies and Supervision
5010.15 PageViolations
5010.16 PageOther Matters
5010.17 PageClassified Assets and Capital Ratios of

Subsidiary Banks
5010.18 PageOrganization Chart
5010.19 PageHistory and Structure
5010.20 PageInvestment in and Advances to Subsidiaries
5010.21 PageCommercial Paper (Parent)
5010.22 PageLines of Credit (Parent)
5010.23 PageQuestions on Commercial Paper and Lines of

Credit (Parent)

Page 13
Tabs Sections Title
5010.24 PageContingent Liabilities and Other Accounts
5010.25 PageStatement of Changes in Stockholders Equity

(Parent)
5010.26 PageIncome from Subsidiaries
5010.27 PageCash Flow Statement (Parent)
5010.28 PageParent Company Liquidity Position
5010.29 PageClassified Parent Company and Nonbank

Assets
5010.30 PageBank Subsidiaries
5010.31 PageNonbank Subsidiary
5010.32 PageNonbank Subsidiary Financial Statements
5010.33 PageFidelity and Other Indemnity Insurance
5010.34 Reserved
5010.35 PageOther Supervisory Issues
5010.36 PageExtensions of Credit to BHC Officials . . .
5010.37 PageInterest Rate SensitivityAssets and Liabilities
5010.38 Treasury Activities/Capital Markets
5010.39 Reserved
5010.40 Confidential Page APrincipal Officers and Directors
5010.41 Confidential Page B Condition of BHC
5010.42 Confidential Page CLiquidity and Debt Information
5010.43 Confidential Page DAdministrative and

Other Matters
5020.1 Bank Subsidiary (FR 1241)
5020.2 Other Supervisory Issues (FR 1241)
5030.0 BHC Inspection Report Forms
5040.0 Procedures for Limited-Scope Inspection Report

PreparationGeneral Instructions

Page 14
Tabs Sections Title
5050.0 Procedures for Targeted Inspection Report

PreparationGeneral Instructions
5052.0 Targeted MIS Inspection
5060.0 Portions of Bank Holding Company Inspections

Conducted in Federal Reserve Bank Office
6000 ALPHABETICAL SUBJECT INDEX
6000.0 Alphabetical Subject Index

Page 15
Preface
Section 1020.0
The Bank Holding Company Supervision succeeded by the 1950s in expanding over an
Manual is designed to aid personnel of the entire region of the country, operating banks in
Federal Reserve System in supervising bank several states.
holding companies (BHCs). As such, it will During the 1960s, many banks, especially the
provide supervisory guidance in considerable largest ones, desired to expand into new lines of
detail regarding the Boards current policies and activity. In most cases, these new activities were
procedures for supervising the financial affairs financial in nature and were closely related to
of these banking organizations and will also traditional banking operations. While some banks
discuss their respective statutes, regulations, were successful in obtaining supervisory approval
interpretations, and orders that pertain to BHC to enter certain of these new activities, the courts
supervision. Before proceeding, however, it is subsequently voided many of these approvals.
desirable to step back and view BHCs and their Unable to enter these activities as a bank, many
supervision in a broader perspective. This pref- of these organizations converted into the hold-
ace is designed to provide that perspective. ing company form and entered these activities
While the holding company form of organiza- through the holding company.
tion exists in many industries, it is particularly In more recent years banking organizations
prevalent in the regulated industriestelephone, also have used the holding company device to
electric and gas utility, railroad, savings and increase their financial flexibility. For example,
loan associations, and banking. Regulated indus- in order to avoid the reserve requirements and
tries have learned that a holding company struc- interest rate ceilings applicable to deposits of
ture allows certain entities to avoid some of the their bank subsidiaries, many banking organiza-
constraints of regulation. For example, regulations utilized the parent company as a vehicle to
tion often limits the geographic area that a regu- fund the organization. The holding company
lated firm can serve. The first purpose of form- structure has allowed organizations to attain
ing a holding company is that certain regulated higher leverage levels than otherwise might
organizations can serve a broader area, thereby have been permitted.
potentially benefiting from economies of scale Historically, the BHC Act sought to provide
and risk reduction through geographic diversifi- for the separation of banking from commerce.
cation. A second purpose for the use of a hold- In order to avoid any detrimental effects on the
ing company structure by regulated firms is to public interest, the activities of BHCs were lim-
expand into other product markets, often ones ited by law and regulation, and transactions with
that are not subject to regulation. A third pur- banking subsidiaries were virtually prohibited.
pose for the use of a holding company structure This basic rationale is the cornerstone for regu-
is to increase the organizations financial flex- lating the financial affairs of BHCs.
ibility, thereby avoiding some of the financing
constraints imposed by regulation. These con-
straints can include limitations on leverage, the 1020.0.1 POSSIBLE CONSEQUENCES
types of assets that the firm can acquire, and the OF HOLDING COMPANY
types of liabilities that it can issue. Another FORMATION
possible financial advantage of the holding com-
pany is to obtain tax benefits. There are two primary ways that a holding
BHCs were created for essentially the same company can have an adverse effect on the
reasons that holding companies were created in financial condition of a regulated subsidiary.
other industries; to expand geographically, to The first is for the holding company (or its
move into other product markets, and to obtain unregulated/regulated subsidiaries) to take exces-
greater financial flexibility and tax benefits. The sive risks and fail. This failure could have a
primary use of the BHC device prior to the late ripple effect on the regulated firm, impairing
1960s was to expand banking operations geo- its access to financial markets. The classic case
graphically. The holding company form was was the Insull empire in the electric utility
needed because many states either prohibited or industry, which involved the pyramiding of
sharply curtailed branching within the state. numerous highly leveraged holding companies.
Moreover, banks generally did not have the The collapse of this pyramid during the Depres-
authority to branch beyond the geographic lim- sion of the 1930s severely impacted the regu-
its of the state in which the bank was chartered.
By employing the holding company form of BHC Supervision Manual July 2009
organization, several banking organizations had Page 1
Preface 1020.0
lated electric utility operating companies and character of its management, and the effect of
impaired their ability to service the public. granting the permit on the bank. Congress also
A second major way that a holding company gave the Federal Reserve the right to inspect
can have a harmful effect on the financial condi- BHCs.
tion of a regulated subsidiary is through adverse About two decades later, Congress passed the
intercompany transactions and excessive divi- BHC Act of 1956. This legislation required the
dends. Adverse intercompany transactions typi- Federal Reserve, when reviewing proposed bank
cally involve both the purchase and sale of acquisitions by holding companies, to consider
goods and services or financial transactions that the competitive, financial, and managerial impli-
are on nonmarket terms. Concern over the use cations of the proposal. More recently, the BHC
of the holding company device to transfer finan- Act amendments of 1970 required the Federal
cial resources from the regulated firm has been Reserve to make a similar determination in
particularly prevalent. In this case, there has applications by holding companies to acquire
been a conflict of views between the govern- nonbanking companies. The amendments also
ment and the firms which want to diversify in brought one-BHCs (BHCs that controlled a single
order to increase their return on investment. bank) into the Federal Reserves jurisdiction.
In the mid 1970s, concern over holding com- Subsequently, Congress and the public became
panies forcing regulated firms into adverse trans- seriously concerned over the possible adverse
actions surfaced in the banking industry. In this impact of holding companies on the financial
instance, the objective was not to divert resources condition of subsidiary banks. These adverse
from the bank to more profitable areas, but developments led to two results; additional leg-
rather to use bank resources to save a nonbank islation and stepped-up holding company super-
affiliate from failure. vision. The major congressional action was to
give the Federal Reserve much needed cease
and desist powers over BHCs. This authority
1020.0.2 STATUTORY AND now supplements certain statutes, such as divi-
REGULATORY RESPONSE TO THE dend restrictions and limitations on bank trans-
HOLDING COMPANY actions with affiliates, which tend to protect
banks in a holding company organization.
Historically, public policymakers have recog- In the mid-1970s, the Federal Reserve stepped
nized that holding companies can have both up its supervision and monitoring of BHCs in a
positive and negative effects on regulated sub- variety of ways. First, the Federal Reserve
sidiaries. The fact that policymakers have per- increased the scope and frequency of holding
mitted holding companies to exist in all of the company inspections, and later introduced a
major regulated industries indicates that the BHC rating system (BOPEC rating system),
effects, on balance, have not been decidedly which was designed to focus attention on those
negative. However, there have been enough organizations having the most serious problems.
problems over the years that holding companies Second, the Federal Reserve began to monitor
in most regulated industries are subject to at transactions between bank subsidiaries and the
least some form of regulation. This regulation rest of the holding company organization through
varies substantially from one regulated industry quarterly intercompany transactions reports.
to another. Third, the Federal Reserve implemented a
Until the mid-1970s, congressional concerns computer-based surveillance program designed
with BHCs were primarily oriented to competi- to identify emerging financial problems. Finally,
tion, concentration of financial resources, and the Federal Reserve began to employ its new
the proper range of banking activities. However, holding company cease and desist powers in an
there was also some limited recognition of the effort to curtail unsafe and unsound practices.
possible impact of holding companies on the The period prior to 1980 marked a gradual
financial condition of banks. The earliest evi- decline in the ratio of equity capital to total
dence was the Banking Act of 1935, in which assets within the U.S. commercial banking sys-
Congress gave the Federal Reserve Board author- tem, particularly for the nations largest banking
ity to issue permits to holding companies to vote organizations. In an effort to reverse that trend,
the stock of their banks. In acting on permit the Federal Reserve System and the Office of
applications, the Board was required to consider the Comptroller of the Currency (OCC) adopted
the holding companys financial condition, the guidelines for national and state member banks
and BHCs in December 1981. The guidelines
BHC Supervision Manual July 2009 established minimum capital levels and capital
Page 2 zones. The guidelines provided state member
Preface 1020.0
banks and BHCs with targets or objectives to be ture, as part of the examination/inspection pro-
reached over time. As a result, many of the cess. Such policy areas include the consolidated
banks and BHCs improved their capital posi- planning process, risk management, funding,
tions. However, other developments, including liquidity, lending, management information sys-
deregulation of interest rates on bank liabilities, tems, loan review, and audit and internal controls.
weakening of loan portfolios (asset quality) of On November 14, 1985, the Board, con-
some banking institutions occasioned by eco- cerned with strengthening the supervision over
nomic shocks in certain industries or geographi- member banks and BHCs, adopted a policy
cal areas, and increased competition in the finan- statement regarding cash dividends not fully
cial services areas, combined to place additional covered by earnings. The policy statement
pressures on the profitability of banking institu- addressed cash dividends that are not fully cov-
tions and accentuate the potential demands on ered by earnings, which represents a return of a
the capital positions of those institutions. portion of an organizations capital (refer to
The Federal Reserve System continued to Manual section 2020.5 for a discussion regard-
stress the importance of the capital guidelines in ing the policy statement).
setting standards of capital adequacy. The Board The Board adopted a policy statement on
thus amended its guidelines in June 1983, to set April 24, 1987, also related to the strengthening
explicit minimum capital levels for multina- of the supervision over subsidiary banks of
tional organizations. BHCs. The Board reaffirmed its long-standing
In November 1983, congressional concern policy that a BHC should act as a source of
over existing conditions prompted the enact- financial and managerial strength to its subsidi-
ment of the International Lending Supervision ary financial institutions. The policy statement
Act of 1983 (ILSA). ILSA directed that the provides that a BHC should not withhold finan-
federal banking agencies cause banking institu- cial support from a subsidiary bank in a weak-
tions to establish minimum capital levels for ened or failing condition when the holding com-
banking organizations. In December 1983, the pany is in a position to provide the support. The
Board, therefore, published the guidelines as Board emphasized that a BHCs failure to pro-
appendix A to the totally revised Regulation Y vide assistance to a troubled or failing subsidi-
(12 C.F.R. 225). Then in April 1985, the Board ary bank under these circumstances would gen-
adopted new capital adequacy guidelines to erally be viewed as an unsafe and unsound
increase the required minimum primary and banking practice or a violation of the Boards
total capital levels for the larger regional and Regulation Y (refer to section 225.4 (a)(1)) or
multinational BHCs and state member banks. section 2010.0 of this manual.
This action, when considered in conjunction Congress limited the expansion of nonbank
with the capital maintenance regulations of the banks with the passage of the Competitive Equal-
OCC and the Federal Deposit Insurance Corpo- ity Banking Act of 1987. The legislation rede-
ration (FDIC), established uniform minimum fined the definition of bank in the BHC Act
capital levels for all federally supervised BHCs, so that an FDIC-insured institution is a bank.
regardless of size, type of charter, primary super- Existing nonbank banks were grandfathered but
visor or membership in the Federal Reserve certain limitations were imposed on their
System. operations.
The strengthening of supervision over banks In an effort to further strengthen the capital
and BHCs is an equally imposing supervisory position in banks and BHCs, the Board, on
concern. The Federal Reserve System adopted a January 19, 1989, issued guidelines to imple-
number of supervisory policies in 1985 that ment risk-based capital requirements for state
directly affected the supervision of BHCs, such member banks and BHCs. The guidelines are
as the increased frequency and scope of inspec- based on the framework adopted on July 11,
tions and the communicating of the results of 1988, by the Basle Committee on Banking Regu-
inspections (refer to section 5000.0). In addi- lations and Supervisory Practices, which included
tion, the scope of the inspection was expanded supervisory authorities from 12 major industrial
to provide for a comprehensive analysis of man- countries. The guidelines were designed to
agements ability to direct and control the orga- achieve certain important goals:
nization, using the basic assumption that the
BHC is responsible for the direction and vitality 1. the establishment of a uniform capital frame-
of the organization. Overseeing the supervision work, applicable to all federally supervised
of banking organizations entails evaluating man-
agements policies and procedures, wherever BHC Supervision Manual July 2009
they are established within the corporate struc- Page 3
Preface 1020.0
banking organizations (the guidelines were in determining a final assessment of an organi-

also adopted by the OCC and the FDIC); zations capital adequacy, however.
2. the encouragement of international banking Congress addressed the thrift crisis with the
organizations to strengthen their capital posi- passage of thrift legislation, the Financial Insti-
tions; and, tutions Reform, Recovery, and Enforcement Act
3. the reduction of a source of competitive of 1989 (FIRREA), which was signed into law
inequality arising from differences in super- in August 1989. The legislation brought forth a
visory requirements among nations. number of important developments affecting
BHCs. The legislation addressed the
The guidelines establish a systematic analytical
framework that 1. acquisition of thrifts by a BHC;
2. conversion of thrifts to banks; and the
1. makes regulatory capital requirements more 3. enhancement of enforcement authority.
sensitive to differences in risk profiles among
banking organizations; The Federal Deposit Insurance Corporation
2. factors off-balance-sheet exposures into Improvement Act of 1991 (FDICIA) was enacted
explicit account in assessing capital adequacy; to require the least-cost resolution of insured
3. minimizes disincentives to holding liquid, depository institutions, to improve supervision
low-risk assets; and and examinations, to provide additional resources
4. achieves greater consistency in the evalua- to the Bank Insurance Fund, and for other pur-
tion of the capital adequacy of major banking poses. It required the federal banking agencies
organizations throughout the world. and their holding companies to prescribe stan-
dards for credit underwriting, loan documenta-
The risk-based capital guidelines include both a tion, as well as numerous other standards that
definition of capital and a framework for calcu- were intended to preserve the safety and sound-
lating weighted risk assets by assigning assets ness of banking organizations.
and off-balance-sheet items to broad risk catego- FDICIA further amended the International
ries. An institutions risk-based capital is calcu- Banking Act of 1978. The Federal Reserves
lated by dividing its qualifying total capital (the authority over foreign bank operations (includ-
numerator of the ratio) by its weighted risk ing representative offices in the United States)
assets (the denominator). was significantly increased. FDICIA required
The guidelines provided for phasing in of the federal banking agencies to adopt standards
risk-based capital standards through the end of for undercapitalized financial institutions. As a
1992, at which time the standards became fully result, the Board, in September 1992, issued
effective. At that time, banking organizations Prompt Corrective Action Measures for state
were required to have capital equivalent to 8 per- member banks.
cent of assets, weighted by risk. Banking organi- During 1992, the Federal Reserve issued guid-
zations must also have at least 4 percent tier 1 ance on such issues as the monitoring and con-
capital, which consists of core capital elements, trolling of risk from asset concentrations, the
including common stockholders equity, retained disclosure, accounting, and reporting of past due
earnings, and noncumulative and limited amounts (nonaccrual) loans, and the need for consistent
of cumulative perpetual preferred stock, com- methods in determining the amount of the allow-
pared to weighted risk assets. The other half of ance for loan and lease losses.
required capital (tier 2), could include, among With the FIRREA and FIDICIA legislation,
other supplementary capital elements, the non- Congress re-emphasized the need for continued
tier 1 portion of cumulative perpetual preferred strengthening of the supervision over financial
stock, limited-life preferred stock and subordi- institutions. The strengthening of supervision
nated debt, and loan loss reserves up to certain over banks and BHCs continues to be a primary
limits. The risk weights assigned to assets and objective of the Federal Reserve. It is empha-
credit equivalent amounts of off-balance-sheet sized during the examination of state member
items are based primarily on credit risk. Other banks and the inspection of BHCs.
types of exposure, such as interest rate, liquid- In 1994, section 3(d) (the Douglas Amend-
ity, and funding risk, as well as asset quality ment) of the BHC Act was repealed with the
problems, are not factored into the risk-based passage of the Riegle-Neal Interstate Banking
measure. Such risks are to be taken into account and Branching Efficiency Act. The Douglas
Amendment prohibited the acquisition of banks
BHC Supervision Manual July 2009 across state lines without the specific approval
Page 4 of the state where the acquiring bank was
Preface 1020.0
located. By the time the legislation was The Gramm-Leach Bliley Act (GLB Act) of
implemented, most of the states had already 1999 repealed sections 20 and 32 of the Glass-
entered into interstate banking compacts on a Steagall Act. Section 4 of the BHC Act was
regional basis, which permitted interstate amended to allow BHCs that meet certain stan-
expansion by BHCs. dards to be financial holding companies (FHCs),
In 1996 the BHC Act was amended by the allowing them to engage in a broader range of
Economic Growth and Regulatory Paperwork activities that are determined to be either finan-
Reduction Act. As a result, the notice require- cial in nature or incidental to a financial activity.
ments for expansion proposals were reduced for The GLB Act also provided for FHCs to seek
well-run BHCs. The notice requirement for the Board approval to engage in any activities that
de novo activities included on the Regulation Y the Board determined to be complementary to a
laundry list of authorized nonbank activities was financial activityactivities that do not pose a
reduced to permit filing of a notice with the significant risk to the safety and soundness of
Federal Reserve after the activity was com- insured depository institutions or the financial
menced. The 1996 Act also extended for an system generally. The GLB Act also provided
additional five years the holding period (pos- that an interested party could request the Board
sible total of 10 years) for shares acquired by to determine if an activity was financial in
BHCs in satisfaction of debts previously nature or incidental to a financial activity.
contracted. For grandfathered nonbank banks, The GLB Act increased the range of affilia-
the previous 7 percent growth limit was tions permitted to banking organizations. A key
repealed. Also, an exemption from BHC status control to this aspect of the GLB Act was its
for certain qualified family partnerships was revisions to sections 23A and 23B of the Fed-
authorized. eral Reserve Act, to limit the risk to insured
Beginning in 1996, a greater emphasis was depository institutions from these broader affili-
given to the risk management of banks and ations. Effective April 2003, the Board approved
BHCs in Federal Reserve examination and super- Regulation W. The rule implemented revisions
visory policy statements. System examiners were stemming from changes to sections 23A and
instructed to assign a formal supervisory rating 23B of the Federal Reserve Act.
to the adequacy of an institutions risk- To align more closely the ratings with the
management processes, including its internal necessary supervisory processes, the Board of
controls. (See SR-95-51, as amended by SR-04- Governors, on December 1, 2004, approved for
18.) This was an extension of existing proce- Systemwide implementation the revised BHC
dures that incorporated an assessment of risk rating system (the RFI/C(D) rating system). It
management and internal controls during each further emphasizes risk management while
on-site, full-scope examination or inspection. applying a more comprehensive and adaptable
The specific rating of risk management and framework for analyzing and rating financial
internal controls are given significant weight factors. It provides a framework for assessing
when evaluating management under the rating and rating the potential impact of the parent
systems for banks (CAMELS) and bank holding holding company and its nonbank subsidiaries
company rating systems (the former BOPEC on its subsidiary depository institution(s). Each
and the current RFI/C(D) rating systems). Like BHC is assigned a composite rating (C) based
the components of those systems, the risk- on an evaluation and rating of its managerial
management rating is to be based on an estab- and financial condition and an assessment of
lished five point numeric scale. future potential risk to its subsidiary depository
The increased emphasis on rating the overall institution(s). The main components of the rat-
risk management of BHCsfocusing on their ing system represent Risk Management (R);
principal risks and on their internal systems and Financial Condition (F); and potential Impact
processes for identifying, measuring, managing, (I) of the parent company and nondepository
and controlling these risksserves as the foun- subsidiaries (collectively nondepository enti-
dation for Federal Reserve Systems risk- ties) on the subsidiary depository institution(s).
focused supervisory reviews. The rating of risk A fourth component rating, Depository Institu-
management places an emphasis on effective tion (D), will generally mirror the primary
planning and scoping to tailor examinations and regulators assessment of the subsidiary deposi-
inspections to the size and complexity of activi- tory institution(s). See SR-04-18 and section
ties of banks and BHCs, allowing the concentra- 4070.1.
tion of examiner resources to those areas that
expose an institution to the greatest degree of BHC Supervision Manual July 2009
risk. Page 5
Preface 1020.0
The continuing growth in the size and com- areas of focus for consolidated supervision
plexity of many banking organizations exposes activities. It provides for consistent Federal
these firms to a wide array of potential risks, Reserve supervisory practices and assessments
while at the same time making it more challeng- across organizations with similar activities and
ing for a single supervisor to have a complete risks. (See SR-08-9 and sections 1050.0 through
view of firmwide risks and controls. In response 1050.2). The Federal Reserves approach to
to these trends, and to better fulfill both its consolidated supervision includes a focus on
responsibilities as consolidated supervisor and corporate governance, capital adequacy, funding
its other central bank objectives, the Federal and liquidity management, and the supervision
Reserve has continued to refine and enhance its of material nonbank subsidiaries, as well as
programs for the consolidated supervision of other aspects of the Federal Reserves consoli-
BHCs and the combined U.S. operations of for- dated supervision activities designed to further
eign banking organizations (FBOs). Therefore, the objectives of fostering financial stability and
in October 2008, the Federal Reserve issued deterring or managing the potential for possible
supervisory guidance that specifies principal financial crises.

Page 6
Use of the Manual
Section 1030.0
The Manual is presented in sections which nized that in some instances the procedures may
have been grouped together into parts that not apply in their entirety to all bank holding
have in common a central theme pertaining to companies.
BHC supervision. For example, Part II is com- Examiners may exercise a measure of discre-
posed of sections which discuss topics of spe- tion depending upon the characteristics of the
cial interest for supervisory review. Part III is organization under inspection.
composed of sections which discuss the various References to the Examiners Comments
exemptive provisions to the nonbank prohibi- inspection report page throughout this Manual
tions of the BHC Act. Part IV presents sections are synonymous with Core Page 1 of the inspec-
on the preparation of a financial analysis while tion reportExaminers Comments and Mat-
Part V discusses the methods used to prepare ters Requiring Special Board Attentionas
the inspection report forms. discussed in Part V of the Manual.
In preparing to conduct an inspection and Part V of the Manual concerns the inspection
complete the inspection report forms, the exam- program and report forms.
iner should review the information requirements
presented in Part V which include a section
for each page within the inspection report. Many 1030.0.2 NUMBERING SYSTEM
of these sections contain cross-references to
other sections within Parts IIIV of the Manual The Manual is arranged using a numerical cod-
that present in greater detail the issues to be ing system based on the Manuals parts, sec-
considered during the inspection process. The tions and subsections. Parts are differentiated
examiner assigned to complete a particular in- using thousands notations, sections using dig-
spection report page should review the sections its notations, and subsections using tenths
cross-referenced in Part V. placed after a decimal point as follows:
Given that the overall objective of the Manual
is to standardize and formalize inspection objec- Part IITopics for Supervisory 2000.0
tives and procedures that provide guidance to Review
the examiner and enhance the supervisory pro- Section 6Management Information 60.0
cess, the content of the sections within Parts System
IIIV are grouped into broad categories. They Subsection lAudit .1
are: 2060.1
1030.0.1 INSPECTION OBJECTIVES; 1030.0.3 ABBREVIATION

INSPECTION PROCEDURES;
LAWS, REGULATIONS, The Bank Holding Company Act of 1956, as
INTERPRETATIONS, AND ORDERS amended, is abbreviated as the Act through-
out the Manual.
Not all of the categories are presented in each
section. Where a particular topic is exclusively
financially related and does not involve legal 1030.0.4 AMENDMENTS TO THE
considerations, the subsection on Laws, Regu- MANUAL
lations, . . . may be omitted.
These procedures were designed for a full- Amendments will be published periodically as
scope, comprehensive inspection. It is recog- needed.

Page 1
Bank Holding Company Examination and Inspection Authority
Section 1040.0
WHATS NEW IN THIS REVISED 1040.0.1.1 Authority for Bank Holding

SECTION Company Inspections
Effective July 2012, this section has been revised Section 5 of the BHC Act of 1956 authorizes the
to discuss the current authority for the Federal Board to require reports and to conduct inspec-
Reserve (FR) to conduct BHC inspections (ex- tions of bank holding companies and their affili-
aminations) under section 5(c) of the Bank ates.1 Subject to the limitations discussed below,
Holding Company Act of 1956 (12 U.S.C. 1844(c)) Section 5 authorizes the Board to examine each
and also 12 U.S.C. 5361(a)(c). The section also bank holding company and nonbank subsidiary
is revised to include provisions of the Dodd- thereof. Within those limitations, the Federal
Frank Wall Street Reform and Consumer Pro- Reserve Systems supervisory staff (includes
tection Act (section 604(c )(2)), which removed BHC inspection and examination staff) may
the enforcement provisions of section 10A of the review all books and records of a banking orga-
Bank Holding Company Act that limited the nization that is subject to Federal Reserve (FR)
FRs rulemaking and enforcement authority. supervision.2
Previously, the FR was only able to take enforce-
ment actions against a functionally regulated
subsidiary when its actions posed a threat to the
safety and soundness of a depository institution
affiliate. 1040.0.2 FOCUS AND SCOPE OF BHC
INSPECTIONS
1040.0.1 BHC INSPECTIONS The focus and scope of an inspection is to be

limited, to the fullest extent possible, to the
The Gramm-Leach-Bliley Act (GLB Act) BHC and any subsidiary of the BHC that could
amended section 5(c) of the Bank Holding Com- have a materially adverse effect on the safety
pany Act (BHC Act) pertaining to BHC reports and soundness of any DI subsidiary of the hold-
and examinations (or inspections, in the case of ing company due to (1) the size, condition, or
BHCs). The GLB Act provides specific supervi- activities of the subsidiary, or (2) the nature or
sory guidance to the Board of Governors (Board) size of the transactions between the subsidiary
of the Federal Reserve System (and the Federal and any DI subsidiary of the BHC.
Reserve Banks via delegated authority) with The Board is to use, to the fullest extent
respect to the breadth of BHC inspections. It possible, the bank examination reports of DIs
also emphasized the focus and scope of BHC prepared by the appropriate federal or state DI
inspections and the inspections of BHC subsidi- supervisory authority. The Board also is to use,
aries. An inspection is to be conducted to to the fullest extent possible, the examination
reports for non-DIs prepared by the following:
1. inform the board of the nature of the opera-
tions and financial condition of each BHC 1. the Securities and Exchange Commission
and its subsidiaries, including (SEC) for any registered broker or dealer
a. the financial and operational risks within 2. the SEC or any state for any investment
the holding company system that may adviser registered under the Investment Com-
pose a threat to the safety and soundness pany Act of 1940
of any depository institution (DI) subsidi- 3. any state insurance regulatory authority for
ary of such bank holding company, and any licensed insurance company
b. the systems for monitoring and control- 4. any federal or state authority for any other
ling such financial and operational risks; subsidiary that the Board finds to be compre-
and hensively supervised
2. monitor compliance by any entity with the
provisions of the BHC Act or any other
federal law that the Board has specific juris- 1. See 12 U.S.C. 1844.
diction to enforce against the entity, and to 2. Supervisory staff includes individuals that are on and/or
monitor compliance with any provisions of off site.
federal law governing transactions and rela-
tionships between any DI subsidiary of a BHC Supervision Manual July 2012
BHC and its affiliates. Page 1
Bank Holding Company Examination-Inspection Authority 1040.0
1040.0.3 EXAMINATIONS OF 1040.0.3.2 Coordination with Other

FUNCTIONALLY REGULATED Regulators
SUBSIDIARIES
The Board is to
In general, the Board may examine (inspect)
any BHC and each subsidiary to inform the provide reasonable notice to, and to consult
Board of with, the primary financial regulatory agency
for any subsidiary before requiring a report or
the nature of the operations and financial con- commencing an examination of such subsidi-
dition of the company and such subsidiary; ary under this section; and
the financial, operational, and other risks of avoid duplication of examination activities,
the company or such subsidiary that may pose reporting requirements, and requests for infor-
a threat to the safety and soundness of such mation, to the fullest extent possible.
company or subsidiary or to the financial sta-
bility of the United States; (See 12 U.S.C. 5361(c).)
the systems for monitoring and controlling
such risks; and
compliance by the company or such subsidi- 1040.0.4 SUPERVISION OF A
ary with the requirements of 12 U.S.C. 5361(b) NONBANK FINANCIAL COMPANY
and other provisions of the BHC Act and
certain other federal statutes. The FR, as the appropriate federal supervisory
banking agency, must, to the fullest extent pos-
sible, rely on (1) reports and other supervisory
information that the BHC, or any subsidiary
1040.0.3.1 Use of Examination Reports thereof, has been required to provide to other
and Information federal and state regulatory agencies; (2) exter-
nally audited financial statements of the BHC or
The Board is required, to the fullest extent pos- subsidiary; (3) information that is otherwise
sible, to rely on reports of examination of any available from federal and state regulatory agen-
subsidiary depository institution or functionally cies; and (4) information that is required to be
regulated subsidiary made by the primary finan- reported publicly. (See 12 U.S.C. 1844(c)(1) or
cial regulatory agency for that subsidiary, and section 5(c) of the BHC Act.)
on information described for reports under 12
U.S.C. 5361(a)(2). (See 12 U.S.C. 5361(b)(2).)

Page 2
Consolidated Supervision of Bank Holding Companies and the Combined
U.S. Operations of Foreign Banking Organizations Section 1050.0
WHATS NEW IN THIS REVISED the importance of coordination with, and reli-
SECTION ance on, the work of other relevant primary
supervisors and functional regulators.
Effective January 2015, this section was revised The Federal Reserves enhanced approach to
to delete a reference to SR-99-15, which was consolidated supervision emphasizes several
superseded by SR-12-17/CA-12-14, Consoli- elements that should help make the financial
dated Supervision Framework for Large Finan- system more resilient. These include focus on
cial Institutions. corporate governance, capital adequacy, funding
and liquidity management, and the supervision
The continuing growth in the size and complex- of material nonbank subsidiaries,2 as well as
ity of many banking organizations exposes other aspects of the Federal Reserves consoli-
these firms to a wide array of potential risks, dated supervision activities designed to further
while at the same time making it more challeng- the objectives of fostering financial stability and
ing for a single supervisor to have a complete deterring or managing financial crises. In addi-
view of firmwide risks and controls. In response tion, the Federal Reserve continues to work,
to these trends, and to better fulfill both its both independently and in conjunction with
responsibilities as consolidated supervisor and other domestic and foreign bank supervisors and
its other central bank objectives, the Federal functional regulators, on a number of other ini-
Reserve continues to refine and enhance its tiatives to strengthen supervisory approaches
programs for the consolidated supervision of and reinforce expectations for sound practices in
bank holding companies (BHCs) and the response to recent lessons learned.
combined U.S. operations of foreign banking
organizations (FBOs).
The Federal Reserve has set forth its consoli- 1050.0.1 SUPERVISION AND
dated supervision program for bank holding REGULATION FRAMEWORK FOR
companies and the combined U.S. Operations of COMPANIES THAT CONTROL A
Foreign Banking Organizations in SR-08-9/CA- BANK AND THE SUBSIDIARIES OF
08-12 and its attachments. (See sections 1050.1 SUCH COMPANIES
for the consolidated supervision of large com-
plex banking organizations and see 1050.2 for The Bank Holding Company Act (BHC Act),
the consolidated supervision of regional bank- originally enacted in 1956, provides a federal
ing organizations.) The primary objectives of framework for the supervision and regulation of
this supervisory guidance are to specify princi- all domestic and foreign companies that control
pal areas of focus for consolidated supervision a bank and the subsidiaries of such companies.
activities and thereby provide for consistent Among the principal purposes of the BHC Act
Federal Reserve supervisory practices and assess- is to protect the safety and soundness of corpo-
ments across organizations with similar activi- rately controlled banks. Financial trouble in one
ties and risks. Consistent with these objectives, part of an organization can spread rapidly to
the SR letter and its attached guidance detail other parts of the organization; moreover, large
specific expectations for Federal Reserve staff BHCs increasingly operate and manage their
for understanding and assessing primary gover- businesses on an integrated basis across corpo-
nance functions and risk controls, material busi- rate boundaries. Risks that cross legal entities or
ness lines, nonbank operations, financial condi- that are managed on a consolidated basis cannot
tion, and other key activities and risks at banking be monitored properly through supervision
organizations; address unique aspects of super- directed at any one of the legal entity subsidi-
vising the combined U.S. operations of FBOs; aries within the overall organization.
and highlight the supervisory attention that should The BHC Act provides for all BHCs, includ-
be paid to risk-management systems and inter- ing financial holding companies formed under
nal controls used by BHCs and FBOs that pro-
vide core clearing and settlement services (core settlement organizations, critical financial markets, and
key financial markets.
clearing and settlement organizations) or that 2. The term nonbank subsidiaries as used in SR-08-
have a significant presence in critical or key 9/CA-08-12 and its attachments does not include savings
financial markets.1 The guidance also reiterates associations.
1. See Attachment C to SR-08-9/CA-08-12 or this sec- BHC Supervision Manual January 2015
tions appendix for the definitions of core clearing and Page 1
Consolidated Supervision of BHCs and the Combined U.S. Operations of FBOs 1050.0
the Gramm-Leach-Bliley Act (GLBA), to be established by the International Banking Act of

supervised on a consolidated basis by the Fed- 1978, which introduced a policy of national
eral Reserve. Consolidated supervision of a treatment3 promoting competitive equality
BHC encompasses the parent company and its between FBOs operating in the United States
subsidiaries, and allows the Federal Reserve to and domestic banking organizations. The For-
understand the organizations structure, activi- eign Bank Supervision Enhancement Act of
ties, resources, and risks, as well as to address 1991 established uniform federal standards for
financial, managerial, operational, or other defi- entry, expansion, and supervision of FBOs in
ciencies before they pose a danger to the BHCs the United States and increased the Federal
subsidiary depository institutions. Reserves supervisory responsibility and author-
To carry out these responsibilities, the BHC ity over the U.S. operations of FBOs. This act
Act grants the Federal Reserve broad authority also introduced the requirement that the Federal
to inspect and obtain reports from a BHC and its Reserve approve the establishment of all U.S.
subsidiaries concerning, among other things, the banking offices of foreign banks and, in that
companys financial condition, systems for regard, take into account whether the foreign
monitoring and controlling financial and bank is subject to comprehensive, consolidated
operational risks, and compliance with the BHC supervision by its home-country supervisor.
Act and other federal law (including consumer The Federal Reserves consolidated supervi-
protection laws) that the Board has specific sion activities closely complement its other cen-
jurisdiction to enforce. In addition, federal law tral bank responsibilities, including the objec-
authorizes the Federal Reserve to take action tives of fostering financial stability and deterring
against a BHC or nonbank subsidiary to prevent or managing financial crises. The information,
these entities from engaging in unsafe or expertise, and powers that the Federal Reserve
unsound practices or to address violations of derives from its supervisory authority enhance
law that occur in connection with their own its ability to help prevent financial crises and to
business operations even if those operations are manage such crises (in consultation and con-
not directly connected to the BHCs subsidiary junction with the Treasury Department and other
depository institutions. Using its authority, the U.S. and foreign authorities) should they occur.
Federal Reserve also has established consoli- Similarly, the supervisory responsibilities of the
dated capital standards for BHCs, helping to Federal Reserve benefit from its responsibilities
ensure that a BHC maintains adequate capital to for financial stability. For example, knowledge
support its groupwide activities, does not gained about financial market developments
become excessively leveraged, and is able to through interactions with primary dealers in
serve as a source of strength for its depository government securities and capital market exper-
institution subsidiaries. tise derived from nonsupervisory activities
The Federal Reserves consolidated supervi- improve the Federal Reserves ability to under-
sion program has served as the benchmark for stand and evaluate the activities of banking
many of the current and evolving international organizations and otherwise enhance its contri-
standards for the consolidated supervision of butions to supervisory and regulatory policy
financial groups. Key concepts that have been initiatives.
part of the Federal Reserves approach to con- Effective consolidated supervision requires
solidated supervision for many years are reflected strong, cooperative relationships between the
in the Basel Committee on Banking Supervi- Federal Reserve and relevant primary supervi-
sions Minimum Standards for Internationally sors and functional regulators.4 These relation-
Active Banks (1992), capital accords (1988 and
2006), and Core Principles for Effective Bank- 3. National treatment refers to a policy that generally
ing Supervision (1997 and 2006), and are now gives foreign banks operating in the United States the same
powers as U.S. banking organizations and subjects them to the
used by the International Monetary Fund and same restrictions and obligations.
the World Bank in connection with their assess- 4. The term primary supervisor as used in this document
ments of countries bank supervisory regimes. refers to the primary federal banking or thrift supervisor (for
In addition to its role as consolidated supervi- example, the Office of the Comptroller of the Currency for a
nationally chartered bank) of a depository institution subsidi-
sor of BHCs, the Federal Reserve also is respon- ary of a BHC, or of a U.S. banking office of an FBO. For
sible for the overall supervision of the U.S. state-chartered depository institutions or banking offices, this
operations of foreign banks that have a banking term also includes the relevant bank supervisory authority of
presence in the United States. This role was the institutions chartering/licensing state. Where a BHC has
multiple depository institution subsidiaries or an FBO has
multiple U.S. banking offices, there may also be multiple
BHC Supervision Manual January 2015 primary banking supervisors, depending on how the subsidi-
Page 2 aries are chartered/licensed. The term functional regulator
ships respect the individual statutory authorities policies, and operations of a banking organiza-
and responsibilities of the respective supervisors tion that may have a material impact on regu-
and regulators and provide for appropriate infor- lated subsidiaries, as well as information con-
mation flows and coordination so that individual cerning transactions or relationships between
responsibilities can be carried out effectively, regulated subsidiaries and their affiliates.
while limiting the potential for duplication or
undue burden. Information sharing among domes-
tic and foreign supervisors, consistent with appli- 1050.0.2 KEY OBJECTIVES FOR, AND
cable law and the jurisdiction of each supervi- APPROACHES TO, CONSOLIDATED
sor, is essential to ensure that a banking SUPERVISION
organizations global activities are supervised
on a consolidated basis. The Federal Reserve uses a systematic approach
These concepts underlie the provisions of the to develop an assessment of a BHC on a consoli-
GLBA governing the interaction between the dated basis and of the combined U.S. operations
Federal Reserve, as consolidated supervisor, and of an FBO. These assessments are reflected in
the other primary supervisors or functional regu- the RFI (Risk-Management, Financial Condi-
lators that may be involved in supervising one tion, and Impact) rating assigned to a BHC6 and
or more subsidiaries of a BHC.5 Under these the combined U.S. operations rating assigned to
provisions, the Federal Reserve, in conducting an FBO with multiple U.S. operations.7 The
its consolidated supervisory responsibilities, relies Federal Reserve utilizes three principal pro-
to the fullest extent possible on (1) the reports cesses to understand, supervise, and assess BHCs
that a BHC or subsidiary has provided to another and FBOs: continuous monitoring activities,8
federal or state supervisor or to an appropriate discovery reviews,9 and testing.10
self-regulatory organization, (2) information that
is otherwise required to be reported publicly,
6. The RFI rating system for BHCs is discussed in SR-04-
and (3) externally audited financial statements. 18, Bank Holding Company Rating System and section
In addition, the Federal Reserve relies to the 4070.0. RFI ratings are assigned at least annually for BHCs
fullest extent possible on the reports of examina- with $1 billion or more in consolidated assets, and are com-
tion of a depository institution made by its municated via a comprehensive summary supervisory report
that supports the BHCs assigned ratings and encompasses the
appropriate federal or state bank supervisor, of a results of the entire supervisory cycle.
brokerdealer or investment adviser made by or 7. SR-00-14, Enhancements to the Interagency Program
on behalf of the SEC or relevant state regulatory for Supervising the U.S. Operations of Foreign Banking Orga-
authority, or of a licensed insurance company nizations, discusses the U.S. combined operations rating for
an FBO and other aspects of the FBO Supervision Program.
made by or on behalf of its appropriate state The Federal Reserves rating and assessment, as well as a
regulatory authority. In developing its overall summary of condition analysis describing the strengths and
assessment of a BHC or the combined U.S. weaknesses of the FBOs combined U.S. operations, are pro-
operations of an FBO, the Federal Reserve also vided to the head office of each FBO. This information is also
shared with the FBOs home-country supervisor so that it may
relies to the fullest extent possible on the infor- assess the impact of U.S. operations on the parent banking
mation gathered and assessments developed by organization in its role as consolidated supervisor of the
these other supervisors and regulators. banking organizations global operations.
Similarly, the Federal Reserve seeks to assist 8. Continuous monitoring activities are nonexamination/
inspection supervisory activities primarily designed to develop
relevant primary supervisors and functional regu- and maintain an understanding of the organization, its risk
lators in performing their supervisory responsi- profile, and associated policies and practices. These activities
bilities with respect to regulated subsidiaries by also provide information that is used to assess inherent risks
sharing pertinent information that relates to these and internal control processes. Such activities include meet-
ings with banking organization management; analysis of man-
regulated subsidiaries consistent with each agen- agement information systems (MIS) and other internal and
cys supervisory responsibilities and applicable external information; review of internal and external audit
law. Examples include shared information relat- findings; and other efforts to coordinate with, and utilize the
ing to the financial condition, risk-management work of, other relevant supervisors and functional regulators
(including analysis of reports filed with, or prepared by, these
supervisors or regulators, or appropriate self-regulatory orga-
nizations, as well as related surveillance results).
as used in this document refers to the appropriate federal
9. A discovery review is an examination/inspection
(examples include the U.S. Securities and Exchange Commis-
activity designed to improve the understanding of a particular
sion and the U.S. Commodity Futures Trading Commission)
business activity or control processfor example, to address
or state regulator for a functionally regulated nondepository
a knowledge gap identified during the risk assessment or other
subsidiary or affiliate of a BHC or FBO. (See SR-00-13,
supervisory process.
Framework for Financial Holding Company Supervision.)
For U.S. operations of FBOs, the U.S. supervisor of a U.S.
banking office is referred to as a domestic primary supervisor. BHC Supervision Manual January 2015
5. See SR-00-13. Page 3
The Federal Reserves supervisory objectives 1050.0.2.1.1 Understanding the Bank

are the same for all BHCs and FBOs. However, Holding Company on a Consolidated
the type and amount of information and the Basis and the Combined U.S. Operations
scope and extent of Federal Reserve supervisory of an FBO
and examination11 work that are necessary to
understand, supervise, and develop an assess- Supervisory Objective: The Federal Reserve
ment of an individual BHC or the U.S. opera- develops a comprehensive understanding of each
tions of an individual FBO vary. Federal Reserve BHC and the combined U.S. operations of each
supervisory activities are tailored for each orga- FBO. Key elements in developing this under-
nization based on a variety of factors, including standing include
the organizations legal entity and regulatory
structure;12 the risks posed by the organizations corporate strategy and significant activities;
specific activities and systems; and the potential business line, legal entity, and regulatory struc-
effect of weaknesses in control functions on the ture, including interrelationships and depen-
organization, its subsidiary depository institu- dencies across multiple legal entities;
tions, or key financial markets. For example, corporate governance, risk management, and
additional supervisory activities, including trans- internal controls for managing risks; and
action testing in appropriate circumstances, may for certain organizations, presence in critical
be conducted when there are information gaps or key financial market activities.
relating to material risks or activities, indica-
tions of weaknesses in risk-management sys-
tems or internal controls, or indications of viola- 1050.0.2.1.2 Assessing the Bank Holding
tions of consumer protection or other laws, or Company on a Consolidated Basis and
when a consolidated organization or subsidiary the Combined U.S. Operations of an FBO
depository institution is in less-than-satisfactory
condition. Supervisory Objective: The Federal Reserve
supervises each BHC on a consolidated basis
and assigns an RFI rating through an evaluation
and assessment of the following areas
1050.0.2.1 Key Supervisory Objectives
key corporate governance, risk management,
In fulfilling its responsibilities for supervising a and control functions (including, where appli-
BHC on a consolidated basis and the combined cable, such functions as they relate to core
U.S. operations of an FBO, the Federal Reserve clearing and settlement activities and activi-
is guided by the following key supervisory ties where the organization has a significant
objectives. presence in critical or key financial markets);
the adequacy of the financial condition of the
consolidated organization; and
the potential negative impact of nonbank enti-
ties on subsidiary depository institutions.
10. Testing is an examination/inspection activity to
assess whether a control process is appropriately designed and
achieving its objectives or to validate a management assertion
The Federal Reserve also supervises and
about an organizations operations. Activities may include the assesses the combined U.S. operations of each
review and validation of internal MIS, such as business FBO and assigns a U.S. combined operations
records related to an internal control process; audit findings rating based on analysis of these same elements.
and processes; or a sample of transactions that have been
entered into by a banking organization.
11. While by definition examination activities are appli-
cable to the supervision of banks and other depository institu- 1050.0.2.1.3 Interagency Coordination
tions, as well as U.S. banking offices of FBOs, and inspec-
tion activities are applicable to the supervision of BHCs and
nonbank subsidiaries and affiliates, the term examination is
Supervisory Objective: As noted earlier, effec-
generally used throughout this guidance to refer to both tive consolidated supervision requires strong,
examination and inspection activities. cooperative relationships between the Federal
12. An organizations regulatory structure refers to the Reserve and relevant domestic and foreign super-
various legal entities within the organization that are subject
to oversight by different domestic and foreign supervisors or
visors and functional regulators. To achieve this
functional regulators. objective, while limiting the potential for dupli-
cation or undue burden, the nature and scope of
BHC Supervision Manual January 2015 Federal Reserve work is tailored to the organiza-
Page 4 tions legal entity and regulatory structure as
well as the risks associated with the organiza- impact across the banking and financial system,
tions activities. In this regard, the Federal Reserve these activities pose special legal, reputational,
and other risks to the banking organization and
relies to the fullest extent possible on assess- its depository institution subsidiaries. The Fed-
ments and information developed by other eral Reserve has unique expertise and perspec-
relevant domestic and foreign supervisors and tive in these areas based on its broader central
functional regulators; bank responsibilities and functions.
focuses supervisory attention on material risks Unlike banks, nonbank subsidiaries of a bank-
from activities that are not supervised by ing organization may not accept FDIC-insured
another supervisor or regulator or that cut deposits and do not have routine access to the
across legal entities; and Federal Reserves discount window and pay-
participates in the sharing of information among ment system. As a result, certain laws and super-
domestic and foreign supervisors and func- visory policies that apply to banks (e.g., the
tional regulators, consistent with applicable prompt-corrective-action framework13) do not
law, to provide for the comprehensive, con- apply to nonbank subsidiaries, and the manner
solidated supervision of each banking organi- in which the Federal Reserve supervises the
zations global activities. nonbank subsidiaries of a banking organization
reflects these differences. The Federal Reserves
Since coordination with, and reliance on, the supervision of nonbank subsidiaries under the
work of other relevant primary supervisors and BHC Act is primarily directed toward, and
functional regulators is so central to the Federal focused on, ensuring that the nonbank subsidi-
Reserves conduct of consolidated supervision, ary does not present material financial, legal, or
direction for achieving these objectives is closely reputational risks to affiliated depository institu-
integrated into the attached guidance for under- tions or to the BHCs or FBOs ability to sup-
standing and assessing consolidated BHCs and port these depository institutions. The Federal
the combined U.S. operations of FBOs. Reserve also may interact with nonbank entities,
such as primary dealers in government securi-
ties, in connection with its other central bank
1050.0.2.2 Risk-Focused Approach to functions and responsibilities, including con-
Consolidated Supervision ducting monetary policy, fostering financial sta-
bility, and deterring or managing financial crises.
The Federal Reserve uses a risk-focused approach As part of the supervisory process, the Fed-
to supervision of banking organizations in general Reserve reviews the systems and controls
eral and to each organization individually. In used by BHCs and the U.S. operations of FBOs
this regard, the Federal Reserve focuses supervi- to monitor and ensure that the organization,
sory activities on identifying the areas of great- including its nonbank subsidiaries, complies
est risks to a banking organization and assessing with applicable laws and regulations, including
the ability of the organizations management to those related to consumer protection. The Fed-
identify, measure, monitor, and control these eral Reserve develops and maintains an under-
risks. In addition, the Federal Reserve typically standing and assessment of consumer compli-
is more actively and comprehensively engaged ance risk at nonbank subsidiaries of a BHC or
in the supervision of the largest and most com- FBO primarily through continuous monitoring
plex BHCs and FBOs, as well as those with the activities, relying to the fullest extent possible
most dynamic risk profiles. By paying particular on work performed by the relevant functional
attention to these organizations, the Federal regulator, if any. While the Federal Reserve
Reserve aims to minimize significant adverse routinely conducts examinations of the compli-
effects on the public (including consumers), the ance function at the BHC, including its systems
financial markets, and the financial systems in for monitoring and ensuring compliance with
the United States and abroad, as well as on consumer and other applicable laws, the Federal
taxpayers, who provide the ultimate resources Reserve currently does not routinely conduct
behind the federal safety net. examinations for the purpose of determining
The Federal Reserve also focuses special
supervisory attention on the risk-management 13. For more information on the prompt-corrective-action
framework for banks, see section 4133.1 of the Federal
systems and internal controls used by core clear- Reserves Commercial Bank Examination Manual, or see
ing and settlement organizations or organiza- 12 C.F.R. 208, Subpart D.
tions that have a significant presence in key
financial markets. In light of the potential for BHC Supervision Manual January 2015
problems in these areas to transmit an adverse Page 5
compliance with specific consumer laws enforced (multi-office FBOs)

primarily by other supervisors regarding non- single-office foreign banking organizations
bank subsidiaries of BHCs and FBOs. When (single-office FBOs)
consumer compliance-related deficiencies are
noted as part of the ongoing supervision of a LCBOs are characterized by the scope and com-
BHC or FBO, however, consumer compliance plexity of their domestic and international opera-
examiners may conduct onsite examinations tions; their participation in large volume pay-
(including transaction testing, if appropriate) of ment and settlement systems; the extent of their
nonbank subsidiaries to resolve significant issues custody operations and fiduciary activities; and
that have the potential for widespread violations the complexity of their regulatory structures,
or harm to consumers.14 both domestically and in foreign jurisdictions.
The Federal Reserve also seeks to reinforce To be designated as an LCBO, a banking organi-
market discipline by encouraging public disclo- zation must meet specified criteria to be consid-
sures that balance quantitative and qualitative ered a significant participant in at least one key
information with clear discussions about risk- financial market.
management processes and that reflect evolving Banking organizations that are not designated
disclosure practices for peer organizations. as LCBOs belong to the portfolios of regional or
community BHCs, or multi-office or single-
office FBOs. While there is considerable variety
1050.0.2.3 Supervisory Portfolios among organizations across these portfolios, the
simpler regulatory structure of most non-LCBO
An important aspect of the Federal Reserves organizations increases the likelihood that a
consolidated supervision programs for BHCs single primary supervisor has a substantially
and the combined U.S. operations of FBOs is complete view of, and ability to address, signifi-
the assessment and evaluation of practices across cant areas of firmwide (or combined U.S. opera-
groups of organizations with similar characteris- tions for FBOs) activities, risks, risk manage-
tics and risk profiles. This portfolio approach ment, and controls.
to consolidated supervision facilitates greater
consistency of supervisory practices and assess-
ments across comparable organizations and
enhances the Federal Reserves ability to iden- 1050.0.3 SUPERVISORY GUIDANCE
tify outlier organizations among established peer
groups. The supervisory portfolios that the Fed- The guidance attached to SR-08-9/CA-08-12
eral Reserve currently uses in structuring its (e.g., sections 1050.1 and 1050.2) describes how
supervisory programs for BHCs and the U.S. Federal Reserve staff will develop an under-
operations of FBOs are as follows: standing and assessment of a BHC or the U.S.
operations of an FBO through continuous moni-
BHC Portfolios: toring activities, discovery reviews, and testing
activities, as well as through interaction with,
large complex banking organizations (LCBO and reliance to the fullest extent possible on,
BHCs) other relevant primary supervisors and func-
regional bank holding companies (regional tional regulators. Because the Federal Reserves
BHCs) supervisory activities are tailored in the manner
community bank holding companies (commu- described above, separate guidance documents
nity BHCs) are provided for four different supervisory port-
folios to promote appropriate and consistent
FBO Portfolios: supervision of organizations that broadly share
similar characteristics and risk profiles. The
large complex foreign banking organizations documents guidance addresses
(LCBO FBOs)
multi-office foreign banking organizations consolidated supervision of LCBO BHCs
(Attachment A.1) (See section 1050.1);
consolidated supervision of regional BHCs
14. See SR-03-22/CA-03-15, Framework for Assessing
Consumer Compliance Risk at Bank Holding Companies,
(Attachment A.2) (See section 1050.2);
and section 2124.01.6.1.2. supervision of the combined U.S. operations
of LCBO FBOs (Attachment B.1); and
BHC Supervision Manual January 2015 supervision of the combined U.S. operations
Page 6 of multi-office FBOs (Attachment B.2).
As a supplement to these four guidance docu- cial markets in which the organization plays
ments, definitions of key terms for consolidated a significant role, as well as related risk
supervision are provided in Attachment C to management and internal controls;
SR-08-9/CA-08-12 (See appendix, section 5. where applicable, areas of emerging interest
1050.0.4). with potential financial market conse-
Consolidated supervision of community BHCs quences;
follows the procedures contained in SR-02-1 6. consolidated financial strength (in the case of
and section 5000.0.4.3, Revisions to Bank FBOs, the financial strength of combined
Holding Company Supervision Procedures for U.S. operations);
Organizations with Total Consolidated Assets of 7. risk management and financial condition of
$5 Billion or Less, while supervision of single- significant nonbank subsidiaries; and
office FBOs follows the procedures contained in 8. parent company and nonbank funding and
SR-00-14. liquidity (in the case of FBOs, funding and
liquidity of U.S. operations).
1050.0.3.1 Overview of Significant By their nature, understanding and assessing

Federal Reserve Supervisory Activities some areassuch as the risk management and
financial condition of significant nonbank sub-
The Federal Reserve will maintain for each sidiaries that are not functionally regulated
BHC and the combined U.S. operations of each will typically require more independent Federal
FBO Reserve supervisory work. Other areassuch
as primary firmwide risk management and con-
an understanding of key elements of the bank- trol functionstypically will require a greater
ing organizations strategy, primary revenue degree of coordination with other relevant pri-
sources, risk drivers, business lines, legal entity mary supervisors or functional regulators, who
structure, governance and internal control will likely have information or assessments upon
framework, and presence in key financial mar- which the Federal Reserve can draw.
kets; and The guidance in the attachments to SR-08-
an assessment of (1) the effectiveness of risk- 9/CA-08-12 outlines when the Federal Reserve
management systems and controls over the will conduct (i.e., participate in or lead) testing
primary risks inherent in the organizations activities in order to determine whether a con-
activities, (2) the organizations financial control process is appropriately designed and achiev-
dition, and (3) the potential negative impact of ing its objectives or to otherwise validate man-
nonbank operations on affiliated depository agement assertions. Testing activities are an
institutions. important element of the Federal Reserves con-
solidated supervision program for BHCs and the
This understanding and assessment will combined U.S. operations of FBOs. They supple-
encompass both prudential and consumer ment ongoing continuous monitoring activities
compliance supervision and reflect judgments and periodic discovery reviews necessary to
developed by Federal Reserve staff drawing maintain an understanding and assessment for
from all available sources, including the work each of these key functions.
of other relevant primary supervisors and The guidance in the SR letters attachments
functional regulators and the organizations also discusses in greater detail control processes
internal control functions. Primary areas of for several areas subject to testing on at least a
focus will include three-year cycle, supplemented by a reassess-
ment on at least an annual basis to identify
1. key corporate governance functions, includ- whether changes in inherent risk or control
ing internal audit; structures, or potential concerns regarding con-
2. risk management and internal control func- trols, merit interim targeted testing activities.
tions for primary risks of the consolidated These areas are
organization (or combined U.S. operations
for FBOs), and supporting MIS; internal audit infrastructure;
3. where applicable, core clearing and settle- parent company and nonbank funding and
ment activities and related risk management liquidity (in the case of FBOs, funding and
and internal controls of firms that are large- liquidity of U.S. operations);
value payment system operators and market
utilities; BHC Supervision Manual January 2015
4. for LCBOs, activities in critical or key finan- Page 7
where applicable, core clearance and settle- ary if, after reviewing relevant reports, it reason-
ment activities; and, ably determines that the examination is neces-
where applicable, activities in critical finan- sary to adequately inform the Federal Reserve
cial markets in which the organization plays a about the systems used to monitor and control
significant role.15 financial and operational risks within the con-
solidated organization that may pose a direct or
There may also be instances when additional indirect threat to the safety and soundness of a
supervisory activities are necessary to improve depository institution subsidiary.
the understanding and/or to assess the adequacy
of key corporate governance functions or risk
management or internal control functions for
primary risks due to significant changes, poten- 1050.0.3.2 Application of Supervisory
tial concerns, or the absence of recent testing. Guidance
All cycle times set forth in the guidance for
testing represent maximum periods between test- As a general matter, the supervisory expecta-
ing activities. Shorter cycle times should be tions and processes of the guidance documents
utilized whenever significant changes occur in, that are attached to SR-08-9/CA-08-12 are
or material concern exists regarding, a key gov- intended for use in supervising BHCs and the
ernance, risk-management, or internal control combined U.S. operations of FBOs in circum-
function. stances where both the banking organization
In conducting the activities described in the and its subsidiary depository institutions are in
guidance, the Federal Reserve will rely to the at least satisfactory condition and there are no
fullest extent possible on the information and indications of material weakness in the organi-
assessments of relevant primary supervisors and zations risk management or internal controls.
functional regulators, and will work with such Additional Federal Reserve supervisory activi-
supervisors and regulators to align each agen- ties may be necessary or appropriate if the bank-
cys assessment of key corporate governance ing organization is facing, or is expected to face,
functions, risk-management and internal control material financial, managerial, operational, legal,
functions for primary risks, financial condition, or reputational difficulties, or is the subject of an
and other areas of consolidated BHC or com- investigation or formal or informal enforcement
bined U.S. FBO operations, as applicable. In action.
addition, because of the specific statutory limita- Section IV of each of the documents attached
tions that apply with respect to functionally to SR-08-9/CA-08-12 (see sections 1050.1.4 and
regulated subsidiaries of a BHC or FBO, the section 1050.2.4) provides additional guidance
Federal Reserve will continue to adhere to the on the steps the Federal Reserve will take to
procedures and limits described in SR-00-13 coordinate with other supervisors in certain spe-
(see sections 3900.0 and 1040.0) in conducting cial situations. This guidance does not limit any
any examination of, or requesting a specialized authority that the Federal Reserve may have
report from, a functionally regulated subsidiary under applicable law and regulations, including
of a BHC or FBO.16 Under these provisions, for the authority to obtain reports or conduct exami-
example, the Federal Reserve may conduct an nations or inspections. Moreover, because this
examination of a functionally regulated subsidi- guidance relates to supervisory practices, it does
not address or limit the circumstances under
15. For these activities, the three-year testing cycle focuses which the Federal Reserve may take formal or
on adherence with expectations of the Interagency Paper on informal enforcement action against a banking
Sound Practices to Strengthen the Resilience of the U.S. organization or other person.
Financial System (see SR-03-9), including the geographic
diversity and resiliency of data centers and operations, and
This supervisory guidance is not intended to
testing of recovery and resumption arrangements. comprehensively describe all elements of an
16. For these purposes, a specialized report means a effective supervision program for BHCs or U.S.
report that the functionally regulated subsidiary is not required operations of FBOs. Rather, the guidance supple-
to prepare for another federal or state regulatory authority or
an appropriate self-regulatory organization. Consistent with
ments, and should be used in conjunction with,
the GLBA, if the Federal Reserve seeks to obtain a special- existing Federal Reserve guidance, including
ized report from a functionally regulated subsidiary, the Fed- among others the Bank Holding Company Super-
eral Reserve will first request that the subsidiarys appropriate vision Manual; the Examination Manual for
regulatory authority or self-regulatory organization obtain the
report and make it available to the Federal Reserve.
U.S. Branches and Agencies of Foreign Banking
Organizations; SR-04-18; SR-03-22/CA-03-15;
BHC Supervision Manual January 2015 SR-00-14; and SR-00-13.
Page 8
1050.0.4 APPENDIXDEFINITIONS Discovery review: An examination/inspection

OF KEY TERMS FOR supervisory activity designed to improve the
CONSOLIDATED SUPERVISION understanding of a particular business activity
or control processfor example, to address a
1050.0.4.1 Supervisory Objectives knowledge gap identified during the risk assess-
ment or other supervisory process. If questions
Assessing: To go beyond developing an under- regarding the adequacy of practices or suffi-
standing by making supervisory judgments ciency of information are raised during this
regarding the degree of inherent risks or evaluat- review, it will likely be necessary to conduct
ing whether risk-management and internal con- further and more in-depth examination activity
trol practices are functioning as intended, and (e.g., testing).
whether they are adequate relative to the risk
taken. It is often necessary for bank supervisors Examination/inspection: Examination activities
or functional regulators to conduct testing activi- are applicable to the supervision of banks and
ties as a means to arrive at an assessment. other depository institutions, as well as U.S.
banking offices of FBOs, and inspection activi-
Understanding: To gain comprehensive insight ties are applicable to the supervision of BHCs
into the nature of a business activity, its related and nonbank subsidiaries and affiliates. Exami-
risks, and the design of risk-management and nation and inspection activities are generally
compensating controls. Understanding also described as examinations throughout this
involves comprehending the significance of such guidance.
activities, risks, and controls for the institutions
safety and soundness. Continuous monitoring or Testing: An examination/inspection supervisory
discovery reviews are often utilized to develop activity designed to go beyond a discovery
an understanding of a banking organizations review, as it will result in an assessment of
operations and the related inherent risk and whether a control process is appropriately
controls. designed and achieving its objectives, or valida-
tion of a management assertion about an organi-
zations operations. Such activities may include
the review and validation of internal MIS, such
1050.0.4.2 Supervisory Activities as business records related to an internal control
process; audit findings and processes; or a sample
Active participation: When the Federal Reserve of transactions that have been entered into by a
has input into determining the objectives, final banking organization.
conclusions, and related communications to
institution management for an examination led
by another relevant primary supervisor or func- 1050.0.4.3 Foreign Banking Organization
tional regulator. Supervision
Continuous monitoring: Non-examination/ Booked in: Recorded on the books and records
inspection supervisory activities primarily of the legal entity in question. For supervisory
designed to develop and maintain an purposes, the U.S. operations of FBOs include
understanding of the organization, its risk activities that are booked in or traded through
profile, and associated policies and practices. U.S. operations.
These activities also provide information that is
used to assess inherent risks and internal control Comprehensive, consolidated supervision: An
processes. Such activities include meetings with FBO is supervised or regulated in such a man-
banking organization management; analysis of ner that its home-country supervisor receives
management information systems (MIS) and sufficient information on the worldwide opera-
other internal and external information; review tions of the FBO (including the relationship of
of internal and external audit findings; and other the bank to any affiliate) to assess the FBOs
efforts to coordinate with, and utilize the work overall financial condition and compliance with
of, other relevant supervisors and functional law and regulation. The Foreign Bank Supervi-
regulators, including analysis of reports filed sion Enhancement Act of 1991 introduced the
with, or prepared by, these supervisors or requirement that the Federal Reserve approve
regulators, or appropriate self-regulatory
organizations, as well as related surveillance BHC Supervision Manual January 2009
results. Page 9
the establishment of all U.S. banking offices of subsidiaries of FBOs and branches/agencies of
FBOs, and in that connection, take into account FBOs.
whether the FBO is subject to comprehensive,
consolidated supervision by its home-country U.S. nonbank affiliates of U.S. banking offices:
supervisor. U.S. BHC parent companies and their nonbank
subsidiaries, as well as other U.S. nonbank affili-
Multi-office foreign banking organizations: All ates and representative offices held directly by
FBOs except for (1) those that are designated as the FBO.
being part of the portfolio of LCBOs and
(2) FBOs whose U.S. operations consist solely
of a single U.S. banking office. 1050.0.4.4 Other Terms
National treatment: As established by the Banking Organization National Desktop
International Banking Act of 1978 (IBA), a pol- (BOND): A Federal Reserve information tech-
icy that requires nondiscrimination between nology platform providing secure interagency
domestic and foreign firms or treatment of for- access to documents, supervisory and financial
eign entities that is no less favorable than that data, and other information utilized in the con-
accorded to domestic enterprises in like solidated supervision of individual BHCs and
circumstances. This policy generally gives for- FBOs, and in developing comparative analyses
eign banks operating in the United States the of institutions with similar business lines and
same powers as U.S. banking organizations and risk characteristics.
subjects them to the same restrictions and
obligations. College of supervisors: A multilateral group of
supervisors that discusses issues related to spe-
Net due to / from positions: Net due to and from cific internationally active banking organiza-
positions refer to the flow of funds between a tions. The Federal Reserve participates in col-
U.S. branch or agency and its parent FBO (includ- leges of supervisors as both a home-country
ing other affiliated depository institutions). For supervisor of internationally active U.S. BHCs
example, a U.S. branch is in a net due from and as a host-country supervisor of the U.S.
position with its parent FBO if the parent owes operations of FBOs.
funds to the branch once all transactions between
the branch and the parent are netted. Consolidated supervision (also known as
umbrella or groupwide supervision):
Qualifying foreign banking organizations Supervision of a BHC on a groupwide basis,
(QFBOs): FBOs that are entitled to certain including its nonbanking subsidiaries, provid-
exemptions from the nonbanking activities ing important protection to its subsidiary banks
restrictions of the Bank Holding Company Act, and to the federal safety net beyond that af-
including for certain limited commercial and forded by supervision of a bank individually.
industrial activities in the United States. The Consolidated supervision allows the Federal
Federal Reserve does not examine or supervise Reserve to understand the financial and
these commercial/industrial activities. The Fed- managerial strength and risks within the
eral Reserve monitors the extensions of credit consolidated organization as a whole, provid-
by U.S. banking offices of foreign banks to U.S. ing the ability to address significant manage-
companies held directly under this authority to ment, operational, capital, or other deficiencies
ensure that such loans are made on market within the overall organization before they pose
terms. a threat to subsidiary banks.
Traded through: Transacted or arranged by the Core clearing and settlement organizations: As
personnel of the institution in question (in an defined in the Interagency Paper on Sound
agent role), but booked at a different related Practices to Strengthen the Resilience of the
legal entity. For supervisory purposes, the U.S. U. S. Financial System (SR-03-9), two groups
operations of FBOs include activities that are of organizations that provide clearing and settle-
booked in or traded through U.S. operations. ment services for critical financial markets or
act as large-value payment system operators,
U.S. banking offices: U.S. depository institution and present the potential for systemic risk should
they be unable to perform. The first group con-
BHC Supervision Manual January 2009 sists of market utilities (government-sponsored
Page 10 services or industry-owned organizations), whose
primary purpose is to clear and settle transac- Key financial markets: Includes critical finan-
tions for critical markets or transfer large-value cial markets as well as (1) broader U.S. capital
wholesale payments. The second group consists market activity, including underwriting, securiti-
of those private-sector firms that provide clear- zation, derivatives, and trading; (2) retail finan-
ing and settlement services that are integral to a cial services; and (3) international financial
critical market (i.e., their aggregate market share markets.
is significant enough to present the potential for
systemic risk in the event of their sudden failure Key models and processes: Those where evalua-
to carry out those activities because there are no tion of the model/process will influence the Fed-
viable immediate substitutes). eral Reserves assessment of the activity or con-
trol area that is supported by the model/process.
Critical financial markets: As defined in the
Interagency Paper on Sound Practices to Large complex banking organizations (LCBOs):
Strengthen the Resilience of the U. S. Financial LCBOs are characterized by the scope and com-
System, the markets for federal funds, foreign plexity of their domestic and international opera-
exchange, and commercial paper; U.S. govern- tions; their participation in large volume pay-
ment and agency securities; and corporate debt ment and settlement systems; the extent of their
and equity securities. custody operations and fiduciary activities; and
the complexity of their regulatory structure,
Domestic BHC: A BHC incorporated in the both domestically and in foreign jurisdictions.
United States that is not controlled by an FBO. To be designated as an LCBO, a banking organi-
zation must meet specified criteria to be consid-
Double leverage: Situations in which debt is ered a significant participant in at least one key
issued by the parent company and the proceeds financial market.
are invested in subsidiaries as equity.
Material portfolios or business lines: Portfolio
Financial instability: When external events or risk areas (such as retail or wholesale credit
market behavior in the financial system are sub- risk) or individual business lines (such as mort-
stantial enough to significantly distort or impair gage lending or leveraged lending) that are pri-
national or global financial markets or to create mary drivers of risk or revenue for the BHC, or
significant risks for real aggregate economic that otherwise materially contribute to under-
performance. Banking organizations with a con- standing inherent risk or assessing related con-
siderable presence in activities that are poten- trols for a broader corporate function (such as
tially vulnerable to such externalitiesor that consolidated credit-risk management). When
are capable of contributing to financial instabil- identifying these areas during the development
ity if not adequately managedrequire supervi- of the institutional overview and risk assess-
sors to develop an understanding of these activi- ment, as well as during other supervisory pro-
ties and their risk profile. cesses, consideration is given to all associated
risk elements, including legal and compliance
Functional regulator: With respect to domestic risks.
authorities, the appropriate federal (examples
include the U.S. Securities and Exchange Com- Net debit cap: The maximum dollar amount of
mission and the U.S. Commodity Futures Trad- uncollateralized daylight overdrafts that an insti-
ing Commission) or state regulator for a func- tution may incur in its Federal Reserve account.
tionally regulated nondepository subsidiary or
affiliate of a BHC or FBO. Nonmaterial business lines: Business lines that
are not primary drivers of risk or revenue for the
Key corporate governance functions: Primary BHC, and are not principal contributing fac-
firmwide governance mechanisms relied upon tors to either understanding risk inherent in a
by the board of directors and senior manage- broader corporate function or to assessing
ment. This includes the board and its commit- related controls.
tees, senior management and its executive com-
mittees, internal audit, and other functions (e.g., Nontraditional BHCs: BHCs in which most or
corporate finance and treasury functions), whose all of the organizations significant nondeposi-
effectiveness is essential to sustaining the con- tory subsidiaries are regulated by a functional
solidated organization as well as a firms busi-
ness resiliency and crisis management BHC Supervision Manual January 2009
capabilities. Page 11
regulator, and subsidiary depository institutions of FBOs, the U.S. supervisor of a U.S.
tion(s) are small in relation to nondepository banking office is referred to as a domestic pri-
subsidiaries. mary supervisor.
Other relevant primary supervisors: Primary Regional bank holding companies: BHCs with
bank or thrift supervisors of BHC subsidiaries, $10 billion or more in consolidated assets (includ-
including host-country supervisors (or home- ing nontraditional BHCs) that are not desig-
country supervisors for FBOs), whose under- nated as LCBOs.
standing and assessments are key to effective
firmwide consolidated supervision. Regulatory structure: The various legal entities
within the organization that are subject to over-
Primary firmwide risk management and control sight by different domestic and foreign primary
functions: Mechanisms relied upon by the board supervisors or functional regulators.
of directors and senior management for identify-
ing, measuring, monitoring, and controlling pri- Significant nonbank activities and risks: Where
mary risks to the consolidated organization. This the parent company or nonbank subsidiaries
includes risk management and control functions engage in risk-taking activities or hold expo-
for primary credit, legal and compliance, liquid- sures that are material to the risk management
ity, market, operational, and reputational risks or financial condition of the consolidated orga-
for the consolidated organization. nization or a depository institution affiliate.
Primary supervisor: The primary federal bank- Specialized report from a functionally regulated
ing or thrift supervisor (for example, the Office subsidiary: As discussed in the GLBA, a report
of the Comptroller of the Currency for a nation- that the functionally regulated subsidiary is not
ally chartered bank) of a depository institution required to prepare by another federal or state
subsidiary of a BHC, or of a U.S. banking office regulatory authority or an appropriate self-
of an FBO. For state-chartered depository insti- regulatory organization.
tutions or banking offices, this term also includes
the relevant bank supervisory authority of the Systemic risk: The risk that the failure of one
institutions chartering/licensing state. Where a participant to meet its required obligations in a
BHC has multiple depository institution subsid- transfer system or financial market will cause
iaries, or an FBO has multiple U.S. banking other participants to be unable to meet their
offices, there may also be multiple primary obligations when due, causing significant liquid-
banking supervisors, depending on how the sub- ity or credit problems or threatening the stability
sidiaries are chartered/licensed. For U.S. opera- of national or global financial markets.

Page 12
Guidance for the Consolidated Supervision of Domestic Bank Holding
Companies That Are Large Complex Banking Organizations Section 1050.1
WHATS NEW IN THIS REVISED 1050.1.1.1 Federal Reserve Activities and

SECTION Those Activities of Other Supervisors and
Regulators
Effective January 2015, this section is revised
for the adoption of a new consolidated supervi- The nature and scope of independent Federal
sion framework for large banking organiza- Reserve supervisory work required to develop
tions. Refer to SR-12-17/CA-12-14, Consoli- and maintain an understanding and assessment
dated Supervision Framework for Large of a large complex BHC depends largely on the
Financial Institutions. SR-99-15 was super- extent to which other relevant primary supervi-
seded by SR-12-17/CA-12-14. sors or functional regulators have information or
assessments upon which the Federal Reserve
can draw. By their nature, understanding and
1050.1.1 ACTIVITIES OF THE assessing some areassuch as the risk manage-
FEDERAL RESERVE AND OTHER ment and financial condition of significant non-
SUPERVISORS AND REGULATORS, bank subsidiaries that are not functionally
AND FUNCTIONAL REGULATION regulatedtypically will require more indepen-
dent Federal Reserve supervisory work. Other
In 1999, the Federal Reserve established its areassuch as primary firmwide risk-
supervisory program for large complex banking management and control functionstypically
organizations (LCBOs).1 LCBOs are character- will require a greater degree of coordination
ized by the scope and complexity of their domes- with other relevant primary supervisors or func-
tic and international operations; their participa- tional regulators, who will likely have informa-
tion in large volume payment and settlement tion or assessments upon which the Federal
systems; the extent of their custody operations Reserve can draw.
and fiduciary activities; and the complexity of The following sections provide further detail
their regulatory structure, both domestically and on how the Federal Reserve will develop, work-
in foreign jurisdictions. To be designated as an ing in coordination with other relevant primary
LCBO, a banking organization must meet speci- supervisors and functional regulators, an under-
fied criteria to be considered a significant par- standing and assessment of a large complex
ticipant in at least one key financial market.2 BHC. In conducting the activities described
As outlined in the following sections, a range throughout this document, the Federal Reserve
of continuous monitoring activities is utilized, will, to the fullest extent possible
along with discovery reviews and testing activi-
ties (examination/inspection activities),3 to rely on the information and assessments of
develop and maintain an understanding and relevant primary supervisors and functional
assessment of each domestic bank holding com- regulators, including the information and
pany (BHC) that is an LCBO.4 These organiza- assessments reflected in the reports of exami-
tions are collectively referred to as large com- nation of such supervisors and regulators;
plex BHCs. focus its supervisory activities on the bank
holding company, as well as on those of its
nonbank subsidiaries that could have a direct
1. With the implementation of the Consolidated Supervi-
sion Framework for Large Financial Institutions (refer to
or indirect materially adverse effect on the
SR-12-17/CA-12-14), SR-99-15, Risk-Focused Supervision safety and soundness of a depository institu-
of Large Complex Banking Organizations, was superseded. tion subsidiary of the BHC due to the size,
(Refer to section 2124.05 of this manual). condition, or activities of the nonbank subsid-
2. See section 1050.0.4, Appendix, for the definitions of
terms commonly used in this section and sections 1050.1 and
iary, or the nature or size of its transactions
1050.2. with the depository institution; and
3. The term examination is generally used throughout use publicly reported information (including
this guidance to refer to both commercial bank examination externally audited financial statements), as
and BHC inspection activities.
4. The term domestic BHC refers to a BHC incorpo-
well as reports that a large complex BHC or a
rated in the United States that is not controlled by a foreign subsidiary prepares for other primary supervi-
banking organization (FBO). Attachment B.1. to SR-08-9/CA- sors, functional regulators, or self-regulatory
08-12 addressesin the context of supervising the combined organizations.
U.S. operations of FBOshow the Federal Reserve will
develop and maintain an understanding and assessment of a
BHC that is, or is controlled by, an FBO that is itself an BHC Supervision Manual January 2015
LCBO. Page 1
1050.1 Guidance for the Consolidated Supervision of Domestic BHCs That Are LCBOs
1050.1.1.2Functionally Regulated organization and its primary strategies, business

Subsidiaries lines, and risk-management and internal control
functions.6 This understanding will inform the
As discussed below, in certain situations, the development of a risk assessment and supervi-
Federal Reserve may find it necessary to con- sory plan for the BHC. Typically, the informa-
duct an examination of a functionally regulated tion necessary to gain this understanding may
nonbank subsidiary in order to fulfill the Federal be obtained from the organizations manage-
Reserves responsibilities as supervisor of the ment, public reports, regulatory reports, surveil-
consolidated organization. In any such case, the lance screens, third-party sources (e.g., credit
Federal Reserve will continue to adhere to the rating agency and market analyst reports), and
procedural and other requirements governing other relevant primary supervisors or functional
examinations of, or requests for a specialized regulators. Key elements that should be identi-
report from, a functionally regulated subsidiary fied and understood include the following:
as discussed in SR-00-13 and sections 1040.0
and 3900.0. Under these provisions, for exam- Corporate strategy. Primary business strate-
ple, the Federal Reserve may conduct an exami- gies; institutional risk tolerance; key changes
nation of a functionally regulated subsidiary if, in strategic direction or risk profile; signifi-
after reviewing relevant reports, it reasonably cant new business activities, areas of growth
determines that the examination is necessary to and emerging areas with potential to become
adequately inform the Federal Reserve about the primary drivers of risk or revenue; and plans
systems used to monitor and control financial for expansion through mergers or acquisitions.
and operational risks within the consolidated Significant activities. Key revenue and risk
organization that may pose a direct or indirect drivers; primary business lines; product mix;
threat to the safety and soundness of a deposi- budget and internal capital allocations; market
tory institution subsidiary.5 share for revenue and customers served; key
external trends, including competitive pres-
sures; and areas that are vulnerable to volatil-
1050.1.2 UNDERSTANDING THE ity in revenue, earnings, capital, or liquidity.
ORGANIZATION Structure. Business line and legal entity struc-
ture; domestic and foreign regulatory respon-
For each large complex BHC, the Federal Reserve sibilities for legal entities and business lines;
will develop an understanding of the legal, oper- key interrelationships and dependencies
ating, and corporate governance structure of the between depository institution subsidiaries and
nonbank affiliates; material business lines op-
5. The Federal Reserve also may examine a functionally erated across multiple legal entities for account-
regulated subsidiary of a large complex BHC if, after reviewing or risk-management purposes; and the
ing relevant reports and other information, it has reasonable activities and risk profiles of Edge and agree-
cause to believe that the subsidiary is engaged in an activity
that poses a material risk to an affiliated depository institution,
ment corporation subsidiaries.
or that the subsidiary is not in compliance with any federal Corporate governance, risk management, and
law that the Federal Reserve Board has specific jurisdiction to internal controls for primary risks. Board of
enforce against the subsidiary (and the Federal Reserve can- directors (board) and executive-level commit-
not determine compliance by examining the BHC or its affili-
ated depository institutions).
tees; senior management and management
Similarly, before requiring a specialized report from a func- committees; key risk-management and inter-
tionally regulated subsidiary, the Federal Reserve first will nal control functions, and associated manage-
request that the subsidiarys appropriate functional regulator ment information systems (MIS), relied upon
obtain the report and make it available to the Federal Reserve.
In the event that the report is not obtained or made available
by the board, senior management, and senior
as requested, the Federal Reserve may, consistent with the risk managers and committees; and consis-
Bank Holding Company Act, obtain the report directly from tency of public disclosures with how the board
the functionally regulated subsidiary if the report is necessary and senior management assess and manage
to allow the Federal Reserve to adequately assess (1) a mate-
rial risk to the BHC or any of its depository institution
risks.
subsidiaries, (2) the systems used to monitor and control
financial and operational risks within the consolidated organi-
6. This understanding is formally documented during devel-
zation that may pose a threat to the safety and soundness of a
opment of the institutional overview, which coincides with
depository institution subsidiary, or (3) compliance with any
creation of the annual risk assessment. SR-97-24, Risk-
federal law that the Federal Reserve Board has specific juris-
Focused Framework for Supervision of Large Complex Insti-
diction to enforce against the BHC or a subsidiary.
tutions (see section 2124.01), describes processes for devel-
oping an institutional overview, risk assessment, and supervisory
BHC Supervision Manual January 2015 plan. Each of these products is kept current to reflect signifi-
Page 2 cant changes in an organizations risks or activities.
Presence in critical or key financial markets.7 operate the organization in a safe and sound
Core clearing and settlement activities; busi- manner, and regularly evaluating senior man-
ness lines with a significant presence in criti- agers performance;
cal or key national or global financial mar- 2. establishing, communicating, and monitoring
kets; and related risk-management and (for example, by reviewing comprehensive
disclosure practices. MIS reports produced by senior manage-
ment) institutional risk tolerances and a cor-
To ensure the quality and consistency of con- porate culture that emphasizes the impor-
solidated supervision across the large complex tance of compliance with the law and ethical
BHC portfolio, it also is necessary to understand business practices;
how these key elements compare with industry 3. approving significant strategies and policies;
trends and with evolving practices of well- 4. demonstrating leadership, expertise, and
managed organizations with similar effectiveness;
characteristics. 5. ensuring the organization has an effective
and independent internal audit function;
6. ensuring the organization has appropriate
1050.1.3 ASSESSING THE policies governing the segregation of duties
LARGE COMPLEX BHC ON A and avoiding conflicts of interest; and
CONSOLIDATED BASIS 7. ensuring that public disclosures
are consistent with how the board and
The Federal Reserve uses a systematic approach senior management assess and manage the
to develop an assessment of a BHC on a consoli- risks of the organization,
dated basis. This assessment is reflected in the balance quantitative and qualitative infor-
RFI (Risk Management, Financial Condition, mation with clear discussions about risk-
and Impact) rating assigned to a BHC.8 management processes, and
reflect evolving disclosure practices for
peer organizations.
1050.1.3.1 Risk Management
A large complex BHCs senior management
1050.1.3.1.1 Key Corporate Governance and its committees should be able to clearly
Functions communicate risk tolerances and measures, con-
trol risks, hire and retain competent staff, and
Objectives: One of the primary areas of focus
respond to changes in the organizations risk
for consolidated supervision of large complex
profile and the external environment. Members
BHCs is the adequacy of governance provided
of senior management are expected to have
by the board and senior management. The cul-
qualifications and experience commensurate with
ture, expectations, and incentives established by
the size and complexity of the organization.
the highest levels of corporate leadership set the
Primary expectations for senior management
tone for the entire organization and are essential
include
determinants of whether a banking organization
is capable of maintaining fully effective risk-
1. establishing effective oversight and an appro-
management and internal control processes.
priate risk culture;
The board and its committees should have an
2. appropriately delegating authority and over-
ongoing understanding of key inherent risks,
seeing the establishment and implementation
associated trends, primary control functions, and
of effective policies for the proper segrega-
senior management capabilities. Primary expec-
tion of duties and for the avoidance or man-
tations for the board and its committees include
agement of conflicts of interest;
3. establishing and implementing an effective
1. selecting competent senior managers, ensur-
risk-management framework capable of iden-
ing that they have the proper incentives to
tifying and controlling both current and emerg-
ing risks, and effective independent control
7. See sections 1050.1.3.1.6 and 1050.1.3.1.7 for defini-
tions of critical financial markets and key financial markets.
functions that ensure risk taking is consistent
8. The RFI rating system for BHCs is discussed in SR-04- with the organizations established risk
18, Bank Holding Company Rating System (see section appetite;
4070.0). RFI ratings are assigned for BHCs that are complex 4. establishing and implementing incentives for
or that have $1 billion or more in consolidated assets, and are
communicated via a comprehensive summary supervisory
report that supports the BHCs assigned ratings and encom- BHC Supervision Manual January 2015
passes the results of the entire supervisory cycle. Page 3
personnel that are consistent with institu- The results of continuous monitoring activi-
tional risk tolerances, compliance with the ties, as documented in the institutional over-
law, and ethical business practices; view, risk assessment, and other supervisory
5. promoting a continuous dialogue between products, may identify certain corporate gov-
and across business areas and risk- ernance functions that will require more inten-
management functions to help align the orga- sive supervisory focus due to (1) significant
nizations established risk appetite and risk changes in corporate strategy, activities, orga-
controls; nizational structure, oversight mechanisms, or
6. ensuring that the board and its committees key personnel; (2) potential concerns regard-
are provided with timely, accurate, and coming the adequacy of a specific governance
prehensive MIS reports that are adaptive to function; or (3) the absence of sufficiently
changing circumstances regarding risks and recent examination activities for a key func-
controls; and tion by the Federal Reserve or another pri-
7. ensuring timely resolution of audit, compli- mary supervisor or functional regulator.
ance, and regulatory issues. Internal audit. Continuous monitoring and
examination activities will be used to
An effective internal audit function plays an understand and assess key elements of
essential role by providing an independent and internal audit governance for the organiza-
objective evaluation of all key governance, risk- tion on a consolidated basis, including (1) the
management, and internal control processes. As adequacy and independence of the audit com-
the complexity of financial products and sup- mittee; (2) the independence, professional
porting technology has grown, in combination competence, and quality of the internal audit
with greater reliance on third-party service pro- function; (3) the quality and scope of the audit
viders, the importance of internal audits role in methodology, audit plan, and risk-
identifying risks and testing internal controls assessment process; and (4) the adequacy of
has increased. audit programs and workpaper standards. On
In addition, the extent to which supervisors at least an annual basis, the results of these
can rely on or utilize the work of internal audit supervisory activities will be reviewed to
is an essential determinant of the risk-focused determine whether there have been significant
supervisory program that is tailored to the activi- changes in the internal audit infrastructure or
ties and risks of each large complex BHC. whether there are potential concerns regard-
ing the adequacy of key elements of internal
Supervisory Activities: For each large complex audit. In addition to this periodic audit
BHC, the Federal Reserve will understand and infrastructure review, testing activities for
assess the adequacy of oversight provided by specific control functions or business lines
the board and senior management, as well as the should include an assessment of internal
adequacy of internal audit and associated MIS. audits recent work in these areas to the extent
The Federal Reserve also will understand and possible as a means of validating internal
assess other key corporate governance functions audits findings.
(e.g., corporate finance and treasury functions), Additional supervisory activities. If continu-
whose effectiveness is essential to sustaining ous monitoring activities identify a key corpo-
consolidated holding company operations, as rate governance function or element of inter-
well as the organizations business resiliency nal audit requiring more intensive supervisory
and crisis management capabilities. focus due to significant changes, potential
concerns, or the absence of sufficiently recent
Board, senior management, and other key cor- examination activities, the Federal Reserve
porate governance functions. Continuous moni- will work with other relevant primary supervi-
toring activitieswhich draw from all avail- sors or functional regulators (where applica-
able sources, including internal control ble) in developing discovery reviews or test-
functions, the work of other relevant primary ing activities focusing on the area of concern.
supervisors and functional regulators, regula- In situations where another primary supervi-
tory reports, and related surveillance results sor or functional regulator leads the examina-
will be used to understand and assess the tion activities, the Federal Reserve will par-
effectiveness of board and senior management ticipate as actively as appropriate in those
resources and oversight. activities.9
BHC Supervision Manual January 2015 9. Active participation by the Federal Reserve in an exami-
Page 4 nation led by another primary supervisor or functional regula-
If the area of concern is not within the

oversight of another primary supervisor or
functional regulator, or if the supervisor or
regulator does not conduct or coordinate the
examination activities in a reasonable period
tor includes having input into determining the examination

objectives, final conclusions, and related communications to
the organizations management. In the event that a material
aspect of the Federal Reserves input is not reflected in the
examinations objectives, conclusions, or related communica-
tions with the organization, the Federal Reserve will review
the situation to determine whether additional steps are appro-
priate to address any remaining concerns.

Page 4.1
of time, the Federal Reserve will lead the For example, for large complex BHCs with
necessary examination activities in coordina- particularly dynamic corporate strategies, the
tion with other relevant primary supervisors Federal Reserve will understand and assess the
and functional regulators to the extent possible. adequacy of the control mechanisms relevant to
Additional required audit testing activities. In such strategies, including strategic planning,
all instances, the Federal Reserve will conduct merger integration, new business approval, and
testing activities as part of its audit infrastruc- processes for ensuring that risk management
ture review (either by leading the activities and controls keep pace with areas of growing
and coordinating with other relevant primary inherent risk. Furthermore, large complex BHCs
supervisors or functional regulators or partici- operating across a range of financial intermedi-
pating as actively as appropriate in activities ary activities are more likely to face potential
led by other relevant supervisors or regula- conflicts of interest due to their greater likeli-
tors) on at least a three-year cycle to ensure hood of acting as agents for both issuers and
that the internal audit program is appropri- investors. For these holding companies, it is
ately designed and achieving its objectives. necessary to assess the adequacy of processes
for identifying and avoiding or managing con-
In all cases involving a functionally regulated flicts of interest.
subsidiary, the Federal Reserve will conduct its In all instances, the adequacy of each primary
supervisory and testing activities in accordance firmwide risk management or control mecha-
with the provisions described above in section nism depends on the appropriateness of the
1050.1.1.2. following:
1. control infrastructure and governance, includ-

1050.1.3.1.2 Risk Management and ing degree of oversight by the board and
Internal Control Functions for Primary senior management;
Risks to the Consolidated Organization 2. development, maintenance, and communica-
tion of appropriate policies, procedures, and
Objectives: Underlying the risk-focused approach internal controls;
to consolidated supervision of large complex 3. risk identification and measurement systems
BHCs is the premise that it is each organiza- and processes, and associated MIS, that are
tions responsibility to develop an appropriate adaptive to changing circumstances and
control structure for identifying, measuring, moni- capable of providing timely, accurate, and
toring, and controlling key risks as measured comprehensive information to senior man-
against supervisory standards and expectations, agement and the board;
applicable laws and regulations, and evolving 4. monitoring and testing the effectiveness of
practices of well-managed organizations. controls;
The Federal Reserve will understand and 5. processes for identifying, reporting, and esca-
assess risk-management and control functions lating issues and emerging risks;
for primary risks to the consolidated organiza- 6. ability to implement corrective actions in a
tion (primary firmwide risk-management and timely manner;
control functions), and associated MIS, for each 7. appropriate authority and independence of
large complex BHC. This will include risk- staff to carry out responsibilities; and
management and control functions for primary 8. integration of risk-management and control
credit, legal and compliance,10 liquidity, market, objectives within management goals and the
operational, and reputational risks for the con- organizations compensation structure.
solidated organization. The Federal Reserve also
will understand and assess other risk- Most large complex BHCs have evolved toward
management and control functions that, based comprehensive, consolidated risk management
on the specific characteristics and activities of to measure and assess the range of their expo-
the individual BHC, relate to primary risks to sures and the way these exposures interrelate.
the organization as a whole. Nonetheless, a variety of control structures are
in place across this portfolio, and in some instances
10. Federal Reserve processes for understanding and assess- there is not a firmwide mechanism in place to
ing legal and compliance risk management apply to the oversee and manage a key control function
domestic and international operations of large complex BHCs across the organizations business lines and
and, as described in SR-03-22/CA-03-15, Framework for
Assessing Consumer Compliance Risk at Bank Holding Com-
panies, (see section 2124.01) encompass consumer compli- BHC Supervision Manual January 2009
ance risk inherent in the organizations business activities. Page 5
legal entities. nificant changes in inherent risk, control pro-

In all instances, the Federal Reserve will cesses, or key personnel; (2) potential concerns
focus on individual control structures in place regarding the adequacy of controls; or (3) the
for primary business lines or legal entities as absence of sufficiently recent examination activi-
needed to reach an understanding and assess- ties for a primary firmwide risk-management or
ment of the consolidated organization. When control function by the Federal Reserve or another
applicable, the Federal Reserve also will assess relevant primary supervisor or functional
whether a decentralized approach to a key con- regulator.
trol function is sufficient by evaluating the effec- In these instances, the Federal Reserve will
tiveness of such an approach in controlling pri- work with other relevant primary supervisors or
mary risks to the consolidated organization.11 functional regulators (where applicable) to
develop discovery reviews or testing activities
Supervisory Activities: The Federal Reserve will focusing on the area of concern. In situations
use continuous monitoring activities to under- where another primary supervisor or functional
stand and assess each primary firmwide risk- regulator leads the examination activities, the
management or control function. This process Federal Reserve will participate as actively as
begins with the overarching design and architec- appropriate in those activities.
ture of each primary firmwide risk-management If the primary firmwide risk-management or
or control function, and drills down, as appropri- control function is not within the oversight of
ate, through analysis of risk management and another primary supervisor or functional regula-
controls for material portfolio areas and busi- tor, or if the primary supervisor or functional
ness lines (described in section 1050.1.3.1.3 regulator does not conduct or coordinate the
below). Activities will verify the sufficiency of examination activities in a reasonable period of
fundamental aspects of internal controls in rela- time, the Federal Reserve will lead the neces-
tion to the holding companys current risk pro- sary examination activities in coordination with
file and in comparison with supervisory expecta- other relevant supervisors and regulators to the
tions and evolving sound practices and assess extent possible. In all cases involving a func-
the capability of these primary functions (whether tionally regulated subsidiary, the Federal Reserve
centralized or decentralized) to remain effective will conduct its supervisory and testing activi-
in the face of growth, changing strategic direc- ties in accordance with the provisions described
tion, significant market developments, and other above in section 1050.1.1.2.
internal or external factors.
The results of continuous monitoring activi-
ties, as documented in the institutional over- 1050.1.3.1.3 Risk Management of
view, risk assessment, and other supervisory Material Portfolios and Business Lines
products, may identify certain primary firmwide
risk-management or control functions that require Objectives: For each large complex BHC, there
more intensive supervisory focus due to (1) sig- are selected portfolio risk areas (such as retail or
wholesale credit risk) or individual business
11. As outlined in SR-08-8/CA-08-11, Compliance Risk- lines (such as mortgage lending or leveraged
Management Programs and Oversight at Large Banking Orga- lending) that are primary drivers of risk or rev-
nizations with Complex Compliance Profiles (see section
2124.07), while the Federal Reserve does not prescribe a
enue, or that otherwise materially contribute to
particular organizational structure for primary firmwide risk- understanding inherent risk or assessing con-
management and control functions, establishment of a firm- trols for a broader corporate function (such as
wide function that is dedicated to managing and overseeing consolidated credit-risk management).
compliance risk, and that promotes a strong compliance cul-
ture, is particularly important for large banking organizations
During the development of the institutional
with complex compliance profiles, due to the unique chal- overview and risk assessment, as well as during
lenges associated with compliance risk management for these other supervisory processes, the Federal Reserve
organizations. In addition to the oversight provided by the will analyze external factors and internal trends
board and various executive and management committees, a
key component of firmwide compliance oversight for these
in the BHCs strategic initiativesas evidenced
organizations is a corporate compliance function that has by budget and internal capital allocations and
day-to-day responsibility for overseeing and supporting the other factorsto identify significant activities
implementation of the organizations firmwide compliance and areas vulnerable to volatility in revenue,
risk-management program, and that plays a key role in con-
trolling compliance risks that transcend business lines, legal
earnings, capital, or liquidity that represent mate-
entities, and jurisdictions of operation. rial risks of the organization. This determination
of material portfolios and business lines consid-
BHC Supervision Manual January 2009 ers all associated risk elements, including legal
Page 6 and compliance risks. For example, when evalu-
ating whether retail activities such as mortgage focus will be on identifying and understanding
or credit card lending are material to a banking those business lines that are increasing in impor-
organization, the extent of inherent consumer tance and have the potential to become material.
compliance and reputational risks, as well as
credit and market risks, should be considered. Supervisory Activities: When a primary supervi-
sor or functional regulator has a sufficient view
Supervisory Activities: Because an understand- of nonmaterial business lines, the Federal Reserve
ing of material risks and activities is needed to will, to the fullest extent possible, use informa-
assess the primary firmwide risk-management tion developed by that supervisor or regulator to
and control functions (as discussed in preceding monitor areas of increasing importance with the
section 1050.1.3.1.2), the Federal Reserve will potential to become material. The Federal Reserve
maintain an understanding of inherent risk and also will maintain an ability to access internal
assess the adequacy of risk-management and MIS for these businesses to facilitate a more
internal controls for material portfolios and busi- in-depth analysis of a business line, if appropri-
ness lines. To form this understanding and assess- ate, to understand its growing importance to the
ment, the Federal Reserve will rely primarily on organization.
continuous monitoring activities, supplemented For nonmaterial business lines that are not
as appropriate by examination activities. subject to oversight by a single primary supervi-
To the fullest extent possible, the Federal sor or functional regulator, the Federal Reserve
Reserve will draw its understanding and assess- will engage in continuous monitoring activities
ment of these risks and risk-management prac- to identify meaningful trends in risks and risk-
tices from the information and assessments of a management practices, initiate discovery reviews
primary supervisor or functional regulator where (in coordination with relevant primary supervi-
the BHCs legal and operating structure pro- sors or functional regulators as appropriate and
vides the supervisor or regulator a sufficient in accordance with section 1050.1.1.2 above if
view of these areas. In these instances, the Fed- relevant) to increase understanding of selected
eral Reserve will undertake continuous monitor- business lines that have the potential to become
ing and participate in activities led by primary material, and maintain an understanding of asso-
supervisors and functional regulators as neces- ciated MIS to facilitate more in-depth analysis
sary to maintain an understanding and assess- of a business line, if appropriate, to understand
ment of related firmwide risk-management and its growing importance to the organization.
control functions.
Many activities of large complex BHCs span
legal entities that are subject to oversight by 1050.1.3.1.5 Core Clearing and
multiple supervisors or regulators or that are Settlement Activities (Where Applicable)
outside the oversight of other supervisors or
regulators. If this is the case, or if the primary Objectives: The Federal Reserve will under-
supervisor or functional regulator does not con- stand and assess the adequacy of risk-
duct or coordinate the necessary continuous management and internal controlsincluding
monitoring or examination activities in a reason- credit risk-management practicesrelated to core
able period of time, the Federal Reserve will clearing and settlement organizations.12 In light
initiate and lead these activities in coordination
with other relevant primary supervisors and 12. Core clearing and settlement organizations, as defined
functional regulators to the extent possible. In in the Interagency Paper on Sound Practices to Strengthen
all cases involving a functionally regulated sub- the Resilience of the U.S. Financial System (interagency sound
sidiary, the Federal Reserve will conduct its practices paper, see SR-03-9), consist of two groups of organi-
zations that provide clearing and settlement services for criti-
supervisory and testing activities in accordance cal financial markets or act as large-value payment system
with the provisions described above in section operators, and that present the potential for systemic risk
1050.1.1.2. should they be unable to perform. These organizations are
(1) market utilities (government-sponsored services or industry-
owned organizations) whose primary purpose is to clear and
settle transactions for critical markets (see section 1050.1.3.1.6)
1050.1.3.1.4 Risk Management of or transfer large-value wholesale payments, and (2) private-
Nonmaterial Business Lines sector firms that provide clearing and settlement services that
are integral to a critical market (i.e., their aggregate market
share is significant enough to present the potential for sys-
Objectives: For nonmaterial business lines iden- temic risk in the event of their sudden failure to carry out
tified during the development of the institutional
overview and risk assessment, as well as during BHC Supervision Manual January 2009
other supervisory processes, the Federal Reserves Page 7
of the potential for problems in these areas to participating as actively as appropriate in

transmit an adverse impact across the banking activities led by other relevant supervisors or
and financial system, and given the Federal regulators) on at least a three-year cycle to
Reserves unique expertise and perspective with ensure that these control mechanisms are
respect to these activities, the Federal Reserve appropriately designed and achieving their
focuses special supervisory attention on the risk- objectives. In addition to assessing the adequacy
management and internal control practices and of risk-management and internal controls, test-
the public disclosures made by an organization ing activities will focus on assessing the
with respect to these activities. contribution of the organization to the resilience
or fragility of the clearance and settlement
Supervisory Activities: Continuous monitoring system as a whole, and on the organizations
and examination activities will be used to main- adherence to the expectations of the interagency
tain an understanding of inherent risk and assess sound practices paper. Key expectations include
risk-management and internal controls, includ- geographic diversity and resiliency of data
ing related credit risk-management practices. centers and operations, testing of recovery and
On at least an annual basis, the results of these resumption arrangements, and identification of
supervisory activities will be reviewed to deter- downstream implications of failure of a major
mine whether there is (1) a significant change in counterparty or clearing organization.
inherent risk for core clearing and settlement In all cases involving a functionally regulated
activities stemming from changing strategies or subsidiary, the Federal Reserve will conduct its
activities; (2) a significant change in organiza- activities in accordance with the provisions
tional structure, oversight mechanisms, key per- described above in section 1050.1.1.2.
sonnel, or other key elements of related risk-
management or internal controls; or (3) any
potential concern regarding the adequacy of 1050.1.3.1.6 Significant Presence in
related risk-management or internal controls. Critical Financial Markets (Where
If significant changes or potential concerns Applicable)
are identified, the Federal Reserve will work
with other relevant primary supervisors or func- Objectives: The Federal Reserve will under-
tional regulators (where applicable) to design stand and assess the adequacy of risk manage-
testing activities focused on understanding and ment and controls for LCBO business lines with
assessing areas of change and/or concern, as a significant presence in critical financial mar-
well as ensure that risk-management and control kets.
functions are appropriately designed and achiev- Critical financial markets are defined in
ing their intended objectives. In situations where the interagency sound practices paper as the
another primary supervisor or functional regula- markets for federal funds, foreign exchange, and
tor leads the discovery review or testing activi- commercial paper; U.S. government and agency
ties, the Federal Reserve will participate as securities; and corporate debt and equity securi-
actively as appropriate in those activities. ties. A business line may have a significant
If the area of change and/or concern is not presence in a critical financial market even
within the oversight of another primary supervi- though the business line accounts for a rela-
sor or functional regulator, or if the primary tively small portion of the organizations total
supervisor or functional regulator does not con- consolidated assets or revenues. These business
duct or coordinate the examination activities in lines are subject to special supervisory focus by
a reasonable period of time, the Federal Reserve the Federal Reserve in light of their potential to
will lead the examination activities in coordina- transmit a collective adverse impact across mul-
tion with other relevant primary supervisors and tiple firms and financial markets and the result-
functional regulators to the extent possible. ing significant reputational and other risks they
In all instances, the Federal Reserve will pose to the organization.
conduct testing activities (either by leading the
activities and coordinating with other relevant Supervisory Activities: Continuous monitoring
primary supervisors or functional regulators, or and examination activities will be used to under-
stand inherent risk and assess risk-management
those activities because there are no viable immediate
and internal controls for business lines with a
substitutes). significant presence in a critical financial mar-
ket. On at least an annual basis, the results of
BHC Supervision Manual January 2009 these supervisory activities will be reviewed to
Page 8 determine whether there is (1) a significant
change in inherent risk stemming from changing market.13 For each key financial market activ-
strategies or activities; (2) a significant change ity where the large complex BHC is a
in organizational structure, oversight mecha- significant participant, the Federal Reserve will
nisms, key personnel, or other key elements of maintain an understanding of inherent risk,
related risk-management or internal controls; or assess the adequacy of related risk-
(3) any potential concern regarding the adequacy management and internal controls (including the
of related risk-management or internal controls. sufficiency of business continuity planning), and
If significant changes or potential concerns understand the organizations potential impact
are identified in these business lines, the Fed- on the overall functioning of the market.
eral Reserve will work with other relevant
primary supervisors or functional regulators Supervisory Activities: Continuous monitoring
(where applicable) to design testing activities and examination activities will be used to under-
focused on understanding and assessing areas of stand inherent risk for key financial market
change and/or concern, as well as ensure that activities and assess related risk-management
risk-management and control functions are and internal controls.
appropriately designed and achieving their To the fullest extent possible, the Federal
intended objectives. In situations where another Reserve will draw its understanding and assess-
primary supervisor or functional regulator leads ment of these risks and risk-management prac-
the testing activities, the Federal Reserve will tices from the information and assessments of a
participate as actively as appropriate in those primary supervisor or functional regulator where
activities. the BHCs legal and operating structure pro-
If the area of change and/or concern is not vides the supervisor or regulator a sufficient
within the oversight of another primary supervi- view of these areas. In these instances, the Fed-
sor or functional regulator, or if the primary eral Reserve will undertake continuous monitor-
supervisor or functional regulator does not con- ing and participate in activities led by primary
duct or coordinate the examination activities in supervisors and functional regulators as neces-
a reasonable period of time, the Federal Reserve sary to maintain an understanding and assess-
will lead the testing activities and will coordi- ment of risk-management and control functions
nate these activities with other relevant primary for key financial market activities.
supervisors and functional regulators to the extent For activities that span legal entities subject
possible. to oversight by multiple supervisors or regula-
In all instances, the Federal Reserve will con- tors, or that are outside the oversight of other
duct testing activities (either by leading the supervisors or regulators, the Federal Reserve
activities and coordinating with other relevant will develop and conductin coordination with
primary supervisors or functional regulators, or other relevant primary supervisors and func-
participating as actively as appropriate in activi- tional regulators to the extent possible and in
ties led by other relevant supervisors or regula- accordance with the provisions described above
tors) on at least a three-year cycle. These activi- in section 1050.1.1.2 if relevanttesting and
ties will focus on the organizations adherence discovery review activities as necessary to
to the expectations set forth in the interagency complement continuous monitoring work.
sound practices paper, including geographic
diversity and resiliency of data centers and
operations, and testing of recovery and resump- 1050.1.3.1.8 Issues and Developments in
tion arrangements. Areas of Emerging Interest with Potential
In all cases involving a functionally regulated Financial Market Consequences
subsidiary, the Federal Reserve will conduct its
activities in accordance with the provisions Objectives: The Federal Reserve will use infor-
described above in section 1050.1.1.2. mation obtained in the course of supervising
LCBOs, as well as information and analysis
1050.1.3.1.7 Risk Management of 13. Key financial markets include the critical financial
Activities in Key Financial Markets markets defined in section 1050.1.3.1.6 above as well as
(1) broader U.S. capital market activity, including underwrit-
ing, securitization, derivatives, and trading; (2) retail financial
Objectives: To be designated as an LCBO by services; and (3) international financial markets. Each LCBO
the Federal Reserve, a banking organization meets at least one of these key market thresholds.
must meet specified criteria as a significant
participant in at least one key financial BHC Supervision Manual January 2009
Page 9
obtained through relationships with other domes- obtained from other Federal Reserve functions,
tic and foreign supervisors and regulators or such as monetary policy and payments activi-
other sources, to ties, to help mitigate the likelihood or
consequences of a financial crisis and to help
1. identify potential vulnerabilities across the develop sound policy responses to market
portfolio of LCBOs and their nonbank developments. Periodic examination activities
peerssuch as the operational infrastructure also may be used to review a specific activity or
that underpins the credit derivatives risk-management practice across a group of peer
marketthat have the potential to affect bank- organizations to obtain a more complete
ing organizations generally, financial stabil- understanding of industry practice.14
ity, systemic risk, or domestic or global finan- These activities will be designed and con-
cial markets; ducted in coordination with other relevant pri-
2. identify areas of supervisory focussuch as mary supervisors and functional regulators to
counterparty credit risk-management the fullest extent possible and in accordance
practicesto further the Federal Reserves with the provisions described above in section
understanding of markets, their linkages with 1050.1.1.2, where relevant. Coordination oppor-
banking organizations, and potential implica- tunities, however, may be limited in special
tions for financial stability; circumstances, such as when addressing urgent
3. understand the activities of nonbank counter- matters with potentially adverse financial mar-
parties of LCBOs and the implications of ket consequences, due to the inherent time con-
such activities on the risks, risk management, straints when information must be gathered
and internal controls of banking organiza- quickly.
tions; and
4. enhance the Federal Reserves ability to act
effectively during periods of financial stress 1050.1.3.2 Financial Condition
by combining timely and reliable informa-
tion on conditions in the banking system and Objectives: The Federal Reserves evaluation of
capital markets that is obtained through its a large complex BHCs consolidated financial
supervisory activities with information condition focuses on the ability of the organiza-
obtained through the Federal Reserves mone- tions resources to support the level of risk
tary policy and payments activities. associated with its activities. Assessments are
developed for each CAEL subcomponent
Supervisory Activities: During each supervisory Capital Adequacy (C), Asset Quality (A), Earn-
planning cycle, and more frequently as required, ings (E), and Liquidity (L).15
continuous monitoring opportunities will be iden- In developing this evaluation, the Federal
tified that utilize information gained through Reserves primary focus is on developing an
LCBO supervision to further the Federal understanding and assessment of
Reserves understanding of risks and activities
that could adversely affect LCBOs or the stabil- 1. the sufficiency of the BHCs consolidated
ity of domestic or global financial markets. capital to support the level of risk associated
Activities will include meetings with chief risk with the organizations activities and provide
officers, chief financial officers, and other LCBO a sufficient cushion to absorb unanticipated
senior management, as well as collaboration losses;
with other domestic and foreign supervisors and 2. the capability of liquidity levels and funds-
regulators and foreign central banks. management practices to allow reliable access
These activities also will be used to review to sufficient funds to meet present and future
areas of specific supervisory interest; answer ad liquidity needs; and
hoc information requests related to areas of 3. other aspects of financial strength that need
emerging interest or concern; help in to be assessed on a consolidated basis across
understanding the contribution of the entity to the organizations various legal entities, or
the resilience or fragility of key markets as a that relate to the financial soundness of the
whole; and provide insights into interdependen- parent company and significant nonbank sub-
cies across firms, markets, and the real econ-
omy. During periods of financial stress, this 14. In order to minimize burden while obtaining informa-
information will be combined with knowledge tion necessary to understand market developments, these
activities will focus on those organizations that are most
active in the area of interest or concern.
BHC Supervision Manual January 2009 15. See SR-04-18 and section 4070.0.2.3.1 for more infor-
Page 10 mation about the CAEL subcomponents.
sidiaries, as discussed in section 1050.1.3.3 correlated market conditions for the organi-
below. zation and/or across financial markets; and
3. the sufficiency of liquidity planning tools,
In assessing consolidated regulatory capital, such as stress testing, scenario analysis, and
the Federal Reserve looks to ensure that the contingency planning efforts, including
BHC demonstrates the effectiveness of its (1) whether liquidity bufferscomprised of
framework for complying with relevant capital unencumbered liquid assets as well as access
adequacy guidelines and meeting supervisory to stable funding sourcesadequately reflect
expectations, and focuses on analyzing key the possibility and duration of severe liquid-
models and processes7 that influence this ity shocks; (2) the reasonableness of assump-
assessment. This assessment utilizes results tions about the stability of secured funding in
from examinations led by the Federal Reserve circumstances in which the liquidity of
or other primary supervisors or functional markets for the underlying collateral
regulators, as well as information gained from becomes impaired; and (3) whether these
the BHCs internal control functions and from efforts adequately reflect the potential for the
market-based assessments. organization to be called on in stressed
Capital planning activities for large complex environments to provide contingent liquid-
BHCs should be forward looking and provide ity support to off-balance-sheet entities or
for a sufficient range of stress scenarios com- bring additional assets on the balance sheet
mensurate with the organizations activities. (even if not legally or contractually obligated
Many LCBOs require more rigorous and to do so).
structured internal processes for assessing
capital adequacy beyond regulatory capital Beyond capital adequacy and liquidity, the
measures, as these measures often do not nature of independent Federal Reserve supervi-
adequately capture the full spectrum of risk- sory work required to evaluate a large complex
taking activities for these organizations.8 For BHCs consolidated financial condition depends
these organizations, the Federal Reserve focuses largely on the extent to which other relevant
on whether internal processes for assessing primary supervisors or functional regulators have
capital adequacy ensure that all risks are information or assessments upon which the Fed-
properly identified, reliably quantified (where eral Reserve can draw. For example, more inde-
possible) across the entire organization, and pendent Federal Reserve work typically will be
supported by adequate capital. required to assess consolidated asset quality or
When assessing the adequacy of a BHCs earnings for large complex BHCs with signifi-
liquidity levels and funds management prac- cant nonbank activities that are not functionally
tices, areas of focus include9 regulated. However, where all material holding
company assets are concentrated in a single
1. the extent to which the treasury function is depository institution subsidiary, a minimal level
aligned with risk-management processes, and of incremental Federal Reserve efforts typically
whether incentives are in place for business will be required to assess consolidated asset
lines to compile and provide information on quality and earnings.
expected liquidity needs and contingency
funding plans so that the treasury function is Supervisory Activities: The Federal Reserve will
able to develop a firmwide perspective and primarily utilize continuous monitoring activi-
incorporate business-line information into ties to assess a large complex BHCs financial
assessments of actual and contingent liquid- strength. Such activities will include periodic
ity risk; meetings with BHC management (such as the
2. whether funds management practices pro- chief financial officer); review of regulatory
vide sufficient funding flexibility to respond reports, surveillance screens, and internal MIS;
to unanticipated, evolving, and potentially and analysis of market indicators, including
external debt ratings, subordinated debt spreads,
and credit default swap spreads. Testing and
16. Key models and processes are those where evalua-
tion of the model/process will influence the Federal Reserves
discovery activities will be used as necessary to
assessment of the activity or control area that is supported by assist in the understanding and assessment of
the model/process. areas of concern.
17. Footnote reserved.
18. Assessing liquidity levels and funding practices for a
consolidated BHC also incorporates elements presented in
section 1050.1.3.3.2, Parent company and nonbank funding BHC Supervision Manual January 2016
and liquidity. Page 11
Testing and discovery activities also will be tory institution; a depository institution provid-
used to understand and assess the sufficiency of ing funding for nonbank affiliates; and risk-
the BHCs consolidated capital and liquidity management or internal control functions being
positions to support the level of risk associated shared between depository and nonbank
with its activities, including (1) regulatory operations.
capital calculation methodologies10 and internal Due to these interrelationships, financial,
assessments of capital adequacy and (2) funds legal, compliance, or reputational troubles in
management and liquidity planning tools and one part of a BHC can spread rapidly to other
practices. The Federal Reserve will work with parts of the organization. Even absent these
other relevant primary supervisors and interactions, the parent or nonbank subsidiaries
functional regulators to participate as actively as of an organization may present financial, legal,
appropriate in or, if necessary, to coordinate compliance, or reputational risk to the consoli-
activities designed to analyze key capital and dated entity, and thus directly or indirectly to its
liquidity models or processes of a depository depository institution subsidiaries. As the fed-
institution or functionally regulated subsidiary eral banking agency charged with supervising
that are of such significance that they will influ- the organization on a consolidated basis, the
ence the Federal Reserves assessment of these Federal Reserve is responsible for understand-
areas. In all cases involving a functionally ing and assessing the risks that the parent bank
regulated subsidiary, the Federal Reserve will holding company and its nonbank subsidiaries
conduct its activities in accordance with the may pose to the BHC itself or its depository
provisions described above in section institution subsidiaries.
1050.1.1.2. The primary objectives of Federal Reserve
supervision of the nonbank subsidiaries of a
bank holding company are to
1050.1.3.3 Impact
1. identify significant nonbank activities and
1050.1.3.3.1 Risk Management and riskswhere the parent company or non-
Financial Condition of Significant bank subsidiaries engage in risk-taking activi-
Nonbank Subsidiaries ties or hold exposures that are material to the
risk management or financial condition of
Objectives: Most large complex BHCs engage
the consolidated organization or a depository
in activities and manage control functions on a
institution subsidiaryby developing an
firmwide basis, spanning depository institution
understanding of the size and nature of pri-
and nonbank legal entities. These BHCs often
mary activities and key trends, and the extent
have considerable intra-group exposures and
to which business lines, risks, or control
servicing arrangements across affiliates, present-
functions are shared with or may impact a
ing increased potential risks for depository insti-
depository institution affiliate;
tution subsidiaries and a higher likelihood of
2. evaluate the financial condition and the
aggregate risk concentrations across the organi-
adequacy of risk-management practices of
zations legal entities. Common interactions
the parent and significant nonbank subsidi-
between a large complex BHCs depository
aries, including the ability of nonbank sub-
institution subsidiaries and their nonbank affili-
sidiaries to repay advances provided by the
ates (including the parent company) include
parent, using benchmarks and analysis appro-
assets originating in, or being marketed by, a
priate for those businesses;
nonbank affiliate that are booked in the deposi-
3. evaluate the degree to which nonbank entity
risks may present a threat to the safety and
19. Assessments of the adequacy of regulatory capital for soundness of subsidiary depository institu-
large complex BHCs that have received Federal Reserve tions, including through transmission of legal,
supervisory approval to use internal estimates of risk in their compliance, or reputational risks;
regulatory capital calculations should include, among other
things, regular verification that these organizations continue
4. identify and assess any intercompany rela-
to meet on an ongoing basis all applicable requirements tionships, dependencies, or exposuresor
associated with internal estimates. See, for example, the capi- aggregate firmwide concentrationswith the
tal adequacy guidelines for market risk at BHCs (Regulation potential to threaten the condition of a deposi-
Y: 12 C.F.R. 225, Appendix E) and the new advanced capital
adequacy framework for BHCs (Regulation Y: 12 C.F.R. 225,
tory institution affiliate; and
Appendix G). 5. evaluate the effectiveness of the policies,
procedures, and systems that the holding
BHC Supervision Manual January 2016 company and its nonbank subsidiaries use to
Page 12 ensure compliance with applicable laws and
regulations, including consumer protection supervisor) whether compliance issues are

laws.20 present; and
8. understand and assess the sufficiency, relia-
Supervisory Activities: For all significant non- bility, and timeliness of associated MIS relied
bank subsidiaries and activities of the parent upon by the board, senior management, and
BHC, the Federal Reserve will use continuous senior risk managers and committees to moni-
monitoring activities and discovery reviews to tor key nonbank activities and risks.
1. maintain an understanding of the holding Periodic testing may be used to supplement

companys business line and legal entity continuous monitoring and discovery reviews to
structure, including key interrelationships and (1) ensure that key risk-management and
dependencies between depository institution internal control practices conform to internal
subsidiaries and nonbank affiliates, utilizing policies and/or are designed to ensure compli-
regulatory structure reports, internal MIS, ance with the law and (2) understand and assess
and other information sources; operations presenting a moderate or greater
2. understand and assess the exposure to, and likelihood of significant negative impact to a
tolerance for, legal, compliance, and reputa- subsidiary depository institution or the consoli-
tional risks, as well as the extent to which dated organization. Areas of potential negative
potential conflicts of interest are identified impact include financial or operational risks that
and avoided or managed; pose a potential threat to the safety and sound-
3. understand the scope of intercompany trans- ness of a depository institution subsidiary, or to
actions and aggregate concentrations, and the holding companys ability to serve as a
assess the adequacy of risk-management pro- source of financial and managerial strength to
cesses, accounting policies, and operating its depository institution subsidiaries. Testing
procedures to measure and manage related will focus on controls for identifying, monitor-
risks; ing, and controlling such risks. In all cases
4. identify and assess key interrelationships and involving a functionally regulated subsidiary,
dependencies between subsidiary depository the Federal Reserve will conduct its activities in
institutions and nonbank affiliates, such as accordance with the provisions described above
the extent to which a depository institution in section 1050.1.1.2.
subsidiary is reliant on services provided by
the parent company or other nonbank affili-
ates and the reasonableness of associated 1050.1.3.3.2 Parent Company and
management fees; Nonbank Funding and Liquidity
5. identify those nonbank subsidiaries whose
activities present material financial, legal, Objectives: One of the Federal Reserves pri-
compliance, or reputational risk to the con- mary responsibilities as consolidated supervisor
solidated entity and/or a depository institu- is to help ensure that the parent company and its
tion subsidiary; nonbank subsidiaries do not have an adverse
6. identify significant businesses operated impact on the organizations depository institu-
across multiple legal entities for account- tion subsidiaries. To meet this objective, the
ing, risk management, or other purposes, as Federal Reserve will assess the extent to which
well as activities that functionally operate as funding and liquidity policies and practices of
separate business units for legal or other the parent company or nonbank subsidiaries
reasons; may undermine the BHCs ability to act as a
7. identify intercompany transactions subject to source of strength to the organizations deposi-
Regulation Wutilizing information submit- tory institution subsidiaries.
ted on quarterly regulatory reporting form Areas of focus will include an assessment of
FR Y-8 (The Bank Holding Company Report
of Insured Depository Institutions Section 1. the ability of the parent company and non-
23A Transactions with Affiliates), internal bank subsidiaries to maintain sufficient liquid-
MIS, and other information sourcesand ity, cash flow, and capital strength to service
determine (in conjunction with the primary their debt obligations and cover fixed charges;
2. the likelihood that parent company or non-
20. The Federal Reserves supervisory objectives and bank funding strategies could undermine pub-
activities related to the effectiveness of consumer compliance
policies, procedures, and systems at nonbank subsidiaries of a
BHC currently are under review, and additional or modified BHC Supervision Manual January 2009
guidance on this topic may be issued in the future. Page 13
lic confidence in the liquidity or stability of basis, the results of these supervisory activities
subsidiary depository institutions; will be reviewed to determine whether there is
3. policies and practices that are aimed at ensur- (1) a significant change in inherent funding or
ing the stability of parent company funding liquidity risk stemming from changing strate-
and liquidity, as evidenced by the utilization gies or activities; (2) a significant change in
of long-term or permanent financing to sup- organizational structure, oversight mechanisms,
port capital investments in subsidiaries and key personnel, or other key elements of related
other long-term assets, and the degree of risk-management or internal controls; or (3) any
dependence on short-term funding mecha- potential concern regarding the adequacy of
nisms such as commercial paper; related risk-management or internal controls.
4. the extent of double leverage21 and the If significant changes or potential concerns
organizations capital-management policies, are identified, the Federal Reserve will design
including the distribution and transferability and conduct testing activities focused on under-
of capital across jurisdictions and legal entities; standing and assessing the areas of change and/or
5. the parent companys ability to provide finan- concern in order to ensure that funding and
cial and managerial support to its depository liquidity risk-management and control functions
institution subsidiaries during periods of finan- are appropriately designed and achieving their
cial stress or adversity, including the suffi- intended objectives.
ciency of related stress testing, scenario analy- In all instances the Federal Reserve will under-
sis, and contingency planning efforts; and take testing activities on at least a three-year
6. intraday liquidity management policies and cycle, assessing the individual elements of risk
practices, and compliance with the Federal management for parent company and nonbank
Reserve Policy on Payments System Risk,22 funding and liquidity: board and senior manage-
including expectations for depository institu- ment oversight; policies, procedures, and limits;
tions with a self-assessed net debit cap (the risk-monitoring and management information
maximum dollar amount of uncollateralized systems; and related internal controls.
daylight overdrafts that the institution may For large complex BHCs with a depository
incur in its Federal Reserve account). institution that has a self-assessed net debit cap,
the Federal Reserve will conduct an annual
The Federal Reserve also will remain apprised review of the self-assessment file to ensure that
of the funding profile and market access of the institution has appropriately applied the pay-
material depository institution subsidiaries, as in ment system risk guidelines. The Federal Reserve
most instances these entities represent the con- will either lead this review and coordinate its
solidated BHCs primary and most active vehi- activities with other relevant primary supervi-
cles for external funding and liquidity manage- sors or participate as actively as appropriate in
ment. The primary supervisor retains the related work of such supervisors. In all cases
responsibility for assessing liquidity risk- involving a functionally regulated subsidiary,
management practices with respect to the deposi- the Federal Reserve will conduct its activities in
tory institution subsidiary. accordance with the provisions described above
in section 1050.1.1.2.
Supervisory Activities: The Federal Reserve will
use continuous monitoring activitiesincluding
monitoring market conditions and indicators 1050.1.4 INTERAGENCY
where availableand discovery reviews to COORDINATION
understand and assess parent company and non-
bank subsidiary funding and liquidity policies 1050.1.4.1 Coordination and Information
and practices, as well as any potential negative Sharing Among Domestic Primary Bank
impact these policies and practices might have Supervisors and Functional Regulators
on a subsidiary depository institution or the
Objective: Effective consolidated supervision
consolidated organization. On at least an annual
requires strong, cooperative relationships between
the Federal Reserve and other relevant domestic
21. Double leverage refers to situations in which debt is
issued by the parent company and the proceeds are invested in
primary bank supervisors and functional regula-
subsidiaries as equity. tors.23 To achieve this objective, the Federal
22. This policy statement is available on the Boards pub- Reserve has worked over the years to enhance
lic website at www.federalreserve.gov/paymentsystems/psr.
BHC Supervision Manual January 2009 23. Section 1050.1.4.2 discusses cross-border cooperation
Page 14 and information sharing among foreign supervisors.
interagency coordination through the develop- The Federal Reserve also will continue to use
ment and use of information-sharing protocols a variety of formal and informal channels to
and mechanisms. These protocols and mecha- facilitate interagency information sharing and
nisms respect the individual statutory authorities coordination consistent with the principles out-
and responsibilities of the respective supervisors lined above, including
and regulators, provide for appropriate informa-
tion flows and coordination to limit unnecessary supervisory protocols, agreements, and MOUs
duplication or burden, comply with restrictions with primary supervisors and functional regu-
governing access to information, and ensure that lators that allow the coordination of supervi-
the confidentiality of information is maintained. sory activities and that permit the ongoing
For example, the Federal Reserve and the U.S. exchange of information, including confiden-
Securities and Exchange Commission entered tial information on a confidential basis;
into a memorandum of understanding (MOU) in bilateral exchanges of letters to facilitate infor-
July 2008 that, among other things, provides for mation sharing on a situation-specific basis;
the parties to share specific types of information periodic and as-needed contacts with primary
concerning entities under the parties respective supervisors and functional regulators to dis-
supervision as well as information on other cuss and coordinate matters of common inter-
areas of mutual regulatory or supervisory interest. est, including the planning and conduct of
As discussed in section 1050.1.3, in under- examinations and continuous monitoring
standing and assessing the activities and risks of activities;
the organization as a whole, the Federal Reserve the use of information technology platforms,
will rely to the fullest extent possible on the such as the Banking Organization National
examination and other supervisory work con- Desktop (BOND),25 to provide secure auto-
ducted by the domestic primary bank supervi- mated access to examination/inspection reports
sors and functional regulators of a BHCs sub- and other supervisory information prepared
sidiaries. In addition, the Federal Reserve will by the Federal Reserve and other relevant
seek to coordinate its supervisory activities with supervisors and regulators; and
relevant supervisors and regulators and will participation in a variety of interagency forums
work to align each agencys assessment of key that facilitate the discussion of broad industry
corporate governance functions, risk- issues and supervisory strategies, including
management and internal control functions for the Federal Financial Institutions Examination
primary risks, financial condition, and other Council, the Presidents Working Group on
areas of the consolidated BHCs operations as Financial Markets, and the Federal Reserve-
applicable. sponsored cross-sector meetings of financial
supervisors and regulators.
Supervisory Activities. The Federal Reserve will
continue to work with the relevant primary
supervisors and functional regulators of a large 1050.1.4.1.1 Coordination of
complex BHCs subsidiaries to ensure that the Examination Activities at a Supervised
necessary information flows and coordination BHC Subsidiary
mechanisms exist to permit the effective super-
vision of the BHC on a consolidated basis. The As discussed in section 1050.1.3, the Federal
Federal Reserve will continue to share informa- Reserve will seek to work cooperatively with
tion, including confidential supervisory informa- the relevant primary supervisor or functional
tion, obtained or developed through its consoli- regulator to address information gaps or indica-
dated supervisory activities with other relevant tions of weakness or risk identified in a super-
primary supervisors or functional regulators when vised BHC subsidiary that are material to the
appropriate and permitted by applicable laws Federal Reserves understanding or assessment
and regulations.24 of the consolidated organizations risks, activi-
25. BOND is a Federal Reserve information technology

24. Among the federal laws that may limit the sharing of
platform providing secure interagency access to documents,
information among supervisors are the Right to Financial
supervisory and financial data, and other information utilized
Privacy Act (12 U.S.C. 3401 et seq.) and the Trade Secrets
in the consolidated supervision of individual BHCs and FBOs,
Act (18 U.S.C. 1905). The Federal Reserve has established
and in developing comparative analyses of organizations with
procedures to authorize the sharing of confidential supervi-
similar business lines and risk characteristics.
sory information, and Federal Reserve staff must ensure that
appropriate approvals are obtained prior to releasing such
information. See Subpart C of the Boards Rules Regarding BHC Supervision Manual January 2009
the Availability of Information (12 C.F.R. 261.20 et seq.). Page 15
ties, or key corporate governance, risk- often facilitated by an MOU that establishes a
management, or control functions. Prior to con- framework for bilateral relationships and includes
ducting discovery reviews or testing activities at provisions for cooperation during the licensing
a depository institution (other than where the process, in the supervision of ongoing activities,
Federal Reserve is the primary federal supervi- and in the handling of problem institutions. The
sor) or functionally regulated subsidiary of a Federal Reserve has established bilateral and
BHC, the Federal Reserve will multilateral information-sharing MOUs and other
arrangements with numerous host-country for-
review available information sources as part eign supervisors. The Federal Reserve also moni-
of its continuous monitoring activities, includ- tors changes in foreign bank regulatory and
ing examination reports and the BHCs inter- supervisory systems and seeks to understand
nal MIS, to determine whether such informa- how these systems affect supervised banking
tion addresses the Federal Reserves organizations. In addition to its longstanding
information needs or supervisory concerns; cooperative relationships with home- and host-
and country foreign supervisors, the Federal Reserve
if needed, seek to gain a better understanding expects to increasingly lead and participate in
of the primary supervisors or functional regu- colleges of supervisors and other multilateral
lators basis for its supervisory activities and groups of supervisors that discuss issues related
assessment of the subsidiary. This may include to specific internationally active banking
a request to review related examination work. organizations.
The Federal Reserve also is a member of the
If, following these activities, the Federal Basel Committee on Banking Supervision, which
Reserves information needs or supervisory con- is a forum for supervisors from member coun-
cerns remain, the Federal Reserve will work tries to discuss important supervisory issues,
cooperatively with the relevant primary supervi- foster consistent supervision of organizations
sor or functional regulator in the manner dis- with similar business and risk profiles, promote
cussed in section 1050.1.3 above. 26 the sharing of leading supervisory practices, and
formulate guidance to enhance and refine bank-
ing supervision globally.
1050.1.4.2 Cooperation and Information The Federal Reserves processes for under-
Sharing With Host-Country Foreign standing and assessing firmwide legal and com-
Supervisors pliance risk management, as described earlier,
encompass both domestic and international
Objectives: Many large complex BHCs have operations. Most areas of supervisory focus for
considerable international banking and other management of legal and compliance risks are
operations that are licensed and supervised by applicable to both domestic and international
foreign host-country authorities. As home- entities, and include proper oversight of licensed
country supervisor for domestic BHCs, the Fed- operations, compliance with supervisory and
eral Reserve is responsible for the comprehen- regulatory requirements, and the sufficiency of
sive, consolidated supervision of these global associated MIS.
organizations, while each host country is respon- There are, however, areas of focus for the
sible for supervision of the legal entities (includ- Federal Reserve that are unique to a holding
ing foreign subsidiaries of U.S. BHCs) in its companys international operations. For exam-
jurisdiction. ple, some host-country legal and regulatory
Information sharing among domestic and for- structures and supervisory approaches are fun-
eign supervisors, consistent with applicable laws, damentally different from those in the United
is essential to ensure that a large complex BHCs States. As a result, the banking organization
global activities are supervised on a consoli- often must devote additional resources to main-
dated basis. Cross-border information sharing is tain expertise in local regulatory requirements.
In some instances, privacy concerns have led to
26. As outlined in section 1050.1.3, certain Federal Reserve limits on the information a BHCs foreign office
examination activities are to be conducted on a minimum may share with its parent company, thereby
three-year cycle to verify, through testing, the sufficiency of limiting the parent companys ability to exercise
key control processes. These activities are to be conducted consolidated risk management on a global basis.
regardless of whether or not there is an information gap or
indication of weakness or risk. Additionally, while considerable progress has
been made to strengthen supervisory cross-
BHC Supervision Manual January 2009 border cooperation and information sharing, the
Page 16 Federal Reserve and other U.S. supervisors have,
at times, faced challenges in accessing informa- 1050.1.4.3 Indications of Weakness or

tion on a banks or BHCs foreign operations or Risk Related to Subsidiary Depository
in carrying out examinations of cross-border or Institutions
foreign activities. These circumstances are to be
taken into account when developing a supervi- Objectives: For areas beyond those specifically
sory strategy for a large complex BHC with addressed in section 1050.1.3, there may be
cross-border or foreign operations. circumstances where the Federal Reserve has
indications of material weakness or risk in a
Supervisory Activities: Continuous monitoring depository institution subsidiary of a BHC that
will be used to understand and assess each large is supervised by another primary supervisor, and
complex BHCs international strategy, trends, it is not clear that the weakness or risk is
operations, and legal entity structure, as well as adequately reflected in the assessment or super-
related governance, risk-management, and inter- visory activities of that supervisor. Because a
nal controls. For a large complex BHC with primary objective of consolidated supervision is
significant international operations or risks, an to protect the BHCs depository institution sub-
assessment of cross-border and foreign opera- sidiaries, the Federal Reserve will follow up
tions will be incorporated into the evaluation of with the appropriate primary supervisor in these
key corporate governance functions and pri- circumstances to help ensure that, to the extent
mary firmwide risk-management and internal that a material weakness or risk exists, it is
control functions, including legal and regulatory addressed appropriately.
risk management.
Continuous monitoring activities will include Supervisory Activities: The Federal Reserve will
review of materials prepared by host-country take the following steps if it has indications of
supervisors, including examination reports and material weakness or risk in a depository institu-
assessments, and ongoing communication with tion subsidiary (other than where the Federal
relevant foreign and domestic supervisors regard- Reserve is the primary federal supervisor) in an
ing trends and assessments of cross-border and area beyond those specifically addressed in sec-
foreign operations. These continuous monitor- tion 1050.1.3, and it is not clear that the weak-
ing activities may be supplemented, as appropri- ness or risk is adequately reflected in the assess-
ate, by examination activities to understand and ment or supervisory activities of the depository
assess the large complex BHCs international institutions primary supervisor.
strategy, trends, operations, and legal entity
structure, as well as related governance, risk- The Federal Reserve will first review avail-
management, and internal controls. able information sources, discuss the areas of
When assessing the sufficiency of a large concern with the primary supervisor, and seek
complex BHCs management of its interna- to review the supervisors related work.
tional operations, consideration is given to the If concerns remain following these activities,
extent that foreign laws restrict the transmission the Federal Reserve will request that the pri-
of information to the BHCs head office. Impedi- mary supervisor conduct a discovery review
ments to sharing information imposed by a host or testing activity at the depository institution
country may constrain the BHCs ability to to address the area of concern.
effectively oversee its international operations In the event the primary supervisor does not
and globally manage its risks, and the material- undertake activities to address the concern in
ity of such impediments should be a determi- a reasonable period of time, the Federal Reserve
nant of whether the organization should be con- will design and lead an examination of the
ducting operations in that host country. depository institution to address the matter in
In addition, any limits placed on the Federal consultation with the primary supervisor. A
Reserves ability to access information on host- senior Federal Reserve official will communi-
country operations, or to engage in onsite activi- cate this decision in writing to a senior official
ties at the organizations operations in the host of the primary supervisor.
country, should be considered when assessing
whether the organizations activities in that juris-
diction are appropriate.

Page 17
1050.1.4.4 Condition or Management of to determine if the holding company is provid-

BHC Subsidiary is Less-than-Satisfactory ing appropriate support to the depository insti-
tution. The Federal Reserve will coordinate its
Objectives: As noted above, a primary activities with those of the primary supervisor
responsibility of the Federal Reserve as consoli- to the extent appropriate.
dated BHC supervisor is to ensure that a hold- Nonbank subsidiary. When any nonbank sub-
ing companys activities, policies, and practices sidiary faces financial stress or material risks,
do not undermine its ability to serve as a source the Federal Reserve will seek to ensure that its
of financial and managerial strength to its condition and activities do not jeopardize the
depository institution subsidiaries. In situations safety and soundness of the BHC or its deposi-
where the condition or management of a tory institution subsidiaries, as discussed above
supervised or functionally regulated BHC sub- in sections 1050.1.3.3.1, Risk Management
sidiary is determined to be less-than- and Financial Condition of Significant Non-
satisfactory, the Federal Reserves focus as bank Subsidiaries and 1050.1.3.3.2, Parent
consolidated supervisor is on complementing Company and Nonbank Funding and Liquid-
the efforts of the primary supervisor or ity. The Federal Reserve also will take appro-
functional regulator. In doing so, the Federal priate steps to ensure that any actions taken by
Reserve will seek to ensure that the parent com- the parent company to assist a nonbank sub-
pany provides appropriate support to the subsidiary do not impair the BHCs continuing
sidiary and does not take actions that may ability to serve as a source of strength to its
further weaken the parent companys deposi- depository institution subsidiaries. The Fed-
tory institution subsidiaries or its ability to act eral Reserve will coordinate its activities with
as a source of strength for such subsidiaries. those of any relevant functional regulator to
Beyond the specific activities noted below, the extent appropriate.
these circumstances also may require the Fed-
eral Reserve to enhance the activities addressed
in section 1050.1.3 for understanding and assess- 1050.1.4.5 Edge and Agreement
ing key corporate governance functions or pri- Corporations
mary firmwide risk-management and internal
controls. In addition, the Federal Reserve will Objectives: Many large complex BHCs control
adjust its supervisory activities as necessary an Edge or agreement corporation subsidiary.
when the consolidated BHC is in weakened The Federal Reserve serves as the primary
condition or when there are questions regarding supervisor of each Edge and agreement corpora-
the capabilities of the holding companys tion subsidiary in addition to its role as consoli-
management. dated BHC supervisor.27 When the Edge or
agreement corporation is held by a U.S. bank,
Supervisory Activities: the primary supervisor often relies on informa-
tion provided by the Federal Reserve in
Depository institution subsidiary. In instances developing its own understanding and assess-
when a depository institution subsidiarys con- ment of the parent bank.
dition or management is rated less than satis- During each calendar year, the Federal
factory, or when the depository institution Reserve performs an examination of each Edge
subsidiary otherwise faces financial stress or and agreement corporation, assesses the Bank
material risks, the Federal Reserves primary Secrecy Act/Anti-Money Laundering
supervisory objectives as consolidated super- (BSA/AML) compliance program, and assigns a
visor are to ensure that the parent company CAMEO rating. In addition, the Federal
(1) provides appropriate support to the deposi- Reserve periodically conducts assessments of
tory institution and (2) does not take action Edge and agreement corporations to determine
that could harm the depository institution. The whether a consumer compliance examination is
Federal Reserve will work closely with the warranted, in which case a compliance
primary supervisor to understand whether the
BHC or a nonbank affiliate has contributed to 27. The Federal Reserve is solely responsible for approv-
the depository institutions weakened condi- ing, and supervising the activities of, U.S. Edge and agree-
tion, to understand the impact of the deposi- ment corporations. As discussed in SR-90-21, Rating Sys-
tem For International Examinations, one of the Federal
tory institution on the BHCs condition, and Reserves supervisory responsibilities is the assignment of a
CAMEO rating (Capital, Asset Quality, Management, Earn-
BHC Supervision Manual January 2009 ings, and Operations and Internal Controls) to each Edge and
Page 18 agreement corporation.
examination is conducted and a consumer Supervisory Activities: The Federal Reserve will
compliance rating is assigned. maintain an understanding and perform an annual
The Federal Reserve will coordinate the con- examination of each Edge and agreement corpo-
duct of its activities as Edge and agreement ration. While the examination scope will be risk
corporation supervisor with its activities as con- focused to reflect the organizations scale, activi-
solidated supervisor. To this end, the extent and ties, and risk profile, in all cases the Federal
scope of Federal Reserve supervisory work related Reserve will assess the adequacy of processes to
to an Edge or agreement corporation will be ensure compliance with BSA/AML require-
tailored to the entitys activities, risk profile, ments and other applicable U.S. laws and regula-
and other attributes. A number of specific ele- tions and with applicable foreign laws and
ments will be considered when developing a regulations.
supervisory approach, including In developing its supervisory strategy, the
Federal Reserve will identify those elements
1. structure and attributes, including whether that are unique to the Edge or agreement corpo-
the Edge or agreement corporation is a bank- ration and those that are shared with the parent
ing or investment organization; bank or BHC and will coordinate fulfillment of
2. the size, nature, and location of its primary the Federal Reserves responsibilities as Edge
activities, as well as key financial and other and agreement corporation supervisor with
trends; execution of its consolidated supervision role.
3. the business lines and risks, and associated This strategy will reflect the extent to which
trends, of the Edge or agreement corpora- reliance can be placed on (1) the Federal Reserves
tions primary activities on a standalone basis, understanding and assessments of key corporate
as well as their significance to the risk profile governance, risk-management, and control func-
of the parent bank (if applicable) and BHC; tions, as well as material portfolios and business
4. the extent to which risk-management and lines, of the consolidated BHC; (2) assessments
internal control functions are unique to the developed by the primary supervisor (when
Edge or agreement corporation, or are shared applicable) for business lines, risk management,
with a parent bank, another affiliate, or the control functions, or financial factors that are
consolidated BHC; common to the Edge or agreement corporation
5. any potential Regulation K limitations or and its parent bank; and (3) findings developed
other U.S. compliance issues, and the adequacy by host-country supervisors for activities under
of processes to ensure ongoing compliance; their jurisdiction.
and In addition, where the primary supervisor of
6. the adequacy of processes for ensuring com- an Edge or agreement corporations parent bank
pliance with all applicable laws and regula- relies on the Federal Reserves understanding
tions imposed by host-country supervisors and assessment in order to develop its CAMELS
for the Edge or agreement corporations inter- rating,28 the Federal Reserve will work to fulfill
national operations. that supervisors information needs.
28. The U.S. banking agencies assign CAMELS (Capital

Adequacy, Asset Quality, Management, Earnings, Liquidity,
and Sensitivity to Market Risk) ratings to U.S. banking orga-
nizations as part of the ongoing supervision of these organiza-
tions. See SR-96-38, Uniform Financial Institutions Rating
System, (see section A.5020.1 of the Commercial Bank
Examination Manual.) and SR-97-4, Interagency Guidance
on Common Questions About the Application of the Revised
CAMELS Rating System.

Page 19
Guidance for the Consolidated Supervision of Regional
Bank Holding Companies Section 1050.2
WHATS NEW IN THIS REVISED each regional BHC. For organizations within
SECTION this portfolio, continuous monitoring activities
typically take the form of meetings with BHC
Effective July 2016, this section is revised to management, analysis of internal management
include SR-16-4, Relying on the Work of the information system (MIS) reports and regula-
Regulators of the Subsidiary Insured Depository tory reports, review of surveillance screens, and
Institutions of Bank Holding Companies and discussions and coordination with other relevant
Savings and Loan Holding Companies with primary supervisors and functional regulators
Total Consolidated Assets of Less than $50 Bil- and review of their work. The scale and fre-
lion. This guidance provides an explanation of quency of monitoring activities will differ by
the Federal Reserves expectations for its exam- organization. For many regional BHCs that are
iners reliance on the work of the regulators of in sound condition, monitoring activities typi-
insured depository institution subsidiaries (IDI cally are performed on a periodic or quarterly
regulators) in the supervision of bank holding basis, supplemented by more frequent or inten-
companies (BHCs) and savings and loan hold- sive activities as necessary, and, in most instances,
ing companies (SLHCs). SR-16-4 presents a tai- Federal Reserve staff do not maintain a day-to-
lored supervisory approach for regional bank- day onsite presence at the organization.
ing organizations (RBOs), which are defined as
companies with total consolidated assets between
$10 billion and $50 billion. 1050.2.1.1 Federal Reserve Activities and
Those Activities of Other Supervisors and
Regulators
1050.2.1 ACTIVITIES OF THE
FEDERAL RESERVE AND OTHER The nature and scope of independent Federal
SUPERVISORS AND REGULATORS, Reserve supervisory work required to develop
AND FUNCTIONAL REGULATION and maintain an understanding and assessment
of a regional BHC depend largely on the extent
The objectives of the Federal Reserves consoli- to which other relevant primary supervisors or
dated supervision program for the portfolio of functional regulators have information or assess-
regional bank holding companies (regional ments upon which the Federal Reserve can
BHCs, defined as non-LCBO BHCs with draw. Many regional BHCs conduct the major-
$10 billion or more in total consolidated assets, ity of their business operations through a single
including nontraditional organizations1) are the bank subsidiary, increasing the likelihood that a
same as those applicable to other portfolios. The single primary supervisor has a complete view
manner in which the Federal Reserve achieves of, and ability to address, major aspects of the
these objectives, however, is tailored to the char- organizations business activities and related
acteristics and risk profiles of regional bank risks, risk management, and controls. In these
holding companies.2 instances, the Federal Reserve typically will be
As outlined in the following sections, a range able to use the information and assessments
of continuous monitoring activities is utilized, developed by this primary supervisor to develop
along with discovery reviews and testing activi- its understanding and assessment of significant
ties (examination activities),3 to develop and aspects of the consolidated organization. Simi-
maintain an understanding and assessment of larly, for regional BHCs with limited nonbank
activities, the Federal Reserve typically will
1. Nontraditional BHCs, as defined in SR-04-18, Bank need to conduct less work to understand and
Holding Company Rating System, (see section 4070.0) are
bank holding companies where most or all of the organiza-
assess the risk-management systems and finan-
tions significant nondepository subsidiaries are regulated by cial condition of nonbank subsidiaries than the
a functional regulator, and subsidiary depository institution(s) level of monitoring and examination work
are small in relation to nondepository subsidiaries. required for organizations with more-extensive
2. See section 1050.0.4, appendix, for definitions of terms
commonly used in this section.
or complex nonbank activities.
3, While by definition examination activities are appli- By their nature, understanding and assessing
cable to the supervision of banks and other depository institu- some areassuch as the risk management and
tions, as well as U.S. banking offices of FBOs, and inspec- financial condition of significant nonbank
tion activities are applicable to the supervision of BHCs and
nonbank subsidiaries and affiliates, the term examination is
generally used throughout this section to refer to both exami- BHC Supervision Manual July 2016
nation and inspection activities. Page 1
Consolidated Supervision of Regional BHCs 1050.2
subsidiaries that are not functionally and 3900.0. Under these provisions, for exam-
regulatedtypically will require more indepen- ple, the Federal Reserve may conduct an exami-
dent Federal Reserve supervisory work. Other nation of a functionally regulated subsidiary if,
areassuch as primary firmwide risk- after reviewing relevant reports, it reasonably
management and control functionstypically determines that the examination is necessary to
will require a greater degree of coordination with adequately inform the Federal Reserve about the
other relevant primary supervisors or functional systems used to monitor and control financial
regulators, who will likely have information or and operational risks within the consolidated
assessments upon which the Federal Reserve can organization that may pose a direct or indirect
draw. threat to the safety and soundness of a deposi-
The following sections provide further detail tory institution subsidiary.4
on how the Federal Reserve will develop, work-
ing in coordination with other relevant primary
supervisors and functional regulators, an under- 1050.2.2 UNDERSTANDING THE
standing and assessment of a regional BHC. In ORGANIZATION
conducting the activities described throughout
this document, the Federal Reserve will, to the For each regional BHC, the Federal Reserve
fullest extent possible will develop an understanding of the legal,
operating, and corporate governance structure
rely on the information and assessments of of the organization and its primary strategies,
relevant primary supervisors and functional business lines, and risk-management and
regulators, including the information and internal control functions.5 This understanding
assessments reflected in the reports of exami- will inform the development of a risk-
nation of such supervisors and regulators; assessment and supervisory plan for the BHC.
focus its supervisory activities on the bank The extent of information necessary to gain this
holding company, as well as on those of its understanding is tailored to the scope and
nonbank subsidiaries that could have a direct complexity of the regional BHCs operations,
or indirect materially adverse effect on the and typically may be obtained from the
safety and soundness of a depository institu- organizations management, public reports,
tion subsidiary of the BHC due to the size,
condition, or activities of the nonbank subsid-
4. The Federal Reserve also may examine a functionally
iary, or the nature or size of its transactions regulated subsidiary of a regional BHC if, after reviewing
with the depository institution; and relevant reports and other information, it has reasonable cause
use publicly reported information (including to believe that the subsidiary is engaged in an activity that
externally audited financial statements) as well poses a material risk to an affiliated depository institution, or
that the subsidiary is not in compliance with any federal law
as reports that a large complex BHC or a that the Federal Reserve Board has specific jurisdiction to
subsidiary prepares for other primary supervi- enforce against the subsidiary (and the Federal Reserve can-
sors, functional regulators, or self-regulatory not determine compliance by examining the BHC or its affili-
organizations. ated depository institutions).
Similarly, before requiring a specialized report from a
functionally regulated subsidiary, the Federal Reserve first
will request that the subsidiarys appropriate functional regu-
1050.2.1.2 Functionally Regulated lator obtain the report and make it available to the Federal
Reserve. In the event that the report is not obtained or made
Subsidiaries available as requested, the Federal Reserve may, consistent
with the Bank Holding Company Act, obtain the report
As discussed below, in certain situations, the directly from the functionally regulated subsidiary if the report
Federal Reserve may find it necessary to con- is necessary to allow the Federal Reserve to adequately assess
(1) a material risk to the BHC or any of its depository
duct an examination of a functionally regulated institution subsidiaries, (2) the systems used to monitor and
nonbank subsidiary in order to fulfill the Federal control financial and operational risks within the consolidated
Reserves responsibilities as supervisor of the organization that may pose a threat to the safety and sound-
consolidated organization. In any such case, the ness of a depository institution subsidiary, or (3) compliance
with any federal law that the Federal Reserve Board has
Federal Reserve will continue to adhere to the specific jurisdiction to enforce against the BHC or a subsidiary.
procedural and other requirements governing 5. This understanding is formally documented during devel-
examinations of, or requests for a specialized opment of the institutional overview, which coincides with
report from, a functionally regulated subsidiary creation of the annual risk assessment. SR-97-24, Risk-
Focused Framework for Supervision of Large Complex Insti-
as discussed in SR-00-13 and sections 1040.0 tutions, (see section 2124.01) describes processes for devel-
oping an institutional overview, risk assessment, and supervisory
BHC Supervision Manual July 2016 plan. Each of these products is kept current to reflect signifi-
Page 2 cant changes in an organizations risks or activities.
regulatory reports, surveillance screens, third- RFI (Risk Management, Financial Condition,
party sources (e.g., credit-rating agency and and Impact) rating assigned to a BHC.6
market analyst reports), and other relevant
primary supervisors or functional regulators.
Key elements that should be identified and 1050.2.3.1 Risk Management
understood include the following:
1050.2.3.1.1 Key Corporate Governance
Corporate strategy. Primary business strate- Functions
gies; institutional risk tolerance; key changes
Objectives: One of the primary areas of focus
in strategic direction or risk profile; signifi-
for consolidated supervision of regional BHCs
cant new business activities; areas of growth
is the adequacy of governance provided by the
and emerging areas with potential to become
board and senior management. The culture,
primary drivers of risk or revenue; and plans
expectations, and incentives established by the
for expansion through mergers or acquisitions.
highest levels of corporate leadership set the
Significant activities. Key revenue and risk
tone for the entire organization and are essential
drivers; primary business lines; product mix;
determinants of whether a banking organization
budget and internal capital allocations (as
is capable of maintaining fully effective risk-
applicable); market share for revenue and cus-
management and internal control processes.
tomers served; key external trends, including
The board and its committees should have an
competitive pressures; and areas that are vul-
ongoing understanding of key inherent risks,
nerable to volatility in revenue, earnings, capi-
associated trends, primary control functions,
tal, or liquidity.
and senior management capabilities. Primary
Structure. Business line and legal entity struc-
expectations for the board and its committees
ture; domestic and foreign regulatory respon-
include
sibilities for legal entities and business lines;
key interrelationships and dependencies
1. selecting competent senior managers, ensur-
between depository institution subsidiaries and
ing that they have the proper incentives to
nonbank affiliates; material business lines
operate the organization in a safe and sound
operated across multiple legal entities for
manner, and regularly evaluating senior man-
accounting or risk-management purposes; and
agers performance;
the activities and risk profile of Edge and
2. establishing, communicating, and monitoring
agreement corporation subsidiaries.
(for example, by reviewing comprehensive
Corporate governance, risk management, and
MIS reports produced by senior manage-
internal controls for primary risks. Board of
ment) institutional risk tolerances and a cor-
directors (board) and executive-level commit-
porate culture that emphasizes the impor-
tees; senior management and management
tance of compliance with the law and ethical
committees; key risk-management and inter-
business practices;
nal control functions and associated MIS relied
3. approving significant strategies and policies;
upon by the board, senior management, and
4. demonstrating leadership, expertise, and
senior risk managers and committees; and
effectiveness;
consistency of public disclosures with how
5. ensuring the organization has an effective
the board and senior management assess and
and independent internal audit function;
manage risks.
6. ensuring the organization has appropriate
policies governing the segregation of duties
To ensure the quality and consistency of con-
and avoiding conflicts of interest; and
solidated supervision across the regional BHC
7. for publicly held organizations, ensuring that
portfolio, it also is necessary to understand how
public disclosures
these key elements compare with industry trends
are consistent with how the board and
and with evolving practices of well-managed
organizations with similar characteristics.
6. The RFI rating system for BHCs is discussed in SR-
04-18 and section 4070.0. RFI ratings are assigned at least
annually for BHCs that are complex or that have $1 billion or
1050.2.3 ASSESSING THE REGIONAL more in consolidated assets, and are communicated via a
comprehensive summary supervisory report that supports the
BHC ON A CONSOLIDATED BASIS BHCs assigned ratings and encompasses the results of the
entire supervisory cycle.
The Federal Reserve uses a systematic approach
to develop an assessment of a BHC on a consoli- BHC Supervision Manual July 2016
dated basis. This assessment is reflected in the Page 3
senior management assess and manage the porting technology has grown, in combination
risks of the organization, with greater reliance on third-party service pro-
balance quantitative and qualitative infor- viders, the importance of internal audits role in
mation with clear discussions about risk- identifying risks and testing internal controls
management processes, and has increased.
reflect evolving disclosure practices for In addition, the extent to which supervisors
peer organizations. can rely on or utilize the work of internal audit
is an essential determinant of the risk-focused
A regional BHCs senior management and its supervisory program that is tailored to the activi-
committees should be able to clearly communities and risks of individual regional BHCs.
cate risk tolerances and measures, control risks,
hire and retain competent staff, and respond to Supervisory Activities: For each regional BHC,
changes in the organizations risk profile and the Federal Reserve will understand and assess
the external environment. Members of senior the adequacy of oversight provided by the board
management are expected to have qualifications and senior management, as well as the adequacy
and experience commensurate with the size and of internal audit and associated MIS. The Fed-
complexity of the organization. Primary expec- eral Reserve also will understand and assess
tations for senior management include other key corporate governance functions (e.g.,
corporate finance and treasury functions), whose
1. establishing effective oversight and an appro- effectiveness is essential to sustaining consoli-
priate risk culture; dated holding company operations, as well as
2. appropriately delegating authority and over- the organizations business resiliency and crisis
seeing the establishment and implementation management capabilities.7
of effective policies for the proper segrega-
tion of duties and for the avoidance or man- Board, senior management, and other key cor-
agement of conflicts of interest; porate governance functions. Continuous moni-
3. establishing and implementing an effective toring activitieswhich draw from all avail-
risk-management framework capable of iden- able sources on an as-needed basis, including
tifying and controlling both current and emerg- internal control functions, the work of other
ing risks, and effective independent control relevant primary supervisors and functional
functions that ensure risk taking is consistent regulators, regulatory reports, and related sur-
with the organizations established risk veillance resultswill be used to understand
appetite; and assess the effectiveness of board and
4. establishing and implementing incentives for senior management resources and oversight.8
personnel that are consistent with institu- The results of continuous monitoring activi-
tional risk tolerances, compliance with the ties, as documented in supervisory products
law, and ethical business practices; that reflect the Federal Reserves overview
5. promoting a continuous dialogue between and risk assessment of the organization, may
and across business areas and risk- identify certain corporate governance func-
management functions to help align the orga- tions that will require more intensive supervi-
nizations established risk appetite and risk sory focus due to (1) significant changes in
controls; corporate strategy, activities, organizational
6. ensuring that the board and its committees structure, oversight mechanisms, or key per-
are provided with timely, accurate, and com- sonnel; (2) potential concerns regarding the
prehensive MIS reports that are adaptive to adequacy of a specific governance function;
changing circumstances regarding risks and or (3) the absence of sufficiently recent exami-
controls; and
7. ensuring timely resolution of audit, compli- 7. As discussed further in section 1050.2.4.6, because of
ance, and regulatory issues. the special structure of nontraditional BHCs and the relatively
small size of their depository institution subsidiaries, much of
An effective internal audit function plays an the information necessary to develop the assessments of the
risk-management (as described in this section 1050.2.3.1) and
essential role by providing an independent and financial condition elements (as described in section 1050.2.3.2)
objective evaluation of all key governance, risk- typically may be obtained or drawn from the work of the
management, and internal control processes. As relevant functional regulator.
the complexity of financial products and sup- 8. As noted in section 1050.2.1 above, the scale and fre-
quency of monitoring activities will differ by organization.
For many regional BHCs in sound condition, these activities
BHC Supervision Manual July 2016 are typically performed on a periodic or quarterly basis and
Page 4 supplemented as necessary.
nation activities for a key function by the Fed- independence, professional competence, and
eral Reserve or another primary supervisor or the quality of the internal audit function; (3) the
functional regulator. quality and scope of the audit methodology,
Internal audit. Continuous monitoring activi- audit plan, and risk-assessment process; and
ties will be used to understand and assess key (4) the adequacy of audit programs and
elements of internal audit governance for the
organization on a consolidated basis, including
(1) the adequacy (and, where applicable, Act of 2002, section 301 of the Sarbanes-Oxley Act requires
that each public company (including banks and bank holding
independence9) of the audit committee; (2) the companies that are public companies) have an audit commit-
tee composed entirely of independent directors. (See 15 U.S.C.
9. As outlined in section 2060.05, The Sarbanes-Oxley 78j-1.)

Page 4.1
workpaper standards. On at least an annual In all cases involving a functionally regulated

basis, the results of these supervisory activities subsidiary, the Federal Reserve will conduct its
will be reviewed to determine whether there supervisory and testing activities in accordance
have been significant changes in the internal with the provisions described above in section
audit infrastructure or whether there are 1050.2.1.2.
potential concerns regarding the adequacy of
key elements of internal audit. In addition to
this periodic audit infrastructure review, 1050.2.3.1.2 Risk-Management and
testing activities for specific control functions Internal Control Functions for Primary
or business lines should include an assessment Risks to the Consolidated Organization
of internal audits recent work in these areas to
the extent possible as a means of validating Objectives: Underlying the risk-focused approach
internal audits findings. to consolidated supervision of regional BHCs is
Additional supervisory activities. If continu- the premise that it is each organizations respon-
ous monitoring activities identify a key corpo- sibility to develop an appropriate control struc-
rate governance function or element of inter- ture for identifying, measuring, monitoring, and
nal audit requiring more intensive supervisory controlling key risks as measured against super-
focus due to significant changes, potential visory standards and expectations, applicable
concerns, or the absence of sufficiently recent laws and regulations, and evolving practices of
examination activities, the Federal Reserve well-managed organizations.
will work with other relevant primary supervi- The Federal Reserve will understand and
sors or functional regulators (where applica- assess risk-management and control functions
ble) in developing discovery reviews or test- for primary risks to the consolidated organiza-
ing activities focusing on the area of concern. tion (primary firmwide risk-management and
In situations where another primary supervi- control functions), and associated MIS, for each
sor or functional regulator leads the examina- regional BHC. This will include risk-
tion activities, the Federal Reserve may con- management and control functions for primary
duct portions of the examination, or otherwise credit, legal and compliance,11 liquidity, market,
participate as necessary (e.g., in determining operational, and reputational risks for the con-
the examination objectives and scope), to solidated organization. The Federal Reserve also
ensure that the review provides sufficient infor- will understand and assess other risk-
mation on the specific area of concern to form management and control functions that, based
a comprehensive and timely understanding on the specific characteristics and activities of
and assessment. the individual BHC, relate to primary risks to
If the area of concern is not within the the organization as a whole.
oversight of another primary supervisor or For example, for regional BHCs with particu-
functional regulator, or if the supervisor or larly dynamic corporate strategies, the Federal
regulator does not conduct or coordinate the Reserve will understand and assess the adequacy
examination activities in a reasonable period of the control mechanisms relevant to such strat-
of time, the Federal Reserve will lead the egies, including strategic planning, merger inte-
necessary examination activities in coordina- gration, new business approval, and processes
tion with other relevant primary supervisors for ensuring that risk management and controls
and functional regulators to the extent possible. keep pace with areas of growing inherent risk.
Additional required audit testing activities. In In all instances, the adequacy of each primary
all instances, the Federal Reserve will conduct firmwide risk-management or control mecha-
testing activities as part of its audit infrastruc- nism depends on the appropriateness of the
ture review (either by leading the activities following:
and coordinating with other relevant primary
supervisors or functional regulators, or partici-
pating in activities led by other relevant super- lator has not developedor, because of the organizations
legal, operating, and regulatory structure, is not able to
visors or regulators) on at least a three-year developa comprehensive understanding and assessment of
cycle to ensure that the internal audit program the internal audit infrastructure.
is appropriately designed and achieving its 11. Federal Reserve processes for understanding and assess-
objectives.10 ing legal and compliance risk management encompass con-
sumer compliance risk inherent in the organizations business
activities.
10. For nontraditional BHCs, the Federal Reserve will
routinely conduct testing activities on at least a three-year BHC Supervision Manual January 2009
cycle in instances where the BHCs relevant functional regu- Page 5
1. control infrastructure and governance, includ- Supervisory Activities: The Federal Reserve will
ing degree of oversight by the board and use continuous monitoring activities to under-
senior management; stand and assess each primary firmwide risk-
2. development, maintenance, and communica- management and control function. This process
tion of appropriate policies, procedures, and begins with the overarching design and architec-
internal controls; ture of each primary firmwide risk-management
3. risk identification and measurement systems or control function, and drills down, as appropri-
and processes, and associated MIS, that are ate, through analysis of risk management and
adaptive to changing circumstances and controls for material portfolio areas and busi-
capable of providing timely, accurate, and ness lines (described in section 1050.2.3.1.3
comprehensive information to senior man- below). Activities will verify the sufficiency of
agement and the board; fundamental aspects of internal controls in rela-
4. monitoring and testing the effectiveness of tion to the holding companys current risk pro-
controls; file and in comparison with supervisory expecta-
5. processes for identifying, reporting, and esca- tions and evolving sound practices, and assess
lating issues and emerging risks; the capability of these primary functions (whether
6. ability to implement corrective actions in a centralized or decentralized) to remain effective
timely manner; in the face of growth, changing strategic direc-
7. appropriate authority and independence of tion, significant market developments, and other
staff to carry out responsibilities; and internal or external factors.
8. integration of risk-management and control The results of continuous monitoring activi-
objectives within management goals and the ties, as documented in supervisory products that
organizations compensation structure. reflect the Federal Reserves overview and risk
assessment of the organization, may identify
Organizations in the regional BHC portfolio certain primary firmwide risk-management or
use a variety of control structures to monitor, control functions that require more intensive
manage, and control firmwide risks. A number supervisory focus due to (1) significant changes
of larger organizations have implemented firm- in inherent risk, control processes, or key per-
wide risk-management functions to measure and sonnel; (2) potential concerns regarding the
assess the range of their exposures across busi- adequacy of controls; or (3) the absence of
ness lines and legal entities and the way these sufficiently recent examination activities for a
exposures interrelate. However, many organiza- primary firmwide risk-management or control
tions within the portfolio effectively control function by the Federal Reserve or another rel-
risks using a decentralized approach that relies evant primary supervisor or functional regulator.
on individual control structures for the organiza- In these instances, the Federal Reserve will
tions primary business lines or legal entities. In work with other relevant primary supervisors or
all instances, the Federal Reserve will assess functional regulators (where applicable) to
whether the approach to a key control function develop discovery reviews or testing activities
used by a particular organization is effective in focusing on the area of concern. In situations
controlling primary risks to the consolidated where another primary supervisor or functional
organization.12 regulator leads the examination activities, the
Federal Reserve may conduct portions of the
12. As outlined in SR-08-8/CA-08-11, Compliance Risk- examination, or otherwise participate as neces-
Management Programs and Oversight at Large Banking Orga- sary (e.g., in determining the examination objec-
nizations with Complex Compliance Profiles, (see section tives and scope), to ensure that the review pro-
2124.07), while the Federal Reserve does not prescribe a vides sufficient information on the specific area
particular organizational structure for primary firmwide risk-
management and control functions, establishment of a firm- of concern to form a comprehensive and timely
wide function that is dedicated to managing and overseeing understanding and assessment.
compliance risk, and that promotes a strong compliance cul- If the primary firmwide risk-management or
ture, is particularly important for large banking organizations control function is not within the oversight of
with complex compliance profiles, due to the unique chal-
lenges associated with compliance risk management for these another primary supervisor or functional regula-
organizations. In addition to the oversight provided by the tor, or if the primary supervisor or functional
board and various executive and management committees, a regulator does not conduct or coordinate the
key component of firmwide compliance oversight for these
organizations is a corporate compliance function that has
day-to-day responsibility for overseeing and supporting the
implementation of the organizations firmwide compliance
risk-management program and that plays a key role in control-
BHC Supervision Manual January 2009 ling compliance risks that transcend business lines, legal
Page 6 entities, and jurisdictions of operation.
examination activities in a reasonable period of To the fullest extent possible, the Federal
time, the Federal Reserve will lead the neces- Reserve will draw its understanding and assess-
sary examination activities in coordination with ment of these risks and risk-management prac-
other relevant supervisors and regulators to the tices from the information and assessment of the
extent possible. In all cases involving a func- primary supervisor or functional regulator where
tionally regulated subsidiary, the Federal Reserve the BHCs legal and operating structure pro-
will conduct its supervisory and testing activi- vides the supervisor or regulator a sufficient
ties in accordance with the provisions described view of these areas. In these instances, the Fed-
above in section 1050.2.1.2. eral Reserve will undertake continuous monitor-
ing and participate in activities led by primary
supervisors and functional regulators, as neces-
1050.2.3.1.3 Risk Management of sary, to maintain an understanding and assess-
Material Portfolios and Business Lines ment of related firmwide risk-management and
control functions.
Objectives: For each regional BHC, there are A regional BHCs activities may span legal
selected portfolio risk areas (such as retail or entities that are subject to oversight by multiple
wholesale credit risk) or individual business supervisors or regulators or that are outside the
lines (such as residential mortgage or com- oversight of other supervisors or regulators. If
mercial real estate lending) that are primary this is the case, or if the primary supervisor or
drivers of risk or revenue, or that otherwise functional regulator does not conduct or coor-
materially contribute to either understanding dinate the necessary continuous monitoring or
inherent risk within the consolidated organiza- examination activities in a reasonable period of
tion or assessing controls for a broader time, the Federal Reserve will initiate and lead
corporate function (such as consolidated credit- these activities in coordination with other
risk management). relevant primary supervisors and functional
During the development of supervisory prod- regulators to the extent possible. In all cases
ucts that reflect the Federal Reserves overview involving a functionally regulated subsidiary,
and risk assessment of the organization, the the Federal Reserve will conduct its supervisory
Federal Reserve will analyze external factors and testing activities in accordance with the
and internal trends in the BHCs strategic provisions described above in section
initiativesas evidenced by budget and (where 1050.2.1.2.
applicable) internal capital allocations and other
factorsto identify significant activities and
areas vulnerable to volatility in revenue, earn- 1050.2.3.1.4 Risk Management of
ings, capital, or liquidity that represent material Nonmaterial Business Lines
risks or activities of the organization. This deter-
mination of material portfolios and business Objectives: For nonmaterial business lines iden-
lines considers all associated risk elements, tified during the development of supervisory
including legal and compliance risks. For exam- products that reflect the Federal Reserves over-
ple, when evaluating whether retail activities view and risk assessment of the organization,
such as mortgage or automobile lending are the Federal Reserves focus will be on identify-
material to a banking organization, the extent of ing and understanding those business lines that
inherent consumer compliance and reputational are increasing in importance and have the poten-
risks, as well as interest rate and credit risks, tial to become material.
should be considered.
Supervisory Activities: When a primary supervi-
Supervisory Activities: Because an understand- sor or functional regulator has a sufficient view
ing of material risks and activities is needed to of nonmaterial business lines, the Federal Reserve
assess the primary firmwide risk-management will, to the fullest extent possible, use informa-
and control functions (as discussed in preceding tion developed by that supervisor or regulator to
section 1050.2.3.1.2), the Federal Reserve will monitor areas of increasing importance with the
maintain an understanding of inherent risk and potential to become material. The Federal Reserve
assess the adequacy of risk-management and also will maintain an ability to access internal
internal controls for material portfolios and busi- MIS for these businesses to facilitate a more
ness lines. To form this understanding and assess- in-depth analysis of a business line, if appropri-
ment, the Federal Reserve will rely primarily on
continuous monitoring activities, supplemented, BHC Supervision Manual January 2009
as appropriate, by examination activities. Page 7
ate, to understand its growing importance to the els and processes14 that influence this assess-
organization. ment. This assessment utilizes results from
For nonmaterial business lines that are not examinations led by the Federal Reserve or
subject to oversight by a single primary supervi- other primary supervisors or functional regula-
sor or functional regulator, the Federal Reserve tors, as well as information gained from the
will engage in continuous monitoring activities BHCs internal control functions and from
to identify meaningful trends in risks and risk- market-based assessments, where available.
management practices, and will maintain an When assessing the adequacy of a BHCs
understanding of associated MIS to facilitate liquidity levels and funds-management prac-
more in-depth analysis of a business line, if tices, areas of focus include15
appropriate, to understand its growing impor-
tance to the organization. 1. the extent to which the treasury function is
aligned with risk-management processes, and
whether incentives are in place for business
1050.2.3.2 Financial Condition lines to compile and provide information on
expected liquidity needs and contingency
funding plans so that the treasury function is
Objectives: The Federal Reserves evaluation of
able to develop a firmwide perspective and
a regional BHCs consolidated financial condi-
incorporate business line information into
tion focuses on the ability of the organizations
assessments of actual and contingent liquid-
resources to support the level of risk associated
ity risk;
with its activities. Assessments are developed
2. whether funds-management practices pro-
for each CAEL subcomponent: Capital
vide sufficient funding flexibility to respond
Adequacy (C), Asset Quality (A), Earnings (E),
to unanticipated, evolving, and potentially
and Liquidity (L).13
correlated market conditions for the organi-
In developing this evaluation, the Federal
zation and/or across financial markets; and
Reserves primary focus is on developing an
3. the sufficiency of liquidity planning tools,
understanding and assessment of
such as stress testing, scenario analysis, and
contingency planning efforts, including
1. the sufficiency of the BHCs consolidated
(1) whether liquidity bufferscomprised of
capital to support the level of risk associated
unencumbered liquid assets as well as access
with the organizations activities and provide
to stable funding sourcesadequately reflect
a sufficient cushion to absorb unanticipated
the possibility and duration of severe liquid-
losses;
ity shocks; (2) the reasonableness of assump-
2. the capability of liquidity levels and funds-
tions about the stability of secured funding in
management practices to allow reliable access
circumstances in which the liquidity of mar-
to sufficient funds to meet present and future
kets for the underlying collateral becomes
liquidity needs; and
impaired; and (3) whether these efforts
3. other aspects of financial strength that need
adequately reflect the potential for the orga-
to be assessed on a consolidated basis across
nization to be called on in stressed environ-
the organizations various legal entities, or
ments to provide contingent liquidity support
that relate to the financial soundness of the
to off-balance-sheet entities or bring addi-
parent company and significant nonbank sub-
tional assets on the balance sheet (even if not
sidiaries, as discussed in section 1050.2.3.3
legally or contractually obligated to do so).
below.
Beyond capital adequacy and liquidity, the
In assessing consolidated regulatory capital,
nature of independent Federal Reserve supervi-
the Federal Reserve looks to ensure that the
sory work required to evaluate a regional BHCs
BHC demonstrates the effectiveness of its frame-
consolidated financial condition depends largely
work for complying with relevant capital
on the extent to which other relevant primary
adequacy guidelines and meeting supervisory
expectations, and focuses on analyzing key mod-
14. Key models and processes are those where evalua-
tion of the model/process will influence the Federal Reserves
assessment of the activity or control area that is supported by
13. See SR-04-18 and section 4070.0 for more information
the model/process.
about the CAEL subcomponents.
15. Assessing liquidity levels and funding practices for a
consolidated BHC also incorporates elements presented in
BHC Supervision Manual January 2009 section 1050.2.3.3.2 below on Parent Company and Non-
Page 8 bank Funding and Liquidity.
supervisors or functional regulators have infor- ally regulated subsidiary that are of such signifi-
mation or assessments upon which the Federal cance that they will influence the Federal
Reserve can draw. For example, more indepen- Reserves assessment of these areas. In all cases
dent Federal Reserve work typically will be involving a functionally regulated subsidiary,
required to assess consolidated asset quality or the Federal Reserve will conduct its activities in
earnings for regional BHCs with significant accordance with the provisions described above
nonbank activities that are not functionally regu- in section 1050.2.1.2.
lated. However, where all material holding com-
pany assets are concentrated in a single deposi-
tory institution subsidiary, a minimal level of 1050.2.3.3 Impact
incremental Federal Reserve efforts typically
will be required to assess consolidated asset
quality and earnings. 1050.2.3.3.1 Risk Management and
Financial Condition of Significant
Supervisory Activities: The Federal Reserve will Nonbank Subsidiaries
primarily utilize continuous monitoring activi-
ties to assess a regional BHCs financial strength. Objectives: Many regional BHCs engage in
Such activities will include periodic meetings activities and manage control functions on a
with BHC management (such as the chief finan- firmwide basis, spanning depository institution
cial officer); review of regulatory reports, sur- and nonbank legal entities. In some instances,
veillance screens, and internal MIS; and analy- these BHCs have intra-group exposures and ser-
sis of market indicators (where available), vicing arrangements across affiliates, presenting
including external debt ratings, subordinated increased potential risks for depository institu-
debt spreads, and credit default swap spreads. tion subsidiaries and a higher likelihood of
Testing and discovery activities will be used as aggregate risk concentrations across the organi-
necessary to assist in the understanding and zations legal entities. Common interactions
assessment of areas of concern. between a regional BHCs depository institution
Testing and discovery activities also will be subsidiaries and their nonbank affiliates (includ-
used to understand and assess the sufficiency of ing the parent company) include assets originat-
the BHCs consolidated capital and liquidity ing in, or being marketed by, a nonbank affiliate
positions to support the level of risk associated that are booked in the depository institution; a
with its activities, including (1) regulatory capi- depository institution providing funding for non-
tal calculation methodologies16 and, where appli- bank affiliates; and risk-management or internal
cable, internal assessments of capital adequacy17 control functions being shared between deposi-
and (2) funds-management and liquidity plan- tory and nonbank operations.
ning tools and practices. The Federal Reserve Due to these interrelationships, financial, legal,
will work with other relevant primary supervi- compliance, or reputational troubles in one part
sors and functional regulators to participate in of a BHC can spread rapidly to other parts of the
or, if necessary, to coordinate activities designed organization. Even absent these interactions, the
to analyze key capital and liquidity models or parent or nonbank subsidiaries of an organiza-
processes of a depository institution or function- tion may present financial, legal, compliance, or
reputational risk to the consolidated entity, and
thus directly or indirectly to its depository insti-
16. Assessments of the adequacy of regulatory capital for
BHCs that have received Federal Reserve supervisory approval
tution subsidiaries. As the federal banking agency
to use internal estimates of risk in their regulatory capital charged with supervising the organization on a
calculations should include, among other things, regular veri- consolidated basis, the Federal Reserve is respon-
fication that these organizations continue to meet on an ongo- sible for understanding and assessing the risks
ing basis all applicable requirements associated with internal
estimates. See, for example, the capital adequacy guidelines
that the parent bank holding company and its
for market risk at BHCs (Regulation Y: 12 C.F.R. 225, Appen- nonbank subsidiaries may pose to the BHC itself
dix E) and the new advanced capital adequacy framework for or its depository institution subsidiaries.
BHCs (Regulation Y: 12 C.F.R. 225, Appendix G). The primary objectives of Federal Reserve
17. Capital planning activities for all BHCs should be
forward looking and provide for a sufficient range of stress
supervision of the nonbank subsidiaries of a
scenarios commensurate with the organizations activities. bank holding company are to
For those regional BHCs that utilize more-rigorous and struc-
tured internal processes for assessing capital adequacy beyond
regulatory capital measures, the Federal Reserve focuses on
whether such internal processes ensure that all risks are prop-
erly identified, reliably quantified (where possible) across the BHC Supervision Manual January 2016
entire organization, and supported by adequate capital. Page 9
1. identify significant nonbank activities and tional risks, as well as the extent to which
riskswhere the parent company or non- potential conflicts of interest are identified
bank subsidiaries engage in risk-taking activi- and avoided or managed;
ties or hold exposures that are material to the 3. understand the scope of intercompany trans-
risk management or financial condition of actions and aggregate concentrations, and
the consolidated organization or a depository assess the adequacy of risk-management pro-
institution subsidiaryby developing an un- cesses, accounting policies, and operating
derstanding of the size and nature of primary procedures to measure and manage related
activities and key trends, and the extent to risks;
which business lines, risks, or control func- 4. identify and assess key interrelationships and
tions are shared with or may impact a deposi- dependencies between subsidiary depository
tory institution affiliate; institutions and nonbank affiliates, such as
2. evaluate the financial condition and the the extent to which a depository institution
adequacy of risk-management practices of subsidiary is reliant on services provided by
the parent and significant nonbank subsidi- the parent company or other nonbank affili-
aries, including the ability of nonbank sub- ates and the reasonableness of associated
sidiaries to repay advances provided by the management fees;
parent, using benchmarks and analysis appro- 5. identify those nonbank subsidiaries whose
priate for those businesses; activities present material financial, legal,
3. evaluate the degree to which nonbank entity compliance, or reputational risk to the con-
risks may present a threat to the safety and solidated entity and/or a depository institu-
soundness of subsidiary depository institution subsidiary;
tions, including through transmission of legal, 6. identify significant businesses operated across
compliance, or reputational risks; multiple legal entities for accounting, risk
4. identify and assess any intercompany rela- management, or other purposes, as well as
tionships, dependencies, or exposuresor activities that functionally operate as sepa-
aggregate firmwide concentrationswith the rate business units for legal or other reasons;
potential to threaten the condition of a deposi- 7. identify intercompany transactions subject to
tory institution affiliate; and Regulation Wutilizing information submit-
5. evaluate the effectiveness of the policies, ted on quarterly regulatory reporting form
procedures, and systems that the holding FR Y-8 (The Bank Holding Company Report
company and its nonbank subsidiaries use to of Insured Depository Institutions Section
ensure compliance with applicable laws and 23A Transactions with Affiliates), internal
regulations, including consumer protection MIS, and other information sourcesand
laws.18 determine (in conjunction with the primary
supervisor) whether compliance issues are
Supervisory Activities: For all significant non- present; and
bank subsidiaries and activities of the parent 8. understand and assess the sufficiency, relia-
BHC, the Federal Reserve will use continuous bility, and timeliness of associated MIS relied
monitoring activities and discovery reviews to upon by the board, senior management, and
senior risk managers and committees to moni-
1. maintain an understanding of the holding tor key activities and risks.
companys business line and legal entity
structure, including key interrelationships and Periodic testing may be used to supplement
dependencies between depository institution continuous monitoring and discovery reviews to
subsidiaries and nonbank affiliates, utilizing (1) ensure that key risk-management and inter-
regulatory structure reports, internal MIS, nal control practices conform to internal poli-
and other information sources; cies and/or are designed to ensure compliance
2. understand and assess the exposure to, and with the law and (2) understand and assess
tolerance for, legal, compliance, and reputa- operations presenting a moderate or greater like-
lihood of significant negative impact to a subsid-
18. The Federal Reserves supervisory objectives and iary depository institution or the consolidated
activities related to the effectiveness of consumer compliance organization. Areas of potential negative impact
policies, procedures, and systems at nonbank subsidiaries of a
BHC currently are under review, and additional or modified
include financial or operational risks that pose a
guidance on this topic may be issued in the future. potential threat to the safety and soundness of a
depository institution subsidiary, or to the hold-
BHC Supervision Manual January 2016 ing companys ability to serve as a source of
Page 10 financial and managerial strength to its deposi-
tory institution subsidiaries. Testing will focus of the funding profileincluding intraday liquid-
on controls for identifying, monitoring, and con- ity management policies and practices, and com-
trolling such risks. In all cases involving a func- pliance with the Federal Reserve Policy on
tionally regulated subsidiary, the Federal Reserve Payments System Risk20and market access
will conduct its activities in accordance with the of material depository institution subsidiaries,
provisions described above in section 1050.2.1.2. as in most instances these entities represent the
consolidated BHCs primary and most active
vehicles for external funding and liquidity man-
1050.2.3.3.2 Parent Company and agement. The primary supervisor retains respon-
Nonbank Funding and Liquidity sibility for assessing liquidity risk-management
practices with respect to the depository institu-
Objectives: One of the Federal Reserves pri- tion subsidiary.
mary responsibilities as consolidated supervisor
is to help ensure that the parent company and its Supervisory Activities: The Federal Reserve will
nonbank subsidiaries do not have an adverse use continuous monitoring activitiesincluding
impact on the organizations depository institu- monitoring market conditions and indicators
tion subsidiaries. To meet this objective, the where availableand discovery reviews to
Federal Reserve will assess the extent to which understand and assess parent company and
funding and liquidity policies and practices of nonbank subsidiary funding and liquidity poli-
the parent company or nonbank subsidiaries cies and practices, as well as any potential nega-
may undermine the BHCs ability to act as a tive impact these policies and practices might
source of strength to the organizations deposi- have on a subsidiary depository institution or
tory institution subsidiaries. the consolidated organization. On at least an
Areas of focus will include an assessment of annual basis, the results of these supervisory
activities will be reviewed to determine whether
1. the ability of the parent company and non- there is (1) a significant change in inherent
bank subsidiaries to maintain sufficient liquid- funding or liquidity risk stemming from chang-
ity, cash flow, and capital strength to service ing strategies or activities; (2) a significant
their debt obligations and cover fixed charges; change in organizational structure, oversight
2. the likelihood that parent company or non- mechanisms, key personnel, or other key ele-
bank funding strategies could undermine pub- ments of related risk-management or internal
lic confidence in the liquidity or stability of controls; or (3) any potential concern regard-
subsidiary depository institutions; ing the adequacy of related risk-management or
3. policies and practices that are aimed at ensur- internal controls.
ing the stability of parent company funding If significant changes or potential concerns
and liquidity, as evidenced by the utilization are identified, the Federal Reserve will design
of long-term or permanent financing to sup- and conduct testing activities focused on under-
port capital investments in subsidiaries and standing and assessing the areas of change and/or
other long-term assets, and the degree of concern in order to ensure that funding and
dependence on short-term funding mecha- liquidity risk-management and control functions
nisms such as commercial paper; are appropriately designed and achieving their
4. the extent of double leverage19 and the intended objectives.
organizations capital management policies, For regional BHCs where parent company or
including the distribution and transferability nonbank subsidiary third-party debt obligations
of capital across jurisdictions and legal enti- are deemed to be material in relation to equity
ties; and or may otherwise have a potentially negative
5. the parent companys ability to provide finan- impact on the BHCs ability to serve as a source
cial and managerial support to its depository of strength for its depository institution subsidi-
institution subsidiaries during periods of finan- aries, the Federal Reserve will undertake testing
cial stress or adversity, including the suffi- activities on at least a three-year cycle, assess-
ciency of related stress testing, scenario analy- ing the individual elements of risk management
sis, and contingency planning efforts. for parent company and nonbank funding and
The Federal Reserve also will remain apprised

20. This policy statement is available on the Boards pub-
lic website at www.federalreserve.gov/paymentsystems/psr.
19. Double leverage refers to situations in which debt is
issued by the parent company and the proceeds are invested in BHC Supervision Manual January 2009
subsidiaries as equity. Page 11
liquidity: board and senior management over- BHCs subsidiaries to ensure that the necessary
sight; policies, procedures, and limits; risk moni- information flows and coordination mechanisms
toring and management information systems; exist to permit the effective supervision of the
and related internal controls. In all cases involv- BHC on a consolidated basis. The Federal Reserve
ing a functionally regulated subsidiary, the Fed- will continue to share information, including
eral Reserve will conduct its activities in accor- confidential supervisory information, obtained
dance with the provisions described above in or developed through its consolidated supervi-
section 1050.2.1.2. sory activities with other relevant primary super-
visors or functional regulators when appropriate
and permitted by applicable laws and
1050.2.4 INTERAGENCY regulations.22
COORDINATION The Federal Reserve also will continue to use
a variety of formal and informal channels to
1050.2.4.1 Coordination and Information facilitate interagency information sharing and
Sharing Among Domestic Primary Bank coordination consistent with the principles out-
Supervisors and Functional Regulators lined above, including
Objectives: Effective consolidated supervision
supervisory protocols, agreements, and memo-
requires strong, cooperative relationships between
randa of understanding (MOUs) with primary
the Federal Reserve and other relevant domestic
supervisors and functional regulators that allow
primary bank supervisors and functional regula-
the coordination of supervisory activities and
tors.21 To achieve this objective, the Federal
that permit the ongoing exchange of informa-
Reserve has worked over the years to enhance
tion, including confidential information on a
interagency coordination through the develop-
confidential basis;
ment and use of information-sharing protocols
bilateral exchanges of letters to facilitate infor-
and mechanisms. These protocols and mecha-
mation sharing on a situation-specific basis;
nisms respect the individual statutory authorities
periodic and as-needed contacts with primary
and responsibilities of the respective supervisors
supervisors and functional regulators to dis-
and regulators, provide for appropriate informa-
cuss and coordinate matters of common inter-
tion flows and coordination to limit unnecessary
est, including the planning and conduct of
duplication or burden, comply with restrictions
examinations and continuous monitoring
governing access to information, and ensure that
activities;
the confidentiality of information is maintained.
the use of information technology platforms,
As discussed in section 1050.2.3, in
such as the Banking Organization National
understanding and assessing the activities and
Desktop (BOND),23 to provide secure auto-
risks of the organization as a whole, the Fed-
mated access to examination/inspection reports
eral Reserve will rely to the fullest extent pos-
and other supervisory information prepared
sible on the examination and other supervisory
by the Federal Reserve and other relevant
work conducted by the domestic primary bank
supervisors and regulators; and
supervisors and functional regulators of a
participation in a variety of interagency forums
BHCs subsidiaries. In addition, the Federal
that facilitate the discussion of broad industry
Reserve will seek to coordinate its supervisory
issues and supervisory strategies, including
activities with relevant supervisors and regula-
the Federal Financial Institutions Examination
tors, and will work to align each agencys
Council, the Presidents Working Group on
assessment of key corporate governance func-
Financial Markets, and the Federal Reserve-
tions, risk-management and internal control
functions for primary risks, financial condition, 22. Among the federal laws that may limit the sharing of
and other areas of the consolidated BHCs information among supervisors are the Right to Financial
operations as applicable. Privacy Act (12 U.S.C. 3401 et seq.) and the Trade Secrets
Act (18 U.S.C. 1905). The Federal Reserve has established
procedures to authorize the sharing of confidential supervi-
Supervisory Activities: The Federal Reserve will sory information, and Federal Reserve staff must ensure that
continue to work with the relevant primary appropriate approvals are obtained prior to releasing such
supervisors and functional regulators of a regional information. See Subpart C of the Boards Rules Regarding
the Availability of Information (12 C.F.R. 261.20 et seq.).
23. BOND is a Federal Reserve information technology
21. Section 1050.2.4.2 discusses cooperation and informa-
platform providing secure interagency access to documents,
tion sharing among foreign supervisors.
supervisory and financial data, and other information utilized
in the consolidated supervision of individual BHCs and FBOs,
BHC Supervision Manual January 2009 and in developing comparative analyses of organizations with
Page 12 similar business lines and risk characteristics.
sponsored cross-sector meetings of financial country authorities. As home-country supervi-

supervisors and regulators. sor for domestic BHCs, the Federal Reserve is
responsible for the comprehensive, consolidated
supervision of these organizations, while each
1050.2.4.1.1 Coordination of host country is responsible for supervision of
Examination Activities at a Supervised the legal entities (including foreign subsidiaries
BHC Subsidiary of U.S. BHCs) in its jurisdiction.
Information sharing among domestic and for-
As discussed in section III, the Federal Reserve eign supervisors, consistent with applicable laws,
will seek to work cooperatively with the rel- is essential to ensure that a regional BHCs
evant primary supervisor or functional regulator global activities are supervised on a consoli-
to address information gaps or indications of dated basis. Cross-border information sharing is
weakness or risk identified in a supervised BHC often facilitated by an MOU that establishes a
subsidiary that are material to the Federal framework for bilateral relationships and includes
Reserves understanding or assessment of the provisions for cooperation during the licensing
consolidated organizations risks, activities, or process, in the supervision of ongoing activities,
key corporate governance, risk-management, or and in the handling of problem institutions. The
control functions. Prior to conducting discovery Federal Reserve has established bilateral and
reviews or testing activities at a depository insti- multilateral information-sharing MOUs and other
tution (other than where the Federal Reserve is arrangements with numerous host-country for-
the primary federal supervisor) or functionally eign supervisors. The Federal Reserve also moni-
regulated subsidiary of a BHC, the Federal tors changes in foreign bank regulatory and
Reserve will supervisory systems and seeks to understand
how these systems affect supervised banking
review available information sources as part organizations. In addition to its longstanding
of its continuous monitoring activities, includ- cooperative relationships with home- and host-
ing examination reports and the BHCs inter- country foreign supervisors, the Federal Reserve
nal MIS, to determine whether such informa- expects to increasingly lead and participate in
tion addresses the Federal Reserves colleges of supervisors and other multilateral
information needs or supervisory concerns; groups of supervisors that discuss issues related
and to specific, internationally active banking
if needed, seek to gain a better understanding organizations.
of the primary supervisors or functional regu- The Federal Reserve also is a member of the
lators basis for its supervisory activities and Basel Committee on Banking Supervision, which
assessment of the subsidiary. This may include is a forum for supervisors from member coun-
a request to review related examination work. tries to discuss important supervisory issues,
foster consistent supervision of organizations
If, following these activities, the Federal with similar business and risk profiles, promote
Reserves information needs or supervisory con- the sharing of leading supervisory practices, and
cerns remain, the Federal Reserve will work formulate guidance to enhance and refine bank-
cooperatively with the relevant primary supervi- ing supervision globally.
sor or functional regulator in the manner dis- The Federal Reserves processes for under-
cussed in section 1050.2.3.24 standing and assessing firmwide legal and com-
pliance risk management, as described earlier,
encompass both domestic and international
1050.2.4.2 Cooperation and Information operations. Most areas of supervisory focus for
Sharing With Host-Country Foreign management of legal and compliance risks are
Supervisors applicable to both domestic and international
entities, and include proper oversight of licensed
Objectives: A number of regional BHCs have operations, compliance with supervisory and
international banking and other operations that regulatory requirements, and the sufficiency of
are licensed and supervised by foreign host- associated MIS.
There are, however, areas of focus for the
24. As outlined in section 1050.2.3, certain Federal Reserve Federal Reserve that are unique to a holding
examination activities are to be conducted on a minimum companys international operations. For exam-
three-year cycle to verify, through testing, the sufficiency of
key control processes. These activities are to be conducted
regardless of whether or not there is an information gap or BHC Supervision Manual January 2009
indication of weakness or risk. Page 13
ple, some host-country legal and regulatory whether the organization should be conducting
structures and supervisory approaches are operations in that host country.
fundamentally different from those in the In addition, any limits placed on the Federal
United States. As a result, the banking organiza- Reserves ability to access information on host-
tion often must devote additional resources to country operations, or to engage in onsite activi-
maintain expertise in local regulatory require- ties at the organizations operations in the host
ments. In some instances, privacy concerns country, should be considered when assessing
have led to limits on the information a BHCs whether the organizations activities in that juris-
foreign office may share with its parent com- diction are appropriate.
pany, thereby limiting the parent companys
ability to exercise consolidated risk manage-
ment on a global basis. 1050.2.4.3 Indications of Weakness or
Additionally, while considerable progress has Risk Related to Subsidiary Depository
been made to strengthen supervisory cross- Institutions
border cooperation and information sharing, the
Federal Reserve and other U.S. supervisors have Objectives: For areas beyond those specifically
at times faced challenges in accessing informa- addressed in section 1050.2.3, there may be
tion on a banks or BHCs foreign operations or circumstances where the Federal Reserve has
in carrying out examinations of cross-border or indications of material weakness or risk in a
foreign activities. These circumstances are to be depository institution subsidiary of a BHC that
taken into account when developing a supervi- is supervised by another primary supervisor, and
sory strategy for a regional BHC with cross- it is not clear that the weakness or risk is
border or foreign operations. adequately reflected in the assessment or super-
visory activities of that supervisor. Because a
Supervisory Activities: For regional BHCs with primary objective of consolidated supervision is
international operations, continuous monitoring to protect the BHCs depository institution sub-
will be used to understand and assess each sidiaries, the Federal Reserve will follow up
BHCs international strategy, trends, opera- with the appropriate primary supervisor in these
tions, and legal entity structure, as well as circumstances to help ensure that, to the extent
related governance, risk-management, and that a material weakness or risk exists, it is
internal controls. For a regional BHC with addressed appropriately.
significant international operations or risks, an
assessment of cross-border and foreign opera- Supervisory Activities: The Federal Reserve will
tions will be incorporated into the evaluation of take the following steps if it has indications of
key corporate governance functions and primary material weakness or risk in a depository institu-
firmwide risk-management and internal control tion subsidiary (other than where the Federal
functions, including legal and regulatory risk Reserve is the primary federal supervisor) in an
management. area beyond those specifically addressed in sec-
Continuous monitoring activities will include tion 1050.2.3, and it is not clear that the weak-
review of materials prepared by host-country ness or risk is adequately reflected in the assess-
supervisors, including examination reports and ment or supervisory activities of the depository
assessments, and ongoing communication with institutions primary supervisor.
relevant foreign and domestic supervisors regard-
ing trends and assessments of cross-border and The Federal Reserve will first review avail-
foreign operations. able information sources, discuss the areas of
When assessing the sufficiency of a regional concern with the primary supervisor, and seek
BHCs management of its international opera- to review the supervisors related work.
tions, consideration is given to the extent that If concerns remain following these activities,
foreign laws restrict the transmission of infor- the Federal Reserve will request that the pri-
mation to the BHCs head office. Impediments mary supervisor conduct a discovery review
to sharing information imposed by a host coun- or testing activity at the depository institution
try may constrain the BHCs ability to effec- to address the area of concern.
tively oversee its international operations and In the event the primary supervisor does not
globally manage its risks, and the materiality of undertake activities to address the concern in
such impediments should be a determinant of a reasonable period of time, the Federal Reserve
will design and lead an examination of the
BHC Supervision Manual January 2009 depository institution to address the matter in
Page 14 consultation with the primary supervisor. A
senior Federal Reserve official will communi- tory institution on the BHCs condition, and
cate this decision in writing to a senior official to determine if the holding company is provid-
of the primary supervisor. ing appropriate support to the depository insti-
tution. The Federal Reserve will coordinate its
activities with those of the primary supervisor
1050.2.4.4 Condition or Management of to the extent appropriate.
BHC Subsidiary is Less than Satisfactory Nonbank subsidiary. When any nonbank sub-
sidiary faces financial stress or material risks,
Objectives: As noted above, a primary responsi- the Federal Reserve will seek to ensure that its
bility of the Federal Reserve as consolidated condition and activities do not jeopardize the
BHC supervisor is to ensure that a holding safety and soundness of the BHC or its deposi-
companys activities, policies, and practices do tory institution subsidiaries, as discussed above
not undermine its ability to serve as a source of in sections 1050.2.3.3.1, Risk Management
financial and managerial strength to its deposi- and Financial Condition of Significant Non-
tory institution subsidiaries. In situations where bank Subsidiaries and 1050.2.3.3.2, Parent
the condition or management of a supervised or Company and Nonbank Funding and Liquid-
functionally regulated BHC subsidiary is deter- ity. The Federal Reserve also will take appro-
mined to be less than satisfactory, the Federal priate steps to ensure that any actions taken by
Reserves focus as consolidated supervisor is on the parent company to assist a nonbank sub-
complementing the efforts of the primary super- sidiary do not impair the BHCs continuing
visor or functional regulator. In doing so, the ability to serve as a source of strength to its
Federal Reserve will seek to ensure that the depository institution subsidiaries. The Fed-
parent company provides appropriate support to eral Reserve will coordinate its activities with
the subsidiary and does not take actions that those of any relevant functional regulator to
may further weaken the parent companys deposi- the extent appropriate.
tory institution subsidiaries or its ability to act
as a source of strength for such subsidiaries.
Beyond the specific activities noted below, 1050.2.4.5 Edge and Agreement
these circumstances also may require the Fed- Corporations
eral Reserve to enhance the activities addressed
in section 1050.2.3 for understanding and assess- Objectives: Some regional BHCs control an
ing key corporate governance functions, or pri- Edge or agreement corporation subsidiary. The
mary firmwide risk-management and internal Federal Reserve serves as the primary supervi-
controls. In addition, the Federal Reserve will sor of each Edge and agreement corporation
adjust its supervisory activities as necessary subsidiary in addition to its role as consolidated
when the consolidated BHC is in weakened BHC supervisor.25 When the Edge or agreement
condition or when there are questions regarding corporation is held by a U.S. bank, the primary
the capabilities of the holding companys supervisor often relies on information provided
management. by the Federal Reserve in developing its own
understanding and assessment of the parent bank.
Supervisory Activities: During each calendar year, the Federal Reserve
performs an examination of each Edge and
Depository institution subsidiary. In instances agreement corporation, assesses the Bank Secrecy
when a depository institution subsidiarys con- Act/Anti-Money-Laundering (BSA/AML) com-
dition or management is rated less than satis- pliance program, and assigns a CAMEO rating.
factory, or when the depository institution In addition, the Federal Reserve periodically
subsidiary otherwise faces financial stress or conducts assessments of Edge and agreement
material risks, the Federal Reserves primary
supervisory objectives as consolidated super-
25. The Federal Reserve is solely responsible for approv-
visor are to ensure that the parent company ing, and supervising the activities of, U.S. Edge and agree-
(1) provides appropriate support to the deposi- ment corporations. As discussed in SR-90-21, Rating Sys-
tory institution and (2) does not take action tem For International Examinations, one of the Federal
that could harm the depository institution. The Reserves supervisory responsibilities is the assignment of a
CAMEO rating (Capital, Asset Quality, Management, Earn-
Federal Reserve will work closely with the ings, and Operations and Internal Controls) to each Edge and
primary supervisor to understand whether the agreement corporation.
BHC or a nonbank affiliate has contributed to
the depository institutions weakened condi- BHC Supervision Manual January 2009
tion, to understand the impact of the deposi- Page 15
corporations to determine whether a consumer ration and those that are shared with the parent
compliance examination is warranted, in which bank or BHC, and will coordinate fulfillment of
case a compliance examination is conducted and the Federal Reserves responsibilities as Edge
a consumer compliance rating is assigned. and agreement corporation supervisor with
The Federal Reserve will coordinate the con- execution of its consolidated supervision role.
duct of its activities as Edge and agreement This strategy will reflect the extent to which
corporation supervisor with its activities as con- reliance can be placed on (1) the Federal Reserves
solidated supervisor. To this end, the extent and understanding and assessments of key corporate
scope of Federal Reserve supervisory work related governance, risk-management, and control func-
to an Edge or agreement corporation will be tions, as well as material portfolios and business
tailored to the entitys activities, risk profile, lines, of the consolidated BHC; (2) assessments
and other attributes. A number of specific ele- developed by the primary supervisor (when
ments will be considered when developing a applicable) for business lines, risk management,
supervisory approach, including control functions, or financial factors that are
common to the Edge or agreement corporation
1. structure and attributes, including whether and its parent bank; and (3) findings developed
the Edge or agreement corporation is a bank- by host-country supervisors for activities under
ing or investment organization; their jurisdiction.
2. the size, nature, and location of its primary In addition, where the primary supervisor of
activities, as well as key financial and other an Edge or agreement corporations parent bank
trends; relies on the Federal Reserves understanding
3. the business lines and risks, and associated and assessment in order to develop its CAMELS
trends, of the Edge or agreement corpora- rating,26 the Federal Reserve will work to fulfill
tions primary activities on a standalone basis, that supervisors information needs.
as well as their significance to the risk profile
of the parent bank (if applicable) and BHC;
4. the extent to which risk-management and 1050.2.4.6 Nontraditional Bank Holding
internal control functions are unique to the Companies
Edge or agreement corporation, or are shared
with a parent bank, another affiliate, or the Objectives: A small number of regional BHCs
consolidated BHC; are considered to be nontraditional bank holding
5. any potential Regulation K limitations or companies because most or all of their signifi-
other U.S. compliance issues, and the adequacy cant nondepository subsidiaries are regulated by
of processes to ensure ongoing compliance; a functional regulator, and subsidiary depository
and institutions are small in relation to the nonde-
6. the adequacy of processes for ensuring com- pository entities. As with all BHCs, the level of
pliance with all applicable laws and regula- analysis conducted and resources needed to
tions imposed by host-country supervisors supervise and assess nontraditional BHCs should
for the Edge or agreement corporations inter- be commensurate with the level of risk posed by
national operations. the organizations depository institution subsidi-
aries to the federal safety net and the level of
Supervisory Activities: The Federal Reserve will risk posed by the parent or its nonbank subsidi-
maintain an understanding and perform an annual aries to the BHCs subsidiary depository
examination for each Edge and agreement cor- institutions.
poration. While the examination scope will be Due to the unique structure of nontraditional
risk focused to reflect the organizations scale, BHCs, it is likely that a single functional regula-
activities, and risk profile, in all cases the Fed- tor will have a complete view of, and ability to
eral Reserve will assess the adequacy of pro- address, significant aspects of the organizations
cesses to ensure compliance with BSA/AML
requirements and other applicable U.S. laws and
regulations, and with applicable foreign laws 26. The U.S. banking agencies assign CAMELS (Capital
and regulations. Adequacy, Asset Quality, Management, Earnings, Liquidity,
and Sensitivity to Market Risk) ratings to U.S. banking orga-
In developing its supervisory strategy, the nizations as part of their ongoing supervision of these organi-
Federal Reserve will identify those elements zations. See SR-96-38, Uniform Financial Institutions Rat-
that are unique to the Edge or agreement corpo- ing System, (see A.5020.1 of the Commercial Bank
Examination Manual and sections 4020.9, 4070.0.4, and
4080.0) Also see SR-97-4, Interagency Guidance on Com-
BHC Supervision Manual January 2009 mon Questions About the Application of the Revised CAM-
Page 16 ELS Rating System.
firmwide activities, risks, risk management, and on the assessment of the IDI as reflected in the
controls. Therefore, assessments and informa- examination work performed by the IDI reg-
tion developed by the primary functional regula- ulator(s).
tor typically will be the main tool utilized by the The Federal Reserve tailors its supervision of
Federal Reserve in developing and assigning the holding companies based on the size of the
R and F components of the consolidated organization, complexity, and the degree of sys-
RFI rating. More independent Federal Reserve temic risk that the organization poses to the U.S.
work typically will be required to understand financial system and the economy, including the
and assess the impact of the nondepository enti- deposit insurance fund. Within this framework
ties on the subsidiary depository institutions in of tailored supervision, the Federal Reserve
order to assign the I rating. focuses on the goals of both macroprudential
and microprudential supervision for systemati-
Supervisory Activities: The Federal Reserve will cally important institutions, and microprudential
primarily utilize continuous monitoring activi- supervisory goals for BHCs and SLHCs with
ties to maintain its assessments of risk manage- total consolidated assets of less than $50 bil-
ment and financial condition for nontraditional lion.28
BHCs, relying on the assessments and informa- The BHC Act and the HOLA authorize the
tion developed by the primary functional regula- Federal Reserve to conduct examinations of
tor to the fullest extent possible. BHCs and SLHCs, and certain subsidiaries of
In addition to continuous monitoring, discov- such holding companies, to obtain information
ery reviews and periodic testing will be used to needed to assess the safety and soundness of
maintain an understanding and assessment of the supervised financial institutions.29 At the same
potential negative impact of nonbank entities on time, the Dodd-Frank Act requires the Federal
subsidiary depository institutions as discussed Reserve, to the fullest extent possible, to rely on
above in sections 1050.2.3.3.1 and 1050.2.3.3.2 the reports and supervisory information from
on, respectively, Risk Management and other regulatory agencies to avoid duplication of
Financial Condition of Significant Nonbank examination activities, reporting requirements,
Subsidiaries and Parent Company and and requests for information. Supervisory over-
Nonbank Funding and Liquidity. In all cases lap at the level of the IDI can be avoided
involving a functionally regulated subsidiary, the through reliance on the examination work per-
Federal Reserve will conduct its activities in formed by the IDI regulators, as each agency
accordance with the provisions described above follows similar rules and supervisory guidance
in section 1050.2.1.2. when assessing the financial and managerial
condition of an insured depository institution.
Consistent with this mandate to rely on the
1050.2.5 Relying on the Work of work of the IDI regulators, the IDI regulators
Regulators of Subsidiary Insured and the Federal Reserve have the mutual respon-
Depository Institutions sibility to foster the timely sharing of informa-
tion, including their risk-focused supervisory
The principle of relying on the work of the
Insured Depository Institution (IDI) regulators 28. While recognizing that a large number of smaller
BHCs and SLHCs simultaneously experiencing financial dis-
is a well-established tenet of Federal Reserve tress could have a harmful effect on a local economys avail-
supervisory policy and is required by statute.27 ability of credit or on certain sectors or regions of the U.S.
BHC and SLHC supervision focuses on the economy, institutions that are not systemically important do
Federal Reserves assessment of the consoli- not have the size or degree of interconnectedness to the
dated organization based on a review of parent financial system to individually pose macroprudential risk.
29. 12 U.S.C. 1844(c)(2); 12 U.S.C. 1467a(b)(4)(A). This
and nonbank activities, together with an assess- information pertains to the nature of the operations and finan-
ment of the organizations IDI subsidiaries. cial condition of the holding company and its subsidiaries; the
When assigning Federal Reserve supervisory financial, operational, and other risks within the holding com-
ratings to BHCs and SLHCs where the Federal pany system that may pose a threat to the safety and sound-
ness of the holding company or of any depository institution
Reserve is not the IDI regulator, the Federal subsidiary of the holding company, or the stability of the
Reserve will rely to the fullest extent possible financial system of the United States; the systems of the
holding company for monitoring and controlling any such
risks; and the holding companys and subsidiaries compli-
27. Refer to sections 5(c)(1)(2) of the Bank Holding
ance with federal law, other than in the case of an insured
Company Act of 1956 (BHC Act) and sections 10(b)(2) and
depository institution or functionally regulated subsidiary.
(b)(4) of the Home Owners Loan Act (HOLA), as amended
by section 604 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act). 12 U.S.C. BHC Supervision Manual July 2016
1844(c)(1)(2); 12 U.S.C 1467a(b)(2), (b)(4). Page 17
analysis and conclusions. Moreover, the sharing ers inspections and examinations to support
of information is necessary so that Federal Reserve and complement each others work as neces-
staff have an adequate basis for relying on the sary. Through ongoing dialogue and exchange
IDI regulators work. While exercising the Fed- of supervisory documents and information,
eral Reserves responsibility to assess and assign Federal Reserve staff are expected to:
appropriate supervisory ratings to the consoli- understand the IDI regulators risk assess-
dated holding company, the microprudential su- ment and supervisory plan for each IDI, to
pervision framework for smaller BHCs and include this information into the Federal
SLHCs provides the Federal Reserve with the Reserves evaluation of consolidated hold-
flexibility to rely on the assessment of an IDIs ing company risk, and to support develop-
condition by another regulator. ment of the Federal Reserves supervisory
The following guidance explains the Federal plan for the holding company;
Reserves expectations for its examiners reli- understand the IDI regulators examination
ance on the work of the regulators of insured work, including the scope, basis for, and
depository institution subsidiaries (IDI regula- support of conclusions reached, and the
tors30) in the supervision of regional bank hold- goal of any supervisory action;
ing companies (BHCs) and savings and loan communicate to the IDI regulators the Fed-
holding companies (SLHCs) with total consoli- eral Reserves supervision goals and ap-
dated assets of between $10 billion and $50 proach with respect to the holding com-
billion.31 Refer to SR-16-4. pany and any subsidiaries not subject to
the supervision of IDI regulators; and
use all information made available from
1050.2.5.1 Relying on the Work of IDI the IDI regulators to reach conclusions
Regulators for RBOs regarding the consolidated holding com-
panys overall condition and to assign ap-
The Federal Reserve supervises RBOs using a propriate Federal Reserve supervisory rat-
program of continuous oversight which is char- ings.
acterized by a series of targeted examinations 3. Federal Reserve staff should verify that the
during the annual supervisory cycle, a roll-up Federal Reserves supervisory ratings of the
examination at the end of the cycle, and continu- consolidated holding company are ad-
ous monitoring between examination events dur- equately supported by information that is
ing the cycle. timely and complete, including the informa-
tion received from the IDI regulators.
1. Taking into account a holding companys 4. Federal Reserve staff will scale their supervi-
complexity, risk profile, and condition, the sory approach, including the review of and
Federal Reserve will rely to the fullest extent reliance on the IDI regulators work, accord-
possible on the work of the IDI regulators to ing to the complexity,32 risk, and condition
supplement its own supervisory work regard- of the consolidated organization, and to the
ing the consolidated holding company and its timeliness of information available from the
nonbank subsidiaries. IDI regulators. For noncomplex holding com-
2. Federal Reserve staff will promote the shar- panies with satisfactory supervisory ratings,
ing of information with the IDI regulators Federal Reserve consolidated ratings should
throughout the supervisory cycle, which will rely heavily on the IDI regulators work for
foster collaborative interagency relation- IDI subsidiaries exhibiting the following char-
ships. Federal Reserve staff and the IDI regu- acteristics:
lators generally may participate on each oth- CAMELS Composite 1 or 2;
low or moderate risk profiles;
30. For the purpose of this guidance, IDI regulator is stable financial condition;
defined as the prudential bank regulator(s) other than the
Federal Reserve, which includes the Federal Deposit Insur-
32. The Federal Reserve distinguishes between complex
ance Corporation, the Office of the Comptroller of the Cur-
and noncomplex holding companies by evaluating a number
rency, and the state banking supervisory authorities.
of factors, including: the size and structure of the company;
31. [A]ll bank holding companies{with total consolidated
the extent of intercompany transactions between IDI subsidi-
assets of less than $50 billion includes by definition any U.S.
aries and the holding company or its non-depository subsidi-
bank holding company with total consolidated assets of less
aries; the risk, scale, and complexity of activities of any
than $50 billion that is owned or controlled by a foreign
non-depository subsidiaries; and the degree of leverage at the
banking organization.
holding company, including the extent of debt outstanding to
the public. Companies are also designated complex if mate-
BHC Supervision Manual July 2016 rial risk management processes for the holding company and
Page 18 its affiliates are consolidated at the parent company.
satisfactory management practices and an companys complexity, risk, condition of the

associated satisfactory management com- consolidated organization, and timeliness of
ponent rating; and information available from the IDI regulator.
IDI regulator examination reports issued For example, a holding company with the
within the past year. following characteristics is a candidate for
In these situations, the Federal Reserve closer Federal Reserve supervision to ensure
expects to limit its supervisory work to verify the conclusions reached by the IDI regulators
that the holding company can serve as a remain a valid basis for assigning the super-
source of strength to, and the non-bank sub- visory ratings to the consolidated holding
sidiaries do not pose a threat to, the safety company:
and soundness of the IDI(s). Thus, Federal the IDI examination reports are not cur-
Reserve staff will likely need to perform only rent;33
limited analysis outside of the required annual the composite rating for the holding com-
on-site holding company inspection of the pany or any of its IDI subsidiaries is less
parent and nonbank subsidiaries. In addition, than satisfactory; or
this analysis will be supplemented by the the holding company has deteriorating finan-
Federal Reserves continuous monitoring cial or risk trends that are not reflected in
process. the most current IDI regulators examina-
In other situations, the Federal Reserve will tion reports.
scale its supervisory approach, including per- 5. If Federal Reserve staff do not have an ad-
forming more detailed monitoring of a con- equate basis for relying on the IDI regula-
solidated holding companys internal man- tors supervisory findings, the Federal Reserve
agement information systems, internal audit, will work to resolve information gaps with
and loan review reports, depending on the the IDI regulators.34
33. For the purpose of this guidance, RBO IDI examina-

tion reports that are not current are defined as reports older
than one year, measured from the mailing date of a IDI
regulators report to the start date of the Federal Reserve
supervisory evaluation.
34. In rare and limited circumstances, where unresolved
information gaps exist or reliance upon information obtained
from the IDI regulators does not sufficiently support the
Federal Reserves supervision of a consolidated holding com-
pany, the Federal Reserve would consider invoking its expanded
examination authority under section 5(c)(2) of the BHC Act
and section 10(b)(4) of the HOLA, as amended by section 604
of the Dodd-Frank Act, to examine IDIs for which the Federal
Reserve is not the primary regulator. 12 U.S.C. 1844(c)(2); 12
U.S.C. 1467a(b)(4).

Page 19
Table of Contents
2000 Supervisory Policy and Issues
Sections Subsections Title
2000.0 Introduction to Topics for Supervisory Review
2010.0 Supervision of Subsidiaries
2010.0.1 Policy Statement on the Responsibility of Bank

Holding Companies to Act as Sources of Strength
to Their Subsidiary Banks
2010.0.2 Board Order Requesting a Waiver from the Boards
Source of Strength Policy
2010.0.3 Inspection Objectives
2010.0.4 Inspection Procedures
2010.1 Funding Policies

2010.2 Loan Administration
2010.2.1 Uniform Real Estate Lending Standards

2010.2.2 Lending Standards for Commercial Loans
2010.2.2.1 Sound Practices in Loan Standards and Approval
2010.2.2.1.1 Formal Credit Policies
2010.2.2.1.2 Formal Credit-Staff Approval of Transactions
2010.2.2.1.3 Loan-Approval Documents
2010.2.2.1.4 Use of Forward-Looking Tools in the Approval Process
2010.2.2.1.5 Stress Testing of the Borrowers Financial Capacity
2010.2.2.1.6 Management and Lender Information
2010.2.3 Leveraged Lending
2010.2.3.1 Interagency Guidance on Leveraged Lending
2010.2.3.1.1 Risk-Management Framework
2010.2.3.1.2 Leveraged Lending Definition
2010.2.3.1.3 General Policy Expectations
2010.2.3.1.4 Participations Purchased
2010.2.3.1.5 Underwriting Standards
2010.2.3.1.6 Valuation Standards
2010.2.3.1.7 Pipeline Management
2010.2.3.1.8 Reporting and Analytics
2010.2.3.1.9 Risk Rating Leveraged Loans
2010.2.3.1.10 Credit Analysis
2010.2.3.1.11 Problem-Credit Management
2010.2.3.1.12 Deal Sponsors
2010.2.3.1.13 Credit Review
2010.2.3.1.14 Stress Testing
2010.2.3.1.15 Conflicts of Interest
2010.2.3.1.16 Reputational Risk
2010.2.3.1.17 Compliance
2010.2.4 Credit-Risk Management Guidance for Home Equity
Lending
2010.2.4.1 Credit-Risk Management Systems

Page 1
Table of Contents 2000 Supervisory Policy and Issues
2010.2.4.1.1 Product Development and Marketing

2010.2.4.1.2 Origination and Underwriting
2010.2.4.1.3 Third-Party Originations
2010.2.4.1.4 Collateral-Valuation Management
2010.2.4.1.5 AVMs
2010.2.4.1.6 Account Management
2010.2.4.1.7 Portfolio Management
2010.2.4.1.8 Operations, Servicing, and Collections
2010.2.4.1.9 Secondary-Market Activities
2010.2.4.1.10 Portfolio Classifications, Allowance for Loan and
Lease Losses, and Capital
2010.2.5 Oversight of Concentrations in Commercial Real Estate
Lending and Sound Risk-Management Lending
2010.2.5.1 Scope of the CRE Concentration Guidance
2010.2.5.2 CRE Concentration Assessments
2010.2.5.3 CRE Risk Management
2010.2.5.3.1 Board and Management Oversight of CRE Concentration
Risk
2010.2.5.3.2 CRE Portfolio Management
2010.2.5.3.3 CRE Management Information Systems
2010.2.5.3.4 Market Analysis
2010.2.5.3.5 Credit Underwriting Standards
2010.2.5.3.6 CRE Portfolio Stress Testing and Sensitivity Analysis
2010.2.5.3.7 Credit-Risk Review Function
2010.2.5.4 Supervisory Oversight of CRE Concentration Risk
2010.2.5.4.1 Evaluation of CRE Concentrations
2010.2.5.4.2 Assessment of Capital Adequacy for CRE Concentration
Risk
2010.2.6 Guidance on Private Student Loans with Graduated
Repayment Terms at Origination
2010.2.6.1 Principles for Private Student Loans with Graduated
Repayment Terms at Origination
2010.2.7 Loan Participations, the Agreements and Participants
2010.2.7.1 Board Policies on Loan Participations
2010.2.7.2 Loan Participation Agreement
2010.2.7.3 Accounting for Loan Participations
2010.2.7.4 Structuring the Loan Participation Agreement
2010.2.7.5 Independent Credit Analysis
2010.2.7.6 Sales of Loan Participations in the Secondary Market
2010.2.7.7 Sale of Loan Participations With or Without the Right of
Recourse
2010.2.7.8 Sales of 100 Percent Participations
2010.2.7.9 Participation Transactions Between Affiliates
2010.2.7.9.1 Transfer of Low-Quality Assets
2010.2.7.10 Concentrations of Credit Involving Loan Participations
2010.2.7.11 Loan Participations and Environmental Liability
2010.2.7.12 Red Flag Warning Signals
2010.2.10 Internal Control Questionnaire
2010.2.11 Appendix I Examiner Loan-Sampling Requirements for
Credit-Extending Nonbank Subsidiaries of BHCs with
$10-50 Billion in Total Consolidated Assets

Page 2
2010.2.11.1 Loan Sampling Methodology

2010.2.11.2 Documentation of Loan Sampling Analysis and
Methodology
2010.2.11.3 Follow-Up Expectations for Inspections with Adverse
Findings
2010.3 Investments

Page 2.1
2010.4 Consolidated Planning Process

2010.5 Environmental Liability
2010.5.1 Background Information on Environmental Liability

2010.5.2 Overview of Environmental Hazards
2010.5.3 Impact on Banking Organizations
2010.5.4 Protection against Environmental Liability
2010.5.5 Conclusion
2010.6 Financial Institution Subsidiary Retail Sales

2010.6.1 Interagency Statement on Retail Sales of Nondeposit

Investment Products
2010.6.1.1 Scope
2010.6.1.2 Adoption of Policies and Procedures
2010.6.1.2.1 Program Management
2010.6.1.2.2 Arrangements with Third Parties
2010.6.1.3 General Guidelines
2010.6.1.3.1 Disclosures and Advertising
2010.6.1.3.2 Setting and Circumstances
2010.6.1.3.3 Qualifications and Training
2010.6.1.3.4 Suitability and Sales Practices
2010.6.1.3.5 Compensation
2010.6.1.4 Supervision by Banking Agencies
2010.6.2 Supplementary Federal Reserve Supervisory and
Examination Guidance Pertaining to the Sale of
Uninsured Nondeposit Investment Products
2010.6.2.1 Program Management
2010.6.2.1.1 Types of Products Sold
2010.6.2.1.2 Use of Identical or Similar Names
2010.6.2.1.3 Permissible Use of Customer Information
2010.6.2.1.4 Arrangements with Third Parties
2010.6.2.1.5 Contingency Planning
2010.6.2.2 Disclosures and Advertising
2010.6.2.2.1 Content, Form, and Timing of Disclosure
2010.6.2.2.2 Advertising
2010.6.2.2.3 Additional Disclosures
2010.6.2.3 Setting and Circumstances
2010.6.2.3.1 Physical Separation from Deposit Activities
2010.6.2.4 Designation, Training, and Supervision of Sales
Personnel and Personnel Making Referrals
2010.6.2.4.1 Hiring and Training of Sales Personnel
2010.6.2.4.2 Training of Bank Personnel Who Make Referrals
2010.6.2.4.3 Supervision of Personnel

Page 3
2010.6.2.5 Suitability and Sales Practices

2010.6.2.5.1 Suitability of Recommendations
2010.6.2.5.2 Sales Practices
2010.6.2.5.3 Customer Complaints
2010.6.2.6 Compensation
2010.6.2.7 Compliance
2010.6.2.8 Audit
2010.6.2.9 Joint Interpretations of the Interagency Statement
2010.6.2.9.1 Disclosure Matters
2010.6.2.9.2 Joint Interpretations on Retail Sales of Nondeposit
Investment Products
2010.6.3 Inspection/Examination Objectives
2010.6.4 Inspection/Examination Procedures
2010.6.4.1 Scope of the Procedures
2010.7 Reserved
2010.8 Sharing of Facilities and Staff by Banking

Organizations
2010.8.1 Identification of Facilities and Staff

2010.8.2 Examiner Guidance on Sharing Facilities and Staff
2010.9 Supervision of SubsidiariesRequired Absences

from Sensitive Positions
2010.9.1 Statement on Required Absences from Sensitive Positions
2010.10 Internal Loan Review

2010.11 Private-Banking Functions and Activities
2010.11.1 Overview of Private Banking and Its Associated Activities

2010.11.1.1 Products and Services
2010.11.1.1.1 Personal Investment Companies, Offshore Trusts,
and Token-Name Accounts
2010.11.1.1.2 Deposit-Taking Activities of Subsidiary Institutions
2010.11.1.1.3 Investment Management
2010.11.1.1.4 Credit
2010.11.1.1.5 Payable-Through Accounts
2010.11.1.1.6 Personal Trust and Estates
2010.11.1.1.7 Custody Services
2010.11.1.1.8 Funds Transfer
2010.11.1.1.9 Hold Mail, No-Mail, and Electronic-Mail Only
2010.11.1.1.10 Bill-Paying Services
2010.11.2 Functional Review
2010.11.2.1 Supervision and Organization

Page 4
2010.11.2.2.1 Customer-Due Diligence Policy and Procedures

2010.11.2.2.1.1 Suspicious Activity Reports
2010.11.2.2.2 Credit-Underwriting Standards
2010.11.2.3 Fiduciary Standards
2010.11.2.4 Operational Controls
2010.11.2.4.1 Segregation of Duties
2010.11.2.4.2 Inactive and Dormant Accounts
2010.11.2.4.3 Pass-Through Accounts and Omnibus Accounts
2010.11.2.4.4 Hold-Mail, No-Mail, and E-mail-Only Controls
2010.11.2.4.5 Funds TransferTracking Transaction Flows
2010.11.2.4.6 CustodyDetection of Free-Riding
2010.11.2.5 Management Information Systems
2010.11.2.6 Audit
2010.11.2.7.1 Office of Foreign Assets Control
2010.11.2.7.2 Bank Secrecy Act
2010.11.3 Preparation for Inspection
2010.11.3.1 Pre-Inspection Review
2010.11.3.2 Inspection Staffing and Scope
2010.11.3.3 Reflection of Organizational Structure
2010.11.3.4 Risk-Focused Approach
2010.11.3.5 First-Day Letter
2010.11.5.1 Private-Banking Pre-Inspection Procedures
2010.11.5.2 Full-Inspection Phase
2010.12 Fees Involving Investments of Fiduciary Assets in
Mutual Funds and Potential Conflicts of Interest
2010.12.1 Due-Diligence Review Needed before Entering

into Fee Arrangements
2010.13 Establishing Accounts for Foreign Governments,

Embassies, and Political Figures
2010.13.1 Interagency Advisory on Accepting Accounts for Foreign

Governments, Embassies, and Political Figures
2020.0 Intercompany TransactionsIntroduction
2020.0.1 Analysis of Intercompany Transactions

2020.0.2 Role of the Examiner
2020.1 Intercompany Transactions Between Affiliates

Sections 23A and 23B of the Federal Reserve Act
2020.1.01 Whats New in this Revised Section

2020.1.05 Sections 23A and 23B of the Federal Reserve Act, and
Regulation W
2020.1.1 Section 23A of the Federal Reserve Act

Page 4.1
2020.1.1.1 Definition of an Affiliate

2020.1.1.2 Definition of Affiliates by Type of Entity
2020.1.1.2.1 Investment Funds Advised by the Member Bank or an
Affiliate of the Member Bank
2020.1.1.2.2 Financial Subsidiaries
2020.1.1.2.3 Partnerships
2020.1.1.2.4 Subsidiaries of Affiliates
2020.1.1.2.5 Companies Designated by the Appropriate Federal Banking
Agency
2020.1.1.2.6 Merchant Banking
2020.1.1.2.7 Companies that are not Affiliates
2020.1.1.2.8 Employee Benefit Plans
2020.1.2 Quantitative Limits
2020.1.3 Capital Stock and Surplus
2020.1.3.1 Determination of Control
2020.1.4 Covered Transactions
2020.1.4.1 Attribution Rule
2020.1.4.2 Credit Transactions with an Affiliate
2020.1.4.2.1 Extension of Credit to an Affiliate or Other Credit
Transaction with an Affiliate
2020.1.4.2.2 Valuation of Credit Transactions with an Affiliate
2020.1.4.2.3 Timing of a Credit Transaction with an Affiliate
2020.1.4.2.4 Leases
2020.1.4.2.5 Extensions of Credit Secured by Affiliate Securities
General Valuation Rule (Section 223.24(a) and (b))
2020.1.4.2.6 Extensions of Credit Secured by Affiliate Securities
Mutual Fund Shares
2020.1.4.3 Asset Purchases
2020.1.4.3.1 Purchase of Assets under Regulation W
2020.1.4.4 IDIs Purchase of Securities Issued by an Affiliate
2020.1.4.5 Issuance of a Letter of Credit or Guarantee
2020.1.4.5.1 Confirmation of a Letter of Credit Issued by an Affiliate
2020.1.4.5.2 Credit Enhancements Supporting a Securities Underwriting
2020.1.4.5.3 Cross-Guarantee Agreements and Cross-Affiliate Netting
Arrangements
2020.1.4.5.4 Keepwell Agreements
2020.1.4.5.5 Prohibition on the Purchase of Low-Quality Assets
2020.1.5 Collateral for Certain Transactions with Affiliates
2020.1.5.1 Collateral Requirements in Regulation W
2020.1.5.1.1 Deposit Account Collateral
2020.1.5.1.2 Ineligible Collateral
2020.1.5.1.3 Perfection and Priority
2020.1.5.1.4 Unused Portion of an Extension of Credit
2020.1.5.1.5 Purchasing Affiliate Debt Securities in the Secondary
Market
2020.1.5.1.6 Credit Transactions with Nonaffiliates that Become
Affiliates
2020.1.6 Limitations on Collateral
2020.1.7 Derivative Transactions with Affiliates
2020.1.7.1 Derivative Transactions between Insured Depository
Institutions and Their Affiliates

Page 4.2
2020.1.7.1.1 Section 23A on Derivatives Transactions

2020.1.7.1.2 Section 23B and Regulation W Regarding Derivative
Transactions
2020.1.7.1.3 Covering Derivatives that are the Functional Equivalent of
a Guarantee
2020.1.8 Intraday Extensions of Credit
2020.1.8.1 Standard under Which the Agencies May Grant Additional
Exemptions
2020.1.9 Exemptions from Section 23A
2020.1.9.1 Covered Transactions Exempt from the Quantitative Limits
and Collateral Requirements
2020.1.9.1.1 Parent Institution/Subsidiary Institution Transactions
2020.1.9.1.2 Sister-Bank Exemption (Section 223.41(b)).
2020.1.9.1.3 Purchase of Loans on a Non-Recourse Basis from an
Affiliate IDI
2020.1.9.1.4 Internal Corporate Reorganizations
2020.1.9.2 Other Covered Transactions Exempt from the Quantitative
Limits, Collateral Requirements, and Low-Quality-Asset
Prohibition
2020.1.9.2.1 Correspondent Banking
2020.1.9.2.2 Secured Credit Transactions
2020.1.10 Asset Purchases from an AffiliateExemptions
2020.1.10.1 Purchase of a Security by an Insured Depository Institution
from an Affiliate
2020.1.10.2 Purchases of Assets with Readily Identifiable Market Quotes
2020.1.10.3 Purchasing Certain Marketable Securities
2020.1.10.3.1 Broker-dealer Requirement and Securities Purchases from
Foreign Broker-Dealers
2020.1.10.3.2 Securities Eligible for Purchase by a State Member Bank
2020.1.10.3.3 No Purchases Within 30 Days of an Underwriting
2020.1.10.3.4 No Securities Issued by an Affiliate
2020.1.10.3.5 Price-Verification Methods
2020.1.10.3.6 Record Retention
2020.1.10.4 Purchasing Municipal Securities
2020.1.10.5 Purchase of Loans on a Non-Recourse Basis
2020.1.10.6 Purchases of Assets by Newly Formed Institutions
2020.1.10.7 Transactions Approved under the Bank Merger Act
2020.1.11 Purchases of Extensions of Creditthe Purchase
Exemption
2020.1.12 Other Board-Approved Exemptions from Section 23A
2020.1.12.1 Exemptions and Interpretations from the Attribution Rule
of Section 23A
2020.1.12.2 InterpretationLoans to a Nonaffiliate that Purchases
Securities or Other Assets Through a Depository
Institution Affiliate Agent or Broker
2020.1.12.3 ExemptionLoans to a Nonaffiliate that Purchases
Securities from a Depository Institution Securities
Affiliate That Acts as a Riskless Principal
2020.1.12.4 ExemptionDepository Institution Loan to a Nonaffiliate
Pursuant to a Preexisting Line of Credit and the
Proceeds Are Used to Purchase Securities from the
Institutions Broker-Dealer Affiliate

Page 4.3
2020.1.12.5 ExemptionCredit Card Transactions

2020.1.13 An IDIs Acquisition of an Affiliate that Becomes an
Operating Subsidiary
2020.1.14 Step-Transaction Exemption (Section 223.31(d) and (e))
2020.1.14.1 Application of Sections 23A and 23B of Subpart G to U.S.
Branches and Agencies of Foreign Banks
2020.1.14.1.1 Applicability of Sections 23A and 23B to Foreign Banks
Engaged in Underwriting Insurance, Underwriting or
Dealing in Securities, Merchant Banking, or Insurance
Company Investment in the United States
2020.1.15 Section 23B of the Federal Reserve Act
2020.1.15.1 Transactions Exempt from Section 23B of the FRA
2020.1.15.2 Purchases of Securities for Which an Affiliate Is the
Principal Underwriter
2020.1.15.3 Definition of Affiliate under Section 23B
2020.1.15.4 Advertising and Guarantee Restriction
2020.1.18 Laws, Regulations, Interpretations, and Orders
2020.2 Loan ParticipationsIntercompany Transactions

Page 4.4

2020.3 Sale and Transfer of Assets

2020.4 Compensating Balances

2020.5 Dividends
2020.5.1 Policy Statement on Cash Dividend Payments

2020.5.1.1 Policy Statement on the Payment of Cash Dividends
by State Member Banks and Bank Holding
Companies
2020.6 Management and Service Fees
2020.6.1 Transactions Subject to Federal Reserve Act

Section 23B
2020.7 Transfer of Low-Quality Loans or Other Assets

2020.8 (Reserved for Future Use)
2020.9 Split-Dollar Life Insurance
2020.9.1 Split-Dollar Life Insurance Arrangements

2020.9.1.1 Split-Dollar Life Insurance Endorsement Plan
2020.9.1.2 Split-Dollar Life Insurance Collateral Assignment
2020.9.2 Compliance with Applicable Laws
2020.9.2.1 Compliance with Sections 23A and 23B of the FRA
2020.9.2.2 Investment Authority under the National Banking Act
2020.9.3 Safety-and-Soundness Concerns
2020.9.4 Examiner Review of Split-Dollar Life Insurance

Page 5
2030.0 Grandfather RightsRetention and Expansion of

Activities
2030.0.1 Indefinite Grandfather Privileges

2030.0.2 Activities and Securities of New Bank Holding
Companies
2030.0.3 Limitations on Expansion of Grandfather Rights for
Insurance Agency Nonbanking Activities of Bank
Holding Companies
2030.0.4 Successor Rights
2030.0.5 Expansion of Grandfather Activities
2030.0.6 Divestitures
2030.0.10 Appendix 1Expansion of Grandfathered Activities
2040.0 Commitments to the Federal Reserve


2050.0.1 BHC Official and Related Interest Transactions
between the Parent Company or Its Nonbank
Subsidiaries
2050.0.2 Transactions Involving Other Property or Services
2050.0.3 Regulation O
2050.0.3.1 FDICIA and BHC Inspection Guidance for
Regulation O
2050.0.3.2 Definitions in Regulation O (abbreviated listing)
2050.0.3.2.1 Extension of Credit
2050.0.3.2.2 Insiders Use of a Bank-Owned Credit Card
2050.0.3.3 General Prohibitions and Limitations of Regulation O
2050.0.3.4 Additional Restrictions on Loans to Executive Officers
of Member Banks
2050.0.3.5 Grandfathering Provisions
2050.0.3.6 Reports by Executive Officers
2050.0.3.7 Report on Credit to Executive Officers
2050.0.3.8 Disclosure of Credit from Member Banks to Executive
Officers and Principal Shareholders
2050.0.3.9 Civil Penalties of Regulation O
2050.0.3.10 Records of Member Banks (and BHCs)
2050.0.3.10.1 Recordkeeping for Insiders of the Member Banks
Affiliates
2050.0.3.10.2 Special Rule for Noncommercial Lenders
2050.0.3.11 Section 23A Ramifications
2050.0.4 Remedial Action

Page 6
2060.0 Management Information Systems
2060.05 Policy Statement on the Internal Audit Function

and Its Outsourcing
2060.05.01 An Effective System of Internal Controls
2060.05.02 Reserved
2060.05.04
2060.05.05 Application of the Sarbanes-Oxley Act to Nonpublic
Banking Organizations
2060.05.06 Interagency Policy Statement on the Internal Audit
Function and Its Outsourcing
2060.05.1 Internal Audit Function (Part I)
2060.05.1.1 Director and Senior Management Responsibilities for
Internal Audit
2060.05.1.1.1 Internal Audit Placement and Structure Within the
Organization
2060.05.1.1.2 Internal Audit Management, Staffing, and Audit Quality
2060.05.1.1.3 Internal Audit Frequency and Scope
2060.05.1.1.4 Communication of Internal Findings to the Directors,
Audit Committee, and Management
2060.05.1.2 U.S. Operations of Foreign Banking Organizations
2060.05.1.3 Internal Audit Systems and the Audit Function for
Small Financial Institutions
2060.05.2 Internal Audit Outsourcing Arrangements (Part II)
2060.05.2.1 Examples of Internal Audit Outsourcing Arrangements
2060.05.2.2 Additional Inspection and Examination Considerations
for Internal Audit Outsourcing Arrangements
2060.05.2.2.1 Management of the Outsourced Internal Audit Function
2060.05.2.2.2 Communication of Outsourced Internal Audit Findings
to Directors and Senior Management
2060.05.2.3 Independence of the External Auditor
2060.05.2.3.1 Agencies Views on Independence
2060.05.3 Independence of the Independent Public Accountant
(Part III)
2060.05.3.1 Applicability of the SECs Auditor Independence
Requirements
2060.05.3.1.1 Institutions That Are Public Companies
2060.05.3.1.2 Depository Institutions Subject to the Annual Audit
and Reporting Requirements of Section 36 of the
FDI Act
2060.05.3.1.3 Institutions Not Subject to Section 36 of the FDI Act
That Are Neither Public Companies Nor Subsidiaries
of Public Companies
2060.05.3.1.4 AICPA Guidance
2060.05.4 Inspection Guidance (Part IV)
2060.05.4.1 Review of Internal Audit Function and Outsourcing
Arrangements
2060.05.4.2 Inspection Concerns About the Adequacy of the
Internal Audit Function
2060.05.4.3 Concerns About the Independence of the Outsourcing
Vendor

Page 7

2060.05.6.1 Internal Audit Function Inspection Procedures
2060.05.6.2 Other Internal Audit Function Inspection Procedures
2060.05.6.3 Additional Aspects of the Examiners Review of an
Outsourcing Arrangement
2060.05.6.4 Assessment of Auditor Independence
2060.05.6.5 Supplemental Procedures to Evaluate the Effectiveness
of the Internal Audit Function
2060.05.6.6 Continuous Monitoring between Inspections of Internal
Audit
2060.05.6.7 Evaluating the Ability to Rely on Internal Audit
2060.05.6.8 Considerations for Consolidated Supervision
2060.07 Supplemental Policy Statement on the Internal Audit

Function and its Outsourcing
2060.07.1 Supplemental Policy Guidance
2060.07.1.1 Enhanced Internal Audit Practices
2060.07.1.1.1 Risk Analysis
2060.07.1.1.2 Thematic Control Issues
2060.07.1.1.3 Challenging Management and Policy
2060.07.1.1.4 Infrastructure
2060.07.1.1.5 Risk Tolerance
2060.07.1.1.6 Governance and Strategic Objectives
2060.07.1.2 Internal Audit Function (Part I of the 2003 Policy
Statement)
2060.07.1.2.1 Attributes of Internal Audit
2060.07.1.2.2 Corporate Governance Considerations
2060.07.1.2.3 The Adequacy of the Internal Audit Functions Processes
2060.07.1.2.4 Internal Audit Performance and Monitoring Processes
2060.07.1.3 Internal Audit Outsourcing Arrangements (Part II of the
2003 Policy Statement)
2060.07.1.3.1 Vendor Competence
2060.07.1.3.3 Quality of Audit Work
2060.07.1.4 Independence Guidance for the Independent Public
Accountant (Part III of the 2003 Policy Statement)
2060.07.1.4.1 Depository Institutions Subject to the Annual Audit and
Reporting Requirements of Section 36 of the FDI Act
2060.07.1.5 Examination Guidance (Part IV of the 2003 Policy
Statement)
2060.07.1.5.1 Determining the Overall Effectiveness of Internal Audit
2060.07.1.5.2 Relying on the Work Performed by Internal Audit
2060.1 Audit
2060.1.2 External Auditors and the Release of Required

Information
2060.1.3 External Auditor Inquiries
2060.1.4 Unsafe and Unsound Use of Limitation-of-Liability
Provisions in External Audit Engagement Letters
2060.1.4.1 Scope of the Advisory on Engagement Letters
2060.1.4.2 External Audits and Their Engagement Letters

Page 8
2060.1.4.3 Limitation-of-Liability Provisions

2060.1.4.4 Auditor Independence
2060.1.4.5 Alternative Dispute-Resolution Agreements and Jury-Trial
Waivers
2060.1.4.6 The Advisorys Conclusion
2060.1.4.7 Examples of Unsafe and Unsound Limitation-of-Liability
Provisions
2060.1.4.8 Frequently Asked Questions on the Application of the
SECs Auditor-Independence Rules
2060.1.7 Reserved
2060.1.8 Overview: Interagency Advisory on External Audits of
Internationally Active U.S. Financial Institutions
2060.1.8.1 Appendix AInteragency Advisory on External Audits of
Internationally Active U.S. Financial Institutions
2060.2 Budget

2060.3 Records and Statements

2060.4 Structure and Reporting

2060.5 Insurance
2060.5.1 Introduction
2060.5.2 Bankers Blanket Bond
2060.5.3 Types of Blanket Bonds
2060.5.4 Determining the Coverage Needed
2060.5.5 Notification of Loss
2060.5.6 Directors and Officers Liability Insurance
2065.1 Accounting, Reporting, and Disclosure Issues

2065.1.1 Cash-Basis Income Recognition on Nonaccrual Assets

2065.1.2 Nonaccrual Assets Subject to SFAS 15 and SFAS 114
Restructurings
2065.1.3 Restructurings Resulting in a Market Interest Rate
2065.1.4 Nonaccrual Treatment of Multiple Loans to One
Borrower

Page 9
2065.1.4.1 Troubled-Debt RestructuringReturning a

Multiple-Note Structure to Accrual Status
2065.1.4.2 Nonaccrual Loans That Have Demonstrated Sustained
Contractual Performance
2065.1.5 Acquisition of Nonaccrual Assets
2065.1.6 Treatment of Nonaccrual Loans with Partial
Charge-Offs
2065.1.7 In-Substance Foreclosures
2065.1.8 Liquidation Values of Real Estate Loans
2065.2 Determining an Adequate Level for the Allowance for


2065.3 Maintenance of an Appropriate Allowance for Loan

and Lease Losses (ALLL)
2065.3.0 Overview of the ALLL Policy Statement

2065.3.1 2006 Interagency Policy Statement on the Allowance for
2065.3.1.1 Nature and Purpose of the ALLL
2065.3.1.2 Responsibility of the Board of Directors and Management
2065.3.1.2.1 Appropriate ALLL Level
2065.3.1.2.2 Factors to Consider in the Estimation of Credit Losses
2065.3.1.2.3 Measurement of Estimated Credit Losses
2065.3.1.2.4 Analyzing the Overall Measurement of the ALLL
2065.3.1.2.5 Estimated Credit Losses in Credit-Related Accounts
2065.3.1.3 Examiner Responsibilities
2065.3.1.4 ALLL Level Reflected in Regulatory Reports
2065.3.1.5 Appendix 1Loan-Review Systems
2065.3.1.5.1 Loan Classification or Credit Grading Systems
2065.3.1.5.2 Elements of Loan-Review Systems
2065.3.1.6 Appendix 2International Transfer Risk Considerations
2065.4 ALLL Methodologies and Documentation
2065.4.1 2001 Policy Statement on ALLL Methodologies

and Documentation
2065.4.1.1 Documentation Standards
2065.4.1.2 Policies and Procedures
2065.4.1.3 Methodology
2065.4.1.3.1 Documentation of ALLL Methodology in Written Policies
and Procedures
2065.4.1.4 ALLL Under FAS 114
2065.4.1.5 ALLL Under FAS 5
2065.4.1.5.1 Segmenting the Portfolio
2065.4.1.5.2 Estimating Loss on Groups of Loans
2065.4.1.6 Consolidating the Loss Estimates
2065.4.1.7 Validating the ALLL Methodology
2065.4.1.7.1 Supporting Documentation for the Validation Process

Page 10
2065.4.1.8 AppendixApplication of GAAP

2065.5 ALLL Estimation Practices for Loans Secured

by Junior Liens
2065.5.1 ALLL Estimation Practices for Loans and Lines of Credit

Secured by Junior Liens on 14 Family Residential
Properties
2065.5.1.1 Responsibilities of Management
2065.5.1.1.1 Consideration of All Significant Factors
2065.5.1.1.2 Adequate Segmentation
2065.5.1.1.3 Qualitative or Environmental Factor Adjustments
2065.5.1.1.4 Charge-Off and Nonaccrual Policies
2065.5.1.1.5 Responsibilities of Examiners
2068.0 Sound Incentive Compensation Policies
2068.0.1 Scope of Application

2068.0.2 Principles of a Sound Incentive Compensation System
2068.0.2.1 Principle 1: Balanced Risk-Taking Incentives
2068.0.2.2 Principle 2: Compatibility with Effective Controls
and Risk-Management
2068.0.2.3 Principle 3: Strong Corporate Governance
2068.0.3 Conclusion on Sound Incentive Compensation
2070.0 TaxesConsolidated Tax Filing
2070.0.1 Interagency Policy Statement on Income Tax Allocation

in a Holding Company Structure
2070.0.1.1 Tax-Sharing Agreements
2070.0.1.2 Measurement of Current and Deferred Income Taxes
2070.0.1.3 Tax Payments to the Parent Company
2070.0.1.4 Tax Refunds from the Parent Company
2070.0.1.5 Income-Tax-Forgiveness Transactions
2070.0.2 Qualifying Subchapter S Corporations
2080.0 FundingIntroduction
2080.05.1 Funding and Liquidity

2080.05.2 Additional Supervisory Considerations
2080.05.3 Examiners Application of Principles in Evaluating
Liquidity and in Formulating Corrective Action
Programs

Page 11
2080.1 Commercial Paper and Other Short-Term Uninsured

Debt Obligations and Securities
2080.1.1 Meeting the SEC Criteria

2080.1.1.1 Nine-Month Maturity Standard
2080.1.1.2 Prime Quality
2080.1.1.3 Current Transactions
2080.1.1.4 Sales to Institutional Investors
2080.1.2 Marketing of Commercial Paper
2080.1.3 Thrift Notes and Similar Debt Instruments
2080.1.4 Other Short-Term Indebtedness
2080.1.5 Current Portion of Long-Term Debt
2080.2 Long-Term Debt
2080.2.1 Convertible Subordinated Debenture

2080.2.2 Convertible Preferred Debenture
2080.2.3 Negative Covenants
2080.3 Equity
2080.3.1 Preferred Stock

2080.4 Retention of Earnings
2080.4.1 Payment of Dividends by Bank Subsidiaries

2080.4.1.1 Net Income Test
2080.4.1.2 Undivided Profits Test
2080.5 Pension Funding and Employee Stock Option Plans
2080.5.1 Stock Option Programs

2080.5.2 Employee Stock Ownership Plans (ESOPs)
2080.5.2.1 Accounting Guidelines for Leveraged ESOP
Transactions
2080.5.2.2 Fiduciary Standards under ERISA Pertaining
to ESOPs
2080.5.3 Status of ESOPs under the BHC Act
2080.5.4 Inspection Considerations
2080.6 Bank Holding Company Funding from Sweep Accounts
2080.6.1 Funding by Sweeping Deposit Accounts
2090.0 Control and OwnershipGeneral

Page 12
2090.0.05 Definitions
2090.0.1 Conclusive Presumptions of Control
2090.0.2 Direct Control
2090.0.3 Indirect Control
2090.0.4 Rebuttable Presumptions of Control
2090.0.4.1 Regulation Y Determinants of Control
2090.0.4.2 Other Presumptions of Control
2090.0.5 Procedures for Determining Control
2090.05 Qualified Family Partnerships
2090.05.1 Qualified Family Partnership Exemption

2090.05.2 Assignment of Economic Partnership Interest that is a QFP
2090.1 Change in Control
2090.1.1 Commitments and Conditions for Approval

2090.1.2 Completion of the Transaction
2090.1.3 Information to Be Included in Notices
2090.1.4 Transactions Requiring Submission of Prior Notice
2090.1.4.1 Rebuttable Presumption of Control
2090.1.4.2 Rebuttable Presumption of Concerted Action
2090.1.5 Transactions Not Requiring Any Notice
2090.1.6 Transactions Not Requiring Prior Notice
2090.1.7 Unauthorized or Undisclosed Changes in Bank Control
2090.1.8 Changes or Replacement of an Institutions Chief Executive
Officer or Any Director
2090.1.9 Disapproval of Changes in Control
2090.1.10 Additional Reporting Requirements
2090.1.11 Stock Redemptions
2090.1.12 Corrective Action
2090.2 BHC Formations
2090.2.1 Formation of a Bank Holding Company and Changes

in Ownership
2090.2.2 History of the Policy Statement on the Formation of
Small Bank Holding Companies
2090.2.3 Small Bank Holding Company and Savings and Loan
Holding Company Policy Statement
2090.2.3.1 Applicability of Policy Statement
2090.2.3.2 Ongoing Requirements
2090.2.3.2.1 Reduction in Parent Company Leverage
2090.2.3.2.2 Capital Adequacy
2090.2.3.2.3 Dividend Restrictions
2090.2.3.3 Core Requirements for All Applicants
2090.2.3.3.1 Minimum Down Payment

Page 12.1
2090.2.3.3.2 Ability to Reduce Parent Company Leverage

2090.2.3.4 Additional Application Requirements for Expedited
Processing
2090.2.3.4.1 Expedited Notices under Sections 225.14 and 225.23
of Regulation Y
2090.2.3.4.2 Waiver of Stock-Redemption Filing
2090.3 Treasury Stock Redemptions
2090.3.1 Change in Control Act Considerations

2090.4 Policy Statements on Equity Investments in Banks

and Bank Holding Companies
2090.4.1 Overview and Guiding Principles
2090.4.2 Boards 1982 Policy Statement on Nonvoting Equity
Investments by Bank Holding Companies
2090.4.2.1 Statutory and Regulatory Provisions
2090.4.2.2 Review of Agreements

2090.4.2.3 Provisions that Avoid Control
2090.4.2.4 Review by the Board
2090.4.3 Activities of Banking Organizations and Board
Determinations Subsequent to the 1982 Policy Statement
2090.4.4 Boards 2008 Policy Statement on Equity Investments
in Banks and Bank Holding Companies
2090.4.4.1 Specific Approaches to Avoid Control
2090.4.4.1.1 Director Representation
2090.4.4.1.2 Total Equity
2090.4.4.1.3 Consultations with Management
2090.4.4.1.4 Other Indicia of Control
2090.4.4.1.4.1 Business Relationships
2090.4.4.1.4.2 Covenants
2090.4.4.2 Conclusion of the 2008 Policy Statement
2090.5 Acquisitions of Bank Shares through Fiduciary

Accounts
2090.6 Divestiture Control Determinants
2090.6.05 Control Determinants


Page 12.2
2090.7 Nonbank Banks
2090.7.1 CEBA and FIRREA Provisions for Nonbank Banks

2090.7.2 Retaining Grandfather Rights Under Section 4(f)
of the BHC Act
2090.8 Control and OwnershipLiability of Commonly

Controlled Depository Institutions
2090.8.1 Five-Year Protection from Liability (5-Year
Transition Rule)
2090.8.2 Cross-Guarantee Provisions
2090.8.3 Exclusions for Institutions Acquired in Debt
Collections
2092.0 Reserved
2093.0 Control and OwnershipShareholder Protection

Arrangements
2093.0.1 Shareholder Protection ArrangementsSupervisory Issues
2093.0.2 Supervisory Oversight
2100.0 International Banking Activities

2100.0.1 Foreign Operations of U.S. Banking Organizations
2100.0.2 Edge Act and Agreement Corporations
2100.0.3 Supervision of Foreign Banking Organizations

Page 12.3
2110.0 Formal Corrective Actions
2110.0.1 Statutory Tools for Formal Supervisory Action

2110.0.2 Types of Corrective Actions
2110.0.2.1 Cease-and-Desist Orders
2110.0.2.2 Temporary Cease-and-Desist Orders
2110.0.2.3 Written Agreements
2110.0.2.4 Prohibition and Removal Authority
2110.0.2.5 Termination of Nonbank Activity
2110.0.2.6 Violations of Final Orders and Written Agreements
2110.0.2.7 Civil Money Penalties
2110.0.2.8 Administration of Formal Actions
2110.0.2.8.1 Publication of Final Orders
2110.0.2.8.2 Public Hearings
2110.0.2.8.3 Subpoena Power
2110.0.3 Indemnification Payments and Golden Parachute Payments
2110.0.3.1 Indemnification Agreements and Payments
2110.0.3.2 Golden Parachute Payments
2110.0.4 Disciplinary Actions Against Accountants and Accounting
Firms Performing Certain Audit Services
2110.0.5 Appointment of Directors and Senior Executive Officers
2120.0 Foreign Corrupt Practices Act and Federal Election

Campaign Act
2120.0.2 Summary of the Federal Election Campaign Act
2120.0.3 Banks and the FECA
2120.0.4 Contributions and Expenditures
2120.0.5 Separate Segregated Funds and Political Committees
2120.0.8 Apparent Violations of the Statutes
2120.0.9 Advisory Opinions
2122.0 Internal Credit-Risk Ratings at Large Banking

Organizations
2122.0.1 Application to Large Bank Holding Companies

2122.0.2 Sound Practices in Function and Design of Internal Rating
Systems
2122.0.3 Sound Practices in Assigning and Validating Internal Risk
Ratings
2122.0.4 Application of Internal Risk Ratings to Internal
Management and Analysis
2122.0.4.1 Limits and Approval Requirements
2122.0.4.2 Reporting to Management on Credit-Risk Profile of
the Portfolio
2122.0.4.3 Allowance for Loan and Lease Losses
2122.0.4.4 Pricing and Profitability
2122.0.4.5 Internal Allocation of Capital

Page 13
2124.0 Risk-Focused Safety-and-Soundness Inspections
2124.0.1 Full Scope Inspections and Transaction Testing

2124.0.2 Risk-Focused Inspections
2124.0.2.1 Risk Assessment
2124.0.2.2 Preparation of a Scope Memorandum
2124.0.2.3 On-Site Procedures
2124.0.2.4 Evaluation of Audit Function as Part of Assessment
of Internal Control Structure
2124.0.2.5 Evaluation of Overall Risk-Management Process
2124.0.2.6 Evaluation of Compliance with Laws and Regulations
2124.0.2.7 Documentation of Supervisory Findings
2124.0.2.8 Communication of Supervisory Findings
2124.0.5 Appendix ADefinitions of Risk Types Evaluated
at Inspections
2124.01 Risk-Focused Supervision Framework for Large
2124.01.1 Inspection Approach for Risk-Focused Supervision
2124.01.1.1 Risk-Focused Supervisory Objectives
2124.01.1.2 Key Elements of the Risk-Focused Framework
2124.01.1.3 Banking Organizations Covered by the Framework
2124.01.1.3.1 Foreign Institutions
2124.01.1.3.2 Nonbank Subsidiaries of Domestic Institutions
2124.01.1.3.3 Edge Act Corporations
2124.01.1.3.4 Specialty Areas Covered by the Framework
2124.01.2 Coordination of Supervisory Activities
2124.01.2.1 Responsible Reserve Bank
2124.01.2.2 RRBs Working with Local Reserve Banks
2124.01.2.2.1 RRB Defined
2124.01.2.2.2 Duties of RRB
2124.01.2.2.3 Sharing of RRB Duties
2124.01.2.3 Central Point of Contact
2124.01.2.4 Sharing of Information
2124.01.2.5 Coordination with Other Supervisors
2124.01.3 Functional Approach and Targeted Inspections
2124.01.4 Overview of the Process and Products
2124.01.5 Understanding the Institution
2124.01.5.1 Sources of Information
2124.01.5.2 Preparation of the Institutional Overview
2124.01.6 Assessing the Institutions Risks
2124.01.6.1 Assessment of the Overall Risk Environment
2124.01.6.1.1 Internal Risk-Management Evaluation
2124.01.6.1.2 Supervision Program for Consumer Compliance Risk
Assessment at BHCs
2124.01.6.1.3 Adequacy of Information Technology Systems
2124.01.6.2 Preparation of the Risk Matrix
2124.01.6.2.1 Identification of Significant Activities

Page 14
2124.01.6.2.2 Type and Level of Inherent Risk of Significant Activities

2124.01.6.2.3 Risk-Management Adequacy Assessment for Significant
Activities
2124.01.6.2.4 Composite Risk Assessment of Significant Activities
2124.01.6.2.5 Overall Composite Risk Assessment
2124.01.6.2.6 Preparation of the Risk Assessment
2124.01.7 Planning and Scheduling Supervisory Activities
2124.01.7.1 Preparation of the Supervisory Plan
2124.01.7.2 Preparation of the Inspection or Examination Program
2124.01.8 Defining Inspection or Examination Activities
2124.01.8.1 Scope Memorandum
2124.01.8.2 Entry Letter
2124.01.9 Performing Inspection or Examination Procedures
2124.01.10 Reporting the Findings
2124.01.11 Appendix ARisk-Focused Supervisory Letters with BHC
Supervision Manual Section Number References
2124.01.12 Appendix BRisk-Assessment Questionnaire
2124.01.13 Appendix CFederal Reserve Bank Cover Letter and BHC
Inspection Questionnaire
2124.022124.04 Reserved
2124.05 Consolidated Supervision Framework for Large Financial

Institutions
2124.05.1 Framework Applicability
2124.05.2 Framework Overview
2124.05.3 Enhancing Resiliency of a Firm
2124.05.3.1 Capital and Liquidity Planning and Positions
2124.05.3.2 Corporate Governance
2124.05.3.3 Recovery Planning
2124.05.4 Reducing the Impact of a Firms Failure
2124.05.4.1 Management of Critical Operations
2124.05.4.2 Support for Banking Offices
2124.05.4.3 Resolution Planning
2124.05.4.4 Additional Macroprudential Supervisory Approaches to
Address Risks to Financial Stability
2124.05.5 Conduct of Supervisory Activities
2124.05.6 Appendix A
2124.05.6.1 Risk Transfer Considerations When Assessing Capital
Adequacy
2124.05.7 Managing Foreign Exchange Settlement Risks for
Physically Settled Transactions
2124.07 Compliance Risk-Management Programs and Oversight
at Large Banking Organizations with Complex
Compliance Profiles
2124.07.1 Firmwide Compliance Risk Management and Oversight

2124.07.1.1 Overview
2124.07.1.2 Federal Reserve Supervisory Policies on Compliance Risk
Management and Oversight
2124.07.1.2.1 Large Banking Organizations with Complex Compliance
Profiles

Page 15
2124.07.1.2.2 Large Banking Organizations with Less-Complex

Compliance Profiles
2124.07.1.2.3 Foreign Banking Organizations
2124.07.2 Independence of Compliance Staff
2124.07.3 Compliance Monitoring and Testing
2124.07.3.1 Risk Assessments and Monitoring and Testing Programs
2124.07.3.2 Testing
2124.07.4 Responsibilities of the Board of Directors and Senior
Management
2124.07.4.1 Boards of Directors
2124.07.4.2 Senior Management
2124.1 Assessment of Information Technology in Risk-Focused

Supervision
2124.1.1 Changing Role of Information Technology

2124.1.2 Implications for Risk-Focused Supervision
2124.1.3 Framework for Evaluating Information Technology
2124.1.4 Aligning Examiner Staffing with the Technology
Environment
2124.1.7 Appendix AExamples of Information Technology
Elements That Should Be Considered in Assessing
Business Risks of Particular Situations
2124.2 Reserved
2124.3 Managing Outsourcing Risk
2124.4 Information Security Standards
2124.4.1 Interagency Guidelines Establishing Information Security
Standards
2124.4.1.1 Disposal of Customer and Consumer Information
2124.4.2 Response Programs for Unauthorized Access to Customer
Information and Customer Notice
2124.4.2.1 Response Programs
2124.4.2.1.1 Components of a Response Program
2124.4.2.2 Customer Notice
2124.4.2.2.1 Standard for Providing Notice
2124.4.2.2.2 Sensitive Customer Information
2124.4.2.2.3 Affected Customers
2124.4.2.2.4 Content of Customer Notice
2124.4.2.2.5 Delivery of Customer Notice
2124.4.3 Inspection Objective
2124.4.5 Appendix AInteragency Guidelines Establishing
Information Security Standards
2124.5 Identity Theft Red Flags and Address Discrepancies
2124.5.1 Identity Theft Red Flags Prevention Program

2124.5.1.1 Risk Assessment

Page 16
2124.5.1.2 Elements of the Program

2124.5.1.3 Guidelines
2124.5.1.3.1 Identification of Red Flags
2124.5.1.3.2 Categories of Red Flags
2124.5.1.3.3 Detect the Programs Red Flags
2124.5.1.3.4 Respond Appropriately to any Detected Red Flags
2124.5.1.3.5 Periodically Updating the Programs Relevant Red Flags
2124.5.1.4 Administration of Program

Risk Management and Internal Controls
2125.0.1 Oversight of the Risk Management Process

2125.0.1.1 Board of Directors Approval of Risk Management
Policies
2125.0.1.2 Senior Managements Risk Management
Responsibilities
2125.0.1.3 Independent Risk Management Functions
2125.0.2 The Risk Management Process
2125.0.2.1 Risk Measurement Systems
2125.0.2.2 Limiting Risks
2125.0.2.3 Reporting
2125.0.2.4 Management Evaluation and Review of the Risk
Management Process
2125.0.2.5 Managing Specific Risks
2125.0.2.5.1 Credit Risks
2125.0.2.5.2 Market Risk
2125.0.2.5.3 Liquidity Risk
2125.0.2.5.4 Operational Risk, Legal Risk, and Business Practices
2125.0.3 Internal Controls and Audits
2126.0 Model Risk Management
2126.0.1 IntroductionPart I
2126.0.2 Purpose and ScopePart II
2126.0.3 Overview of Model Risk ManagementPart III
2126.0.4 Model Development, Implementation, and UsePart IV
2126.0.4.1 Model Development and Implementation
2126.0.4.2 Model Use
2126.0.5 Model ValidationPart V
2126.0.5.1 Key Elements of Comprehensive Validation
2126.0.5.1.1 Evaluation of Conceptual Soundness
2126.0.5.1.2 Ongoing Monitoring
2126.0.5.1.3 Outcomes Analysis
2126.0.5.2 Validation of Vendor and Other Third-Party Products
2126.0.6 Governance, Policies, and ControlsPart VI
2126.0.6.1 Board of Directors and Senior Management
2126.0.6.2 Policies and Procedures
2126.0.6.3 Roles and Responsibilities
2126.0.6.4 Internal Audit
2126.0.6.5 External Resources

Page 17
2126.0.6.6 Model Inventory

2126.0.6.7 Documentation
2126.0.7 ConclusionPart VII
2126.1 Investment Securities and End-User Derivatives Activities
2126.1.0 Sound Risk-Management Practices for Portfolio Investment
2126.1.1 Supervisory Policy Statement on Investment Securities
and End-User Derivatives Activities
2126.1.1.1 Purpose
2126.1.1.2 Scope
2126.1.1.3 Board and Senior Management Oversight
2126.1.1.4 Risk-Management Process
2126.1.1.4.1 Policies, Procedures, and Limits
2126.1.1.4.2 Risk Identification, Measurement, and Reporting
2126.1.1.4.3 Internal Controls
2126.1.1.5 Risks of Investment Activities
2126.1.1.5.1 Market Risk
2126.1.1.5.2 Credit Risk
2126.1.1.5.3 Liquidity Risk
2126.1.1.5.4 Operational (Transaction) Risk
2126.1.1.5.5 Legal Risk
2126.2 Investing in Securities without Reliance on Ratings of

Nationally Recognized Statistical Rating Organizations
2126.2.1 Appendix 1OCC Guidance on Due Diligence Require-
ments in Determining Whether Securities are Eligible for
Investment.
2126.3 Counterparty Credit Risk Management Systems
2126.3.1 Fundamental Elements of Counterparty-Credit-Risk

Management
2126.3.2 Targeting Supervisory Resources
2126.3.3 Assessment of Counterparty Creditworthiness
2126.3.4 Credit-Risk-Exposure Measurement
2126.3.5 Credit Enhancements
2126.3.6 Credit-Risk-Exposure Limit-Setting and Monitoring
Systems
2126.5 Procedures for a Banking Entity to Request an Extended

Transition Period for Illiquid Funds
2126.5.1 Volcker Rules Background

2126.5.2 Requirements for Submitting Requests
2126.5.3 Procedures for Filing an Extension Request
2127.0 Interest-Rate RiskRisk Management and Internal

Controls
2127.0.1 Assessing the Management and Internal Controls Over

Interest-Rate Risk

Page 18
2127.0.2 Joint Agency Policy Statement: Interest-Rate Risk

2127.0.3 Interagency Advisory on Interest Rate Risk Management
2128.0 Structured Notes
2128.0.1 Supervisory PolicyStructured Notes

2128.02.1 Overview of Asset Securitization

2128.02.2 Securitization Process
2128.02.3 Credit Enhancement
2128.02.4 Structure of Asset-Backed Securities
2128.02.5 Supervisory Considerations Regarding Asset
Securitization
2128.02.6 Policy Statement on Investment Securities and End-User
Derivatives Activities
2128.02.6.1 Mortgage-Derivative Products
2128.02.7 Risk-Based Capital Provisions Affecting Asset
Securitization
2128.02.7.1 Assigning Risk Weights
2128.02.7.2 Recourse Obligations
2128.02.7.2.1 Residuals
2128.02.7.2.2 Credit-Equivalent Amounts and Risk Weights of Recourse
Obligations and Direct-Credit Substitutes
2128.02.7.2.3 Low-Level-Recourse Treatment
2128.02.7.2.4 Standby Letters of Credit
2128.02.8 Concentration Limits Imposed on Residual Interests
2128.03 Credit-Supported and Asset-Backed Commercial

Paper
2128.03.1 Credit-Supported and Asset-Backed Commercial

Paper as an Alternative Funding Source
2128.03.2 Commercial Bank Involvement in Credit-Enhanced
and Asset-Backed Commercial Paper
2128.03.3 Risk-Based Capital Asset-Backed Commercial
Paper Program
2128.03.3.1 Liquidity Facilities Supporting ABCP
2128.03.3.2 Overlapping Exposures to an ABCP Program
2128.03.3.3 Asset-Quality Test
2128.03.3.4 Market Risk Capital Requirements for ABCP Programs
2128.03.4 Board-of-Directors Policies Pertaining to Credit-
Enhanced or Asset-Backed Commercial Paper
2128.04 Implicit Recourse Provided to Asset Securitizations


Page 18.1
2128.05 Securitization Covenants Linked to Supervisory Actions

or Thresholds
2128.06 Valuation of Retained Interests and Risk Management

of Securitization Activities
2128.06.05 Retained Interests from Securitization Activities
2128.06.1 Asset Securitization
2128.06.2 Independent Risk-Management Function
2128.06.3 Valuation and Modeling Processes
2128.06.4 Use of Outside Parties
2128.06.5 Internal Controls
2128.06.6 Audit Function or Internal Review
2128.06.7 Regulatory Reporting of Retained Interests
2128.06.8 Market Discipline and Disclosures
2128.06.9 Risk-Based Capital for Recourse and Low-Level-Recourse
Transactions

Page 18.2
2128.06.10 Concentration Limits Imposed on Retained Interests

2128.07 Reserved
2128.08 Subprime Lending
2128.08.1 Interagency Guidance on Subprime Lending

2128.08.1.2 Examination Review and Analysis
2128.08.1.2.1 Transaction-Level Testing
2128.08.1.3 Adequacy of the ALLL
2128.08.1.3.1 New Entrants to the Business
2128.08.1.3.2 Pools of Subprime LoansNot Classified
2128.08.1.4 Classification Guidelines for Subprime Lending
2128.08.1.4.1 Individual Loans
2128.08.1.4.2 Portfolios
2128.08.1.5 Required Documentation for Cure Programs
2128.08.1.6 Predatory or Abusive Lending Practices
2128.08.1.7 Capitalization
2128.08.1.7.1 Stress Testing
2128.08.1.8 Subprime-Lending Examiner Responsibilities
2128.08.1.9 AppendixQuestions and Answers for Examiners
Regarding the Expanded Guidance for Subprime-
Lending Programs
2128.08.1.9.1 Applicability of the Guidance
2128.08.1.9.2 Subprime Characteristics
2128.08.1.9.3 Capital Guidance
2128.09 Elevated-Risk Complex Structured Finance Activities
2128.09.1 Interagency Statement on Sound Practices Concerning
Elevated-Risk Complex Structured Finance Activities
2128.09.2 Scope and Purpose of Statement
2128.09.3 Identification and Review of Elevated-Risk Complex
Structured Finance Transactions
2128.09.3.1 Identifying Elevated-Risk CSFTs
2128.09.3.2 Approval and Documentation Process for Elevated-Risk
CSFTs
2128.09.3.2.1 Due Diligence
2128.09.3.2.2 Approval Process
2128.09.3.2.3 Documentation
2128.09.3.3 Other Risk-Management Principles for Elevated-Risk
CSFTs
2128.09.3.3.1 General Business Ethics
2128.09.3.3.2 Reporting
2128.09.3.3.3 Monitoring Compliance with Internal Policies and
Procedures
2128.09.3.3.4 Audit
2128.09.3.3.5 Training
2128.09.4 Conclusion

Page 19
2129.0 Credit Derivatives
2129.0.1 Supervisory and Examiner Guidance

2129.0.2 Types of Credit Derivatives
2129.0.2.1 Credit-Default Swaps
2129.0.2.2 Total-Rate-of-Return Swaps
2129.0.3 Other Supervisory Issues
2129.0.3.1 Credit Exposure
2129.0.3.2 Concentrations of Credit
2129.0.3.3 Classifications of Assets
2129.0.3.4 Transactions Involving Affiliates
2129.05 Risk and Capital Adequacy Management of the Exposures

Arising from Secondary-Market Credit Activities
2129.05.05 Risk Identification and Risk Management of Secondary

Market Credit Activities
2129.05.1 Credit Risks in Secondary-Market Credit Activities
2129.05.1.1 Loan Syndications
2129.05.1.2 Credit Derivatives
2129.05.1.3 Recourse Obligations, Direct Credit Substitutes, and
Liquidity Facilities
2129.05.1.3.1 Recourse Obligations
2129.05.1.3.2 Direct Credit Substitutes
2129.05.1.3.3 Liquidity Facilities
2129.05.1.4 Asset Securitization Structures
2129.05.2 Reputational Risks
2129.05.3 Liquidity Risks
2129.05.4 Incorporating the Risks of Secondary-Market Credit
Activities into Risk Management
2129.05.4.1 Board of Directors and Senior Management
Responsibilities
2129.05.4.2 Management Information and Risk-Measurement Systems
2129.05.4.3 System of Internal Controls
2129.05.5 Stress Testing
2129.05.6 Capital Adequacy
2130.0.2 Definitions
2130.0.3 Financial Contract Transactions
2130.0.3.1 Markets and Contract Trading
2130.0.3.1.1 Forward Contracts
2130.0.3.1.2 Standby Contracts
2130.0.3.1.3 Futures Contracts
2130.0.4 Margin Requirements
2130.0.4.1 Variation Margin Calls

Page 20
2130.0.5 The Delivery Process

2130.0.6 Mechanics and Operation of Futures Exchanges
2130.0.7 Comparison of Futures, Forward, and Standby
Contracts
2130.0.8 Option Contracts
2130.0.8.1 Other Options
2130.0.8.1.1 Stock Index Options
2130.0.8.1.2 Foreign Currency Options
2130.0.8.2 Caps, Floors, and Collars
2130.0.9 Regulatory Framework
2130.0.10 Examples of Contract Strategies
2130.0.10.1 The Mortgage Banking Price Hedge
2130.0.10.2 Basis
2130.0.10.3 Trading Account Short Hedge
2130.0.10.3.1 Example 1: A Perfect Short Hedge
2130.0.10.4 Long Hedge
2130.0.10.4.1 Evaluation of the Hedge
2130.0.10.5 Using Options to Create an Interest Rate Floor
2130.0.10.6 Hedging a Borrowing with an Interest Rate Cap
2130.0.11 AssetLiability Management
2130.0.13.1 Evaluating the Risks of Contract Activities
2130.0.13.2 Reviewing Financial Contract Positions
2130.0.13.3 Factors to Consider in Evaluating Overall Risk
2130.0.13.4 Contract Liquidity
2130.0.13.5 Relationship to Banking Activities
2130.0.13.6 Parties Executing or Taking the Contra Side of a
Financial Contract
2130.0.14 Accounting for Futures Contracts
2130.0.14.1 Performance Bonds under Futures Contracts
2130.0.14.2 Valuation of Open Positions
2130.0.14.3 Criteria for Hedge Accounting Treatment
2130.0.14.4 Gains and Losses from Monthly Contract Valuations
of Futures Contracts That Qualify as Hedges
2130.0.14.5 Gains and Losses from Monthly Contract Valuations
of Futures Contracts That Do Not Qualify as Hedges
2130.0.15 Preparing Inspection Reports
2130.0.16 Internal Controls and Internal Audit
2130.0.16.1 Internal Controls
2130.0.16.2 Internal Audit
2140.0 Securities Lending
2140.0.1 Securities Lending Market

2140.0.2 Definitions of Capacity
2140.0.3 Guidelines
2140.0.3.1 Recordkeeping
2140.0.3.2 Administrative Procedures
2140.0.3.3 Credit Analysis and Approval of Borrowers
2140.0.3.4 Credit and Concentration Limits

Page 21
2140.0.3.5 Collateral Management

2140.0.3.6 Cash as Collateral
2140.0.3.7 Letters of Credit as Collateral
2140.0.3.8 Written Agreements
2140.0.3.9 Use of Finders
2140.0.3.10 Employee Benefit Plans
2140.0.3.11 Indemnification
2150.0.1 Credit Policy Guidelines

2150.0.1.1 Dealings with Unregulated Securities Dealers
2150.0.2 Guidelines for Controlling Repurchase Agreement
Collateral
2150.0.2.1 Confirmations
2150.0.2.2 Control of Securities
2150.0.2.3 Margin Requirements
2150.0.2.4 Overcollateralization
2150.0.3 Operations
2160.0 Recognition and Control of Exposure to Risk
2160.0.1 Risk Evaluation

2160.0.2 Risk Control
2170.0 Purchase and Sale of Loans Guaranteed by the U.S.

Government
2170.0.2 Recommendations for Originating and Selling
Institutions
2170.0.3 Recommendations for Purchasing Institutions
2175.0 Sale of Uninsured Annuities
2175.0.2 Permissibility of Uninsured Annuity Sales
2175.0.3 Characteristics of Annuity Instruments
2175.0.4 Improper Marketing Practices
2178.0 Support of Bank-Affiliated Investment Funds
2178.0.1 Policy on Banks Providing Financial Support to Advised

Funds
2178.0.2 Notification and Consultation with the Primary
Federal Regulator

Page 22

2180.0 Securities Activities in Overseas Markets
2187.0 Violations of Federal Reserve Margin Regulations

Resulting from Free-Riding Schemes
2187.0.1 Typical Day Trading or Free-Riding Activities

2187.0.2 Securities Credit Regulations
2187.0.2.1 Regulation U, Credit by Banks or Persons Other
Than Brokers or Dealers for the Purpose
of Purchasing or Carrying Margins Stocks
2187.0.2.2 Regulation T, Credit by Brokers and Dealers, and
Regulation X, Borrowers of Securities Credit
2187.0.3 New-Customer Inquiries and Warning Signals
2187.0.4 Scope of the Inspection for Free-Riding Activities
2187.0.5 SEC and Federal Reserve Sanctions and
Enforcement Actions
2220.3 Note Issuance and Revolving Underwriting Credit

Facilities
2220.3.1 Note Issuance Facility (NIF)

2220.3.2 Revolving Underwriting Facility (RUF)
2220.3.3 Risk
2220.3.4 Pricing and Fees
2220.3.5 Standby RUFs
2220.3.6 RUF Documents
2231.0 Real Estate Appraisals and Evaluations
2231.0.1 Interagency Appraisal and Evaluation Guidelines

2231.0.2 Supervisory Policy
2231.0.3 Appraisal and Evaluation Program
2231.0.4 Independence of the Appraisal and Evaluation Program
2231.0.5 Selection of Appraisers or Persons Who Perform
Evaluations
2231.0.5.1 Approved Appraiser List
2231.0.5.2 Engagement Letters
2231.0.6 Transactions that Require Appraisals
2231.0.7 Minimum Appraisal Standards
2231.0.8 Appraisal Development
2231.0.9 Appraisal Reports
2231.0.10 Transactions that Require Evaluations
2231.0.11 Evaluation Development
2231.0.12 Evaluation Content
2231.0.13 Validity of Appraisals and Evaluations
2231.0.14 Reviewing Appraisals and Evaluations

Page 23
2231.0.14.1 Reviewer Qualifications

2231.0.14.2 Depth of Review
2231.0.14.3 Resolution of Deficiencies
2231.0.14.4 Documentation of the Review
2231.0.15 Third-Party Arrangements
2231.0.16 Program Compliance
2231.0.16.1 Monitoring Collateral Values
2231.0.16.2 Portfolio Collateral Risk
2231.0.16.3 Modifications and Workouts of Existing Credits
2231.0.17 Referrals
2231.0.18 Appendixes in Interagency Appraisal And Evaluation
Guidelines
2231.0.19 Background Information On Appraisal Valuation
Approaches
2231.0.19.1 Cost Approach
2231.0.19.2 Sales Comparison Approach
2231.0.19.3 Income Approach
2231.0.19.4 Value Correlation
2231.0.19.5 Other Definitions of Value
2231.0.20 Supervisory Expectations and Findings
2231.0.23.1 Policies
2231.0.23.2 Appraisals
2231.0.23.3 Appraisers
2231.0.23.4 Evaluations
2231.0.23.5 Evaluators
2231.0.23.6 Monitoring Collateral Values
2231.0.23.7 Third Party Arrangements
2231.0.23.8 Analytical Methods and Technological Tools
2231.0.24 Laws, Regulations, Interpretations, Board Orders
2240.0 Guidelines for the Review and Classification of

Troubled Real Estate Loans
2240.0.1 Examiner Review of Commercial Real Estate Loans

2240.0.1.1 Loan Policy and Administration Review
2240.0.1.2 Indicators of Troubled Real Estate Markets and Projects,
and Related Indebtedness
2240.0.1.3 Examiner Review of Individual Loans, Including
Analysis of Collateral Value
2240.0.2 Classification Guidelines
2240.0.2.1 Classification of Troubled Project-Dependent
Commercial Real Estate Loans
2240.0.2.2 Guidelines for Classifying Partially Charged-Off Loans
2240.0.2.3 Guidelines for Classifying Formally Restructured Loans
2240.0.3 Treatment of Guarantees in the Classification Process
2240.0.3.1 Considerations Relating to a Guarantors Financial
Capacity
2240.0.3.2 Considerations Relating to a Guarantors Willingness
to Repay

Page 24
2240.0.3.3 Other Considerations as to the Treatment of

Guarantees in the Classification Process
2241.0 Retail-Credit Classification
2241.0.1 Uniform Retail-Credit Classification and Account-

Management Policy
2241.0.1.1 Other Considerations for Classification
2241.0.1.2 Partial Payments on Open-End and Closed-End Credit
2241.0.1.3 Re-aging, Extensions, Deferrals, Renewals, or Rewrites
2241.0.1.4 Depository Institution Examination Considerations
2250.0 Domestic and Other Reports to Be Submitted
to the Federal Reserve
2250.0.1 Penalties for Errors in Reports
2250.0.2 Approval of Directors and Senior Officers of
Depository Institutions
2260.0 Venture Capital
2260.0.2 Loans and Investments
2260.0.3 Funding
2260.0.4 Profitability
2260.0.5 Capitalization
2260.0.7.1 Pre-Inspection
2260.0.7.2 On-Site Inspection
2260.0.7.3 Matters Warranting Recommendation in Inspection
Report
2260.0.9 Appendix 1Venture Capital Company Sample
Balance Sheet
2260.0.10 Appendix 2Venture Capital Company Sample Income
Statement
2500.0 Supervision of Savings and Loan Holding Companies
2500.0.1 Applicable Law, Regulations, and Guidance

Page 25
Introduction To Topics For Supervisory Review
Section 2000.0
Discussed within these subsections are topics agement information systems, taxes, funding,
associated with regard to the overall bank control and ownership, reporting by foreign
holding company organization. Included is gen- and domestic banking organizations, formal
eral information, inspection objectives and corrective actions, sharing of criminal referral
procedures, and in some instances references to information, investment transactions, recog-
laws, interpretations, and Board orders. The nition and control of risk, purchase and sale of
primary topics addressed are the supervision of U.S. Government guaranteed loans, and venture
subsidiaries, grandfather rights, commitments, capital.
extensions of credit to BHC officials, man-
BHC Supervision Manual December 1992

Page 1
Supervision of Subsidiaries
Section 2010.0
WHATS NEW IN THIS REVISED of the bank holding company organization
SECTION should be disadvantaged by a transaction with
another affiliate. Management of the investment
This section is revised to include a revision of portfolio, budgets, tax planning, personnel, cor-
the Federal Deposit Insurance Act (FDIA) that respondent relationships, loans and loan partici-
requires a BHC or SLHC to serve as a source pations, and liability management are usually
of strength to its depository institution subsidi- controlled by the parent or lead bank in a cen-
aries. See section 38A of the FDIA and section tralized system.
616(d) of the Dodd-Frank Act. A decentralized system is one in which the
banks act independently of the parent company,
The relative merit of the degree of supervision with infrequent contacts with affiliates, place-
is dependent upon a number of factors, and must ment of parent or lead bank directors and offi-
be analyzed in light of efficiency and operating cers in less than a majority of the banks within
performance. The degree and nature of control the system and infrequent reporting by subsidi-
over subsidiary organizations in a holding aries concerning investments and operating per-
company system usually falls between two formance. The bank holding company might act
extremes: a tightly controlled, centralized net- only in a minor advisory capacity. In such a
work similar to a branch system, or a loosely decentralized system each subsidiary operates
controlled, decentralized system with each sub- as a relatively autonomous unit, with authority
sidiary operating autonomously. A bank holding and responsibility for certain actions delegated
company might originate as a shell corpora- by the parent to the board and/or chief executive
tion organized by investors interested in pur- officer of each subsidiary.
chasing a bank, or by a bank interested in reor- It is the responsibility of the directors and
ganizing into a holding company structure in management of the parent company to establish
order to expand through acquisition of nonbank and supervise the policies of subsidiaries, either
concerns or other banks. The management and directly or through delegation of authority. The
directorate of such a holding company are often importance of written policies in a delegated,
the same as that of the bank. As the holding decentralized organization cannot be over-
company expands through acquisitions, the par- emphasized, and the selection of qualified offi-
ent may continue to exercise control through the cers to carry out policies is equally important. If
staff of the lead bank, or may form a separate written policies have not been developed by the
staff to overview the operations of all subsidi- holding company, the examiner should recom-
aries. The relative merit of the degree of super- mend that major policies be written and commu-
vision is dependent upon a number of factors, nicated to subsidiaries. Policies should ensure
and must be analyzed in light of efficiency and that subsidiaries are not managed for cross pur-
operating performance. poses and should avoid concentrations of risks
The level at which policies are established on a consolidated basis.
and supervised, the frequency of contact
between the parent and subsidiaries, and the
extent to which officers and directors of the 2010.0.1 POLICY STATEMENT ON
parent serve also as officers and directors of the THE RESPONSIBILITY OF BANK
subsidiary organizations are indicative of the HOLDING COMPANIES TO ACT AS
level of control exercised by the parent. A cen- SOURCES OF STRENGTH TO THEIR
tralized bank holding company is characterized SUBSIDIARY BANKS
by the placement of directors and officers of the
parent company (or those of the lead bank) in The Board is concerned about situations where
each of its subsidiaries, with frequent group a bank has been threatened with failure
meetings held between the officers of the lead notwithstanding the availability of resources to
bank or holding company and those of the sub- its parent bank holding company. In order to
sidiary organizations. While this is an efficient assure that the Boards policy that bank hold-
method of operation, this type of organization ing companies serve as sources of financial
builds in the potential for conflicts of interest for strength to subsidiary banks is understood by
those individuals who serve in dual capacities. bank holding companies, the Board has issued a
Corporate policies should recognize this poten-
tial and provide guidance for resolution. The BHC Supervision Manual January 2013
overriding principle should be that no member Page 1
Supervision of Subsidiaries 2010.0
general policy statement reaffirming and A bank holding company shall serve as a
articulating these principles, and confirming that source of financial and managerial strength to
the policy applies to failing bank situations. its subsidiary banks and shall not conduct its
This long-standing policy has been recognized operations in an unsafe or unsound manner.
by the Supreme Court in its decision in Board of
Governors v. First Lincolnwood Corp., 439 U.S. The important public policy interest in the sup-
234 (1978), and has been incorporated explicitly port provided by a bank holding company to its
in the Boards Regulation Y, 12 C.F.R. subsidiary banks is based upon the fact that in
225.4(a)(1). acquiring a commercial bank, a bank holding
A fundamental and long-standing principle company derives certain benefits at the
underlying the Federal Reserves supervision corporate level that result, in part, from the
and regulation of bank holding companies is ownership of an institution that can issue
that bank holding companies should serve as federally-insured deposits and has access to
sources of financial and managerial strength to Federal Reserve credit. The existence of the
their subsidiary banks. The Federal Deposit federal safety net reflects important
Insurance Act (FDIA) requires that a bank hold- governmental concerns regarding the critical
ing company or savings and loan holding com- fiduciary responsibilities of depository institu-
pany act as a source of strength to its depository tions as custodians of depositors funds and
institution(s). The term source of strength their strategic role within our economy as
means the ability of a company that directly or operators of the payments system and impartial
indirectly owns or controls an insured deposi- providers of credit. Thus, in seeking the
tory institution to provide financial assistance to advantages flowing from the ownership of a
such insured depository institution in the event commercial bank, bank holding companies have
of financial stress to the insured depository insti- an obligation to serve as a source of strength
tution. (See the FDIA, section 38A(a)(c).) It is and support to their subsidiary banks.
the policy of the Board that in serving as a An important determinant of a banks finan-
source of strength to its subsidiary banks, a bank cial strength is the adequacy of its capital base.
holding company should stand ready to use Capital provides a buffer for individual banking
available resources to provide adequate capital organizations to absorb losses in times of finan-
funds to its subsidiary banks during periods of cial strain, promotes the safety of depositors
financial stress or adversity and should maintain funds, helps to maintain confidence in the bank-
the financial flexibility and capital-raising ing system, and supports the reasonable expan-
capacity to obtain additional resources for assist- sion of banking organizations as an essential
ing its subsidiary banks in a manner consistent element of a strong and growing economy. A
with the provisions of this policy statement. strong capital cushion also limits the exposure
Since the enactment of the Bank Holding of the federal deposit insurance fund to losses
Company Act in 1956, the Board has formally experienced by banking institutions. For these
stated on numerous occasions that a bank hold- reasons, the Board has long considered adequate
ing company should act as a source of financial capital to be critical to the soundness of indi-
and managerial strength to its subsidiary banks. vidual banking organizations and to the safety
As the Supreme Court recognized, in the 1978 and stability of the banking and financial
First Lincolnwood decision, Congress has system.
expressly endorsed the Boards long-standing Accordingly, it is the Boards policy that a
view that holding companies must serve as a bank holding company should not withhold
source of strength to subsidiary financial insti- financial support from a subsidiary bank in a
tutions.1 In addition to frequent pronounce- weakened or failing condition when the holding
ments over the years and the 1978 Supreme company is in a position to provide the support.
Court decision, this principle has been incorpo- A bank holding companys failure to assist a
rated explicitly in Regulation Y since 1983. In troubled or failing subsidiary bank under these
particular, Section 225.4(a)(1) of Regulation Y circumstances would generally be viewed as an
provides that: unsafe and unsound banking practice or a viola-
tion of Regulation Y or both.
Where necessary, the Board is prepared to
1. Board of Governors v. First Lincolnwood Corp., 439
U.S. 234, 252 (1978), citing S. Rep. No. 95323, 95th Cong.,
take supervisory action to require such assis-
1st Sess. 11 (1977). tance. Finally, the Board recognizes that there
may be unusual and limited circumstances
BHC Supervision Manual January 2013 where flexible application of the principles set
Page 2 forth in this policy statement might be neces-
sary, and the Board may from time to time 2010.0.3 INSPECTION OBJECTIVES
identify situations that may justify exceptions to
the policy. 1. To determine whether the board of direc-
This statement is not meant to establish new tors of the parent company is cognizant of and
principles of supervision and regulation; rather, performing its duties and responsibilities.
as already noted, it builds on public policy con- 2. To determine the adequacy of written poli-
siderations as reflected in banking laws and cies and compliance with such policies by the
regulations and long-standing Federal Reserve parent and its subsidiaries.
supervisory policies and practices. A bank hold- 3. To determine whether the board is prop-
ing companys failure to meet its obligation to erly informed as to the financial conditions,
serve as a source of strength to its subsidiary trends and policies of its subsidiaries.
bank(s), including an unwillingness to provide 4. To determine the level of supervision over
appropriate assistance to a troubled or failing subsidiaries and whether the supervision as
bank, will generally be considered an unsafe structured has a beneficial or detrimental effect
and unsound banking practice or a violation of upon the subsidiaries.
Regulation Y, or both, particularly if appropriate
resources are on hand or are available to the
bank holding company on a reasonable basis. 2010.0.4 INSPECTION PROCEDURES
Consequently, such a failure will generally
result in the issuance of a cease and desist order 1. Determine if the holding company main-
or other enforcement action as authorized under tains its own staff, or whether the holding com-
banking law and as deemed appropriate under pany management and directorate are the same
the circumstances. as those of a subsidiary.
2. Determine whether the board of directors
of the parent company reviews the audit reports,
regulatory examination reports, and board min-
2010.0.2 BOARD ORDER utes of its subsidiaries.
REQUESTING A WAIVER FROM THE 3. Determine the extent to which subsidiaries
BOARDS SOURCE OF STRENGTH rely upon the parent for investment and lending
POLICY guidance.
4. Determine which specific functions and
On December 23, 1991, the Board approved an decisions are performed only at the parent com-
application of a BHC to eventually acquire pany level.
100 percent of the outstanding stock of another 5. Determine the extent to which repre-
BHC under a 5 year option. Initially, the BHC sentatives of the parent company serve as offi-
would acquire approximately 26 percent of the cers and/or directors of subsidiaries.
acquirees total capital by purchasing a 15-year 6. Review minutes of the board and execu-
subordinated capital note agreement. It would tive committees of the parent to determine
then have the option to acquire all of the remain- whether the parent company reviews loan de-
ing stock within 5 years. The acquiring BHC linquency reports, comparative balance sheets
requested that the Board waive any requirement and comparative income statements of the
of the Board that it serve as a source of financial subsidiaries.
strength to the subsidiary bank (the Boards 7. Review the extent of influence and control
Source of Strength policy) of the BHC over both bank and nonbank subsidiaries.
acquired until such time that the option is exer- 8. Determine the degree of influence by the
cised to acquire the actual ownership of all the parent company over:
shares. The Board considered the request and a. Appointment of officers;
determined that it would not be appropriate to b. Salary administration;
waive the responsibility to serve as a source of c. Budget and tax planning;
financial strength to the bank in this case. The d. Capital expenditures;
Board noted that the option agreement and the e. Dividend policy;
capital note agreement together provide a f. Investment portfolio management;
mechanism for the acquiring BHC to exert con- g. Loan portfolio management;
trol over the future ownership of the acquired h. Asset/liability and interest rate/risk
BHC and many of the most important manage- management.
ment decisions. Refer to 1992 FRB 159 and the
F.R.R.S. at 4-271.3. Page 3
9. Determine the degree to which man-

agement of the subsidiary companies interfaces
with management of the parent company to
discuss policies.

Page 4
(Funding Policies) Section 2010.1
The responsibility for the performance of the calculate dividends based strictly on the parents
organization rests with the board of directors cash needs and thus keep any excess capital at
of the parent company. Parent company man- the bank level.
agement should have policies in place to pre- 2. Asset/Liability ManagementThe holding
vent funding practices that put at risk the wel- companys policies in the area of asset/liability
fare of the subsidiary banks or the consolidated management should include interest rate sensi-
organization. tivity matching, maturity matching, and the use
The parents supervision and control of sub- of interest rate futures and forwards. These
sidiary funding activities and the funding be- topics should be addressed for each entity as
tween itself and its subsidiaries should be thus well as the organization as a whole. It is the
evaluated. The parent should be expected to parents responsibility to see that each entity is
maintain policies for itself and its subsidiaries operating consistently with the corporate goals.
that provide guidance and controls for funding
practices. The presence and wording of funding The interest rate sensitivity policies should
policies and the degree to which the policies be designed to reduce the organizations vulner-
are followed by the subsidiaries, and the effec- ability to interest rate movements. Policies con-
tiveness of the policies in reducing risk to the cerning the asset/liability rate sensitivity match
entire organization should also be assessed. should not be limited to the subsidiary lead
The importance of the parents involvement bank. The rate charged on parent company debt
in funding decisions and the need for monitor- and the rate received by the parent on its ad-
ing and control at the parent level needs to be vances to subsidiaries should also be addressed
emphasized. As a minimum, the parents fund- to monitor the parents ability to service its debt
ing policies should address the following areas: in the face of changing interest rates. The policy
1. CapitalizationThe holding companys should specify what degree of mismatching is
policy on capital levels should address capital considered acceptable. The interest rate sensitiv-
for the bank subsidiaries, the nonbank subsidi- ity matching of the organization should be mon-
aries, and the consolidated organization. The itored on a frequent basis through the timely
policy for bank and consolidated capital should preparation of a matching schedule.
be consistent with the Boards Capital Ade- Maturity matching policies should be de-
quacy Guidelines and should address the asset signed to provide adequate liquidity to the orga-
quality of the entity in question. The policy for nization. These policies should not be limited to
nonbank capital should include maintaining the the subsidiary lead bank, since a parent com-
capital level at industry standards and should pany serving as a funding vehicle for nonbank
also address the asset quality of the subsidiary, subsidiaries can have substantial exposure
the holding companys capital for each entity through its advances to these subsidiaries. The
should address what measures would be taken holding companys policies should include some
in the event capital falls below a targeted level. measure of the liquidity of the assets in the
Capital should also be addressed at the nonbank subsidiary (determined partially by the
parent company level by specifying the degree quality of these assets), for comparison against
of double leverage that the parent is willing the parents source of funding. The policies
to accept. The parents capital policy should should quantify the maximum degree of expo-
provide some measure of assessing each indi- sure in the organization that is considered ac-
vidual subsidiarys capital adequacy in the ceptable to management. The reporting in this
context of the double leverage within the area should clearly indicate the current exposure
organization. and thus the potential for liquidity problems.
The capital policies should include the
method for calculating dividends from each en- The holding companys policies ad-
tity. The amount of dividends from subsidiaries dressing interest rate futures and forwards
to the parent is affected by the parents philoso- should be consistent with the Boards policy in
phy on the distribution of capital throughout the this area. Involvement in this activity should be
organization. Some companies tend to keep geared towards hedging against interest rate
minimum capital levels in their subsidiary banks movements rather than speculating that interest
by transferring the excess capital to the parent in rates will either increase or decrease. The policy
the form of dividends. The parent then invests
these funds for its own benefit, and down- BHC Supervision Manual December 1992
streams the funds as needed. Other companies Page 1
Supervision of Subsidiaries (Funding Policies) 2010.1
should specify what use of futures and forwards tent with the companys asset/liability manage-
is considered appropriate. ment policies. The policy should include contin-
3. Funding of Nonbank SubsidiariesThe gency measures to be used in the event of liquid-
parent company should have policies addressing ity problems.
how nonbank subsidiaries fund their activities.
If the subsidiaries obtain their own funding,
market discipline may be a factor in controlling 2010.1.1 INSPECTION OBJECTIVES
the activities of the subsidiaries. However, the
parent cannot rely solely on market discipline 1. To determine if the parents funding poli-
due to the risks from interdependence. The par- cies adequately address funding risks to the
ent company is still responsible under the cen- organization.
tralized accountability approach to approve and 2. To determine if the implementation of the
supervise the subsidiaries funding policies. parents policies is effective in controlling fund-
If the subsidiaries obtain funds from the ing risks to the organization.
parent, the risk from interdependence is in- 3. To determine if the parent is adequately
creased. The subsidiary is less able to stand informed of actual funding practices and
alone since it is reliant on the parent for fund- decisions.
ing. If the parent capitalizes the nonbank subsid-
iary through borrowed funds, bank capital is put
at risk due to the increased exposure of the 2010.1.2 INSPECTION PROCEDURES
organization. If the borrowing results in double-
leverage, the risk is increased since less hard 1. Review the funding policies at the parent
capital is available for support. The parents and the subsidiary levels.
policy on advances to nonbank subsidiaries 2. Determine how effectively the policies are
should address this additional risk by specifying implemented throughout the organization.
the level of borrowings that is considered ac- 3. Discuss with management the funding
ceptable relative to nonbank capital and consoli- practices of each subsidiary and any interorgani-
dated capital. The terms of the borrowings zational funding.
should also be specified, and should be consis-

Page 2
(Loan Administration and Lending Standards) Section 2010.2
WHATS NEW IN THIS REVISED Following are the components that generally
SECTION form the basis for a sound loan policy:
Effective January 2016, section 2010.2.5 is 1. Geographic limits. The trade area should be
revised to reference SR-15-17, Interagency clearly defined and loan officers should be
Statement on Prudent Risk Management for fully aware of specific geographic limita-
Commercial Real Estate Lending and its tions for lending purposes. Such a policy
attachment. Refer to the Boards December 18, avoids approval of loans to customers out-
2015, press release. side the trade area in opposition to primary
objectives. The primary trade area should
be distinguished from any secondary trade
2010.2.05 LOAN ADMINISTRATION area so that emphasis for each trade area
may be properly placed.
The examiner should make a qualitative assess- 2. Distribution of loans by category. Limita-
ment of the parents supervision and control of tions based on aggregate percentages of
subsidiary lending activities. The Systems abil- total loans in commercial, real estate, con-
ity to evaluate the effectiveness of a companys sumer, and other categories are common.
supervision and control of subsidiary lending Such policies are beneficial; however, they
activities can be strengthened not only by evalu- should contain provisions for deviations
ating the parents role in light of efficiency and that are approved by the directorate or a
operating performance, but also by evaluating committee. This allows credit to be distrib-
the quality of control and supervision. uted in relation to the market conditions of
In order to assess quality, there must be a the trade area. During times of heavy loan
standard measure against which a companys demand in one category, an inflexible loan-
policies can be evaluated. Establishing the mini- distribution policy would cause that cate-
mum areas that a companys loan-administration gory to be slighted in favor of another.
policies should address will create a standard Deviations from loan distributions by cate-
that will aid in evaluating the quality of the gory may be beneficial but are appropriate
companys control and its supervision of that only until the risk of further increasing the
activity. loan concentration outweighs the benefits
Current inspection procedures include the to be derived from expanding the portfolio
testing of subsidiaries compliance with a parent to satisfy credit demand. See component
companys policies. This section summarizes 11, Concentrations of credit, below.
the parents responsibilities with regard to 3. Types of loans. The lending policy should
supervising subsidiary lending. It defines the state the types of loans that will be made
internal and external factors that should be con- and the maximum amount for each type of
sidered in the formulation of loan policies and a loan. The policy should also set forth
strategic plan. It also outlines the minimum guidelines to follow in making specific
elements that the lending policies should loans. Decisions about the types of loans to
include. be granted should be based on the exper-
Internal and external factors that a banking tise of the lending officers, the deposit
organization should consider when formulating structure, and anticipated creditworthy
its loan policies and strategic plan are demands of the trade area. Sophisticated
credits or loans secured by collateral that
1. the size and financial condition of the credit- require more than normal supervision
extending subsidiaries, should be avoided unless or until there are
2. the expertise and size of the lending staff, the necessary personnel to properly
3. the need to avoid undue concentrations of administer them. Information systems and
risk, internal controls should be in place to
4. compliance with all respective laws and identify, monitor, and control the types of
regulations, and credit that have resulted in abnormal loss.
5. market conditions. The amount of real estate and other types
of term loans should be considered in rela-

Page 1
Loan Administration and Lending Standards 2010.2
tion to the amount of stable funds. tions imposed by Federal Reserve Regula-
4. Maximum maturities. The loan policy tion U, the lending policy should set forth
should call for underwriting standards that margin requirements for all types of securi-
ensure realistic repayment plans. Loan ties acceptable as collateral. Margin require-
maturities should be set by taking into con- ments should be related to the marketability
sideration the anticipated source of repay- of the security (for example, closely held,
ment, the purpose of the loan, the type of over-the-counter, actively traded). The pol-
property, and the useful life of the collat- icy should assign responsibility and set a
eral. For term loans, the lending policy frequency for the periodic pricing of the
should state the maximum time within collateral.
which loans may be amortized. Specific 8. Financial information. Extension of credit
procedures should be developed for situa- on a safe and sound basis depends on com-
tions requiring balloon payments and/or plete and accurate information regarding
modification of the original terms of the the borrowers credit standing. One pos-
loan. If a clean-up period1 sible exception is when the loan is predi-
5. Loan pricing. Rates on various loan types cated on readily marketable collateral, the
must be sufficient to cover the cost of disposition of which was originally desig-
funds loaned and the servicing of the loan, nated as the source of repayment for the
including overhead and possible losses, advance. Current and complete financial
while providing an acceptable margin of information is necessary, including second-
profit over the long run. These costs must ary sources of repayment, not only at the
be known and taken into consideration inception of the loan, but also throughout
before rates are established. Periodic the term of the advance. The lending pol-
reviews should be conducted to determine icy should define the financial-statement
whether adjustments are necessary to re- requirements for businesses and individu-
flect changes in costs or competitive fac- als at various borrowing levels and should
tors. Specific guidelines for other factors, include requirements for audited, nonau-
such as compensating balances and com- dited, fiscal, interim, operating, cash-flow,
mitment fees, are also germane to loan and other statements.3 It should include ex-
pricing. ternal credit checks required at various in-
6. Loan amount to appraised value. The pol- tervals. The requirements for financial
icy should outline where the responsibility information should be defined in such a
for appraisals rests and should define for- way that any credit-data exception would
mal, standard appraisal procedures, includ- be a clear violation of the lending policy.
ing procedures for possible reappraisals in 9. Limits and guidelines for loan partici-
case of renewal or extension. Acceptable pations. Section 2020.2 provides significant
types of appraisals and limits on the dollar information regarding intercompany loan
amount and the type of property that per- participations between holding company
sonnel are authorized to appraise should be affiliates. The lending policy should place
outlined. Circumstances requiring apprais- limits on the amount of loans purchased
als by qualified independent appraisers from any one source and also place an
should be described. The maximum ratio of
the loan amount to appraised value,2 the 3. On March 30, 1993, federal bank regulators set forth an
expanded interagency policy to encourage small-business
method of valuation, and differences for
lending. Under the policy, banks and thrifts that are well or
various types of property should be adequately capitalized and that are rated CAMELS 1 or 2 may
detailed. The policy should contain a sched- make small-business and agricultural loans, the aggregate
ule listing the downpayment requirements value of which cannot exceed 20 percent of their total capital.
To qualify for the exemption, each loan may not exceed the
for financing consumer goods and business lesser of $900,000 or 3 percent of the institutions total
equipment. capital. Further, the loans selected for this exemption by the
7. Loan amount to market value of pledged institution may not be delinquent as of the selection date and
securities. In addition to the legal restric- may not be made to an insider. The loans must be separately
listed or have an accounting segregation from other loans in
the portfolio. They will be evaluated solely on the basis of
1. A clean-up period is when a borrower is asked to
performance and will be exempt from examiner criticism of
repay the entire balance of a credit line and to refrain from
documentation. The institutions records must include an
further borrowing for a specified period of time.
evaluation of its ability to collect the loan in determining the
2. This is often referred to as the loan-to-value ratio.
adequacy of its allowance for loan and lease losses. If a loan
becomes more than 60 days past due, it may be reviewed and
BHC Supervision Manual January 2016 classified by an examiner based on its credit quality, not the
Page 2 level of loan documentation.
aggregate limit on such loans. The policy holdback and reserve requirements, and the
should set forth credit standards for any manner in which the loan will be handled
loan purchased as well as require that com- and serviced.
plete documentation be maintained by the 10. Loans to insiders. Lending policies should
purchasing entities. The policy should address loans to insiders. Such policies
define the extent of contingent liability, should incorporate applicable regulatory

Page 2.1
limitations (for example, Federal Reserve frequent monitoring and reporting of all
Regulation O) and should also address situ- concentrations.
ations in which it would be prudent to exer- Banking organizations with asset concen-
cise certain restrictions even though not trations are expected to put in place effec-
explicitly required to do so by regulation tive internal policies, systems, and controls
(for example, loans by nonbank subsidiaries to monitor and manage this risk. Concentra-
to insiders). tions that involve excessive or undue risks
11. Concentrations of credit. Credit concentra- require close scrutiny and should be
tions may be defined as loans collateralized reduced over a reasonable period of time.
by a common security; loans to one bor- When there is a need to reduce asset con-
rower or related group of borrowers; loans centrations, banking organizations are nor-
dependent upon a particular agricultural mally expected to develop a plan that is
commodity; aggregate loans to major realistic, prudent, and achievable in view of
employers, their employees, and their major the particular circumstances and market
suppliers; loans within industry groups; out- conditions. In situations where concentra-
of-territory loans; aggregate amount of tion levels have built up over an extended
paper purchased from any one source; or period, it may take timein some cases
those loans that often have been included several yearsto achieve a more balanced
in other homogeneous risk groupings. and diversified portfolio. What is critical is
Credit concentrations, by their nature, are that adequate systems and controls are in
dependent on common key factors, and place for reducing undue or excessive con-
when weaknesses develop, they have an centrations in accordance with a prudent
adverse impact on each individual loan plan, along with strong credit policies and
making up the concentration. loan-administration standards to control the
In identifying asset concentrations, com- risks associated with new loans, and
mercial real estate loans and residential real adequate capital to protect the institution
estate loans can be viewed separately when while its portfolio is being restructured.
their performance is not subject to similar Institutions that have in place effective
economic or financial risks. In the same internal controls to manage and reduce con-
vein, commercial real estate development centrations over a reasonable period of time
loans need not necessarily be grouped with need not automatically refuse credit to
residential real estate development loans, sound borrowers simply because of the bor-
especially when the residential developer rowers industry or geographic location.
has firm, reliable purchase contracts for the This principle applies to prudent loan
sale of the homes upon completion. Even renewals and rollovers, as well as to new
within the commercial development and extensions of credit that are underwritten in
construction sector, distinctions for concen- a sound manner.
tration purposes may be made, when appro- The purpose of a lending organizations
priate, between those loans that have firm policies should be to improve the overall
take-out commitments and those that do quality of its portfolio. The replacement of
not. Groups or classes of real estate loans unsound loans with sound loans can
should, of course, be combined and viewed enhance the quality of a portfolio, even
as concentrations when they do share sig- when concentration levels are not reduced.
nificant common characteristics and are 12. Refinancing or renewal of loans. Refinanc-
similarly affected by adverse economic, ings or renewals should be structured in a
financial, or business developments. manner that is consistent with sound bank-
Banking organizations should establish ing, supervisory, and accounting practices,
and adhere to policies that control concen- and in a manner that protects the banking
tration risk. The lending policy should organization and improves its prospects for
address the risk involved in various concen- collecting or recovering on the asset.
trations and indicate those that should be 13. Loan origination and loan approvals. The
avoided or limited. However, before con- policy should establish loan-origination and
centrations can be limited or reviewed, loan-approval procedures, both generally
accounting systems must be in place to and by size and type of loan. The loan
allow for the retrieval of information neces- limitations for all lending officers should be
sary to determine and monitor concentra-
tions. The lending policy should provide for
Page 3
set accordingly. Lending limits should also the acceptance of deeds in lieu of foreclo-
be set for group authority, allowing a com- sure, and the timing of foreclosure. The
bination of officers or a committee to policy must be consistent with supervisory
approve larger loans. Reporting procedures instructions in the financial statements of
and the frequency of committee meetings condition and income for financial institu-
should also be defined. The loan policy tions and BHCs (bank call report and the
should further establish identification, FR Y-9C and the other FR Y-series
review, and approval procedures for excep- reports). Guidelines should be established
tion loans, including real estate and other to ensure that all accounts are presented to
loans with loan-to-value percentages in and reviewed by management for charge-
excess of supervisory limits.4 off after a stated period of delinquency. See
14. Loan-administration procedures for loans section 2065.1 for disclosure, accounting,
secured by real estate. The loan policy and reporting issues related to nonaccrual
should establish loan-administration proce- loans and restructured debt.
dures covering documentation, disburse- 16. Reserve for loan losses and provisions for
ment, collateral administration and inspec- loan losses. The policy should set forth the
tion, escrow administration, collection, loan parameters that management considers in
payoffs, and loan review. Documentation determining an appropriate level of loan-
procedures would specify, among other loss reserves as well as provisions neces-
things, the types and frequency of financial sary to attain this level.
statements and the requirements for verify- Because an analysis of the allowance for
ing information provided by the borrower. loan and lease losses (ALLL) requires an
They would also cover the type and fre- assessment of the relative credit risks in the
quency of collateral evaluations (appraisals portfolio, many banking organizations, for
and other estimates of value). In addition, analytical purposes, attribute portions of the
loan-administration policies should address ALLL to loans and other assets classified
procedures for servicing and participation substandard by management or a super-
agreements and other loan-administration visory agency. Management may do this
procedures such as those for claims process- because it believes, based on past history or
ing (for example, seeking recovery on other factors, that there may be unidentified
defaulted loans that are partially or fully losses associated with loans classified sub-
guaranteed by a government entity or insur- standard in the aggregate.
ance program). Furthermore, management may use this
15. Collection and foreclosure and the as an analytical approach in estimating the
reporting and disclosure of delinquent obli- total amount necessary for the ALLL and in
gations and charge-offs. The lending policy comparing the ALLL to various categories
should define delinquent obligations, proof loans over time. As a general rule, an
vide guidelines on when loans are to be individual loan classified substandard may
placed on nonaccrual or to be restructured, remain in an accrual status as long as the
dictate appropriate procedures for reporting regulatory reporting requirements for
to senior management and to the directorate accrual treatment are met, even when an
past-due credits, and provide appropriate attribution of the ALLL has been made.
guidance on the extent of disclosure of such 17. Other. The policy should address the han-
credits. The policy should establish and dling of exceptions to the policy as well as
require a follow-up collection procedure provide for adherence to the policy via
that is systematic and progressively stronger internal audits, centralized loan review,
and should set forth guidelines (where and/or directors examinations. The pol-
applicable) for close surveillance by a loan icy should be reviewed annually to deter-
work-out division. It should also address mine if it continues to be compatible with
extensions and other forms of forbearance, the BHCs objectives as well as market
conditions.
4. For subsidiaries that are insured depository institutions,
real estate loans that are in excess of supervisory loan-to-
value limits are to be identified in the subsidiaries records.
The aggregate amount of these loans is to be reported quar- 2010.2.1 UNIFORM REAL ESTATE
terly to the depository institutions board of directors. LENDING STANDARDS
BHC Supervision Manual December 1999 On December 23, 1992, the Board announced
Page 4 adoption of a uniform rule and guidelines on
real estate lending, along with the FDIC, OCC, Sound lending practices address formal credit
and OTS, as mandated by section 304 of the policies, formal credit-staff approval of transac-
Federal Deposit Insurance Corporation tions, loan-approval documentation, the use of
Improvement Act of 1991 (FDICIA). The forward-looking tools in the approval process,
Boards Regulation H (12 C.F.R. 208, Member- and management and lender information sys-
ship of State Banking Institutions in the Federal tems. In addition to evaluating adherence to
Reserve System) was amended to implement the these sound practices during inspections, super-
uniform real estate lending standards for state visory personnel and examiners may wish to
member banks. Although the Board did not discuss these standards with loan portfolio man-
directly apply the regulation to bank holding agers at institutions where a full credit review is
companies and their nonbank subsidiaries, those being performed. Senior management should be
entities are expected to conduct and to supervise made aware of the potential for deterioration in
real estate lending activities prudently, consis- the loan portfolio if lending discipline is not
tent with safe and sound lending standards. maintained, whether from inadequate assess-
The agencies regulations require that each ment or communication of lending risks, incom-
insured depository institution adopt and main- plete adherence to prudent lending standards
tain comprehensive written real estate lending that reflect the risk appetite of the board of
policies appropriate to the institution and the directors, or both.
nature and scope of its lending activities. Lend- Examiners should evaluate whether adequate
ing policies must be reviewed and approved by internal oversight exists and whether institution
the institutions board of directors at least annu- management has timely and accurate informa-
ally. The policies are to include standards for tion. As always, examiners should also discuss
loan diversification and prudent underwriting as matters of concern with the institution and
well as loan-administration procedures and include them in their reports of inspection, even
documentation, approval, and reporting require- if cited practices and problem loans have not yet
ments. Depository institutions policies are to reached harmful or criticized levels. Such cau-
reflect consideration of the appendix to the tionary remarks help to alert institution manage-
banking agencies regulations, Interagency ment to potential or emerging sources of con-
Guidelines for Real Estate Lending Policies. cern and may help to deter future problems.
The guidelines are designed to help an institu- Any practices that extend beyond prudent
tion formulate and maintain real estate lending bounds should be promptly corrected. See
policy that is appropriate to its size and the SR-98-18.
nature and scope of its operations, as required
by the regulations. These guidelines are gener-
ally comparable to the inspection guidance pro- 2010.2.2.1 Sound Practices in Loan
vided in this section. Standards and Approval
Certain sound practices in lending can help to
maintain strong credit discipline and ensure that
2010.2.2 LENDING STANDARDS FOR
an institutions decision to take risk in lending is
COMMERCIAL LOANS
well informed, balanced, and prudent. Several
The lending decision is properly that of the of these sound practices are listed and described
senior management and boards of directors of below.
banking institutions, and not of their supervi-
sory agencies. However, in fulfilling their roles, 2010.2.2.1.1 Formal Credit Policies
directors and senior managers have the obliga-
tion to monitor lending practices and to ensure The Federal Reserve and other supervisory
that their policies are enforced and that lending authorities have long stressed the importance of
practices generally remain within the overall formal written credit policies in a sound credit-
ability of the institution to manage. The follow- risk-management process. Such policies can
ing subsections describe certain sound practices provide crucial discipline to an institutions
regarding lending standards and credit-approval lending process, especially when the institu-
processes for commercial loans.5 tions standards are under assault due to intense
competition for loans. They can serve to com-
5. This guidance is derived, in part, from the June 1998
municate formally an institutions appetite for
Federal Reserve supervisory staff report, The Significance of
Recent Changes in Bank Lending Standards: Evidence from BHC Supervision Manual January 2016
the Loan Quality Assessment Project. Page 5
credit risk in a manner that will support sound policies is necessary if such covenant require-
lending decisions, while focusing appropriate ments are to be waived.
attention on loans being considered that diverge Internal processes and requirements for
from approved standards. underwriting decisions should be consistent with
In developing and refining loan policies, some the nature, size, and complexity of the banking
institutions specify guidance minimums for organizations (BO) activities. Departures from
financial performance ratios that apply to certain underwriting policies and standards, however,
types of loans or borrowers (for example, com- can have serious consequences for BOs of all
mercial real estate). Such guidance makes sizes. Internal controls and credit reviews should
explicit that loans not meeting certain financial be established and maintained to ensure compli-
tests (based on current performance, projected ance with those policies and procedures. When
future performance, or both) should in general there are continued favorable economic and
not be made, or alternatively should only be financial conditions, compliance monitoring of
made under clearly specified situations. Institu- the BOs lending policies and procedures needs
tions using this approach most effectively tend to be diligent to make certain that there is no
to avoid specifying standards for broad ranges undue reliance on optimistic outlooks for bor-
of lending situations and instead focus on those rowers. Undue reliance on continued favorable
areas of lending most vulnerable to excessive economic conditions can be demonstrated by
optimism, or where the institution expects loan the following characteristics:
volume to grow most significantly.
Formal policies can also provide lending dis- 1. dependence on very rapid growth in a bor-
cipline by clearly stating the type of covenants rowers revenue as the most likely case
to be imposed for specific loan types. When
designed and enforced properly, financial cov- 2. heavy reliance on favorable collateral
enants can help significantly to reduce credit appraisals and valuations that may not be
losses by communicating clear thresholds for sustainable over the longer term
financial performance and potentially triggering 3. greater willingness to make loans without
corrective or protective action at an early stage. scheduled amortization prior to the loans
Often, however, loan-approval documents do final maturity
not describe the key financial covenants even 4. willingness to readily waive violations of
when discussions with institutional staff dis- key covenants, to release collateral or guar-
close that such covenants are present. The staff antee requirements, or even to restructure
and/or management of many institutions loan agreements, without corresponding con-
acknowledge that they have a common prac- cessions on the part of the borrower, on the
tice of imposing certain types of covenants on assumption that a favorable environment will
various types of loans. They indicate that such a allow the borrower to recover quickly
practice is well known to lenders and others at
the institution (but not articulated in their writ-
Among the adverse effects of undue reliance
ten loan policies), so that describing the actual
on a continued favorable economy is the possi-
covenants in the loan-approval document would
bility that problem loans will not be identified
be redundant. However, management and other
properly or in a timely manner. Timely identifi-
approving authorities within an institution then
cation of problem loans is critical for providing
receive no formal positive indication that com-
a full awareness of the BOs risk position,
mon practice controls have been imposed and
informing management and directors of that
no indication of the level of financial perfor-
position, taking steps to mitigate risk, and pro-
mance that the covenants require of the bor-
viding a proper assessment of the adequacy of
rower. As such, management and other approv-
the allowance for credit losses and capital.6
ing authorities may be inadequately informed as
Similarly, an overreliance on continued ready
to the risks and controls associated with the loan
access to financial markets on favorable terms
under consideration. In contrast, loan policies
can originate from the following situations:
can create a clear expectation that (1) all key
covenants should be described in loan-approval
documents, (2) certain covenant types should be
applied to all loans meeting certain criteria, and 6. See section 2122.0 and SR-98-25, Sound Credit-Risk
Management and the Use of Internal Credit-Risk-Rating Sys-
(3) explicit approval of any exception to these tems at Large Banking Organizations. Federal Reserve guid-
ance on credit-risk management and mitigation covers both
BHC Supervision Manual January 2016 loans and other forms of on- and off-balance-sheet credit
Page 6 exposure.
1. explicit reliance on future public market debt informing management and directors of the
or equity offerings, or on other sources of number and nature of material deviations from
refinancing, as the ultimate source of princi- the policies that they have designed and
pal repayment, which presumes that market approved.
liquidity and the markets appetite for such
instruments will be favorable at the time that
the facility is to be repaid 2010.2.2.1.2 Formal Credit-Staff
2. ambiguous or poorly supported analysis of Approval of Transactions
the sources of repayment of the loans princi-
pal, together with implicit reliance for repay- Credit discipline is also enhanced when experi-
ment on some realization of the implied mar- enced credit professionals are involved in the
ket valuation of the borrower (for example, approval process and are independent of the line
through refinancing, asset sales, or some lending functions.7 Such staff can play a vital
form of equity infusion), which also assumes role in ensuring adherence to formal policies
that markets will be receptive to such trans- and in ensuring that individual loan approvals
actions at the time that the facility is to be are consistent with the overall risk appetite of
repaid the institution. These independent credit profes-
3. measuring a borrowers leverage (for exam- sionals can be most valuable if they have the
ple, debt-to-equity) based solely on the mar- authority to reject a loan that does not meet the
ket capitalization of the firm without regard institutions credit standards or, alternatively, if
to book equity, thereby implicitly assum- they must concur with a loan before it can be
ing that currently unrealized appreciation in approved.
the value of the firm can be readily realized if Providing credit staff with independent
needed approval authority over lending decisions, rather
4. more generally, extending loans with a risk than with a more traditional requirement for
profile that more closely resembles the pro- consultation between the lending function
file of an equity investment, under circum- and credit staff, allows credit staff to influence
stances that leave additional credit or default outcomes on a broad and ongoing basis. This
as the borrowers only resort if favorable influence and indeed the ability of credit staff to
expectations are not met reinforce lending discipline is clearly enhanced
by their early involvement in negotiations with
Banking organizations that become lax in adher- borrowers; a more traditional approach might be
ing to established loan-underwriting policies and to only involve credit staff once the loan pro-
procedures, as a result of overreliance on favor- posal is well developed, allowing credit staff the
able economic and financial market conditions, opportunity to have only minor influence on the
may have significant credit concentrations that outcome of negotiations except in extreme
are at great risk to possible economic and finan- cases. Maintaining a proper balance of lending
cial market downturns. See SR-99-23. and control functions calls for a degree of part-
Some institutions have introduced credit scor- nership between line lenders and credit staff, but
ing techniques into their small-business lending also requires that the independence of credit
in an effort to improve credit discipline while staff not be compromised by conflicting com-
allowing heavier reliance on statistical analysis pensation policies or reporting structures.
rather than detailed and costly analysis of indi- Independent credit staff can also support
vidual loans. Institutions should take care to sound lending practice by maintaining complete
make balanced and careful use of credit scoring and centralized credit files that contain all key
technology for small-business lending and, in documents relevant to each loan, including com-
particular, avoid using this technology for loans plete loan-approval packages. Such files ensure
or credit relationships that are large or complex that decisions are well documented and avoid
enough to warrant a formal and individualized
credit analysis. 7. For example, loan officers might be compensated for
bringing loan business into the institution. Independent credit
In formalizing their lending standards and professionals, however, would be another person who would
practices, institutions are not precluded from not be compensated for bringing any loan business into the
making loans that do not meet all written stan- institution. That person would, however, serve as a quality
dards. Exceptions to policies, though, should be control monitor that would have the independent authority to
reject a loan(s) and to ensure that the institutions risk appetite
approved and monitored by management. For- and credit standards are not exceeded.
mal reporting that describes exceptions to loan
policies, by type of exception and organiza- BHC Supervision Manual December 1999
tional unit, can be extremely valuable for Page 7
undue reliance on the files maintained by indi- folio, institutions should give sufficient consid-
vidual loan officers. eration to the potential for negative events or
developments that might limit the ability of
borrowers to fulfill their loan obligations.
2010.2.2.1.3 Loan-Approval Documents Unforeseen changes in interest rates, sales rev-
enue, and operating expenses can have material
Institutions can help ensure a careful loan- and adverse effects on the ability of many bor-
approval decision by requiring thorough and rowers to meet their obligations. In prior
standardized loan-approval documents. Thor- decades, inadequate attention to these possibili-
oughness can be enhanced by requiring formal ties during the underwriting process contributed
analysis of the borrowers financial condition, significantly to asset-quality problems in the
key characteristics and trends in the borrowers system. Also, sudden turmoil within various
industry, information on collateral and its valua- countries can result in quick changes in cur-
tion, as well as financial analysis of the entities rency valuations and economic conditions.
providing support or guarantees and formal Examiners should evaluate the frequency and
forward-looking analyses appropriate to the size adequacy with which institutions conduct
and type of loan being considered. Incorporat- forward-looking analysis of borrower financial
ing such elements into standardized formats and performance when considering an institutions
requiring that analysis and supporting commen- credit-risk-management process. Formal use of
tary be complete and in adequate depth allows forward-looking financial analysis in the loan-
approving authorities access to all relevant approval process, and financial projections in
information on the risk profile of the borrower. particular, can be important in guarding against
Loan-approval documents should also include such complacency, especially when financial
all material details on the proposed loan agree- institutions are competing intensely to attract
ment itself, including key financial covenants. borrowers. Such projections, if they include less
Standardization of formats, and to some extent favorable scenarios for the key determinants of
content, can be useful in ensuring that all rel- the borrowers financial performance, can help
evant information is provided to management to contain undue optimism and ensure that man-
and other approving authorities in a manner that agement and other approving authorities within
is understandable. Standard formats also draw the organization are formally presented with a
attention to cases in which certain key informa- robust analysis of the risks associated with each
tion is not presented. credit. They also provide credit staff and other
One area of particular interest in this regard is risk-management personnel with information
analysis and commentary on participations in that is important for ensuring adherence to the
syndicated loans. While it may be tempting to institutions lending standards and overall appe-
rely on the analysis and documentation provided tite for loan risk.
by the agent institution to the transaction, it has The formal presentation of financial projec-
been long-standing Federal Reserve policy that tions and/or other forms of forward-looking
participating institutions should conduct their analyses of the borrower is important in making
own analysis of the borrower and the transac- explicit the conditions required for a loan to
tions, particularly if the risk appetite or portfolio perform and in communicating the vulnerabili-
characteristics of the agent differs from that of ties of the transaction to those responsible for
the participating institution. approving loans. Analyses also provide a useful
benchmark against which institutions can assess
the borrowers future performance. Although it
2010.2.2.1.4 Use of Forward-Looking may be tempting to avoid analyzing detailed
Tools in the Approval Process projections for smaller borrowers, such as
middle-market firms, these customers may col-
During continued periods of favorable economic lectively represent a significant portion of the
conditions, institutions should guard against institutions loan portfolio. As such, applying
complacency and, in particular, the temptation formal forward-looking analysis even on a basic
to base expectations of a borrowers future level assists the institution in identifying and
financial performance almost exclusively on that managing the overall risk of its lending
borrowers recent performance. In making lend- activities.
ing decisions, and in evaluating their loan port- Detailed analysis of industry performance and
trends can be a useful supplement to such analy-
BHC Supervision Manual December 1999 ses. Such projections have the most value in
Page 8 maintaining credit discipline when, rather than
only describing the single most likely sce- 5. adverse developments in key product or input
nario for future events, they characterize the markets
kind of negative events that might impair the 6. reversals in, or the borrowers reduced access
performance of the loan in the future. to, public debt and equity markets
Proper stress testing typically incorporates an

2010.2.2.1.5 Stress Testing of the evaluation of the borrowers alternatives for
Borrowers Financial Capacity meeting its financial obligations under each sce-
nario, including asset sales, access to alternative
The analysis of alternative scenarios, or stress funding or refinancing, or ability to raise new
testing, should generally focus on the key equity. In particular, the evaluation should focus
determinants of performance for the borrower not only on the borrowers ability to meet near-
and the loan, such as the level of interest rates, term interest obligations, but also on its ability
the rate of sales or revenue growth, or the rate at to repay the principal of the obligation. See
which expense reductions can be realized. SR-99-23.
Meaningful stress testing of the prospective
borrowers ability to meet its obligations is a
vital part of a sound credit decision. Failure to 2010.2.2.1.6 Management and
recognize the potential for adverse events Lender Information
whether specific to the borrower or its industry
(for example, a change in the regulatory climate Management information systems that support
or the emergence of new competitors) or, alter- the loan-approval process should clearly indi-
natively, to the economy as a whole (for exam- cate the composition of the institutions current
ple, a recession)can prove costly to a banking portfolio or exposure to allow for consideration
organization. of whether a proposed new loanregardless of
Mechanical reliance on threshold financial its own meritsmight affect this composition
ratios (and the cushion they imply) alone is sufficiently to be inconsistent with the institu-
generally not sufficient, particularly for complex tions risk appetite. In particular, institutions
loans and loans to leveraged borrowers or others active in commercial real estate lending should
that must perform exceptionally well to meet know the nature and magnitude of aggregate
their financial obligations successfully. Scenario exposure within relevant subclasses, such as by
analysis specific to the borrower, its industry, the type of property being financed (that is,
and its business plan is critical to identify the office, residential, or retail).
key risks of a loan. Such an analysis should In addition to portfolio information, institu-
have a significant influence on the decision to tions should be encouraged to acquire or
extend credit and, if credit is extended, on the develop information systems that provide ready
decisions as to the appropriate loan size, repay- access for lenders and credit analysts to infor-
ment terms, collateral or guarantee require- mation sources that can support and enhance the
ments, financial covenants, and other elements financial analysis of proposed loans. Depend-
of the loans structure. ing on the nature of an institutions borrowers,
When properly conducted, meaningful stress appropriate information sources may include
testing can include assessing the effect the fol- industry financial data, economic data and fore-
lowing situations or events will have on the casts, and other analytical tools such as bank-
borrower: ruptcy scoring and default-probability models.
1. unexpected reductions in revenue growth or

reversals, including shocks to revenue of the 2010.2.3 LEVERAGED LENDING
type and magnitude that would normally be
experienced during a recession Leveraged lending has been a financing vehicle
2. unfavorable movements in market interest for transactions involving mergers and acquisi-
rates, especially for firms with high debt tions, business recapitalizations, and business
burdens expansions.8 It is an important type of financing
3. unplanned increases in capital expenditures
due to technological obsolescence or com- 8. For the purpose of this guidance, references to leveraged
petitive factors finance, or leveraged transactions encompass the entire debt
4. deterioration in the value of collateral, guar-
antees, or other potential sources of principal BHC Supervision Manual July 2013
repayment Page 9
for national and global economies, and the U.S. agency Guidance on Leveraged Lending. 9a
financial industry plays an integral role in mak- The statement provides guidance about risk rat-
ing credit available and syndicating that credit ing leveraged-financed loans. See SR-13-3 and
to investors. Leveraged transactions are charac- its attachment.
terized by a degree of financial leverage that
may significantly exceed industry norms as
measured by ratios such as debt-to-assets, debt- 2010.2.3.1 Interagency Guidance on
to-equity, cash flow-to-total debt, or other ratios Leveraged Lending
and standards that are unique to a particular
industry. Leveraged borrowers, however, can The vast majority of community banks should
have a diminished ability to respond to chang- not be affected by this guidance, as they have
ing economic conditions or unexpected events, limited involvement in leveraged lending. Com-
creating significant implications for an institu- munity and smaller institutions that are involved
tions overall credit-risk exposure and chal- in leveraged lending activities should discuss
lenges for bank risk-management systems. with their primary regulator the implementation
Leveraged lending activities can be conducted of cost-effective controls appropriate for the
in a safe-and-sound fashion if pursued with a complexity of their exposures and activities. 9b
risk-management structure that provides for the
appropriate underwriting, pricing, monitoring,
and controls. Comprehensive credit analysis 2010.2.3.1.1 Risk-Management
processes, frequent monitoring, and detailed Framework
portfolio reports are needed to better understand
and manage the inherent risk in leveraged port- Given the high-risk profile of leveraged transac-
folios. Sound valuation methodologies must be tions, financial institutions engaged in leveraged
used in addition to ongoing stress testing and lending should adopt a risk-management frame-
monitoring. work that has an intensive and frequent review
Financial institutions should ensure they do and monitoring process. The framework should
not unnecessarily heighten risks by originating have as its foundation written risk objectives,
and then distributing poorly underwritten loans.9 risk-acceptance criteria, and risk controls. A
For example, a poorly underwritten leveraged lack of robust risk-management processes and
loan that is pooled with other loans or is partici- controls at a financial institution with significant
pated with other institutions may generate risks leveraged lending activities could contribute to
for the financial system. The leveraged lending supervisory findings that the financial institution
guidance that follows is designed to assist finan- is engaged in unsafe and unsound banking prac-
cial institutions in providing leveraged lending tices. This guidance outlines the agencies mini-
to creditworthy borrowers in a safe-and-sound mum expectations on the following topics:
manner.
On March 21, 2013, the Federal Reserve Leveraged Lending Definition
Board, along with the Office of the Comptroller General Policy Expectations
of the Currency (OCC) and the Federal Deposit Participations Purchased
Insurance Corporation (FDIC), issued Inter- Underwriting Standards
Valuation Standards
structure of a leveraged obligor (including loans and letters of Pipeline Management
credit, mezzanine tranches, senior and subordinated bonds) Reporting and Analytics
held by both bank and nonbank investors. References to Risk Rating Leveraged Loans
leveraged lending and leveraged loan transactions and credit Credit Analysis
agreements refer to all debt with the exception of bond and
high-yield debt held by both bank and nonbank investors. Problem-Credit Management
9. For purposes of this guidance, the term financial insti- Deal Sponsors
tution or institution includes national banks, federal sav- Credit Review
ings associations, and federal branches and agencies super-
vised by the OCC; state member banks, bank holding 9a. This guidance augments previously issued supervisory
companies, savings and loan holding companies, and all other statements on sound credit-risk management. Refer to SR-98-
institutions for which the Federal Reserve is the primary 18, Lending Standards for Commercial Loans.
federal supervisor; and state nonmember banks, foreign banks 9b. The agencies do not intend that a financial institution
having an insured branch, state savings associations, and all that originates a small number of less complex, leveraged
other institutions for which the FDIC is the primary federal loans should have policies and procedures commensurate with
supervisor. a larger, more complex leveraged loan origination business.
However, any financial institution that participates in lever-
BHC Supervision Manual July 2013 aged lending transactions should follow applicable supervi-
Page 10 sory guidance provided in Participations Purchased of this
section.
Stress Testing from both direct exposure and indirect exposure

Conflicts of Interest via limited-recourse financing secured by lever-
Reputational Risk aged loans, or financing extended to financial
Compliance intermediaries (such as conduits and special pur-
pose entities (SPEs)) that hold leveraged loans.
2010.2.3.1.2 Leveraged Lending

Definition 2010.2.3.1.3 General Policy Expectations
The policies of financial institutions should A financial institutions credit policies and pro-
include criteria to define leveraged lending that cedures for leveraged lending should address
are appropriate to the institution. 9c For example, the following:
numerous definitions of leveraged lending exist
throughout the financial services industry and Identification of the financial institutions risk
commonly contain some combination of the fol- appetite, including clearly defined amounts of
lowing: leveraged lending that the institution is will-
ing to underwrite (for example, pipeline lim-
proceeds used for buyouts, acquisitions, or its) and is willing to retain (for example,
capital distributions transaction and aggregate hold levels). The
transactions where the borrowers Total Debt institutions designated risk appetite should
divided by EBITDA (earnings before interest, be supported by an analysis of the potential
taxes, depreciation, and amortization) or effect on earnings, capital, liquidity, and other
Senior Debt divided by EBITDA exceed risks that result from these positions, and
4.0 * EBITDA or 3.0 * EBITDA, respec- should be approved by its board of directors.
tively, or other defined levels appropriate to A limit framework that includes limits or
the industry or sector 9d guidelines for single obligors and transac-
a borrower recognized in the debt markets as tions, aggregate hold portfolio, aggregate
a highly leveraged firm, which is character- pipeline exposure, and industry and geo-
ized by a high debt-to-net-worth ratio graphic concentrations. The limit framework
transactions when the borrowers post- should identify the related management-
financing leverage, as measured by its lever- approval authorities and exception-tracking
age ratios (for example, debt-to-assets, debt- provisions. In addition to notional pipeline
to-net-worth, debt-to-cash flow, or other limits, the agencies expect that financial insti-
similar standards common to particular indus- tutions with significant leveraged transactions
tries or sectors), significantly exceeds industry will implement underwriting-limit frame-
norms or historical levels 9e works that assess stress losses, flex terms,
economic capital usage, and earnings at risk
A financial institution engaging in leveraged or that otherwise provide a more nuanced
lending should define it within the institutions view of potential risk. 9f
policies and procedures in a manner sufficiently Procedures for ensuring the risks of leveraged
detailed to ensure consistent application across lending activities are appropriately reflected
all business lines. A financial institutions defi- in an institutions allowance for loan and lease
nition should describe clearly the purposes and losses (ALLL) and capital adequacy analyses.
financial characteristics common to these trans- Credit and underwriting approval authorities,
actions, and should cover risk to the institution including the procedures for approving and
documenting changes to approved transaction
9c. This guidance is not meant to include asset-based loans structures and terms.
unless such loans are part of the entire debt structure of a Guidelines for appropriate oversight by senior
leveraged obligor. Asset-based lending is a distinct segment
of the loan market that is tightly controlled or fully monitored, management, including adequate and timely
secured by specific assets, and usually governed by a borrow- reporting to the board of directors.
ing formula (or borrowing base). Expected risk-adjusted returns for leveraged
9d. Cash should not be netted against debt for purposes of
this calculation.
9e. The designation of a financing as leveraged lending
9f. Flex terms allow the arranger to change interest-rate
is typically made at loan origination, modification, extension,
spreads during the syndication process to adjust pricing to
or refinancing. Fallen angels or borrowers that have exhib-
current liquidity levels.
ited a significant deterioration in financial performance after
loan inception and subsequently become highly leveraged
would not be included within the scope of this guidance, BHC Supervision Manual July 2013
unless the credit is modified, extended, or refinanced. Page 11
transactions. including the size that the institution will

Minimum underwriting standards (see the arrange both individually and in the aggregate
Underwriting Standards section below). for distribution. The originating institution
Effective underwriting practices for primary should be mindful of reputational risks associ-
loan origination and secondary loan acquisi- ated with poorly underwritten transactions, as
tion. these risks may find their way into a wide vari-
ety of investment instruments and exacerbate
systemic risks within the general economy. At a
2010.2.3.1.4 Participations Purchased minimum, an institutions underwriting stan-
dards should consider the following:
Financial institutions purchasing participations
and assignments in leveraged lending transac- Whether the business premise for each trans-
tions should make a thorough, independent action is sound and the borrowers capital
evaluation of the transaction and the risks structure is sustainable regardless of whether
involved before committing any funds. 9g They the transaction is underwritten for the institu-
should apply the same standards of prudence, tions own portfolio or with the intent to dis-
credit assessment and approval criteria, and tribute. The entirety of a borrowers capital
in-house limits that would be employed if the structure should reflect the application of
purchasing organization were originating the sound financial analysis and underwriting
loan. At a minimum, policies should include principles.
requirements for A borrowers capacity to repay and the ability
to de-lever to a sustainable level over a rea-
obtaining and independently analyzing full sonable period. As a general guide, institu-
credit information both before the participations also should consider whether base-case
tion is purchased and on a timely basis there- cash-flow projections show the ability to fully
after; amortize senior secured debt or repay a sig-
obtaining from the lead lender copies of all nificant portion of total debt over the medium
executed and proposed loan documents, legal term. 9h Also, projections should include one
opinions, title insurance policies, Uniform or more realistic downside scenarios that
Commercial Code (UCC) searches, and other reflect key risks identified in the transaction.
relevant documents; Expectations for the depth and breadth of due
carefully monitoring the borrowers perfor- diligence on leveraged transactions. This
mance throughout the life of the loan; and should include standards for evaluating vari-
establishing appropriate risk-management ous types of collateral, with a clear definition
guidelines as described in this document. of credit-risk-managements role in such due
diligence.
Standards for evaluating expected risk-
2010.2.3.1.5 Underwriting Standards adjusted returns. The standards should include
identification of expected distribution strate-
A financial institutions underwriting standards gies, including alternative strategies for fund-
should be clear, written, and measurable, and ing and disposing of positions during market
should accurately reflect the institutions risk disruptions, and the potential for losses during
appetite for leveraged lending transactions. A such periods.
financial institution should have clear underwrit- The degree of reliance on enterprise value and
ing limits regarding leveraged transactions, other intangible assets for loan repayment,
along with acceptable valuation methodolo-
9g. Refer to other joint agency guidance regarding pur- gies, and guidelines for the frequency of peri-
chased participations: OCC Loan Portfolio Management odic reviews of those values.
Handbook, www.occ.gov/publications/publications-by-type/ Expectations for the degree of support pro-
comptrollers-handbook/lpm.pdf, Loan Participations;
Board Commercial Bank Examination Manual,
www.federalreserve.gov/boarddocs/supmanual/cbem/
9h. In general, the base-case cash-flow projection is the
cbem.pdf, section 2045.1, Loan Participations, the Agree-
borrower or deal sponsors expected estimate of financial
ments and Participants; and FDIC Risk Management Manual
performance using the assumptions that are deemed most
of Examination Policies, Section 3.2-Loans, www.fdic.gov/
likely to occur. The financial results for the base case should
regulations/safety/manual/section3-2.html#otherCredit, Loan
be better than those for the conservative case but worse than
Participations (last updated Feb. 2, 2005).
those for the aggressive or upside case. A financial institution
may adjust the base-case financial projections, if necessary.
BHC Supervision Manual July 2013 The most realistic financial projections should be used when
Page 12 measuring a borrowers capacity to repay and de-lever.
vided by the sponsor (if any), taking into 2010.2.3.1.6 Valuation Standards
consideration the sponsors financial capacity,
the extent of its capital contribution at incep- Institutions often rely on enterprise value and
tion, and other motivating factors. Institutions other intangibles when (1) evaluating the feasi-
looking to rely on sponsor support as a sec- bility of a loan request; (2) determining the debt
ondary source of repayment for the loan reduction potential of planned asset sales;
should be able to provide documentation, (3) assessing a borrowers ability to access the
including, but not limited to, financial or capital markets; and (4) estimating the strength
liquidity statements, showing recently docu- of a secondary source of repayment. Institutions
mented evidence of the sponsors willingness may also view enterprise value as a useful
and ability to support the credit extension. benchmark for assessing a sponsors economic
Whether credit-agreement terms allow for the incentive to provide financial support. Given the
material dilution, sale, or exchange of collat- specialized knowledge needed for the develop-
eral or cash-flow-producing assets without ment of a credible enterprise valuation and the
lender approval. importance of enterprise valuations in the under-
Credit-agreement covenant protections, writing and ongoing risk-assessment processes,
including financial performance (such as debt- enterprise valuations should be performed by
to-cash flow, interest coverage, or fixed- qualified persons independent of an institutions
charge coverage), reporting requirements, and origination function.
compliance monitoring. Generally, a leverage There are several methods used for valuing
level after planned asset sales (that is, the businesses. The most common valuation meth-
amount of debt that must be serviced from ods are assets, income, and market. Asset valua-
operating cash flow) in excess of 6* Total tion methods consider an enterprises under-
Debt/EBITDA raises concerns for most indus- lying assets in terms of its net going-concern or
tries. liquidation value. Income valuation methods
Collateral requirements in credit agreements consider an enterprises ongoing cash flows or
that specify acceptable collateral and risk- earnings and apply appropriate capitalization or
appropriate measures and controls, including discounting techniques. Market valuation meth-
acceptable collateral types, loan-to-value ods derive value multiples from comparable
guidelines, and appropriate collateral- company data or sales transactions. However,
valuation methodologies. Standards for asset- final value estimates should be based on the
based loans that are part of the entire debt method or methods that give supportable and
structure also should outline expectations for credible results. In many cases, the income
the use of collateral controls (for example, method is generally considered the most reli-
inspections, independent valuations, and payable.
ment lockbox), other types of collateral and There are two common approaches employed
account maintenance agreements, and peri- when using the income method. The capital-
odic reporting requirements. ized cash flow method determines the value of
a company as the present value of all future cash
Whether loan agreements provide for distribu-
flows the business can generate in perpetuity.
tion of ongoing financial and other relevant
An appropriate cash flow is determined and then
credit information to all participants and
divided by a risk-adjusted capitalization rate,
investors.
most commonly the weighted average cost of
capital. This method is most appropriate when
Nothing in the preceding standards should be cash flows are predictable and stable. The dis-
considered to discourage providing financing to counted cash flow method is a multiple-period
borrowers engaged in workout negotiations, or valuation model that converts a future series of
as part of a pre-packaged financing under the cash flows into current value by discounting
bankruptcy code. Neither are they meant to dis- those cash flows at a rate of return (referred to
courage well-structured, standalone asset-based as the discount rate) that reflects the risk
credit facilities to borrowers with strong lender inherent therein. This method is most appropri-
monitoring and controls, for which a financial ate when future cash flows are cyclical or vari-
institution should consider separate underwrit- able over time. Both income methods involve
ing and risk-rating guidance. numerous assumptions, and therefore, support-
ing documentation should fully explain the

Page 13
evaluators reasoning and conclusions. borrower characteristics (for example, industry).

When a borrower is experiencing a financial In addition, an institution should develop and
downturn or facing adverse market conditions, a maintain the following:
lender should reflect those adverse conditions in
its assumptions for key variables such as cash A clearly articulated and documented appetite
flow, earnings, and sales multiples when assess- for underwriting risk that considers the poten-
ing enterprise value as a potential source of tial effects on earnings, capital, liquidity, and
repayment. Changes in the value of a borrowers other risks that result from pipeline exposures.
assets should be tested under a range of stress Written policies and procedures for defining
scenarios, including business conditions more and managing distribution failures and
adverse than the base-case scenario. Stress tests hung deals, which are identified by an
of enterprise values and their underlying inability to sell down the exposure within a
assumptions should be conducted and docu- reasonable period (generally 90 days from
mented at origination of the transaction and transaction closing). The financial institutions
periodically thereafter, incorporating the actual board of directors and management should
performance of the borrower and any adjust- establish clear expectations for the disposition
ments to projections. The institution should per- of pipeline transactions that are not sold
form its own discounted cash-flow analysis to according to their original distribution plan.
validate the enterprise value implied by proxy Such transactions that are subsequently reclas-
measures such as multiples of cash flow, earn- sified as hold-to-maturity should also be
ings, or sales. reported to management and the board of
Enterprise value estimates derived from even directors.
the most rigorous procedures are imprecise and Guidelines for conducting periodic stress tests
ultimately may not be realized. Therefore, insti- on pipeline exposures to quantify the potential
tutions relying on enterprise value or illiquid impact of changing economic and market con-
and hard-to-value collateral should have poli- ditions on the institutions asset quality, earn-
cies that provide for appropriate loan-to-value ings, liquidity, and capital.
ratios, discount rates, and collateral margins. Controls to monitor performance of the pipe-
Based on the nature of an institutions leveraged line against original expectations, and regular
lending activities, the institution should estab- reports of variances to management, including
lish limits for the proportion of individual trans- the amount and timing of syndication and
actions and the total portfolio that are supported distribution variances and reporting of
by enterprise value. Regardless of the methodol- recourse sales to achieve distribution.
ogy used, the assumptions underlying enterprise Reports that include individual and aggregate
value estimates should be clearly documented, transaction information that accurately risk
well supported, and understood by the institu- rates credits and portrays risk and concentra-
tions appropriate decisionmakers and risk- tions in the pipeline.
oversight units. Further, an institutions valua- Limits on aggregate pipeline commitments.
tion methods should be appropriate for the Limits on the amount of loans that an institu-
borrowers industry and condition. tion is willing to retain on its own books (that
is, borrower, counterparty, and aggregate hold
levels), and limits on the underwriting risk
2010.2.3.1.7 Pipeline Management that will be undertaken for amounts intended
for distribution.
Market disruptions can substantially impede the Policies and procedures that identify accept-
ability of an underwriter to consummate syndi- able accounting methodologies and controls
cations or otherwise sell down exposures, which in both functional as well as dysfunctional
may result in material losses. Accordingly, markets, and that direct prompt recognition of
financial institutions should have strong risk losses in accordance with generally accepted
management and controls over transactions in accounting principles.
the pipeline, including amounts to be held and Policies and procedures addressing the use of
those to be distributed. A financial institution hedging to reduce pipeline and hold expo-
should be able to differentiate transactions sures, which should address acceptable types
according to tenor, investor class (for example, of hedges and the terms considered necessary
pro-rata and institutional), structure, and key for providing a net credit exposure after
hedging.
BHC Supervision Manual July 2013 Plans and provisions addressing contingent
Page 14 liquidity and compliance with the Boards
Regulation W (12 CFR part 223) when mar- Gross and net exposures, hedge counterparty
ket illiquidity or credit conditions change, concentrations, and policy exceptions.
interrupting normal distribution channels. Actual versus projected distribution of the
syndicated pipeline, with regular reports of
excess levels over the hold targets for the
2010.2.3.1.8 Reporting and Analytics syndication inventory. Pipeline definitions
should clearly identify the type of exposure.
The agencies expect financial institutions to dili- This includes committed exposures that have
gently monitor higher-risk credits, including not been accepted by the borrower, commit-
leveraged loans. A financial institutions man- ments accepted but not closed, and funded
agement should receive comprehensive reports and unfunded commitments that have closed
about the characteristics and trends in such but have not been distributed.
exposures at least quarterly, and summaries Total and segmented leveraged lending expo-
should be provided to the institutions board of sures, including subordinated debt and equity
directors. Policies and procedures should iden- holdings, alongside established limits. Reports
tify the fields to be populated and captured by a should provide a detailed and comprehensive
financial institutions Management Information view of global exposures, including situations
Systems, which should yield accurate and timely when an institution has indirect exposure to
reporting to management and the board of direc- an obligor or is holding a previously sold
tors that may include the following: position as collateral or as a reference asset in
a derivative.
Individual and portfolio exposures within and Borrower and counterparty leveraged lending
across all business lines and legal vehicles, reporting should consider exposures booked
including the pipeline. in other business units throughout the institu-
Risk-rating distribution and migration analy- tion, including indirect exposures such as
sis, including maintenance of a list of those default swaps and total return swaps, naming
borrowers who have been removed from the the distributed paper as a covered or refer-
leveraged portfolio due to improvements in enced asset or collateral exposure through
their financial characteristics and overall risk repo transactions. Additionally, the institution
profile. should consider positions held in available-
Industry mix and maturity profile. for-sale or traded portfolios or through struc-
Metrics derived from probabilities of default tured investment vehicles owned or sponsored
and loss given default. by the originating institution or its subsidi-
Portfolio performance measures, including aries or affiliates.
noncompliance with covenants, restructurings,
delinquencies, non-performing amounts, and
charge-offs. 2010.2.3.1.9 Risk Rating
Amount of impaired assets and the nature of Leveraged Loans
impairment (that is, permanent, or tempo-
rary), and the amount of the ALLL attribut- Previously, the agencies issued guidance on rat-
able to leveraged lending. ing credit exposures and credit-rating systems,
The aggregate level of policy exceptions and which applies to all credit transactions, includ-
the performance of that portfolio. ing those in the leveraged lending category. 9i
Exposures by collateral type, including unse- The risk rating of leveraged loans involves
cured transactions and those where enterprise the use of realistic repayment assumptions to
value will be the source of repayment for determine a borrowers ability to de-lever to a
leveraged loans. Reporting should also con- sustainable level within a reasonable period. For
sider the implications of defaults that trigger example, supervisors commonly assume that the
pari passu (in a fair way) treatment for all ability to fully amortize senior secured debt or
lenders and, thus, dilute the secondary support
from the sale of collateral. 9i. Board SR-98-25, Sound Credit Risk Management and
Secondary-market-pricing data and trading the Use of Internal Credit Risk Ratings at Large Banking
volume, when available. Organizations; OCC Comptrollers Handbooks Rating
Credit Risk and Leveraged Lending; and FDIC Risk
Exposures and performance by deal sponsors. Management Manual of Examination Policies, Loan
Deals introduced by sponsors may, in some Appraisal and Classification.
cases, be considered exposure to related bor-
rowers. An institution should identify, aggre- BHC Supervision Manual July 2013
gate, and monitor potential related exposures. Page 15
the ability to repay at least 50 percent of total downside scenarios, including a covenant
debt over a five- to seven-year period provides breach;
evidence of adequate repayment capacity. If the transactions are reviewed at least quarterly to
projected capacity to pay down debt from cash determine variance from plan, the related risk
flow is nominal with refinancing the only viable implications, and the accuracy of risk ratings
option, the credit will usually be adversely rated and accrual status. From inception, the credit
even if it has been recently underwritten. In file should contain a chronological rationale
cases when leveraged loan transactions have no for and analysis of all substantive changes to
reasonable or realistic prospects to de-lever, a the borrowers operating plan and variance
substandard rating is likely. Furthermore, when from expected financial performance;
assessing debt service capacity, extensions and enterprise and collateral valuations are inde-
restructures should be scrutinized to ensure that pendently derived or validated outside of the
the institution is not merely masking repayment origination function, are timely, and consider
capacity problems by extending or restructuring potential value erosion;
the loan.
If the primary source of repayment becomes collateral liquidation and asset sale estimates
inadequate, the agencies believe that it would are based on current market conditions and
generally be inappropriate for an institution to trends;
consider enterprise value as a secondary source potential collateral shortfalls are identified and
of repayment unless that value is well sup- factored into risk rating and accrual decisions;
ported. Evidence of well-supported value may contingency plans anticipate changing condi-
include binding purchase and sale agreements tions in debt or equity markets when expo-
with qualified third parties or thorough asset sures rely on refinancing or the issuance of
valuations that fully consider the effect of the new equity; and
borrowers distressed circumstances and poten- the borrower is adequately protected from
tial changes in business and market conditions. interest rate and foreign exchange risk.
For such borrowers, when a portion of the loan
may not be protected by pledged assets or a
well-supported enterprise value, examiners gen- 2010.2.3.1.11 Problem-Credit
erally will rate that portion doubtful or loss and Management
place the loan on nonaccrual status.
A financial institution should formulate indi-
vidual action plans when working with borrow-
2010.2.3.1.10 Credit Analysis ers experiencing diminished operating cash
flows, depreciated collateral values, or other
Effective underwriting and management of significant plan variances. Weak initial under-
leveraged lending risk is highly dependent on writing of transactions, coupled with poor struc-
the quality of analysis employed during the ture and limited covenants, may make problem-
approval process as well as ongoing monitoring. credit discussions and eventual restructurings
A financial institutions policies should address more difficult for an institution as well as result
the need for a comprehensive assessment of in less favorable outcomes.
financial, business, industry, and management
risks including, whether A financial institution should formulate credit
policies that define expectations for the manage-
ment of adversely rated and other high-risk bor-
cash-flow analyses rely on overly optimistic
rowers whose performance departs significantly
or unsubstantiated projections of sales, mar-
from planned cash flows, asset sales, collateral
gins, and merger and acquisition synergies;
values, or other important targets. These poli-
liquidity analyses include performance met-
cies should stress the need for workout plans
rics appropriate for the borrowers industry,
that contain quantifiable objectives and mea-
predictability of the borrowers cash flow,
sureable time frames. Actions may include
measurement of the borrowers operating cash
working with the borrower for an orderly resolu-
needs, and ability to meet debt maturities;
tion while preserving the institutions interests,
projections exhibit an adequate margin for
sale of the credit in the secondary market, or
unanticipated merger-related integration costs;
liquidation of collateral. Problem credits should
projections are stress tested for one or more be reviewed regularly for risk rating accuracy,
accrual status, recognition of impairment
Page 16 through specific allocations, and charge-offs.
2010.2.3.1.12 Deal Sponsors strates the ability to identify portfolio risks and
documented authority to escalate inappropriate
A financial institution that relies on sponsor risks and other findings to its senior manage-
support as a secondary source of repayment ment. Due to the elevated risks inherent in lever-
should develop guidelines for evaluating the aged lending, and depending on the relative size
qualifications of financial sponsors and should of a financial institutions leveraged lending
implement processes to regularly monitor a business, the institutions credit-review function
sponsors financial condition. Deal sponsors should assess the performance of the leveraged
may provide valuable support to borrowers such portfolio more frequently and in greater depth
as strategic planning, management, and other than other segments in the loan portfolio. Such
tangible and intangible benefits. Sponsors may assessments should be performed by individuals
also provide sources of financial support for with the expertise and experience for these types
borrowers that fail to achieve projections. Gen- of loans and the borrowers industry. Portfolio
erally, a financial institution rates a borrower reviews should generally be conducted at least
based on an analysis of the borrowers stand- annually. For many financial institutions, the
alone financial condition. However, a financial risk characteristics of leveraged portfolios, such
institution may consider support from a sponsor as high reliance on enterprise value, concentra-
in assigning internal risk ratings when the insti- tions, adverse risk rating trends, or portfolio
tution can document the sponsors history of performance, may dictate reviews that are more
demonstrated support as well as the economic frequent.
incentive, capacity, and stated intent to continue A financial institution should staff its internal
to support the transaction. However, even with credit-review function appropriately and ensure
documented capacity and a history of support, that the function has sufficient resources to
the sponsors potential contributions may not ensure timely, independent, and accurate assess-
mitigate supervisory concerns absent a documents of leveraged lending transactions.
mented commitment of continued support. An Reviews should evaluate the level of risk, risk
evaluation of a sponsors financial support rating integrity, valuation methodologies, and
should include the following: the quality of risk management. Internal credit
reviews should include the review of the institu-
the sponsors historical performance in sup- tions leveraged lending practices, policies, and
porting its investments, financially and other- procedures to ensure that they are consistent
wise with regulatory guidance.
the sponsors economic incentive to support,
including the nature and amount of capital
contributed at inception 2010.2.3.1.14 Stress Testing
documentation of degree of support (for
example, a guarantee, comfort letter, or verbal A financial institution should develop and
assurance) implement guidelines for conducting periodic
consideration of the sponsors contractual portfolio stress tests on loans originated to hold
investment limitations as well as loans originated to distribute, and
to the extent feasible, a periodic review of the sensitivity analyses to quantify the potential
sponsors financial statements and trends, and impact of changing economic and market condi-
an analysis of its liquidity, including the abil- tions on its asset quality, earnings, liquidity, and
ity to fund multiple deals capital. 9j The sophistication of stress testing
consideration of the sponsors dividend and
capital contribution practices
9j. See interagency guidance Supervisory Guidance on
the likelihood of the sponsor supporting a Stress Testing for Banking Organizations with More Than
particular borrower compared to other deals $10 Billion in Total Consolidated Assets (see Board SR
in the sponsors portfolio Letter 12-7 and its attachment), 77 Fed. Reg. 29458 (May 17,
guidelines for evaluating the qualifications of 2012), at www.gpo.gov/fdsys/pkg/FR-2012-05-17/html/2012-
11989.htm, and the joint Statement to Clarify Supervisory
a sponsor and a process to regularly monitor Expectations for Stress Testing by Community Banks,May
the sponsors performance 14, 2012, by the OCC at www.occ.gov/news-issuances/ news
-releases/2012/nr-ia-2012-76a.pdf; the Board at www.federal
reserve.gov/newsevents/press/bcreg/bcreg20120514b1.pdf;
and the FDIC at www.fdic.gov/news/news/press/2012/
2010.2.3.1.13 Credit Review pr12054a.pdf. See also FDIC final rule, Annual Stress Test,
A financial institution should have a strong and BHC Supervision Manual July 2013
independent credit-review function that demon- Page 16.1
practices and sensitivity analyses should be con- and distributing transactions can damage its
sistent with the size, complexity, and risk char- market reputation and impair its ability to com-
acteristics of the institutions leveraged loan pete. Similarly, a financial institution that dis-
portfolio. To the extent a financial institution is tributes transactions, which over time have sig-
required to conduct enterprise-wide stress tests, nificantly higher default or loss rates and
the leveraged portfolio should be included in performance issues, may also see its reputation
any such tests. damaged.
2010.2.3.1.15 Conflicts of Interest 2010.2.3.1.17 Compliance
A financial institution should develop appropri- The legal and regulatory issues raised by lever-
ate policies and procedures to address and to aged transactions are numerous and complex.
prevent potential conflicts of interest when it To ensure potential conflicts are avoided and
has equity and lending positions. For example, laws and regulations are adhered to, an institu-
an institution may be reluctant to use an aggres- tions independent compliance function should
sive collection strategy with a problem borrower periodically review the institutions leveraged
because of the potential impact on the value of lending activity. This guidance is consistent with
an institutions equity interest. A financial insti- the principles of safety and soundness and other
tution may encounter pressure to provide finan- agency guidance related to commercial lending.
cial or other privileged client information that In particular, because leveraged transactions
could benefit an affiliated equity investor. Such often involve a variety of types of debt and bank
conflicts also may occur when the underwriting products, a financial institution should ensure
financial institution serves as financial advisor that its policies incorporate safeguards to pre-
to the seller and simultaneously offers financing vent violations of anti-tying regulations. Section
to multiple buyers (that is, stapled financing). 106(b) of the Bank Holding Company Act
Similarly, there may be conflicting interests Amendments of 1970 9k prohibits certain forms
among the different lines of business within a of product tying by financial institutions and
financial institution or between the financial their affiliates. The intent behind Section 106(b)
institution and its affiliates. When these situa- is to prevent financial institutions from using
tions occur, potential conflicts of interest arise their market power over certain products to
between the financial institution and its custom- obtain an unfair competitive advantage in other
ers. Policies and procedures should clearly products.
define potential conflicts of interest, identify In addition, equity interests and certain debt
appropriate risk-management controls and pro- instruments used in leveraged transactions may
cedures, enable employees to report potential constitute securities for the purposes of fed-
conflicts of interest to management for action eral securities laws. When securities are
without fear of retribution, and ensure compli- involved, an institution should ensure compli-
ance with applicable laws. Further, management ance with applicable securities laws, including
should have an established training program for disclosure and other regulatory requirements.
employees on appropriate practices to follow to An institution should also establish policies and
avoid conflicts of interest and provide for report- procedures to appropriately manage the internal
ing, tracking, and resolution of any conflicts of dissemination of material, nonpublic informa-
interest that occur. tion about transactions in which it plays a role.
2010.2.4 CREDIT-RISK
2010.2.3.1.16 Reputational Risk MANAGEMENT GUIDANCE FOR
HOME EQUITY LENDING
Leveraged lending transactions are often syndi-
cated through the financial and institutional mar- On May 16, 2005, the federal bank and thrift
kets. A financial institutions apparent failure to regulatory agencies collectively issued the fol-
meet its legal responsibilities in underwriting lowing interagency guidance. The guidance is
intended to promote sound credit-risk manage-
77 Fed. Reg. 62417 (Oct. 15, 2012) (to be codified at 12 CFR ment practices at banking organizations10 that
part 325, subpart C).
9k. 12 USC 1972.
BHC Supervision Manual July 2013 10. The agencies are the Board of Governors of the Federal
Page 16.2 Reserve System, the Office of the Comptroller of the Cur-
have home equity lending programs, including that project or have already experienced signifi-
open-end home equity lines of credit (HELOCs) cant growth or concentrations, particularly in
and closed-end home equity loans (HELs). higher-risk products such as high-LTV, low
Banking organizations credit-risk management doc or no doc, interest-only, or third-party-
practices for home equity lending need to keep generated loans. (See SR-05-11.)
pace with the rapid growth in home equity lend-
ing and should emphasize compliance with
sound underwriting standards and practices.
The risk factors listed below, combined with 2010.2.4.1 Credit-Risk Management
an inherent vulnerability to rising interest rates, Systems
suggest that banking organizations need to fully
recognize the risk embedded in their home 2010.2.4.1.1 Product Development and
equity portfolios. Following are the specific Marketing
product, risk-management, and underwriting
risk factors and trends that deserve scrutiny: In the development of any new product offering,
product change, or marketing initiative, manage-
1. interest-only features that require no amorti- ment should have a review and approval process
zation of principal for a protracted period that is sufficiently broad to ensure compliance
2. limited or no documentation of a borrowers with the banking organizations internal policies
assets, employment, and income (known as and applicable laws and regulations11 and to
low do or no doc lending) evaluate the credit, interest-rate, operational,
3. higher loan-to-value (LTV) and debt-to- compliance, reputation, and legal risks. In par-
income (DTI) ratios ticular, risk-management personnel should be
4. lower credit-risk scores for underwriting involved in product development, including an
home equity loans; evaluation of the targeted population and the
5. greater use of automated valuation models product(s) being offered. For example, material
(AVMs) and other collateral-evaluation tools changes in the targeted market, origination
for the development of appraisals and source, or pricing could have a significant
evaluations impact on credit quality and should receive
6. an increase in the number of transactions senior management approval.
generated through a loan broker or other When HELOCs or HELs are marketed or
third party closed by a third party, banking organizations
should have standards that provide assurance
Home equity lending can be conducted in a that the third party also complies with applica-
safe and sound manner if pursued with the ble laws and regulations, including those on
appropriate risk-management structure, includ- marketing materials, loan documentation, and
ing adequate allowances for loan and lease closing procedures. (For further details on agent
losses and appropriate capital levels. Sound relationships, see section 2010.2.4.1.3, Third-
practices call for fully articulated policies that Party Originations.) Finally, management
address marketing, underwriting standards, should have appropriate monitoring tools and
collateral-valuation management, individual- management information systems (MIS) to mea-
account and portfolio management, and sure the performance of various marketing ini-
servicing. tiatives, including offers to increase a line,
Banking organizations should ensure that extend the interest-only period, or adjust the
risk-management practices keep pace with the interest rate or term.
growth and changing risk profile of home equity
portfolios. Management should actively assess a
portfolios vulnerability to changes in consum-
ers ability to pay and the potential for declines
in home values. Active portfolio management is
11. Applicable laws include the Federal Trade Commis-
especially important for banking organizations sion Act; the Equal Credit Opportunity Act (ECOA); the
Truth in Lending Act (TILA), including the Home Ownership
and Equity Protection Act (HOEPA); the Fair Housing Act;
rency, the Federal Deposit Insurance Corporation, and the
the Real Estate Settlement Procedures Act (RESPA); and the
National Credit Union Administration. The interagency guid-
Home Mortgage Disclosure Act (HMDA), as well as applica-
ance frequently uses the term financial institutions. Bank
ble state consumer protection laws.
holding companies have financial institutions and various
credit-extending nonbanking subsidiaries. The combined
entity is being referred to in this guidance as a banking BHC Supervision Manual July 2013
organization. Page 16.3
2010.2.4.1.2 Origination and

Underwriting
All relevant risk factors should be considered
when establishing product offerings and under-
writing guidelines. Generally, these factors
should include a borrowers income and debt
levels, credit score (if obtained), and credit his-
tory, as well as the loan size, collateral value
(including valuation methodology), lien posi-
tion, and property type and location.
Consistent with the Federal Reserves regula-
tions on real estate lending standards, prudently
underwritten home equity loans should include
an evaluation of a borrowers capacity to
adequately service the debt.12 Given the home
equity products long-term nature and the large
credit amount typically extended to a consumer,
an evaluation of repayment capacity should con-
sider a borrowers income and debt levels and
not just a credit score.13 Credit scores are based
upon a borrowers historical financial perfor-
mance. While past performance is a good indi-
cator of future performance, a significant change
in a borrowers income or debt levels can
adversely alter the borrowers ability to pay.
How much verification these underwriting fac-
tors require will depend upon the individual
loans credit risk.
HELOCs generally do not have interest-rate
caps that limit rate increases.14 Rising interest
rates could subject a borrower to significant
payment increases, particularly in a low-
interest-rate environment. Therefore, underwrit-
ing standards for interest-only and variable-rate
HELOCs should include an assessment of the
borrowers ability to amortize the fully drawn
line over the loan term and to absorb potential
increases in interest rates.
12. On December 23, 1992, the Federal Reserve

announced the adoption of uniform rules on real estate lend-
ing standards and issued the Interagency Guidelines for Real
Estate Lending Policies. See subsection 2010.2.1. See also 12
C.F.R., section 208.51 and appendix C.
13. The Interagency Guidelines Establishing Standards for
Safety and Soundness also call for documenting the source of
repayment and assessing the ability of the borrower to repay
the debt in a timely manner. See 12 C.F.R. 208, appendix D-1.
14. While there may be periodic rate increases, the lender
must state in the consumer credit contract the maximum
interest rate that may be imposed during the term of the
obligation. See 12 C.F.R. 226.30(b).

Page 16.4
2010.2.4.1.3 Third-Party Originations prior to entering a relationship. In addition, once

a relationship is established, the banking organi-
Banking organizations often use third parties, zation should have adequate audit procedures
such as mortgage brokers or correspondents, to and controls to verify that the third parties are
originate loans. When doing so, they should not being paid to generate incomplete or fraudu-
have strong control systems to ensure the qual- lent mortgage applications or are not otherwise
ity of originations and compliance with all receiving referral or unearned income or fees
applicable laws and regulations, and to help contrary to RESPA prohibitions.15 Monitoring
prevent fraud. the quality of loans by origination source, and
Brokers are firms or individuals, acting on uncovering such problems as early payment
behalf of either the banking organization or the defaults and incomplete packages, enables man-
borrower, who match the borrowers needs with agement to know if third-party originators are
institutions mortgage-origination programs. producing quality loans. If ongoing credit or
Brokers take applications from consumers. documentation problems are discovered, the
Although they sometimes process the applica- banking organization should take appropriate
tion and underwrite the loan to qualify the appli- action against the third party, which could
cation for a particular lender, they generally do include terminating its relationship with the
not use their own funds to close loans. Whether third party.
brokers are allowed to process and perform any
underwriting will depend on the relationship
between the banking organization and the bro- 2010.2.4.1.4 Collateral-Valuation
ker. For control purposes, the banking organiza- Management
tion should retain appropriate oversight of all
critical loan-processing activities, such as verifi- Competition, cost pressures, and advancements
cation of income and employment and indepen- in technology have prompted banking organiza-
dence in the appraisal and evaluation function. tions to streamline their appraisal and evaluation
Correspondents are financial companies that processes. These changes, coupled with banking
usually close and fund loans in their own name organizations underwriting to higher LTVs, have
and subsequently sell them to a lender. Banking heightened the importance of strong collateral-
organizations commonly obtain loans through valuation management policies, procedures, and
correspondents and, in some cases, delegate processes.
the underwriting function to the correspondent. Banking organizations should have appropri-
In delegated underwriting relationships, a bank- ate collateral-valuation policies and procedures
ing organization grants approval to a correspon- that ensure compliance with the Federal
dent financial company to process, underwrite, Reserves appraisal regulations16 and the Inter-
and close loans according to the delegators agency Appraisal and Evaluation Guidelines
processing and underwriting requirements and (the guidelines).17 In addition, the banking orga-
is committed to purchase those loans. The nization should
delegating banking organization should have
systems and controls to provide assurance that 1. establish criteria for determining the appro-
the correspondent is appropriately managed, is priate valuation methodology for a particular
financially sound, and provides mortgages that transaction, based on the risk in the transac-
meet the banking organizations prescribed tion and loan portfolio (For example, higher-
underwriting guidelines and that comply with
applicable consumer protection laws and regula-
15. In addition, a banking organization that purchases loans
tions. A quality-control unit or function in subject to TILAs rules for HELs with high rates or high
the delegating banking organization should closing costs (loans covered by HOEPA) can incur assignee
closely monitor the quality of loans that the liability unless the banking organization can reasonably show
correspondent underwrites. Monitoring activi- that it could not determine the transaction was a loan covered
by HOEPA. Also, the nature of its relationship with brokers
ties should include post-purchase underwriting and correspondents may have implications for liability under
reviews and ongoing portfolio-performance- ECOA, and for reporting responsibilities under HMDA.
management activities. 16. 12 C.F.R. 208, subpart E, and 12 C.F.R. 225, subpart
Both brokers and correspondents are compen- G.
17. See SR-94-55, dated October 27, 1994. These revised
sated based upon mortgage-origination volume guidelines include the June 1994 amendments. See also sec-
and, accordingly, have an incentive to produce tion 2231.0.15, appendix A.
and close as many loans as possible. Therefore,
banking organizations should perform compre- BHC Supervision Manual July 2005
hensive due diligence on third-party originators Page 17
risk transactions or nonhomogeneous prop- basis for the collateral valuation, the banking
erty types should be supported by more- organization should be able to demonstrate and
thorough valuations. The banking organi- document the correlation between the assess-
zation should also set criteria for determining ment value of the taxing authority and the prop-
the extent to which an inspection of the col- ertys market value as part of the validation
lateral is necessary.) process.
2. ensure that an expected or estimated value of
the property is not communicated to an
appraiser or individual performing an 2010.2.4.1.6 Account Management
evaluation
3. implement policies and controls to preclude Since HELOCs often have long-term, interest-
value shopping (Use of several valuation only payment features, banking organizations
tools may return different values for the same should have risk-management techniques that
property. These differences can result in sys- identify higher-risk accounts and adverse
tematic overvaluation of properties if the changes in account risk profiles, thereby
valuation choice becomes driven by the high- enabling management to implement timely pre-
est property value. If several different valua- ventive action (e.g., freezing or reducing lines).
tion tools or AVMs are used for the same Further, a banking organization should have
property, the banking organization should ad- risk-management procedures to evaluate and
here to a policy for selecting the most reli- approve additional credit on an existing line or
able method, rather than the highest value.) extending the interest-only period. Account-
4. require sufficient documentation to support management practices should be appropriate for
the collateral valuation in the appraisal or the size of the portfolio and the risks associated
evaluation with the types of home equity lending.
Effective account-management practices for
large portfolios or portfolios with high-risk char-
2010.2.4.1.5 AVMs acteristics include
When AVMs are used to support evaluations or 1. periodically refreshing credit-risk scores on
appraisals, the banking organization should vali- all customers;
date the models on a periodic basis to mitigate 2. using behavioral scoring and analysis of indi-
the potential valuation uncertainty in the model. vidual borrower characteristics to identify
As part of the validation process, the banking potential problem accounts;
organization should document the validations 3. periodically assessing utilization rates;
analysis, assumptions, and conclusions. The 4. periodically assessing payment patterns,
validation process includes back-testing a repre- including borrowers who make only mini-
sentative sample of the valuations against mar- mum payments over a period of time or those
ket data on actual sales (where sufficient infor- who rely on the line to keep payments
mation is available). The validation process current;
should cover properties representative of the 5. monitoring home values by geographic area;
geographic area and property type for which the and
tool is used. 6. obtaining updated information on the collat-
Many AVM vendors, when providing a value, erals value when significant market factors
will also provide a confidence score, which indicate a potential decline in home values,
usually relates to the accuracy of the value or when the borrowers payment perfor-
provided. Confidence scores, however, come in mance deteriorates and greater reliance is
many different formats and are calculated based placed on the collateral.
on differing scoring systems. Banking organiza-
tions that use AVMs should have an understand- The frequency of these actions should be
ing of how the model works as well as what the commensurate with the risk in the portfolio.
confidence scores mean. Confidence levels Banking organizations should conduct annual
should be established by the banking organiza- credit reviews of HELOC accounts to determine
tion that are appropriate for the risk in a given whether the line of credit should be continued,
transaction or group of transactions. based on the borrowers current financial
When tax-assessment valuations are used as a condition.18
BHC Supervision Manual July 2005 18. Under the Federal Reserves risk-based capital guide-
Page 18 lines, an unused HELOC commitment with an original matu-
When appropriate, banking organizations that the banking organizations board of direc-
should refuse to extend additional credit or tors review and approve these policies at least
reduce the credit limit of a HELOC, bearing in annually. Before implementing any changes to
mind that under Regulation Z such steps can be policies or underwriting standards, management
taken only in limited circumstances. These should assess the potential effect on the banking
include, for example, when the value of the organizations overall risk profile, which would
collateral declines significantly below the include the effect on concentrations, profitabil-
appraised value for purposes of the HELOC, ity, and delinquency and loss rates. The accu-
default of a material obligation under the loan racy of these estimates should be tested by
agreement, or deterioration in the borrowers comparing them with actual experience.
financial circumstances.19 In order to freeze or
reduce credit lines due to deterioration in a
borrowers financial circumstances, two condi- 2010.2.4.1.7.2 Portfolio Objectives and Risk
tions must be met: (1) there must be a mate- Diversification
rial change in the borrowers financial circum-
stances and (2) as a result of this change, the Effective portfolio management should clearly
banking organization must have a reasonable communicate portfolio objectives, such as
belief that the borrower will be unable to fulfill growth targets, utilization, rate-of-return
the plans payment obligations. hurdles, and default and loss expectations. For
Account-management practices that do not banking organizations with significant concen-
adequately control authorizations and provide trations of HELs or HELOCs, limits should be
for timely repayment of over-limit amounts may established and monitored for key portfolio seg-
significantly increase a portfolios credit risk. ments, such as geographic area, loan type, and
Authorizations of over-limit home equity lines higher-risk products. When appropriate, consid-
of credit should be restricted and subject to eration should be given to the use of risk miti-
appropriate policies and controls. A banking gants, such as private mortgage insurance, pool
organizations practices should require over- insurance, or securitization. As the portfolio
limit borrowers to repay in a timely manner the approaches concentration limits, the banking
amount that exceeds established credit limits. organization should analyze the situation suffi-
Management information systems should be ciently to enable the banking organizations
sufficient to enable management to identify, board of directors and senior management to
measure, monitor, and control the unique risks make a well-informed decision to either raise
associated with over-limit accounts. concentration limits or pursue a different course
of action.
Effective portfolio management requires an
2010.2.4.1.7 Portfolio Management understanding of the various risk characteristics
of the home equity portfolio. To gain this under-
Banking organizations should implement an standing, a banking organization should analyze
effective portfolio credit-risk management pro- the portfolio by segment, using criteria such as
cess for their home equity portfolios that product type, credit-risk score, DTI, LTV, prop-
includes the following. erty type, geographic area, collateral-valuation
method, lien position, size of credit relative to
prior liens, and documentation type (such as
2010.2.4.1.7.1 Policies no doc or low doc).
The Federal Reserves real estate lending stan-

dards regulations require that a banking organi- 2010.2.4.1.7.3 Management Information
zations real estate lending policies be consis- Systems
tent with safe and sound banking practices and
By maintaining adequate credit MIS, a banking
rity of one year or more may be allocated a zero percent
conversion factor if the banking organization conducts at least
organization can segment loan portfolios and
an annual credit review and is able to unconditionally cancel accurately assess key risk characteristics. The
the commitment (i.e., prohibit additional extensions of credit, MIS should also provide management with suf-
reduce the credit line, and terminate the line) to the full extent ficient information to identify, monitor, mea-
permitted by relevant federal law. See 12 C.F.R. 208, appen-
dix A, III.D.4., and 12 C.F.R. 225, appendix A, III.D.4.
sure, and control home equity concentrations.
19. Regulation Z does not permit these actions to be taken
in circumstances other than those specified in the regulation. BHC Supervision Manual July 2005
See 12 C.F.R. 226.5b(f)(3)(vi)(A)(F). Page 19
Banking organizations should periodically expected to ensure compliance with the supervi-
assess the adequacy of their MIS in light of sory loan-to-value limits of the Interagency Real
growth and changes in their appetite for risk. Estate Lending Guidelines. The HLTV guidance
For banking organizations with significant con- outlines controls that the banking organizations
centrations of HELs or HELOCs, MIS should should have in place when engaging in HLTV
include, at a minimum, reports and analysis of lending. Banking organizations should accu-
the following: rately track the volume of HLTV loans, includ-
ing HLTV home equity and residential mort-
1. production and portfolio trends by product, gages, and report the aggregate of such loans to
loan structure, originator channel, credit the banking organizations board of directors.
score, LTV, DTI, lien position, documenta- Specifically, banking organizations are
tion type, market, and property type reminded that:
2. delinquency and loss-distribution trends by
product and originator channel with some 1. Loans in excess of the supervisory LTV lim-
accompanying analysis of significant under- its should be identified in the banking organi-
writing characteristics (such as credit score, zations records. The aggregate of high-LTV
LTV, DTI) one-to four-family residential loans should
3. vintage tracking not exceed 100 percent of the banking orga-
4. the performance of third-party originators nizations total capital.20 Within that limit,
(brokers and correspondents) high-LTV loans for properties other than
5. market trends by geographic area and prop- one- to four-family residential properties
erty type to identify areas of rapidly appreci- should not exceed 30 percent of capital.
ating or depreciating housing values 2. In calculating the LTV and determining com-
pliance with the supervisory LTVs, the bank-
ing organization should consider all senior
2010.2.4.1.7.4 Policy and Underwriting- liens. All loans secured by the property and
Exception Systems held by the banking organization are reported
as an exception if the combined LTV of a
Banking organizations should have a process for loan and all senior liens on an owner-
identifying, approving, tracking, and analyzing occupied one- to four-family residential
underwriting exceptions. Reporting systems that property equals or exceeds 90 percent and if
capture and track information on exceptions, there is no additional credit enhancement in
both by transaction and by relevant portfolio the form of either mortgage insurance or
segments, facilitate the management of a portfo- readily marketable collateral.
lios credit risk. The aggregate data is useful to 3. For the LTV calculation, the loan amount is
management in assessing portfolio risk profiles the legally binding commitment (that is, the
and monitoring the level of adherence to policy entire amount that the banking organization
and underwriting standards by various origina- is legally committed to lend over the life of
tion channels. Analysis of the information may the loan).
also be helpful in identifying correlations 4. All realestate secured loans in excess of
between certain types of exceptions and delin- supervisory LTV limits should be aggregated
quencies and losses. and included in a quarterly report for the
banking organizations board of directors.
2010.2.4.1.7.5 High-LTV Monitoring Certain insurance products help banking or-

ganizations mitigate the credit risks of HLTV
To clarify the real estate lending standards regu-
lations and interagency guidelines, the agencies 20. For purposes of the Interagency Real Estate Lending
issued Guidance on High Loan-To-Value Standards Guidelines, high-LTV one- to four-family residen-
(HLTV) Residential Real Estate Lending (the tial property loans include (1) a loan for raw land zoned for
one- to four-family residential use with an LTV ratio greater
HLTV guidance) in October 1999. The HLTV than 65 percent; (2) a residential land development loan or
guidance clarified the Interagency Real Estate improved lot loan with an LTV greater than 75 percent; (3) a
Lending Guidelines and the supervisory loan-to- residential construction loan with an LTV ratio greater than
value limits for loans on one- to four-family 85 percent; (4) a loan on non-owner occupied one- to four-
family residential property with an LTV greater than 85 per-
residential properties. Banking organizations are cent; and (5) a permanent mortgage or home equity loan on an
owner-occupied residential property with an LTV equal to or
BHC Supervision Manual July 2005 exceeding 90 percent without mortgage insurance, readily
Page 20 marketable collateral, or other acceptable collateral.
residential loans. Insurance policies that cover a mation is necessary to determine the loans LTV
pool of loans can be an efficient and effective ratio and to assess the credit support of the
credit-risk management tool. But if a policy has collateral. Senior liens include first mortgages,
a coverage limit, the coverage may be exhausted outstanding liens for unpaid taxes, outstanding
before all loans in the pool mature or pay off. mechanics liens, and recorded judgments on
The Federal Reserve considers pool insurance to the borrower.
be a sufficient credit enhancement to remove the
HLTV designation in the following circum-
stances: (1) the policy is issued by an acceptable 2010.2.4.1.8.2 Problem-Loan Workouts and
mortgage insurance company, (2) it reduces the Loss-Mitigation Strategies
LTV for each loan to less than 90 percent, and
(3) it is effective over the life of each loan in the Banking organizations should have established
pool. policies and procedures for problem loan work-
outs and loss-mitigation strategies. Policies
2010.2.4.1.7.6 Stress Testing for Portfolios should be in accordance with the requirements
of the FFIECs Uniform Retail Credit Classifi-
Banking organizations with home equity con- cation and Account Management Policy, issued
centrations as well as higher-risk portfolios are June 2000 (see SR-00-8 and section 2241.0) and
encouraged to perform sensitivity analyses on should, at a minimum, address the following:
key portfolio segments. This type of analysis
identifies possible events that could increase 1. circumstances and qualifying requirements
risk within a portfolio segment or for the port- for various workout programs including
folio as a whole. Banking organizations should extensions, re-ages, modifications, and
consider stress tests that incorporate interest- re-writes (Qualifying criteria should include
rate increases and declines in home values. an analysis of a borrowers financial capacity
Since these events often occur simultaneously, to service the debt under the new terms.)
the agencies recommend testing for these events 2. circumstances and qualifying criteria for
together. Banking organizations should also loss-mitigating strategies, including
periodically analyze markets in key geographic foreclosure
areas, including identified soft markets. Man- 3. appropriate MIS to track and monitor the
agement should consider developing contin- effectiveness of workout programs, including
gency strategies for scenarios and outcomes that tracking the performance of all categories of
extend credit risk beyond internally established workout loans (For large portfolios, vintage
risk tolerances. These contingency plans might delinquency and loss tracking also should be
include increased monitoring, tightening under- included.)
writing, limiting growth, and selling loans or
portfolio segments. While banking organizations are encouraged
to work with borrowers on a case-by-case basis,
a banking organization should not use workout
2010.2.4.1.8 Operations, Servicing, and strategies to defer losses. Banking organizations
Collections should ensure that credits in workout programs
are evaluated separately for the allowance for
Effective procedures and controls should be loan and lease losses (ALLL), because such
maintained for such support functions as per- credits tend to have higher loss rates than other
fecting liens, collecting outstanding loan docu- portfolio segments.
ments, obtaining insurance coverage (including
flood insurance), and paying property taxes.
Credit-risk management should oversee these 2010.2.4.1.9 Secondary-Market Activities
support functions to ensure that operational risks
are properly controlled. More banking organizations are issuing HELOC
mortgage-backed securities (that is, securitizing
HELOCs). Although such secondary-market
2010.2.4.1.8.1 Lien Recording activities can enhance credit availability and a
banking organizations profitability, they also
Banking organizations should take appropriate pose certain risk-management challenges. A
measures to safeguard their lien position. They
should verify the amount and priority of any BHC Supervision Manual July 2015
senior liens prior to closing the loan. This infor- Page 21
banking organizations risk-management sys- parent companys supervision and control over
tems should address the risks of HELOC its subsidiary lending activities, which includes
securitizations.21 an overall assessment of the banking organiza-
tions credit-risk concentrations, including the
risk concentrations in commercial real estate
2010.2.4.1.10 Portfolio Classifications, lending. (See also section 2010.2.) Banking
Allowance for Loan and Lease Losses, organizations, including bank holding compa-
and Capital nies, are responsible for establishing the neces-
sary and appropriate management oversight of
The FFIECs Uniform Retail Credit Classifica- their bank and nonbank subsidiaries by adminis-
tion and Account Management Policy governs tering, monitoring, and assuring adherence to
the classification of consumer loans and estab- the organizations lending policies and practices
lishes general classification thresholds that are for controlling concentration risk. Banking
based on delinquency. Banking organizations organizations should therefore have adequate
and the Federal Reserves examiners have the management information systems (including the
discretion to classify entire retail portfolios, or appropriate accounting and internal control
segments thereof, when underwriting weak- systems) in place to accomplish their supervi-
nesses or delinquencies are pervasive and pres- sory oversight and to control such credit
ent an excessive level of credit risk. Portfolios concentrations.
of high-LTV loans to borrowers who exhibit The following guidance, Concentrations in
inadequate capacity to repay the debt within a Commercial Real Estate (CRE) Lending, Sound
reasonable time may be subject to classification. Risk-Management Practices (the guidance) was
Banking organizations should establish issued on December 6, 2006 (effective on
appropriate ALLL and hold capital commensu- December 12, 2006).23 The guidance was devel-
rate with the riskiness of their portfolios. In oped to reinforce sound risk-management prac-
determining the ALLL adequacy, a banking tices for institutions (includes banking organiza-
organization should consider how the interest- tions) with high and increasing concentrations
only and draw features of HELOCs during the of commercial real estate loans on their balance
lines revolving period could affect the loss sheets. An institutions strong risk-management
curves for its HELOC portfolio. Those banking practices and its maintenance of appropriate lev-
organizations engaging in programmatic sub- els of capital are important elements of a sound
prime home equity lending or banking organiza- CRE lending program, particularly when an
tions that have higher-risk products are expected institution has a concentration in CRE or a CRE
to recognize the elevated risk of the activity lending strategy leading to a concentration.
when assessing capital and ALLL adequacy.22 However, institutions needing to improve their
risk-management processes may have been pro-
vided the opportunity for some flexibility on the
2010.2.5 OVERSIGHT OF time frame for complying with the guidance.
CONCENTRATIONS IN This time frame will be commensurate with the
COMMERCIAL REAL ESTATE level and nature of CRE concentration risk, the
LENDING AND SOUND quality of the institutions existing risk-
RISK-MANAGEMENT LENDING management practices, and its levels of capital.
(See 71 Fed. Reg. 74,580 [December 12, 2006],
As part of a bank holding company inspection, the Federal Reserve Boards press release dated
the examiner should make an assessment of the
23. The guidance was jointly adopted by the Board of

21. See the risk management and capital adequacy of expo-
Governors of the Federal Reserve System, the Office of the
sures arising from secondary-market credit activities discus-
Comptroller of the Currency, and the Federal Deposit Insur-
sion in SR-97-21 (see also section 2129.05).
ance Corporation after the bank supervisory agencies careful
22. See the January 2001 Interagency Expanded Guid-
consideration of the comments received following the initial
ance for Subprime Lending Programs (section 2128.08) for
issuance of the January 10, 2006, proposed guidance on
supervisory expectations regarding risk-management pro-
concentrations in commercial real estate lending. The final
cesses, the allowance for loan and lease losses, and capital
guidance is applicable to state member banks and broadly
adequacy for banking organizations engaging in subprime-
applicable to bank holding companies and their nonbank
lending programs.
subsidiaries. For the purposes of this section the references to
banks, institutions, and banking organizations is confined to
BHC Supervision Manual July 2015 those entities for which the Board of Governors of the Federal
Page 22 Reserve System has supervisory authority.
December 6, 2006, and SR-07-01 and its have common risk characteristics or sensitivities
attachments.) See also SR-15-17, Interagency to economic, financial, or business develop-
Statement on Prudent Risk Management for ments. A banks CRE portfolio stratification
Commercial Real Estate Lending and its should be reasonable and supportable. The CRE
attachment and the Boards December 18, 2015, portfolio should not be divided into multiple
press release. segments simply to avoid the appearance of
concentration risk.
The Federal Reserve recognizes that risk
2010.2.5.1 Scope of the CRE characteristics vary among CRE loans secured
Concentration Guidance by different property types. A manageable level
of CRE concentration risk will vary by bank
The guidance focuses on those CRE loans for
depending on the portfolio risk characteristics,
which the cash flow from the real estate is the
the quality of risk-management processes, and
primary source of repayment rather than loans
capital levels. Therefore, the guidance does not
to a borrower for which real estate collateral is
establish a CRE concentration limit that applies
taken as a secondary source of repayment or
to all banks. Rather, banks are encouraged to
through an abundance of caution. For the pur-
identify and monitor credit concentrations and
poses of this guidance, CRE loans include those
to establish internal concentration limits, and all
loans with risk profiles sensitive to the condition
concentrations should be reported to senior
of the general CRE market (for example, market
management and the board of directors on a
demand, changes in capitalization rates, vacancy
periodic basis. Depending on the results of the
rates, or rents). CRE loans are land development
risk assessment, the bank may need to enhance
and construction loans (including one- to four-
its risk-management systems.
family residential and commercial construction
loans) and other land loans. CRE loans also
include loans secured by multifamily property, 2010.2.5.3 CRE Risk Management
and nonfarm nonresidential property where the
primary source of repayment is derived from The sophistication of a banks CRE risk-
rental income associated with the property (that management processes should be appropriate to
is, loans for which 50 percent or more of the the size of the portfolio, as well as the level and
source of repayment comes from third-party, nature of concentrations and the associated risk
nonaffiliated, rental income) or the proceeds of to the bank. Banks should address the following
the sale, refinancing, or permanent financing of key elements in establishing a risk-management
the property. Loans to real estate investment framework that effectively identifies, monitors,
trusts and unsecured loans to developers also and controls CRE concentration risk:
should be considered CRE loans for purposes of
this guidance if their performance is closely 1. board and management oversight
linked to performance of the CRE markets. The 2. portfolio management
scope of the guidance does not include loans 3. management information systems
secured by nonfarm nonresidential properties 4. market analysis
where the primary source of repayment is the 5. credit underwriting standards
cash flow from the ongoing operations and 6. portfolio stress testing and sensitivity
activities conducted by the party, or affiliate of analysis
the party, who owns the property. Rather than 7. credit-risk review function
defining a CRE concentration, the guidances
Supervisory Oversight section describes the 2010.2.5.3.1 Board and Management
criteria that the Federal Reserve will use as Oversight of CRE Concentration Risk
high-level indicators to identify banks poten-
tially exposed to CRE concentration risk. A banks board of directors has ultimate respon-
sibility for the level of risk assumed by the
bank. If the bank has significant CRE concentra-
2010.2.5.2 CRE Concentration tion risk, its strategic plan should address the
Assessments rationale for its CRE levels in relation to its
overall growth objectives, financial targets, and
Banks that are actively involved in CRE lending capital plan. In addition, the Federal Reserves
should perform ongoing risk assessments to real estate lending regulations require that each
identify CRE concentrations. The risk assess-
ment should identify potential concentrations by BHC Supervision Manual January 2016
stratifying the CRE portfolio into segments that Page 23
bank adopt and maintain a written policy that the portfolio. This should include an evaluation
establishes appropriate limits and standards for of the banks ability to access the secondary
all extensions of credit that are secured by liens market and a comparison of its underwriting
on or interests in real estate, including CRE standards with those that exist in the secondary
loans. Therefore, the board of directors or a market.
designated committee thereof should
2010.2.5.3.3 CRE Management
1. establish policy guidelines and approve an
Information Systems
overall CRE lending strategy regarding the
level and nature of CRE exposures accept- A strong management information system
able to the bank, including any specific com- (MIS) is key to effective portfolio management.
mitments to particular borrowers or property The sophistication of the MIS will necessarily
types, such as multifamily housing; vary with the size and complexity of the CRE
2. ensure that management implements proce- portfolio and level and nature of concentration
dures and controls to effectively adhere to risk. The MIS should provide management with
and monitor compliance with the banks sufficient information to identify, measure,
lending policies and strategies; monitor, and manage CRE concentration risk.
3. review information that identifies and quanti- This includes meaningful information on CRE
fies the nature and level of risk presented by portfolio characteristics that is relevant to the
CRE concentrations, including reports that banks lending strategy, underwriting standards,
describe changes in CRE market conditions and risk tolerances. A bank should periodically
in which the bank lends; and assess the adequacy of the MIS in light of
4. periodically review and approve CRE risk growth in CRE loans and changes in the CRE
exposure limits and appropriate sublimits portfolios size, risk profile, and complexity.
(for example, by nature of concentration) to Banks are encouraged to stratify the CRE
conform to any changes in the banks strate- portfolio by property type, geographic market,
gies and to respond to changes in market tenant concentrations, tenant industries, devel-
conditions. oper concentrations, and risk rating. Other use-
ful stratifications may include loan structure (for
example, fixed-rate or adjustable), loan purpose
2010.2.5.3.2 CRE Portfolio Management (for example, construction, short-term, or per-
manent), loan-to-value (LTV) limits, debt ser-
Banks with CRE concentrations should manage vice coverage, policy exceptions on newly
not only the risk of individual loans but also underwritten credit facilities, and affiliated loans
portfolio risk. Even when individual CRE loans (for example, loans to tenants). A bank should
are prudently underwritten, concentrations of also be able to identify and aggregate exposures
loans that are similarly affected by cyclical to a borrower, including its credit exposure relat-
changes in the CRE market can expose a bank ing to derivatives.
to an unacceptable level of risk if not properly Management reporting should be timely and
managed. Management regularly should evalu- in a format that clearly indicates changes in the
ate the degree of correlation between related portfolios risk profile, including risk-rating
real estate sectors and establish internal lending migrations. In addition, management reporting
guidelines and concentration limits that control should include a well-defined process through
the banks overall risk exposure. which management reviews and evaluates con-
Management should develop appropriate centration and risk-management reports, as well
strategies for managing CRE concentration lev- as special ad hoc analyses in response to poten-
els, including a contingency plan to reduce or tial market events that could affect the CRE loan
mitigate concentrations in the event of adverse portfolio.
CRE market conditions. Loan participations,
whole loan sales, and securitizations are a few
examples of strategies for actively managing 2010.2.5.3.4 Market Analysis
concentration levels without curtailing new
originations. If the contingency plan includes Market analysis should provide the banks man-
selling or securitizing CRE loans, management agement and board of directors with information
should assess periodically the marketability of to assess whether its CRE lending strategy and
policies continue to be appropriate in light of
BHC Supervision Manual January 2016 changes in CRE market conditions. A bank
Page 24 should perform periodic market analyses for the
various property types and geographic markets and maintenance of hard equity by the bor-
represented in its portfolio. rower
Market analysis is particularly important as a 8. minimum standards for borrower net worth,
bank considers decisions about entering new property cash flow, and debt service cover-
markets, pursuing new lending activities, or age for the property
expanding in existing markets. Market informa-
tion also may be useful for developing sensitiv- A banks lending policies should permit
ity analysis or stress tests to assess portfolio exceptions to underwriting standards only on a
risk. limited basis. When a bank does permit an
Sources of market information may include exception, it should document how the transac-
published research data, real estate appraisers tion does not conform to the banks policy or
and agents, information maintained by the prop- underwriting standards, obtain appropriate man-
erty taxing authority, local contractors, builders, agement approvals, and provide reports to the
investors, and community development groups. board of directors or designated committee
The sophistication of a banks analysis will vary detailing the number, nature, justifications, and
by its market share and exposure, as well as the trends for exceptions. Exceptions to both the
availability of market data. While a bank operat- banks internal lending standards and the Fed-
ing in nonmetropolitan markets may have access eral Reserves supervisory LTV limits25 should
to fewer sources of detailed market data than a be monitored and reported on a regular basis.
bank operating in large, metropolitan markets, a Further, banks would analyze trends in excep-
bank should be able to demonstrate that it has an tions to ensure that risk remains within the
understanding of the economic and business banks established risk tolerance limits.
factors influencing its lending markets. Credit analysis should reflect both the bor-
rowers overall creditworthiness and project-
specific considerations as appropriate. In addi-
2010.2.5.3.5 Credit Underwriting tion, for development and construction loans,
Standards the bank should have policies and procedures
governing loan disbursements to ensure that the
A banks lending policies should reflect the banks minimum borrower equity requirements
level of risk that is acceptable to its board of are maintained throughout the development and
directors and should provide clear and measur- construction periods. Prudent controls should
able underwriting standards that enable the include an inspection process, documentation
banks lending staff to evaluate all relevant on construction progress, tracking pre-sold
credit factors. When a bank has a CRE concen- units, pre-leasing activity, and exception moni-
tration, the establishment of sound lending poli- toring and reporting.
cies becomes even more critical. In establishing
its policies, a bank should consider both internal
and external factors, such as its market position, 2010.2.5.3.6 CRE Portfolio Stress Testing
historical experience, present and prospective and Sensitivity Analysis
trade area, probable future loan and funding
trends, staff capabilities, and technology A bank with CRE concentrations should per-
resources. Consistent with the Federal Reserves form portfolio-level stress tests or sensitivity
real estate lending guidelines, CRE lending poli- analysis to quantify the impact of changing eco-
cies should address the following underwriting nomic conditions on asset quality, earnings, and
standards: capital. Further, a bank should consider the sen-
sitivity of portfolio segments with common risk
1. maximum loan amount by type of property characteristics to potential market conditions.
2. loan terms The sophistication of stress testing practices and
3. pricing structures sensitivity analysis should be consistent with
4. collateral valuation24 the size, complexity, and risk characteristics of
5. LTV limits by property type the CRE loan portfolio. For example, well-
6. requirements for feasibility studies and sensi-
25. The Interagency Guidelines for Real Estate Lending
tivity analysis or stress testing state that loans exceeding the supervisory LTV guidelines
7. minimum requirements for initial investment should be recorded in the banks records and reported to the
board at least quarterly.
24. Refer to the Federal Reserves appraisal regulations: BHC Supervision Manual July 2007
12 C.F.R. 208 subpart E and 12 C.F.R. 225, subpart G. Page 25
margined and seasoned performing loans on 2. total commercial real estate loans as
multifamily housing normally would require defined in this guidance28 represent
significantly less robust stress testing than most 300 percent or more of the banks total
acquisition, development, and construction capital, and the outstanding balance of the
loans. banks commercial real estate loan portfo-
Portfolio stress testing and sensitivity analy- lio has increased by 50 percent or more
sis may not necessarily require the use of a during the prior 36 months.
sophisticated portfolio model. Depending on the
risk characteristics of the CRE portfolio, stress The Federal Reserve will use the criteria as a
testing may be as simple as analyzing the poten- preliminary step to identify banks that may have
tial effect of stressed loss rates on the CRE CRE concentration risk. Because regulatory
portfolio, capital, and earnings. The analysis reports capture a broad range of CRE loans with
should focus on the more vulnerable segments varying risk characteristics, the supervisory
of a banks CRE portfolio, taking into consider- monitoring criteria do not constitute limits on a
ation the prevailing market environment and the banks lending activity but rather serve as high-
banks business strategy. level indicators to identify banks potentially
exposed to CRE concentration risk. Nor do the
criteria constitute a safe harbor for banks if
2010.2.5.3.7 Credit-Risk Review Function other risk indicators are present, regardless of
their measurements under (1) and (2).
A strong credit-risk review function is critical
for a banks self-assessment of emerging risks.
An effective, accurate, and timely risk-rating 2010.2.5.4.1 Evaluation of CRE
system provides a foundation for the banks Concentrations
credit-risk review function to assess credit qual-
ity and, ultimately, to identify problem loans. The effectiveness of a banks risk-management
Risk ratings should be risk sensitive, objective, practices will be a key component of the super-
and appropriate for the types of CRE visory evaluation of the banks CRE concentra-
loans underwritten by the bank. Further, risk tions. Examiners will engage in a dialogue with
ratings should be reviewed regularly for the banks management to assess CRE exposure
appropriateness. levels and risk-management practices. Banks
that have experienced recent, significant growth
in CRE lending will receive closer supervisory
2010.2.5.4 Supervisory Oversight Of review than those that have demonstrated a suc-
CRE Concentration Risk cessful track record of managing the risks in
CRE concentrations.
As part of its ongoing supervisory monitoring In evaluating CRE concentrations, the Fed-
processes, the Federal Reserve will use certain eral Reserve will consider the banks own analy-
criteria to identify banks that are potentially sis of its CRE portfolio, including consideration
exposed to significant CRE concentration risk. of factors such as
A bank that has experienced rapid growth in
CRE lending, has notable exposure to a specific 1. portfolio diversification across property types
type of CRE, or is approaching or exceeds the 2. geographic dispersion of CRE loans
following supervisory criteria may be identified 3. underwriting standards
for further supervisory analysis of the level and 4. level of pre-sold units or other types of take-
nature of its CRE concentration risk: out commitments on construction loans
5. portfolio liquidity (ability to sell or securitize
1. total reported loans for construction, land exposures on the secondary market)
development, and other land26 represent
100 percent or more of the banks total capi- While consideration of these factors should
tal27 or not change the method of identifying a credit
concentration, these factors may mitigate the
risk posed by the concentration.
26. For commercial banks as reported in the Call Report
FFIEC 031 and 041, schedule RC-C, item 1a.
means the total risk-based capital as reported for commercial
27. For purposes of this guidance, the term total capital
banks in the Call Report FFIEC 031 and 041 schedule
RC-RRegulatory Capital, line 21.
BHC Supervision Manual July 2007 28. For commercial banks as reported in the Call Report
Page 26 FFIEC 031 and 041, schedule RC-C, item 1a.
2010.2.5.4.2 Assessment of Capital tion into the labor market because of a number
Adequacy for CRE Concentration Risk of factors, such as competitive job markets,
traditionally low entry-level salaries, and higher
The Federal Reserves existing capital adequacy student debt loads. Graduated repayment terms
guidelines note that a bank should hold capital may align borrowers income levels with loan
commensurate with the level and nature of the repayment requirements, provide flexibility to
risks to which it is exposed. Accordingly, banks repay the debt sooner if borrowers incomes
with CRE concentrations are reminded that their increase more quickly than projected, and may
capital levels should be commensurate with the help long-term probability of full repayment.
risk profile of their CRE portfolios. In assessing Financial institutions that originate private
the adequacy of a banks capital, the Federal student loans with graduated repayment terms
Reserve will consider the level and nature of should prudently underwrite the loans in a man-
inherent risk in the CRE portfolio as well as ner consistent with safe and sound lending prac-
management expertise, historical performance, tices. Financial institutions should provide dis-
underwriting standards, risk-management prac- closures that clearly communicate the timing
tices, market conditions, and any loan loss and the amount of payments to facilitate a
reserves allocated for CRE concentration risk. A borrowers understanding of the loans terms
bank with inadequate capital to serve as a buffer and features.
against unexpected losses from a CRE concen-
tration should develop a plan for reducing its
CRE concentrations or for maintaining capital
2010.2.6.1 Principles for Private Student
appropriate to the level and nature of its CRE
Loans with Graduated Repayment Terms
concentration risk.
at Origination
Financial institutions should consider the fol-
lowing principles in their policies and proce-
2010.2.6 GUIDANCE ON PRIVATE dures for underwriting private student loans
STUDENT LOANS WITH with graduated repayment terms at origin-
GRADUATED REPAYMENT TERMS ation: 28d
AT ORIGINATION
Ensure orderly repayment. Private student
On January 29, 2015, interagency 28a loans should have defined repayment periods
guidance 28b was issued to provide financial and promote orderly repayment over the life
institutions with principles applicable to private of the loans. Graduated repayment terms
student loans that have graduated repayment should ensure timely loan repayment and be
terms. Financial institutions that originate pri- appropriately calibrated according to reason-
vate student loans may offer borrowers gradu- able industry and market standards based on
ated repayment terms in addition to fixed amor- the amount of debt outstanding. Graduated
tizing terms at the time of loan origination. repayment terms should avoid negative amor-
Graduated repayment terms are structured to tization or balloon payments.
provide for lower initial monthly payments that Avoid payment shock. 28e Graduated repay-
gradually increase. Refer to SR-15-2/CA-15-1 ment terms should result in monthly payments
and its attachment. that a borrower can meet in a sustained man-
Although most student loan agreements ner over the life of the loan. Graduated
include a grace period 28c to help with the post- increases in a borrowers monthly payment
education transition, the agencies and SLC rec- should begin early in the repayment period
ognize that students leaving higher education and phase in the amortization of the principal
programs may prefer more flexibility to transi-
28d. In addition to offering graduated repayment terms at
origination, financial institutions may also offer graduated
28a. The agencies consist of the Board of Governors of the
repayment terms as well as other types of workout options to
Federal Reserve System, the Consumer Financial Protection
borrowers experiencing financial difficulties, as addressed in
Bureau, the Federal Deposit Insurance Corporation, the
Banking Agencies Encourage Financial Institutions to Work
National Credit Union Administration, and the Office of the
With Student Loan Borrowers Experiencing Financial Diffi-
Comptroller of the Currency.
culties, issued July 25, 2013.
28b. In implementing this guidance, the agencies will
28e. Payment shock occurs when a borrower experiences a
examine financial institutions consistent with their respective
significant increase in the amount of the monthly payment
authorities.
after a reset date.
28c. A grace period is the allotted amount of time during
which borrowers are not expected to make payments on
student loans after initially leaving higher education programs BHC Supervision Manual January 2015
or dropping below half-time enrollment status. Page 27
balance to limit payment shock to the bor- ing effectively to payment increases and other
rower. potential repayment challenges.
Align payment terms with a borrowers
income. Graduated repayment terms should
be based on reasonable assumptions about the 2010.2.7 LOAN PARTICIPATIONS,
ability to repay of the borrower and cosigner, THE AGREEMENTS AND
if any. Lender underwriting should include an PARTICIPANTS
assessment of a borrowers (and, if applica-
ble, a cosigners) ability to repay the highest This subsection provides supervisory and
amortizing payment over the term of the loan. accounting guidance for examiners to use in
Graduated repayment terms should not be their inspection (or examination) and review of
structured in a way that could mask delin- a bank holding companys (BHCs) or banks
quencies or defer losses. use, purchase, or sale of loan participation
Provide borrowers with clear disclosures. agreements.29 BHCs should manage and control
Financial institutions that offer private student aggregate credit and other risk exposures on a
loans with graduated repayment terms should consolidated basis while recognizing legal dis-
provide borrowers with disclosures in compli- tinctions and possible obstacles to asset move-
ance with all applicable laws and regulations. ments within the parent company or its subsidi-
For example, the Truth in Lending Act, as aries. Additional guidance, research, and
implemented by Regulation Z, includes spe- information on loan participations and loan par-
cific private student loan disclosure content ticipation agreements will be developed and
requirements. 28f Ensuring that disclosures considered for future issuance and
clearly communicate the timing and the implementation.
amount of payments facilitates borrowers A loan participation is an agreement that
understanding of their loans terms and fea- transfers a stated ownership interest in a loan to
tures. one or more other BHCs or subsidiaries, or
Comply with all applicable federal and state other entities. The transfer represents an owner-
consumer laws and regulations and reporting ship interest in an individual financial asset. The
standards. 28g Private student loans with lead BHC (or lead subsidiary) retains a partial
graduated repayment terms must comply with interest in the loan, holds all loan documenta-
all applicable consumer protection laws. tion in its own name, services the loan, and
These include, but are not limited to, the deals directly with the customer for the benefit
Electronic Fund Transfer Act, the Equal of all participants. The lead BHC or lead subsid-
Credit Opportunity Act, federal and state pro- iary should ensure that comprehensive participa-
hibitions against unfair, deceptive, or abusive tion agreements with originating institutions are
acts or practices (such as section 5 of the in place for each loan facility before they con-
Federal Trade Commission Act and sections sider purchasing any participating interest.
1031 and 1036 of the Dodd-Frank Wall Street Many BHCs and their subsidiaries purchase
Reform and Consumer Protection Act), the loans or participate in loans originated by oth-
Truth in Lending Act, and the regulations ers. In some cases, such transactions are con-
issued pursuant to those laws. ducted with BHC affiliates, groups of BHCs or
Contact borrowers before reset dates. Before chain banks, or other subsidiaries. Alternatively,
originating private students loans with gradu- a purchasing BHC or subsidiary may also wish
ated repayment terms, financial institutions to supplement its loan portfolio when loan
should develop processes for contacting bor- demand is weak. In still other cases, a BHC or
rowers before the start of the repayment subsidiary may purchase or participate in a loan
period and before each payment reset date. to accommodate another unrelated bank with
These contacts can help establish student debt which it has established an ongoing business
as a priority in borrowers payment relationship.
hierarchies 28h and aid borrowers in respond- Purchasing or selling loans, if done properly,
can have a legitimate role in a BHCs or banks
28f. 12 CFR 1026.46 and 12 CFR 1026.47. overall asset and liability management and can
28g. Reporting standards include, but are not limited to, contribute to the efficient functioning of the
quarterly Consolidated Reports of Condition and Income.
28h. Payment hierarchy refers to the prioritization of a
borrowers payment obligations.
29. As determined by the Board, it is permissible for a
BHC or its subsidiary to make, acquire, broker, or service
BHC Supervision Manual January 2015 loans or other extensions of credit (12 CFR 225.28(b)(1) and
Page 28 (2)).
financial system. In addition, these activities ary is a borrower. The purchase of loan par-
help a BHC or bank diversify its risks and ticipations without a comprehensive agreement
improve its liquidity. could be viewed as an unsafe and unsound
banking practice.
2010.2.7.1 Board Policies on Loan

Participations 2010.2.7.3 Accounting for Loan
Participations
BHCs and their subsidiaries should have suffi-
cient board-approved policies in place that gov- A loan participation agreement usually is struc-
ern their loan participation activities. At a mini- tured to allow the participation transaction to
mum, the policy should include (1) the receive sale treatment of a portion of the loan by
requirements for entering into a loan participa- the originating BHC or its subsidiary even
tion agreement, (2) limits for the aggregate though the participation agreement may restrict
amount of loans purchased from and sold to an the purchaser when reselling its interest in the
outside source, (3) limits of all loans purchased loan, subject to certain conditions.30 Sale treat-
and sold, (4) limits for the aggregate amount of ment is achieved by structuring the loan partici-
loans to particular industries, (5) comprehensive pation agreement so that interests sold to a
participation agreements with originating BHCs purchaser meet the definition of a participating
or banks, (6) complete analysis and documenta- interest and the transaction satisfies all condi-
tion of the credit quality of obligations pur- tions for transfer of control over the interests. In
chased, (7) an analysis of the value and lien general, FAS 166 (paragraph 8B) briefly defines
status of the collateral, (8) appraisal guidelines, a participating interest as a portion of a financial
(9) the maintenance of full independent credit asset that
information on the borrower throughout the
term of the loan, (10) guidelines for the timely 1. conveys proportionate ownership rights with
transfer of all financial and nonfinancial credit equal priority to each participating interest
information to participant BHCs or banks, and holder.
(11) collection procedures. 2. involves no recourse (other than standard
representations and warranties) to, or subor-
dination by, any participating interest holder.
2010.2.7.2 Loan Participation Agreement 3. does not entitle any participating interest
holder to receive cash before any other par-
A loan participation agreement may enable a ticipating interest holder.
smaller lead BHC or lead subsidiary, acting as
transferor, to originate a large loan in excess of A transfer of a participating interest in an
its legal lending limit. Participants having an entire financial asset in which the transferor
ownership interest are able to offset low local surrenders control over those interests is to be
loan demand or invest in large loans without the accounted for as a sale if and only if all the
burden of servicing the loan or incurring origi- following conditions are met:
nation costs. A loan participation agreement
may also allow the originating BHC or subsidi- 30. Three sale recognition conditions denote the transfer-
ary to facilitate and grant a larger loan without ors surrender of control under Financial Accounting Stan-
causing it to have a concentration of credit (i.e., dards (FAS) 166, Accounting for Transfers of Financial
enabling risk diversification) or an impairment Assets (an amendment of FAS 140). Those conditions must
be met in order for the originator (transferor) to account for
of its liquidity position. The participation agree- the transfer of the financial assets to the participating trans-
ment should contain provisions that require the feree as a sale. When a loan participation is accounted for as a
originator to transfer, in a timely manner, all sale, the seller (transferor) removes the participated interest in
financial and nonfinancial credit information to the loan from its financial statements. FAS 166 applies to both
the transferor (seller) of the participated assets and the trans-
the participant banks upon the loans origination feree (purchaser). (See the complete text of FAS 166 (para-
and throughout the term of the loan. The agree- graphs 8B and 9) that defines a participating interest and
ment should specify the allocation of payments, the conditions for sale recognition). See also the reporting
losses, and expenses. It should also state that a instructions for the Consolidated Financial Statements for
Bank Holding Companies (FR Y-9C), and the FFIEC Con-
participant has the right to perform its own solidated Reports of Condition and Income (FFIEC 031)
independent review of the transaction. The (bank Call Report).
agreement should contain no language indicat-
ing that the lead BHC or lead subsidiary is a BHC Supervision Manual January 2015
lender or that a participating BHC or subsidi- Page 28.1
1. The transferred financial assets have been

isolated from the transferorput presump-
tively beyond the reach of the transferor and
its creditors, even in bankruptcy or other
receivership.31
2. Each purchaser has the right to pledge or
exchange the interests it received, and no
condition both constrains the purchaser from
taking advantage of its right to pledge or
exchange and provides more than a trivial
benefit to the transferor.
3. The transferor does not maintain effective
control over the interests.32
31. Transferred financial assets are isolated in bankruptcy

or other receivership only if the transferred financial assets
would be beyond the reach of the powers of a bankruptcy
trustee or other receiver for the transferor or any of its
consolidated affiliates included in the financial statements
being presented.
32. Examples of a transferors effective control over the
transferred financial assets include (a) an agreement that both
entitles and obligates the transferor to repurchase or redeem
the financial asset (or its third-party beneficial interests) before
its maturity, (b) an agreement that provides the transferor with
both the unilateral ability to cause the holder to return specific
financial assets and a more-than-trivial benefit attributable to
that ability, other than through a cleanup call, or (c) an
agreement that permits the transferee to require the transferor
to repurchase the transferred financial assets at a price that is
so favorable to the transferee that it is probable that the
transferee will require the transferor to repurchase them.

Page 28.2
2010.2.7.4 Structuring the Loan reserves the right to call at any time from who-
Participation Agreement ever holds the ownership interest. The origina-
tor can then enforce the call option by cutting
The written participation agreement should con- off or restricting the flow of interest at the call
sider contingent events such as a defaulting date.34 In this situation, the originating lender
borrower, the lead BHC or lead subsidiary has retained effective control over the participa-
becoming insolvent, or a party to the participant tion; such a call option precludes sale account-
arrangement that is not performing as expected. ing treatment by the transferor. The transaction,
The agreement should clearly state the limita- therefore, should be accounted for as a secured
tions the originator or participants impose on borrowing.
each other and any rights that the parties retain.
The participation agreement should clearly
include 2010.2.7.5 Independent Credit Analysis
the obligation of the lead BHC or lead subsid- A BHC or subsidiary that acquires a loan par-
iary to furnish timely credit information and ticipation should regularly perform a rigorous
to notify the parties of significant changes in credit analysis on its loan participation as if it
the borrowers status; had originated the loan. Due to the indirect
a requirement that the lead BHC or lead sub- relationship that a participant has with a bor-
sidiary consult with the participants prior to rower, it may be difficult for the participant to
any proposed change to the loan, guarantee, receive timely credit information to allow it to
or security agreements, or taking any action conduct a comprehensive credit analysis of the
when the borrower defaults; transaction. However, the participant should not
the lead BHCs or lead subsidiarys and par- rely solely on the originators credit analysis. It
ticipants specific rights if the borrower should gather all available relevant credit infor-
defaults; mation, including the details on the collaterals
the resolution procedures to be followed when value (for example, values determined by an
the lead BHC or lead subsidiary or partici- independent appraisal or an evaluation), lien
pants; status, loan agreements, and the loans other
do not agree on the procedures to be taken participation agreements that existed prior to
when the borrower defaults and/or; making its commitment to acquire the loan par-
have potential conflicts when the bor- ticipation. A participant also should reach an
rower defaults on more than one loan agreement with the loan originator (transferor)
provisions for terminating the agency relation- that it will provide ongoing, complete, and
ship between the lead BHC or lead subsidiary timely credit information about the borrower. It
and the participants upon events such as insol- is important for the participants to maintain
vency, breach of duty, negligence, or misap- current and complete records on their loan par-
propriation by one of the parties to the ticipations. The absence of such information
agreement. may indicate that the originator did not perform
the necessary due diligence prior to making its
Some participation agreements may allocate decision to acquire the loan participation. Dur-
payments using a method other than a pro rata ing the life of the loan participation, the origina-
sharing based on each participants ownership tor should monitor the loans servicing and
interest. The first principal payment could be repayment status.
applied based on the participants ownership
interest while the remaining payments would be
applied according to the lead BHCs or lead 2010.2.7.6 Sales of Loan Participations in
subsidiarys ownership interest. In this situation, the Secondary Market
the participation agreement should specify that
if a borrower defaults, the participants would If a BHC or a subsidiary has a concentration in
share subsequent payments and collections in loan participations, it may be possible for it to
proportion to their ownership interest at the time
of default.33
34. The cash flows from a loan participation agreement,
A participation agreement may provide that
except servicing fees, should be divided in proportion to the
the originating lender allow a participating BHC third parties participating interests.
or subsidiary to resell, but the originator
33. This is not a participating interestno sale. Page 29
sell its participating interests in the secondary borrowerthe originator should structure
market to reduce its dependence on an asset 100 percent loan participation programs only
group. If the BHC or a subsidiary is not large for borrowers who meet its credit require-
enough to participate in the secondary market, ments
an alternative might be to sell loans without the program participants accessibility to the
recourse to another subsidiary or correspondent borrowers financial information (as autho-
bank that also desires to diversify its loan rized by the borrower)the originator should
portfolio. allow potential loan participants to obtain and
review appropriate credit and other informa-
tion that would enable them to make an
2010.2.7.7 Sale of Loan Participations informed credit decision.
With or Without the Right of Recourse
The parties to a participation agreement (those 2010.2.7.9 Participation Transactions
having a participating ownership interest) gener- Between Affiliates
ally may have no recourse to the transferor or to
each other even though the transferor (e.g., the BHCs or their subsidiaries should not relax their
originating lender) continues to service the loan. credit standards when participation agreements
No participants interest should be subordinate involve their affiliates. Such agreements must be
to another. Some loan participation agreements, structured to comply with sections 23A and 23B
however, may give the seller a contractual right of the Federal Reserve Act (FRA) and the
to repurchase the participated loan interest for Boards Regulation W. The Federal Reserve has
purposes of working out or modifying the sale. determined that in certain very limited circum-
When the seller has the right to repurchase the stances the purchase or sale of a participation
participation, it may provide the seller with a agreement may be exempt from these
call option on a specific loan participation asset. provisions.
If the sellers right to repurchase precludes the
seller from recognizing the transaction as a sale,
the transaction should be accounted for as a 2010.2.7.9.1 Transfer of Low-Quality
secured borrowing. Assets
In general, a bank cannot purchase a low-quality
2010.2.7.8 Sales of 100 Percent asset, including a loan participation from an
Participations affiliate. Section 23A of the FRA provides a
limited exception to the general rule prohibiting
Some loan participation agreements may be the purchase of low-quality assets if the bank
structured so that the transferor sells the entire performs an independent credit evaluation and
underlying loan amount (100 percent) to the commits to the purchase of the asset before the
agreements participants. If participation agree- affiliate acquires the asset.35 Section 223.15 of
ments are not structured properly they can pose the Boards Regulation W provides an excep-
unnecessary and increased risks (for example, tion from the prohibition on the purchase of a
legal, compliance, or reputational risks) to the low-quality asset by a member bank from an
originator and the participants. The originator affiliate for certain loan renewals. The rule
would have no ownership in the loan. Such allows a member bank that purchased a loan
agreements should therefore clearly state that participation from an affiliate to renew its par-
the loan participants are participating in the loan ticipation in the loan, or provide additional fund-
and that they are not investing in a business ing under the existing participation, even if the
enterprise. The policies of a BHC or subsidiary underlying loan had become a low-quality asset,
engaged in such loan participation agreements so long as certain criteria were met. These
should focus on safety and soundness concerns renewals or additional credit extensions may
that include enable both the affiliate and the participating
member bank to avoid or minimize potential
the programs objectives losses. The exception is available only if (1) the
the plan of distribution underlying loan was not a low-quality asset at
the credit requirements that pertain to the the time the member bank purchased its partici-
pation and (2) the proposed transaction would
Page 30 35. 12 U.S.C. 371c(a)(3).
not increase the member banks proportional operations of a borrowers business. Such
share of the credit facility. The member bank actions could lead to potential liability under the
must also obtain the prior approval of its entire Comprehensive Environmental Response, Com-
board of directors (or its delegees) and it must pensation, and Liability Act (CERCLA). BHCs
give a 20-day post-consummation notice to its or their subsidiaries that originate loans to bor-
appropriate federal banking agency. A member rowers through loan participation agreements
bank is permitted to increase its proportionate could be transferring environmental risk and
share in a restructured loan by 5 percent (or by a liability to the holders of participations, thus
higher percentage with the prior approval of the making them susceptible to such losses. The
banks appropriate federal banking agency). The originator should establish and follow policies
scope of the exemption includes renewals of and procedures designed to control environmen-
participations in loans originated by any affiliate tal risks. See the Commercial Bank Examination
of the member bank (not just affiliated deposi- Manual, section 2140.1 (the Environmental
tory institutions). Liability subsection) for a more detailed dis-
cussion on ways banks can protect themselves
as lenders, and their loan participation agree-
2010.2.7.10 Concentrations of Credit ment holders, from environmental liability.
Involving Loan Participations
BHCs or their subsidiaries should avoid pur- 2010.2.7.12 Red Flag Warning Signals
chasing loans that generate unacceptable credit
concentrations. Such concentrations may arise The following conditions may indicate that there
solely from the BHCs or subsidiarys pur- are significant problems with the management
chases, or they may arise when loans or pur- of the BHCs or a subsidiarys loan participa-
chased participations are aggregated with loans tion portfolio:
originated and retained by the purchaser. The
extent of contingent liabilities, holdbacks, 1. the absence of formal loan participation
reserve requirements, and the manner in which policies.
loans will be handled and serviced should be 2. the absence of any formal participation
clearly defined. In addition, loans purchased agreement.
from another source should be evaluated in the 3. the absence of credit evaluations and inde-
same manner as originated loans. Guidelines pendent credit analysis.
should be established for the type and frequency 4. the absence of complete loan documentation.
of credit and other information the BHC or its 5. a higher volume of loan participations when
subsidiary needs to obtain from the originator to compared to the volume of other loans in the
keep itself continually updated on the status of loan portfolio.
the credit. Guidelines should also be established 6. missing loan participation agreements and
for supplying complete and regularly updated documentation which should denote the
credit information to the purchasers of loans rights and responsibilities of all participants.
originated and sold by the BHC or its subsidiary. 7. the existence of numerous disputes or dis-
agreements among the participants regarding
the receipt of payment(s) in accordance with
2010.2.7.11 Loan Participations and the participation agreements, documentation
Environmental Liability requirements, or any other significant aspects
of the entitys loan participation transactions.
Environmental risk represents the adverse con- 8. the originator is making loan payments to
sequences that result from generating or han- loan participation acquirers without receiv-
dling hazardous substances or from being asso- ing reimbursement by the original borrower.
ciated with the aftermath of contamination.
BHCs or their subsidiaries may be indirectly
liable via their lending activities for the costs 2010.2.8 INSPECTION OBJECTIVES
resulting from cleaning up hazardous substance
contamination. BHCs and their subsidiaries Loan Administration
need to be careful that their actions making,
administering, and collecting loansincluding 1. To determine if the parents loan policies are
assessing and controlling environmental
liabilitycannot be construed as taking an BHC Supervision Manual January 2014
active role in the management or day-to-day Page 31
adequate in relation to the responsibilities it nomic conditions and robust financial

has for the supervision of its credit-extending markets to support a borrowers capacity to
subsidiaries and whether those policies are service its debts.
consistent with safe and sound lending 9. To be attentive in reviewing a banking orga-
practices. nizations assessment and monitoring of
2. To determine if internal and external factors credit risk to ensure that undue reliance on
(for example, the size and financial condition favorable conditions does not lead to
of the credit-extending subsidiary, the size delayed recognition of emerging weak-
and expertise of its staff, avoidance of or nesses in some loans.
control over credit concentrations, market 10. To ascertain whether the banking organiza-
conditions, and statutory and regulatory com- tion has relied, to a significant and undue
pliance) are considered in formulating and extent, on favorable assumptions about bor-
monitoring the organizations loan policies rowers or the economy and financial mar-
and strategic plan. kets. If so, to carefully consider downgrad-
3. To determine if the loan policy is being ing, under the applicable supervisory rating
monitored and complied with. framework, a banking organizations risk-
4. To establish whether the loan policy ensures management, management, and/or asset-
sound assessments of the value of real estate quality ratings and, if deemed sufficiently
and other collateral. significant to the banking organization, its
capital adequacy rating.
11. To determine if the banking organizations
Lending Standards for Commercial Loans loan-review activities or other internal con-
trol and risk-management processes have
1. To focus on and evaluate the strength of the been weakened by staff turnover, failure to
credit-risk management process. commit sufficient resources, inadequate
2. To determine whether the bank holding training, and reduced scope or by less-
company has formal credit policies that thorough internal loan reviews. To incorpo-
(1) provide clear guidance on its appetite rate such findings into the determination of
for credit risk and (2) support sound lending supervisory ratings.
decisions.
3. To determine whether experienced credit
professionals who are independent of line Leveraged Lending
lending functions provide adequate internal
control in the loan-approval process. 1. Risk-Management Framework, Definition,
4. To evaluate whether loan-approval docu- and Policy Expectations. To determine
ments provide internal approving authori- a. whether the institution has established a
ties and management with sufficient infor- sound definition of leveraged lending
mation on the risks of loans being that is appropriate for the types of lever-
considered, and that the information is in a aged loans that are underwritten and if it
clear and understandable format. can be applied across all business lines;
5. To evaluate whether forward-looking analy- b. whether it has adjusted (if necessary) its
sis tools are being adequately and appropri- risk appetite and limit structure (includ-
ately used as part of the loan-approval ing pipeline limits and overall portfolio
process. limits) to conform with the institutions
6. To determine whether credit-risk manage- definition of leveraged lending and
ment information systems provide adequate whether it has the necessary reporting in
information to management and lenders. place to assess conformance with limits.
7. To incorporate the examiners evaluation of c. if there are appropriate policies and pro-
the bank holding companys adherence to cedures limits in place and if the institu-
sound practices into the overall assessment tion maintains sound leveraged lending
of credit-risk management. standards both for transactions that it
8. To be alert to indications of insufficiently intends to hold as well as transactions
rigorous risk assessment at banking organi- that are underwritten to distribute.
zations, particularly inadequate stress test- d. if the institutions risk-management
ing and excessive reliance on strong eco- structure has strong and effective pro-
cesses and controls and if they are appro-
BHC Supervision Manual January 2014 priate based on its leveraged lending
Page 32 activity.
2. Participations Purchased. To ensure that reported in the appropriate amount of

the institution applies the same standards of detail to senior management and the
prudence and credit assessment techniques board.
and in-house limits that would apply as if it b. To determine if the necessary risk infor-
had originated the loan(s). mation (as outlined in the guidance)
3. Underwriting Standards. To assess the about leveraged lending exposures (port-
effectiveness of the institutions underwrit- folio holds and pipeline exposures) are
ing policy standards for leveraged lending captured in reports that are distributed
to determine whether they timely and that adequate information is
a. are clear, written, and measurable; distributed to senior management and the
b. contain underwriting limits that reflect institutions board of directors at least
the institutions definition and risk appe- quarterly.
tite for leveraged lending; 7. Risk Rating. To verify that leveraged loans
c. are applied equally to loans that are are risk rated based on the borrowers abil-
originated to be held and to loans that ity to repay and de-lever to a sustainable
are originated to distribute; and level.
d. fully reflect the underwriting standards 8. Credit Analysis.
listed in the guidance, including: a. To test transactions to determine if
i. sound business premise and sustain- underwriting practices are effective and
able capital structure for each trans- comprehensive.
action b. To determine if individual leveraged
ii. capacity to repay and ability to lending exposures contain a comprehen-
de-lever to a sustainable level over a sive assessment of financial, business,
reasonable period industry, and management risks based on
iii. appropriate depth and breadth of due the elements of the guidance.
diligence 9. Problem Credit Management.
iv. standards for valuating expected risk- a. To ascertain whether the institution for-
adjusted returns mulates individual action plans and
v. appropriate credit agreement cov- expectations
enant protections b. To evaluate workout plans to confirm
vi. acceptable collateral agreements. that they contain quantifiable objectives
4. Valuation Standards. To determine: and measureable time frames
a. whether enterprise valuation methodolo- c. To determine if problem credits are regu-
gies are appropriate to the borrowers larly reviewed for risk-rating accuracy,
industry and condition; accrual status, impairment status, and
b. whether the assumptions are clearly charge off.
documented, well supported, and under- 10. Deal Sponsors
stood by the institutions appropriate a. To determine if the institution has guide-
decision makers and risk-oversight units lines for evaluating deal sponsors that
c. whether enterprise valuations are per- are based on the sponsors ability and
formed by qualified persons independent willingness to support the transaction
of an institutions origination function where sponsors are viewed as a source
d. whether an institution has policies and of repayment.
provides for appropriate loan to value 11. Credit Review
ratios, discount rates and collateral mar- a. To ensure that the institution regularly
gins for loans dependent on enterprise conducts an independent credit review of
value or illiquid and hard-to-value collat- the leveraged lending portfolio more fre-
eral. quently and in greater depth than other
5. Pipeline Management. To find out if there segments of the portfolio generally at
are strong risk-management standards and least annually. For firms making signifi-
controls over transactions in and to the pipe- cant changes to policies, underwriting
line and if those standards are applied uni- standards, procedures etc., ensure that a
formly to transactions held in the portfolio credit review is scheduled to test compli-
and those that are distributed. ance with changes.
6. Reporting and Analytics. b. To ensure that credit review personnel
a. To determine if individual and portfolio
exposures within and across all business BHC Supervision Manual January 2014
lines and legal vehicles are captured and Page 33
have the expertise and experience to a. ensures prudent underwriting standards

evaluate leveraged loans. for home equity lending, including stan-
12. Stress Testing. dards to ensure that a thorough evaluation
a. To determine if the institution is con- of a borrowers capacity to service the
ducting periodic loan- and portfolio debt is conducted (that is, the banking
stress tests on leveraged loan portfolios organization is not relying solely on the
or if the portfolio has been incorporated borrowers credit score);
into enterprise-wide stress testing prac- b. provides risk-management safeguards for
tices. potential declines in home values;
b. To verify the effectiveness of the institu- c. ensures that the standards for interest-only
tions periodic portfolio stress tests (in and variable-rate home equity lines of
accordance with stress testing guidance) credit (HELOCs) include an assessment
in identifying what effect economic and of a borrowers ability to (1) amortize the
market events could have on the institu- fully drawn line of credit over the loan
tions financial condition and leveraged term and (2) absorb potential increases in
lending transactions. interest rates; and
13. Conflict of Interest. To determine d. provides appropriate collateral-valuation
a. if policies identify and if there are proce- policies and procedures and provides for
dures to address transactions in which the use and validation of automated valua-
the institution holds both an equity and tion models.
lending positions;
b. the adequacy and effectiveness of con- Loan Participations, the Agreements and
trols and training programs that aim to Participants
curb any potential conflicts of interests
that result from leveraged lending. 1. To ascertain if the BHC engages in the pur-
14. Reputational Risk. chase or sale of loans via loan participation
a. To determine if the institution has suf- agreements.
fered reputational damage by failing to 2. To determine if the BHCs lending policy
meet its legal responsibilities in under- a. places limits on the amount of loan par-
writing and syndicating leveraged loan ticipations originated, purchased, or sold
transactions into the wider financial mar- based on any one source or in the
ket. aggregate;
Credit-Risk Management for Home Equity b. has set credit standards for the BHCs
Lending borrowers requesting loans as well as
third parties acquiring loan participations
1. To determine if the banking organization has from the bank as originator;
an appropriate review and approval process c. requires the same credit standards for loan
for new product offerings, product changes, participations as it does for other loans;
and marketing initiatives. d. sets the amount of contingent liability,
2. To ascertain whether the banking organiza- holdback (retained ownership), and the
tion has appropriate control procedures for manner in which the loan should be ser-
third parties that generate loans on its behalf viced; or
and if the control procedures comply with e. requires complete loan documentation for
the laws and regulations that are applicable loan participations.
to the organization. 3. To assess the impact of any concentrations of
3. To determine if the banking organization has credit to a borrower, or in the aggregate, that
given full recognition to the risks embedded arise from loans involved in loan participa-
in its home equity lending. tion agreements.
4. To determine whether the banking organiza- 4. To determine if there are any informal repur-
tions risk-management practices have kept chase agreements that exist between loan
pace with the growth and changing risk pro- participation acquirers that are designed to
file of its home equity portfolios and whether circumvent the originating BHCs or its sub-
underwriting standards have eased. sidiarys legal lending limits, disguise delin-
5. To determine whether the loan policy quencies, and avoid adverse classifications.
5. To determine whether the BHCs financial
BHC Supervision Manual January 2014 condition is compromised by assessing the
Page 34 impact of the BHCs loan participations with
its affiliates. and bank examination reports for critical

6. To ascertain whether loan participation trans- comments concerning loan-policy excep-
actions with affiliates are in compliance with tions and administration. Determine
sections 23A and 23B of the Federal Reserve whether action was taken in response to any
Act and the Boards Regulation W. identified exceptions. Determine who is
7. To determine if there are disputes between responsible for follow-up and what the time
the BHC or its subsidiaries as originator of frames are; seek rationale if no action was
loan participations and its participants. taken or if the action taken was half-
8. To determine if any loan participations have hearted.
been adversely classified by examiners, 6. Review the organizations financial state-
including examiners from other supervisory ments, the bank Call Reports, and the BHC
agencies (includes loan participations held FR Y-series reports submitted to the Fed-
by the other institutions). eral Reserve. Determine whether reporting
is accurate and disclosure is sufficient to
2010.2.9 INSPECTION PROCEDURES indicate the organizations financial posi-
tion and the nature of its loan portfolios,
Loan Administration including nonaccrual loans.
7. When reviewing lending policies, ascertain
1. Obtain an organizational chart and deter- whether
mine the various levels of responsibility a. the loan policies facilitate extensions of
and job functions of individuals involved credit to sound borrowers and facilitate
with the lending function. the workout of problem loans, and
2. Obtain and review the BHCs loan policy; b. the loan policies control and reduce con-
determine if the policy contains the appro- centration risk by placing emphasis on
priate components, as summarized in this effective internal policies, systems, and
section. Determine how the policy is com- controls to monitor the risk.
municated to subsidiaries. Also determine 8. Through interviews with, or review of
whether the loan policy reflects the Decem- reports submitted by, the internal auditor,
ber 1992 uniform interagency real estate lending officers, loan-review personnel, and
lending standards and guidelines as they senior management, (1) evaluate the effec-
apply to subsidiary depository institutions. tiveness of the BHCs self-monitoring of
3. Obtain a copy of the most recent manage- adherence to loan policy, (2) determine how
ment reports concerning the quality of loans changes to the loan policy occur, (3) deter-
and other aspects of the loan portfolio mine how loans made in contradiction to
(delinquency list, concentrations, yield the loan policy are explained, and (4) deter-
analysis, loan-distribution lists, watch loan mine the various circumstances involving
reports, charge-off reports, participation levels of approval and what specific consid-
listings, internal and external audit reports, eration occurs at these levels.
etc.). Determine the scope and sufficiency 9. Presuming the inspection is concurrent with
of the work performed by any committees a banks primary regulator, coordinate, on a
related to the lending function. Determine if random basis, the selection of loans subject
the information provided to the directorate to classification. Determine whether they
and senior management is sufficient for conform to loan policy.
them to make judgments about the quality 10. Review managements policies and proce-
of the portfolio and to determine appropri- dures for their determination of an appropri-
ate corrective action. ate level of loan-loss reserves.
4. Determine if an internal process has been 11. On the Policies and Supervision or an
established for the review and approval of equivalent page of the inspection report,
loans that do not conform to internal lend- evaluate the BHCs oversight regarding
ing policy. Establish whether such loans are effective lending policy and procedures.
supported by written documentation that
clearly states all the relevant credit factors Lending Standards for Commercial Loans
that culminated in the underwriting deci-
sion. Determine if exception loans of a sig- 1. Review formal credit policies for clear
nificant size are reported to the board of articulation of current lending standards,
directors of the subsidiary or to the holding
company. BHC Supervision Manual January 2014
5. Review internal and external audit reports Page 35
including tices or credit discipline are indicated as a

a. a description of the characteristics of result of the preexamination risk assessment,
acceptable loans and (if applicable) the inspection, or bank or other examina-
guidance minimum financial ratios, tions, arrange for the commitment of suffi-
b. standards for the types of covenants to be cient supervisory resources to conduct
imposed for specific loan types, and in-depth reviews, including transaction test-
c. the treatment and reporting of policy ing, that are adequate to ensure that the Fed-
exceptions, both for individual loans and eral Reserve achieves a full understanding of
the entire portfolio. the nature, scope, and implications of the
2. Evaluate the role played by independent deficiencies.
credit staff in loan approvals and, in particu- 7. When reviewing loans, lending policies, and
lar, whether these credit professionals are lending practices
adequately experienced, are independent of a. observe and analyze loan-pricing policies
line lending functions, and have authority to and practices to determine whether the
reject loans either because of specific excep- institution may be unduly weighting the
tions to policy or because the loan does not short-term benefit of retaining or attract-
meet the institutions credit-risk appetite. ing new customers through price conces-
3. Review written policies and determine oper- sions, while not giving sufficient consi-
ating practice in preparing loan-approval deration to potential longer-term
documents to evaluate whether sufficient consequences;
information is provided on the characteristics b. be alert for indications of insufficiently
and risks of loans being considered, and rigorous risk assessment, in particular
whether such information is provided clearly (1) excessive reliance on strong economic
and can be easily understood. conditions and robust financial markets to
4. Based on written policies and review of oper- support the capacity of borrowers to ser-
ating practice, evaluate whether loans being vice their debts and (2) inadequate stress
considered are evaluated not only on the testing;
basis of the borrowers current performance c. be attentive in reviewing an institutions
but on the basis of forward-looking analysis assessment and monitoring of credit risk
of the borrower. to ensure that undue reliance on favorable
a. Determine whether financial projections conditions does not lead that institution to
or other forward-looking tools are an inte- delay recognition of emerging weaknesses
gral part of the preapproval analysis and in some loans or to lessen staff resources
loan-approval documents. assigned to internal loan review;36 and
b. Determine the extent to which alternative d. give careful consideration to downgrad-
or downside scenarios are identified, ing, under the applicable supervisory rat-
considered, and analyzed in the loan- ing framework, a banking organizations
approval process. risk-management, management, and/or
5. Review credit-risk management information asset-quality ratings and its capital
systems and reports to determine whether adequacy rating (if sufficiently signifi-
they provide adequate information to man- cant) when there is significant and undue
agement and lenders about reliance on favorable assumptions about
a. the composition of the institutions cur- borrowers or the economy and financial
rent portfolio or exposure, to allow for markets, or when that reliance has slowed
consideration of whether proposed loans the recognition of loan problems.
might affect this composition sufficiently 8. Discuss matters of concern with the senior
to be inconsistent with the institutions management and the board of directors of the
risk appetite, and bank holding company and report those areas
b. data sources, analytical tools, and other of concern on core page 1, Examiners
information to support credit analysis. Comments and Matters Requiring Special
6. When appropriate, coordinate or conduct suf- Board Attention.
ficient loan reviews and transaction testing in
the lending function to accurately determine
the quality of loan portfolios and other credit 36. Examiners should recognize that an increase in classi-
fied or special-mention loans is not per se an indication of lax
exposures. If deficiencies in lending prac- lending standards. Examiners should review and consider the
nature of these increases and the surrounding circumstances in
BHC Supervision Manual January 2014 reaching their conclusions about the asset quality and risk
Page 36 management of an institution.
Leveraged Lending includes related exposures and direct and

indirect exposures.
Overview 5. General Policy Expectations
a. Review the policy for the key risk ele-
Complete or update the Leveraged Lending ments referred to in the guidance (See
Internal Control Questionnaire if selected for the section on General Policy Expecta-
implementation. tions in the guidance and in the Internal
Control Questionnaire). Determine if the
1. Based on an evaluation of internal controls, policy includes the following elements:
determine the scope of the inspection. The Risk Appetite that clearly defines the
scope should include exposures related amount of leveraged lending the insti-
through common ownership, guarantors, or tution is willing to underwrite and is
sponsors. Also include direct and indirect willing to retain.
leveraged lending exposure found in finan- Limit Framework for aggregate port-
cial intermediaries formed to house or dis- folio held on balance sheet, single
tribute leveraged loans (for example CLOs, obligors and transactions, aggregate
SPEs, conduits etc.). pipeline exposure, industry and geo-
2. Inspection procedures should include both a graphic concentrations. For institutions
policy review and transaction testing with significant underwriting expo-
approach to determine the effectiveness of sure, determine if limits have been
the institutions leveraged lending control established for stress losses, flex terms,
process. economic capital, or earnings at risk
associated with leveraged loans.
If the institution is found to lack robust risk- Allowance for loan and lease losses
management processes and controls around (ALLL) and capital adequacy analysis
leveraged lending that reinforces the institu- that reflect the risk of leveraged lend-
tions risk profile, a supervisory finding of ing activities.
unsafe and unsound banking practices should be Credit approval and underwriting
considered. authorities.
Guidelines for senior management
3. Applicability/Risk Management Framework oversight and timely reporting to
a. At the start of the inspection, ascertain senior management and the board of
whether the institution has adopted an directors.
appropriate risk-management framework Expected risk adjusted returns.
for leveraged lending that includes Minimum underwriting standards.
robust policies, procedures, and risk lim- Underwriting practices for origination
its that have been approved by the board and secondary loan acquisition.
of directors. 6. Participations Purchased
b. Implementation of this guidance should a. Ascertain if the institution participating
be consistent with the size and risk pro- or purchasing into a leveraged loan has a
file of the institution. clear understanding of the credit and the
c. All aspects of the guidance should be risks involved and also has a clear under-
applied to institutions that originate and standing of its rights and responsibilities
distribute leveraged loans. under the participation agreement.
d. The section on Participations Purchased b. Determine if the institution has con-
should be applied to banking organiza- ducted its own independent underwriting
tions that have limited involvement in of participations and has applied the
leveraged lending; community banks same standards of prudence, credit
overall may not be materially affected by assessment techniques, and in-house lim-
the guidance. its as if the institution had originated the
4. Definition of Leveraged Lending loan(s).
a. Determine if the institution has a written c. Verify that the institution has received
policy for leveraged lending and if that copies of all participation documents and
policy contains criteria for defining any other documents relevant to the
leveraged lending that are appropriate credit transaction(s).
for the institution and consistent with the
guidance standards. BHC Supervision Manual July 2014
b. Determine if the institutions definition Page 37
7. Underwriting Standards cies and procedures for handling distri-

a. Determine if the institution employs bution failures.
similar and consistent underwriting stan- Determine if there are procedures for
dards for leveraged loans it plans to hold stress testing pipeline deals.
or it plans to distribute. Ascertain if management reports show
Confirm that the institutions under- that transactions can be differentiated
writing standards are clear, written, based on their key characteristics,
measurable, and reflect the institu- tenor, and investor class (pro-rata and
tions policy-based risk appetite for institutional), structure, and key bor-
leveraged lending. rower characteristics (for example,
Evaluate the underwriting policies and industry).
standards and determine if they con- Determine if there are clearly articu-
tain the elements found in guidance lated rationales for the effectiveness of
(Refer to the section on Underwriting hedging methods and if there is appro-
Standards in the guidance and in the priate measurement and monitoring.
Internal Control Questionnaire): Confirm that the institution has devel-
8. Valuation Standards oped and maintained the pipeline pro-
a. Confirm that the institution has policies cedures referred to in the guidance (see
and procedures in place for estimating the section on Pipeline Management in
enterprise value or for valuing other the guidance and in the Internal Con-
illiquid collateral. If enterprise value is trol Questionnaire).
relied on as a secondary source of repay- 10. Reporting and Analytics
ment, determine the following: a. Ascertain if the institutions risk-
If one or a combination of the three management framework includes an
methods referred to in the guidance is intensive and frequent review and moni-
used (asset, income, or market valua- toring process.
tion). b. Establish whether management receives
If the underlying assumptions and the comprehensive reports about the charac-
resulting values are well documented, teristics and trends of the institutions
supportable, and credible (Refer to the leveraged-lending portfolio at least quar-
Valuations Standards section of the terly and if summaries are provided to
guidance and the Internal Control the board of directors.
Questionnaire). c. Find out if internal reports provide a
If enterprise value was calculated by detailed and comprehensive view of
qualified persons independent of the global exposures, including situations
origination function. when an institution has an indirect expo-
If stress tests of key enterprise value sure to an obligor or is holding a previ-
variables and assumptions (such as ously sold position as collateral or as a
cash flow earnings and sales multiples) reference asset in a derivative. Borrower
are conducted. and counterparty leveraged lending
That firms have policies that provide reporting should aggregate total expo-
for appropriate loan-to-value ratios, sure and consider exposures booked
discount rates and collateral margins. across business lines or legal entities.
If the institution has established limits d. Verify that internal policies identify the
for the proportion of individual trans- data fields to be populated and captured
actions and the total portfolio that are by the institutions MIS and whether the
supported by enterprise value. reports are accurate, timely, and if the
9. Pipeline Management information is provided to management
a. Determine if the institution has strong and the board of directors.
risk management and controls that are e. Confirm that MIS reporting on the lever-
extended to deals in the pipeline, aged lending portfolio contains the appli-
whether those deals are intended for cable measures listed in the guidance.
hold, or if they are intended for distribu- (Refer to the section on Reporting and
tion. Analytics in the guidance and in the
Determine if the institution has poli- Internal Control Questionnaire.)
11. Credit Analysis
BHC Supervision Manual July 2014 a. Conduct transaction testing on individual
Page 38 leveraged lending credits to determine if
the credit analysis contains a comprehen- for evaluating the sponsors creditwor-
sive assessment of financial, business, thiness.
and industry and management risks. b. Evaluate the sponsor based on the crite-
b. Evaluate individual credits to determine ria listed in the guidance (See the section
if they fit the institutions definition of a on Deal Sponsors in the guidance and in
leveraged loan. the Internal Control Questionnaire).
c. Determine if individual credits were ana- 14. Credit Review/Problem Credit Management
lyzed in conjunction with the parameters
in the guidance. (Refer to the section on a. Assess credit review staffs expertise
Credit Analysis in the guidance and in relative to leveraged lending.
the Internal Control Questionnaire). b. Verify that the institution conducts fre-
d. Verify that there are guidelines for evalu- quent internal credit review of
ating deal sponsors and their willingness leveraged-lending portfolio that is done
and ability to support the credit. independently of the origination func-
e. Confirm that sponsors are used as a section. Portfolio reviews should generally
ondary and not a primary source of be conducted no less than annually.
repayment. c. Evaluate the institutions procedures for
f. Assess the credit agreement to determine dealing with problem credits including if
if it contains language for: work out plans contain quantifiable
Material dilution, sale, or exchange of objectives and measurable time frames.
collateral or cash flow producing 15. Stress Testing
assets without lender approval. a. Determine if the institution has devel-
Financial performance covenants; oped stress tests for leveraged loans or if
covenant-lite, and payment-in-kind the loans are included in the existing
(PIK) toggle loan structures stress testing protocol.
Reporting requirements and compli-
ance monitoring. 16. Conflicts of Interest/
The distribution of reporting and other Reputational Risk/Compliance
credit information to participants and a. Confirm that the institution is meeting its
investors. legal responsibilities by underwriting
Acceptable collateral types, loan to and distributing transactions that do not
value guidelines and appropriate col- result in undue reputational risk.
lateral valuation methodologies b. Determine if potential conflicts of inter-
12. Internal Risk Rating est exist if the institution has both equity
a. Determine if individual loans are risk and lending positions in a particular
rated based on the borrowers demon- transaction. Confirm that policies and
strated ability to repay the loan and procedures are in place to handle con-
de-lever over a reasonable period of flicts of interest.
time. c. Ascertain whether the institutions com-
Confirm that the institution has evi- pliance function periodically reviews the
dence of adequate repayment capacity, institutions leveraged-lending activity.
for example borrowers demonstrate d. Ascertain whether the institutions poli-
the ability to fully amortize senior debt cies incorporate safeguards to prevent
or repay at least 50 percent of total violations of anti-tying regulations.
debt over a 57 year period. Ensure
that extensions or other restructuring e. When securities are involved, determine
are not masking an inability to repay. how the institution ensures compliance
Consider adversely rating credits that with applicable securities laws, includ-
do not show the capacity to pay down ing disclosure and other regulatory
debt from cash flow or if refinancing is requirements.
the only option for repayment. f. Ascertain what plans and provisions
Consider a substandard rating if there have been developed to ensure compli-
are no reasonable or realistic prospects ance with the Boards Regulation W (12
for repayment or de-levering. CFR part 223).
13. Deal Sponsors
a. If a deal sponsor is relied on as a second-
ary source of repayment, determine if BHC Supervision Manual July 2014
management has developed guidelines Page 39
Credit-Risk Management for Home Equity quality of loans that the third party
Lending underwrites; and
f. whether the banking organization has
1. Review the credit policies for home equity adequate audit procedures and controls
lending to determine if the underwriting to verify that third parties are not being
standards address all relevant risk factors paid to generate incomplete or fraudu-
(that is, an analysis of a borrowers income lent mortgage applications or are not
and debt levels, credit score, and credit otherwise receiving referral or unearned
history versus the loans size, the collateral income or fees contrary to RESPA
value (including valuation methodology), prohibitions.
the lien position, and the property type and 5. Evaluate the adequacy of the banking orga-
location. nizations collateral-valuation policies and
2. Determine whether the banking organiza- procedures. Ascertain whether the
tions underwriting standards include organization
a. a properly documented evaluation of a. establishes criteria for determining the
the borrowers financial capacity to appropriate valuation methodology for a
adequately service the debt and particular transaction (based on the risk
b. an adequately documented evaluation of in the transaction and loan portfolio);
the borrowers ability to (1) amortize the b. sets criteria for determining when a
fully drawn line of credit over the loan physical inspection of the collateral is
term and (2) absorb potential increases necessary;
in interest rates for interest-only and c. ensures that an expected or estimated
variable-rate HELOCs. value of the property is not communi-
3. Assess the reasonableness and adequacy of cated to an appraiser or individual per-
the analyses and methodologies underlying forming an evaluation;
the banking organizations evaluation of d. implements policies and controls to pre-
borrowers. clude value shopping;
4. If the organization uses third parties to e. requires sufficient documentation to sup-
originate home equity loans, find out port the collateral valuation in the
a. if the organization delegates the under- appraisal or evaluation.
writing function to a broker or corre- 6. If the banking organization uses automated
spondent; valuation models (AVMs) to support evalu-
b if the banking organizations internal ations or appraisals, find out if the
controls for delegated underwriting are organization
adequate; a. periodically validates the models, to
c. whether the banking organization retains mitigate the potential valuation uncer-
appropriate oversight of all critical loan- tainty in the model;
processing activities, such as verification b. adequately documents the validations
of income and employment and the inde- analysis, assumptions, and conclusions;
pendence of the appraisal and evaluation c. back-tests a representative sample of
function; evaluations and appraisals supporting
d. if there are adequate systems and con- loans outstanding; and
trols to ensure that a third-party origina- d. evaluates the reasonableness and
tor is appropriately managed, is finan- adequacy of its procedures for validating
cially sound, provides mortgages that AVMs.
meet the banking organizations pre- 7. If tax-assessment valuations are used as a
scribed underwriting guidelines, and basis for collateral valuation, ascertain
adheres to applicable consumer protec- whether the banking organization is able to
tion laws and regulations; demonstrate and document the correlation
e. if the banking organization has a quality- between the assessment value of the taxing
control unit or function that closely authority and the propertys market value,
monitors (monitoring activities should as part of the validation process.
include post-purchase underwriting 8. Review the risk- and account-management
reviews and ongoing portfolio- procedures. Verify that the procedures are
performance-management activities) the appropriate for the size of the banking
organizations loan portfolio, as well as
BHC Supervision Manual July 2014 for the risks associated with the types of
Page 40 home equity lending conducted by the
organization. c. provides management with sufficient

9. If the banking organization has large home information to identify, monitor, mea-
equity loan portfolios or portfolios with sure, and control home equity concentra-
high-risk characteristics, determine if the tions.
organization 14. Determine whether management periodi-
a. periodically refreshes credit-risk scores cally assesses the adequacy of its MIS, in
on all customers; light of growth and changes in the banking
b. uses behavioral scoring and analysis of organizations risk appetite.
individual borrower characteristics to 15. If the banking organization has significant
identify potential problem accounts; concentrations of home equity loans (HELs)
c. periodically assesses utilization rates; or HELOCs, determine if the MIS includes,
d. periodically assesses payment patterns, at a minimum, reports and analysis of the
including borrowers who make only following:
minimum payments over a period of a. production and portfolio trends by prod-
time or those who rely on the credit line uct, loan structure, originator channel,
to keep payments current; credit score, loan to value (LTV), debt to
e. monitors home values by geographic income (DTI), lien position, documenta-
area; and tion type, market, and property type
f. obtains updated information on the colla- b. the delinquency and loss-distribution
terals value when significant market trends by product and originator chan-
factors indicate a potential decline in nel, with some accompanying analysis
home values, or when the borrowers of significant underwriting characteris-
payment performance deteriorates and tics (such as credit score, LTV, or DTI)
greater reliance is placed on the c. vintage tracking
collateral.
d. the performance of third-party origina-
Determine that the frequency of these tors (brokers and correspondents)
actions is commensurate with the risk in the
portfolio. e. market trends by geographic area and
property type, to identify areas of rapidly
10. Verify that annual credit reviews of home
appreciating or depreciating housing
equity line of credit (HELOC) accounts are
values
conducted. Verify if the reviews of HELOC
accounts determine whether the line of 16. Determine whether the banking organiza-
credit should be continued, based on the tion accurately tracks the volume of high-
borrowers current financial condition. LTV (HLTV) loans, including HLTV home
equity and residential mortgages, and if the
11. Determine that authorizations of over-limit
organization reports the aggregate of these
home equity lines of credit are restricted
loans to its board of directors.
and subject to appropriate policies and
controls. 17. Determine whether loans in excess of the
supervisory LTV limits are identified as
a. Verify that the banking organization
high-LTV loans in the banking organiza-
requires over-limit borrowers to repay,
tions records. Determine whether the orga-
in a timely manner, the amount that
nization reports, on a quarterly basis, the
exceeds established credit limits.
dollar value of such loans to its board of
b. Evaluate the sufficiency of management directors.
information systems (MIS) that enable
18. Find out whether the organization has pur-
management to identify, measure, moni-
chased insurance products to help mitigate
tor, and control the risks associated with
the credit risks of its HLTV residential
over-limit accounts.
loans. If a policy has a coverage limit,
12. Verify that the organizations real estate determine whether the coverage may be
lending policies are consistent with safe and exhausted before all loans in the pool
sound banking practices and that its board mature or pay off.
of directors reviews and approves the poli- 19. Determine whether the organizations
cies at least annually. credit-risk management function oversees
13. Determine whether the MIS the support function(s). Evaluate the effec-
a. allows for the segmentation of the loan tiveness of controls and procedures over
portfolios;
b. accurately assesses key risk characteris- BHC Supervision Manual January 2014
tics; and Page 41
staff persons responsible who are respon- documentation for other loans the respec-
sible for perfecting liens, collecting out- tive entity originates);
standing loan documents, obtaining insur- the transfer of loans immediately before
ance coverage (including flood insurance), the date of the inspection to determine if
and paying property taxes. the loan was either nonperforming or
20. Determine whether policies and procedures classified and if the transfer was made to
have been established for home equity avoid possible criticism during the cur-
problem-loan workouts and loss-mitigation rent inspection; and
strategies. losses to determine if they are shared on a
pro rata or other basis according to the
terms of the participation agreement.
Loan Participations, the Agreements and 4. Check participation certificates or agree-
Participants ments and records to determine whether the
parties share in the risks and contractual
These inspection procedures are designed to payments on a pro rata or other basis.
ensure that originated loans that were trans- 5. Determine if loans are purchased on a
ferred via loan participation agreements or cer- recourse basis and that loans are sold on a
tificates to state member banks, bank holding nonrecourse basis.
companies, nonbank affiliates, or other third par- 6. Ascertain that the BHC (or its subsidiaries)
ties were carefully evaluated. The procedures do not buy back or pay interest on defaulted
instruct examiners to determine if the asset loans in contradiction of the underlying par-
transfers were carried out to avoid or circum- ticipation agreement.
vent classification and to determine the effect of 7. Compare the volume of outstanding origi-
the transfers on the BHCs financial condition nated or purchased loans that were issued in
or that of its subsidiaries. In addition, the proce- the form of loan participations with the total
dures are designed to ensure that the primary outstanding loan portfolio.
regulator of another financial institution 8. Determine if the BHC (or its subsidiaries)
involved in the asset transfer of any low-quality has sufficient expertise to properly evaluate
assets is notified. the volume of loans originated or purchased
and sold as loan participations.
1. Review the board of directors or their des- 9. Based on the terms of the loan participation
ignated committees policies and proce- agreements, review the originators distri-
dures governing how loan participation bution of the borrowers payments received
agreements and activities are created, trans- to those entities or persons owning interests
acted, and administered. Refer to section in the loan participations. Ascertain if the
2010.2.7 for the minimum items that should agreements recourse provisions may
be included in board-approved policies on require accounting for the transactions as a
loan participation activities. secured borrowing rather than as a sale.
2. Determine if managerial reports provide 10. Determine if loans are sold primarily to
sufficient information relative to the size accommodate credit overline needs of cus-
and risk profile of the loan participation tomers or to generate fee income.
portfolio and evaluate the accuracy and 11. Determine if loans are purchased or sold to
timeliness of reports produced for the board affiliates or other companies; if so, deter-
and senior management. mine whether the purchasing companies
3. For loan participations held (either in whole request and are given sufficient information
or in part) with another lending institution, to properly evaluate the credit. (Section
review, if applicable, 23A of the Federal Reserve Act and the
the participation certificates and agree- Boards Regulation W prohibit transfers of
ments, on a test basis, to determine if the low-quality assets between affiliates.) See
contractual terms are being adhered to; sections 2020.0, 2020.1, 2020.2.
loan documentation to determine if it 12. Investigate any situations in which assets
meets the BHCs (or its subsidiarys) were transferred before the date of
underwriting procedures (that is, the inspection:
documentation for loan participations a. Determine if any were transferred to
should meet the same standards as the avoid possible criticism during the
inspection.
BHC Supervision Manual January 2014 b. Determine whether any of the loan par-
Page 42 ticipations transferred were nonperform-
ing at the time of transfer, classified dur- assesses the marketability of its loan partici-
ing the previous examination, or pation portfolio and evaluates the BHCs
transferred for any other reason that may (or its subsidiaries) ability to access the
cause the loans to be considered of ques- secondary market.
tionable quality. 19. Verify whether the BHC (or its subsidi-
13. Review the BHCs policies and procedures aries) compare its underwriting standards
to determine whether loan participations for loan participations with those that exist
purchased are required to be given an inde- in the secondary market.
pendent, complete, and adequate credit
evaluation. Review asset participations sold
to affiliates to determine if the asset pur- 2010.2.10 INTERNAL CONTROL
chases were supported by an arms-length QUESTIONNAIRE
and independent credit evaluation.
14. Determine that any assets purchased by the Applicability/Risk-Management
BHC (or its subsidiaries) were properly Framework
recorded at fair market value at the time of
purchase. 1. Has the institution adopted a risk-
15. Determine that transactions involving trans- management framework around leveraged
fers of low-quality assets to the parent hold- lending that includes:
ing company or a nonbank affiliate are a. A leveraged lending policy that is based
properly reflected at fair market value on on risk objectives, risk acceptance crite-
the books of both the bank and the holding ria, and risk controls?
company affiliate. b. Structuring transactions that reflect a
16. If poor-quality assets were transferred by sound business premise, have an appro-
the BHC to another financial institution for priate capital structure, reasonable cash
which the Federal Reserve is not the pri- flow, and balance sheet leverage?
mary regulator, prepare a memorandum to c. A definition of leveraged lending that
be submitted to the Reserve Bank supervi- can be applied across all business lines?
sory personnel. The Reserve Banks appro- d. Well-defined underwriting standards that
priate staff will then inform the local office define acceptable leverage levels and
of the primary federal regulator of the other amortization expectations?
institution involved in the transfer. The e. A limit framework?
memorandum should include the following f. Sound MIS?
information, as applicable, g. Pipeline management procedures, hold
names of originating and receiving limits, and expected timing for distribu-
institutions; tions?
type of assets involved; h. Guidelines for stress testing?
date (or dates) of transfer; 2. Is the institution able to identify leveraged
total number and dollar amount of assets exposures to related borrowers or guaran-
transferred; tors?
status of the assets when transferred (e.g., 3. Is the institution able to identify leveraged
nonperforming, classified, etc.); and loans that are managed in non-lending port-
any other information that would be help- folios (for example collateralized loan obli-
ful to the other regulator. Ascertain gations (CLOs), special purpose entities
whether the bank manages not only the (SPEs), or other indirect exposures)?
risk from individual participation loans 4. Is the institution originating leveraged
but also portfolio risk. loans; participating in leveraged loans, or
17. Find out if management develops appropri- both?
ate strategies for managing concentration
levels, including the development of a con-
tingency plan to reduce or mitigate concen- Definition of Leveraged Lending
trations during adverse market conditions
(such a plan may include strategies involv- 1. Has the institution developed an appropri-
ing not only loan participations, but also ate written definition for leveraged lending
whole loan sales). Find out if the BHCs (or and incorporated it into the leveraged lend-
its subsidiaries) contingency plan includes
selling loans as loan participations. BHC Supervision Manual July 2014
18. Ascertain if management periodically Page 43
ing policy? Participations Purchased

2. Is the policy definition consistent with the
amounts and types of leveraged loans that 1. Has the institution, with respect to participa-
the institution is engaged in? tions purchased, done its own independent
underwriting of its portion of the transac-
tion and has it adequately identified its
General Policy Expectations risks?
2. Has the institution received copies of all
1. Has the institutions leveraged lending pol- documentation relevant to the transaction?
icy been approved by the board of direc- 3. Is there evidence that the institution has
tors? reviewed the participation agreement and
has a clear understanding of its rights and
2. Does the leveraged lending policy contain responsibilities under the agreement?
the following elements:
a. A clear statement of the amounts of
leveraged lending that it is willing to Underwriting Standards
underwrite and the amount(s) it is will-
ing to hold in its own portfolio? 1. Is the institution using similar underwriting
standards for leveraged loans it plans to
b. A limit framework that establishes limits
hold as well as for leveraged loans it plans
or guidelines around the following as
to distribute?
applicable:
1) Single obligors and transactions? 2. Are the institutions underwriting standards
2) Aggregate hold portfolio? clear, written, and measurable?
3) Total pipeline exposure? 3. Do underwriting standards require:
4) Industry and geographic concentra- A sound business premise for each trans-
tion? action and that the borrowers capital
5) Notional pipeline limits? structure is sustainable?
6) Stress losses, flex terms, economic A determination and documentation of
capital usage, and earnings at risk? the borrowers capacity to repay and
7) Other parameters particular to the ability to de-lever to a sustainable level
portfolio? over a reasonable period?
8) The required management approval Standards for evaluating various types of
authorities and exception tracking collateral?
provisions? Standards for evaluating risk-adjusted
returns?
c. Procedures for insuring that leveraged
lending risks are appropriately reflected The acceptable degree of reliance on
in the institutions level of allowance for enterprise value and other intangible
loan and lease losses (ALLL) and capital assets for loan repayment?
adequacy analysis? Expectations for the degree of support
expected to be provided by sponsors?
d. Credit and underwriting approval A prohibition on material dilution, sale,
authorities, including the procedures for or exchange of collateral or cash flow
approving and documenting changes to producing assets without lender
approved transaction structures and approval?
terms?
A credit agreement that contains finan-
e. Guidelines for appropriate oversight by cial covenants, reporting covenants, and
senior management, including adequate compliance monitoring? Does the loan
and timely reporting to the board of contain covenant-lite and PIK toggle
directors? loan structures? If so, does the borrower
f. Expected risk-adjusted returns for lever- have the ability to repay the loan under
aged transactions? the contractual terms?
g. Minimum underwriting standards and Guidelines for acceptable collateral
underwriting practices for primary loan types, loan-to value-guidelines, and
origination and secondary loan acquisi- acceptable collateral valuation method-
tion? ologies?
Loan agreements that provide for the
BHC Supervision Manual July 2014 distribution of financial information to
Page 44 participants and investors?
Valuation Standards down within a reasonable or 90-day

period?
1. Does the institution have policies for valu- Have transactions reclassified as hold-
ing illiquid, intangible, or hard to value to-maturity been reported to manage-
collateral that include appropriate LTV ment and the board of directors?
ratios, discount rates, and collateral mar- Guidelines for conducting periodic stress
gins? tests of pipeline exposures?
2. Is the institution relying on enterprise value Controls to monitor expected vs. actual
to confirm a secondary source of repay- performance?
ment? Reports that show individual and aggre-
a. Has the institution documented its valua- gate transaction information, risk ratings
tion approach to calculating enterprise and concentrations?
value? Limits on hold levels per borrower,
b. Has the valuation been performed by counterparty, and aggregate hold levels?
qualified persons independent of the Limits on the amounts intended for dis-
origination function? tribution?
c. Has one or a combination of three meth- Policies and procedures for acceptable
ods been used for determining enterprise accounting methods, including prompt
value, asset valuation, income valuation, recognition of losses?
or market valuation? Policies and procedures around accept-
d. If the income method is used, is it based able hedging practices if applicable?
on capitalized cash flow or discounted Plans to address contingent liabilities and
cash flow? compliance with Sections 23A and 23B
e. Has the institution confirmed proxy mea- of the Federal Reserve Act and Regula-
sures such as multiples of cash flow tion W?
earnings or sales by performing its own
discounted cash flow analysis?
f. Are stress tests of key variables and Reporting and Analytics
assumptions used in determining enter-
prise value (such as cash flow earnings 1. Does management receive quarterly com-
and sales multiples) conducted at origi- prehensive reports about the characteristics
nation and periodically thereafter? and trends of the institutions leveraged
g. Does the institution have established lim- lending portfolio? Are summaries provided
its for the proportion of individual trans- to the board of directors?
actions and the total portfolio that are 2. Do internal policies identify the data fields
supported by enterprise value? to be populated and captured by the institu-
tions MIS? Are the reports accurate and
timely?
Pipeline Management 3. As dictated by the size and complexity of
the leveraged lending portfolio, does MIS
1. Do strong risk-management controls cover reporting on the leveraged lending portfolio
all transactions in the pipeline, including include the following:
amounts planned for hold and those marked a. Individual and portfolio exposures
for distribution? within and across all business lines and
2. Does the institution have the capability to legal vehicles including the pipeline?
differentiate transactions based on their key b. Risk-rating distribution and migration
characteristics, tenor, and investor class analysis?
(pro-rata and institutional), structure, and c. A list of borrowers who have been
key borrower characteristics (for example, removed from the leveraged-lending
industry)? portfolio due to improvements in their
3. Does the institution have the following con- financial characteristics and risk profile?
trols for pipeline exposure: Is the removal from the profile concur-
A documented appetite for underwriting rent with a refinance, restructure or some
pipeline risk that considers the potential other modification in the loan agree-
effects on earnings, capital, and liquid- ment?
ity?
Written policies and procedures for BHC Supervision Manual July 2014
hung deals or deals that are not sold Page 45
d. Industry mix and maturity profile? Internal Risk Rating

e. Metrics derived from probability of
default and loss-given default? 1. Does the institution have evidence of
f. Portfolio performance measures includ- adequate repayment capacity? For example,
ing covenant breaches, restructurings, do borrowers demonstrate the ability to
delinquencies, nonperforming asset fully amortize senior debt or repay at least
amounts, and charge offs? 50 percent of total debt over a five to seven-
g. Amount and nature of impaired assets year period?
and the amount of ALLL attributable to 2. Are there extensions or other restructuring
leveraged lending? that are masking an inability to repay?
h. The level of policy exceptions in the 3. Has the primary source of repayment
portfolio? become inadequate? Is enterprise value
i. Exposures by collateral type, including being relied on as a secondary source of
unsecured transactions when enterprise repayment? Is enterprise value well sup-
values will be the only source of repay- ported with binding purchase and sale
ment? agreements with qualified third parties?
Does enterprise value consider the
j. Defaults that trigger pari-passu treat-
borrowers distressed circumstances?
ment for all lenders?
k. Secondary market pricing data and trad-
ing volume (when available)?
Credit Analysis
l. An aggregation of exposures by and per-
formance of deal sponsors? 1. Does transaction testing of individual lever-
m. An indication of gross and net expo- aged lending credits contain the following
sures, hedge and counterparty concentra- elements and show that :
tions; and indication of policy excep- a. Cash flow analysisThe analysis does
tions? not rely on overly optimistic or unsub-
n. Actual vs. projected distribution levels stantiated projections of sales, margins,
of the pipeline with reports of excess or merger and acquisition synergies?
levels of exposure over hold targets? b. Liquidity analysisThere are measures
o. Types of exposure in the pipeline: com- to determine operating cash needs and
mitted exposures not accepted by the cash needed to meet debt maturities?
borrower; exposures committed and Analyze liquidity based on industry per-
accepted but not closed; funded and formance metrics?
unfunded commitments closed but not c. ProjectionsThere is adequate margin
distributed? for unanticipated merger-related integra-
p. Total and segmented exposures: subordi- tion costs?
nated debt and equity holdings (com- d. Stress testsProjections are stress tested
pared to limits); global exposures; indi- for one or more downside scenarios,
rect exposure (to an obligor or if the including a covenant breach?
institution is holding a previously sold e. Variances from planTransactions are
position as collateral or as a reference reviewed at least quarterly to determine
asset in a derivative)? variance from plan; does the credit file
q. Exposures booked in other business units contain a chronological rationale for and
throughout the institution that are related analysis of all changes to the operating
to a leveraged loan or borrower? (For plan and variances from the expected
example, default swaps or total return financial performance?
swaps naming the distributed paper as a f. Enterprise ValueWere enterprise val-
covered or referenced asset or as collat- ues independently derived and validated
eral exposure through repo transactions). outside of the origination function? Were
r. Positions held in leveraged loans in values calculated timely and did they
available for sale or traded portfolios or consider value erosion?
held in structured-investment vehicles g. Collateral shortfallsHave shortfalls
owned or operated by the originating been identified and factored into the risk
institution or its subsidiaries or affiliates? rating?
h. Collateral liquidation and asset sales
BHC Supervision Manual July 2014 Are any liquidations and sales based on
Page 46 current market conditions and trends?
i. Contingency plansAre there contin- folio regularly, but at least once per year?
gency analyses to anticipate changing 2. Does the institution ensure that credit
conditions in debt or equity markets? Do review personnel have the knowledge and
the exposures rely on refinancing or the ability to identify risks in the leveraged
issuance of new equity? lending portfolio?
j. Interest Rate Risk and Foreign Exchange
RiskHave these risks been addressed
in the analysis? Are mitigants in place? Stress Testing
1. Has the institution developed and imple-
Problem Credit Management mented guidelines for conducting periodic
portfolio stress tests on loans originated to
1. Has the institution formulated and estab- hold and on loans originated to distribute?
lished procedures for dealing with problem 2. Has the institution conducted periodic loan
credits? and leveraged lending portfolio level stress
2. Do work out plans contain quantifiable tests?
objectives and measurable time frames? 3. If applicable, has the leveraged-lending
3. Are problem credits regularly reviewed for portfolio been included in enterprise wide
risk-rating accuracy, accrual status, recogni- stress tests?
tion of impairment through specific alloca- 4. Does stress testing of leveraged credits
tions and charge-offs. include sensitivity analyses to quantify the
potential impact of changing economic and
market conditions on the institutions asset
Deal Sponsors quality, earnings, liquidity, and capital?
1. Has the institution developed guidelines for

evaluating the willingness and ability of Reputational Risk
sponsors to support the credit exposure and
a process to regularly monitor sponsor per- 1. Does the institution have procedures, safe-
formance? guards, actions, training, and staff remind-
2. Determine if the credit analysis has considers about the potential reputational risk
ered: associated with poorly underwritten origi-
a. If the sponsor is relied on as a secondary nated leveraged loans?
source of repayment and not a primary 2. Has there been any failure or apparent fail-
source of repayment? ure by the institution to meet its legal
b. If the sponsor has a historical pattern of responsibilities in underwriting and distrib-
supporting investments, financially or uting transactions that could damage its
otherwise? reputation or its ability to compete?
c. If the degree of support has been docu-
mented via a guarantee, comfort level, or
verbal assurance? Conflicts of Interest
d. If there has been a periodic review of the
sponsors financial statements, an analy- 1. Has the institution developed appropriate
sis of liquidity, and an analysis of the policies and procedures to address and to
sponsors ability to support multiple prevent potential conflicts of interest when
deals? it has both equity and lending positions?
e. If consideration has been given to the 2. Do policies and procedures:
sponsors dividend and capital contribu- a. Clearly define potential conflicts of inter-
tion practices and the likelihood that the est?
sponsor will support the borrower as b. Identify appropriate risk-management
compared to other deals in the sponsors controls and procedures?
portfolio? c. Enable employees to report potential
conflicts of interest to managements
without fear of retribution?
Credit Review d. Ensure compliance with applicable laws?
1. Does the institution conduct an internal BHC Supervision Manual July 2014
credit review of the leveraged-lending port- Page 47
3. Has management: A thorough review of a BHCs credit-

a. Established a training program for extending nonbank subsidiarys loan and lease
employees on appropriate practices to portfolio remains a fundamental element of the
follow to avoid conflicts of interest? Federal Reserves inspection program for these
b. Provided for reporting, tracking, and organizations. Such credit reviews are a primary
resolution of any conflicts? means for examiners to (1) evaluate the effec-
tiveness of a BHCs credit-extending nonbank
Compliance internal loan review program and internal grad-
ing systems for determining the reliability of
1. Does the institution maintain an indepen-
internal reporting of classified credits, (2) assess
dent compliance review function to periodi-
compliance with applicable guidance and regu-
cally review its leveraged-lending activity?
lations, and (3) determine the efficacy of credit-
2. Do the institutions policies include safe-
risk management and credit administration pro-
guards to prevent violations of anti-tying
cesses. Further, examiners use the findings from
regulations?
their credit review to identify the overall the-
3. How does the institution ensure compliance
matic credit-risk management issues, to assess
with applicable securities laws, including
asset quality, to assist in the assessment of the
disclosure and other regulatory require-
adequacy of the allowance for loan and lease
ments when equity interests and certain debt
losses (ALLL), and to inform their analysis of
instruments have been used in leveraged
capital adequacy.
transactions that may constitute securi-
ties under federal securities laws?
4. Have plans and provisions been developed
to ensure compliance with sections 23A and 2010.2.11.1 Loan Sampling Methodology
23B of the Federal Reserve Act and Regula-
Reserve Banks will establish the annual loan-
tion W?
sampling objective during the supervisory plan-
ning process. The annual sampling objective
2010.2.11 APPENDIX I - EXAMINER should provide coverage of material exposures,
LOAN-SAMPLING REQUIREMENTS including those in the retail segments.38 Reserve
FOR CREDIT-EXTENDING NONBANK Banks should plan on conducting at least two
SUBSIDIARIES OF BHCS WITH loan quality reviews during the annual supervi-
$10-50 BILLION IN TOTAL sory cycle of the BHCs credit-extending non-
CONSOLIDATED ASSETS bank subsidiaries with $1050 billion in total
consolidated assets.
This guidance sets forth loan sampling expecta- Each review should focus on one or more
tions for the Federal Reserves examination of material commercial loan segment exposures
state member bank (SMB) and the inspection of using the comparable FR Y-9C Report loan
credit-extending nonbank subsidiaries of bank types and, in total over the annual cycle, should
holding companies (BHCs) with $10-50 billion cover the four highest concentrations for com-
in total consolidated assets. Examiners will have mercial credits in terms of total risk-based capi-
the flexibility, depending upon the structure and tal for any FR Y-9C Report loan type from
size of subsidiary SMBs or credit-extending Schedule HC-C. Loan segments that generate
nonbank subsidiaries of BHCs, to utilize the substantial revenues are generally likely to entail
guidance applicable to smaller organizations higher risk. To the extent that examiners can
when the subsidiarys total assets are below $10 determine that a loan category contributes
billion. This guidance clarifies expectations for 25 percent or more to annual revenues,39 exam-
the assessment of material37 retail credit port- iners should sample these segments. Examiners
folios for these institutions. The guidance that
follows has been solely adapted to BHC credit- 38. Commercial loan segments include commercial and
extending nonbank subsidiaries. industrial (C&I) loans, 1-4 family construction, other con-
struction loans, multifamily loans, farm loans, non-farm non-
residential owner occupied, and non-farm non-residential
37. A loan portfolio or portfolio segment is considered
other loans. Retail loan segments include first lien mortgages,
material when the portfolio or segment exceeds 25 percent of
closed-end junior liens, home equity lines of credit
total risk-based capital (tier 1 capital plus the allowance for
(HELOCs), credit cards, automobile loans, and other con-
loan and lease losses) or contributes 25 percent or more to
sumer loans.
annual revenues.
39. The 25 percent threshold should be based on internal
MIS and may not be applicable or available in all instances.
BHC Supervision Manual July 2014 For the purposes of this guidance, annual revenue equals net
Page 48 interest income plus non interest income.
should also sample other loan segments that 4. unreliable internal credit-risk grading.
they or the banks internal loan review have
identified as exhibiting high-risk characteristics. Conversely, sample sizes should be based on the
Such risk characteristics include liberal under- 10 percent minimum if
writing, high levels of policy exceptions, high-
delinquency trends, rapid growth, new lending 1. previous inspections concluded that internal
products, concentrations and concentrations to loan review and credit-risk identification is
industry, or significant levels of classified cred- effective,
its. In addition to these risk-focused samples, a 2. internal loan review has reviewed a loan
sample of loans to insiders must be reviewed.40 segment within the last 12 months and
Annual loan sampling coverage by examiners noted no material weaknesses, and
should take into consideration the severity of 3. the inspection scoping process reveals no
the asset quality component rating, the effective- significant credit-risk management issues.
ness of the internal loan review program, the
results of internal loan portfolio stress testing, In general, the lower range of 10 percent sam-
and current asset quality financial trends. pling of each segment or the entire commercial
During the inspection scoping phase, Reserve portfolio would be acceptable when all aspects
Bank staff should analyze the results of recent of credit risk indicate low and stable risk.
loan review reports or audits prepared for an Examiners should determine classification
institutions internal use and the Reserve Banks amounts for retail credits using the Uniform
most current assessment of credit-risk manage- Retail Classification Guidance (SR letter 00-8,
ment to help establish the size and composition Revised Uniform Retail Credit Classification
of loans to be selected for review. A nonbank and Account Management Policy). Annually,
subsidiarys internal loan review program examiners should focus on one or more material
should achieve substantial coverage beyond the retail loan segment exposures as divided by the
examiners annual judgmental sample of mate- comparable FR Y-9C Report loan type. Examin-
rial loan portfolios. Examiners should review ers should determine the appropriate sample of
the findings and recommendations of the nonretail loans from material segments based on
bank subsidiarys internal loan review program risk to be tested for compliance with internal
to help identify areas of risk. In selecting loans credit administration policies and underwriting
from each segment of the loan portfolio to standards. While there is no minimum coverage
review, examiners should include a selection of expectation for retail portfolios or segments, the
the largest loans, problem loans (past due goal of sampling is to assist examiners in mak-
90 days or more, nonaccrual, restructured, or ing an informed assessment of all aspects of
internally classified loans), and newly origi- retail credit-risk management. If applicable,
nated loans. Examiners should ensure the examiners should evaluate and test secondary
sample selection includes robust coverage of market origination and servicing practices and
classified credits. At a minimum, loans selected quality assurance programs. Examiners should
for review from commercial loan segments also sample other retail loan segments, as
should represent 10 percent of the committed needed, from segments the examiners or inter-
dollar amount of credit exposure within the loan nal loan review identify as exhibiting high-risk
segment. characteristics such as liberal underwriting,
Sample sizes should be increased beyond the high-delinquency trends, rapid growth, new
10 percent minimum, based on examiner judg- lending products, or significant levels of classi-
ment, for segments when the inspection scoping fied credits.
process or the internal loan review program has
identified
2010.2.11.2 Documentation of Loan
1. deficiencies with credit-risk management Sampling Analysis and Methodology
and administration practices,
2. unusually high loan growth, Examiners should discuss their analysis and
3. credit quality or collateral values that have objectives for achieving loan sampling coverage
been adversely affected since the prior with Board staff during the annual supervisory
review by volatile local or national eco- planning process. Upon reaching a consensus
nomic conditions, or with Board staff, the analysis and methodology
40. Federal Reserve examiners must test and evaluate BHC Supervision Manual July 2014
Regulation O compliance annually. Page 49
should be retained in workpapers and docu- 2010.2.11.3 Follow-Up Expectations for

mented in the supervisory plan. Further, examin- Inspections with Adverse Findings
ers should document their loan sample selection
methods in scoping memoranda and in the con- Examiners should generally consider a credit-
fidential section of the report of inspection. The extending nonbank subsidiarys internal risk-
required workpaper documentation of the com- rating system to be less reliable when examiner
mercial loan coverage calculation should be downgrades42 or internal loan review down-
based on total loan commitments and should grades equal 10 percent of the total number of
generally exclude loans reviewed outside of the loans reviewed, or 5 percent of the total dollar
Reserve Banks supervisory plan when a amount of loans and commitments reviewed.
detailed analysis of the loans by an examiner When a credit-extending nonbank subsidiarys
and an assessment of credit-risk management risk-rating system is determined to be unreli-
were not performed. Review of syndicated loans able, examiners may need to expand sampling
and participations, such as those from the to better evaluate the effect of rating differences
Shared National Credits (SNCs) annual review, on the entitys ALLL and capital. In such situa-
should only be included in the coverage ratio if tions, examiners should direct the BHC and its
Reserve Bank staff reviewed the credit-risk credit-extending nonbank subsidiary to take cor-
management aspects of the credit (for example, rective action to validate its internal ratings and
adherence to underwriting policies) and these to evaluate whether the ALLL or capital should
findings are included in the examiners assess- be increased. The Reserve Bank will follow-up
ment of overall credit-risk management prac- with the BHC and its nonbank subsidiary to
tices. Examiners should continue to follow the assess progress on corrective action and verify
SNC grading guidance.41 satisfactory completion. The timeframe for
follow-up should correspond with the timeframe
during which actions are to be completed.43 All
follow-up actions on adverse findings should be
discussed with Board staff.
42. A credit-risk grading difference is considered a down-

grade when (a) a risk rating is changed by the examiner from
41. Refer to SR-77-377, Shared National Credit Pro-
an internal Pass rating to a classified category or (b) a risk
gram.
rating is changed by the examiner within the classified catego-
ries.
BHC Supervision Manual July 2014 43. Refer to SR-13-13/CA -13-10, Supervisory Consider-
Page 50 ations for the Communications of Supervisory Findings.
(Investments) Section 2010.3
The Systems ability to evaluate the effective- methods and/or process through which prior
ness of a companys supervision and control of approval of new activities and investments in
subsidiary investment activities can be strength- new instruments is granted.
ened not only by evaluating the parents role in 3. Determine whether the boards of directors
light of efficiency and operating performance, and the management of subsidiaries appear to
but also by evaluating the quality of control and be sufficiently involved in their respective roles
supervision. In order to assess quality there must to assure that the performance of fiduciary re-
be a standard or measuring block against which sponsibilities of each appears adequate.
a companys policies can be evaluated. By es- 4. Assess the adequacy of the level of man-
tablishing the minimum areas that a companys agement expertise in relation to its involvement
policies should address with respect to subsidi- in various investment activities.
ary investments, a standard is created which can 5. Evaluate the reasonableness of investment
evaluate the quality of companys control and activity initiated to achieve corporate objectives
supervision of that activity. The examiner needs in light of its potential impact on the risk expo-
to make a qualitative assessment of the parents sure of subsidiaries.
supervision and control of subsidiary invest- 6. Assess the adequacy of investment policy
ment activities. directives in regard to the required mainte-
nance of adequate recordkeeping systems at
subsidiaries.
2010.3.1 INSPECTION OBJECTIVES 7. Evaluate policy directives regarding the
appropriateness of accounting practices in re-
1. Determine if the parents investment pol- gard to transactions involving investment partic-
icy is adequate for the organization. ipations, swaps, other transfers of investments
2. Determine if the investment policy is be- as well as specialized investment activities.
ing complied with. 8. Evaluate whether investment policies ade-
quately provide for the maintenance of a stable
income stream at bank subsidiaries as well as
2010.3.2 INSPECTION PROCEDURES the parent company level.
9. Determine whether investment policy di-
1. Determine whether the management has rectives adequately address statutory limitations,
developed a flow chart on investment authoriza- particularly those involving intercompany trans-
tion procedures sufficiently detailed to assure actions.
that the execution of transactions precludes the 10. Evaluate the effectiveness of the bank
ability to circumvent policy directives. holding companys audit function in assuring
2. Determine whether all investment policies that investment policies and directives are ad-
appear to be adequately tailored to fit the busi- hered to at each corporate level.
ness needs of each subsidiary. Review the

Page 1
(Consolidated Planning Process) Section 2010.4
This section emphasizes the importance of inte- ronmental change. For these areas, flexibility
grating subsidiaries into a consolidated plan, the should exist for contingency plans.
essential elements of the planning process, and 7. Methods should be determined, in the
the ultimate accountability of the board of direc- plan, to monitor and evaluate compliance with
tors of the holding company. As a minimum, the the plan.
parents consolidated plan should include the 8. The consolidated plan should have a mea-
following ten elements: surable aspect to determine whether budgets,
1. All plans should address a long-range objectives, and goals are being met. If they are
goal or focus, intermediate term objectives, and not met, determination as to the controllability
short-term budgets. A long-range focus is par- of variances should be ascertained.
ticularly important during a changing environ- 9. Plans and goals must continually be eval-
ment and during expansions of the organization. uated to determine whether accomplishing the
Long-range plans generally are broad with a goal results in the desired and expected out-
service or customer orientation and market come. For example, the desired outcome may be
share emphasis. These plans provide the entire to increase net income by granting loans with
organization with a consistent direction and higher interest rates and above normal risk. The
facilitate changes in the organization arising granting of such loans may result in a need to
from environmental changes. Intermediate goals increase the provision for loan losses, thus caus-
generally are narrower in scope. Short-term ing a decrease in earnings.
budgets are generally developed at the subsidi- 10. Plans should be flexible enough to re-
ary level; however, they are subject to review main effective in a volatile environment. If plans
and revision by the parent in an effort are too rigid, they may become disfunctional if
to maintain consistency throughout the the environment changes and actually constrain
organization. an organizations ability to react. On the other
2. The planning process should be formal- hand, flexible goals and plans should enhance
ized. A long-range focus, intermediate term ob- an organizations ability to compete by provid-
jectives, and budgets should be written and ing the entire organization with a fluid consis-
adopted by the parents board of directors to tent direction.
insure centralized accountability.
3. Plans should be consistent and interre-
lated over the differing time periods. For exam- 2010.4.1 INSPECTION OBJECTIVES
ple, budgets should be consistent with long-
range goalsthe implementation of a short- 1. To determine if the board of directors at
term, high return orientation may be inconsistent the parent company is cognizant of and perform-
with a long-term goal of increasing market ing its duties and responsibilities.
share, or short-term compensation plans may be 2. To determine if the level of supervision
disfunctional in the long run. over subsidiaries is both adequate and
4. A consolidated plan should increase the beneficial.
consistency of goals among differing subsidi- 3. To evaluate the consolidated plan for con-
aries and the parent. The long-range goals, in- sistency, controls, and effectiveness.
termediate term objectives, and short term goals 4. To ascertain if the board of directors of the
and objectives should be periodically reviewed, parent company is making judgments and deci-
preferably, annually, by the BHCs board of sions based on adequate information flowing
directors. A consolidated plan should reduce from the management and financial reporting
unnecessary internal competition. systems of the organization.
5. A consolidated plan should facilitate the
allocation of resources throughout the organiza-
tion. This is particularly important when the 2010.4.2 INSPECTION PROCEDURES
parent is providing most, or all, of the short-
term funds and long-term capital. As the parent 1. Evaluate the participation by the board of
has an awareness of all subsidiaries, it can better directors of the parent company in giving over-
allocate funds and personnel to areas where they all direction to the organization.
will be utilized most effectively. 2. Obtain and evaluate descriptions of all im-
6. Plans should be formulated with an
awareness to possible weaknesses and recog- BHC Supervision Manual December 1992
nition to areas likely to be influenced by envi- Page 1
Supervision of Subsidiaries (Consolidated Planning Process) 2010.4
portant management and financial policies, pro- 5. Spell out the lines of authority associated
cedures, and practices. with the planning process.
3. Determine if contradictions or conflicts 6. Determine the degree of control exercised
between expressed and unexpressed strategies by the parent company over the entire organiza-
and between long-term and short-term goals tion.
exist. Also determine that goals are consistent 7. Test compliance with policies at all levels.
with concern over safety and soundness.
4. Determine whether the planning process is
sufficiently flexible and if contingency plans
exist.

Page 2
(Environmental Liability) Section 2010.5
2010.5.1 BACKGROUND The liability imposed by the superfund statute

INFORMATION ON is strict liability which means the government
ENVIRONMENTAL LIABILITY does not have to prove that the owners or opera-
tors had knowledge of or caused the hazardous
Banking organizations are increasingly becom- substance contamination. Moreover, liability is
ing exposed to liability associated with the joint and several, which allows the government
clean-up of hazardous substance contamination to seek recovery of the entire cost of the
pursuant to, the Comprehensive Environmental clean-up from any individual party that is liable
Response, Compensation and Liability Act for those clean-up costs under CERCLA. In this
(CERCLA), the federal superfund statute. It connection, CERCLA does not limit the bring-
was enacted in response to the growing problem ing of such actions to the EPA, but permits such
of improper handling and disposal of hazardous actions to be brought by third parties.
substances. CERCLA authorizes the Environ- CERCLA provides a secured creditor exemp-
mental Protection Agency (EPA) to clean-up tion in the definition of owner and operator
hazardous waste sites and to recover costs asso- by stating that these terms do not include . . . a
ciated with the clean-up from entities specified person, who, without participating in the man-
in the statute. The superfund statute is the agement of a vessel or facility, holds indicia of
primary federal law dealing with hazardous ownership primarily to protect his security inter-
substance contamination. However, there are est in the vessel or facility. 3 However, this
numerous other federal statutes, as well as state exception has not provided banking organiza-
statutes, that establish environmental liability tions with an effective safe harbor because
that could place banking organizations at risk. recent court decisions have worked to limit the
For example, underground storage tanks are also application of this exemption. Specifically,
covered by separate federal legislation.1 courts have held that actions by lenders to pro-
While the superfund statute was enacted a tect their security interests may result in the
decade ago, it has been only since the mid- banking organization participating in the man-
1980s that court actions have resulted in some agement of a vessel or facility, thereby voiding
banking organizations being held liable for the the exemption. Additionally, once the title to a
clean-up of hazardous substance contamination. foreclosed property passes to the banking orga-
In this connection, recent court decisions have nization, courts have held that the exemption no
had a wide array of interpretations as to whether longer applies and that the banking organization
banking organizations are owners or operators is liable under the superfund statute as an
of contaminated facilities, and thereby liable owner of the property. Under some circum-
under the superfund statute for clean-up costs. stances, CERCLA may exempt landowners who
This has led to uncertainty on the part of bank- acquire property without the knowledge of pre-
ing organizations as to how to best protect them- existing conditions (the so-called innocent
selves from environmental liability. landowner defense). However, the courts have
The relevant provisions of CERCLA, the so- applied a stringent standard to qualify for this
called superfund statute, as it pertains to defense. Because little guidance is provided by
banking organizations, indicate which persons the statute as to what constitutes the appropriate
or entities are subject to liability for clean-up timing and degree of due diligence to suc-
costs of hazardous substance contamination. cessfully employ this defense, banking organi-
These include . . . the owner and operator of a zations should exercise caution before relying
vessel or a facility, (or) any person who at the on it.
time of disposal of any hazardous substance
owned or operated any facility at which such
hazardous substances were disposed of. . . . 2 A 2010.5.2 OVERVIEW OF
person or entity that transports or arranges to ENVIRONMENTAL HAZARDS
transport hazardous substances can also be held
liable for cleaning-up contamination under the Environmental risk can be characterized as ad-
superfund statute. verse consequences resulting from having gen-
3. CERCLA, Section 101(20)(A)..

1. Resource Conservation and Recovery Act of 1986
(RCRA). BHC Supervision Manual December 1992
2. CERCLA, Section 107(a). Page 1
Supervision of Subsidiaries (Environmental Liability) 2010.5
erated or handled hazardous substances, or other- 2010.5.3 IMPACT ON BANKING

wise having been associated with the aftermath ORGANIZATIONS
of subsequent contamination. The following dis-
cussion highlights some common environmental Banking organizations may encounter losses
hazards, but by no means covers all environ- arising from environmental liability in several
mental hazards. ways. The greatest risk to banking organiza-
Hazardous substance contamination is most tions, resulting from the superfund statute and
often associated with industrial or manufactur- other environmental liability statutes, is the pos-
ing processes that involve chemicals or solvents sibility of being held solely liable for costly
in the manufacturing process or as waste prod- environmental clean-ups such as hazardous sub-
ucts. For years, these types of hazardous substance contamination. If a banking organization
stances were disposed of in land fills, or just is found to be a responsible party under
dumped on industrial sites. Hazardous sub- CERCLA, the banking organization may find
stances are also found in many other lines of itself responsible for cleaning-up a contami-
business. The following examples demonstrate nated site at a cost that far exceeds any outstand-
the diverse sources of potential hazardous sub- ing loan balance. This risk of loss results from
stance contamination which should be of con- an interpretation of the superfund statute as pro-
cern to banking organizations: viding for joint and several liability. Any re-
sponsible party, including the banking organiza-
Farmers and ranchers (use of fuel, fertilizers, tion, could be forced to pay the full cost of any
herbicides, insecticides, and feedlot runoff). clean-up. Of course, the banking organization
Dry cleaners (various cleaning solvents). may attempt to recover such costs from the
Service station and convenience store opera- borrower, or the owner if different than the
tors (underground storage tanks). borrower, provided that the borrower or owner
Fertilizer and chemical dealers and applica- continues in existence and is solvent. Banking
tors (storage and transportation of chemicals). organizations may be held liable for the
Lawn care businesses (application of lawn clean-up of hazardous substance contamination
chemicals). in situations where the banking organization:
Trucking firms (local and long haul transport-
ers of hazardous substances such as fuel or Takes title to property pursuant to foreclosure;
chemicals). Involves the banking organizations personnel
or contractors engaged by the bank in day-to-
The real estate industry has taken the brunt of day management of the facility;
the adverse affects of hazardous waste contami- Takes actions designed to make the contami-
nation. In addition to having land contaminated nated property salable, possibly resulting in
with toxic substances, construction methods for further contamination;
major construction projects, such as commercial Acts in a fiduciary capacity, including man-
buildings, have utilized materials that have been agement involvement in the day-to-day
subsequently determined to be hazardous, re- operations of industrial or commercial con-
sulting in significant declines in their value. For cerns, and purchasing or selling contaminated
example, asbestos was commonly used in com- property;
mercial construction from the 1950s to the late Owns existing, or acquires (by merger or ac-
1970s. Asbestos has since been found to be a quisition), subsidiaries involved in activities
health hazard and now must meet certain federal that might result in a finding of environmental
and, in many instances, state requirements for liability;
costly removal or abatement (enclosing or other- Owns existing, or acquires for future expan-
wise sealing off). sion, premises that have been previously con-
Another common source of hazardous sub- taminated by hazardous substances. For exam-
stance contamination is underground storage ple, site contamination at a branch office
tanks. Leaks in these tanks not only contaminate where a service station having underground
the surrounding ground, but often flow into storage tanks once operated. Also, premises
ground water and travel far away from the orig- or other real estate owned could be contami-
inal contamination site. As contamination nated by asbestos requiring costly clean-up or
spreads to other sites, clean-up costs escalate. abatement.
BHC Supervision Manual December 1992 A more common situation encountered by

Page 2 banking organizations has been where real prop-
erty collateral is found to be contaminated by 2010.5.4 PROTECTION AGAINST

hazardous substances. The value of contami- ENVIRONMENTAL LIABILITY
nated real property collateral can decline dra-
matically, depending on the degree of contami- Banking organizations have numerous ways to
nation. As the projected clean-up costs increase, identify and minimize their exposure to environ-
the borrower may not be able to provide the mental liability. Because environmental liability
necessary funds to remove contaminated materi- is relatively recent, procedures used to safe-
als. In making its determination whether to fore- guard against such liability are evolving. The
close, the banking organization must estimate following discussion briefly describes methods
the potential clean-up costs. In many cases this currently being employed by banking organiza-
estimated cost has been found to be well in tions and others to minimize potential environ-
excess of the outstanding loan balance, and the mental liability.
banking organization has elected to abandon its Banking organizations should have in place
security interest in the property and write off the adequate safeguards and controls to limit their
loan. This situation occurs regardless of the fact exposure to potential environmental liability.
that the superfund statute provides a secured Loan policies and procedures should address
creditor exemption. Some courts have not methods for identifying potential environmental
extended this exemption to situations where problems relating to credit requests as well as
banking organizations have taken title to a prop- existing loans. The loan policy should describe
erty pursuant to foreclosure. These rulings have an appropriate degree of due diligence investi-
gation required for credit requests. Borrowers in
been based on a strict reading of the statute that
high-risk industries or localities should be held
provides the exemption to security interests
to a more stringent due diligence investigation
only.
than borrowers in low-risk industries or locali-
Risk of credit losses can also arise where the ties. In addition to establishing procedures for
credit quality of individual borrowers (opera- granting credit, procedures should be developed
tors, generators, or transporters of hazardous and applied to portfolio analysis, credit monitor-
substances) deteriorates markedly as a result of ing, loan workout situations, andprior to tak-
being required to clean up hazardous substance ing title to real propertyforeclosures. Banking
contamination. Banking organizations must be organizations may avoid or mitigate potential
aware that significant clean-up costs borne by environmental liability by having sound policies
the borrower could threaten the borrowers sol- and procedures designed to identify, assess and
vency and jeopardize the banking organizations control environmental liability.
ultimate collection of outstanding loans to that At the same time, banking organizations must
borrower, regardless of the fact that no real be careful that any lending policies and proce-
property collateral is involved. Therefore, ulti- dures, but especially those undertaken to assess
mate collection of loans to fund operations, or to and control environmental liability, cannot be
acquire manufacturing or transportation equip- construed as taking an active role in participat-
ment can be jeopardized by the borrowers gen- ing in the management or day-to-day operations
erating or handling of hazardous substances in of the borrowers business. Activities which
an improper manner. Further, some bankruptcy could be considered active participation in the
courts have required clean-up of hazardous sub- management of the borrowers business, and
stance contamination prior to distribution of a therefore subject the bank to potential liability,
debtors estate to secured creditors. include, but are not limited to:
Borrowers may have existing subsidiaries or
may be involved in merger and acquisition having bank employees as members of the
activity that may place the borrower at risk for borrowers board of directors or actively par-
ticipating in board decisions;
the activities of others that result in environmen-
assisting in day-to-day management and oper-
tal liability. Some courts have held that for the
ating decisions; and
purposes of determining liability under the super- actively determining management changes.
fund statute, the corporate veil may not protect
parent companies that participate in the day-to- These considerations are especially important
day operations of their subsidiaries from envi- when the banking organization is actively in-
ronmental liability and court imposed clean-up volved in loan workouts or debt restructuring.
costs. Additionally, borrowers can be held liable
for contamination which occurred prior to their BHC Supervision Manual June 1996
owning or using real estate. Page 3
The first step in identifying and minimizing result in losses arising from hazardous sub-
environmental risk is for banking organiza- stance contamination because banking organiza-
tions to perform environmental reviews. Such tions are held directly liable for costly court
reviews may be performed by loan officers or ordered clean-ups. Additionally, the banking
others, and typically identify past practices and organizations ability to collect the loans it
uses of the facility and property, evaluate regu- makes may be hampered by significant declines
latory compliance, if applicable, and identify in collateral value, or the inability of a
potential future problems. This is accomplished borrower to meet debt payments after paying
by interviewing persons familiar with present for costly clean-ups of hazardous substance
and past uses of the facility and property, contamination.
reviewing relevant records and documents, and Banking organizations must understand the
visiting and inspecting the site. nature of environmental liability arising from
Where the environmental review reveals pos- hazardous substance contamination. Addition-
sible hazardous substance contamination, an ally, they should take prudential steps to identify
environmental assessment or audit may be re- and minimize their potential environmental lia-
quired. Environmental assessments are made by bility. Indeed, the common thread to environ-
personnel trained in identifying potential envi- mental liability is the existence of hazardous
ronmental hazards and provide a more thorough substances, not types of borrowers, lines of busi-
review and inspection of the facility and prop- ness, or real property.
erty. Environmental audits differ markedly from
environmental assessments in that independent
environmental engineers are employed to inves- 2010.5.6 INSPECTION OBJECTIVES
tigate, in greater detail, those factors listed pre-
viously, and actually test for hazardous sub- 1. To determine whether adequate safeguards
stance contamination. Such testing might and controls have been established to limit
require collecting and analyzing air samples, exposure to potential environmental liability.
surface soil samples, subsurface soil samples, or 2. To determine whether the banking organi-
drilling wells to sample ground water. zation has identified specific credits and any
Other measures used by some banking orga- lending and other banking and nonbanking
nizations to assist in identifying and minimizing activities that expose the organization to envi-
environmental liability include: obtaining in- ronmental liability.
demnities from borrowers for any clean-up costs
incurred by the banking organization, and
including affirmative covenants in loan agree- 2010.5.7 INSPECTION PROCEDURES
ments (and attendant default provisions) requir-
ing the borrower to comply with all applicable 1. Review loan policies and procedures and
environmental regulations. Although these mea- establish whether these and other adequate safe-
sures may provide some aid in identifying and guards and controls have been established to
minimizing potential environmental liability, avoid or mitigate potential environmental liabil-
they are not a substitute for environmental ity.4 In performing this task, ascertain whether:
reviews, assessments and audits, because their a. an environmental policy statement has
effectiveness is dependent upon the financial been adopted;
strength of the borrower. b. training programs are being conducted
so that lending personnel are aware of environ-
mental liability issues and are able to identify
2010.5.5 CONCLUSION borrowers with potential problems;
c. guidelines and procedures have been
Potential environmental liability can touch on a established for dealing with new borrowers and
great number of loans to borrowers in many real property offered as collateral.
industries or localities. Moreover, nonlending d. the lending policies and procedures and
activities as well as corporate affiliations can other safeguards, including those to assess and
lead to environmental liability depending upon control environmental liability, may not be con-
the nature of the these activities and the degree strued as actively participating in the manage-
of participation that the parent exercises in the ment of day-to-day operations of borrowers
operations of its subsidiaries. Such liability can businesses.

Page 4 4. Refer to SR-91-20.
2. When reviewing individual credits deter- structured analysis as previously indicated

mine whether the loan policy has been complied for environmental assessments, however,
with in regard to a borrowers activities or more comprehensive testing might involve
industry that is associated with hazardous sub- collecting and analyzing air samples, sur-
stances or environmental liability. face soil samples, subsurface soil samples,
3. Ascertain whether appropriate periodic or drilling wells to sample ground water.
analysis of potential environmental liability is
conducted. 4. Determine whether existing loans are
Such analysis should be more rigorous as reviewed internally to identify credits having
the risk of hazardous substance contamination potential environmental problems.
increases. The following are examples of types 5. Review recordkeeping procedures and
of analyses and procedures that should be pro- determine whether there is documentation as to
gressively considered as the risk of environmen- the due diligence efforts taken at the time of
tal liability increases: making loans or acquiring real property.
6. Review loan agreements to determine if
Environmental reviewscreening of the warranties, representations, and indemnifica-
borrowers activities by lending personnel tions have been included in loan agreements
or real estate appraisers for potential envi- designed to protect the banking organization
ronmental problems (using questionnaires, from losses stemming from hazardous substance
interviews, or observations). contamination. (Although such provisions pro-
Review procedures might include a sur- vide some protection for the lender, these agree-
vey of past ownership and uses of the prop- ments are not binding against the government or
erty, a property inspection, a review of adja- third parties. Such contractual protections are
cent or contiguous parcels of property, a only as secure as the borrowers financial
review of company records for past use or strength.)
disposal of hazardous materials, and a 7. For situations involving potential environ-
review of any relevant Environmental Pro- mental liability arising from a banking organiza-
tection Agency records. tions nonlending activities, verify that similar
Environmental assessmentstructured policies and procedures are in place. 5
analysis by a qualified individual that iden-
tifies the borrowers past practices, regula-
5. A banking organizations policies and procedures relat-
tory compliance, and potential future ing to environmental liability should apply to nonlending
problems. This analysis would include situations where appropriate. For example, banking organiza-
reviewing relevant documents, visiting and tions engaged in trust activities or contemplating a merger or
inspecting the site, and, in some cases, per- acquisition should evaluate the possibility of existing or sub-
sequent environmental liability arising from these activities.
forming limited tests.
Environmental audita professional envi-
ronmental engineer performs a similar

Page 5
Supervision of Subsidiaries (Financial Institution Subsidiary
Retail Sales of Nondeposit Investment Products) Section 2010.6
WHATS NEW IN THIS REVISED 2010.6.1 INTERAGENCY STATEMENT
SECTION ON RETAIL SALES OF NONDEPOSIT
INVESTMENT PRODUCTS
Effective July 2009, this section has been
revised to delete a cancelled SR letter reference. Insured depository institutions have expanded
their activities in recommending or selling such
products. Many depository institutions are pro-
2010.6.05 INTERAGENCY viding these services at the retail level, directly
STATEMENT OVERVIEW or through various types of arrangements with
third parties.
The Board of Governors of the Federal Reserve
Sales activities for nondeposit investment
System, along with the other federal banking
products should ensure that customers for these
regulators, issued an interagency statement on
products are clearly and fully informed of the
February 15, 1994, that provides comprehensive
nature and risks associated with these products.
guidance on retail sales of nondeposit invest-
In particular, where nondeposit investment prod-
ment products occurring on or from depository
ucts are recommended or sold to retail custom-
institution premises. The interagency statement
ers, depository institutions should ensure that
unifies pronouncements previously issued by the
customers are fully informed that the products
banking agencies that addressed various aspects
of retail sales programs involving mutual funds,
annuities, and other nondeposit investment are not insured by the FDIC;
products. are not deposits or other obligations of the
The interagency statement applies to all institution and are not guaranteed by the insti-
depository institutions, including state member tution; and
banks and the U.S. branches and agencies of are subject to investment risks, including pos-
foreign banks, supervised by the Federal sible loss of the principal invested.
Reserve. The policy statement does not apply
directly to bank holding companies. However, Moreover, sales activities involving these
the board of directors and management of bank investment products should be designed to mini-
holding companies should consider and admin- mize the possibility of customer confusion and
ister the provisions of the statement with regard to safeguard the institution from liability under
to the holding companys supervision of its the applicable antifraud provisions of the fed-
banking and thrift subsidiaries that offer such eral securities laws, which, among other things,
products to retail customers. Reserve Bank prohibit materially misleading or inaccurate
examiners will continue to review nondeposit representations in connection with the sale of
investment product sales activities during securities.
examinations of institutions engaging in such
The four federal banking agenciesthe
activities on their premises, either directly or
Board of Governors of the Federal Reserve Sys-
through a third party or an affiliate. The review
tem, the Federal Deposit Insurance Corporation,
process will consist of, at a minimum, an assess-
the Office of the Comptroller of the Currency,
ment of whether the interagency statement is
and the Office of Thrift Supervisionissued
being followed, particularly with regard to the
the statement to provide uniform guidance to
nature and sufficiency of an institutions disclo-
depository institutions engaging in these
sures, the separation of functions, and the train-
activities.1
ing of personnel involved with the sales of
mutual funds and other nondeposit products.
(See SR-94-11.)
The interagency policy statement was further 1. Each of the four banking agencies has in the past issued
clarified by a September 12, 1995, joint interpre- guidelines addressing various aspects of the retail sale of
tation (SR-95-46). Section numbers have been nondeposit investment products, which are superseded by this
added for reference. statement. Some of the banking agencies had adopted addi-
tional guidelines covering the sale of certain specific types of
instruments by depository institutions, i.e., obligations of the
institution itself or of an affiliate of the institution.

Page 1
Supervision of Subsidiaries (Financial Institution Subsidiary Retail Sales of Nondeposit Investment Products) 2010.6
2010.6.1.1 Scope acting as professional money managers. Fidu-

ciary accounts administered by an affiliated trust
This statement applies when retail recommenda- company on the depository institutions prem-
tions or sales of nondeposit investment products ises should be treated as fiduciary accounts of
are made by the institution. However, as part of its fiduciary
responsibility, an institution should take appro-
employees of the depository institution; priate steps to avoid potential customer confu-
employees of a third party, which may or may sion when providing nondeposit investment
not be affiliated with the institution,2 occur- products to the institutions fiduciary customers.
ring on the premises of the institution (includ-
ing telephone sales or recommendations by
employees or from the institutions premises
and sales or recommendations initiated by 2010.6.1.2 Adoption of Policies and
mail from its premises); and Procedures
sales resulting from a referral of retail custom-
ers by the institution to a third party when the 2010.6.1.2.1 Program Management
depository institution receives a benefit for
the referral. A depository institution involved in the activi-
ties described above for the sale of nondeposit
Retail sales include (but are not limited to) investment products to its retail customers
sales to individuals by depository institution should adopt a written statement that addresses
personnel or third-party personnel conducted in the risks associated with the sales program and
or adjacent to the institutions lobby area. Sales contains a summary of policies and procedures
of government or municipal securities away outlining the features of the institutions pro-
from the lobby area are not subject to the inter- gram and addressing, at a minimum, the con-
agency statement. The statement also applies to cerns described in this statement. The written
sales activities of an affiliated standalone statement should address the scope of activities
brokerdealer resulting from a referral of retail of any third party involved as well as the proce-
customers from the depository institution to the dures for monitoring compliance by third parties
brokerdealer. in accordance with the guidelines below. The
These guidelines generally do not apply to scope and level of detail of the statement should
the sale of nondeposit investment products to appropriately reflect the level of the institutions
nonretail customers, such as sales to fiduciary involvement in the sale or recommendation of
accounts administered by an institution.3 The nondeposit investment products. The institu-
disclosures provided by the interagency state- tions statement should be adopted and reviewed
ment, however, should be provided to customers periodically by its board of directors. Deposi-
of fiduciary accounts where the customer directs tory institutions are encouraged to consult
investments, such as self-directed IRA accounts. with legal counsel with regard to the implemen-
Such disclosures need not be made to customers tation of a nondeposit investment product sales
program.
The institutions policies and procedures
2. This statement does not apply to the subsidiaries of should include the following:
insured state nonmember banks, which are subject to separate
provisions, contained in 12 C.F.R. 337.4, relating to securities
activities. For OTS-regulated institutions that conduct sales of Compliance procedures. The procedures for
nondeposit investment products through a subsidiary, these ensuring compliance with applicable laws and
guidelines apply to the subsidiary. 12 C.F.R. 545.74 also regulations and consistency with the provisions
applies to such sales. Branches and agencies of U.S. foreign
banks should follow these guidelines with respect to their of this statement.
nondeposit investment sales programs. Supervision of personnel involved in sales.
3. Restrictions on a national banks use as fiduciary of the A designation by senior managers of specific
banks brokerage service or other entity with which the bank individuals to exercise supervisory responsibil-
has a conflict of interest, including purchases of the banks
proprietary and other products, are set out in 12 C.F.R. 9.12. ity for each activity outlined in the institutions
Similar restrictions on transactions between funds held by a policies and procedures.
federal savings association as fiduciary and any person or Types of products sold. The criteria governing
organization with whom there exists an interest that might
affect the best judgment of the association acting in its fidu-
the selection and review of each type of product
ciary capacity are set out in 12 C.F.R. 550.10. sold or recommended.
Permissible use of customer information. The
BHC Supervision Manual July 2009 procedures for the use of information regarding
Page 2 the institutions customers for any purpose in
connection with the retail sale of nondeposit are employees of both the institution and the
investment products. third party.
Designation of employees to sell investment
products. A description of the responsibilities of
those personnel authorized to sell nondeposit 2010.6.1.3 General Guidelines
investment products and of other personnel who
may have contact with retail customers concern- 2010.6.1.3.1 Disclosures and Advertising
ing the sales program, and a description of any
appropriate and inappropriate referral activities The banking agencies believe that recommend-
and the training requirements and compensation ing or selling nondeposit investment products to
arrangements for each class of personnel. retail customers should occur in a manner that
ensures that the products are clearly differenti-
ated from insured deposits. Conspicuous and
2010.6.1.2.2 Arrangements with Third easy-to-comprehend disclosures concerning the
Parties nature of nondeposit investment products and
the risk inherent in investing in these products
If a depository institution directly or indirectly, are one of the most important ways of ensuring
including through a subsidiary or service corpo- that the differences between nondeposit prod-
ration, engages in activities as described above ucts and insured deposits are understood.
under which a third party sells or recommends
nondeposit investment products, the institution
should, prior to entering into the arrangement, 2010.6.1.3.1.1 Content and Form of
conduct an appropriate review of the third party. Disclosure
The institution should have a written agreement
with the third party that is approved by the Disclosures with respect to the sale or recom-
institutions board of directors. Compliance with mendation of these products should, at a mini-
the agreement should be periodically monitored mum, specify that the product is
by the institutions senior management. At a
minimum, the written agreement should not insured by the FDIC;
not a deposit or other obligation of, or guaran-
describe the duties and responsibilities of each teed by, the depository institution; and
party, including a description of permissible subject to investment risks, including possible
activities by the third party on the institutions loss of the principal amount invested.
premises; terms as to the use of the institu-
tions space, personnel, and equipment; and The written disclosures described above
compensation arrangements for personnel of should be conspicuous and presented in a clear
the institution and the third party; and concise manner. Depository institutions may
specify that the third party will comply with provide any additional disclosures that further
all applicable laws and regulations, and will clarify the risks involved with particular nonde-
act consistently with the provisions of this posit investment products.
statement and, in particular, with the provi-
sions relating to customer disclosures;
2010.6.1.3.1.2 Timing of Disclosure
authorize the institution to monitor the third
party and periodically review and verify that
the third party and its sales representatives The minimum disclosures should be provided to
are complying with its agreement with the the customer
institution;
orally during any sales presentation;
authorize the institution and the appropriate orally when investment advice concerning
banking agency to have access to such records nondeposit investment products is provided;
of the third party as are necessary or appropri- orally and in writing prior to or at the time an
ate to evaluate such compliance; investment account is opened to purchase
require the third party to indemnify the insti- these products; and
tution for potential liability resulting from in advertisements and other promotional
actions of the third party with regard to the materials, as described below.
investment product sales program; and
provide for written employment contracts, sat- BHC Supervision Manual July 2008
isfactory to the institution, for personnel who Page 3
A statement, signed by the customer, should not FDIC-insured

be obtained at the time such an account is no bank guarantee
opened, acknowledging that the customer has may lose value
received and understands the disclosures. Third-
party vendors not affiliated with the depository The logo format should be boxed, set in bold-
institution need not make the minimum disclo- face type, and displayed in a conspicuous man-
sures on confirmations and account statements ner. Radio broadcasts of 30 seconds or less,
that contain the name of the depository institu- electronic signs, and signs, such as banners and
tion as long as the name of the depository insti- posters, when used only as location indicators,
tution is there only incidentally and with a valid need not contain the minimum disclosures. Any
business purpose, and as long as it is clear on third-party advertising or promotional material
the face of the document that the brokerdealer, should clearly identify the company selling the
and not the depository institution, has sold the nondeposit investment product and should not
nondeposit investment products. For investment suggest that the depository institution is the
accounts established prior to the issuance of seller. If brochures, signs, or other written mate-
these guidelines, the institution should consider rial contain information about both FDIC-
obtaining such a signed statement at the time of insured deposits and nondeposit investment
the next transaction. products, these materials should clearly segre-
Confirmations and account statements for gate information about nondeposit investment
such products should contain at least the mini- products from the information about deposits.
mum disclosures if the confirmations or account
statements contain the name or the logo of the
depository institution or an affiliate.4 If a cus- 2010.6.1.3.1.4 Additional Disclosures
tomers periodic deposit account statement
includes account information concerning the Where applicable, the depository institution
customers nondeposit investment products, the should disclose the existence of an advisory or
information concerning these products should other material relationship between the insti-
be clearly separate from the information con- tution or an affiliate of the institution and an
cerning the deposit account and should be intro- investment company whose shares are sold by
duced with the minimum disclosures and the the institution and any material relationship
identity of the entity conducting the nondeposit between the institution and an affiliate involved
transaction. in providing nondeposit investment products. In
addition, where applicable, the existence of any
fees, penalties, or surrender charges should be
2010.6.1.3.1.3 Advertisements and Other disclosed. These additional disclosures should
Promotional Material be made prior to or at the time an investment
account is opened to purchase these products. If
Advertisements and other promotional and sales sales activities include any written or oral repre-
material, written or otherwise, about nondeposit sentations concerning insurance coverage pro-
investment products sold to retail customers vided by any entity other than the FDIC, e.g.,
should conspicuously include at least the mini- the Securities Investor Protection Corporation
mum disclosures discussed above and must not (SIPC), a state insurance fund, or a private
suggest or convey any inaccurate or misleading insurance company, then clear and accurate
impression about the nature of the product or its written or oral explanations of the coverage
lack of FDIC insurance. The minimum disclo- must also be provided to customers when the
sures should also be emphasized in telemarket- representations concerning insurance coverage
ing contacts. A shorter version of the minimum are made, in order to minimize possible confu-
disclosures is permitted in advertisements. The sion with FDIC insurance. Such representations
text of an acceptable logo-format disclosure should not suggest or imply that any alternative
would include the following statements: insurance coverage is the same as or similar to
FDIC insurance.
Because of the possibility of customer confu-
4. These disclosures should be made in addition to any sion, a nondeposit investment product must not
other confirmation disclosures that are required by law or
regulation, e.g., 12 C.F.R. 12 and 344, and 12 C.F.R.
have a name that is identical to the name of the
208.8(k)(3). depository institution. Recommending or selling
a nondeposit investment product with a name
BHC Supervision Manual July 2008 similar to that of the depository institution
Page 4 should only occur pursuant to a sales program
designed to minimize the risk of customer mend securities, the training should be the
confusion. The institution should take appro- substantive equivalent of that required for per-
priate steps to ensure that the issuer of the sonnel qualified to sell securities as registered
product has complied with any applicable representatives.5 Depository institution person-
requirements established by the Securities and nel with supervisory responsibilities should
Exchange Commission regarding the use of receive training appropriate to that position.
similar names. Training should also be provided to employees
of the depository institution who have direct
contact with customers to ensure a basic under-
standing of the institutions sales activities and
2010.6.1.3.2 Setting and Circumstances the policy of limiting the involvement of
employees who are not authorized to sell invest-
Selling or recommending nondeposit invest-
ment products to customer referrals. Training
ment products on the premises of a depository
should be updated periodically and should occur
institution may give the impression that the
on an ongoing basis.
products are FDIC-insured or are obligations of
the depository institution. To minimize cus- Depository institutions should investigate the
tomer confusion with deposit products, sales or backgrounds of employees hired for their non-
recommendations of nondeposit investment deposit investment products sales programs,
products on the premises of a depository institu- including checking for possible disciplinary
tion should be conducted in a physical location actions by securities and other regulators if the
distinct from the area where retail deposits are employees have previous investment industry
taken. Signs or other means should be used to experience.
distinguish the investment sales area from the
retail deposit-taking area of the institution.
However, in the limited situation where physical 2010.6.1.3.4 Suitability and Sales
considerations prevent sales of nondeposit prod- Practices
ucts from being conducted in a distinct area, the
institution has a heightened responsibility to Depository institution personnel involved in
ensure appropriate measures are in place to selling nondeposit investment products must
minimize customer confusion. adhere to fair and reasonable sales practices and
In no case, however, should tellers and other be subject to effective management and compli-
employees, while located in the routine deposit- ance reviews with regard to such practices. In
taking area, such as the teller window, make this regard, if depository institution personnel
general or specific investment recommendations recommend nondeposit investment products to
regarding nondeposit investment products, customers, they should have reasonable grounds
qualify a customer as eligible to purchase such for believing that the specific product recom-
products, or accept orders for such products, mended is suitable for the particular customer
even if unsolicited. Tellers and other employees on the basis of information disclosed by the
who are not authorized to sell nondeposit invest- customer. Personnel should make reasonable
ment products may refer customers to individu- efforts to obtain information directly from the
als who are specifically designated and trained customer regarding, at a minimum, the cus-
to assist customers interested in the purchase of tomers financial and tax status, investment
such products. objectives, and other information that may be
useful or reasonable in making investment
2010.6.1.3.3 Qualifications and Training recommendations to that customer. This infor-
mation should be documented and updated
The depository institution should ensure that its periodically.
personnel who are authorized to sell nondeposit
investment products or to provide investment
advice with respect to such products are ade-
quately trained with regard to the specific prod- 5. Savings associations are not exempt from the definitions
ucts being sold or recommended. Training of broker and dealer in sections 3(a)(4) and 3(a)(5) of
the Securities Exchange Act of 1934; therefore, all securities
should not be limited to sales methods, but sales personnel in savings associations must be registered
should impart a thorough knowledge of the representatives.
products involved, of applicable legal restric-
tions, and of customer-protection requirements. BHC Supervision Manual July 2008
If depository institution personnel sell or recom- Page 5
2010.6.1.3.5 Compensation 2010.6.1.4 Supervision by Banking

Agencies
Depository institution employees, including
tellers, may receive a one-time nominal fee The federal banking agencies will continue to
of a fixed dollar amount for each customer review a depository institutions policies and
referral for nondeposit investment products. procedures governing recommendations and
The payment of this referral fee should not sales of nondeposit investment products, as well
depend on whether the referral results in a as managements implementation and compli-
transaction. ance with such policies and all other applicable
Personnel who are authorized to sell nonde- requirements. The banking agencies will moni-
posit investment products may receive incentive tor compliance with the institutions policies
compensation, such as commissions, for trans- and procedures by third parties that participate
actions entered into by customers. However, in the sale of these products. The failure of a
incentive compensation programs must not be depository institution to establish and observe
structured in such a way as to result in unsuit- appropriate policies and procedures consistent
able recommendations or sales being made to with this statement in connection with sales
customers. activities involving nondeposit investment prod-
ucts will be subject to criticism and appropriate
Depository institution compliance and audit corrective action.
personnel should not receive incentive compen-
sation directly related to results of the nonde-
posit investment sales program.
2010.6.2 SUPPLEMENTARY FEDERAL
RESERVE SUPERVISORY AND
2010.6.1.3.6 Compliance EXAMINATION GUIDANCE
PERTAINING TO THE SALE OF
Depository institutions should develop and UNINSURED NONDEPOSIT
implement policies and procedures to ensure INVESTMENT PRODUCTS
that nondeposit investment product sales activi-
ties are conducted in compliance with applica- The above guidelines contained in the Inter-
ble laws and regulations, the institutions interagency Statement on Retail Sales of Nondeposit
nal policies and procedures, and in a manner Investment Products apply to retail recommen-
consistent with this statement. Compliance pro- dations or sales of nondeposit investment prod-
cedures should identify any potential conflicts ucts made by
of interest and how such conflicts should be
addressed. The compliance procedures should employees of a banking organization,
also provide for a system to monitor customer employees of an affiliated or unaffiliated third
complaints and their resolution. Where applica- party occurring on the premises of the bank-
ble, compliance procedures also should call for ing organization (including telephone sales,
verification that third-party sales are being con- investment recommendations by employees,
ducted in a manner consistent with the govern- and sales or recommendations initiated by
ing agreement with the depository institution. mail from its premises), and
a referral of retail customers by the institution
The compliance function should be conducted
to a third party when the depository institution
independently of nondeposit investment product
receives a benefit for the referral.
sales and management activities. Compliance
personnel should determine the scope and
The following examination procedures are
frequency of their own review, and findings
intended to determine if the banks policies and
of compliance reviews should be periodically
procedures provide for an operating environ-
reported directly to the institutions board of
ment that is designed to ensure customer protec-
directors, or to a designated committee of the
tions in all facets of the sales program. Further-
board. Appropriate procedures for the non-
more, examiners are expected to assess the
deposit investment product program should
banks ability to conduct such sales activities in
also be incorporated into the institutions audit
a safe and sound manner.
program.
These procedures apply when reviewing the
nondeposit investment product retail sales
activities conducted by state member banks or
BHC Supervision Manual July 2008 the state-licensed U.S. branches or agencies of
Page 6 foreign banks. They also apply to such activities
conducted by a bank holding company nonbank customers, examiners should apply these exami-
subsidiary on the premises of a bank.6 nation procedures when retail customers are
The Rules of Fair Practice of the Financial directed to the banks trust department where
Industry Regulatory Authority (FINRA) govern they may purchase nondeposit investment
sales of securities by its member brokerdealers. products simply by completing a customer
In addition, the federal securities laws prohibit agreement.
materially misleading or inaccurate representa- For additional information on the subject of
tions in connection with the offer or sale of retail sales of nondeposit investment products,
securities7 and require that sales of registered examiners and other interested parties may find
securities be accompanied by a prospectus that it helpful to refer to Retail Investment Sales
complies with Securities and Exchange Com- Guidelines for Banks, February 1994 (industry
mission (SEC) disclosure requirements. guidelines), published collectively by six bank
In view of the existence of these securities trade associations and available from the Ameri-
rules and laws that are applicable to broker can Bankers Association, 1120 Connecticut
dealers subject to supervision by the SEC and Avenue, N.W., Washington, D.C. 20036.
the FINRA, examiners should note that the
examination procedures contained herein have
been tailored to avoid duplication of examina-
tion efforts by relying on the most recent exami- 2010.6.2.1 Program Management
nation results or sales-practice review conducted
by the FINRA and provided to the third party. Banking organizations must adopt policies and
To the extent that no such FINRA examinations procedures governing nondeposit investment
or reviews have been completed within the product retail sales programs. Such policies and
last two years, Reserve Banks should consult procedures should be in place before the com-
with Board staff to determine an appropriate mencement of the retail sale of nondeposit
examination/inspection scope before proceeding investment products on bank premises.
further. The board of directors of a banking organiza-
Notwithstanding Reserve System use of tion is responsible for ensuring that retail sales
FINRA results of sales-practice reviews, exam- of nondeposit investment products comply with
iners should still complete the balance of these the interagency statement (see section 2010.6.1)
examination procedures, particularly those per- and all applicable state and federal laws and
taining to the separation of sales of nondeposit regulations. Therefore, the board or a designated
investment products from the deposit-taking committee of the board should adopt written
activities of the bank. Examiners should deter- policies that address the risks and management
mine whether the institution has adequate poli- of such sales programs. Policies and procedures
cies and procedures to govern the conduct of the should reflect the size, complexity, and volume
sales activities on a banks premises and, in of the institutions activities or, when applica-
particular, whether sales of nondeposit invest- ble, address the institutions arrangements with
ment products are distinguished from the any third parties selling such products on bank
deposit-taking activities of the bank through premises. The banking organizations policies
disclosure and physical means that are designed and procedures should be reviewed periodically
to prevent customer confusion. by the board of directors or its designated com-
Although the interagency statement does not mittee to ensure that the policies are consistent
apply to sales of nondeposit investment prod- with the institutions current practices, applica-
ucts to nonretail customers, such as fiduciary ble laws, regulations, and guidelines.
As discussed in more detail below, an institu-
6. The interagency statement and the majority of these
tions policies and procedures for nondeposit
examination procedures apply to all depository institutions. investment products should, at a minimum,
Many of the procedures, however, may not apply directly to address disclosure and advertising, physical
the inspection of bank holding companies. Some procedures separation of investment sales from deposit-
may be applicable to bank holding companies from the per-
spective of inspecting a bank holding company with regard to
taking activities, compliance and audit, suitabil-
its responsibility to supervise its depository institution and ity, and other sales practices and related risks
holding company nonbank subsidiaries. Depository institution associated with such activities. In addition, poli-
examination procedures and bank holding company inspec- cies and procedures should address the follow-
tion procedures have been included in this section to keep
bank holding company examiners fully informed.
ing areas.
7. See, for example, section 10(b) of the Securities
Exchange Act (15 U.S.C. 78j(b)) and rule 10b-5 (17 C.F.R. BHC Supervision Manual July 2008
240.10b-5) thereunder. Page 7
2010.6.2.1.1 Types of Products Sold the customers prior acknowledgment and writ-
ten consent.
When evaluating nondeposit investment prod-
ucts, management should consider what prod- 2010.6.2.1.4 Arrangements with Third
ucts best meet the needs of customers. Policies Parties
should outline the criteria and procedures that
will be used to select and periodically review A majority of all nondeposit investment prod-
nondeposit investment products that are recom- ucts sold on bank premises are sold by represen-
mended or sold on a depository institutions tatives of third parties. Under such arrange-
premises. Institutions should periodically review ments, the third party has access to the
products offered to ensure that they meet their institutions customers, while the bank is able to
customers needs. make nondeposit investment products available
to interested customers without having to com-
2010.6.2.1.2 Use of Identical or Similar mit the resources and personnel necessary to
Names directly sell such products. Third parties include
wholly owned subsidiaries of a bank, bank-
Because of the possibility of customer confu- affiliated brokerdealers, unaffiliated broker
sion, a nondeposit investment product must not dealers, insurance companies, or other compa-
have a name that is identical to the name of a nies in the business of distributing nondeposit
bank or its affiliates. However, a bank may sell a investment products on a retail basis.
nondeposit investment product with a name A banking institution should conduct a com-
similar to the banks as long as the sales pro- prehensive review of an unaffiliated third party
gram addresses the even greater risk that cus- before entering into any arrangement. The
tomers may regard the product as an insured review should include an assessment of the third
deposit or other obligation of the bank. More- partys financial status, management experience,
over, the bank should review the issuers dis- reputation, and ability to fulfill its contractual
closure documents for compliance with SEC obligations to the bank, including compliance
requirements, which call for a thorough explana- with the interagency statement.
tion of the relationship between the bank and The interagency statement calls for banks to
the mutual fund. enter into written agreements with any affiliated
The Federal Reserve applies a stricter rule and unaffiliated third parties that sell nondeposit
under Regulation Y (12 C.F.R. 225.125) when a investment products on a banks premises. Such
bank holding company (as opposed to a bank) agreements should be approved by a banks
or nonbank subsidiary acts as an investment board of directors or its designated committee.
adviser to a mutual fund. In such a case, the Agreements should outline the duties and
fund may not have a name that is identical to, responsibilities of each party; describe third-
similar to, or a variation of the name of the bank party activities permitted on bank premises;
holding company or a subsidiary bank. address the sharing or use of confidential cus-
tomer information for investment sales activi-
ties; and define the terms for use of the institu-
2010.6.2.1.3 Permissible Use of tions office space, equipment, and personnel. If
Customer Information an arrangement includes dual employees, the
agreement must provide for written employment
Banking organizations should adopt policies and contracts that specify the duties of such employ-
procedures regarding the use of confidential cus- ees and their compensation arrangements.
tomer information for any purpose in connec- In addition, a third-party agreement should
tion with the sale of nondeposit investment specify that the third party will comply with all
products. The industry guidelines permit banks applicable laws and regulations and will con-
to share with third parties only limited customer duct its activities in a manner consistent with
information, such as name, address, telephone the interagency statement. The agreement
number, and types of products owned. It does should authorize the bank to monitor the third
not permit the sharing of more confidential partys compliance with its agreement, and
information, such as specific or aggregate dollar authorize the institution and Federal Reserve
amounts of investments, net worth, etc., without examination staff to have access to third-party
records considered necessary to evaluate such
BHC Supervision Manual July 2008 compliance. These records should include
Page 8 examination results, sales-practice reviews, and
related correspondence provided to the third They are subject to investment risks, includ-
party by securities regulatory authorities. ing the possible loss of the principal invested.
Finally, an agreement should provide for indem-
nification of the bank by an unaffiliated third Disclosure is the most important way of
party for the conduct of its employees in ensuring that retail customers understand the
connection with sales activities. differences between nondeposit investment
Notwithstanding the provisions of a third- products and insured deposits. It is critical that
party agreement, a bank should monitor the the minimum disclosures be presented clearly
conduct of nondeposit investment product sales and concisely in both oral and written communi-
programs to ensure that sales of nondeposit cations. In this regard, the minimum disclosures
investment products are distinct from other bank should be provided
activities and are not conducted in a manner that
could confuse customers about the lack of insur- orally during any sales presentations (includ-
ance coverage for such investments. ing telemarketing contacts) or when invest-
ment advice is given,
orally and in writing before or at the time an
2010.6.2.1.5 Contingency Planning investment account to purchase these prod-
ucts is opened, and
Nondeposit investment products are subject to
price fluctuations caused by changes in interest in all advertisements and other promotional
rates, stock market valuations, etc. In the event materials (as discussed further below).
of a sudden, sharp drop in the market value of
nondeposit investment products, banking insti- The minimum disclosures may be made on a
tutions may experience a heavy volume of cus- customer-account agreement or on a separate
tomer inquiries, complaints, and redemptions. disclosure form. The disclosures must be con-
Management should develop contingency plans spicuous (highlighted through bolding, boxes,
to address these situations. A major element of or a larger typeface). Disclosures contained
any contingency plan should be the provision of directly on a customer-account agreement
customer access to information pertaining to should be located on the front of the agreement
their investments. Other factors to consider in or adjacent to the customer signature block.
contingency planning include public relations Banking organizations are to obtain a written
and the ability of operations staff to handle acknowledgmenton the customer-account
increased volumes of transactions. agreement or on a separate formfrom a cus-
tomer confirming that the customer has received
and understands the minimum disclosures. For
2010.6.2.2 Disclosures and Advertising nondeposit investment product accounts estab-
lished before the interagency statement, bank-
2010.6.2.2.1 Content, Form, and Timing ing organizations should obtain a disclosure
of Disclosure acknowledgment from the customer at the time
of the customers next purchase transaction. If
Nondeposit investment product sales programs an institution solicits customers by telephone or
should be conducted in a manner that ensures mail, it should ensure that the customers receive
that customers are clearly and fully informed of the written disclosures and an acknowledgment
the nature and risks associated with these prod- to be signed and returned to the institution.
ucts. In addition, nondeposit investment prod- Customer-account statements (including com-
ucts must be clearly differentiated from insured bined statements for linked accounts) and trade
deposits. The interagency statement identifies confirmations that are provided by the bank or
the following minimum disclosures that must be an affiliate should contain the minimum disclo-
made to customers when providing investment sures if they display the name or logo of the
advice, making investment recommendations, bank or its affiliate. Statements that provide
or effecting nondeposit investment product account information about insured deposits and
transactions: nondeposit investment products should clearly
segregate the information about nondeposit
They are not insured by the Federal Deposit investment products from the information about
Insurance Corporation (FDIC). deposits to avoid customer confusion.
They are not deposits or other obligations of
the depository institution and are not guaran- BHC Supervision Manual July 2008
teed by the depository institution. Page 9
2010.6.2.2.2 Advertising state insurance fund, or a private insurance

company), then clear and accurate explanations
The interagency statement provides that adver- of the coverage must also be provided to cus-
tisements in all media forms that identify tomers at that time to minimize possible con-
specific investment products must conspicu- fusion with FDIC insurance. Such disclosures
ously include the minimum disclosures and should not suggest that other forms of insurance
must not suggest or convey any inaccurate or are the substantive equivalent to FDIC deposit
misleading impressions about the nature of a insurance.
nondeposit investment product. Promotional
material that contains information about both
FDIC-insured products and nondeposit invest- 2010.6.2.3 Setting and Circumstances
ment products should clearly segregate the
information about the two product types. Dis- 2010.6.2.3.1 Physical Separation from
plays of promotional sales materials related to Deposit Activities
nondeposit investment products in a banks
retail areas should be grouped separately from Selling or recommending nondeposit invest-
material related to insured bank products. ment products on the premises of a banking
Examiners should review telemarketing institution may give the impression that the
scripts to determine whether bank personnel are products are FDIC-insured or are obligations of
making inquiries about customer investment the bank. To minimize customer confusion with
objectives, offering investment advice, or identi- deposit products, nondeposit investment prod-
fying particular investment products or types of uct sales activities should be conducted in a
products. In such cases, the scripts must contain location that is physically distinct from the areas
the minimum disclosures. Bank personnel rely- where retail deposits are taken. Bank employees
ing on the scripts must be formally authorized to located at teller windows may not provide
sell nondeposit investment products by their investment advice, make investment recommen-
employers and must have training that is the dations about investment products, or accept
substantive equivalent of that required for per- orders (even unsolicited orders) for nondeposit
sonnel qualified to sell securities as registered investment products.
representatives (see the discussion on training Examiners must evaluate the particular cir-
below). cumstances of each bank in order to form an
opinion about whether nondeposit investment
product sales activities are sufficiently separate
2010.6.2.2.3 Additional Disclosures from deposit activities. FDIC insurance signs
and promotional material related to FDIC-
A depository institution should apprise cus- insured deposits should be removed from the
tomers of certain material relationships. For investment-product sales area and replaced with
example, sales personnel should inform a signs indicating that the area is for the sale of
customer orally and in writing before the sale investment products. Signs referring to specific
about any advisory relationship existing be- investments should prominently contain the
tween the bank (or an affiliate) and a mutual minimum disclosures. In the limited situation
fund whose shares are being sold by the depos- where physical constraints prevent nondeposit
itory institution. Similarly, sales personnel investment product sales activities from being
should disclose fees, penalties, or surrender conducted in a distinct and separate area, the
charges associated with a nondeposit invest- institution has a heightened responsibility to
ment product orally and in writing before or ensure that appropriate measures are taken to
at the time the customer purchases the prod- minimize customer confusion.
uct. The SEC requires written disclosure of A bank that enters into a third-party broker-
this information in the investment products age arrangement with a broker or dealer regis-
prospectus. tered under the Securities Exchange Act of 1934
If sales activities include any written or oral (the 1934 Act) will not itself be considered to be
representations concerning insurance coverage a broker subject to registration under the 1934
by any entity other than the FDIC (for example, Act if the bank complies with the nine require-
Securities Investor Protection Corporation ments set forth in section 3(a)(4)(B) of the 1934
(SIPC) insurance of brokerdealer accounts, a Act. These requirements include clear identifi-
cation of the broker or dealer as the person
BHC Supervision Manual July 2008 providing the brokerage services; clear physical
Page 10 separation of deposit-taking activities from bro-
kerage transactions; prohibition of bank employ- 2010.6.2.4 Designation, Training, and

ees receiving incentive compensation based on Supervision of Sales Personnel and
brokerage transactions; limitation of bank Personnel Making Referrals
employees to clerical or ministerial functions
with respect to brokerage transactions; and spe- 2010.6.2.4.1 Hiring and Training of Sales
cific disclosures and other requirements. Failure Personnel
by a bank to comply with these requirements
will not automatically require the bank to regis- Banking organizations hiring sales personnel for
ter but brings into question the exemption of the nondeposit investment product programs should
bank from the registration requirements of the investigate the backgrounds of prospective
1934 Act. employees. In cases in which candidates for
Business cards for designated sales personnel employment have previous investment industry
should clearly indicate that they sell nondeposit experience, the bank should check whether the
investment products or, if applicable, are individual has been the subject of any disci-
employed by a brokerdealer. plinary actions by securities, state, or other
The interagency statement was intended to regulators.
generally cover sales made to retail customers Unregistered bank sales personnel should
in a banks lobby. However, some banks may receive training that is the substantive equiva-
have an arrangement whereby retail customers lent of that provided to personnel qualified to
purchase nondeposit investment products at a sell securities as registered representatives.
location generally confined to institutional ser- Training should cover the areas of product
vices (such as the corporate money desk). In knowledge, trading practices, regulatory
such cases, the banking institutions should still requirements and restrictions, and customer-
ensure that retail customers receive the mini- protection issues. In addition, training programs
mum disclosures to minimize any possible cus- should cover the institutions policies and proce-
tomer confusion about nondeposit investment dures regarding sales of nondeposit investment
products and insured deposits. products and should be conducted continually to
ensure that staff are kept abreast of new prod-
ucts and compliance issues.
2010.6.2.3.2 Hybrid Instruments and Bank employees whose sales activities are
Accounts limited to mutual funds or variable annuities
should receive training equivalent to that ordi-
In cases in which a depository institution offers narily needed to pass FINRAs Series 6 limited
accounts that link traditional bank deposits with representative examination, which typically
nondeposit investment products, such as a cash involves approximately 30 to 60 hours of prepa-
management account,8 the accounts should be ration, including about 20 hours of classroom
opened at the investment sales area by trained training. Bank employees who are authorized to
personnel. In light of the hybrid characteristics sell additional investment products and securi-
of these products, the opportunity for customer ties should receive training that is appropriate to
confusion is amplified, so the depository institu- pass the NYSEs Series 7 general securities
tion must take special care in the account- representative examination, which typically
opening process to ensure that a customer is involves 160 to 250 hours of study, including at
accurately informed that least 40 hours of classroom training.
The training of third-party or dual employees
is the responsibility of the third party. When
funds deposited into a sweep account will entering into an agreement with a third party, a
only be FDIC-insured until they are swept banking organization should be satisfied that the
into a nondeposit investment product account third party is able to train third-party and dual
and employees about compliance with the minimum
customer-account statements may disclose disclosures and other requirements of the
balances for both insured and nondeposit interagency statement. The bank should obtain
product accounts. and review copies of third-party training and
compliance materials in order to monitor the
third partys performance regarding its training
obligations.
8. A hybrid account may incorporate deposit and broker-
age services, credit/debit card features, and automated sweep BHC Supervision Manual July 2008
arrangements. Page 11
2010.6.2.4.2 Training of Bank Personnel are conducted by a third party, supervisory per-
Who Make Referrals sonnel should be responsible for monitoring
compliance with the agreement between the
Bank employees, such as tellers and platform bank and the third party, as well as compliance
personnel, who are not authorized to provide with the interagency statement, particularly the
investment advice, make investment recommen- guideline calling for nondeposit investment
dations, or sell nondeposit investment products product sales to be separate and distinct from
but who may refer customers to authorized the deposit activities of the bank.
nondeposit investment products sales personnel,
should receive training regarding the strict limi-
tations on their activities. In general, bank per- 2010.6.2.5 Suitability and Sales Practices
sonnel who are not authorized to sell nondeposit
investment products are not permitted to dis- 2010.6.2.5.1 Suitability of
cuss general or specific investment products, Recommendations
prequalify prospective customers as to financial
status and investment history and objectives, Suitability refers to the matching of customer
open new accounts, or take orders on a solicited financial means and investment objectives with
or unsolicited basis. Such personnel may con- a suitable product. If customers are placed into
tact customers for the purposes of unsuitable investments, the resulting loss of con-
sumer confidence could have detrimental effects
determining whether the customer wishes to on an institutions reputation. Many first-time
receive investment information; investors may not fully understand the risks
inquiring whether the customer wishes to associated with nondeposit investment products
discuss investments with an authorized sales and may assume that the banking institution is
representative; and responsible for the preservation of the principal
arranging appointments to meet with autho- of their investment.
rized bank sales personnel or third-party Banking institutions that sell nondeposit
brokerdealer registered sales personnel. investment products directly to customers
should develop detailed policies and proce-
The minimum disclosure guidelines do not dures addressing the suitability of investment
apply to referrals made by personnel not autho- recommendations and related record-keeping
rized to sell nondeposit investment products if requirements. Sales personnel who recommend
the referral does not provide investment advice, nondeposit investment products to customers
identify specific investment products, or make should have reasonable grounds for believing
investment recommendations. that the products recommended are suitable
for the particular customer on the basis of infor-
mation provided by the customer. A reasonable
2010.6.2.4.3 Supervision of Personnel effort must be made to obtain, record, and
update information concerning the customers
Banking institution policies and procedures financial profile (such as tax status, other
should designate, by title or name, the indi- investments, income), investment objectives,
viduals responsible for supervising nondeposit and other information necessary to make
investment product sales activities, as well as recommendations.
referral activities initiated by bank employees In determining whether sales personnel are
not authorized to sell these products. Personnel
meeting their suitability responsibilities, exam-
assigned responsibility for management of sales
iners should review the practices for conform-
programs for these products should have super-
ance with the banking institutions policies and
visory experience and training equivalent to that
procedures. The examiners review should
required of a general securities principal as
required by the FINRA for brokerdealers. include a sample of customer files to determine
Supervisory personnel should be responsible for the extent of customer information collected,
the institutions compliance with policies and recorded, and updated (for subsequent pur-
procedures on nondeposit investment products, chases), and whether investment recom-
applicable laws and regulations, and the inter- mendations appear unsuitable in light of such
agency statement. When sales of these products information.
Nondeposit investment product sales pro-
BHC Supervision Manual July 2008 grams conducted by third-party brokerdealers
Page 12 are subject to FINRAs suitability and other
sales-practice rules. To avoid duplicating 1987). Compensation policies should establish

FINRA examination efforts, examiners should appropriate limits on the extent of compensa-
rely on FINRAs most recent sales-practice tion that may be paid to banking organization
review of the third party, when available. To staff by unaffiliated third parties.
the extent that no such FINRA review has Incentive compensation programs must not
been completed within the last two years, be structured in such a way as to result in
Reserve Banks should consult with Board staff unsuitable investment recommendations or sales
to determine an appropriate examination scope to customers. In addition, if sales personnel sell
for suitability compliance before proceeding both deposit and nondeposit products, similar
further. financial incentives should be in place for sales
of both types of products. A compensation pro-
gram that offers significantly higher remunera-
2010.6.2.5.2 Sales Practices tion for selling a specific product (for example,
a proprietary mutual fund) may be inappropriate
The banking organization should have policies if it results in unsuitable recommendations to
and procedures that address undesirable prac- customers. A compensation program that is
tices by sales personnel intended to generate intended to provide remuneration for a group of
additional commission income through the bank employees (such as a branch or depart-
churning or switching of accounts from one ment) is permissible as long as the program is
product to another. based on the overall performance of the group
in meeting bank objectives regarding a broad
variety of bank services and products, and is not
based principally on the volume of sales on
2010.6.2.5.3 Customer Complaints
nondeposit investment products.
The banking organization should have policies Individual bank employees, such as tellers,
and procedures for handling customer com- may receive a one-time nominal fee of a fixed
plaints related to nondeposit investment prod- dollar amount for referring customers to autho-
ucts. The process should provide for the record- rized sales personnel to discuss nondeposit
ing and tracking of all complaints and require investment products. However, the payment of
periodic reviews of complaints by compliance the fee should not depend on whether the refer-
personnel. The merits and circumstances of each ral results in a transaction. Nonmonetary com-
complaint (including all documentation relating pensation to bank employees for referrals should
to the transaction) should be considered when be similarly structured.
determining the proper form of resolution. Auditors and compliance personnel should
Reasonable timeframes should be established not participate in incentive compensation pro-
for addressing complaints. grams directly related to the results of non-
deposit investment product sales programs.
2010.6.2.6 Compensation 2010.6.2.7 Compliance

Incentive compensation programs specifically Institutions must develop and maintain written
related to the sale of nondeposit investment policies and procedures that effectively monitor
products may include sales commissions, and assess compliance with the interagency
limited fees for referring prospective cus- statement and other applicable laws and regula-
tomers to an authorized sales representative, and tions and ensure appropriate follow-up to cor-
nonmonetary compensation (prizes, awards, and rect identified deficiencies. Compliance pro-
gifts). Compensation that is paid by unaffili- grams should be independent of sales activities
ated third parties (such as mutual fund distribu- with respect to scheduling, compensation, and
tors) to banking organization staff must be performance evaluations. Compliance personnel
approved in writing by bank management; be should periodically report compliance findings
consistent with the banks written internal code to the institutions board of directors or a desig-
of conduct relating to the acceptance of nated committee of the board as part of the
remuneration from third parties; and be boards ongoing oversight of nondeposit invest-
consistent with the proscriptions of the Bank ment product activities. Compliance personnel
Bribery Act (18 U.S.C. 215) and the banking
agencies implementing guidelines to that act BHC Supervision Manual July 2009
(see 52 Federal Register 39277, October 21, Page 13
should have appropriate training and experience to the board of directors or a designated commit-
with nondeposit investment product sales pro- tee of the board, and proper follow-up should be
grams, applicable laws and regulations, and the performed. Audit activities with respect to third
interagency statement. parties should include a review of their compli-
Banking organizations should institute com- ance function and the effectiveness of the banks
pliance programs for nondeposit investment oversight of the third partys activities.
products that are similar to those of securities
brokerdealers. This includes a review of new
accounts and a periodic review of transactions 2010.6.2.9 Joint Interpretations of the
in existing accounts to identify any potential Interagency Statement
abusive practices, such as unsuitable recommen-
dations or churning or switching practices. In response to a banking associations inquiry,
Compliance personnel should also oversee the the banking supervisory agencies issued on Sep-
prompt resolution of customer complaints and tember 12, 1995, joint interpretations regarding
review complaint logs for questionable sales the February 1994 Interagency Statement on
practices. Compliance personnel should use Retail Sales of Nondeposit Investment Products
MIS reports on early redemptions and sales by banking and thrift organizations, previously
patterns for specific sales representatives and discussed. The agencies also authorized the use
products to identify any potentially abusive of alternative abbreviated minimum disclosures
practices. In addition, referral activities of bank for advertisements. The alternative minimum
personnel should be reviewed to ensure that disclosures need not be made at all in certain
they are conducted in a manner that conforms to types of advertisements. The use of abbreviated
the guidelines in the interagency statement. disclosures offers an optional alternative to the
When nondeposit investment products are longer disclosures prescribed by the interagency
sold by third parties on bank premises, the statement.
banks compliance program should provide for
oversight of the third partys compliance with
its agreement with the bank, including conform- 2010.6.2.9.1 Disclosure Matters
ance to the disclosure and separate facilities
guidelines of the interagency statement. The The agencies agreed that there are limited situa-
results of such oversight should be reported to tions in which the disclosure guidelines need
the board of directors or to a designated commit- not apply or where a shorter logo format may be
tee of the board. Management should promptly used in lieu of the longer written disclosures
obtain the third partys commitment to correct called for by the interagency statement.
identified problems. Proper follow-up by the The interagency statement disclosures do not
banks compliance personnel should verify the need to be provided in the following situations:
third partys corrective actions.
radio broadcasts of 30 seconds or less
electronic signs 9
2010.6.2.8 Audit signs, such as banners and posters, when used
only as location indicators
Audit personnel should be responsible for
assessing the effectiveness of the depository Additionally, third-party vendors not affili-
institutions compliance function and overall ated with the depository institution need not
management of the nondeposit investment prod- make the interagency statement disclosures on
uct sales program. The scope and frequency of nondeposit investment product confirmations
audits review of nondeposit investment product and in account statements that may incidentally,
activities will depend on the complexity and with a valid business purpose, contain the name
sales volume of a sales program, and whether of the depository institution.
there are any indications of potential or actual The banking agencies have been asked
problems. Audits should cover all of the issues whether shorter, logo-format disclosures may be
discussed in the interagency statement. Internal used in visual media, such as television broad-
audit staff should be familiar with nondeposit casts, ATM screens, billboards, signs, and post-
investment products and receive ongoing train-
ing. Audit personnel should report their findings 9. Electronic signs may include billboard-type signs
that are electronic, time and temperature signs, and ticker-tape
BHC Supervision Manual July 2009 signs. Electronic signs would not include media such as
Page 14 television, online services, or ATMs.
ers, and in written advertisements and promo- ment of the Treasury, the SEC, and designated
tional materials, such as brochures. The text of securities self-regulatory organizations.
an acceptable logo-format disclosure would Fiduciary accounts, affiliated trust com-
include the following statements: panies, and custodian accounts. The
interagency statement generally does not
not FDIC-insured apply to fiduciary accounts administered by a
no bank guarantee depository institution. However, for fiduciary
may lose value accounts in which the customer directs invest-
ments, such as self-directed individual retire-
The logo-format disclosures would be boxed, ment accounts, the disclosures prescribed by
set in boldface type, and displayed in a con- the interagency statement should be provided.
spicuous manner. The full disclosures prescribed Nevertheless, disclosures need not be made to
by the interagency statement should continue to customers acting as professional money
be provided in written acknowledgment forms managers. Fiduciary accounts administered by
that are signed by customers. An example of an an affiliated trust company on the depository
acceptable logo disclosure is institutions premises would be treated the
same way as the fiduciary accounts of the
institution.
With respect to custodian accounts main-
tained by a depository institution, the inter-
May lose
NOT value
agency statement does not apply to traditional
custodial activities, for example, collecting
FDIC- No bank
interest and dividend payments for securities
held in the accounts or handling the delivery
INSURED guarantee or collection of securities or funds in connec-
tion with a transaction.
Affiliated standalone brokerdealers. The
statement applies specifically to sales of non-
deposit investment products on the premises
2010.6.2.9.2 Joint Interpretations on of a depository institution, for example, when-
Retail Sales of Nondeposit Investment ever sales occur in the lobby area. The state-
Products ment also applies to sales activities of an
affiliated standalone brokerdealer resulting
The banking agencies joint statement also from a referral of retail customers by the
addressed the following: depository institution to the brokerdealer.
Sales from lobby area presumed retail. Retail

sales include (but are not limited to) sales to 2010.6.3 INSPECTION/EXAMINATION
individuals by depository institution person- OBJECTIVES
nel or third-party personnel conducted in or
adjacent to a depository institutions lobby 1. To determine that the banking organization
area. Sales activities occurring in another has taken appropriate measures to ensure that
location of a depository institution may also retail customers clearly understand the differ-
be retail sales activities covered by the inter- ences between insured deposits and non-
agency statement depending on the facts and deposit investment products and receive the
circumstances. minimum disclosures both orally during sales
Government or municipal securities dealers presentations (including telemarketing) and
or desks. Sales of government and muni- in writing.
cipal securities made in a depository institu- 2. To assess the adequacy of the institutions
tions dealer department that is located away policies and procedures, sales practices, and
from the lobby area are not subject to the oversight by management and the board of
interagency statement. Such departments are directors to ensure an operating environment
already regulated by the banking agencies and that fosters customer protection in all facets
are subject to the statutory requirements for of the sales program.
registration of government and municipal 3. To ensure that the sales program is con-
securities brokers and dealers. Further, such
brokers and dealers are subject to sales- BHC Supervision Manual July 2008
practice and other regulations of the Depart- Page 15
ducted in a safe and sound manner that is in unaffiliated third party. Identify the princi-
compliance with the interagency statement, pals responsible for the management of the
Federal Reserve guidelines, regulations, and nondeposit investment products sales pro-
applicable laws. gram. Review their backgrounds, qualifica-
4. To assess the effectiveness of the institutions, and tenure with the institution.
tions compliance and audit programs for 2. Determine the role of the board of directors
nondeposit investment product operations. of each legal entity involved in the sale of
5. To obtain commitments for corrective action nondeposit investment products in authoriz-
when policies, procedures, practices, or man- ing and controlling nondeposit investment
agement oversight is deficient or the institu- products activities on bank premises. Evalu-
tion has failed to comply with the inter- ate the adequacy of MIS reports relied on
agency statement or applicable laws and by the board (or a designated committee)
regulations. and senior management to manage these
activities.
3. Describe the membership and responsibili-
2010.6.4 INSPECTION/EXAMINATION ties of management or board committees
PROCEDURES for nondeposit investment product retail
sales programs. Review the minutes main-
2010.6.4.1 Scope of the Procedures tained by these committees for information
related to the conduct of retail nondeposit
These procedures are based on the guidelines investment product sales programs.
outlined in the interagency statement. The 4. Review and evaluate the institutions poli-
interagency statement applies to all banking cies and procedures, objectives, and budget
organizations, including state member banks for nondeposit investment products activi-
and the U.S. branches and agencies of foreign ties. In so doing, consider the following:
banks supervised by the Federal Reserve. a. who prepared the material
These examination procedures are intended to b. how it fits into the institutions overall
be used when examining a state member bank strategic objectives
(or a state-licensed U.S. branch or agency of a c. whether the goals and objectives are
foreign bank) that engages directly in the retail realistic
sale of nondeposit investment products. d. whether actual results are routinely com-
This set of examination procedures is also pared to plans and budgets
meant to be used in conjunction with other 5. Determine how policies and procedures for
procedures in this manual when examining a nondeposit investment products activities
nonbank subsidiary that sells nondeposit invest- are developed and at what level in the insti-
ment products on bank premises. See the follow- tution they are formally approved. Review
ing sections for related examination procedures: the policies and procedures to see that they
are consistent with the interagency state-
Section 3130.1: Section 4(c)(8) of the BHC ment and address the following matters:
ActInvestment or Financial Advisers a. disclosure and advertising
Section 3230.0: Section 4(c)(8) of the BHC b. physical separation from deposit-taking
ActSecurities Brokerage activities
Section 3600.27: Providing Administrative c. compliance programs and internal audit
and Certain Other Services to Mutual Funds d. hiring, training, supervision, and com-
pensation practices for sales staff and
personnel making referrals
Program Management and Organization e. types of products offered, selection
criteria
1. Evaluate the institutions structure and
f. restrictions on a mutual funds use of
reporting lines (legal and functional) for
names similar or identical to that of the
its retail nondeposit investment products
bank holding company or its subsidiary
operations. Determine whether retail sales
banks
of nondeposit investment products are being
made directly by employees of the deposi- g. suitability and sales practices
tory institution or through an affiliated or h. use of customer information
i. transactions with affiliated parties
BHC Supervision Manual July 2008 j. role of third parties, if applicable
Page 16 6. Determine how management oversees com-
pliance with the policies and procedures in telemarketing contacts) or when giving
item 5. investment advice on specific investment
7. Review the product selection and develop- products.
ment process to ensure that it considers 13. Determine if the customer-account agree-
customer needs and investment objectives. ment (or a separate disclosure form)
8. Determine if the depository institution is presents the minimum disclosures clearly
covered by blanket bond insurance applica- and conspicuously. The disclosures should
ble to nondeposit investment product retail be prominent (highlighted through bold-
sales activities. ing, boxes, or a larger typeface) and should
9. If the institution sells proprietary nonde- be located on the front of the customer-
posit investment products and performs account agreement or adjacent to the cus-
related back-office operations, review tomer signature block.
a. the work flow and position responsibili- 14. Determine whether customers sign an
ties within the sales and operations func- acknowledgment that they have received
tion, and and understand the minimum disclosures.
b. available flow charts, job descriptions, The acknowledgment can be on the
and policies and procedures. customer-account agreement or it can be on
After discussions with management, a separate disclosure form. Determine if
conduct a walk-through, tracing the path customers who opened accounts before the
of a typical transaction. Evaluate the interagency statement was issued receive
effectiveness and efficiency of the work the written minimum disclosures and
flow and the overall operation. acknowledge receipt at the time of their
10. Determine whether the institution has next transaction. Review a sample of cus-
established any contingency plans for han- tomer accounts to determine whether cus-
dling adverse events affecting nondeposit tomers received the minimum oral and
investment product programs, such as a written disclosures.
sudden market downturn or period of heavy 15. When sales confirmations or account state-
redemptions. ments provided by the bank or an affiliate
11. Review the institutions earnings and evalu- bear the name or logo of the bank or an
ate the affiliate, determine whether the minimum
a. profitability of nondeposit investment disclosures are conspicuously displayed on
products activities, including any invest- the front of the documents.
ment advisory fees it may receive, and 16. Review advertisements and promotional
b. income and expense from the sales, material that identify specific nondeposit
investment advisory, and proprietary investment products to determine whether
fund management activities related to they conspicuously display the minimum
nondeposit investment products, as a disclosures or the abbreviated logo-format
percentage of non-interest income and disclosures. Any materials that contain
expense. information about insured deposits and non-
deposit investment products should clearly
segregate the information about investment
Disclosures and Advertising products from the information about
deposits.
The interagency statement identifies certain 17. Review telemarketing material used to
minimum disclosures that must be made to cus- solicit new business. To the extent that
tomers. The disclosures must state that non- employees identify specific products, seek
deposit investment products customer investment objectives, make
investment recommendations, or give
are not insured by the FDIC; investment advice, determine whether
are not deposits or other obligations of the a. the minimum disclosures are included in
institution and are not guaranteed by the insti- the script;
tution; and b. bank employees engaged in telemarket-
are subject to investment risks, including the ing activities are authorized by the bank
possible loss of the principal invested. to recommend or sell nondeposit invest-
ment products, and whether their train-
12. Determine whether the minimum disclo-
sures are being provided orally to custom- BHC Supervision Manual July 2008
ers during sales presentations (including Page 17
ing is the substantive equivalent of that see and verify compliance by the third
required for securities registered repre- party
sentatives; and d. provision for access to relevant records
c. the material contains any statements that to the appropriate bank supervisory
may be misleading or confusing to cus- authorities
tomers regarding the uninsured nature of e. written employment contracts for dual
nondeposit investment products. employees
18. When nondeposit investment products are
f. indemnification of the institution by the
sold by employees of an affiliated broker
third party for the conduct of its employ-
dealer, determine if any written or oral rep-
ees in connection with nondeposit
resentations concerning insurance coverage
investment product sales activities
provided by SIPC, a state insurance fund, or
a private insurance company are clear and g. policies regarding the use of confidential
accurate and do not suggest that they are the customer information for any purpose in
substantive equivalent to FDIC insurance connection with sales of nondeposit
available for certain deposit products. investment products.
19. When the bank or its bank holding com- 22. Obtain and review the most recent FINRA
pany (or affiliate) acts as an investment examination results for the third party from
adviser to or has some other material rela- the bank or the third-party brokerdealer.
tionship with a mutual fund whose shares Also obtain and review examination-related
are sold by the bank, determine whether correspondence and any disciplinary mat-
a. oral and written disclosure of the rela- ters between the brokerdealer and the
tionship is made before the purchase of FINRA or SEC. Review the institutions
the shares; progress in addressing any investment rec-
b. bank-advised mutual funds do not have ommendations or deficiencies noted in the
names identical to the banks; examination results or other material.
c. bank-advised mutual funds with names 23. Where any retail sales facilities of the insti-
similar to the banks are sold pursuant to tution are leased to an affiliated third party
a sales program designed to minimize that sells nondeposit investment products
the risk of customer confusion; and a. assess whether the lease was negotiated
d. mutual funds advised by bank holding on an arms-length basis and on terms
companies do not have names identical comparable to similar lease agreements
to, similar to, or a variation of the name in the local market and
of the holding company or its subsidiary b. review any intercompany relationships
bank. for compliance with sections 23A and
20. Determine whether disclosure of any sales 23B of the Federal Reserve Act.
charges, fees, penalties, or surrender
charges relating to nondeposit investment
products is made orally and in writing Settings and Circumstances
before the purchase of these products.
24. Determine whether the sale of nondeposit
investment products is conducted in a
Third-Party Agreements physical location distinct from deposit-
taking activities of the bank. In so doing
21. When sales of nondeposit investment prod-
a. verify that nondeposit investment prod-
ucts are conducted by employees or repre-
ucts are not sold from teller windows;
sentatives of a third party, review all con-
tractual agreements between the bank and b. determine if signs or other means are
the third party to determine whether they used to distinguish the nondeposit
cover the following: investment products sales area from the
a. duties and responsibilities of each party retail deposit-taking area of the
b. third-party compliance with all applica- institution; and
ble laws and regulations and the inter- c. determine whether space limitations pre-
agency statement clude having a separate investment-
c. authorization for the institution to over- products sales area. If so, note how the
institution clearly distinguishes nonde-
BHC Supervision Manual July 2008 posit investment products from insured
Page 18 bank products or obligations.
Qualifications and Training ing in appropriate referral practices, includ-

ing the limits on their activities.
25. Determine whether employees of a
depository institution are providing invest-
ment advice, making investment recom- Suitability and Sales Practices
mendations, or selling nondeposit invest-
ment products directly to retail customers. The following procedures on suitability and
If so, determine whether sales practices are applicable when conducting
a. the depository institution has performed an examination of a depository institution whose
background checks and employees offer investment advice, make
b. sales personnel have received training investment recommendations, or sell nondeposit
that is the substantive equivalent to investment products. Examinations involving
that provided to a securities registered registered brokerdealers should rely on the
representative. FINRAs review of sales practices or its exami-
26. Review the training program provided to nation to assess the organizations compliance
employees of the depository institution who with suitability requirements.
are authorized to provide investment
advice, make investment recommendations, 30. Determine whether depository institution
or sell nondeposit investment products. personnel recommend nondeposit invest-
Assess whether the program addresses the ment products to customers. If so, deter-
following subject matters: mine whether sales personnel obtain,
a. general overview of U.S. financial record, and update the following
markets information:
b. detailed information concerning specific a. age
product lines being offered for sale b. tax status
c. generally accepted trading practices for c. current investments and overall financial
the products available for sale profile, including an estimate of net
d. general overview of federal securities worth*
laws and regulations (antifraud and d. investment objectives*
disclosure) e. other personal information deemed
e. banking regulations and guidelines appli- necessary to offer reasonable investment
cable to sales activities (such as anti- advice*
tying prohibitions, the interagency state- 31. Review a representative sample of cus-
ment, supervisory letters on sales of tomer accounts that were opened at several
specific investment products, etc.) different branch locations. Assess whether
f. policies and procedures specific to the customer suitability information is obtained
institution and whether investments appear unsuitable
g. appropriate sales practices, including in light of such information.
suitability of investment recommenda- 32. Review customer complaints involving suit-
tions and disclosure obligations ability of investment recommendations.
h. appropriate use of customer lists and Determine whether the banks original rec-
confidential customer information ommendations appear unsuitable in the con-
27. Determine whether the institution has any text of the information available at the time
continuing-education program or periodic of sale. Note how suitability complaints are
seminars on new products or compliance. resolved.
28. Determine whether supervisors of bank
sales personnel receive special training
pertaining to their supervisory responsibili- Compensation
ties that is the substantive equivalent of
training required for supervisors (General 33. If employees of the depository institution
Securities Principals) of registered provide investment advice, make invest-
representatives. ment recommendations, or sell nondeposit
29. Review the training of bank employees who
are not authorized to sell nondeposit invest- * Not necessary when money market mutual funds are
ment products but who make referrals, such being recommended.
as tellers, customer service representatives,
and others. In so doing, determine whether BHC Supervision Manual July 2008
such employees have been provided train- Page 19
investment products, determine whether institutions policies and procedures, spe-

a. any incentive compensation plan avail- cifically those policies relating to disclosure
able to nondeposit investment product and suitability.
sales personnel strongly favors propri- 38. Determine whether compliance personnel
etary or other specific products; if so, approve or review new accounts, periodi-
determine how the institution ensures cally review transactions in accounts, and
that customers are not placed into unsuit- review sales and referral activities of bank
able investments, and personnel.
b. compliance and audit personnel are 39. Review the customer complaint process and
excluded from incentive compensation the associated complaint log to determine if
programs directly related to the results of complaints are addressed on a timely basis.
nondeposit investment product sales. 40. Review progress in addressing identified
34. Determine whether fees paid to bank compliance problems.
employees for referrals to depository insti- 41. Evaluate the experience, training, and quali-
tution sales personnel or third-party sales fications of compliance personnel.
staff are based on a one-time, nominal fee 42. Review the scope of audits and determine
of a fixed dollar amount and are not depen- if the following areas were adequately
dent on a successful sale. addressed:
35. Determine if the banks compensation poli- a. disclosure and advertising
cies address remuneration of bank employ- b. physical separation of nondeposit
ees by third parties and if these policies are investment product sales activities
incorporated into the banks code of con- c. compliance
duct. In so doing, determine whether the d. sales practices and suitability
banks policies were approved by the board e. product selection and development
of directors and are consistent with the pro- f. use of confidential customer information
scriptions of the Bank Bribery Act and the by bank and third-party sales personnel
interagency guidelines adopted thereunder. g. third-party compliance with its agree-
ment with the institution
h. personnel training and background
Compliance and Audit checks
i. operations (clearing, cash receipts and
36. Review and assess the depository institu- disbursements, accounting, redemptions,
tions compliance program for nondeposit etc.), if applicable
investment product sales activities. In so 43. Obtain all internal and external audit reports
doing, consider the following: regarding the institutions nondeposit
a. frequency and scope investment product activities performed
b. workpapers over the past year (including managements
c. degree of independence from the sales responses). Review for exceptions, recom-
program mendations, and follow-up actions. Ascer-
d. follow-up on material findings tain if significant exceptions were presented
e. centralization of findings from all com- to the institutions audit committee or board
pliance areas of directors for their review.
f. role of the board of directors in review- 44. For external audits, obtain a copy of the
ing findings engagement letter and comment on the
37. Review the criteria used to evaluate bank adequacy of the firms audit review.
sales personnel for compliance with the

Page 20
Supervision of Subsidiaries (Sharing of Facilities and Staff
by Banking Organizations) Section 2010.8
A banking organization should be able to readily other entities, particularly in shared facilities,
determine for which entity within the bank hold- the staffs responsibilities should be clearly
ing company an individual is employed, and defined and, when appropriate, disclosed or
members of a banking organizations staff must made clear to customers and the public in gen-
be able to identify which subsidiary of the hold- eral. This procedure clarifies for both the public
ing company employs them. The distinction is and the regulators for which entity officials or
important because complex banking organiza- employees are carrying out their duties and
tions must take steps to ensure that their officials responsibilities. Also, this clarifies whether an
and employees have both the corporate and entity is operating within the scope of its char-
legal authority to carry out their duties, and ter, license, or other legal restrictions. Finally, a
because the organizations personnel should banking organization should establish and main-
only be performing activities that are permitted tain appropriate internal controls designed to
by law to be carried out by the holding company ensure the separation of the functions of the
or its particular subsidiaries. legal entities, when required, as well as have
an adequate audit program to monitor such
activities.
2010.8.1 IDENTIFICATION OF If officials and employees have responsibili-
FACILITIES AND STAFF ties for other offices or affiliates of the banking
organization, particularly those that share facili-
Generally, unless there are statutory restrictions ties, these responsibilities should be clearly
or the Federal Reserve or other regulators have defined and, when appropriate, disclosed or
issued explicit written proscriptions, such as made clear to customers and the public in gen-
those concerning mutual fund sales on bank eral. This procedure clarifies for which entity
premises, there is no fundamental legal prohibi- employees are carrying out their duties. Further-
tion on the entities of a banking organization more, in establishing employee responsibilities,
sharing or using unmarked contiguous facilities management should ensure that they are within
and, in some instances, sharing officials and the scope of the entitys license or charter.
employees. There are, however, concerns about
safety and soundness and conflicts of interest.
These may arise when a banking organization 2010.8.2 EXAMINER GUIDANCE ON
does not take appropriate actions to define and SHARING FACILITIES AND STAFF
differentiate the functions and responsibilities of
each of its entities and staff. Examiners should continue to be fully aware of
Good corporate governance requires that a the issues and potential problems involved in
banking organization be able to readily identify the sharing of staff and the sharing or use of
the authority and responsibilities of its officials unmarked contiguous facilities by the different
and employees at each of its entities, especially entities of a banking organization with varied
where the entities share facilities or use contigu- activities. At a minimum, examiners should
ous offices that are not clearly marked to indi- check to see that a banking organization main-
cate the identity of the different entities. This is tains clear records indicating the duties and
necessary to ensure that responsibilities of the officials and employees at
each of its entities. They should also take steps
1. an official or employee who makes a com- to check whether, in situations when an official
mitment to a counterparty on behalf of the or employee may perform duties for more than
organization has both the corporate and legal one entity in a shared facility, the banking orga-
authority to do so, nization has adequate policies and controls in
2. the counterparty understands with whom it is place to ensure that its staff have the corporate
dealing, and and legal capacity to commit the organization to
3. each entity is in compliance with any legal its counterparties and that the duties are carried
restrictions under which it operates. out in conformance with the statutory restric-
tions applicable to each of the entities. See
To accomplish the goal of ready identifica- SR-95-34 (SUP).
tion, a banking organization should maintain
well-defined job descriptions for each category
of its staff at each entity. When officials and BHC Supervision Manual December 2000
employees of one entity have responsibilities for Page 1
(Required Absences from Sensitive Positions) Section 2010.9
One of the many basic tenets of internal control assessment should consider all employees, but
is that a banking organization (bank holding should focus more on those with authority to
company, state member bank, and foreign bank- execute transactions, signing authority and
ing organization) needs to ensure that its access to the books and records of the banking
employees in sensitive positions are absent from organization, as well as those employees who
their duties for a minimum of two consecutive can influence or cause such activities to occur.
weeks. Such a requirement enhances the viabil- Particular attention should be paid to areas
ity of a sound internal control environment engaged in trading and wire-transfer operations,
because most frauds or embezzlements require including personnel who may have reconcilia-
the continuous presence of the wrongdoer. tion or other back-office responsibilities.
In brief, this section contains a statement After producing a profile of high-risk areas
emphasizing the need for banking organizations and activities, it would be expected that a mini-
to conduct an assessment of significant risk mum absence of two consecutive weeks per
areas before developing a policy on required year be required of employees in sensitive posi-
absences from sensitive positions. After making tions. The prescribed period of absence should,
this assessment, the organization should require under all circumstances, be sufficient to allow
that employees in sensitive key positions, such all pending transactions to clear and to provide
as trading and wire transfer, not be allowed to for an independent monitoring of the trans-
transact or otherwise carry out, either physically actions that the absent employee is responsible
or through electronic access, their assigned for initiating or processing. This practice could
duties for a minimum of two consecutive weeks be implemented through a requirement that
per year. The prescribed period of absence affected employees take vacation or leave, the
should, under all circumstances, be sufficient to rotation of assignments in lieu of required vaca-
allow all pending transactions to clear. It should tion, or a combination of both so the prescribed
also require that an individuals daily work be level of absence is attained. Some banking orga-
processed by another employee during the nizations, particularly smaller ones, might con-
employees absence. (See SR-96-37.) sider compensating controls such as continuous
rotation of assignments in lieu of required
absences to avoid placing an undue burden on
2010.9.1 STATEMENT ON REQUIRED the banking organization or its employees.
ABSENCES FROM SENSITIVE For the policy to be effective, individuals
POSITIONS having electronic access to systems and records
from remote locations must be denied this
A comprehensive system of internal controls is access during their absence. Similarly, indirect
essential for a financial institution to safeguard access can be controlled by not allowing others
its assets and capital, and to avoid undue reputa- to take and carry out instructions from the
tional and legal risk. Senior management is absent employee. Of primary importance is the
responsible for establishing an appropriate sys- requirement that an individuals daily work be
tem of internal controls and monitoring compli- processed by another employee during his or
ance with that system. Although no single con- her absence; this process is essential to bring to
trol element should be relied on to prevent fraud the forefront any unusual activity of the absent
and abuse, these acts are more easily perpetrated employee.
when proper segregation and rotation of duties Exceptions to the required-absence policy
do not exist. As a result, the Federal Reserve is may be necessary from time to time. However,
reemphasizing the following prudent banking management should exercise the appropriate
practices that should be incorporated into a discretion and properly document any waivers
banking organizations internal control proce- that are granted. Internal auditing should be
dures. These practices are designed to enhance made aware of individuals who receive waivers
the viability of a sound internal control environ- and the circumstances necessitating the
ment, as most internal frauds or embezzlements exceptions.
necessitate the constant presence of the offender If a banking organizations internal control
to prevent the detection of illegal activities. procedures do not now include the above prac-
When developing comprehensive internal tices, they should be promptly amended. After
control procedures, each banking organization
should first make a critical assessment of its BHC Supervision Manual July 2009
significant areas and sensitive positions. This Page 1
Supervision of Subsidiaries (Required Absences from Sensitive Positions) 2010.9
the procedures have been enhanced, they should 2. Ascertain if employees assigned to sensitive
be disseminated to all employees, and the docu- positions are required to be absent for a
mentation regarding their receipt and acknowl- minimum of two weeks per year while
edgment maintained. Additionally, adherence to a. pending sensitive transactions are moni-
the procedures should be included in the appro- tored while they clear, and
priate audit schedules, and the auditors should b. daily work is monitored and processed by
be cognizant of potential electronic access or another employee during the regularly
other circumventing opportunities. assigned employees absence.
The development and implementation of pro- 3. Determine if required internal control proce-
cedures on required absences from sensitive dures for minimum absences (for example,
positions is just one element of an adequate rotation of assignments, vacation or leave, or
control environment. Each banking organization a combination of both) are being used in
should take all measures to establish appropriate sensitive operations such as trading, trust,
policies, limits, and verification procedures for wire transfer, reconciliation, or other sensi-
an effective overall risk-management system. tive back-office responsibilities.
4. Ascertain if appropriate policies, limits, and
verification procedures have been established
2010.9.2 INSPECTION OBJECTIVES and maintained for an effective overall risk-
managment system.
1. To determine whether a critical assessment 5. Determine whether the banking
has been performed of a banking organiza- organization
tions significant areas and sensitive posi- a. prohibits others from taking and carry-
tions. ing out instructions from the absent
2. To ascertain that sound internal controls employees, and
exist, including policies and procedures that b. prevents remote electronic access to sys-
provide assurances that employees in sensi- tems and records involving sensitive trans-
tive positions are absent from their duties for actions during the regularly assigned
a minimum of two consecutive weeks per employees required minimum two-week
year. absence.
3. To ascertain whether the banking organiza- 6. Ascertain that the banking organization
tion has taken all measures to establish documents waivers from the two-week mini-
appropriate policies, limits, and verification mum absence policies and procedures
procedures for an effective overall risk- involving sensitive positions.
management system. 7. Determine that the appropriate audit sched-
4. To establish that the appropriate audit schedules and the audits include a review of such
ules and the audits include a review of mini- procedures, including potential electronic
mum absence policies and procedures, access or other circumventing actions by
including potential electronic access or other employees.
circumventing actions by employees.
2010.9.3 INSPECTION PROCEDURES

1. Determine that a profile of high-risk areas
and activities is performed on a regular peri-
odic basis.

Page 2
(Internal Loan Review) Section 2010.10
Internal loan review is an activity which pro- age. The process should also tie problem loans
vides management with information about the or technical exceptions to the particular loan
quality of loans and effectiveness of a banking officer to allow senior management to evaluate
organizations lending policies and procedures. individual performance. Loans should be
The objectives of loan-review procedures are to reviewed shortly after origination to determine
identify, in a timely manner, existing or emerg- their initial quality, technical exceptions, and
ing credit-quality problems and to determine compliance with written loan policies. Reason-
whether internal lending policies are being able frequency guidelines should be set for nor-
adhered to. mal reviews, with problem credits receiving spe-
The size and complexity of a bank holding cial and more frequent analysis. An effective
company will dictate the need for and structure loan-review procedure will incorporate an early
of internal loan review. One-bank holding warning system of red flags, such as over-
companies with no significant credit-extending drafts, adverse published reports, and deteriorat-
nonbank subsidiaries will normally establish ing financial statements. Loan officers should
internal loan-review procedures within the sub- also be encouraged to inform the organizations
sidiary bank. In these cases, there is no need to internal loan-review unit of developing loan
evaluate the loan-review procedures during the problems, and they should be discouraged from
inspection. withholding problem loans or adverse informa-
For larger multibank companies or those with tion from the review process.
significant credit-extending nonbank subsidi- The loan-review process should be indepen-
aries, internal loan review is usually centralized dent of the loan-approval function, with written
at the parent company level. In some cases, a findings reported to a board or senior manage-
centralized loan-review function could operate ment committee that is not directly involved in
in the lead bank and cover all affiliates within lending. Follow-up and monitoring of problem
the organization. However, since parent com- credits should be instituted. The loan officer
pany directors and senior management are ulti- should be responsible for reporting on any cor-
mately accountable for the organizations asset rective actions taken. The maintenance of
quality, an evaluation of the internal loan-review adequate internal controls within the lending
function should be conducted as part of the process, in particular for loan review or credit
inspection process no matter where the opera- audit, is critical for maintaining proper incen-
tions are technically located within the corpo- tives for banking organization staff to be rigor-
rate structure. Since a subsidiary banks primary ous and disciplined in their credit-analysis and
regulator will normally want to evaluate the lending decisions. A banking organizations
loan-review process as it relates to the respec- credit analyses, loan terms and structures, credit
tive bank, a coordination of efforts would be decisions, and internal rating assignments have
appropriate. This should be handled on an ad historically been reviewed in detail by experi-
hoc basis, as deemed necessary by the holding enced and independent loan-review staff. Such
companys examiner-in-charge, to avoid unnec- loan reviews have provided both motivation for
essary duplication of efforts without com- better credit discipline within an institution
promising the independence of the appraisal and greater comfort for examinersand
process. managementthat internal policies are being
Internal loan-review procedures may take followed and that the banking organization con-
various forms, from senior officers review of tinues to adhere to sound lending practice.
junior-officer loans to the formation of an inde- For larger multibank organizations, loan-
pendent department staffed by loan-review review procedures are usually centralized and
analysts. An effective system will identify administered at the parent level, with loan-
deteriorations in credits, loans that do not com- review staff employed by the parent company.
ply with written loan policies, and loans with In some cases, a centralized loan-review func-
technical exceptions. tion may operate in the lead bank, covering all
The loan-review program should be delegated other affiliates in the organization. The parent
to a qualified and adequate staff. The review company directors and senior management are
should be systematic in scope and frequency. ultimately accountable for supervision of the
All related extensions of credit should be identi- entire organizations asset quality. Therefore, it
fied and analyzed together. A minimum credit
size should be established that allows for an BHC Supervision Manual December 1999
efficient review while providing adequate cover- Page 1
Internal Loan Review 2010.10
should be the Systems responsibility to evalu- will normally function within the subsidiary
ate top managements loan-review policies and bank and be supervised by bank directors and
procedures as they relate to the subsidiaries, management.
both bank and nonbank, no matter where the
function is technically established within the
corporate structure. The holding company
examiner-in-charge should attempt to coordi-
2010.10.1 INSPECTION OBJECTIVES
nate efforts and cooperate with the respective
1. Review the operations of the bank holding
banks primary supervisors to avoid unneces-
company to determine whether there is an
sary duplication, without compromising the
internal loan-review program. If not, one
independence of the appraisal process.
should be implemented.
During favorable economic and financial 2. Determine whether the loan-review program
markets, relatively low levels of problem loans is independent from the loan-approval
and credit losses may increase pressure within function.
banking organizations to reduce the resources 3. Determine if the loan-review staff is suffi-
committed to loan-review functions. These ciently qualified and whether its size is
reductions may include a reduction in staff, adequate.
more limited portfolio coverage, and less thor- 4. Determine whether the scope and frequency
ough reviews of individual loans. Undoubtedly, of the loan-review procedure is adequate to
some useful efficiencies may be gained by ensure that problems are being identified.
reducing loan-review resources, but some bank- 5. Determine that findings from the loan-review
ing organizations may reduce the scope and process are being properly reported and
depth of loan-review activities beyond levels receive adequate follow-up attention.
that are prudent over the longer horizon. If
reduced too far, the integrity of the lending
process and the discipline of identifying unreal-
istic assumptions and discerning problem loans 2010.10.2 INSPECTION PROCEDURES
in a timely fashion may deteriorate. This may be
especially true when a large proportion of lend- 1. Review the holding companys operations to
ers may not have had direct lending experience determine what types of internal loan-review
during a credit cycle when there was an procedures are being performed and whether
economic and financial market downturn. See an internal loan-review program exists.
SR-99-23. 2. If no internal loan-review program exists,
If supervisors and examiners find that there determine whether the size, complexity, and
are weaknesses in the internal loan-review func- financial condition of the organization war-
tion and in activities or other internal control rants implementation of a formal loan-review
and risk-management processes (for example, process.
staff turnover, failure to commit sufficient 3. Review the organizational structure of the
resources, inadequate adherence to established loan-review function to ensure its indepen-
internal controls, or inadequate training), such dence from the loan-approval processes.
findings should be discussed with the senior 4. Review the reporting process for internal
management of the parent bank holding com- loan-review findings to determine whether a
pany or other management at a corporate-wide director committee or independent senior
level and, if determined to be a major concern, management committee is being appropri-
presented as comments on the Examiners ately advised of the findings. Determine
Comments and Matters Requiring Special Board whether adequate follow-up procedures are
Attention core page. Findings that could ad- in place.
versely affect affiliated insured depository insti- 5. Through loan reviews, transaction testing,
tutions should be conveyed to the primary fed- and discussions with loan-review manage-
eral or state supervisor of the insured institution. ment, evaluate the quality, effectiveness and
Those findings should also be considered when adequacy of the internal loan-review staff
assigning supervisory ratings. and internal controls in relation to the organi-
Shell one-bank holding companies will not zations size and complexity.
have or need a loan-review program emanating 6. Review the operation of the loan-review pro-
from the parent company level. Loan review cess to identify the method for selecting
loans and the manner in which they are ana-
BHC Supervision Manual December 1999 lyzed and graded. Determine whether these
Page 2 procedures are adequate.
Internal Loan Review 2010.10
7. Determine if loan-review activities or other ment and report those findings on the core
internal control and risk-management pro- page 1, Examiners Comments and Matters
cesses have been weakened by turnover of Requiring Special Board Attention.
internal loan-review staff; a failure to com- 8. Determine what type of early warning
mit sufficient resources; inadequate internal system is in place and whether it is adequate.
controls; inadequate training; or the absence 9. Determine how the scope and frequency of
of other adequate systems, resources, or con- the review procedure is established and
trols. If such significant findings are found, whether this provides adequate coverage.
discuss those concerns with senior manage-

Page 3
Supervision of Subsidiaries (Private-Banking
Functions and Activities) Section 2010.11
WHATS NEW IN THIS REVISED tices governing private-banking activities. In
SECTION addition to providing an overview of private
banking, the general types of customers, and the
Effective July 2012, this section has been revised various products and services typically pro-
to reference the Financial Crimes Enforcement vided, the Functional Review subsection
Networks regulations and those of the Office of describes the critical functions that constitute a
Foreign Assets Control, issued by the U.S. private-banking operation and identifies certain
Department of the Treasury (31 C.F.R. 1020). safe and sound banking practices. These critical
functions are supervision and organization, risk
management, fiduciary standards, operational
2010.11.1 OVERVIEW OF PRIVATE controls, management information systems,
BANKING AND ITS ASSOCIATED audit, and compliance. Included in the risk-
ACTIVITIES management portion is a discussion of the basic
customer-due-diligence (CDD) principle that
The role of bank regulators in supervising is the foundation for the safe and sound opera-
private-banking activities is (1) to evaluate man- tion of a private-banking business. See the CDD
agements ability to measure and control the rules at 31 C.F.R. 1020. The Preparation for
risks associated with such activities and (2) to Inspection subsection assists in defining the
determine if the proper internal control and audit inspection scope and provides a list of core
infrastructures are in place to support effective requests to be made in the first-day letter. Addi-
compliance with relevant laws and regulations. tional inspection and examination guidance can
In this regard, the supervisors may determine be found in this manual, the Federal Financial
that certain risks have not been identified or Institutions Examination Councils (FFIEC)
adequately managed by the institution, a poten- Bank Secrecy Act/AntiMoney Laundering
tially unsafe and unsound banking practice. (BSA/AML) Examination Manual, the Federal
Private-banking functions may be performed Reserve Systems Trading and Capital-Markets
in a specific department of a commercial bank Activities Manual, and in the FFIECs Informa-
or nonbank subsidiary of a commercial bank, a tion Technology Examination Handbook.
bank holding company (including a financial In reviewing specific functional and product-
holding company), an Edge corporation or its inspection procedures (as found in the private-
foreign subsidiaries, a branch or agency of a banking activities module that is part of the
foreign banking organization, or within multiple framework for risk-focused supervision of large
areas of an institution. Private banking may be complex institutions), all aspects of the private-
the sole business of an institution. Regardless of banking review should be coordinated with the
how an institution is organized or where it is rest of the inspection to eliminate unnecessary
located, the results of the private-banking duplication of effort. Furthermore, this section
review should be reflected in the entitys overall has introduced the review of trust activities and
supervisory assessment.1 fiduciary services, critical components of most
This section provides examiners with guid- private-banking operations, as part of the over-
ance for reviewing private-banking activities at all private-banking review. Although the prod-
all types and sizes of banking organizations, uct nature of these activities differs from that of
including financial institutions. It is intended to products generated by other banking activities,
supplement, not replace, existing guidance on such as lending and deposit taking, the func-
the inspection or examination of private-banking tional components of private banking (supervi-
activities and to broaden the examiners review sion and organization, risk management, opera-
of general risk-management policies and prac- tional controls and management information
systems, audit, compliance, and financial
1. Throughout this section, the word institution will be condition/business profile) should be reviewed
used to mean all types of banking organizations, including across product lines.
bank holding companies, their bank and other financial institu-
tion subsidiaries, nonbank subsidiaries, and those entities
Private banking offers the personal and dis-
authorized to operate under section 4(k) of the Bank Holding crete delivery of a wide variety of financial
Company Act. Institution also includes branches and agencies services and products to an affluent market,
of foreign banks and any other types of financial institutions primarily to high net worth individuals and their
and entities supervised by the Federal Reserve System. The
term board of directors will be interchangeable with refer-
ences to the senior management of branches and agencies BHC Supervision Manual July 2012
of foreign banks. Page 1
Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11
corporate interests. A private-banking operation BSA at 31 U.S.C. 5318(l)) requires financial

typically offers its customers an all-inclusive institutions (such as banks, savings associations,
money-management relationship, including trust companies, and credit unions) to have cus-
investment portfolio management, financial- tomer identification programs (CIPs), that is,
planning advice, offshore facilities, custodial programs to collect and maintain certain records
services, funds transfer, lending services, over- and documentation on customers. Institutions
draft privileges, hold mail, letter-of-credit are to develop and use identity verification pro-
financing, and bill-paying services. As the afflu- cedures to ensure the identity of their customers.
ent market grows, both in the United States and Bank holding companies, as a matter of safety
globally, competition to serve it is becoming and soundness, should take appropriate mea-
more intense. Consequently, the private-banking sures to ensure that their financial institution
marketplace includes banks, nonbanks, and subsidiaries are in compliance with the cus-
other types of banking organizations and finan- tomer identification program (CIP) rule.
cial institutions. Private-banking products, ser- The CIP rule (see 31 C.F.R. 1020.220 and 12
vices, technologies, and distribution channels C.F.R. 326.8(b)) applies only to a bank, not to a
are still evolving. A range of private-banking bank holding company solely because it owns a
products and services may be offered to custom- bank. Also, a nonbank subsidiary of a bank
ers throughout an institutions global network of holding company is not subject to the CIP rule
affiliated entitiesincluding branches, subsidi- for banks solely as a result of being affiliated
aries, and representative officesin many dif- with a bank in a holding company structure.
ferent regions of the world, including offshore Even though this rule is not applicable to bank
secrecy jurisdictions. holding companies and their nonbank subsidi-
Typically, private-banking customers are high aries (or to savings and loan holding companies
net worth individuals or institutional investors and their nonsavings association subsidiaries),
who have minimum investible assets of $1 mil- bank holding companies should, as a matter of
lion or more. Institutions often differentiate safety and soundness, take appropriate measures
domestic from international private banking, throughout the organization to ensure that each
and they may further segregate the international of their entities is in compliance with any appli-
function on the basis of the geographic location cable CIP rule. New accounts must receive
of their international client base. International appropriate due diligence, and a holding com-
private-banking clients may be wealthy indi- pany should generally protect the consolidated
viduals who live in politically unstable nations organization from any risks associated with
and are seeking a safe haven for their capital. money laundering and financial crime. The bank
Therefore, obtaining detailed background infor- holding company may still be subject to other
mation and documentation about the interna- CIP rules if it has ownership in a functionally
tional client may be more difficult than it regulated entity, for example, a securities
is for the domestic customer. Private-banking broker-dealer. (See 31 C.F.R. 1023.220 and
accounts may, for example, be opened in the 1026.220)
name of an individual, a commercial business, a The CIPs are to include measures to
law firm, an investment adviser, a trust, a per-
1. require that certain information be obtained
sonal investment company (PIC), or an offshore
at account opening (for individuals, the infor-
mutual fund.
mation would generally include their name,
In 2001, the USA Patriot Act (the Patriot Act)
address, tax identification number, and date
established new and enhanced measures to pre-
of birth);
vent, detect, and prosecute money laundering
2. verify the identity of new account holders
and terrorist financing. In general, these mea-
within a reasonable time period;
sures were enacted through amendments to the
3. ensure that a banking organization has a rea-
Bank Secrecy Act (BSA). The measures directly
sonable belief that it knows each customers
affecting banking organizations are imple-
identity;
mented primarily through regulations issued by
4. maintain records of the information used to
the U.S. Department of the Treasury (31 C.F.R.
verify a persons identity; and
1020).2 Section 326 of the Patriot Act (see the
issued by the U.S. Department of the Treasury, through the

2. For banking organizations, the regulation implementing
Financial Crimes Enforcement Network (FinCEN), and the
the requirements of section 326 of the Patriot Act was jointly
Board of Governors of the Federal Reserve System, the Office
of the Comptroller of the Currency, the Federal Deposit
BHC Supervision Manual July 2012 Insurance Corporation, and the National Credit Union Admin-
Page 2 istration.
5. compare the names of new customers against cedures to review the activity of client accounts
government lists of known or suspected ter- in order to protect the client from any unauthor-
rorists or terrorist organizations. ized activity. In addition, ongoing monitoring of
account activity should be conducted to detect
A customer identification program is an impor- activity that is inconsistent with the client pro-
tant component of a financial institutions over- file (for example, frequent or sizable unex-
all anti-money-laundering and BSA compliance plained transfers flowing through the account).
program. Finally, as clients develop a return-on-assets
The FFIEC BSA/AML Examination Manual (ROA) outlook to enhance their returns, the use
provides the interagency BSA examination proof leveraging and arbitrage is becoming more
cedures that should be used to evaluate banking evident in the private-banking business. Exam-
organizations compliance with the regulation. iners should be alert to the totality of the client
The scope of the examination or inspection can relationship product by product, in light of
be tailored to the reliability of the banking orga- increasing client awareness and use of deriva-
nizations compliance-management system and tives, emerging-market products, foreign
to the level of risk that the organization assumes. exchange, and margined accounts.
Relevant interagency guidance (in a frequently-
asked-question format) has been issued to
address the customer identification program 2010.11.1.1 Products and Services
rules. (See SR-05-9.) 2010.11.1.1.1 Personal Investment
Private-banking accounts are usually gener- Companies, Offshore Trusts, and
ated on a referral basis. Every client of a private- Token-Name Accounts
banking operation is assigned a salesperson or
marketer, commonly known as a relationship Private-banking services almost always involve
manager (RM), as the primary point of contact a high level of confidentiality for clients and
with the institution. The RM is generally their account information. Consequently, it is
charged with understanding and anticipating the not unusual for private bankers to help their
needs of his or her wealthy clients, and then clients achieve their financial-planning, estate-
recommending services and products for them. planning, and confidentiality goals through off-
The number of accounts an RM handles varies, shore vehicles such as personal investment
depending on the portfolio size or net worth of companies (PICs), trusts, or more exotic
the particular accounts. RMs strive to provide a arrangements, such as hedge fund partnerships.
high level of support, service, and investment While these vehicles may be used for legitimate
opportunities to their clients and tend to main- reasons, without careful scrutiny, they may cam-
tain strong, long-term client relationships. Fre- ouflage illegal activities. Private bankers should
quently, RMs take accounts with them to other be committed to using sound judgment and
private-banking institutions if they change enforcing prudent banking practices, especially
employment. Historically, initial and ongoing when they are assisting clients in establishing
due diligence of private-banking clients is not offshore vehicles or token-name accounts.
always well documented in the institutions files Through their global network of affiliated
because of RM turnover and confidentiality entities, private banks often form PICs for their
concerns. clients. These shell companies, which are
Clients may choose to delegate a great deal of incorporated in offshore secrecy jurisdictions
authority and discretion over their financial such as the Cayman Islands, Channel Islands,
affairs to RMs. Given the close relationship Bahamas, British Virgin Islands, and Nether-
between clients and their account officers, an lands Antilles, are formed to hold the cus-
integral part of the inspection process is assess- tomers assets as well as offer confidentiality by
ing the adequacy of managerial oversight of the opening accounts in the PICs name. The ben-
nature and volume of transactions conducted eficial owners of the shell corporations are
within the private-banking department or with typically foreign nationals. The banking institu-
other departments of the financial institution, as tion should know and be able to document that
well as determining the adequacy and integrity it knows the beneficial owners of such corpora-
of the RMs procedures. Policy guidelines and tions and that it has performed the appropriate
management supervision should provide param- due diligence to support these efforts. Emphasis
eters for evaluating the appropriateness of all should be placed on verifying the source or
products, especially those involving market risk.
Moreover, because of the discretion given to BHC Supervision Manual July 2012
RMs, management should develop effective pro- Page 3
origin of the customers wealth. Similarly, off- bank subsidiary of such a foreign bank operat-
shore trusts established in these jurisdictions ing in the United States), is required to file a
should identify grantors of the trusts and sources SAR in accordance with the provision of section
of the grantors wealth. Anonymous relation- 208.62 of the Federal Reserve Boards Regula-
ships or relationships in which the RM does not tion H (12 C.F.R. 208.62) when suspicious
know and document the beneficial owner should transactions or activities are initially discovered
not be permitted. and warrant or require reporting. See the report-
PICs are typically passive personal investing requirements discussed in subsection
ment vehicles. However, foreign nationals have 2010.11.2.2.1.1 and the expanded examination
established PICs as operating accounts for busi- procedures for private banking in the FFIECs
ness entities they control in their home coun- BSA/AML Examination Manual.
tries. Accordingly, financial institutions should
use extra care when dealing with beneficial
owners of PICs and associated trusts; these vehi- 2010.11.1.1.3 Investment Management
cles can be used to conceal illegal activities.
In private banking, investment management
usually consists of two types of accounts:
2010.11.1.1.2 Deposit-Taking Activities of (1) discretionary accounts in which portfolio
Subsidiary Institutions managers make the investment decisions on the
basis of recommendations from the banks
A clients private-banking relationship fre- investment research resources and (2) nondis-
quently begins with a deposit account and then cretionary (investment advisory) accounts in
expands into other products. In fact, many insti- which clients make their own investment deci-
tutions require private-banking customers to sions when conducting trades. For nondiscre-
establish a deposit account before maintaining tionary clients, the banks typically offer invest-
any other accounts. Deposit accounts serve as ment recommendations subject to the clients
conduits for a clients money flows. To distin- written approval. Discretionary accounts consist
guish private-banking accounts from retail of a mixture of instruments bearing varying
accounts, institutions usually require signifi- degrees of market, credit, and liquidity risk that
cantly higher minimum account balances and should be appropriate to the clients investment
assess higher fees. The private-banking function objectives and risk appetite. Both account types
or institution should have account-opening pro- are governed under separate agreements
cedures and documentation requirements that between the client and the institution.
must be fulfilled before a deposit account can be Unlike depository accounts, securities and
opened. (These standards are described in detail other instruments held in the clients investment
in the Functional Review subsection.) accounts are not reflected on the balance sheet
Most private banks offer a broad spectrum of of the institution because they belong to the
deposit products, including multicurrency client. These managed assets are usually
deposit accounts that are used by clients who accounted for on a separate ledger that is segre-
engage in foreign-exchange, securities, and gated according to the customer who owns the
derivatives transactions. The clients transaction assets.
activity, such as wire transfers, check writing,
and cash deposits and withdrawals, is conducted
through deposit accounts (including current 2010.11.1.1.4 Credit
accounts). It is very important that the transac-
tion activity into and out of these deposit Private-banking clients may request extensions
accounts (including internal transfers between of credit on either a secured or an unsecured
affiliated deposit accounts) be closely monitored basis. Loans backed by cash collateral or man-
for suspicious transactions that are inconsistent aged assets held by the private-banking function
with the clients profile of usual transactions. are quite common, especially in international
Suspicious transactions could warrant the fil- private banking. Private-banking clients may
ing of a Suspicious Activity Report (SAR). A pledge a wide range of their assets, including
bank holding company or any nonbank subsidi- cash, mortgages, marketable securities, land, or
ary thereof, or a foreign bank that is subject to buildings, to securitize their loans. Management
the Bank Holding Company Act (or any non- should demonstrate an understanding of the pur-
pose of the credit, the source of repayment, the
BHC Supervision Manual July 2012 loan tenor, and the collateral used in the financ-
Page 4 ing. When lending to individuals with high net
worths, whether on a secured or an unsecured subaccounts, each in the name of one of the
basis, the creditworthiness determination is bol- foreign banks customers. The foreign bank
stered by a thorough and well-structured extends signature authority on its master
customer-due-diligence process. If that process account to its own customers, who may not be
is not thorough, collateral derived from illicit known to the U.S. bank. Consequently, the U.S.
activities may be subject to government bank may have customers who have not been
forfeiture. subject to the same account-opening require-
Borrowing mechanisms are sometimes estab- ments imposed on its U.S. account holders.
lished to afford nonresident-alien customers the These subaccount customers are able to write
ability to keep financial assets in the United checks and make deposits at the U.S. banking
States and to use such assets (via collateralized entity. The number of subaccounts permitted
borrowing arrangements) to provide operating under this arrangement may be virtually
capital for businesses they own and operate in unlimited.
their home countries. Such arrangements enable U.S. banking entities engage in PTAs primar-
these customers to keep the existence of these ily because they attract dollar deposits from the
financial assets secret from their home-country domestic market of their foreign correspondents
authorities and others, while they continue to without changing the primary bank-customer
use the funds (via collateralized borrowings) to relationship; PTAs also provide substantial fee
fund their businesses at home. income. Generally, PTAs at U.S. banking enti-
Private bankers need to maintain in the ties have the following characteristics: they are
United States adequate CDD information on carried on the U.S. banking entitys books as a
such nonresident-alien customers and their pri- correspondent bank account, their transaction
mary business interests. A well-documented volume is high, checks passing through the
CDD file may include information on the cus- account contain wording similar to payable
tomer from whos who and similar services, through XYZ bank, and the signatures appear-
Internet research, foreign tax returns and finan- ing on checks are not those of authorized offi-
cial statements, checks conducted by the Office cers of the foreign bank. See the expanded
of Foreign Assets Control (OFAC), and written examination procedures for PTAs in the
and appropriately documented Call Reports pre- FFIECs BSA/AML Examination Manual.
pared by the RM.
While these lending mechanisms may be used
for legitimate reasons, management needs to 2010.11.1.1.6 Personal Trust and Estates
determine whether the arrangements are being
used primarily to obfuscate the beneficial own- In trust and estate accounts, an institution offers
ership of collateral assets, making it difficult for management services for a clients assets. When
the customers home-country government to dealing with trusts under will, or testamentary
identify who owns the assets. If so, management trusts, the institution may receive an estate
needs to further determine whether the practice appointment (executor) and a trustee appoint-
varies from both the appropriate standards of ment if the will provided for the trust from the
international cooperation for transparency issues probate. These accounts are fully funded at
and with prudent banking practices, and if so, origination with no opportunity for an outside
whether the institution is exposed to elevated party to add to the account, and all activities are
legal risk. subject to review by the probate or surrogates
court. On the other hand, with living trusts, or
grantor trusts, the customer (grantor) may
2010.11.1.1.5 Payable-Through Accounts continually add to and, in some instances, has
control over the corpus of the account. Trusts
Another product that may be available in and estates require experienced attorneys,
private-banking operations is payable-through money managers, and generally well-rounded
accounts (PTAs). PTAs are transaction deposit professionals to set up and maintain the
accounts through which U.S. banking entities accounts. In certain cases, bankers may need to
(payable-through banks) extend check- manage a customers closely held business or
writing privileges to the customers of a foreign sole proprietorship. In the case of offshore trust
bank. The foreign bank (master account facilities, recent changes in U.S. law have
holder) opens a master checking account with imposed additional obligations on those banks
the U.S. bank and uses this account to provide
its customers with access to the U.S. banking BHC Supervision Manual July 2012
system. The master account is divided into Page 5
that function as trustees or corporate manage- 2010.11.1.1.8 Funds Transfer

ment for offshore trusts and PICs.
A critical element in offering personal trust Funds transfer, another service offered by
and estate services is the fiduciary responsibility private-banking functions, may involve the
of the institutions to their customers. This transfer of funds between third parties as part of
responsibility requires that institutions always bill-paying and investment services on the basis
act in the best interest of the clients pursuant to of customer instructions. The adequacy of con-
the trust documentation, perhaps even to the trols over funds-transfer instructions that are
detriment of the bank. In these accounts, the initiated electronically or telephonically is
bank is the fiduciary and the trust officer serves extremely important. Funds-transfer requests are
as a representative of the institution. Fiduciaries quickly processed and, as required by law,
are held to higher standards of conduct than funds-transfer personnel may have limited
other bankers. Proper administration of trusts knowledge of the customers or the purpose of
and estates includes strict controls over assets, the transactions. Therefore, strong controls and
prudent investment and management of assets, adequate supervision over this area are critical.
and meticulous recordkeeping. See the See section 4063.1 and 4125.1 of the Commer-
expanded procedures for trust and asset manage- cial Bank Examination Manual.
ment services in the FFIECs BSA/AML Exami-
nation Manual.
2010.11.1.1.9 Hold Mail, No Mail, and
Electronic-Mail Only
2010.11.1.1.7 Custody Services Hold-mail, no-mail, or electronic-mail-only

accounts are often provided to private-banking
Custodial services offered to private-banking customers who elect to have bank statements
customers include securities safekeeping, receipt and other documents maintained at the institu-
and disbursement of dividends and interest, rection or e- mailed to them, rather than mailed to
ordkeeping, and accounting. Custody relation- their residence. Agreements for hold-mail
ships can be established in many ways, includ- accounts should be in place, and the agreements
ing by referrals from other departments in the should indicate that it was the customers choice
bank or from outside investment advisers. The to have the statements retained at the bank and
customer or a designated financial adviser that the customer will pick up his or her mail at
retains full control of the investment manage- least annually. Variations of hold-mail services
ment of the property subject to the custodian- include delivery of mail to a prearranged loca-
ship. Sales and purchases of assets are made by tion (such as another branch of the bank) by
instruction from the customer, and cash dis- special courier or the banks pouch system.
bursements are prearranged or as instructed.
Custody accounts involve no investment super-
vision and no discretion. However, the custo- 2010.11.1.1.10 Bill-Paying Services
dian may be responsible for certain losses if it
fails to act properly according to the custody Bill-paying services are often provided to
agreement. Therefore, procedures for proper private-banking customers for a fee. If this ser-
administration should be established and vice is provided, an agreement between the bank
reviewed. and the customer should exist. Typically, a cus-
tomer may request that the bank debit a deposit
An escrow account is a form of custody
account for credit card bills, utilities, rent, mort-
account in which the institution agrees to hold
gage payments, or other monthly consumer
cash or securities as a middleman, or a third
charges. In addition, the increased use of the
party. The customer, for example, an attorney or
Internet has given rise to the electronic-mail-
a travel agency, gives the institution funds to
only account, whereby customers elect to have
hold until the ultimate receiver of the funds
statements, notices, etc., sent to them only by
performs in accordance with the written
e-mail.
escrow agreement, at which time the institution
releases the funds to the designated party.
2010.11.2 FUNCTIONAL REVIEW
BHC Supervision Manual July 2012 When discussing the functional aspects of a
Page 6 private-banking operation, functional refers to
managerial processes and procedures, such as the integrity of these processes has become
reporting lines, quality of supervision (including increasingly important as new products and
involvement of the board of directors), informa- technologies are introduced. Similarly, the
tion flows, policies and procedures, risk- client-selection, documentation, approval, and
management policies and methodologies, segre- account-monitoring processes should adhere to
gation of duties, management information sound and well-identified practices.
systems, operational controls (including BSA/ The quality of risk-management practices and
AML monitoring), and audit coverage. The internal controls is given significant weight in
examiner should be able to draw sound conclu- the evaluation of management and the overall
sions about the quality and culture of manage- condition of private-banking operations. A
ment and stated private-banking policies after banks failure to establish and maintain a risk-
reviewing the functional areas described below. management framework that effectively identi-
Specifically, the institutions risk-identification fies, measures, monitors, and controls the risks
process and risk appetite should be carefully associated with products and services should be
defined and assessed. Additionally, the effective- considered unsafe and unsound conduct. Fur-
ness of the overall control environment main- thermore, well-defined management practices
tained by management should be evaluated by should indicate the types of clients that the
an internal or external audit. The effectiveness institution will and will not accept and should
of the following functional areas is critical to establish multiple and segregated levels of
any private-banking operation, regardless of its authorization for accepting new clients. Institu-
size or product offerings. tions that follow sound practices will be better
positioned to design and deliver products and
services that match their clients legitimate
2010.11.2.1 Supervision and Organization needs, while reducing the likelihood that unsuit-
able clients might enter their client account base.
As part of the examiners appraisal of an Deficiencies noted in this area are weighted in
organization, the quality of supervision of context of the relative risk they pose to the
private-banking activities is evaluated. The ap- institution and are appropriately reflected in the
praisal of management covers the full range of appraisal of management.
functions and activities related to the operation The private-banking function is exposed to a
of the private bank. The discharge of number of risks, including reputational, fidu-
responsibilities by bank directors should be ef- ciary, legal, credit, operational, and market. A
fected through an organizational plan that ac- brief description of some of the different types
commodates the volume and business services of risks follows:
handled, local business practices and the banks
competition, and the growth and development 1. Reputational risk is the potential that nega-
of the institutions private-banking business. tive publicity regarding an institutions busi-
Organizational planning is the joint responsibil- ness practices and clients, whether true or
ity of senior bank and private-bank manage- not, could cause a decline in the customer
ment, should be integrated with the long-range base, costly litigation, or revenue reductions.
plan for the institution, and should be consistent 2. Fiduciary risk refers to the risk of loss due to
with any enterprise-wide risk-management the institutions failure to exercise loyalty;
program. safeguard assets; and, for trusts, to use assets
Both the directors and management have productively and according to the appropri-
important roles in formulating policies and ate standard of care. This risk generally
establishing programs for private-banking prod- exists in an institution to the extent that it
ucts, operations, internal controls, and audits. exercises discretion in managing assets on
However, management alone must implement behalf of a customer.
policies and programs within the organizational 3. Legal risk arises from the potential of unen-
framework instituted by the board of directors. forceable contracts, client lawsuits, or
adverse judgments to disrupt or otherwise
negatively affect the operations or condition
2010.11.2.2 Risk Management of a banking organization. One key dimen-
sion of legal risk is supervisory action that
Sound risk-management processes and strong could result in costly fines or other punitive
internal controls are critical to safe and sound
banking generally and to private-banking activi- BHC Supervision Manual July 2012
ties in particular. Managements role in ensuring Page 7
measures being levied against an institution is to disguise the moneys true sourcefrom
for compliance breakdowns. the initial placement of illegally derived cash
4. Credit risk arises from the potential that a proceeds to the layers of financial transactions
borrower or counterparty will fail to perform that disguise the audit trailand make the funds
on an obligation. appear legitimate. Under U.S. money-laundering
5. Operational risk arises from the potential statutes, a bank employee can be held person-
that inadequate information systems, opera- ally liable if he or she is deemed to engage in
tional problems, breaches in internal con- willful blindness. This condition occurs when
trols, fraud, or unforeseen catastrophes will the employee fails to make reasonable inquiries
result in unexpected losses. to satisfy suspicions about client account
activities.
Although effective management of all of the Since the key element of an effective CDD
above risks is critical for an institution, certain policy is a comprehensive knowledge of the
aspects of reputational, legal, and fiduciary risks client, the banks policies and procedures should
are often unique to a private-banking function. clearly reflect the controls needed to ensure the
In this regard, the following customer-due- policy is fully implemented. CDD policies
diligence policies and practices are essential in should clearly delineate the accountability and
the management of reputational and legal risks authority for opening accounts and for determin-
in the private-banking functions. (In addition, ing if effective CDD practices have been per-
sound fiduciary practices and conflicts-of- formed on each client. In addition, policies
interest issues that a private-banking operation should delineate documentation standards and
may face in acting as fiduciary are described in accountability for gathering client information
the subsection on fiduciary standards.) from referrals among departments or areas
within the institution as well as from accounts
brought to the institution by new RMs.
2010.11.2.2.1 Customer-Due-Diligence In carrying out prudent CDD practices on
Policy and Procedures potential private-banking customers, manage-
ment should document efforts to obtain and
Sound customer-due-diligence (CDD) policies corroborate critical background information.
and procedures are essential to minimize the Private-banking employees abroad often have
risks inherent in private banking. The policies local contacts who can assist in corroborating
and procedures should clearly describe the tar- information received from the customer. The
get client base in terms such as minimum information listed below should be corroborated
investable net worth and types of products by a reliable, independent source, when
sought, as well as specifically indicate the type possible:
of clientele the institution will or will not accept.
Policies and procedures should be designed to 1. The customers current address and tele-
ensure that effective due diligence is performed phone number for his or her primary resi-
on all potential clients, that client files are bol- dence, which should be corroborated at regu-
stered with additional CDD information on an lar intervals, can be verified through a variety
ongoing basis, and that activity in client of methods, such as
accounts is monitored for transactions that are a. visiting the residence, office, factory, or
inconsistent with the client profile and may con- farm (with the RM recording the results
stitute unlawful activities, such as money laun- of the visit or conversations in a memo-
dering. The clients identity, background, and randum);
the nature of his or her transactions should be b. checking the information against the tele-
documented and approved by the back office phone directory; the clients residence, as
before opening an account or accepting client indicated on his or her national ID card; a
monies. Certain high-risk clients like foreign mortgage or bank statement or utility or
politicians or money exchange houses should property tax bill; or the electoral or tax
have additional documentation to mitigate their rolls;
higher risk. See 31 C.F.R. 1020, subpart F, for c. obtaining a reference from the clients
due diligence rules. government or known employer or from
Money laundering is associated with a broad another bank;
range of illicit activities: the ultimate intention d. checking with a credit bureau or profes-
sional corroboration organization; or
BHC Supervision Manual July 2012 e. any other method verified by the RM.
Page 8 2. Sufficient business information about the
customer should be gathered so that the RM age of CDD information will be allowed only if
understands the profile of the customers the bank has adopted, as part of its customer-
commercial transactions. This information due-diligence program, specific procedures
should include a description of the nature of designed to ensure that (1) the accounts are
the customers business operations or means subject to ongoing Office of Foreign Assets
of generating income, primary trade or busi- Control screening that is equivalent to the
ness areas, and major clients and their geo- screening afforded other accounts, (2) the
graphic locations, as well as the primary accounts are subject to the same degree of
business address and telephone number. review for suspicious activity, and (3) the bank
These items can be obtained through a com- demonstrates that the appropriate review of the
bination of any of the following sources: information and documentation is being per-
a. a visit to the office, factory, or farm formed by personnel at the offshore location.
b. a reliable third party who has a business CDD procedures should be no different when
relationship with the customer the institution deals with a financial adviser or
c. financial statements other type of intermediary acting on behalf of a
d. Dun and Bradstreet reports client. To perform its CDD responsibilities when
e. newspaper or magazine articles dealing with a financial adviser, the institution
f. Lexis/Nexis reports on the customer or should identify the beneficial owner of the
customers business account (usually the intermediarys client, but in
g. Whos Who reports from the home rare cases, it is the intermediary itself) and per-
country form its CDD analysis with respect to that ben-
h. private investigations eficial owner. The imposition of an intermediary
3. Although it is often not possible to get proof between the institution and counterparty should
of a clients wealth, an RM can use his or her not lessen the institutions CDD responsibilities.
good judgment to derive a reasonable esti- The purpose of all private-banking relation-
mate of the individuals net worth. ships should also be readily identified. Incoming
4. As part of the ongoing CDD process, the RM customer funds may be used for various pur-
should document in memos or call reports poses, such as establishing deposit accounts,
the substance of discussions that take place funding investments, or establishing trusts. The
during frequent visits with the client. Addi- banks CDD procedures should allow for the
tional information about a clients wealth, collection of sufficient information to develop a
business, or other interests provides insight transaction or client profile for each customer,
into potential marketing opportunities for the which will be used in analyzing client transac-
RM and the bank, and updates and strength- tions. Internal systems should be developed for
ens the CDD profile. monitoring and identifying transactions that may
be inconsistent with the transaction or client
As a rule, most private banks make it a policy profile for a customer and which may thus con-
not to accept walk-in clients. If an exception is stitute suspicious activity.
made, procedures for the necessary documenta-
tion and approvals supporting the exception
should be in place. Similarly, other exceptions
to policy and procedures should readily identify
2010.11.2.2.1.1 Suspicious Activity Reports
the specific exception and the required due-
diligence and approval process for overriding
existing procedures. The proper and timely filing of Suspicious
In most instances, all CDD information and Activity Reports (SARs) is an important compo-
documentation should be maintained and avail- nent of a banks CDD program. Since 1996, the
able for examination and inspection at the loca- federal financial institution supervisory agencies
tion where the account is located or where the and the Department of the Treasurys Financial
financial services are rendered. If the bank main- Crimes Enforcement Network (FinCEN) have
tains centralized customer files in locations other required banking organizations to report known
than where the account is located or the finan- or suspected violations of law as well as suspi-
cial services are rendered, complete customer cious transactions on a SAR. See the Boards
information, identification, and documentation SAR regulation (Regulation H, section 208.62
must be made available at the location where [12 C.F.R. 208.62] and Regulation Y, section
the account is located or where the financial
services are rendered within 48 hours of a Fed- BHC Supervision Manual July 2012
eral Reserve examiners request. Off-site stor- Page 9
225.4(f) [12 C.F.R. 225.4(f)]).3 Law enforce- matter should be reported to banking organiza-
ment agencies use the information reported on tions management. Examiners should ensure
the form to initiate investigations, and Federal that the institutions approach to SARs is proac-
Reserve staff use the SAR information in their tive and that well-established procedures cover
examination and oversight of supervised the SAR process. Accountability should exist
institutions. within the organization for the analysis and
A member bank and a BHC are required to follow-up of internally identified suspicious
file a SAR with the appropriate federal law activity; this analysis should conclude with a
enforcement agencies and the Department of the decision on the appropriateness of filing a SAR.
Treasury. A SAR must be prepared in accor- See the core procedures concerning suspicious-
dance with the forms instructions. The com- activity-reporting requirements in the FFIEC
pleted SAR is to be sent to FinCEN when an BSA/AML Examination Manual.
institution detects
1. insider abuse involving any amount; 2010.11.2.2.2 Credit-Underwriting

2. violations aggregating $5,000 or more in Standards
which a suspect can be identified;
3. violations aggregating $25,000 or more The underwriting standards for private-banking
regardless of a potential suspect; or loans to high net worth individuals should be
4. transactions aggregating $5,000 or more that consistent with prudent lending standards. The
involve potential money laundering or viola- same credit policies and procedures that are
tions of the Bank Secrecy Act. applicable to any other type of lending arrange-
ment should extend to these loans. At a mini-
When a SAR is filed, the management of a mum, sound policies and procedures should
member bank must promptly notify its board of address the following: all approved credit prod-
directors or a committee thereof. ucts and services offered by the institution, lend-
A SAR must be filed within 30 calendar days ing limits, acceptable forms of collateral, geo-
after the date of initial detection of the facts that graphic and other limitations, conditions under
may constitute a basis for filing a SAR. If no which credit is granted, repayment terms, maxi-
suspect was identified on the date of detection mum tenor, loan authority, collections and
of the incident requiring the filing, a member charge-offs, and prohibition against capitaliza-
bank may delay filing a SAR for an additional tion of interest.
30 calendar days in order to identify the suspect. An extension of credit based solely on col-
Reporting may not be delayed more than 60 lateral, even if the collateral is cash, does not
calendar days after the date of initial detection ensure repayment. While the collateral en-
of a reportable transaction. In situations involv- hances the banks position, it should not substi-
ing violations requiring immediate attention, tute for regular credit analyses and prudent
such as when a reportable violation is ongoing, lending practices. If collateral is derived from
the financial institution is required to immedi- illegal activities, it is subject to forfeiture
ately notify an appropriate law enforcement through the seizure of assets by a government
authority and the Board by telephone, in addi- agency. The bank should perform its due dili-
tion to its timely filing of a SAR. gence by adequately and reasonably ascertain-
A banking organizations internal systems for ing and documenting that the funds of its
capturing suspicious activities should provide private-banking customers were derived from
essential information about the nature and vol- legitimate means. Banks should also verify that
ume of activities passing through customer the use of the loan proceeds is for legitimate
accounts. Any information suggesting that sus- purposes.
picious activity has occurred should be pursued, In addition, bank policies should explicitly
and, if an explanation is not forthcoming, the describe the terms under which margin loans,
loans collateralized by securities, are made and
3. The Boards SAR rules apply to state member banks, should ensure that they conform to applicable
bank holding companies and their nonbank subsidiaries that regulations. Management should review and
do not report on a different SAR form (for example, broker- approve daily MIS reports. The risk of market
dealers), Edge and agreement corporations, and the U.S.
branches and agencies of foreign banks supervised by the
deterioration in the value of the underlying col-
Federal Reserve. lateral may subject the lender to loss if the
collateral must be liquidated to repay the loan.
BHC Supervision Manual July 2012 In the event of a margin call, any shortage
Page 10 should be paid for promptly by the customer
from other sources pursuant to the terms of the the investment of funds in a fiduciary capac-
margin agreement. ity. PIR is a standard of review that imposes
In addition, policies should address the accep- an obligation to prudently manage the port-
tance of collateral held at another location, such folio as a whole, focusing on the process of
as an affiliated entity, but pledged to the private- portfolio management, rather than on the out-
banking function. Under these circumstances, come of individual investment decisions.
management of the private-banking function Although this rule only governs trusts, the
should, at a minimum, receive frequent reports standard is traditionally applied to all
detailing the collateral type and current valua- accounts for which the institution is manag-
tion. In addition, management of the private- ing funds.
banking function should be informed of any
changes or substitutions in collateral.
2010.11.2.4 Operational Controls
2010.11.2.3 Fiduciary Standards To minimize any operational risks associated
with private-banking activities, management is
Fiduciary risk is managed through the mainte- responsible for establishing an effective internal
nance of an effective and accountable commit- control infrastructure and reliable management
tee structure; retention of technically proficient information systems. Critical operational con-
staff; and development of effective policies, pro- trols over any private-banking activity include
cedures, and controls. In managing its fiduciary the establishment of written policies and proce-
risk, the bank must ensure that it carries out the dures, segregation of duties, and comprehensive
following fiduciary duties: management reporting. Throughout this section,
specific guidelines and inspection procedures
1. Duty of loyalty. Trustees are obligated to for assessing internal controls over different
make all decisions based exclusively on the private-banking activities are provided. Listed
best interests of trust customers. Except as below are some of those guidelines that cover
permitted by law, trustees cannot place them- specific private-banking services.
selves in a position in which their interests
might conflict with those of the trust
beneficiaries. 2010.11.2.4.1 Segregation of Duties
2. Avoidance of conflicts of interest. Conflicts
of interest arise in any transaction in which Banking organizations should have guidelines
the fiduciary simultaneously represents the on the segregation of employees duties in order
interests of multiple parties (including its to prevent the unauthorized waiver of documen-
own interests) that may be adverse to one tation requirements, poorly documented refer-
another. Institutions should have detailed rals, and overlooked suspicious activities. Inde-
policies and procedures regarding potential pendent oversight by the back office helps to
conflicts of interest. All potential conflicts ensure compliance with account-opening proce-
identified should be brought to the attention dures and CDD documentation. Control-
of management and the trust committee, with conscious institutions may use independent
appropriate action taken. Conflicts of interest units, such as compliance, risk management, or
may arise throughout an institution. Care senior management, to fill this function in lieu
should be taken by fiduciary business lines, of the back office. The audit and compliance
in particular, to manage conflicts of interest functions of the private-banking entity should
between fiduciary business lines and other be similarly independent so that they can oper-
business lines (including other fiduciary busi- ate autonomously from line management.
ness lines). Consequently, management
throughout the institution should receive
training in these matters. For more informa- 2010.11.2.4.2 Inactive and Dormant
tion on the supervision of fiduciary activities, Accounts
see section 3120.0 in this manual and section
4200.0 in the Commercial Bank Examination Management should be aware that banking laws
Manual. in most states prohibit banks from offering ser-
3. Duty to prudently manage discretionary trust vices that allow deposit accounts to be inactive
and agency assets. Since 1994, the majority
of states have adopted laws concerning the BHC Supervision Manual July 2012
prudent investor rule (PIR) with respect to Page 11
for prolonged periods of time (generally, 12 or tions. Examiners should carefully review a
more months with no externally generated banks use of such accounts and the adequacy of
account-balance activity). These regulations are its controls on their appropriate use. Generally,
based on the presumption that inactive and dor- client monies should flow through client deposit
mant accounts may be subject to manipulation accounts, which should function as the sole
and abuse by insiders. Policies and procedures conduit and paper trail for client transactions.
should delineate when inactivity occurs and
when inactive accounts should be converted to
dormant status. Effective controls over dormant 2010.11.2.4.4 Hold-Mail, No-Mail, and
accounts should include a specified time E-Mail-Only Controls
between the last customer-originated activity
and its classification as dormant, the segregation Controls over hold-mail, no-mail, and e-mail-
of signature cards for dormant accounts, dual only accounts are critical because the clients
control of records, and the blocking of the have relinquished their ability to detect unau-
account so that entries cannot be posted to the thorized transactions in their accounts in a
account without review by more than one mem- timely manner. Accounts with high volume or
ber of senior management. significant losses warrant further inquiry. Hold-
mail, no-mail, and e-mail-only account opera-
tions should ensure that client accounts are sub-
2010.11.2.4.3 Pass-Through Accounts and ject to dual control and are reviewed by an
Omnibus Accounts independent party.
Pass-through accounts (PTAs) extend checking-

account privileges to the customers of a foreign 2010.11.2.4.5 Funds TransferTracking
bank; several risks are involved in providing Transaction Flows
these accounts. In particular, if the U.S. banking
entity does not exercise the same due diligence One way that institutions can improve their cus-
and customer vetting for PTAs as it does for tomer knowledge is by tracking the transaction
domestic account relationships, the use of PTAs flows into and out of customer accounts and
may facilitate unsafe and unsound banking prac- payable-through subaccounts. Tracking should
tices or illegal activities, including money laun- include funds-transfer activities. Policies and
dering. Additionally, if accounts at U.S. banking procedures to detect unusual or suspicious
entities are used for illegal purposes, the entities activities should identify the types of activities
could be exposed to reputational risk and risk of that would prompt staff to investigate the cus-
financial loss as a result of asset seizures and tomers activities and should provide guidance
forfeitures brought by law enforcement authori- on the appropriate action required for suspicious
ties. It is recommended that U.S. banking enti- activity. The following is a checklist to guide
ties terminate a payable-through arrangement bank personnel in identifying some potential
with a foreign bank in situations in which abuses:
(1) adequate information about the ultimate
users of PTAs cannot be obtained, (2) the for- 1. indications of frequent overrides of estab-
eign bank cannot be relied on to identify and lished approval authority or other internal
monitor the transactions of its own customers, controls
or (3) the U.S. banking entity is unable to ensure 2. intentional circumvention of approval
that its payable-through accounts are not being authority by splitting transactions
used for money laundering or other illicit pur-
3. wire transfers to and from known secrecy
poses.
jurisdictions
Omnibus, or general clearing, accounts may
4. frequent or large wire transfers for persons
also exist in the private-banking system. They
who have no account relationship with the
may be used to accommodate client funds
bank, or funds being transferred into and out
before an account opening to expedite a new
of an omnibus or general clearing account
relationship, or they may fund products such as
instead of the clients deposit account
mutual funds in which client deposit accounts
may not be required. However, these accounts 5. wire transfers involving cash amounts in
could circumvent an audit trail of client transac- excess of $10,000
6. inadequate control of password access
BHC Supervision Manual July 2012 7. customer complaints or frequent error
Page 12 conditions
2010.11.2.4.6 CustodyDetection of expected for that customer; and

Free Riding 4. monitor specific transactions for BSA and
SAR compliance.
Custody departments should monitor account
activity to detect instances of free-riding, the In addition, reports prepared for private-banking
practice of offering the purchase of securities customers should be accurate, timely, and infor-
without sufficient capital and then using the mative. Regular reports and statements prepared
proceeds of the sale of the same securities to for private-banking customers should
cover the initial purchase. Free-riding poses sig- adequately and accurately describe the applica-
nificant risk to the institution and typically tion of their funds and should detail all transac-
occurs without the banks prior knowledge. tions and activity that pertain to the customers
Free-riding also violates margin rules (Regula- accounts.
tions T, U, and X) governing the extension of Furthermore, MIS and technology play a role
credit in connection with securities transactions. in building new and more direct channels of
(See SR-93-13 and section 2187.0.) information between the institution and its
private-banking customers. Active and
sophisticated customers are increasing their
2010.11.2.5 Management Information demand for data relevant to their investment
Systems needs, which is fostering the creation of online
information services. Online information can
Management information systems (MIS) should satisfy customers desire for convenience, real-
accumulate, interpret, and communicate infor- time access to information, and a seamless
mation on (1) the private-banking assets under delivery of information.
management, (2) profitability, (3) business and
transaction activities, and (4) inherent risks. The
form and content of MIS for private-banking 2010.11.2.6 Audit
activities will be a function of the size and
complexity of the private-banking organization. An effective audit function is vital to ensuring
Accurate, informative, and timely reports that the strength of a private banks internal controls.
perform the following functions may be pre- As a matter of practice, internal and external
pared and reviewed by RMs and senior auditors should be independently verifying and
management: confirming that the framework of internal con-
trols is being maintained and operated in a man-
1. aggregate the assets under management ner that adequately addresses the risks associ-
according to customer, product or service, ated with the activities of the organization.
geographic area, and business unit Critical elements of an effective internal audit
2. attribute revenue according to customer and function are the strong qualifications and exper-
product type tise of the internal audit staff and a sound risk-
3. identify customer accounts that are related to assessment process for determining the scope
or affiliated with one another through com- and frequency of specific audits. The audit pro-
mon ownership or common control cess should be risk-focused and should ulti-
4. identify and aggregate customer accounts by mately determine the risk rating of business
source of referral lines and client CDD procedures. Compliance
5. identify beneficial ownership of trust, PIC, with CDD policies and procedures and the
and similar accounts detailed testing of files for CDD documentation
are also key elements of the audit function.
To monitor and report transaction activity and to Finally, examiners should review and evaluate
detect suspicious transactions, management managements responsiveness to criticisms by
reports may be developed to the audit function.
1. monitor a specific transaction criterion, such

as a minimum dollar amount or volume or 2010.11.2.7 Compliance
activity level;
2. monitor a certain type of transaction, such as The responsibility for ensuring effective compli-
one with a particular pattern; ance with relevant laws and regulations may
3. monitor individual customer accounts for
variations from established transaction and BHC Supervision Manual July 2012
activity profiles based on what is usual or Page 13
vary among different forms of institutions, tional Emergency Economic Powers Act, the
depending on their size, complexity, and avail- President can impose sanctions, such as trade
ability of resources. Some institutions may have embargoes, the freezing of assets, and import
a distinct compliance department with the cen- surcharges, on certain foreign countries and the
tralized role of ensuring compliance institution- specially designated nationals of those
wide, including private-banking activities. This countries.
arrangement is strongly preferable to a situation A specially designated national is a person
in which an institution delegates compliance to or entity who acts on behalf of one of the
specific functions, which may result in the man- countries under economic sanction by the
agement of private-banking operations being United States. Dealing with such nationals is
responsible for its own internal review. Compli- prohibited. Moreover, their assets or accounts in
ance has a critical role in monitoring private- the United States are frozen. In certain cases,
banking activities; the function should be inde- the Treasury Department can issue a license to a
pendent of line management. In addition to designated national. This license can then be
ensuring compliance with various laws and presented by the customer to the institution,
regulations such as the Bank Secrecy Act and allowing the institution to debit his or her
those promulgated by the Office of Foreign account. The license can be either general or
Assets Control, compliance may perform its specific.
own internal investigations and due diligence on OFAC screening may be difficult when trans-
employees, customers, and third parties with actions are conducted through PICs, token
whom the bank has contracted in a consulting or names, numbered accounts, or other vehicles
referral capacity and whose behavior, activities, that shield true identities. Management must
and transactions appear to be unusual or suspi- ensure that accounts maintained in a name other
cious. Institutions may also find it beneficial for than that of the beneficial owner are subject to
compliance to review and authorize account- the same level of filtering for OFAC specially
opening documentation and CDD adequacy for designated nationals and blocked foreign coun-
new accounts. The role of compliance is a con- tries as other accounts. That is, the OFAC
trol function, but it should not be a substitute for screening process must include the accounts
regular and frequent internal audit coverage of beneficial ownership as well as the official
the private-banking function. Following is a account name.
description of certain regulations that may be
monitored by the compliance function. Any violation of regulations implementing
designated national sanctions subjects the viola-
tor to criminal prosecution, including prison
sentences and fines to corporations and indi-
2010.11.2.7.1 Office of Foreign Assets viduals, per incident. Any funds frozen because
Control of OFAC orders should be placed in a blocked
account. Release of those funds cannot occur
The Office of Foreign Assets Control (OFAC) of without a license from the Treasury Department.
the U.S. Department of the Treasury administers
and enforces economic and trade sanctions
based on U.S. foreign policy and national secu-
rity goals. Sanctions are imposed against tar-
2010.11.2.7.2 Bank Secrecy Act
geted foreign countries, terrorists, international
narcotics traffickers, and those engaged in Guidelines for compliance with the Bank
activities related to the proliferation of weapons Secrecy Act (BSA) can be found in the FFIEC
of mass destruction. See 31 C.F.R. subtitle B, BSA/AML Examination Manual. See also the
chapter V, part 501. OFAC acts under presiden- question-and-answer format interpretations (SR-
tial wartime and national emergency powers, as 05-9) of the U.S. Department of the Treasurys
well as under authority granted by specific legis- regulation (31 C.F.R. 1010) for banking organi-
lation, to impose controls on transactions and zations, which is based on section 326 of the
freeze foreign assets under U.S. jurisdiction. Patriot Act. In addition, the procedures for con-
Many of the sanctions are based on United ducting BSA examinations of foreign offices of
Nations and other international mandates, are U.S. banks are detailed in the FFIEC BSA/AML
multilateral in scope, and involve close coopera- Examination Manual. The SAR filing require-
tion with allied governments. Under the Interna- ments for nonbank subsidiaries of bank holding
companies and state member banks are also set
BHC Supervision Manual July 2012 forth in SR-10-8.
Page 14
2010.11.3 PREPARATION FOR inspection of private-banking activities.

INSPECTION Review and follow the expanded procedures
for private banking and any other expanded
The following subsections provide examiners procedures that are deemed necessary.
with guidance on preparing for the on-site
inspection of private-banking operations,
including determination of the inspection scope
2010.11.3.2 Inspection Staffing and
and drafting of the first-day-letter questionnaire
Scope
that is provided to the institution.
Once the inspection scope has been established
and before beginning the new inspection, the
2010.11.3.1 Pre-Inspection Review examiner-in-charge and key administrators of
To prepare the examiners for their assignments the inspection team should meet to discuss the
and to determine the appropriate staffing and private-banking inspection scope, the assign-
scope of the inspection, the following guidelines ments of the functional areas of private banking,
should be followed during the pre-inspection and the supplemental reviews of specific
planning process: private-banking products and services. If the
banks business lines and services overlap and if
1. Review the prior report of inspection and its customer base and personnel are shared
workpapers for the inspection scope; struc- throughout the organization, examiners may be
ture and type of private-banking activities forced to go beyond a rudimentary review of
conducted; and findings, conclusions, and private-banking operations. They will probably
recommendations of the prior inspection. need to focus on the policies, practices, and
The prior inspection report and inspection risks within the different divisions of a particu-
plan should also provide insight to key con- lar institution and throughout the institutions
tacts at the institution and to the time frame global network of affiliated entities.
of the prior private-banking review.
2. Obtain relevant correspondence sent since
the prior inspection, such as managements 2010.11.3.3 Reflection of Organizational
response to the report of inspection, any Structure
applications submitted to the Federal
Reserve, and any supervisory action. The review of private-banking activities should
3. Research press releases and published news be conducted on the basis of the bank holding
stories about the institution and its private- companys organizational structure. These
banking activities. structures may vary considerably depending on
4. Review internal and external audit reports the size and sophistication of the institution, its
and any internal risk assessments performed country of origin and the other geographic mar-
by the institution on its private-banking kets in which it competes, and the objectives
activities. Such reports should include an and strategies of its management and board of
assessment of the internal controls and risk directors. To the extent possible, examiners
profile of the private-banking function. should understand the level of consolidated
5. Contact the institutions management to private-banking activities an institution con-
ascertain what changes have occurred since ducts in the United States and abroad. This
the last inspection or are planned in the near broad view is needed to maintain the big pic-
future. For example, examiners should deter- ture impact of private banking for a particular
mine if there have been changes to the strate- institution.
gic plan; senior management; or the level For bank holding company inspections,
and type of private-banking activities, prod- examiners must consider the provisions of the
ucts, and services offered. If there is no men- Gramm-Leach Bliley Act, which amended sec-
tion of private banking in the prior inspection tion 5(c) of the Bank Holding Company Act,
report, management should be asked at this that concern examinations and inspections. In
time if they have commenced or plan to particular, examiners must adhere to those statu-
commence any private-banking activities. tory provisions that pertain to the inspections of
6. Follow these inspection procedures and also bank holding company nobank subsidiaries that
consider the core examination procedures in
the FFIEC BSA/AML Examination Manual BHC Supervision Manual July 2012
in order to establish the base scope for the Page 15
are supervised by functional regulators. See sec- 5. most recent audits for private-banking
tion 1040.0. activities
6. copies of audit committee minutes
7. copy of the CDD and SAR policies and
procedures
2010.11.3.4 Risk-Focused Approach 8. list of all new business initiatives intro-
duced last year and this year, relevant new-
Examiners reviewing the private-banking opera- product-approval documentation that
tions should implement the risk-focused inspec- addresses the evaluation of the unique char-
tion approach. The exam scope and degree of acteristics and risk associated with the new
testing of private-banking practices should activity or product, and an assessment of
reflect the degree of risk assumed, prior exam the risk-management oversight and control
findings on the implementation of policies and infrastructures in place to manage the risks
procedures, the effectiveness of controls, and an 9. list of all accounts in which an intermediary
assessment of the adequacy of the internal audit is acting on behalf of clients of the private
and compliance functions. If initial inquiries bank, for example, as financial advisers or
into the institutions internal audit and other money managers
assessment practices raise doubts about the 10. explanation of the methodology for follow-
internal systems effectiveness, expanded analy- ing up on outstanding account documenta-
sis and review are requiredand examiners tion and a sample report
should perform more transaction testing. Exam- 11. description of the method for aggregating
iners will usually need to follow the core exami- client holdings and activities across busi-
nation procedures in the FFIEC BSA/AML ness units throughout the organization
Examination Manual, as well as the expanded 12. explanation of how related accounts, such
procedures for private banking. Other expanded as common control and family link, are
procedures should be followed if circumstances identified
dictate. 13. name of a contact person for information on
compensation, training, and recruiting pro-
grams for relationship managers
2010.11.3.5 First-Day Letter 14. list of all personal investment company
accounts
As part of the inspection preparation, examiners 15. list of reports that senior management
should customize the first-day-letter question- receives regularly on private-banking
naire to reflect the structure and type of private- activities
banking activities of the institution and the 16. description and sample of the management
scope of the exam. The following is a list of information reports that monitor account
requests regarding private banking that examin- activity
ers should consider including in the first-day 17. description of how senior management
letter. Responses to these items should be monitors compliance with global policies
reviewed in conjunction with responses to the for worldwide operations, particularly for
BSA, fiduciary, audit, and internal control inqui- offices operating in secrecy jurisdictions
ries: 18. appropriate additional items from the core
and expanded procedures for private bank-
1. organizational chart for the private bank on ing, as set forth in the FFIEC BSA/AML
both a functional and legal-entity basis Examination Manual, as well as any other
2. business or strategic plan items from the expanded procedures that
3. income and expense statements for the prior are needed to gauge the adequacy of the
fiscal year and current year to date, with BSA/AML program for private-banking
projections for the remainder of the current activities.
and the next fiscal year, and income by
product division and marketing region
4. balance-sheet and total assets under man- 2010.11.4 INSPECTION OBJECTIVES
agement (list the most active and profitable
accounts by type, customer domicile, and 1. To determine if the policies, practices, proce-
responsible account officer) dures, and internal controls regarding
private-banking activities are adequate for
BHC Supervision Manual July 2012 the risks involved.
Page 16 2. To determine if the institutions officers and
employees are operating in conformance since the prior inspection, such as manage-
with established guidelines for conducting ments response to the report of inspection,
private-banking activities. any applications submitted to the Federal
3. To assess the financial condition and income- Reserve, and any supervisory actions.
generation results of the private-banking 4. Research press releases and published news
activities. stories about the institution and its private-
4. To determine the scope and adequacy of the banking activities.
audit function for private-banking activities. 5. Review internal and external audit reports
5. To determine compliance with applicable and any internal risk assessments performed
laws and regulations for private banking. by the institutions internal or external audi-
6. To initiate corrective action when policies, tors on its private-banking activities. Review
practices, procedures, or internal controls are information on any assessments of the inter-
deficient, or when violations of laws or regu- nal controls and risk profile of the private-
lations are found. banking function.
6. Contact management at the institution to
ascertain what changes in private-banking
2010.11.5 INSPECTION PROCEDURES services have occurred since the last inspec-
tion or if there are any planned in the near
The examiner-in-charge should supplement the future.
following procedures, as appropriate, with the a. Determine if the previous inspection or
examination procedures for private banking, as examination report(s) mention private
set forth in the FFIEC BSA/AML Examination banking; if not, ask management if they
Manual. have commenced or plan to commence
any private-banking activities within any
part of the bank holding company
2010.11.5.1 Private-Banking organization.
Pre-Inspection Procedures b. Determine if there have been any changes
to the strategic plan; senior management;
1. As the examiner-in-charge, conduct a meet- or the level and type of private-banking
ing with the lead members of the private- activities, products, and services offered.
banking inspection team and discuss c. During the entire inspection of private-
a. the private-banking inspection scope (The banking activities, be alert to the totality
inspection may need to extend beyond a of the client relationship, product by prod-
rudimentary review of private-banking uct, in light of increasing client awareness
operations if the institutions business and use of derivatives, emerging-market
lines and services overlap and if its cus- products, foreign exchange, and margined
tomer base and personnel are shared accounts.
throughout the organization. Examiners
will probably need to focus on the poli-
cies, practices, and risks within the differ- 2010.11.5.2 Full-Inspection Phase
ent divisions of each particular institution
and throughout each institutions global 1. After reviewing the private-banking func-
network of affiliated entities.); tional areas, draw sound conclusions about
b. examiner assignments of the functional the quality and culture of management and
areas of private banking; and stated private-banking policies.
c. the supplemental reviews of specific 2. Evaluate the adequacy of risk-management
private-banking products and services. policies and practices governing private-
2. Review the prior report of inspection and the banking activities.
previous inspection workpapers; description 3. Assess the organization of the private-
of the inspection scope; structure and type of banking function and evaluate the quality of
private-banking activities conducted; and managements supervision of private-
findings, conclusions, and recommendations banking activities. An appraisal of manage-
of the prior inspection. The prior inspection ment covers the
report and inspection plan should also pro- a. full range of functions (i.e., supervision
vide information and insight on key contacts and organization, risk management, fidu-
at the institution and on the time frame of the
prior private-banking review. BHC Supervision Manual July 2012
3. Review relevant correspondence exchanged Page 17
ciary standards, operational controls, 8. Ascertain whether the bank holding com-
management information systems, audit, pany adequately supervises the custody ser-
and compliance) and activities related to vices of its subsidiaries. The bank holding
the operation of the private-banking company should ensure that each institution
activities; and has established and currently maintains pro-
b. discharge of responsibilities by the insti- cedures for the proper administration of
tutions directors through a long-range custody services, including the regular
organizational plan that accommodates review of the services on a preset schedule.
the volume and business services 9. Determine whether subsidiary institutions
handled, local business practices and the are required to and actually maintain strong
institutions competition, and the growth controls and supervision over funds
and development of the institutions transfers.
private-banking business. 10. Ascertain if institution management and
4. Determine if management has effective pro- staff are required to perform due diligence,
cedures for conducting ongoing reviews of that is, to verify and document that the
client-account activity to detect, and protect funds of its private-banking customers were
the client from, any unauthorized activity derived through legitimate means, and
and any account activity that is inconsistent when extending credit, to verify that the use
with the clients profile (for example, fre- of loan proceeds was legitimate.
quent or sizeable unexplained transfers 11. Review the institutions use of deposit
flowing through the account). accounts.
5. Determine if the bank holding company has a. Assess the adequacy of the institutions
initiated and maintained controls and proce- controls and whether they are appropri-
dures that require each subsidiary private- ately used.
banking institution to have account-opening b. Determine if client monies flow through
procedures and documentation require- client deposit accounts and whether the
ments that must be satisfied before an accounts function as the sole conduit and
account can be opened. paper trail for client transactions.
6. Determine if the bank holding company 12. Determine and ensure that each institutions
requires its subsidiary institutions to main- approach to Suspicious Activity Reports
tain and adhere to well-structured CCD (SARs) is proactive and that the bank hold-
procedures. ing company and each institution have well-
7. Determine if the bank holding company has established procedures covering the SAR
proper controls and procedures to ensure process. Establish whether there is account-
each institutions proper administration of ability within the organization for the analy-
trust and estates, including strict controls sis and follow-up of internally identified
over assets, prudent investment and man- suspicious activity (this analysis includes a
agement of assets, and meticulous record- sound decision on whether the bank holding
keeping. Review previous trust examination company or an institution needs to file, or is
reports and consult with the designated Fed- required by regulation to file, a SAR).
eral Reserve System trust examiners.

Page 18
Fees Involving Investments of Fiduciary Assets in Mutual Funds
and Potential Conflicts of Interest Section 2010.12
Banking organizations, including trust institu- rity Act of 1974 (ERISA), however, generally
tions, are increasingly encountering various prohibits fee arrangements between fiduciaries
direct or indirect financial incentives to place and third parties, such as mutual fund providers,
trust assets with particular mutual funds. Such with limited exceptions.2 ERISA requirements
incentives include the payment of fees to bank- supersede state laws and guidelines put forth by
ing organizations for using nonaffiliated fund the bank regulatory agencies.
families as well as other incentives for using Similar conflict-of-interest concerns are
those mutual funds that are managed by the raised by the investment of fiduciary-account
institution or an affiliate. The payment of such assets in mutual funds for which the institution
fees, referred to variously as shareholder, subac- or an affiliate acts as investment adviser
counting, or administrative service fees, may be (referred to as proprietary funds). In this case,
structured as payments to reimburse the institu- the institution receives a financial benefit from
tion for performing standard recordkeeping and management fees generated by the mutual fund
accounting functions for the institutions fidu- investments. This activity can be expected to
ciary accounts. Those functions may consist of become more prevalent as banking organiza-
maintaining shareholder subaccounts and tions more actively offer proprietary mutual
records, transmitting mutual fund communica- funds.3 See SR-99-7.
tions as necessary, and arranging mutual fund
transactions. These fees are typically based on a
percentage or basis point amount of the dollar 2010.12.1 DUE-DILIGENCE REVIEW
value of assets invested, or on transaction vol- NEEDED BEFORE ENTERING INTO
ume. Another form of compensation may con- FEE ARRANGEMENTS
sist of a lump-sum payment based on assets
transferred into a mutual fund. Although many state laws now explicitly autho-
In all cases, decisions to place fiduciary assets rize certain fee arrangements in conjunction
in particular investments must be consistent with the investment of trust assets in mutual
with the underlying trust documents and must funds, institutions nonetheless face heightened
be undertaken in the best interests of the trust legal and compliance risks from activities in
beneficiary. The primary supervisory concern is which a conflict of interest exists, particularly if
that an institution may fail to act in the best proper fiduciary standards are not observed and
interest of beneficiaries if it stands to benefit documented. Even when the institution does not
independently from a particular investment. As exercise investment discretion, disclosure or
a result, an institution may expose itself to an other requirements may apply. Therefore, insti-
increased risk of legal action by account benefi- tutions should ensure that they perform and
ciaries, as well as to potential violations of law document an appropriate level of due diligence
or regulation. before entering into any fee arrangements simi-
In recent years, nearly every state legislature lar to those described earlier or placing fiduciary
has modified its laws explicitly to allow fiducia- assets in proprietary mutual funds. The follow-
ries to accept fees from mutual funds under ing measures should be included in this process:
certain conditions. As for the permissibility of
other financial incentives, guidance under appli- 1. Reasoned legal opinion. The institution
cable law may be less clear. Conditions involv- should obtain a reasoned opinion of counsel
ing fee payments under state law often include that addresses the conflict of interest inherent
compliance with standards of prudence, quality, in the receipt of fees or other forms of com-
and appropriateness for the account, and a deter-
mination of the reasonableness of the fees No. 704, February 1996.
received by the institution. The Office of the 2. ERISA section 406(b)(3). See Department of Labor,
Pension Welfare and Benefits Administration Advisory Opin-
Comptroller of the Currency (OCC) has also ion 97-15A and Advisory Opinion 97-16A.
adopted these general standards for national 3. A Board interpretation of Regulation Y addresses invest-
banks.1 The Employee Retirement Income Secu- ment of fiduciary-account assets in mutual funds for which
the trustee banks holding company acts as investment
adviser. In general, such investments are prohibited unless
1. In general, national banks may make these investments specifically authorized by the trust instrument, court order, or
and receive such fees if applicable law authorizes the practice state law. See 12 C.F.R. 225.125.
and if the investment is prudent and appropriate for fiduciary
accounts and consistent with established state law fiduciary
requirements. This includes a reasonableness test for any BHC Supervision Manual June 1999
fees received by the institution. See OCC Interpretive Letter Page 1
Fees Involving Investments of Fiduciary Assets in Mutual Funds and Potential Conflicts of Interest 2010.12
pensation from mutual fund providers in conformed ongoing due-diligence reviews when
nection with the investment of fiduciary it is receiving fees or other compensation for
assets. The opinion should address the per- investing fiduciary assets in mutual funds or
missibility of the investment and compensa- investing such assets in proprietary mutual
tion under applicable state or federal laws, funds.
the trust instrument, or a court order, as well 2. To determine that the institution maintains
as any applicable disclosure requirements or full ongoing documentation of investment
reasonableness standard for fees set forth in decisions and performance, and obtains legal
the law. opinions regarding its compliance with appli-
2. Establishment of policies and procedures. cable laws and fiduciary standards, as well as
The institution should establish written poli- potential conflicts of interest that may arise
cies and procedures governing the accep- from its receiving fees or other compensation
tance of fees or other compensation from for investing fiduciary assets in mutual funds,
mutual fund providers as well as the use of including proprietary funds.
proprietary mutual funds. The policies must
be reviewed and approved by the institu-
tions board of directors or its designated 2010.12.3 INSPECTION PROCEDURES
committee. Policies and procedures should,
at a minimum, address the following issues: 1. Determine if a written legal opinion is on file
(1) designation of decision-making author- that focuses on conflicts of interest that may
ity; (2) analysis and documentation of invest- arise from the receipt of fees and other com-
ment decisions; (3) compliance with applica- pensation from mutual fund providers for
ble laws, regulations, and sound fiduciary investing fiduciary assets, and from the
principles, including any disclosure require- investment of these assets in proprietary
ments or reasonableness standards for mutual funds. Ascertain whether the legal
fees; and (4) staff training and methods for opinion addresses the investments permissi-
monitoring compliance with policies and bility, including its resulting compensation
procedures by internal or external audit staff. and any disclosure requirements under appli-
3. Analysis and documentation of investment cable state or federal laws, the trust instru-
decisions. When fees or other compensation ment, or a court order.
are received in connection with fiduciary- 2. Verify that the institutions board of directors
account investments over which the institu- has approved written policies and procedures
tion has investment discretion or when such governing the acceptance of fees and other
investments are made in the institutions pro- compensation from mutual fund providers
prietary mutual funds, the institution should for placing investments with their firms and
fully document its analysis supporting the for the use of proprietary funds. Ascertain
investment decision. This analysis should be that the policies and procedures, at a
performed on a regular, ongoing basis and minimum
would typically include factors such as his- a. determine what group or individual has
torical performance comparisons with simi- decision-making authority;
lar mutual funds, management fees and b. analyze and document supporting invest-
expense ratios, and ratings by recognized ment decisions;
mutual fund rating services. The institution c. require compliance with applicable laws,
should also document its assessment that the regulations, and sound fiduciary prin-
investment is, and continues to be, (1) appro- ciples, including disclosure requirements
priate for the individual account, (2) in the or reasonableness standards for fees; and
best interest of account beneficiaries, and d. address staff training and methods for
(3) in compliance with the provisions of the monitoring compliance with policies and
prudent investor or prudent man rules, procedures by internal and external audit
as appropriate. staff.
3. When fees and other compensation are being
received in connection with fiduciary-
2010.12.2 INSPECTION OBJECTIVES account investments (those in which the
institution has authorized discretionary
1. To determine that the institution has per- investment authority) or when such assets
are involved in proprietary mutual funds,
BHC Supervision Manual June 1999 ascertain whether there is full documentation
Page 2 of the institutions analysis supporting its
Fees Involving Investments of Fiduciary Assets in Mutual Funds and Potential Conflicts of Interest 2010.12
investment decisions on a regular, ongoing b. an assessment that the investments are,

basis. Ascertain that the documentation and continue to be, appropriate for the
includes individual account and in the best inter-
a. historical performance comparisons with ests of its account beneficiaries; and
other mutual funds, engagement fees and c. evidence of continued compliance with
expense ratios, and ratings by recognized the provisions of the prudent investor
mutual fund rating agencies; or prudent man rules.

Page 3
Supervision of Subsidiaries (Establishing Accounts for Foreign
Governments, Embassies, and Political Figures) Section 2010.13
On June 15, 2004, an interagency advisory con- established by the board of directors, and should
cerning the embassy banking business and be based on the institutions own business
related banking matters was issued by the fed- objectives, its assessment of the risks associated
eral banking and thrift agencies1 in coordination with particular accounts or lines of business,
with the U.S. Department of the Treasurys and its capacity to manage those risks. The
Financial Crimes Enforcement Network. The agencies will not, in the absence of extraor-
purpose of the advisory is to provide general dinary circumstances, direct or encourage any
guidance to banking organizations regarding the institution to open, close, or refuse a particular
treatment of accounts for foreign governments, account or relationship.
foreign embassies, and foreign political figures. Providing financial services to foreign gov-
The joint interagency statement advises bank- ernments and embassies and to foreign political
ing organizations2 that the decision to accept or figures can, depending on the nature of the
reject an embassy or foreign government customer and the services provided, involve
account is theirs alone to make. Financial insti- varying degrees of risk. Such services can range
tutions should be aware, however, that there are from account relationships that enable an
varying degrees of risk associated with such embassy to handle the payment of operational
accounts, depending on the customer and the expensesfor example, payroll, rent, and
nature of the services provided. Financial insti- utilitiesto ancillary services or accounts pro-
tutions should take appropriate steps to manage vided to embassy staff or foreign-government
such risks, consistent with sound practices and officials. Each of these relationships potentially
applicable anti-money-laundering laws and poses different levels of risk. Institutions are
regulations. The advisory also encourages bank- expected to assess the risks involved in any such
ing organizations to direct questions about relationships and to take steps to ensure both
embassy banking to their primary federal bank that such risks are appropriately managed and
regulators. See SR-04-10. that the institution can do so in full compliance
with its obligations under the Bank Secrecy Act,
as amended by the USA Patriot Act, and the
regulations promulgated thereunder.
When an institution elects to establish finan-
2010.13.1 INTERAGENCY ADVISORY cial relationships with foreign governments,
ON ACCEPTING ACCOUNTS FOR embassies, or foreign political figures, the agen-
FOREIGN GOVERNMENTS, cies, consistent with their usual practice of risk-
EMBASSIES, AND POLITICAL based supervision, will make their own assess-
FIGURES ment of the risks involved in such business. As
is the case with all accounts, the institution
The interagency advisory answers questions on should expect appropriate scrutiny by examiners
whether financial institutions should do business that is commensurate with the level of risk
with foreign embassies and whether institutions presented by the account relationship. As in any
should establish account services for foreign case where higher risks are presented, the insti-
governments, foreign embassies, and foreign tution should expect an increased level of
political figures. As it would with any new review by examiners to ensure that the institu-
account, an institution should evaluate whether tion has in place controls and compliance over-
or not to accept a new account for a foreign sight systems that are adequate to monitor and
government, embassy, or political figure. That manage such risks, as well as personnel trained
decision should be made by the institutions in the management of such risks and in the
management, under standards and guidelines requirements of applicable laws and regulations.
Institutions that have or are considering tak-
ing on relationships with foreign governments,
1. The Board of Governors of the Federal Reserve Sys- embassies, or political figures should ensure that
tem, the Federal Deposit Insurance Corporation, the Office of
the Comptroller of the Currency, the Office of Thrift Supervi-
such customers are aware of the requirements of
sion, and the National Credit Union Administration (the U.S. laws and regulations to which the institu-
agencies). tion is subject. Institutions should, to the maxi-
2. The advisory is primarily directed to financial institu- mum extent feasible, seek to structure such
tions located in the United States. The boards of directors of
bank holding companies, however, should consider whether
the advisory should be applied to their other U.S. subsidiaries BHC Supervision Manual December 2004
financial and other services. Page 1
Supervision of Subsidiaries (Establishing Accounts for Foreign Governments, Embassies, and Political Figures) 2010.13
relationships in order to conform them to con- so as to reduce the risks that might be presented
ventional U.S. domestic banking relationships by such relationships.

Page 2
Intercompany Transactions
Section 2020.0
WHATS IN THIS SECTION negative effect on the subsidiarys liquidity

position.
This section was revised as of January 2008 to
incorporate references to the Federal Reserve
Transactions with affiliates. Transactions
Boards Regulation W, primarily with regard to
between subsidiary IDI affiliates is another area
the bank holding company (BHC) inspection
of potential abuse of subsidiary banks. Regula-
process. The section includes also a discussion
tory concern centers on the quantitative limits
of the mandatory reporting of certain intercom-
and collateral restrictions on certain transactions
pany transactions on the FR Y-8, The Bank
by subsidiary banks with their affiliates. These
Holding Company Report of Insured Depository
restrictions are designed to protect subsidiary
Institutions Section 23A Transactions with
IDIs from losses resulting from transactions
Affiliates, and its instructions. The mandatory
with affiliates.
report is to be submitted quarterly to the Fed-
eral Reserve by (1) all top-tier BHCs, including
financial holding companies, and (2) all foreign Fees paid by subsidiaries. Management or ser-
banking organizations that directly own a U.S. vice fees are another cash outflow of bank
subsidiary bank. The examiners inspection subsidiaries. These fees may be paid to the
responsibilities are discussed. parent, the nonbank subsidiaries, or, in some
cases, to the other bank subsidiaries. Regulatory
concern focuses on whether such fees are rea-
sonable in relation to the services rendered and
on the financial impact of the fees on the bank
2020.0.1 ANALYSIS OF
subsidiaries.
INTERCOMPANY TRANSACTIONS
The analysis of intercompany transactions Tax allocation. How a bank holding company
between a parent company, its nonbank sub- organization determines to allocate taxes among
sidiaries, and its bank subsidiaries is primarily its component companies involves questions of
intended to assess the nature of the relation- both the magnitude and timing of the cash-flow
ships between these entities and the effect of the effects. Unreasonable or untimely tax payments
relationships on the subsidiary insured deposi- or refunds to the bank can have an adverse
tory institutions (IDIs). IDIs include any state effect on the financial condition of the banking
bank, national bank, trust company, or banking subsidiaries.
association and any institution that takes depos-
its that are insured by the Federal Deposit Insur- Purchases or swaps of assets. Asset purchases
ance Corporation, including savings associa- or swaps between a bank and its affiliates can
tions. Both the legal and financial ramifications create the potential for abuse of subsidiary
of such transactions are areas of concern. banks. Regulatory concern focuses on the fair-
Certain intercompany transactions are subject to ness of such asset transactions and their finan-
the provisions of section 23A or 23B (or both) cial impact and timing. Fairness and financial
of the Federal Reserve Act and the Federal considerations include the quality and collect-
Reserve Boards Regulation W. Section 23A of ibility and fair values of such assets and their
the Federal Reserve Act is one of the most liquidity effects. IDIs generally are prohibited
important statutes on limiting exposures to from purchasing low-quality assets from affili-
individual institutions and protecting the fed- ates. Asset exchanges may be a mechanism to
eral safety net. Several types of intercompany avoid regulations designed to protect subsidiary
transactions and the primary regulatory banks from becoming overburdened with non-
concerns of each are presented below. earning assets. Improper timing or certain struc-
turings of asset transactions also can cause them
to be regarded as extensions of credit to affili-
Dividends paid by subsidiaries to the parent. ates. As such, these types of transactions could
Dividends are a highly visible cash outflow by potentially violate applicable regulations and
subsidiaries. If the dividend payout ratio statutes.
exceeds the level at which the growth of
retained earnings can keep pace with the growth
of assets, the subsidiarys capital ratios will BHC Supervision Manual January 2014
deteriorate. These dividends may also have a Page 1
Intercompany Transactions 2020.0
Compensating balances. A subsidiary bank may The mandatory report is to be submitted to the
be required to maintain excess balances at a Federal Reserve by (1) all top-tier bank holding
correspondent bank that lends to other parts of companies (BHCs), including financial holding
the holding company organization, possibly to companies, and (2) all foreign banking organiza-
the detriment of the bank. The subsidiary bank tions that directly own a U.S. subsidiary bank.
may be foregoing earnings on such excess The completed quarterly reports are used by the
funds, which may adversely affect its financial Federal Reserve System to monitor bank expo-
condition. sures to affiliates and to ensure banks compli-
ance with section 23A of the Federal Reserve
Other expense allocations. In general, a subsidi- Act. With regard to the BHCs inspection, the
ary bank should be adequately compensated for examiner should review and verify, since the
its services or for the use of its facilities and previous inspection, the BHCs accuracy and
personnel by other parts of the holding company comprehensiveness in its reporting based on the
organization. Furthermore, a subsidiary bank FR Y-8 report form and instructions.
should not pay for expenses for which it does If a subsidiary IDI of a holding company is
not receive a benefit. not a state member bank, the banks primary
regulator should determine the banks compli-
ance with pertinent banking laws. In reviewing
2020.0.2 ROLE OF THE EXAMINER the subsidiary banks examination report, any
violations of laws and regulations applicable to
To properly assess intercompany transactions intercompany transactions should be noted. If
and relationships between affiliates, the exam- the violation resulted from the actions of an
iner must make a thorough analysis of most affiliate, the affiliates role should be identified
intercompany transactions and must have a and be subject to criticism in the inspection
knowledge of applicable laws, regulations, and report.
rulings. In particular, the examiner should be Violations of banking laws discovered during
familiar with sections 23A and 23B of the Fed- the inspection should be brought to manage-
eral Reserve Act and the Boards Regulation W. ments attention and referred to the banks pri-
The examiner should also be familiar with the mary supervisor. However, any action or criti-
FR Y-8, The Bank Holding Company Report of cism levied directly on the bank should come
Insured Depository Institutions Section 23A from the banks primary supervisor.
Transactions with Affiliates, and its instructions.

Page 2
Intercompany Transactions (Transactions Between Member Banks and Their
AffiliatesSections 23A and 23B of the Federal Reserve Act) Section 2020.1
2020.1.01 WHATS NEW IN THIS between a member bank and its affiliates with
REVISED SECTION numerous previously issued Board inter-
pretations.
This section has been revised to discuss statu- During a bank holding company inspection,
tory amendments of sections 23A and 23B of the transactions between an IDI and an affiliate (for
Federal Reserve Act resulting from the Dodd- example, a bank holding company parent or
Frank Act. One amendment involved the defini- other nonbank subsidiary) are reviewed for
tion of an affiliate, with regard to an invest- compliance with sections 23A and 23B and
ment fund when an insured depository Regulation W, as well as other banking regula-
institution (IDI) or one of its affiliates is an tions and statutes. Any violations of sec-
investment adviser. Also, the definition of cov- tions 23A and 23B of the FRA or Regulation W
ered transactions was revised to include the involving a transaction between an IDI and its
credit exposure resulting for derivative and affiliate that are disclosed or found during an
securities lending and borrowing transactions inspection should be brought to managements
between the IDI and its affiliates. In addition, attention, may be discussed in the inspection
the Dodd-Frank Act removed the quantitative 10 report as Other Matters, and referred to the
percent exemption limit between financial sub- banks primary supervisor. However, any action
sidiaries. The retained earnings of a financial or criticism levied directly on the bank should
subsidiary are to be included as part of the come from the banks primary supervisor. See
IDIs investment. The amendments were effec- also SR-03-2.
tive July 21, 2012. (See sections 608(a)(1)(A),
608(a)(1)(B), and 609(a) of the Dodd-Frank
Act.) 2020.1.1 SECTION 23A OF THE
Revised inspection objectives and inspection FEDERAL RESERVE ACT
procedures also are included.
Section 23A of the FRA (12 U.S.C. 371c) is the
primary statute governing transactions between
2020.1.05 SECTIONS 23A AND 23B an IDI and its affiliates. Section 23A (1) desig-
OF THE FEDERAL RESERVE ACT, nates the types of companies that are affiliates of
AND REGULATION W an IDI; (2) specifies the types of transactions
covered by the statute; (3) sets the quantitative
Section 23A of the Federal Reserve Act (FRA) limitations on an IDIs covered transactions
restricts the ability of insured depository insti- with any single affiliate, and with all affiliates
tutions (IDIs)1 to engage in certain covered combined; (4) sets forth collateral requirements
transactions with an affiliate. Transactions that for certain transactions with affiliates; and
are subject to section 23A also are subject to (5) requires all covered transactions to be con-
the provisions of section 23B of the FRA.2 In ducted on terms consistent with safe and sound
addition to these statutory provisions, the banking practices.
Board issued Regulation W (the rule),3 which
implements sections 23A and 23B of the FRA.
The rule provides several exemptions and com- 2020.1.1.1 Definition of an Affiliate
bines the statutory restrictions on transactions
In general, companies that control or are under
1. By their terms, sections 23A and 23B apply to banks common control with an IDI are defined by
that are members of the Federal Reserve System (member section 23A as affiliates of the bank. The
banks). Other federal laws subject FDIC-insured non- definition includes a bank subsidiary of a bank
member banks and FDIC-insured thrifts to sections 23A and
23B in the same manner and to the same extent as if and any company that a bank, or its subsidiaries
they were member banks. (See 12 U.S.C. 1828(j) and or affiliates, sponsors and advises on a
12 U.S.C.1468(a)(4)). The statute also states that most subsid- contractual basis.4 Affiliates, for example, may
iaries of a member bank are to be treated as part of the
member bank itself for purposes of sections 23A and 23B.
Because the statute and regulation apply to all insured deposi- 4. The Board has the authority to expand the definition of
tory institutions, this section will refer to the subject institu- affiliate to include a company that has a relationship with the
tions as insured depository institutions (IDIs). bank so that covered transactions between the company and
2. Federally insured savings associations also are subject
to sections 23A and 23B as if they were banks.
3. In this section of the manual, Regulation W is referred BHC Supervision Manual July 2014
to as the rule or to a specific numbered section of the rule. Page 1
Transactions Between Member Banks and Their AffiliatesSections 23A and 23B 2020.1
include banks, financial holding companies, 6. any investment fund for which the IDI or
savings and loan holding companies, and their any affiliate of the IDI serves as an invest-
subsidiaries. Banks, savings associations, and ment adviser, if the IDI and its affiliates
nonbanking companies that are under common own or control, in the aggregate, more than
individual control or a group of individuals with 5 percent of any class of voting securities or
the bank also are affiliates for the purposes of of the equity capital of the fund;
section 23A. Any investment fund with respect 7. a depository institution that is a subsidiary
to which a member bank or affiliate thereof is an of the IDI;
investment adviser. See section 608(a)(1)(A) of 8. a financial subsidiary of the member bank;
the Dodd-Frank Act. In addition, any transaction
by an IDI with any person is deemed to be a 9. any company in which a holding company
transaction with an affiliate to the extent that the of the IDI owns or controls, directly or
proceeds of the transaction are transferred to, or indirectly, or acting through one or more
used for the benefit of, the affiliate. With respect other persons, 15 percent or more of the
to any IDI within a holding company, its affiliates equity capital pursuant to the merchant
include, among others, its parent, the parents banking authority in section 4(k)(4)(H) or
subsidiaries, and other companies directly or (I) of the Bank Holding Company Act
indirectly controlled by the banks or holding (12 U.S.C. 1843(k)(4)(H) or (I));
companys shareholders. Specifically, Regula- 10. any partnership for which the IDI or any
tion W defines5 an affiliate as affiliate of the IDI serves as a general part-
ner or for which the IDI or any affiliate of
1. any company that controls6 the IDI and any the IDI causes any director, officer, or
other company that is controlled by the employee of the member bank or affiliate to
company that controls the IDI; serve as a general partner;
2. any bank subsidiary of the IDI; 11. any subsidiary of an affiliate described in
3. any company paragraphs (a)(1) through (10) of sec-
that is controlled directly or indirectly, tion 223.2 of Regulation W; and
by a trust or otherwise, by or for the 12. any company that the Board, or the appro-
benefit of shareholders who beneficially priate federal banking agency for the IDI,
or otherwise control, directly or indi- determines by regulation or order to have a
rectly, by trust or otherwise, the mem- relationship with the IDI or any subsidiary
ber bank or any company that controls or affiliate of the member bank, such that
the IDI; or covered transactions by the member bank
in which a majority of its directors or or its subsidiary with that company may be
trustees constitute a majority of the per- affected by the relationship, to the detri-
sons holding any such office with the ment of the IDI or its subsidiary.
IDI or any company that controls the
IDI; The following generally are not considered to
4. any company (including a real estate invest- be affiliates of an IDI:
ment trust) that is sponsored and advised on
a contractual basis by the IDI or any subsid-
iary or affiliate of the IDI; 1. a nonbank subsidiary of the IDI (other than
5. any investment company, with respect to a financial subsidiary), unless the Board
which an IDI or any affiliate thereof is an determines not to exclude such a subsidiary;
investment adviser as defined in sec- 2. a company engaged solely in holding the
tion 2(a)(20) of the Investment Company IDIs premises;
Act of 1940; 3. a company engaged solely in conducting a
safe deposit business;
the bank may be affected by the relationship to the detriment 4. a company engaged solely in holding obli-
of the bank.
5. See 12 C.F.R. 223.2. gations of the United States or its agencies
6. By statute, control is defined as the power to (1) vote or obligations fully guaranteed by the
25 percent or more of the voting shares of a company, United States or its agencies as to principal
excluding situations in which the stock is controlled in a and interest; and
fiduciary capacity; (2) elect a majority of the directors of a
company; or (3) exercise a controlling influence over a com- 5. a company in which control arises from the
pany. Control is discussed in more detail at 2020.1.3.1. exercise of rights arising out of a bona fide
debt previously contracted (for the period
BHC Supervision Manual July 2014 of time specified by section 23A).
Page 2
2020.1.1.2 Definition of Affiliates by underwriting and dealing in bank-ineligible

Type of Entity securities. The GLB Act amended section 23A
to define a financial subsidiary of a bank as an
affiliate of the bank and thus subjected covered
2020.1.1.2.1 Investment Funds Advised transactions between the bank and a financial
by the Member Bank or an Affiliate of the subsidiary to the limitations of sections 23A and
Member Bank 23B.
Section 23A defines a financial subsidiary as
Regulation W includes as an affiliate any com- a subsidiary of any bank (state or national) that
pany that is sponsored and advised on a contrac- is engaged in an activity that is not permissible
tual basis by the IDI or any of its affiliates as for national banks to engage in directly (other
well as any investment company for which the than a subsidiary that federal law specifically
IDI or its affiliate serves as an investment authorizes national banks to own or control).
adviser, as defined in the Investment Company Specifically, a financial subsidiary is defined
Act of 1940 (the 1940 Act). In Regulation W, as any company that is a subsidiary of a bank
the Board used its statutory authority to define that would be a financial subsidiary of a national
as an affiliate any investment fundeven if not bank under section 5136A of the Revised Stat-
an investment company for purposes of the 1940 utes of the United States.9 (See 12 U.S.C.
Actfor which the IDI or an affiliate of the IDI 371c(e)(1).) Section 5136A, in turn, defines a
serves as an investment adviser, if the IDI or an financial subsidiary as any company that is con-
affiliate of the IDI owns or controls more than trolled by one or more member banks, other
5 percent of any class of voting securities or than (1) a subsidiary that engages solely in
similar interests of the fund. activities that national banks are permitted to
Many investment funds that are advised by an engage in directly (and subject to the terms and
IDI (or an affiliate of an IDI) are affiliates of the conditions that apply to national banks) or (2) a
IDI under section 23A because the funds either subsidiary that national banks are specifically
are investment companies under the 1940 Act or authorized to control by the express terms of a
are sponsored by the IDI (or an affiliate of the federal statute (other than section 5136A of the
IDI). The IDI or its affiliate, in some instances, Revised Statutes), such as an Edge Act corpora-
however, may advise but not sponsor an invest- tion or a small business investment company
ment fund that is not an investment company (SBIC).10 (See 12 U.S.C. 24a(g)(3).) Section
under the 1940 Act.7 The advisory relationship 5136A also prohibits a financial subsidiary of a
of an IDI or affiliate with an investment fund national bank from engaging in insurance under-
presents the same potential for conflicts of inter- writing, real estate investment and development,
est regardless of whether the fund is an invest- or merchant banking activities.11 (See 12 U.S.C.
ment company under the 1940 Act.8 The Dodd- 24a(a)(2).)
Frank Act treats any investment fund as an The Dodd-Frank Act amended section 23A as
affiliate if the IDI or an affiliate of the IDI serves it relates to financial subsidiaries of a bank.
as an investment adviser to the fund. First, the 10 percent quantitative limit of sec-
tion 23A between a bank and any individual
affiliate applies to covered transactions between
2020.1.1.2.2 Financial Subsidiaries a bank and a financial subsidiary of the bank. In
addition, for purposes of section 23A, the
In 1999, the Gramm-Leach-Bliley Act (the GLB amount of a banks investment in its financial
Act) authorized banks to own financial subsid- subsidiary includes the retained earnings of the
iaries that engage in activities not permissible financial subsidiary. See section 609(a) of the
for the parent bank to conduct directly, such as Dodd-Frank Act.
Section 23A generally applies only to transac-
7. 12 U.S.C. 371c(b)(1)(E). tions between (1) a bank and an affiliate of the
8. An investment fund typically escapes from the defini- bank and (2) a bank and a third party in which
tion of investment company under the 1940 Act because it some benefit of the transactions accrues to an
(1) sells interests only to a limited number of investors or only
to sophisticated investors or (2) invests primarily in financial
instruments that are not securities. An IDI may face greater
9. 12 U.S.C. 24a(g)(3).
risk from the conflicts of interest arising from its relationships
10. 12 U.S.C. 24a(a)(2).
with an investment fund that is not registered than an invest-
11. 12 U.S.C. 371c(e)(1).
ment company under the 1940 Act because the 1940 Act
restricts transactions between a registered investment com-
pany and entities affiliated with the companys investment BHC Supervision Manual July 2014
adviser. (See 15 U.S.C. 80a-17). Page 3
affiliate of the bank. The statute generally does retained earnings of the financial subsidiary.14
not apply to transactions between two affiliates. In light of this statutory provision, sec-
Section 23A establishes two special anti-evasion tion 223.32(b) of the rule contains a special
provisions, however, that govern transactions valuation provision for investments by a mem-
between a financial subsidiary of a bank and ber bank in the securities of its own financial
another affiliate of the bank. First, the FRA subsidiary.15 Such investments must be valued
provides that any purchase of, or investment in, at the greater of (1) the price paid by the mem-
the securities of a banks financial subsidiary by ber bank for the securities or (2) the carrying
an affiliate of the bank will be deemed to be a value of the securities on the financial state-
purchase of, or investment in, such securities by ments of the member bank (determined in accor-
the bank itself. Second, the GLB Act authorizes dance with generally accepted accounting prin-
the Board to deem a loan or other extension of ciples (GAAP) but without reflecting the banks
credit made by a banks affiliate to any financial pro rata share of any earnings retained, or losses
subsidiary of the bank to be an extension of incurred by, the financial subsidiary after the
credit by the bank to the financial subsidiary, if banks acquisition of the securities).16
the Board determines that such action is neces- This valuation rule differs from the general
sary or appropriate to prevent evasion. valuation rule for investments in securities
issued by an affiliate in that the financial subsid-
iary rule permits, consistent with the GLB Act,
2020.1.1.2.2.1 Regulation W Provisions for that the carrying value of the investment be
Financial Subsidiaries computed without consideration of the retained
earnings or losses of the financial subsidiary
Regulation W (1) defines a financial subsidiary since the time of the member banks investment.
of a bank, (2) exempts certain companies from As a result of this rule, the covered transaction
the definition, and (3) sets forth special valua- amount for a member banks investment in
tion and other rules for financial subsidiaries. securities issued by its financial subsidiary gen-
(See sections 223.2(a)(8), 223.3(p), and 223.32 erally would not increase after the investment
of the rule.) Regulation W also includes several was made except if the member bank made an
special rules that apply to transactions with additional capital contribution to the subsidiary
financial subsidiaries. or purchased additional securities of the
subsidiary.
Applicability of the 10 percent quantitative The following examples were designed to
limit to transactions with a financial subsidiary. assist banks in valuing investments in securities
The 10 percent quantitative limit in section 23A issued by a financial subsidiary of the bank.
applies with respect to covered transactions Each example involves a securities underwriter
between a member bank and any individual that becomes a financial subsidiary of the bank
financial subsidiary of the bank.12 after the transactions described below.
Valuation of investments in securities issued 1. Initial valuation.

by a financial subsidiary. Because financial sub- a. Direct acquisition by a bank. A bank pays
sidiaries of a member bank are considered affili- $500 to acquire 100 percent of the shares
ates of the bank for purposes of section 23A, a of a securities underwriter. The initial car-
member banks purchases of, and investments rying value of the shares on the member
in, the securities of its financial subsidiary are banks parent-only GAAP financial state-
covered transactions under the statute.13 The ments is $500. The member bank initially
Dodd-Frank Act provides that a member banks
investment in its own financial subsidiary, for
purposes of section 23A, shall include the 14. See section 609(a) of the Dodd-Frank Act.
15. The rules special valuation formula for investments by
a member bank in its own financial subsidiary does not apply
to investments by a member bank in a financial subsidiary of
12. A member banks aggregate amount of covered trans-
an affiliated depository institution. Such investments must be
actions with any individual financial subsidiary of the bank
valued using the general valuation formula set forth in sec-
may not exceed 10 percent of the banks capital and surplus.
tion 223.23 for investments in securities issued by an affiliate
13. See section 609(a) of the Dodd-Frank Act. The Dodd-
and, further, may trigger the anti-evasion rule contained in
Frank Act eliminated the 10 percent quantitative limit exemp-
section 223.32(c)(1) of the rule.
tion for certain covered transactions with financial subsidi-
16. The rule also makes clear that if a financial subsidiary
aries and individual affiliates.
is consolidated with its parent bank under GAAP, the subsidi-
ary under the carrying value of the banks investment in the
BHC Supervision Manual July 2014 financial subsidiary shall be determined based on parent-only
Page 4 financial statements of the bank.
must value the investment at $500. FRA or the GLB Act. Section 223.32(c) of the
b. Contribution of a financial subsidiary to a rule incorporates both of these provisions.
member bank. The parent holding com- The Board exercised its authority under the
pany of a bank acquires 100 percent of second anti-evasion rule by stating that an
the shares of a securities underwriter in a extension of credit to a financial subsidiary of a
transaction valued at $500 and immedi- bank by an affiliate of the bank would be treated
ately contributes the shares to the member as an extension of credit by the bank itself to the
bank. The bank gives no consideration in financial subsidiary if the extension of credit is
exchange for the shares. The bank ini- treated as regulatory capital of the financial sub-
tially must value the investment at the sidiary. An example of the kind of credit exten-
carrying value of the shares on the banks sion covered by this provision would be a subor-
parent-only GAAP financial statements. dinated loan to a financial subsidiary that is a
Under GAAP, the banks initial carrying securities broker-dealer in which the loan is
value of the shares would be $500. treated as capital of the subsidiary under the
2. Carrying value not adjusted for earnings and SECs net capital rules. Treating such an exten-
losses of the financial subsidiary. A bank and sion of credit as a covered transaction is appro-
its parent holding company engage in a trans- priate because the extension of credit by the
action whereby the member bank acquires affiliate has a similar effect on the subsidiarys
100 percent of the shares of a securities regulatory capital as an equity investment by the
underwriter in a transaction valued at $500. affiliate, which is treated as a covered transac-
The bank initially values the investment at tion by the terms of the GLB Act (as described
$500. In the following year, the securities above). The rule generally does not prevent a
underwriter earns $25 in profit, which is BHC or other affiliate of a member bank from
added to its retained earnings. The banks providing financial support to a financial subsid-
investment of the shares of the underwriter is iary of the bank in the form of a senior or
not adjusted for purposes of section 23A and secured loan.
Regulation W, and the banks investment
continues to be valued at $500. If, however,
the member bank contributes $100 of addi- 2020.1.1.2.3 Partnerships
tional capital to the securities underwriter,
the bank must value the aggregate invest-
IDIs fund legitimate commercial transactions
ment at $600.
through partnerships. Partnerships for which an
IDI or an affiliate(s) serves as a general partner
Anti-evasion rules as they pertain to financial
are affiliates. Regulation W also defines an affili-
subsidiaries. Section 23A generally applies only
ate of an IDI as any partnership, if the IDI or an
to transactions between a bank and an affiliate
affiliate of the IDI causes any director, officer, or
of the bank and transactions between a member
employee of the IDI or affiliate to serve as a
bank and a third party when some benefit of the
general partner of the partnership (unless the
transaction accrues to an affiliate of the bank.
partnership is an operating subsidiary of the
The statute generally does not apply to transac-
bank.) Also, if a company, such as a bank hold-
tions between two affiliates. The GLB Act estab-
ing company, controls more than 25 percent of
lishes two special anti-evasion rules, however,
the equity through a partnership, that company
that govern transactions between a financial sub-
is an affiliate under Regulation W.
sidiary of a member bank and another affiliate
of the bank.17 First, the GLB Act provides that
any purchase of, or investment in, securities
issued by a member banks financial subsidiary 2020.1.1.2.4 Subsidiaries of Affiliates
by an affiliate of the bank will be deemed to be a
purchase of, or investment in, such securities by Regulation W deems a subsidiary of an affiliate
the bank itself. Second, the GLB Act authorizes as an affiliate of the IDI.
the Board to deem an extension of credit made
by a member banks affiliate to any financial
subsidiary of the bank to be an extension of
credit by the bank to the financial subsidiary, if
the Board determines that such action is neces-
sary or appropriate to prevent evasions of the
17. GLB Act section 121(b)(1), or 12 U.S.C. 371c(e)(3). Page 5
2020.1.1.2.5 Companies Designated by (section 4(k)(4)(H) or (I) of the BHC Act). (See
the Appropriate Federal Banking Agency 12 U.S.C. 371c(b)(11).)
The rule also provides three specific regula-
Under section 223.2(a)(12), the Board or the tory safe harbors from the 15 percent presump-
appropriate federal banking agency for the rel- tion. These safe harbors apply in situations
evant IDI (under authority delegated by the where the holding company owns or controls
Board) can determine that any company that has more than 15 percent of the total equity of the
a relationship with an IDI or an affiliate of the company under the merchant banking or insur-
IDI, such that covered transactions by the IDI ance company investment authority (thereby
with that company may be affected by the rela- triggering the statutory presumption) and less
tionship to the detriment of the IDI, is an affili- than 25 percent of any class of voting securities
ate of the IDI. The Board and the federal bank- of the company (thereby not meeting the statu-
ing agencies can thus protect IDIs in their tory definition of control). The three situations
transactions with associated companies. An IDI are substantially identical to those listed in the
may petition the Board to review any such affili- Boards merchant banking regulation.21
ate determination made by the institutions The first exemption applies where no director,
appropriate federal banking agency under the officer, or employee of the holding company
general procedures established by the Board for serves as a director (or individual exercising
review of actions taken under delegated similar functions) of the company. The second
authority.18 exemption applies where an independent third
party controls a greater percentage of the equity
capital of the company than is controlled by the
2020.1.1.2.6 Merchant Banking holding company, and no more than one officer
or employee of the holding company serves as a
The GLB Act also amended the Bank Holding director (or individual exercising similar func-
Company Act (BHC Act) to permit BHCs and tions) of the company. The third exemption
foreign banks that qualify as financial holding applies where an independent third party con-
companies (FHCs) to engage in merchant bank- trols more than 50 percent of the voting shares
ing and insurance company investment activi- of the company, and officers and employees of
ties.19 If an FHC owns or controls more than the holding company do not constitute a major-
25 percent of a class of voting shares of a ity of the directors (or individuals exercising
company under the merchant banking or insur- similar functions) of the company.22
ance company investment authority, the com- These safe harbors do not require Board
pany is an affiliate of any member bank con- review or approval of the exclusion from affili-
trolled by the FHC by operation of the statutory ate status. Moreover, the safe harbors are not
definitions contained in section 23A. The GLB intended to be a complete list of circumstances
Act also added paragraph (b)(11) to sec- in which the 15 percent presumption may be
tion 23A, which creates a rebuttable presump- rebutted. The rule also provides, consistent with
tion that a company (portfolio companies) is the GLB Act, that a holding company may rebut
an affiliate of a member bank, for purposes of the presumption with respect to a portfolio com-
section 23A, if the bank is affiliated with an pany by presenting information to the Board
FHC and the FHC owns or controls 15 percent that demonstrates, to the Boards satisfaction,
or more of the equity capital of the other com- that the holding company does not control the
pany pursuant to the FHCs merchant banking portfolio company. The Board notes that a com-
or insurance company investment authority20 pany that qualifies as an affiliate under the
15 percent presumption and under another prong
18. See 12 C.F.R. 265.3. of the regulations definition of affiliate cannot
19. GLB Act, section 103(a); 12 U.S.C. 1843(k)(4)(H) and avoid affiliate status through a rebuttal of the
(I). 15 percent presumption (either by qualifying for
20. GLB Act, section 121(b)(2). As noted above, this
rebuttable presumption applies only if the affiliated FHC
aggregate under a combination of authorities, more than 5 per-
owns or controls 15 percent or more of the companys equity
cent of any class of voting securities of the company.
capital under the merchant banking or insurance company
21. See 12 C.F.R. 225.176(b)(2) and (3).
investment authorities. The Board noted, however, that under
22. For purposes of these safe harbors, the rule provides
existing Board precedents, a BHC may not own any shares of
that the term holding company includes any subsidiary of
a company in reliance on section 4(c)(6) or 4(c)(7) of the
the holding company, including any subsidiary bank of the
BHC Act where the holding company owns or controls, in the
holding company. Accordingly, if a director of a subsidiary
bank or nonbank subsidiary of an FHC also serves as a
BHC Supervision Manual July 2014 director of a portfolio company, the first safe harbor, for
Page 6 example, would be unavailable.
one of the three regulatory safe harbors or by any affiliated IDIs. For example, if two affiliated
obtaining an ad hoc rebuttal of the presumption IDIs each own 50 percent of the voting common
from the Board). stock of a company, the company would con-
An FHC generally is considered to own or tinue to qualify as a subsidiary and not an affili-
control only those shares or other ownership ate of each IDI (despite the fact that an affiliate
interests that are owned or controlled by itself or of each IDI owned more than 25 percent of a
by a subsidiary of the holding company. The class of voting securities of the company). The
rule clarifies that, for purposes of applying the Board has retained its authority to treat such
presumption of affiliation described above, an joint ventures as affiliates under section 23A on
FHC that has an investment in a private equity a case-by-case basis.
fund (as defined in the Boards merchant bank-
ing rule) will not be considered indirectly to
own the equity capital of a company in which 2020.1.1.2.8 Employee Benefit Plans
the fund has invested unless the FHC controls
the private equity fund (as described in the Regulation W clarifies, under section
Boards merchant banking rule). 223.2(b)(1)(iv), that an employee stock option
plan (ESOP), of an IDI or an affiliate of the IDI
cannot itself avoid classification as an affiliate
2020.1.1.2.7 Companies that are not of the member bank by also qualifying as a
Affiliates subsidiary of the member bank. Many, but not
all, ESOPs, trusts, or similar entities that exist to
Under the terms of section 23A, subsidiaries of benefit shareholders, members, officers, direc-
an IDI generally are not treated as affiliates of tors, or employees of an IDI or its affiliates are
the member bank.23 The statute contains two treated as affiliates of the IDI for purposes of
specific exceptions to this general rule: finan- sections 23A and 23B. The ESOPs share own-
cial subsidiaries of an IDI and IDI subsidiaries ership or the interlocking management between
of an IDI are treated as affiliates of the parent the ESOP and its associated IDI (or BHC), in
IDI. The statute provides that the Board may many cases, exceeds the statutory thresholds for
determine that other subsidiaries of an IDI determining that a company is an affiliate. For
should be treated as affiliates in appropriate example, if an ESOP controls more than 25 per-
circumstances.24 cent of the voting shares of the member bank or
Under section 223.2(b)(1)(iii) of the rule, cer- bank holding company, the ESOP is an affiliate.
tain joint venture subsidiary companies of an
The relationship between an IDI and its (or
IDI are treated as affiliates. A subsidiary of an
its) affiliates ESOP generally warrants cover-
IDI is treated as an affiliate if one or more
age by sections 23A and 23B. IDIs have made
affiliates of the IDI, or one or more controlling
unsecured loans to their ESOPs or their affili-
shareholders of the IDI, directly control the joint
ates ESOP or have guaranteed loans to such
venture. For example, if an IDI controls 30 per-
ESOPs that were made by a third party. These
cent of company A and an affiliate controls
ESOPs, however, generally have no means to
70 percent of Company A, then Company A is
repay the loans other than with funds provided
an affiliate. This provision also covers situations
by the IDI. In addition, even if the ESOPs
in which a controlling natural-person share-
ownership control does not warrant treatment as
holder or group of controlling natural-person
an affiliate, the issuance of holding company
shareholders of the IDI (who, as natural per-
shares to an ESOP that is funded by a loan from
sons, are not themselves section 23A affiliates
the holding companys subsidiary IDI could be
of the IDI) exercise direct control over the joint
used as a vehicle by the IDI to provide funds to
venture company. The rules treatment of cer-
its parent holding company when the IDI is
tain IDI-affiliate joint ventures as affiliates does
unable to pay dividends or is otherwise
not apply to joint ventures between an IDI and
restricted in providing funds to its holding com-
23. See 12 U.S.C. 371c(b)(1)(A) and (b)(2)(A). Section
pany. The attribution rule (12 C.F.R. 223.16)
23A defines a subsidiary of a specified company as a com- subjects such transactions to the restrictions of
pany that is controlled by the specified company. Under the sections 23A and 23B.
statute, a company controls another company if the first
company owns or controls 25 percent or more of a class of
voting securities of the other company, controls the election of
a majority of the directors of the other company, or exercises
a controlling influence over the policies of the other company
(12 U.S.C. 371c(b)(3) and (4)). BHC Supervision Manual July 2014
24. 12 U.S.C. 371c(b)(2)(A). Page 7
2020.1.2 QUANTITATIVE LIMITS capital guidelines of the appropriate federal

banking agency, based on the institutions
Section 23A(a)(1)(A) states that an IDI may most recent consolidated FFIEC Reports of
engage in a covered transaction with an affiliate Condition and Income (Call Report) filed
only if in the case of any affiliate under 12 U.S.C. 1817(a)(3);
2. the balance of an institutions allowance for
1. the IDI limits the aggregate amount of cov- loan and lease losses not included in its tier 2
ered transactions to that particular affiliate to capital for purposes of the calculation of
not more than 10 percent of the IDIs capital risk-based capital by the appropriate federal
stock and surplus and banking agency (based on the institutions
2. the IDI limits the aggregate amount of all most recent consolidated Call Report of Con-
covered transactions with all of its affiliates dition and Income that is filed under
to 20 percent of the IDIs capital stock and 12 U.S.C. 1817(a)(3)); and
surplus. 3. the amount of any investment in a financial
subsidiary that counts as a covered transac-
The rules interpretation of the 10 percent limit tion that is required to be deducted from the
is consistent with the statutory language.25 An IDIs regulatory capital.26
IDI that has crossed the 10 percent threshold
with one affiliate may still conduct additional Examiners can determine the amount of the
covered transactions with other affiliates, if quantitative limits.27
transactions with all affiliates would not exceed
20 percent of the IDIs capital stock and surplus.
An IDI is prohibited from engaging in a new 2020.1.3.1 Determination of Control
covered transaction with that affiliate if the IDIs
transactions would exceed the 10 percent thresh- The definition of control is similar to the
old with that affiliate or if the level of covered definition used in the BHC Act. Under the rule,
transactions with all its affiliates exceeded the a company or shareholder shall be deemed to
20 percent threshold. The rule generally does have control over another company if
not require an IDI to unwind existing covered
transactions if the member bank exceeds the such company or shareholder, directly or indi-
10 percent or 20 percent limit because its capital rectly, or acting through one or more other
declined or a preexisting covered transaction persons, owns, controls, or has power to vote
increased in value. 25 percent or more of any class of voting
The Board strongly encourages IDIs with securities of the other company;
covered transactions in excess of the 10 percent such company or shareholder controls in any
threshold with any affiliate to reduce those trans- manner the election of a majority of the direc-
actions before expanding the scope or extent of tors or trustees (or general partners or indi-
the member banks relationships with other viduals exercising similar functions), of the
affiliates. other company; or
the Board determines, after notice and oppor-
tunity for hearing, that such company or
2020.1.3 CAPITAL STOCK AND shareholder, directly or indirectly, exercises a
SURPLUS controlling influence over the management or
policies of the other company.28
Under section 23A, the quantitative limits on
covered transactions are based on the capital In addition, three additional presumptions of
stock and surplus of the IDI. An IDIs capital control are provided under the rule. First, a
stock and surplus for purposes of section 23A of company will be deemed to control securities,
the FRA is assets, or other ownership interests controlled
by any subsidiary of the company.29 Second, a
1. the sum of tier 1 and tier 2 capital included in company that controls instruments (including
an institutions risk-based capital under the options and warrants) that are convertible or
exercisable, at the option of the holder or owner,
25. Sections 223.11 and 223.12 of the rule set forth these
26. See section 223.3(d) of the rule (12 C.F.R. 223.3(d)).
quantitative limits.
27. Examiners should refer to the IDIs most recent Call
Report.
BHC Supervision Manual July 2014 28. See section 223.3(g) of the rule (12 C.F.R. 223.3(g)).
Page 8 29. See 12 C.F.R. 225.2(e)(2)(i).
into securities, will be deemed to control the property as may be specifically exempted by
securities.30 Third, a rebuttable presumption the Board by order or regulation;
provides that a company or shareholder that 4. the acceptance by an IDI of securities or
owns or controls 25 percent or more of the other debt obligations issued by an affiliate
equity capital of another company controls the as collateral security for a loan or extension
other company, unless the company or share- of credit by the member bank to any person
holder demonstrates otherwise to the Board or company;34
based on the facts and circumstances of the 5. the issuance by an IDI of a guarantee, accep-
particular case.31 Such a presumption of control tance, or letter of credit, including an
is particularly appropriate in the section 23A endorsement or standby letter of credit, on
context because a BHC may have incentives to behalf of an affiliate.
divert the resources of a subsidiary IDI to any 6. a transaction with an affiliate that involves
company in which the holding company has a the borrowing or lending of securities, to the
substantial financial interest, regardless of extent that the transaction causes an IDI or a
whether the holding company owns any voting subsidiary to have credit exposure to the
securities of the company. affiliate; or
Section 23A and the rule provide that no 7. a derivative transaction, as defined in 12
company shall be deemed to own or control U.S.C. 84(b), with an affiliate, to the extent
another company by virtue of its ownership or that the transaction causes an IDI or a subsid-
control of shares in a fiduciary capacity except iary to have credit exposure to the affiliate.
(1) when a company that is controlled, directly
or indirectly, by a trust for the benefit of share- If a transaction between an IDI and an affiliate is
holders who beneficially or otherwise control, not within one of the above categories, it is not a
directly or indirectly, a member bank, or (2) if covered transaction for the purposes of sec-
the company owning or controlling such shares tion 23A and is not subject to its limitations. All
is a business trust. covered transactions must be made on terms and
conditions that are consistent with safe and
sound banking practices.35
2020.1.4 COVERED TRANSACTIONS Among the transactions that generally are not
subject to section 23A are dividends paid by an
The restrictions of section 23A do not apply to IDI to its holding company, sales of assets by an
every transaction between an IDI and its affili- IDI to an affiliate for cash, an affiliates pur-
ates; section 23A only applies to seven cov- chase of securities issued by an IDI, and many
ered transactions between an IDI and its affili- service contracts between an IDI and an affili-
ates.32 ate.36 Certain classes of transactions between a
A covered transaction under section 23A of member bank and an affiliate are discussed
the FRA means below as to whether they are covered transac-
tions for purposes of section 23A. (See sec-
1. a loan or extension of credit by an IDI to an tion 223.3(h).)
affiliate;
2. a purchase of, or an investment in, the securi-
ties issued by an affiliate of an IDI including 2020.1.4.1 Attribution Rule
a purchase of assets subject to an agreement
to repurchase;33 The attribution rule, found in section 223.16,
3. an IDIs purchase of assets from an affiliate, prevents an IDI from evading its restrictions of
except for purchases of real and personal
34. The acceptance of an affiliates securities for a loan
when proceeds are transferred to, or used for the benefit of, an
30. See 12 C.F.R. 225.31(d)(1)(i). The rule refers more
affiliate is prohibited. (See section 223.3(h)(2).)
generically to convertible instruments. It clarifies that the
35. Board staff has taken the position that safety and
convertibility presumption applies regardless of whether the
soundness requires that the transaction be conducted on mar-
right to convert resides in a financial instrument that techni-
ket terms.
cally qualifies as a security under section 23A or the
36. A transaction when an IDI receives assets from an
federal securities laws.
affiliate and the IDI pays a dividend or returns capital to an
31. See, for example, 12 C.F.R. 225.143 (Board Policy
affiliate may result in a purchase of assets for the purposes of
Statement on Equity Investments in Banks and Bank Holding
section 23A. Although these transactions are not subject to
Companies).
section 23A, they may be subject to section 23B or other laws.
32. 12 U.S.C. 371c(b)(7).
33. The investment by an IDI or its affiliate in a financial
subsidiary of the bank excludes the retained earnings of the BHC Supervision Manual July 2014
financial subsidiary. Page 9
section 23A by using intermediaries, and it lim- 6. any other similar transaction as a result of
its the exposure that an IDI has to customers of which an affiliate becomes obligated to pay
affiliates of the IDI. Section 223.16 provides money (or its equivalent) to an IDI.39
that any covered transaction by an IDI or its
subsidiary with any person is deemed to be a An IDIs purchase of a debt security issued
transaction with an affiliate of the IDI if any of by an affiliate is an extension of credit by the
the proceeds of the transaction are used for the IDI to the affiliate for purposes of section 23A
benefit of, or are transferred to, the affiliate. For under the rule. An IDI that buys debt securities
example, an IDIs loan to a customer for the issued by an affiliate has made an extension of
purpose of purchasing securities from the inven- credit to an affiliate under section 23A and must
tory of a broker-dealer affiliate of the member collateralize the transaction in accordance with
bank would be a covered transaction under sec- the collateral requirements of section 23A. An
tion 23A. exemption from the collateral requirements is
provided for situations in which an IDI pur-
chases an affiliates debt securities from a third
2020.1.4.2 Credit Transactions with an party in a bona fide secondary-market
Affiliate transaction.
2020.1.4.2.1 Extension of Credit to an 2020.1.4.2.2 Valuation of Credit

Affiliate or Other Credit Transaction with Transactions with an Affiliate
an Affiliate
A credit transaction between an IDI and an
Section 23A includes a loan or extension of affiliate initially must be valued at the amount of
credit to an affiliate as a covered transaction, funds provided by the IDI to, or on behalf of,
but does not define these terms. Section 223.3(o) the affiliate plus any additional amount that the
of the rule defines extension of credit to an IDI could be required to provide to, or on behalf
affiliate to mean the making or renewal of a loan of, the affiliate. The section 23A value of a
to an affiliate, the granting of a line of credit to credit transaction between an IDI and an affili-
an affiliate, or the extending of credit to an ate is the greater of (1) the principal amount of
affiliate in any manner whatsoever, including on the credit transaction; (2) the amount owed by
an intraday basis. Transactions that are defined the affiliate to the member bank under the credit
as extensions of credit include but are not lim- transaction; or (3) the sum of (a) the amount
ited to the following: provided to, or on behalf of, the affiliate in the
transaction and (b) any additional amount that
1. an advance to an affiliate by means of an the member bank could be required to provide
overdraft, cash item, or otherwise; to, or on behalf of, the affiliate under the terms
2. a sale of federal funds to an affiliate; of the member transaction. (See 223.21)
3. a lease that is the functional equivalent of an The first prong of the rules valuation formula
extension of credit to an affiliate;37 for credit transactions (the principal amount of
4. an acquisition by purchase, discount, the credit transaction) would likely determine
exchange, or otherwise of a note or other the valuation of a transaction in which an IDI
obligation, including commercial paper or purchased a zero-coupon note issued by an
other debt securities, of an affiliate; affiliate. An IDI should value such an extension
5. any increase in the amount of, extension of of credit at the principal, or face amount of the
the maturity of, or adjustment to the interest- note (that is, at the amount that the affiliate
rate term or other material term of, an exten- ultimately must pay to the IDI) rather than at the
sion of credit to an affiliate;38 and amount of funds initially advanced by the IDI.
For example, assume an IDI purchased from an
37. The Board would consider a full-payout, net lease
permissible for a national bank under 12 U.S.C. 24 (seventh)
which the loans interest rate is calculated. If the member
and 12 C.F.R. 23 to be the functional equivalent of an exten-
bank and the borrower, however, amend the loan agreement to
sion of credit.
change the interest-rate term from LIBOR plus 100 basis
38. A floating-rate loan does not become a new covered
points to LIBOR plus 150 basis points, the parties have
transaction whenever there is a change in the relevant index
engaged in a new covered transaction.
(for example, LIBOR or the member banks prime rate) from
39. The definition of extension of credit would cover,
among other things, situations in which an affiliate fails to pay
BHC Supervision Manual July 2014 on a timely basis for services rendered to the affiliate by the
Page 10 IDI or the affiliate fails to pay a tax refund to the IDI.
affiliate for $50 a 10-year zero-coupon note value the covered transaction at $100.
issued by the affiliate with a face amount of Although the rule considers an IDIs purchase
$100. The rules valuation formula requires the of, or investment in, a debt security issued by an
IDI to value this transaction at $100. affiliate as an extension of credit to an affiliate,
The second prong of the rules valuation for- these transactions are not valued like other
mula for credit transactions (the amount owed extensions of credit. See section 223.23 for the
by the affiliate) likely would determine the valuation rules for purchases of, and invest-
valuation of a transaction in which an affiliate ments in, the debt securities of an affiliate.
fails to pay an IDI when due a fee for services
rendered by the IDI to the affiliate. This prong
of the valuation formula does not include 2020.1.4.2.3 Timing of a Credit
(within section 23As quantitative limits) items Transaction with an Affiliate
such as accrued interest not yet due on an IDIs
loan to an affiliate. An IDI has entered into a credit transaction with
IDIs will be able to determine the section 23A an affiliate at the time during the day that the
value for most credit transactions under the third IDI becomes legally obligated to make the
prong of the rules valuation formula. Under extension of credit to, or issue the guarantee,
this prong, for example, a $100 term loan is a acceptance, or letter of credit on behalf of, the
$100 covered transaction, a $300 revolving affiliate. A covered transaction occurs at the
credit facility is a $300 covered transaction moment that the IDI executes a legally valid,
(regardless of how much of the facility the binding, and enforceable credit agreement or
affiliate has drawn down), and a guarantee back- guarantee and does not occur only when an IDI
stopping a $500 debt issuance of the affiliate is a funds a credit facility or makes payment on a
$500 covered transaction. guarantee. Consistent with section 23A, the rule
Under section 23A and the rule, a member only requires an IDI to compute compliance
bank has made an extension of credit to an with its quantitative limits when the IDI is about
affiliate if the IDI purchases from a third party a to engage in a new covered transaction. The rule
loan previously made to an affiliate of the IDI. does not require an IDI to compute compliance
A different valuation formula is provided for with the rules quantitative limits on a continu-
these indirect credit transactions: The IDI must ous basis. See section 223.21(b)(1) of the rule.
value the transaction at the price paid by the IDI The burden of the timing rule is mitigated
for the loan plus any additional amount that the significantly by the exemption for intraday
IDI could be required to provide to, or on behalf extensions of credit found in section 223.42(l).
of, the affiliate under the terms of the credit The intraday credit exemption generally applies
agreement. only to extensions of credit that an IDI expects
For example, if an IDI pays a third party $90 to be repaid, sold, or terminated by the end of its
for a $100 term loan that the third party previ- U.S. business day. The IDI must have policies
ously made to an affiliate of the IDI (because, and procedures to manage and minimize the
for example, the loan was at a fixed rate and has credit exposure. Any such extension of credit
declined in value because of a rise in the general that is outstanding at the end of the IDIs busi-
level of interest rates), the covered-transaction ness day must be treated as an extension of
amount is $90 rather than $100. The lower credit and must meet the regulatory quantitative
covered-transaction amount reflects the fact that and collateral requirements.
the IDIs maximum loss on the transaction is
$90 rather than the original principal amount of
the loan. For another example, if an IDI pays a 2020.1.4.2.4 Leases
third party $70 for a $100 line of credit to an
affiliate, of which $70 had been drawn down by Lease transactions that constitute the functional
the affiliate, the covered-transaction amount equivalent of a loan or an extension of credit may
would be $100 (the $70 purchase price paid by be subject to section 23A. Such lease
the IDI for the credit plus the remaining $30 that arrangements, in effect, are equivalent to a loan
the IDI could be required to lend under the by the IDI and are essentially financing
credit line). arrangements. Some of the characteristics that
In another example, an IDI makes a term loan would normally cause a lease to be construed as
to an affiliate that has a principal amount of a loan equivalent include the lessees having
$100. The affiliate pays $2 in up-front fees to
the member bank, and the affiliate receives net BHC Supervision Manual July 2014
loan proceeds of $98. The IDI must initially Page 11
responsibility for the servicing, maintenance, securities and other collateral, are valued at the
insurance, licensing, or risk of loss or damage, lesser of (1) the total value of the extension of
and the lessees having the option to purchase the credit minus the fair market value of the other
equipment. collateral or (2) the fair market value of the
affiliate securities (if the securities have a ready
market). The rules ready-market requirement
2020.1.4.2.5 Extensions of Credit Secured applies regardless of the amount of affiliate
by Affiliate SecuritiesGeneral Valuation collateral.42
Rule (Section 223.24(a) and (b))
Section 23A defines as a covered transaction an 2020.1.4.2.6 Extensions of Credit Secured
IDIs acceptance of securities issued by an affili- by Affiliate SecuritiesMutual Fund
ate as collateral for a loan or extension of credit Shares
to any person or company.40 This type of cov-
ered transaction has two classes: one in which Section 23A(b)(7)(D) of the FRA defines as a
the only collateral for the loan is solely affiliate covered transaction a member banks accep-
securities and another in which the loan is tance of securities issued by an affiliate as collat-
secured by a combination of affiliate securities eral security for a loan or extension of credit to
and other collateral.40a any person or company.
Under the rule, if the credit extension is Section 223.24(c) of the rule provides an
secured exclusively by affiliate securities, then exemption for extensions of credit by a member
the transaction is valued at the full amount of bank that are secured by shares of an affiliated
the extension of credit. This approach reflects mutual fund. To qualify for the exemption, the
the difficulty of measuring the actual value of transaction must meet several conditions. First,
typically untraded and illiquid affiliate securities to ensure that the affiliate collateral is liquid and
and conservatively assumes that the value of the trades at a fair price, the affiliated mutual fund
securities is equal to the full value of the loan must be an open-end investment company that
that the securities collateralize. An exception is is registered with the SEC under the 1940 Act.
provided to the general rule when the affiliate Second, to ensure that the IDI can easily estab-
securities held as collateral have a ready market lish and monitor the value of the affiliate collat-
(as defined by section 223.42 of the rule). In that eral, the affiliated mutual funds shares serving
case, the transaction may be valued at the fair as collateral for the extension of credit must
market value of the affiliate securities. The have a publicly available market price. Third, to
exception grants relief in those circumstances reduce the IDIs incentives to use these exten-
when the value of the affiliate securities is inde- sions of credit as a mechanism to support the
pendently verifiable by reference to transactions affiliated mutual fund, the IDI and its affiliates
occurring in a liquid market.41 must not own more than 5 percent of the funds
Covered transactions of the second class, in shares (excluding certain shares held in a fidu-
which the credit extension is secured by affiliate ciary capacity). Finally, the proceeds of the
extension of credit must not be used to purchase
40. See 12 U.S.C. 371c(b)(7)(D). This covered transaction the affiliated mutual funds shares serving as
only arises when the member banks loan is to a nonaffiliate. collateral or otherwise used to benefit an affili-
Under section 23A, the securities issued by an affiliate are not
acceptable collateral for a loan or extension of credit to any ate. In such circumstances, the IDIs extension
affiliate. (See 12 U.S.C. 371(c)(4)) If the proceeds of a loan of credit would be covered by section 23As
that is secured by an affiliates securities are transferred to an attribution rule. For example, an IDI proposes to
affiliate by the unaffiliated borrower (for example, to purchase lend $100 to a nonaffiliate secured exclusively
assets or securities from the inventory of an affiliate), the loan
should be treated as a loan to the affiliate and the affiliates by eligible affiliated mutual fund securities. The
securities cannot be used to meet the collateral requirements IDI knows that the nonaffiliate intends to use all
of sections 23A. The loan must then be secured with other the loan proceeds to purchase the eligible affili-
collateral in an amount and of a type that meets the require- ated mutual fund securities that would serve as
ments of section 23A for loans by an IDI to an affiliate.
40a. The securities issued by an affiliate cannot be used as collateral for the loan. Under the attribution rule
collateral for a loan to any affiliate (12 U.S.C. 371c (c)(4)). in section 223.16, the IDI must treat the loan to
41. In either case, the transaction must comply with sec- the nonaffiliate as a loan to an affiliate, and
tion 23B; that is, the IDI must obtain the same amount of
affiliate securities as collateral on the credit extension that the
IDI would obtain if the collateral were not affiliate securities.
42. Under the rule, an IDI may use the higher of the two
valuation options for these transactions if, for example, the
BHC Supervision Manual July 2014 IDI does not have the procedures and systems in place to
Page 12 verify the fair market value of affiliate securities.
because securities issued by an affiliate are ineli- rule ensures that there are limits on the amount
gible collateral under section 223.14, the loan of risk a company can shift to an affiliated IDI.
would not be in compliance with section 223.14. Section 23A(d)(6) provides an exemption for
purchasing assets having a readily identifiable
and publically available market quotation. Sec-
2020.1.4.3 Asset Purchases tion 224.42(e) of the rule codified this exemp-
tion. Section 223.42(f) expands the statutory
(d)(6) exemption to allow an IDI to purchase
2020.1.4.3.1 Purchase of Assets under securities from an affiliate based on price quotes
Regulation W obtained from certain electronic screens so long
as, among other things, (1) the selling affiliate is
Regulation W provides that a purchase of assets a broker-dealer registered with the SEC, (2) the
by an IDI from an affiliate initially must be securities are traded in a ready market and eli-
valued at the total amount of consideration gible for purchase by state IDIs, (3) the securi-
given by the IDI in exchange for the asset. (See ties are not purchased within 30 days of an
section 223.22.) This consideration can take any underwriting (if an affiliate of the IDI is an
form and includes an assumption of liabilities underwriter of the securities), and (4) the securi-
by the IDI. An assumption of liabilities can ties are not issued by an affiliate. See sec-
include a mortgage, other debt obligations, or tion 2020.1.10.2 for a further discussion of this
the cost associated with the transfer of employ- exemption.
ees, such as pension obligations, bonuses, or In contrast with credit transactions, an asset
accrued vacation. purchase from a nonaffiliate that later becomes
Asset purchases are a covered transaction for an affiliate generally does not become a cov-
an IDI for as long as the IDI holds the asset. The ered transaction for the purchasing IDI. How-
value of the covered transaction after the pur- ever, if an IDI purchases assets from a nonaf-
chase may be reduced to reflect amortization or filiate in contemplation that the nonaffiliate will
depreciation of the asset, to the extent that such become an affiliate of the IDI, the asset pur-
reductions are consistent with GAAP and are chase becomes a covered transaction at the
reflected on the IDIs financial statements. time the nonaffiliate becomes an affiliate. In
Certain asset purchases by an IDI from an addition, the IDI must ensure that the aggregate
affiliate are not valued in accordance with the amount of the IDIs covered transactions
general asset-purchase valuation formula. First, (including any such asset purchase from the
if the IDI buys from one affiliate a loan made to nonaffiliate) would not exceed the quantitative
a second affiliate, the IDI must value the trans- limits of section 23A at the time the nonaffili-
action as a credit transaction with the second ate becomes an affiliate.
affiliate under section 223.21. Second, if the IDI The following examples are provided to assist
buys from one affiliate a security issued by a IDIs in valuing purchases of assets from an
second affiliate, the IDI must value the transac- affiliate. An IDIs receipt of an encumbered
tion as an investment in securities issued by the asset from an affiliate ceases to be a covered
second affiliate under section 223.23. Third, if transaction when, for example, the IDI sells the
the IDI acquires the shares of an affiliate that asset.
becomes an operating subsidiary of the IDI after
the acquisition, the IDI must value the transac- Cash purchase of assets. An IDI purchases a
tion under section 223.31. pool of loans from an affiliate for $10 million.
A special valuation rule applies to an IDIs The IDI initially must value the covered trans-
purchase of a line of credit or loan commitment action at $10 million. Going forward, if the
from an affiliate. An IDI initially must value borrowers repay $6 million of the principal
such asset purchases at the purchase price paid amount of the loans, the IDI may value the
by the IDI for the asset plus any additional covered transaction at $4 million.
amounts that the IDI is obligated to provide Purchase of assets through an assumption of
under the credit facility.43 This special valuation liabilities. An affiliate of an IDI contributes
real property with a fair market value of
43. A member bank would not be required to include $200,000 to the IDI. The IDI pays the affiliate
unfunded, but committed, amounts in the value of the covered no cash for the property, but assumes a
transaction if (1) the credit facility being transferred from the
affiliate to the bank is unconditionally cancelable (without
$50,000 mortgage on the property. The IDI
cause) at any time by the IDI and (2) the IDI makes a separate
credit decision before each drawing under the facility (see BHC Supervision Manual July 2014
12 C.F.R. 223.22). Page 13
has engaged in a covered transaction with the ties issued by a financial subsidiary did not
affiliate and initially must value the transac- include retained earnings of the subsidiary. The
tion at $50,000. Going forward, if the IDI negative implication from this provision is that
retains the real property but pays off the mort- the section 23A value of an IDIs investment in
gage, the IDI must continue to value the cov- other affiliates includes the affiliates retained
ered transaction at $50,000. If the IDI, how- earnings, which would be reflected in the IDIs
ever, sells the real property, the transaction carrying value of the investment under the rule.
ceases to be a covered transaction at the time Finally, the carrying-value approach is
of the sale (regardless of the status of the consistent with the purposes of section 23A
mortgage). imiting the financial exposure of IDIs to their
affiliates and promoting safety and soundness.
The valuation rule requires an IDI to revalue
2020.1.4.3.2 IDIs Purchase of upwards the amount of an investment in affili-
Securities Issued by an Affiliate ate securities only when the IDIs exposure to
the affiliate increases (as reflected on the IDIs
Section 23A includes as a covered transaction financial statements) and the IDIs capital
an IDIs purchase of, or investment in, securi- increases to reflect the higher value of the
ties issued by an affiliate. Section 223.23 of the investment. In these circumstances, the valua-
rule requires an IDI to value a purchase of, or tion rule merely reflects the IDIs greater finan-
investment in, securities issued by an affiliate cial exposure to the affiliate and enhances safety
(other than a financial subsidiary of the IDI) at and soundness by reducing the IDIs ability to
the greater of the IDIs purchase price or carry- engage in additional transactions with an affili-
ing value of the securities. An IDI that paid no ate as the IDIs exposure to that affiliate
consideration in exchange for affiliate securities increases.
has to value the covered transaction at no less The valuation rule also provides that the
than the IDIs carrying value of the securities. In covered-transaction amount of an IDIs invest-
addition, if the IDIs carrying value of the affili- ment in affiliate securities can be no less than
ate securities increased or decreased after the the purchase price paid by the IDI for the
IDIs initial investment (due to profits or losses securities, even if the carrying value of the
at the affiliate), the amount of the IDIs covered securities declines below the purchase price.
transaction would increase or decrease to reflect This aspect of the valuation rule uses the IDIs
the IDIs changing financial exposure to the purchase price for the securities as a floor for
affiliate. However, the amount of the IDIs cov- valuing the covered transaction. First, it ensures
ered transaction cannot decline below the that the amount of the covered transaction never
amount paid by the IDI for the securities. falls below the amount of funds actually
Several important considerations support the transferred by the IDI to the affiliate in connec-
general carrying-value approach of this valuation with the investment. In addition, the
tion rule. First, the approach would require an purchase-price floor limits the ability of an IDI
IDI to reflect its investment in securities issued to provide additional funding to an affiliate as
by an affiliate at carrying value throughout the the affiliate approaches insolvency. If invest-
life of the investment, even if the IDI paid no ments in securities issued by an affiliate were
consideration for the securities. Second, the valued strictly at carrying value, then the IDI
approach is supported by the terms of the stat- could lend more funds to the affiliate as the af-
ute, which defines both a purchase of and an filiates financial condition worsened. As the af-
investment in securities issued by an affiliate filiate declined, the IDIs carrying value of the
as a covered transaction. The statutes invest- affiliates securities would decline, the sec-
ment in language indicates that Congress was tion 23A value of the IDIs investment likely
concerned with an IDIs continuing exposure to would decline, and, consequently, the IDI would
an affiliate through an ongoing investment in the be able to provide additional funding to the
affiliates securities. affiliate under section 23A. This type of increas-
Third, GLB Act amendments to section 23A ing support for an affiliate in distress is what
supported the approach. The GLB Act defined a section 23A was intended to restrict.
financial subsidiary of an IDI as an affiliate of The following examples are designed to assist
the IDI, but specifically provides that the sec- IDIs in valuing purchases of, and investments
tion 23A value of an IDIs investment in securi- in, securities issued by an affiliate:
BHC Supervision Manual July 2014 Purchase of the debt securities of an affiliate.
Page 14 The parent holding company of an IDI owns
100 percent of the shares of a mortgage com- support of securities issued by a third party and
pany. The IDI purchases debt securities issued underwritten by a securities affiliate of the IDI.45
by the mortgage company for $600. The ini- Such a credit enhancement would not be issued
tial carrying value of the securities is $600. on behalf of the affiliate. Although the guar-
The IDI initially must value the investment at antee does provide some benefit to the affiliate
$600. (by facilitating the underwriting), this benefit is
Purchase of the shares of an affiliate. The indirect. The proceeds of the guarantee would
parent holding company of an IDI owns not be transferred to the affiliate for purposes of
51 percent of the shares of a mortgage com- the attribution rule of section 23A.46 Section
pany. The IDI purchases an additional 30 per- 23B would apply to the transaction and, where
cent of the shares of the mortgage company an affiliate was issuer as well as underwriter, the
from a third party for $100. The initial carry- transaction would be covered by section 23A
ing value of the shares is $100. The IDI because the credit enhancement would be on
initially must value the investment at $100. behalf of the affiliate.
Going forward, if the IDIs carrying value of
the shares declines to $40, the IDI must con-
tinue to value the investment at $100. 2020.1.4.5.3 Cross-Guarantee
Contribution of the shares of an affiliate. The Agreements and Cross-Affiliate Netting
parent holding company of an IDI owns Arrangements
100 percent of the shares of a mortgage com-
pany and contributes 30 percent of the shares A cross-guarantee agreement among an IDI, an
to the IDI. The IDI gives no consideration in affiliate, and a nonaffiliate in which the nonaffili-
exchange for the shares. If the initial carrying ate may use the IDIs assets to satisfy the obliga-
value of the shares is $300, then the IDI tions of a defaulting affiliate is a guarantee for
initially must value the investment at $300. purposes of section 23A. The cross-guarantee
Going forward, if the IDIs carrying value of arrangements among IDIs and their affiliates are
the shares increases to $500, the IDI must subject to the quantitative limits and collateral
value the investment at $500. requirements of section 23A. (See sec-
tion 223.3(h)(5).)
As for cross-affiliate netting arrangements
2020.1.4.5 Issuance of a Letter of Credit (CANAs), such arrangements involve an IDI,
or Guarantee one or more affiliates of the IDI, and one or
more nonaffiliates of the IDI, where a nonaffili-
ate is permitted to deduct obligations of an
2020.1.4.5.1 Confirmation of a Letter of affiliate of the IDI to the nonaffiliate when set-
Credit Issued by an Affiliate tling the nonaffiliates obligations to the IDI.
These arrangements also would include agree-
Section 23A includes as a covered transaction ments in which an IDI is required or permitted
the issuance by an IDI of a letter of credit on to add the obligations of an affiliate of the IDI to
behalf of an affiliate, including the confirmation a nonaffiliate when determining the IDIs obli-
of a letter of credit issued by an affiliate as a gations to the nonaffiliate. These types of
covered transaction. (See section 223.3(h)(5).) CANAs expose an IDI to the credit risk of its
When an IDI confirms a letter of credit, it affiliates because the IDI may become liable for
assumes the risk of the underlying transaction to the obligations of its affiliates. Because the
the same extent as if it had issued the letter of exposure of an IDI to an affiliate in such an
credit.44 Accordingly, a confirmation of a letter arrangement resembles closely the exposure of
of credit issued by an affiliate is treated in the an IDI when it issues a guarantee on behalf of
same fashion as an issuance of a letter of credit an affiliate, the rule explicitly includes such
on behalf of an affiliate. arrangements in the definition of covered trans-
action. Accordingly, the quantitative limits of
section 23A would prohibit an IDI from enter-
2020.1.4.5.2 Credit Enhancements ing into such a CANA to the extent that the
Supporting a Securities Underwriting
45. See 62 Fed. Reg. 45295, August 27, 1997.
The definition of guarantee in section 23A does 46. See 12 U.S.C. 371c(a)(2).
not include an IDIs issuance of a guarantee in
44. See UCC 5-107(2). Page 15
netting arrangement does not cap the potential ally as part of an International Monetary Fund
exposure of the IDI to the participating affiliate Program. Although such assets may not be con-
(or affiliates). sidered classified assets, examiners are to con-
sider these assets in their assessment of an IDIs
asset quality and capital adequacy.
2020.1.4.5.4 Keepwell Agreements Second, the rule considers a financial institu-
tions use of its own internal asset-classification
In a keepwell agreement between an IDI and an systems. The rule includes within the definition
affiliate, the IDI typically commits to maintain of low-quality asset not only assets classified
the capital levels or solvency of the affiliate. The during the last examination but also assets clas-
credit risk incurred by the IDI in entering into sified or treated as special mention under the
such a keepwell agreement is similar to the institutions internal classification system (or
credit risk incurred by an IDI in connection with assets that received an internal rating that is
issuing a guarantee on behalf of an affiliate. As substantially equivalent to classified or special
a consequence, keepwell agreements generally mention in such an internal system).
should be treated as guarantees for purposes of The purchase by an IDI from an affiliate of
section 23A and, if unlimited in amount, would assets that have been internally classified raises
be prohibited by the quantitative limits of sec- potentially significant safety-and-soundness
tion 23A. concerns. The Board expects companies with
internal rating systems to use the systems con-
sistently over time and over similar classes of
2020.1.4.5.5 Prohibition on the Purchase assets and will view as an evasion of sec-
of Low-Quality Assets tion 23A any companys deferral or alteration of
an assets rating to facilitate sale of the asset to
Section 23A generally prohibits the purchase by an affiliated institution.
an IDI of a low-quality asset from an affiliate.47 Finally, the rule defines low-quality asset to
In addition, an IDI and its subsidiaries cannot include foreclosed property designated other
purchase or accept as collateral a low-quality real estate owned (OREO), until it is reviewed
asset from an affiliate. Section 23A defines a by an examiner and receives a favorable classi-
low-quality asset to include (1) an asset classification. It further defines as a low-quality asset
fied as substandard, doubtful, or loss, or any asset (not just real estate) that is acquired in
treated as other loans specially mentioned, in satisfaction of a debt previously contracted (not
the most recent report of examination or inspec- just through foreclosure) if the asset has not yet
tion by a federal or state supervisory agency (a been reviewed in an examination or inspection.
classified asset), (2) an asset in nonaccrual Under the rule, if a particular asset is good
status, (3) an asset on which payments are more collateral taken from a bad borrower, the asset
than 30 days past due in the payment of princi- should cease to be a low-quality asset upon
pal or interest, or (4) an asset whose terms have examination.
been renegotiated or compromised due to the Section 23A provides a limited exception to
deteriorating financial condition of the obligor. the general rule prohibiting purchase of low-
Any asset meeting one of the above four crite- quality assets if the IDI performs an indepen-
ria, including securities and real property, is a dent credit evaluation and commits to the pur-
low-quality asset. chase of the asset before the affiliate acquires
Regulation W expands the definition of low- the asset.48 Section 223.15 of the rule also pro-
quality assets in several respects. (See 12 C.F.R. vides an exception from the prohibition on the
223.3(v).) First an asset may be identified by purchase by an IDI of a low-quality asset from
examiners as a low-quality asset if they repre- an affiliate for certain loan renewals. The rule
sent credits to countries that are not complying allows an IDI that purchased a loan participa-
with their external debt-service obligations but tion from an affiliate to renew its participation in
are taking positive steps to restore debt service the loan, or provide additional funding under the
through economic adjustment measures, gener- existing participation, even if the underlying
loan had become a low-quality asset, so long as
47. 12 U.S.C. 371c(a)(3). Section 23A does not prohibit an certain criteria were met. These renewals or
affiliate from donating a low-quality asset to a member bank,
so long as the bank provides no consideration for the asset and
additional credit extensions may enable both the
no liabilities are associated with the asset. affiliate and the participating IDI to avoid or
minimize potential losses. The exception is
Page 16 48. 12 U.S.C. 371c(a)(3).
available only if (1) the underlying loan was not d. a segregated, earmarked deposit account
a low-quality asset at the time the IDI purchased with the member bank that is for the sole
its participation and (2) the proposed transaction purpose of securing credit transactions
would not increase the IDIs proportional share between the member bank and its affili-
of the credit facility. The IDI must also obtain ates and is identified as such.
the prior approval of its entire board of directors 2. 110 percent of the amount of such loan or
(or its delegees) and it must give a 20 days extension of credit, guarantee, acceptance, or
post-consummation notice to its appropriate fed- letter of credit if the collateral is composed
eral banking agency. An IDI is permitted to of obligations of any state or political subdi-
increase its proportionate share in a restructured vision of any state;
loan by 5 percent (or by a higher percentage 3. 120 percent of the amount of such loan or
with the prior approval of the IDIs appropriate extension of credit, guarantee, acceptance, or
federal banking agency). The scope of the letter of credit if the collateral is composed
exemption includes renewals of participations in of other debt instruments, including receiv-
loans originated by any affiliate of the IDI (not ables; or
just affiliated IDIs). 4. 130 percent of the amount of such loan or
extension of credit, guarantee, acceptance, or
letter of credit if the collateral is composed
2020.1.5 COLLATERAL FOR CERTAIN of stock, leases, or other real or personal
TRANSACTIONS WITH AFFILIATES property.
Section 23A requires a member banks use of For example, an IDI makes a $1,000 loan to
collateral for certain transactions between an an affiliate. The affiliate posts as collateral for
IDI and its affiliates.49 Each loan or extension of the loan $500 in U.S. Treasury securities, $480
credit to an affiliate,50 or guarantee, acceptance, in corporate debt securities, and $130 in real
or letter of credit issued on behalf of an affiliate estate. The loan satisfies the collateral require-
by an IDI or its subsidiary, and any credit expo- ments of section 23A because $500 of the loan
sure of an IDI or a subsidiary to an affiliate is 100 percent secured by obligations of the
resulting from a securities borrowing or lending United States, $400 of the loan is 120 percent
transaction, or a derivative transaction, shall be secured by debt instruments, and $100 of the
secured at all times by collateral (credit expo- loan is 130 percent secured by real estate. The
sure) at the amounts required by the statute. statute prohibits an IDI from counting a low-
The required collateral varies,51 depending on quality asset toward section 23As collateral
the type of collateral used to secure the transac- requirements for credit transactions with affili-
tion.52 The specific collateral requirements are ates.54 An IDI must maintain a perfected secu-
rity interest at all times in the collateral that
1. 100 percent of the amount of such loan or secures the credit transaction.
extension of credit, guarantee, acceptance, Each loan or extension of credit to an affiliate
letter of credit or credit exposure, if the col- or guarantee, acceptance, credit exposure or let-
lateral is composed of ter of credit issued on behalf of an affiliate
a. obligations of the United States or its (herein referred to as credit transactions) by an
agencies; IDI or its subsidiary must be secured at the time
b. obligations fully guaranteed by the United of the transaction by collateral.
States or its agencies as to principal and
interest;
c. notes, drafts, bills of exchange, or bank- 2020.1.5.1 Collateral Requirements in
ers acceptances that are eligible for redis- Regulation W
count or purchase by a Federal Reserve
Bank;53 or The collateral requirements for credit transac-
tions are found in section 23A (c) of the statute.
Section 23A (c)(1) requires that an IDI meet the
49. The IDI must perfect the security interest in the collat- collateral requirements of the statute at all times.
eral (Fitzpatrick v. FDIC, 765 F.2d 569 (6th Cir. 1985). A
purchase of assets from an affiliate does not require collateral. A low-quality asset cannot be used to satisfy the
50. 12 U.S.C. 371c(b)(7).
51. Credit extended means the loan or extension of
54. 12 U.S.C. 371c(c)(3).
credit, guarantee, acceptance, or letter of credit.
52. 12 U.S.C. 371c(c)(1).
53. Regulation A includes a representative list of accept- BHC Supervision Manual July 2014
able government obligations (12 C.F.R. 201.108). Page 17
statutes or regulations collateral requirements, eral. A credit transaction between an IDI and an
but can be taken as additional collateral. affiliate supported only by a guarantee or letter
of credit from a third party does not meet the
statutory requirement that the credit transac-
2020.1.5.1.1 Deposit Account Collateral tion be secured by collateral. Guarantees and
letters of credit often are subject to material
Under section 23A, an IDI may satisfy the col- adverse change clauses and other covenants that
lateral requirements of the statute by securing a allow the issuer of the guarantee or letter of
credit transaction with an affiliate with a segre- credit to deny coverage. Letters of credit and
gated, earmarked deposit account maintained guarantees are not balance-sheet assets under
with the IDI in an amount equal to 100 percent GAAP and, accordingly, would not constitute
of the credit extended.55 IDIs may secure cov- real or personal property under sec-
ered transactions with omnibus deposit accounts tion 23A. There is a particularly significant risk
so long as the IDI takes steps to ensure that the that an IDI may have difficulty collecting on a
omnibus deposit accounts fully secure the rel- guarantee or letter of credit provided by a
evant covered transactions. Such steps might nonaffiliate on behalf of an affiliate of the IDI.
include substantial overcollateralization or the Accordingly, guarantees and letters of credit are
use of subaccounts or other recordkeeping not acceptable section 23A collateral.
devices to match deposits with covered transac- As noted above, section 23A prohibits an IDI
tions. To obtain full credit for any deposit from accepting securities issued by an affiliate
accounts taken as section 23A collateral, IDIs as collateral for an extension of credit to any
must ensure that they have a perfected, first- affiliate. The rule clarifies that securities issued
priority security interest in the accounts. (See by the IDI itself also are not eligible collateral to
section 223.14(b)(1)(i)(D).) secure a credit transaction with an affiliate.
Equity securities issued by a lending IDI, and
debt securities issued by a lending IDI that
2020.1.5.1.2 Ineligible Collateral count as regulatory capital of the IDI, are not
eligible collateral under section 23A. If an IDI
The purpose of section 23As collateral require- was forced to foreclose on a credit transaction
ments is to ensure that IDIs that engage in credit with an affiliate secured by such securities, the
transactions with affiliates have legal recourse, IDI may be unwilling to liquidate the collateral
in the event of affiliate default, to tangible assets promptly to recover on the credit transaction
with a value at least equal to the amount of the because the sale might depress the price of the
credit extended. IDIs outstanding securities or result in a change
The statute recognizes that certain types of in control of the IDI. In addition, to the extent
assets are not appropriate to serve as collateral that an IDI is unable or unwilling to sell such
for credit transactions with an affiliate. In par- securities acquired through foreclosure, the
ticular, the statute provides that low-quality transaction would likely result in a reduction in
assets and securities issued by an affiliate are the IDIs capital, thereby offsetting any poten-
not eligible collateral for such covered transac- tial benefit provided by the collateral.
tions.
Under section 223.14(c) of the rule, intan-
gible assets also are not deemed acceptable to 2020.1.5.1.3 Perfection and Priority
meet the collateral requirements imposed by
section 23A.56 Intangible assets, including ser- Under section 223.14(d) of the rule, an IDIs
vicing assets, are particularly hard to value, and security interest in any collateral required by
an IDI may have significant difficulty in collect- section 23A must be perfected in accordance
ing and selling such assets in a reasonable with applicable law to ensure that an IDI has
period of time. good access to the assets serving as collateral
Section 23A(c) requires that credit transac- for its credit transactions with affiliates. This
tions with an affiliate be secured by collat- requirement ensures that the IDI has the legal
right to realize on the collateral in the case of
default, including a default resulting from the
55. 12 U.S.C. 371c(c)(1)(A)(iv).
56. The rule does not confine the definition of intangible
affiliates insolvency or liquidation. An IDI also
assets by reference to GAAP. is required to either obtain a first-priority secu-
rity interest in the required collateral or deduct
BHC Supervision Manual July 2014 from the amount of collateral obtained by the
Page 18 IDI the lesser of (1) the amount of any security
interests in the collateral that are senior to that tional funds without posting the additional col-
obtained by the IDI or (2) the amount of any lateral required by section 23A. If an IDI volun-
credits secured by the collateral that are senior tarily advances additional funds under such a
to that of the IDI. For example, if an IDI lends credit arrangement without obtaining the addi-
$100 to an affiliate and takes as collateral a tional collateral required under section 23A to
second lien on a parcel of real estate worth secure the entire used amount (despite its lack
$200, the arrangement would only satisfy the of a legal obligation to make such an advance),
collateral requirements of section 23A if the the Board views this action as a violation of the
affiliate owed the holder of the first lien $70 or collateral requirements of the statute. The entire
less (a credit transaction secured by real estate amount of the line counts against the IDIs
must be secured at 130 percent of the amount of quantitative limit, even if the line of credit does
the transaction). not need to be secured.
The rule includes the following example of
how to compute the section 23A collateral value
of a junior lien: An IDI makes a $2,000 loan to 2020.1.5.1.5 Purchasing Affiliate Debt
an affiliate. The affiliate grants the IDI a second- Securities in the Secondary Market
priority security interest in a piece of real estate
valued at $3,000. Another institution that previ- An IDIs investment in the debt securities issued
ously lent $1,000 to the affiliate has a first- by an affiliate is an extension of credit by the
priority security interest in the entire parcel of IDI to the affiliate and thus is subject to sec-
real estate. This transaction is not in compliance tion 23As collateral requirements. Section
with the collateral requirements of this section. 223.14(f)(3) of the rule provides an exemption
Because of the existence of the prior third-party that permits IDIs in certain circumstances to
lien on the real estate, the effective value of the purchase debt securities issued by an affiliate
real estate collateral for the IDI for purposes of without satisfying the collateral requirements of
this section is only $2,000$600 less than the section 23A. The exemption is available where
amount of real estate collateral required by this an IDI purchases an affiliates debt securities
section for the transaction ($2,000 130 percent from a third party in a bona fide secondary-
= $2,600). market transaction. When an IDI buys an affili-
ates debt securities in a bona fide secondary-
market transaction, the risk that the purchase is
2020.1.5.1.4 Unused Portion of an designed to shore up an ailing affiliate is
Extension of Credit reduced. Any purchase of affiliate debt securi-
ties that qualifies for this exemption would still
Section 23A requires that the amount of an remain subject to the quantitative limits of sec-
extension of credit be secured by the statutorily tion 23A and the market-terms requirement of
prescribed levels of collateral. Under the statute, section 23B. In analyzing an IDIs good faith
an IDI provides a line of credit to an affiliate, it under this exemption transaction, examiners
must secure the full amount of the line of credit should look at (1) the time elapsed between the
throughout the life of the credit. Section original issuance of the affiliates debt securities
223.14(f)(2) of the rule, however, provides an and the IDIs purchase, (2) the existence of any
exemption to the collateral requirements of sec- relevant agreements or relationships between
tion 23A for the unused portion of an extension the IDI and the third-party seller of the affili-
of credit to an affiliate so long as the IDI does ates debt securities, (3) any history of IDI
not have any legal obligation to advance addi- financing of the affiliate, and (4) any other rel-
tional funds under the credit facility until the evant information.
affiliate has posted the amount of collateral
required by the statute with respect to the entire
used portion of the extension of credit.57 In such 2020.1.5.1.6 Credit Transactions with
credit arrangements, securing the unused por- Nonaffiliates that Become Affiliates
tion of the credit line is unnecessary from a
safety-and-soundness perspective because the IDIs sometimes lend money to, or issue guaran-
affiliate cannot require the IDI to advance addi- tees on behalf of, unaffiliated companies that
later become affiliates of the IDI. Section
57. This does not apply to guarantees, acceptances, and
letters of credit issued on behalf of an affiliate. These instru-
223.21(b)(2) provides transition rules that
ments must be fully collateralized at inception. Moreover,
these transactions are still subject to the 10 and 20 percent BHC Supervision Manual July 2014
limits of the statute. Page 19
exempt credit transactions from the collateral lateral for a loan or extension of credit to, or
requirements in situations in which the IDI for a guarantee, acceptance, or letter of credit
entered into the transactions with the nonaffili- issued on behalf of, an affiliate, or credit
ate at least one year before the nonaffiliate exposure to an affiliate resulting from a secu-
became an affiliate of the IDI. For example, an rities borrowing or lending transaction, or
IDI with capital stock and surplus of $1,000 and derivative transaction.
no outstanding covered transactions makes a 3. Securities or other debt obligations issued by
$120 unsecured loan to a nonaffiliate. The IDI an affiliate of an IDI shall not be acceptable
does not make the loan in contemplation of the as collateral for a loan or extension of credit
nonaffiliate becoming an affiliate. Nine months to, or for a guarantee, acceptance, or letter of
later, the bank holding company purchases all credit issued on behalf of, or credit exposure
the stock of the nonaffiliate, thereby making the from a securities borrowing or lending trans-
nonaffiliate an affiliate of the IDI. The IDI is not action, or derivative transaction to, that affili-
in violation of the quantitative limits of the ate or any other affiliate of the IDI.
rules section 223.11 or 223.12 at the time of the
stock acquisition. The IDI is, however, prohib- The above collateral requirements are not appli-
ited from engaging in any additional covered cable to an acceptance that is already fully
transactions with the new affiliate at least until secured either by attached documents or by
such time as the value of the loan transaction other property that is involved in the transaction
falls below 10 percent of the IDIs capital stock and has an ascertainable market value.
and surplus, and the transaction counts toward
the 20 percent limit for transactions with all
affiliates. In addition, the IDI must bring the 2020.1.7 DERIVATIVE
loan into compliance with the collateral require- TRANSACTIONS WITH AFFILIATES
ments of section 223.14 promptly after the stock
acquisition. Transactions with nonaffiliates in
contemplation of the nonaffiliate becoming an 2020.1.7.1 Derivative Transactions
affiliate must meet the quantitative and collat- between Insured Depository Institutions
eral requirements of the rule at the time of the and Their Affiliates
inception of the credit transaction and of the
affiliation. Derivative transactions between an IDI and its
affiliates generally arise from the risk-
management needs of the institution or the affili-
2020.1.6 LIMITATIONS ON ate. Transactions arising from the institutions
COLLATERAL needs typically occur when an institution enters
into a swap or other derivative contract with a
IDIs may accept as collateral for covered trans- customer but chooses not to hedge directly the
actions receivables, leases, or other real or per- market risk generated by the derivative contract,
sonal property.58 The following are limitations or when the institution is unable to hedge the
and collateral restrictions: risk directly because it is not authorized to hold
the hedging asset. To manage the market risk,
1. Any collateral that is subsequently retired or the institution may have an affiliate acquire the
amortized must be replaced by additional hedging asset. The institution would then do a
eligible collateral. This is done to keep the bridging derivative transaction between itself
percentage of the collateral value relative to and the affiliate maintaining the hedge.
the amount of the outstanding loan or exten- Other derivative transactions between an IDI
sion of credit, guarantee, acceptance, or letter and its affiliate are affiliate-driven. To accom-
of credit equal to the minimum percentage plish its asset-liability-management goals, an
that was required at the inception of the institutions affiliate may enter into an interest-
transaction. rate or foreign-exchange derivative with the
2. A low-quality asset is not acceptable as col- institution. For example, an institutions holding
company may hold a substantial amount of
58. As noted above, letters of credit and mortgage- floating-rate assets but issue fixed-rate debt
servicing rights may not be accepted as collateral for purposes
of section 23A. See section 223.14(c)(4)(5) of the rule
securities to obtain cheaper funding. The hold-
(12 C.F.R. 223.14(c )(4) and (5). ing company may then enter into a fixed-to-
floating interest-rate swap with its subsidiary
BHC Supervision Manual July 2014 member bank to reduce the holding companys
Page 20 interest-rate risk.
IDIs and their affiliates that seek to enter into Regulation W clarifies further that the trans-
derivative transactions for hedging (or risk- actions are subject to the market-terms require-
taking) purposes could enter into the desired ment of section 23B of the FRA (see sec-
derivatives with unaffiliated companies. IDIs tion 223.51). The rule requires IDIs to comply
and their affiliates often choose to use each strictly with section 23B in their derivative
other as their derivative counterparties, how- transactions with affiliates. Section 23B requires
ever, to maximize the profits of, and manage an institution to treat an affiliate no better than a
risks within, the consolidated financial group. similarly situated nonaffiliate. To comply with
section 23B of the FRA, each institution should
have in place credit limits on its derivatives
exposure to affiliates that are at least as strict as
2020.1.7.1.1 Section 23A on Derivatives
the credit limits the institution imposes on unaf-
Transactions
filiated companies that are engaged in similar
The Dodd-Frank Act amended section 23A as it businesses and are substantially equivalent in
relates to derivatives and now provides that a size and credit quality. Similarly, each institu-
derivative transaction, as defined in paragraph tion should monitor derivatives exposure to
(3) of section 5200(b) of the Revised Statutes affiliates at least as rigorously as it monitors
(12 U.S.C. 84(b)) with an affiliate, is a covered derivatives exposure to comparable unaffiliated
transaction to the extent that the transaction companies. In addition, each institution should
causes an IDI or a subsidiary to have credit price and require collateral in its derivative
exposure to the affiliate. The Dodd-Frank Act transactions with affiliates in a way that is at
also requires that any credit exposure must be least as favorable to the institution as the way in
secured consistent with the collateral require- which it would price or require collateral in a
ments of section 23A. This is a significant derivative transaction with comparable unaffili-
change and requires that all IDIs calculate the ated counterparties.
relevant credit exposure and count that amount Section 23B generally does not allow an IDI
towards the institutions quantitative limits. The to use with an affiliate the terms and conditions
Dodd-Frank Act requires the IDI to establish it uses with its most creditworthy unaffiliated
and maintain policies and procedures designed customer unless the institution can demonstrate
to manage the credit exposure arising from the that the affiliate is of comparable creditworthi-
derivative. These policies and procedures ness as its most creditworthy unaffiliated cus-
require, at a minimum, that the institution moni- tomer. Instead, section 23B requires that an
tor and control its exposure to its affiliates by affiliate be treated comparably (with respect to
imposing appropriate credit controls and collat- terms, conditions, and credit limits) to the
eral requirements. Regulation W provides that majority of third-party customers engaged in the
credit derivatives between an institution and an same business, and having comparable credit
unaffiliated third party that reference the obliga- quality and size as the affiliate. Because an IDI
tions of an affiliate of the institution and that are generally has the strongest credit rating within a
the functional equivalent of a guarantee by the holding company, the Board generally would
institution on behalf of an affiliate should be not expect an affiliate to obtain better terms and
treated as a guarantee by the institution on conditions from an IDI than the institution
behalf of an affiliate for the purposes of sec- receives from its major unaffiliated counterpar-
tion 23A. (The novation of a derivative between ties. In addition, market terms for derivatives
an IDI and its affiliate is treated as a purchase among major financial institutions generally
under the statute.) include daily marks to market and two-way
collateralization above a relatively small expo-
sure threshold.
2020.1.7.1.2 Section 23B and
Regulation W Regarding Derivative
Transactions ment of section 23B of the FRA applies broadly to, among
other things, [t]he payment of money or the furnishing of
Derivative transactions between an IDI and an services to an affiliate under contract, lease, or otherwise
affiliate also are subject to section 23B of the (12 U.S.C. 371c-1(a)(2)(C)). Institution-affiliate derivatives
FRA under the express terms of the statute.59 generally involve a contract or agreement to pay money to the
affiliate or furnish risk-management services to the affiliate.
59. In addition to applying to covered transactions, as BHC Supervision Manual July 2014
defined in section 23A of the FRA, the market-terms require- Page 21
2020.1.7.1.3 Covering Derivatives That each affiliate, and to all affiliates in the aggre-
Are the Functional Equivalent of a gate, and ensure that the institutions intraday
Guarantee credit extensions to affiliates comply with sec-
tion 23B.
Although most derivatives are not treated as Section 223.42(l) of the rule provides that
covered transactions, section 223.33 of the rule intraday credit extensions by an IDI to an affili-
provides that credit derivatives between an IDI ate are section 23A covered transactions but
and a nonaffiliate in which the IDI protects the exempts all such intraday credit extensions
nonaffiliate from a default on, or a decline in the from the quantitative and collateral require-
value of, an obligation of an affiliate of the IDI ments of section 23A if the IDI (1) maintains
are covered transactions under section 23A. policies and procedures for the management of
Such derivative transactions are viewed as guar- intraday credit exposure and (2) has no reason
antees by a member bank on behalf of an affili- to believe that any affiliate receiving intraday
ate (and, hence, are covered transactions) under credit would have difficulty repaying the credit
section 23A. in accordance with its terms. The policies and
The rule provides that these credit derivatives procedures are to be established and main-
are covered transactions under section 23A and tained for
gives several examples.60 An IDI is not allowed
to reduce its covered transaction amount for 1. monitoring and controlling the credit expo-
these derivatives to reflect hedging positions sure arising at any one time from the IDIs
established by the IDI with third parties. A intraday extensions of credit to each affiliate
credit derivative is treated as a covered transac- and all affiliates in the aggregate and
tion only to the extent that the derivative pro-
vides credit protection with respect to obliga- 2. ensuring that any intraday extensions of
tions of an affiliate of the IDI. credit by the IDI to an affiliate comply with
the market-terms requirement of sec-
tion 223.51 of the rule.
2020.1.8 INTRADAY EXTENSIONS OF
CREDIT
2020.1.8.1 Standard under Which the
An extension of credit under section 23A of the Agencies May Grant Additional
FRA includes the credit exposure arising from Exemptions
intraday extensions of credit by IDIs to their
affiliates. IDIs regularly provide transaction
The Dodd-Frank Act amended section 23A to
accounts to their affiliates in conjunction with
authorize the appropriate federal banking
providing payment and securities clearing ser-
agency to exempt transactions or relationships
vices. As in the case of unaffiliated commercial
by order if the exemption would be in the public
customers, these accounts are occasionally sub-
interest and consistent with the purposes of sec-
ject to overdrafts during the day that are repaid
tion 23A. The exemption determination requires
in the ordinary course of business.
the concurrence of the Board. The FDIC has a
Intraday extensions of credit by an IDI to an
60-day period to determine whether the
affiliate are subject to the market-terms require-
requested exemption presents an unacceptable
ment of section 23B under the rule. The rule
risk to the insurance fund. The request should
also requires that, under section 23A, institu-
describe in detail the transaction or relation-
tions establish and maintain policies and
ship for which the member bank seeks exemp-
procedures that are reasonably designed to man-
tion. The exemption request also should explain
age the credit exposure arising from an
why the Agency should exempt the transaction
institutions intraday extensions of credit to
or relationship, and why it meets the public
affiliates. The policies and procedures must, at a
interest standard of the statute. The Board has
minimum, provide for monitoring and control-
approved a number of exemptions, most of
ling the institutions intraday credit exposure to
which involve corporate reorganizations. These
exemptions are available on the Boards
60. In most instances, the covered-transaction amount for website, www.federalreserve.gov/boarddocs/
such a credit derivative would be the notional principal legalint/FederalReserve Act.
amount of the derivative.

Page 22
2020.1.9 EXEMPTIONS FROM vides that covered transactions between sister

SECTION 23A banks must be consistent with safe and sound
banking practices.63
Section 23A exempts seven transactions or rela- The sister-bank exemption generally applies
tions from its quantitative limits and collateral only to transactions between IDIs.64 The rules
requirements.61 Regulation W, subpart E, clari- definition of affiliate excludes uninsured deposi-
fies these exemptions and exempts a number of tory institution subsidiaries of a member bank.
additional types of transactions. The Board Covered transactions between a member bank
reserves the right to revoke or modify any addi- and a parent uninsured depository institution or
tional exemption granted by the Board in Regu- a commonly controlled uninsured depository
lation W, if the Board finds that the exemption is institution, under the rule, generally would be
resulting in unsafe or unsound banking prac- subject to section 23A, whereas covered transac-
tices. The Board also reserves the right to termi- tions between a member bank and a subsidiary
nate the eligibility of a particular IDI to use any uninsured depository institution would not be
such exemption if the IDIs use of the exemp- subject to section 23A.65
tion is resulting in unsafe or unsound banking The sister-bank exemption, by its terms, only
practices. exempts transactions by a member bank with a
sister-bank affiliate; hence, the sister-bank
exemption cannot exempt a member banks
2020.1.9.1 Covered Transactions Exempt extension of credit or other covered transaction
from the Quantitative Limits and to an affiliate that is not a sister bank (even if the
Collateral Requirements extension of credit was purchased from a sister
bank). For example, an IDI purchases from
Under the rules section 223.41, the quantitative Sister-Bank Affiliate A a loan to Affiliate B in a
limits (sections 223.11 and 223.12) and the col- purchase that qualifies for the sister-bank
lateral requirements (section 223.14) do not exemption in section 23A. The IDIs asset pur-
apply to the following transactions. The transac- chase from Sister-Bank Affiliate A would be an
tions are, however, subject to the safety-and- exempt covered transaction under sec-
soundness requirement (section 223.13) and the tion 223.41(b), but the member bank also would
prohibition on the purchase of a low-quality have acquired an extension of credit to Affiliate
asset (section 223.15). B, which would be a covered transaction
between the IDI and Affiliate B under sec-
tion 223.3(h)(1) that does not qualify for the
2020.1.9.1.1 Parent Institution/Subsidiary sister-bank exemption.
Institution Transactions
Transactions with an IDI are exempt from the 2020.1.9.1.3 Purchase of Loans on a
quantitative limits and collateral requirements Nonrecourse Basis from an Affiliated IDI
(section 223.14) if the member bank controls
80 percent or more of the voting securities of Banks that are commonly controlled (i.e., at
the IDI or the depository institution controls least 25 percent common ownership) can
80 percent or more of the voting securities of
the IDI. card banks, the two credit card banks would be sister banks,
and the sister-bank exception could be used for transactions
between two credit card banks.
63. 12 U.S.C. 371c(a)(4).
2020.1.9.1.2 Sister-Bank Exemption 64. A member bank and its operating subsidiaries are
(section 223.41(b)) considered a single unit for purposes of section 23A. Under
the statute and the regulation, transactions between a member
Regulation W exempts transactions with an IDI bank (or its operating subsidiary) and the operating subsidiary
if the same company controls 80 percent or of a sister-insured depository institution generally qualify for
the sister-bank exemption.
more of the voting securities of the member 65. The sister-bank exemption in section 23A does not
bank and the IDI.62 In addition, the statute pro- allow a member bank to avoid any restrictions on sister-bank
transactions that may apply to the bank under the prompt
corrective-action framework set forth in section 38 of the FDI
61. See 12 U.S.C. 371c(d)
Act (12 U.S.C. 1831o) and regulations adopted by the banks
62. Banks that are affiliated in this manner are referred to
appropriate federal banking agency.
as sister banks. Sister banks can improve their efficiency
through intercorporate transfers under this exception. Also,
company in this context is not limited to a bank holding BHC Supervision Manual July 2014
company. For example, if a retail corporation owns two credit Page 23
purchase loans on a nonrecourse basis. This IDIs directors must review and approve the
allows chain banks and banks in companies that transaction before consummation. Fourth, the
are not owned 80 percent by the same com- section 23A value of the covered transaction
pany to achieve the same efficiency as sister must be less than 10 percent of the IDIs capital
banks. The exemption only applies to the stock and surplus (or up to 25 percent of the
purchase of loans; other covered transactions, IDIs capital stock and surplus with the prior
such as extensions of credit, are not exempt. approval of the appropriate federal banking
agency) for the IDI. Fifth, the holding company
and all its subsidiary depository institutions
2020.1.9.1.4 Internal Corporate must be well capitalized and well managed and
Reorganizations must remain well capitalized upon consumma-
tion of the transaction.
Section 223.41(d) of the rule provides an
exemption for asset purchases by an IDI from
an affiliate that is part of a one-time internal 2020.1.9.2 Other Covered Transactions
corporate reorganization of a holding com- Exempt from the Quantitative Limits,
pany.66 The exemption includes purchases of Collateral Requirements, and
assets in connection with a transfer of securities Low-Quality-Asset Prohibition
issued by an affiliate to an IDI, as described in
section 223.31(a). The quantitative limits (sections 223.11 and
Under this exemption, an IDI would be per- 223.12), the collateral requirements (sec-
mitted to purchase assets (other than low-quality tion 223.14), and the prohibition on the pur-
assets) from an affiliate (including in connection chase of a low-quality asset (section 223.15) do
with an affiliate share transfer that sec- not apply to the following exempted transac-
tion 223.31 of the rule treats as a purchase of tions (see section 223.42) and certain condi-
assets) that are exempt from the quantitative tions. The transactions are, however, subject to
limits of section 23A if the following conditions the safety-and-soundness requirement (sec-
are met. tion 223.13). Detailed conditions or restrictions
First, the purchase must be part of an internal pertaining to these exemptions are discussed
corporate reorganization of a holding company after this list.
that involves the transfer of all or substantially
all of the shares or assets of an affiliate or of a 1. Making correspondent banking deposits in
division or department of an affiliate. The asset an affiliated depository institution (as
purchase must not be part of a series of periodic, defined in section 3 of the FDI Act
ordinary-course asset transfers from an affiliate (12 U.S.C. 1813) or in an affiliated foreign
to an IDI.67 Second, the IDIs holding company bank that represents an ongoing, working
must provide the Board with contemporaneous balance maintained in the ordinary course
notice of the transaction and must commit to the of correspondent business
Board to make the IDI whole, for a period of 2. Giving immediate credit to an affiliate for
two years, for any transferred assets that become uncollected items received in the ordinary
low-quality assets.68 Third, a majority of the course of business
3. Transactions secured by cash or U. S. gov-
66. See 1998 Fed. Res. Bull. 985 and 1013-14. ernment securities
67. The IDI must provide the Board, as well as the appro- 4. Purchasing securities of a servicing affiliate,
priate federal agency, a notice that describes the primary as defined by section 4(c)(1) of the BHC
business activities of the affiliate whose shares or assets are Act
being transferred to the IDI and must indicate the anticipated
date of the reorganization.
68. The holding company can meet these criteria by either
dollar-for-dollar capital requirement, the risk-based capital
repurchasing the assets at book value plus any write-down
charge for each transferred low-quality loan asset would be
that has been taken or by making a quarterly cash contribution
100 percent (equivalent to a 1250 percent risk weight), rather
to the bank equal to the book value plus any write-downs that
than the 8 percent requirement (equivalent to a 100 percent
have been taken by the bank. The purchase or payment must
risk weight) that would apply to a similar defaulted loan asset
be made within 30 days of each quarter end. In addition, if a
that is not a part of the transferred asset pool. See the Boards
cash payment is made, the IDI will hold an amount of risk-
letter dated December 21, 2007, to Andres L. Navarette
based capital equal to the book value of any transferred assets
(Capital One Financial Corp.). Once the capital pool has been
that become low-quality so long as the IDI retains ownership
allocated to specific assets as described above, the capital
or control of the transferred asset. For example, under this
cannot be applied to other low-quality assets if the initial
low-quality asset returns to performing status. The IDI can
BHC Supervision Manual July 2014 only apply the allocated capital pool to new assets if the initial
Page 24 assets are fully paid or sold.
5. Purchasing certain liquid assets A deposit account meets the segregated,

6. Purchasing certain marketable securities earmarked requirement only if the account
7. Purchasing certain municipal securities exists for the sole purpose of securing credit
8. Purchasing from an affiliate an extension of transactions between the member bank and its
credit subject to a repurchase agreement affiliates and is so identified. Under sec-
that was originated by an IDI and sold to tion 23A, if U.S. government obligations or
the affiliate subject to a repurchase agree- deposit accounts are sufficient to fully secure a
ment or with recourse credit transaction, then the transaction is com-
9. Asset purchases from an affiliate by a newly pletely exempt from the quantitative limits of
formed IDI, if the appropriate federal bank- the statute. If, however, the U.S. government
ing agency for the IDI has approved the obligations or deposit accounts represent less
asset purchase in writing in connection with than full security for the credit transaction, then
the review of the formation of the IDI the amount of U.S. government obligations or
10. Transactions approved under the Bank deposits counts toward the collateral require-
Merger Act that involve affiliated IDIs or an ments of section 23A, but no part of the trans-
IDI and the U.S. branches and agencies of a action is exempt from the statutes quantitative
foreign bank limits.
11. Purchasing, on a nonrecourse basis, an The exemption provides that a credit transac-
extension of credit from an affiliate under tion with an affiliate will be exempt to the
certain conditions extent that the transaction is and remains
12. Intraday extensions of credit secured by appropriate (d)(4) collateral. If an
13. Riskless-principal transactions IDI makes a $100 nonamortizing term loan to
an affiliate that is secured by $50 of U.S. Trea-
sury securities and $75 of real estate, the value
2020.1.9.2.1 Correspondent Banking of the covered transaction will be $50. If the
market value of the U.S. Treasury securities
Section 23A exempts from its quantitative lim- falls to $45 during the life of the loan, the value
its and collateral requirements a deposit by an of the covered transaction would increase to
IDI in an affiliated IDI or affiliated foreign bank $55. The Board expects IDIs that use this
that is made in the ordinary course of correspon- expanded (d)(4) exemption to review the market
dent business, subject to any restrictions that the value of their U.S. government obligations col-
Board may impose.69 Section 223.42(a) of the lateral regularly to ensure compliance with the
rule further provides that such deposits must exemption.
represent ongoing, working balances maintained
by the IDI in the ordinary course of conducting
the correspondent business.70 Although not 2020.1.10 ASSET PURCHASES FROM
specified by section 23A or the Home Owners AN AFFILIATEEXEMPTIONS
Loan Act (HOLA), the rule also provides that
correspondent deposits in an affiliated insured
savings association are exempt if they otherwise
2020.1.10.1 Purchase of a Security by an
meet the requirements of the exemption.
Insured Depository Institution from an
Affiliate
2020.1.9.2.2 Secured Credit Transactions Section 23A of the FRA restricts the ability of
a member bank to fund its affiliates through
Section 23A and section 223.42(c) of the rule asset purchases, loans, or certain other transac-
exempt any credit transaction by an IDI with an tions (referred to as covered transactions).
affiliate that is fully secured by obligations of Paragraph (d)(6) of section 23A contains an
the United States or its agencies, or obliga- exemption from the statute (the (d)(6) exemp-
tions that are fully guaranteed by the United tion) for purchasing assets having a readily
States or its agencies, as to principal and identifiable and publicly available market quo-
interest.71
69. 12 U.S.C. 371c(d)(2).

can be found in the ruless section 201.108 (12 C.F.R.
70. Unlike the sister-bank exemption, the exemption for
201.108).
correspondent banking deposits applies to deposits placed by
a member bank in an uninsured depository institution or
foreign bank. BHC Supervision Manual July 2014
71. 12 U.S.C. 371c(d)(4). A partial list of such obligations Page 25
tation, if the purchase is at or below such 2020.1.10.3 Purchasing Certain

quotation.72 Marketable Securities
Regulation W provided an additional exemp-

2020.1.10.2 Purchases of Assets with tion from section 23A for certain purchases of
Readily Identifiable Market Quotes securities by a member bank from an affiliate.
The rule expanded the statutory (d)(6) exemp-
tion to allow a member bank to purchase secu-
Section 23A(d)(6) exempts the purchase of rities from an affiliate based on price quotes
assets by an IDI from an affiliate if the assets obtained from certain electronic services so
have a readily identifiable and publicly avail- long as, among other things, the selling affiliate
able market quotation and are purchased at is a broker-dealer registered with the SEC, the
their current market quotation. The rule (sec- securities have a ready market and are eligible
tion 223.42(e)) limits the availability of this for purchase by state member banks, the securi-
exemption (the (d)(6) exemption) to purchases ties are not purchased within 30 days of an
of assets with market prices that are recorded in underwriting (if an affiliate of the bank is an
widely disseminated publications that are read- underwriter of the securities), and the securities
ily available to the general public, such as news- are not issued by an affiliate.
papers with a national circulation. Because as a
general matter only exchange-traded assets are
recorded in such publications, this test has 2020.1.10.3.1 Broker-Dealer Requirement
ensured that the qualifying assets are traded and Securities Purchases from Foreign
actively enough to have a true market quota- Broker-Dealers
tion and that examiners can verify that the
assets are purchased at their current market quo- Under the Regulation W exemption, the selling
tation. The rule applies if the asset is purchased affiliate must be a broker-dealer securities
at or below the assets current market affiliate that is registered with the Securities and
quotation.73 Exchange Commission (SEC). Broker-dealers
The (d)(6) exemption may apply to a pur- that are registered with the SEC are subject to
chase of assets that are not traded on an supervision and examination by the SEC and
exchange. In particular, purchases of foreign are required by SEC regulations to keep and
exchange, gold, and silver, and purchases of maintain detailed records concerning each
over-the-counter (OTC) securities and deriva- securities transaction conducted by the broker-
tive contracts whose prices are recorded in dealer. In addition, SEC-registered broker-
widely disseminated publications, may qualify dealers have experience in determining whether
for the (d)(6) exemption. a security has a ready market under SEC
If an IDI purchases from one affiliate, the regulations. The rule does not expand the
securities issued by another affiliate, the IDI has exemption to include securities purchases from
engaged in two types of covered transactions: foreign broker-dealers. The rule explicitly pro-
(1) the purchase of securities from an affiliate vides, however, that an IDI may request that the
and (2) the investment in securities issued by an Board exempt securities purchases from a par-
affiliate. Under the rule, although the ticular foreign broker-dealer, and the Board
(d)(6) exemption may exempt the one-time would consider these requests on a case-by-case
asset purchase from the first affiliate, it would basis in light of all the facts and circumstances.
not exempt the ongoing investment in securi-
ties being issued by a second affiliate.
2020.1.10.3.2 Securities Eligible for
Purchase by a State Member Bank
72. 12 U.S.C. 371c(d)(6).
73. The rule provides that a U.S. government obligation is
The exemption requires that the IDIs purchase
an eligible (d)(6) asset only if the obligations price is quoted of securities be eligible for purchase by a state
routinely in a widely disseminated publication that is readily member bank. For example, the Board deter-
available to the general public. Although all U.S. government mined that a member bank may purchase equity
obligations have low credit risk, not all U.S. government
obligations trade in liquid markets at a publicly available
securities from an affiliate, if the purchase is
market quotation. made to hedge the member banks permissible
customer-driven equity derivative transaction.
BHC Supervision Manual July 2014 The purchase must be treated as a purchase of a
Page 26 security on the Call Report.
2020.1.10.3.3 No Purchases Within 30 IDI is in compliance with the terms of the

Days of an Underwriting exemption.
The exemption generally prohibits an IDI from

using the exemption to purchase securities dur- 2020.1.10.4 Purchasing Municipal
ing an underwriting, or within 30 days of an Securities
underwriting, if an affiliate of the IDI is an
underwriter of the securities. This provision Section 223.42(g) of the rule exempts an IDIs
applies unless the security is purchased as part purchase of municipal securities from an affili-
of an issue of obligations of, or obligations fully ate if the purchase meets certain require-
guaranteed as to principal and interest by, the ments.74 First, the IDI must purchase the
United States or its agencies. The rule includes municipal securities from a broker-dealer affili-
the 30-day requirement because of the uncertain ate that is registered with the SEC. Second, the
and volatile market values of securities during municipal securities must be eligible for pur-
and shortly after an underwriting period and chase by a state member bank, and the IDI
because of the conflicts of interest that may must report the transaction as a securities pur-
arise during and after an underwriting period, chase in its Call Report. Third, the municipal
especially if an affiliate has difficulty selling its securities should either be rated by a nationally
allotment. recognized statistical rating organization
(NRSRO) or be part of an issue of securities
that does not exceed $25 million in size. Fi-
2020.1.10.3.4 No Securities Issued by an nally, the price for the securities purchased
Affiliate must be (1) quoted routinely on an unaffiliated
electronic service that provides indicative data
If an IDI purchases from one affiliate securities from real-time financial networks; (2) verified
issued by another affiliate, it would not exempt by reference to two or more actual independent
the investment in securities issued by the sec- dealer quotes on the securities to be purchased
ond affiliate, even though the exemption may or securities that are comparable to the securi-
exempt the asset purchase from the first affili- ties to be purchased; or (3) in the case of secu-
ate. The transaction would be treated as a pur- rities purchased during the underwriting period,
chase of, or an investment in, securities issued verified by reference to the price indicated in
by an affiliate. the syndicate managers written summary of
the underwriting.75 Under any of the three pric-
ing options, the IDI must purchase the munici-
2020.1.10.3.5 Price-Verification Methods pal securities at or below the quoted or verified
price.
The exemption applies only in situations in
which the IDI is able to obtain price quotes on
the purchased securities from an unaffiliated 2020.1.10.5 Purchase of Loans on a
electronic, real-time pricing service. The Board Nonrecourse Basis
reaffirmed its position that it would not be
appropriate to use independent dealer quotations Section 223.41(c) of the rule exempts the pur-
or economic models to establish a market price chase of loans on a nonrecourse basis from an
for a security under the (d)(6) exemption. A
security that is not quoted routinely in a widely
74. Municipal securities are defined by reference to sec-
disseminated news source or a third-party election 3(a)(29) of the Securities Exchange Act. That Act defines
tronic financial network may not trade in a municipal securities as direct obligations of, or obligations
sufficiently liquid market to justify allowing an guaranteed as to principal or interest by, a state or agency,
IDI to purchase unlimited amounts of the secu- instrumentality, or political subdivision thereof, and certain
tax-exempt industrial development bonds. (See 17 U.S.C.
rity from an affiliate. 78c(a)(29).)
75. Under the Municipal Securities Rulemaking Boards
Rule G-11, the syndicate manager for a municipal bond
2020.1.10.3.6 Record Retention underwriting is required to send a written summary to all
members of the syndicate. The summary discloses the aggre-
gate par values and prices of bonds sold from the syndicate
The rule expressly includes a two-year record- account.
retention and supporting information require-
ment that is sufficient to enable the appropriate BHC Supervision Manual July 2014
federal banking agencies to ensure that the Page 27
affiliated depository institution. Under sec- 2020.1.11 PURCHASES OF

tions 23A(d)(6), a member bank may purchase EXTENSIONS OF CREDITTHE
loans on a nonrecourse basis from an affiliated PURCHASE EXEMPTION
bank exempt from the quantitative limita-
tions of section 23A, even if the transactions Regulation W codified, with changes, the
does not qualify for the sister-bank exemp- exemption that was previously found at sec-
tion.76 The rule clarifies that the scope of the tion 250.250 (12 C.F.R. 250.250). In general,
exemption parallels that of the sister-bank
exemption by stating that this exemption 1. The purchase of an extension of credit on a
applies only to a member banks purchase of a nonrecourse basis from an affiliate is exempt
loan from an affiliated IDI. from section 23As quantitative limits pro-
vided that
a. the extension of credit is originated by the
affiliate;
2020.1.10.6 Purchases of Assets by b. the IDI makes an independent evaluation
Newly Formed Institutions of the creditworthiness of the borrower
before the affiliate makes or commits to
Section 223.42(i) of the rule exempts a purchase make the extension of credit;
of assets by a newly formed IDI from an affiliate c. the IDI commits to purchase the exten-
if the appropriate federal banking agency for the sions of credit before the affiliate makes
IDI has approved the purchase. This exemption or commits to the extensions of credit;
allows companies to charter a new IDI and to and
transfer assets to the IDI free of the quantitative d. the IDI does not make a blanket advance
limits and low-quality-asset prohibition of sec- commitment to purchase extensions of
tion 23A. credit from the affiliate. (See sec-
tion 223.42(k) of the rule.)
2. The rule also includes a 50 percent limit on
the amount of loans an IDI may purchase
2020.1.10.7 Transactions Approved under from an affiliate under the purchase exemp-
the Bank Merger Act tion. When an IDI purchases more than half
of the extensions of credit originated by an
The Bank Merger Act exemption applies to affiliate, the purchases represent the principal
transactions between an IDI and a certain IDI ongoing funding mechanism for the affiliate.
affiliate. Section 223.42(j) exempts transactions The IDIs status as the predominant source
between IDIs that are approved pursuant to the of financing for the affiliate calls into ques-
Bank Merger Act. The rule also makes the Bank tion the availability of alternative funding
Merger Act exemption available for merger and sources for the affiliate, places significant
other related transactions between an IDI and a pressure on the IDI to continue to support the
U.S. branch or agency of an affiliated foreign affiliate through asset purchases, and reduces
bank, if the transaction has been approved by the IDIs ability to make independent credit
the responsible federal banking agency pursuant decisions with respect to the asset purchases.
to the Bank Merger Act. There is no regulatory 3. Substantial, ongoing funding test. The rule
exemption for merger transactions between an allows the appropriate federal banking
IDI and its nonbank affiliate. Any IDI merging agency for an IDI to reduce the 50 percent
or consolidating with a nonbank affiliate may be threshold prospectively, on a case-by-case
able to take advantage of the regulatory exemp- basis, in those situations in which the agency
tion for internal-reorganization transactions con- believes that the IDIs asset purchases from
tained in section 223.41(d) of the rule. an affiliate under the exemption may cause
harm to the IDI.
4. Independent credit review by the IDI. To
qualify for the purchase exemption under
section 223.42(k), an IDI must independently
review the creditworthiness of the borrower
before committing to purchase each loan.
76. See 12 U.S.C. 371c(d)(6). Under established Federal Reserve guidance,
an IDI is required to have clearly defined
BHC Supervision Manual July 2014 policies and procedures to ensure that it per-
Page 28 forms its own due diligence in analyzing the
credit and other risks inherent in a proposed 371c(a)(2)). One respective interpretation and
transaction.77 This function is not delegable three exemptions are discussed below.
to any third party, including affiliates of the
IDI. Also, an IDI cannot rely on the stan-
dards of a government-sponsored enterprise. 2020.1.12.2 InterpretationLoans to a
Accordingly, to qualify for this exemption, Nonaffiliate that Purchases Securities or
the IDI, independently and using its own Other Assets Through a Depository
credit policies and procedures, must itself Institution Affiliate Agent or Broker
review and approve each extension of credit
before giving a purchase commitment to its In Regulation W, the Board issued an interpreta-
affiliate. tion (12 C.F.R. 223.26(b)) regarding an IDIs
5. Purchase of loans from an affiliate must be loan to a nonaffiliate that purchases assets
without recourse. In connection with an IDIs through an institutions affiliate that is acting as
purchase of loans from an affiliate, the affili- agent. This interpretation confirms that sec-
ate cannot retain recourse on the loans. The tion 23A of the FRA does not apply to exten-
rule (section 223.42(k)) specifies that the sions of credit an IDI grants to customers that
exemption does not apply in situations where use the loan proceeds to purchase a security or
the affiliate retains recourse on the loans other asset through an affiliate of the depository
purchased by the IDI. The rule also specifies institution, so long as (1) the affiliate is acting
that the purchase exemption only applies in exclusively as an agent or broker in the transac-
situations where the IDI purchases loans tion and (2) the affiliate retains no portion of the
from an affiliate that were originated by the loan proceeds as a fee or commission for its
affiliate. The exemption cannot be used by an services.
IDI to purchase loans from an affiliate that Under this interpretation, the Board con-
the affiliate purchased from another lender. cluded that when the affiliated agent or broker
The exemption is designed to facilitate an retains a portion of the loan proceeds as a fee or
IDIs using its affiliate as an origination commission, the portion of the loan not retained
agent, not to permit an IDI to take loans off by the affiliate as a fee or commission would
an affiliates books that the affiliate pur- still be outside the coverage of section 23A.
chased from a third party. However, the portion of the loan retained by the
affiliate as a fee or commission would be subject
to section 23A because it represents proceeds of
2020.1.12 OTHER BOARD- a loan by a depository institution to a third party
APPROVED EXEMPTIONS FROM that are transferred to, and used for the benefit
SECTION 23A of, an affiliate of the institution. The Board,
however, granted an exemption from sec-
Section 23A gives the Board the authority to tion 23A for that portion of a loan to a third
grant exemptions from the statutes restrictions party that an affiliate retains as a market-rate
if such exemptions are in the public interest brokerage or agency fee. (See 12 C.F.R.
and consistent with the purposes of this section 223.16(c )(2).)
(12 U.S.C. 371c(f)(2)). Regulation W includes The interpretation would not apply if the
several exemptions that are available to qualify- securities or other assets purchased by the third-
ing IDIs. party borrower through the affiliate of the
depository institution were issued or underwrit-
ten by, or sold from the inventory of, another
affiliate of the depository institution. In that
2020.1.12.1 Exemptions and case, the proceeds of the loan from the deposi-
Interpretation from the Attribution Rule tory institution would be transferred to, and
of Section 23A used for the benefit of, the affiliate that issued,
underwrote, or sold the assets on a principal
The attribution rule of section 23A provides that basis to the third party.
a transaction by a member institution with any The above-mentioned transactions are subject
person shall be deemed a transaction with an to the market-terms requirement of section 23B,
affiliate to the extent that the proceeds of the which applies to any transaction in which an
transaction are used for the benefit of, or trans- affiliate acts as an agent or broker or receives a
ferred to, that affiliate (12 U.S.C.
77. See, for example, SR-97-21. Page 29
fee for its services to the institution or any other 2020.1.12.4 ExemptionDepository
person (12 U.S.C. 371c-1(a)(2)(D)). A market- Institution Loan to a Nonaffiliate Pursuant
rate brokerage commission or agency fee refers to a Preexisting Line of Credit and the
to a fee or commission that is no greater than Proceeds Are Used to Purchase Securities
that prevailing at the same time for comparable from the Institutions Broker-Dealer
agency transactions the affiliate enters into with Affiliate
persons who are neither affiliates nor borrowers
from an affiliated depository institution. (See The Board approved an exemption in Regula-
Regulation W at 12 C.F.R. 223.16(b).) tion W from section 23A for loans by an IDI to
a nonaffiliate pursuant to a preexisting line of
credit, in which the loan proceeds are used to
purchase securities from a broker-dealer affili-
2020.1.12.3 ExemptionLoans to a ate. In more detail, the Board exempted exten-
Nonaffiliate that Purchases Securities sions of credit by an IDI to its customers that
from a Depository Institution Securities use the credit to purchase securities from a reg-
Affiliate that Acts as a Riskless Principal istered broker-dealer affiliate of the institution,
so long as the extension of credit is made pur-
The Board has granted an exemption in Regula- suant to, and consistent with any conditions
tion W from section 23A of the FRA for exten- imposed in, a preexisting line of credit. This
sions of credit by an IDI to customers who use line of credit should not have been established
the loan proceeds to purchase a security that is in expectation of a securities purchase from or
issued by a third party through a broker-dealer through an affiliate of the institution. The pre-
affiliate of the institution that acts as riskless existing requirement is an important safeguard
principal. The exemption for riskless-principal to ensure that the depository institution did not
transactions would not apply if the broker-dealer extend credit for the purpose of inducing a bor-
affiliate sold to the third-party borrower securi- rower to purchase securities from or issued by
ties that were issued or underwritten by, or sold an affiliate. The preexisting line of exemption
out of the inventory of, an affiliate of the deposi- may not be used in circumstances in which the
tory institution. Riskless-principal trades, line has merely been preapproved. (See Regu-
although the functional equivalent of securities lation W at 12 C.F.R. 223.16(c)(3).)
brokerage transactions, involve the purchase of
a security by the depository institutions broker-
dealer affiliate. Accordingly, the broker-dealer 2020.1.12.5 ExemptionCredit Card
retains the loan proceeds at least for some Transactions
moment in time.
There is negligible risk that loans that a Regulation W also provides an exemption from
depository institution makes to borrowers to section 23As attribution rule for general-
engage in riskless-principal trades through a purpose credit card transactions that meet
broker-dealer affiliate of the depository institu- certain criteria. (See section 223.16(c)(4).) The
tion would be used to fund the broker-dealer. rule defines a general-purpose credit card as a
For this reason, the Board adopted an exemption credit card issued by a member institution that
from section 23A to cover riskless-principal is widely accepted by merchants that are not
securities transactions engaged in by depository affiliates of the institution (such as a Visa card
institution borrowers through broker-dealer or Mastercard) if less than 25 percent of the
affiliates of the depository institution. This aggregate amount of purchases with the card are
exemption is applicable even if the broker- purchases from an affiliate of the institution.
dealer retains a portion of the loan proceeds as a Extensions of credit to unaffiliated borrowers
market-rate markup for executing the riskless- pursuant to special-purpose credit cards (that is,
principal securities trade. (See Regulation W at credit cards that may only be used or are
12 C.F.R. 223.16(c)(1) and (2).) substantially used to buy goods from an affili-
ate of the member institution) are subject to the
rule.
The credit card exemption includes several
different methods that are provided for a mem-
ber institution to demonstrate that its credit card
meets the 25 percent test. First, if a member
BHC Supervision Manual July 2014 institution has no commercial affiliates (other
Page 30 than those permitted for an FHC under section 4
of the BHC Act), the institution would be member institution. Unless the credit card
deemed to satisfy the 25 percent test if the returns to compliance with the 25 percent limit
institution has no reason to believe that it would by the 12-calendar-month period ending
fail the test. (A member institution could use August 31, 2008, the card will cease to qualify
this method of complying with the 25 percent as a general-purpose credit card as of
test even if, for example, the institutions FHC September 1, 2008. Any outstanding exten-
controls, under section 4(a)(2), 4(c)(2), or sions of credit under the credit card that were
4(k)(4)(H) of the BHC Act, several companies used to purchase products or services from an
engaged in nonfinancial activities.) Such a mem- affiliate of the member institution would
ber institution would not be obligated to estab- become covered transactions at such time.
lish systems to verify strict, ongoing compliance
with the 25 percent test. Most BHCs and FHCs
should meet this test. If an IDI has commercial 2020.1.13 AN IDIS ACQUISITION OF
affiliates (beyond those permitted for an FHC AN AFFILIATE THAT BECOMES AN
under section 4 of the BHC Act), the institution OPERATING SUBSIDIARY
would be deemed to satisfy the 25 percent test
if Section 223.31 (a)-(c) of the rule provides
guidance to an IDI that acquires an affiliate. The
1. the institution establishes systems to verify first situation is when an IDI directly purchases
compliance with the 25 percent test on an or otherwise acquires the affiliates assets and
ongoing basis and periodically validates its assumes the affiliates liabilities. In this case, the
compliance with the test or transaction is treated as a purchase of assets, and
2. the institution presents information to the the covered-transaction amount is equal to the
Board demonstrating that its card would amount of any consideration paid by the IDI for
comply with the 25 percent test. (One way the affiliates assets (if any) plus the amount of
that a member institution could demonstrate any liabilities assumed by the IDI in the
that its card would comply with the 25 per- transaction.
cent test would be to show that the total sales Regulation W provides that the acquisition by
of the institutions affiliates are less than an IDI of a company that was an affiliate of the
25 percent of the total purchases by IDI before the acquisition is treated as a pur-
cardholders.) chase of assets from an affiliate if (1) as a result
of the transaction, the company becomes an
Second, for those member institutions that operating subsidiary of the IDI and (2) the com-
fall out of compliance with the 25 percent test, pany has liabilities, or the IDI gives cash or any
there is a three-month grace period to return to other consideration in exchange for the securi-
compliance before extensions of credit under ties. The rule also provides that these transac-
the card become covered transactions. Third, tions must be valued initially at the sum of
member institutions that are required to validate (1) the total amount of consideration given by
their ongoing compliance with the 25 percent the IDI in exchange for the securities and (2) the
test have a fixed method, time frames, and total liabilities of the company whose securities
examples for computing compliance. have been acquired by the IDI. In effect, the rule
Example of calculating compliance with the requires IDIs to treat such share donations and
25 percent test. A member institution seeks to purchases in the same manner as if the IDI had
qualify a credit card as a general-purpose credit purchased the assets of the transferred company
card under section 223.16, paragraph at a purchase price equal to the liabilities of the
(c)(4)(ii)(A), of the rule. The member institu- transferred company (plus any separate consid-
tion assesses its compliance under paragraph eration paid by the IDI for the shares). See
(c)(4)(iii) of this section on the 15th day of 12 C.F.R. 223.31.
every month (for the preceding 12 calendar Similarly, when an affiliate donates a control-
months). The credit card qualifies as a general- ling block of an affiliates shares to an IDI, a
purpose credit card for at least three consecu- covered transaction occurs if the affiliate has
tive months. On June 15, 2008, however, the liabilities that the IDI assumes. For example, the
member institution determines that, for the 12- parent holding company of an IDI contributes
calendar-month period from June 1, 2007, between 25 percent and 100 percent of the vot-
through May 31, 2008, 27 percent of the total ing shares of a mortgage company to the IDI.
value of products and services purchased with
the card by all cardholders were purchases of BHC Supervision Manual July 2014
products and services from an affiliate of the Page 31
The parent holding company retains no shares being transferred to the IDI was an affiliate of
of the mortgage company. The IDI gives no the IDI before the transfer. If the transferred
consideration in exchange for the transferred company was not an affiliate before the trans-
shares. The mortgage company has total assets fer, it would not be appropriate to treat the
of $300,000 and total liabilities of $100,000. share transfer as a purchase of assets from an
The mortgage companys assets do not include affiliate. Similarly, the rule only requires asset-
any loans to an affiliate of the IDI or any other purchase treatment for affiliate share transfers
asset that would represent a separate covered when the transferred company becomes a sub-
transaction for the IDI upon consummation of sidiary and not an affiliate of the IDI through
the share transfer. As a result of the transaction, the transfer.
the mortgage company becomes an operating If an IDI purchases, or receives a donation, of
subsidiary of the IDI. The transaction is treated a partial interest in an entity that remains an
as a purchase of the assets of the mortgage affiliate, that transaction is treated as a purchase
company by the IDI from an affiliate under of, or investment in securities issued by an
paragraph (a) of section 223.31. The IDI ini- affiliate. This type of transaction is valued
tially must value the transaction at $100,000, according to its purchase price or carrying value.
the total amount of the liabilities of the mort- (See 12 C.F.R. 223.23.)
gage company. Going forward, if the member
bank pays off the liabilities, the member bank
must continue to value the covered transaction 2020.1.14 STEP-TRANSACTION
at $100,000. However, if the member bank sells EXEMPTION (SECTION 223.31(d)
$15,000 of the transferred assets of the mort- AND (e))
gage company or if $15,000 of the transferred
assets amortize, the IDI may value the covered Under section 223.31(d) of the rule, an exemp-
transaction at $85,000. tion is provided for certain step transactions that
A similar situation is when an IDI acquires an are treated as asset purchases under sec-
affiliate by merger. Because a merger with an tion 223.31(a) when an affiliate owned the trans-
affiliate generally results in the IDIs acquiring ferred company for a limited period of time.
all the assets of the affiliate and assuming all the Regulation W provides an exemption when a
liabilities of the affiliate, this transaction is effec- company acquires the stock of an unaffiliated
tively equivalent to the purchase and assump- company and, immediately after consummation
tion transaction described in the previous para- of the acquisition, transfers the shares of the
graph. Accordingly, the merger transaction also acquired company to the holding companys
is treated as a purchase of assets, and the subsidiary IDI. For example, a bank holding
covered-transaction amount is equal to the company acquires 100 percent of the shares of
amount of any consideration paid by the IDI for an unaffiliated leasing company. At that time,
the affiliates assets (if any) plus the amount of the subsidiary IDI of the holding company noti-
any liabilities assumed by the IDI in the fies its appropriate federal banking agency and
transaction.78 the Board of its intent to acquire the leasing
The assets and liabilities of an operating sub- company from its holding company. On the day
sidiary of an IDI are treated in the rule as after consummation of the acquisition, the hold-
assets and liabilities of the IDI itself for pur- ing company transfers all of the shares of the
poses of section 23A.79 The rule only imposes leasing company to the IDI. No material change
asset-purchase treatment on affiliate share in the business or financial condition of the
transfers when the company whose shares are leasing company occurs between the time of the
holding companys acquisition and the IDIs
78. As noted, section 223.3(dd) of the rule makes explicit acquisition. The leasing company has liabilities.
the Boards view that these merger transactions generally The leasing company becomes an operating sub-
involve the purchase of assets by a member bank from an sidiary of the IDI at the time of the transfer. This
affiliate.
79. Because an IDI usually can merge a subsidiary into
transfer by the holding company to the IDI,
itself, transferring all the shares of an affiliate to an IDI often although deemed an asset purchase by the IDI
is functionally equivalent to a transaction in which the bank from an affiliate under paragraph (a) of sec-
directly acquires the assets and assumes the liabilities of the tion 223.31, would qualify for the exemption in
affiliate. In a direct acquisition of assets and assumption of
liabilities, the covered-transaction amount would be equal to
paragraph (d) of section 223.31.
the total amount of liabilities assumed by the IDI. The rule exempts these step transactions
under certain conditions. First, the IDI must
BHC Supervision Manual July 2014 acquire the target company immediately after
Page 32 the company became an affiliate (by being
acquired by the banks holding company, for 2020.1.14.1 Application of Sections 23A
example). The IDI must acquire the entire and 23B of Subpart G to U.S. Branches
ownership position in the target company that and Agencies of Foreign Banks
its holding company acquired. Also, there must
be no material change in the business or finan-
cial condition of the target company during the 2020.1.14.1.1 Applicability of Sections
time between when the company becomes an 23A and 23B to Foreign Banks Engaged
affiliate of the IDI and when the IDI is in receipt in Underwriting Insurance, Underwriting
of the company. Finally, the entire transaction or Dealing in Securities, Merchant
must comply with the market-terms require- Banking, or Insurance Company
ment of section 23B, and the IDI must notify its Investment in the United States.
appropriate federal banking agency and the
Board, at or before the time that the target com- By its terms, sections 23A and 23B of the FRA
pany becomes an affiliate of the IDI, of its intent do not apply to the U.S. branches, agencies, or
ultimately to acquire the target company. commercial lending offices of foreign banks.
Regulation W requires that the IDI consum- The Board, however, used the authority granted
mate the step transaction immediately to ensure to it by the Gramm-Leach-Bliley Act to impose
the quality and fairness of the transaction. To restrictions on transactions between the
the extent that the IDI acquires the target com- branches, agencies, and lending offices and any
pany some time after the company becomes an affiliate of the foreign bank that operates in the
affiliate, the transaction looks less like a single United States in order to ensure that such trans-
transaction in which the IDI acquires the target actions met certain prudential standards and pro-
company and more like two separate transac- vided competitive equality with U.S. banking
tions, the latter of which involves the IDI acquir- organizations. The Board accomplished these
ing assets from an affiliate. goals by imposing the definition of affiliates
The Board recognized, however, that bank- within sections 23A and 23B on transactions
ing organizations may need a reasonable between the branches, agencies, and lending
amount of time to address legal, tax, and busi- offices and those affiliates if the company is also
ness issues relating to an acquisition. Regula-
tion W thus permits IDIs to avail themselves of 1. directly engaged in the United States in cer-
the step-transaction exemption if the IDI tain activities. These activities are significant
acquires the target company within three because a U.S. bank cannot engage in these
months after the target company becomes an activities directly or through an operating
affiliate so long as the appropriate federal bank- subsidiary and the 23A and 23B limitations
ing agency for the IDI has approved the longer help ensure competitive equality between
time period. U.S. banks and foreign banks. These activi-
The 100 percent ownership requirement (that ties are as follows:
the IDI must acquire the entire ownership posi- Insurance underwriting pursuant to sec-
tion in the target company that its holding com- tion 4(k)(4)(B) of the Bank Holding Com-
pany acquired) prevents a holding company pany Act (12 U.S.C. 1843(k)(4)(B));
from keeping the good assets of the target com- Securities underwriting, dealing, or mar-
pany and transferring the bad assets to the hold- ket making pursuant to section 4(k)(4)(E)
ing companys subsidiary IDI. If a banking of the Bank Holding Company Act (12
organization cannot meet the terms of the step- USC 1843(k)(4)(E));
transaction exemption, the organization may be Merchant banking activities pursuant to
able to satisfy the conditions of the rules section 4(k)(4)(H) of the Bank Holding
internal-corporate-reorganization exemption or Company Act (12 USC 1843(k)(4)(H))
may be able to obtain a case-by-case exemption (but only to the extent that the proceeds of
from the Board. the transaction are used for the purpose of
funding the affiliates merchant banking
activities);
Insurance company investment activities
pursuant to section 4(k)(4)(I) of the Bank
Holding Company Act (12 USC
1843(k)(4)(I)); or

Page 33
Any other activity designated by the 1. Any covered transaction with an affiliate.
Board. 2. The sale of securities or other assets to an
2. a portfolio company (as defined in the mer- affiliate, including assets subject to an agree-
chant banking subpart of Regulation Y (12 ment to repurchase.
CFR 225.177(c)) controlled by the foreign 3. The payment of money or the furnishing of
bank or an affiliate of the foreign bank or a services to an affiliate under contract, lease,
company that would be an affiliate of the or otherwise.
branch, agency, or commercial lending com- 4. Any transaction in which an affiliate acts as
pany of the foreign bank under paragraph an agent or broker or receives a fee for its
(a)(9) of section 223.2 if such branch, services to the institution or to any other
agency, or commercial lending company person.
were a member bank; or 5. Any transaction or series of transactions with
3. a subsidiary of an affiliate as described in a nonaffiliate if an affiliate
paragraph (b)(1) or (2) of section 223.61. has a financial interest in the third party
or
Regulation W also provides that for purposes of is a participant in the transaction or series
subpart G, the capital stock and surplus of a of transactions.
U.S. branch, agency, or commercial lending
company of a foreign bank will be determined Any transaction by an IDI or its subsidiary with
by reference to the capital of the foreign bank as any person is deemed to be a transaction with an
calculated under its home-country capital stan- affiliate of the institution if any of the proceeds
dards. of the transaction are used for the benefit of, or
transferred to, the affiliate. An IDI and its sub-
sidiaries may engage in transactions covered by
section 23B of the FRA, but only on terms and
2020.1.15 SECTION 23B OF THE under certain circumstances, including credit
FEDERAL RESERVE ACT standards, that are substantially the same or at
least as favorable to the institution as those
Section 23B of the FRA became law on prevailing at the time for comparable transac-
August 10, 1987, as part of the Competitive tions with or involving nonaffiliated companies.
Equality Banking Act of 1987. This section also If comparable transactions do not exist, the
regulates transactions with affiliates. Section transaction must be on terms and under circum-
23B applies to any covered transaction with an stances, including credit standards, that in good
affiliate, but excludes banks from the term faith would be offered to or applied to nonfinan-
affiliate as that term is defined in section 23A. cial companies.
Regulation W, subpart F, sets forth the princi- Section 23B restricts the following transac-
pal restrictions of section 23B. These include tions with affiliates:
(1) a requirement that most transactions between
an IDI and its affiliates be on terms and circum- 1. An IDI or its subsidiary cannot purchase as
stances that are substantially the same as those fiduciary any securities or other assets from
prevailing at the time for comparable transac- any affiliate unless the purchase is permitted
tions with nonaffiliates; (2) a restriction on an (1) under the instrument creating the fidu-
IDIs purchase, as fiduciary, of assets from an ciary relationship, (2) by court order, or
affiliate unless certain criteria are met; (3) a (3) by law of the jurisdiction creating the
restriction on an IDIs purchase, during the exis- fiduciary relationship.
tence of an underwriting syndicate, of any secu- 2. An IDI or its subsidiary, whether acting as
rity if a principal underwriter of the security is principal or fiduciary, cannot knowingly pur-
an affiliate; and (4) a prohibition on publishing chase or acquire, during the existence of any
an advertisement or entering into an agreement underwriting or selling syndicate, any secu-
stating that an IDI will be responsible for the rity if a principal underwriter of that security
obligations of its affiliates. For the most part, is an affiliate of the institution. This limita-
subpart F restates the operative provisions of tion applies unless the purchase or acquisi-
section 23B. tion of the security has been approved before
The following transactions with affiliates are it is initially offered for sale to the public by
covered by section 23B: a majority of the directors of the institution.
The purchase should be based on a determi-
BHC Supervision Manual July 2014 nation that it is a sound investment for the
Page 34 institution, irrespective of the fact that an
affiliate is a principal underwriter of the approve the securities purchase before the secu-
securities. rities are initially offered to the public. Second,
such approval must be based on a determination
that the purchase would be a sound investment
2020.1.15.1 Transactions Exempt from for the IDI regardless of the fact that an affiliate
Section 23B of the Federal Reserve Act of the IDI is a principal underwriter of the
securities.84 Section 223.53(b) includes this
The market-terms requirement of section 23B standard and clarifies that if an IDI proposes to
applies to, among other transactions, any cov- make such a securities purchase in a fiduciary
ered transaction between an IDI and an affili- capacity, then the directors of the IDI must base
ate.80 Section 23B(d)(3) makes clear that the their approval on a determination that the pur-
term covered transaction in section 23B has chase is a sound investment for the person on
the same meaning as the term covered transac- whose behalf the IDI is acting as fiduciary.
tion in section 23A, but does not include any An IDI may satisfy this director-approval
transaction that is exempt under section 23A(d). requirement by obtaining specific prior director
For example, transactions between sister banks approval of each securities acquisition other-
and IDIs that are part of a chain banking organi- wise prohibited by section 23B(b)(1)(B). The
zation are exempt from section 23B;81 Also rule clarifies, however, that an IDI also satisfies
exempt are transactions that are fully secured by this director-approval requirement if a majority
a deposit account or U.S. government obliga- of the IDIs directors approve appropriate stan-
tions, and purchases of assets from an affiliate at dards for the IDIs acquisition of securities oth-
a readily identifiable and publicly available mar- erwise prohibited by section 23B(b)(1)(B), and
ket quotation.82 Consistent with the statute, each such acquisition meets the standards ad-
Regulation Ws section 223.52(a)(1) exempts opted by the directors. In addition, a majority
from section 23B any transaction that is exempt of the IDIs directors must periodically review
under section 23A(d).83 such acquisitions to ensure that they meet the
The rule also excludes from section 23B any standards and must periodically review the
covered transaction that is exempt from sec- standards to ensure they meet the sound
tion 23A under section 223.42(i) or (j) (that is, investment criterion of section 23B(b)(2). The
asset purchases by a newly formed IDI and appropriate period of time between reviews
transactions approved under the Bank Merger would vary depending on the scope and nature
Act). The Board excluded from section 23B this of the IDIs program, but such reviews should
additional set of transactions because, in each be conducted by the directors at least annually.
case, the appropriate federal banking agency for Before the passage of the GLB Act, Board staff
the IDI involved in the transaction should ensure informally allowed IDIs, based on the legisla-
that the terms of the transaction are not unfavor- tive history of section 23B, to meet the
able to the IDI. director-approval requirement in this fashion,
and there is no indication that Congress in the
GLB Act intended to alter the procedures that a
2020.1.15.2 Purchases of Securities for member bank could use to obtain the requisite
Which an Affiliate Is the Principal director approval. The rule codifies staffs pre-
Underwriter existing approach to the director-approval
requirement.
The GLB Act amended section 23B to permit an
IDI to purchase securities during an underwrit-
ing conducted by an affiliate if the following 2020.1.15.3 Definition of Affiliate under
two conditions are met. First, a majority of the Section 23B
directors of the IDI (with no distinction drawn
between inside and outside directors) must Section 23B states that the term affiliate
under section 23B has the meaning given to
80. 12 U.S.C. 371c-1(a)(2)(A). such terms in section 23A, except that the term
81. Although transactions between banks are exempt from
section 23B, the safety-and-soundness provisions of sec-
affiliate under section 23B does not include a
tion 23A(a)(4) apply and generally require that transactions be bank, as defined in section 23A. In the case
conducted on terms similar to those terms and standards
outlined in section 23B.
84. See 12 U.S.C. 371c-1(b)(2).
82. 12 U.S.C. 371c-1(d)(3).
83. Regulation W will again be subsequently referred to as
the rule or by its specified section-numbered discussion of BHC Supervision Manual July 2014
section 23B provisions. Page 35
of the sister-bank exemption, the rules sec- sidiary IDI and its affiliates in the holding
tion 223.2(c) clarifies that the only companies company are on terms and conditions and
that qualify for the bank exception to sec- under circumstances, including credit stan-
tion 23Bs definition of affiliate are IDIs. dards, are consistent with safe and sound
banking practices and whether the terms
and conditions of the transactions are the
2020.1.15.4 Advertising and Guarantee same as those that would be offered or
Restriction applied to nonaffiliated companies.
8. To determine whether a subsidiary IDI or
In section 23B(c), the advertising restriction its subsidiary
prohibits an IDI from publishing any advertise- a. has purchased low-quality assets or
ment or entering into any agreement stating or b. has purchased, as fiduciary, any securi-
suggesting that the IDI shall in any way be ties or other assets from an affiliate in the
responsible for the obligations of its affiliates. holding company.
Regulation W clarifies this restriction to permit 9. To determine whether a subsidiary IDI, or
such guarantees and similar transactions if the any subsidiary or affiliate of the IDI, has
transaction satisfies the quantitative and collat- published any advertisement or has entered
eral restrictions of section 23A. The rule also into any agreement that states or suggests
clarifies that section 23B(c) does not prohibit an that it will, in any way, be responsible for
IDI from making reference to such a guarantee, the obligations of affiliates.
acceptance, or letter of credit in a prospectus or 10. To determine if securities were purchased
other disclosure document, for example, if oth- or acquired by the subsidiary IDI or its
erwise required by law. subsidiaries from an underwriting or selling
syndicate affiliated with the IDI and, if so, if
the majority of outside directors of the IDI
2020.1.16 INSPECTION OBJECTIVES approved the purchase or acquisition of
securities before they were offered for sale
1. To analyze and assess the financial impact to the public.
of transactions (including loans and pur- 11. To confirm that the subsidiary IDI or its
chases of assets) between the IDIs and their subsidiary has not purchased as fiduciary
subsidiaries and all affiliates. any securities or other assets from a non-
2. To ascertain if all: bank affiliate in the holding company
a. credit transactions are properly secured; unless the purchase was permitted in
and accordance with the instrument creating
b. covered transactions are consistent with the fiduciary relationship, by court order,
the quantitative limits of section 23A. or by the law governing the fiduciary
3. To ascertain whether the IDIs are calculat- relationship.
ing credit exposure resulting from deriva- 12. To ascertain if any subsidiary IDI (or its
tives and securities borrowing and lending subsidiary) had knowingly purchased or
transactions. Also, to ascertain that any acquired any security from an affiliate in
credit exposure is secured. which the principal underwriter of that
4. To determine if an IDI has engaged in a security was a nonbank affiliate within the
transaction with a third party when the pro- holding company organization.
ceeds are used for the benefit of, or trans- 13. To determine if the subsidiary IDI and its
ferred to, an affiliate. subsidiaries have conducted transactions
5. To determine if an IDI has procedures for with their parent holding company or any
allowing intraday credit. other company affiliated in the holding
6. To determine whether covered transactions company organization that are not in
between a subsidiary IDI (and its subsidi- compliance with the restrictions in sec-
aries), its holding company, and other affili- tions 23A and 23B of the FRA or Regula-
ates are conducted consistent with the quan- tion W.
titative and collateral requirements of
sections 23A and 23B of the FRA and
Regulation W. 2020.1.17 INSPECTION PROCEDURES
7. To determine if transactions between a sub-
1. During the pre-inspection, perform the fol-
BHC Supervision Manual July 2014 lowing activities:
Page 36 a. Review examination reports of sub-
sidiary IDIs for comments on loans to the benefit of, or transferred to, the
affiliates, intercompany transactions, affiliate.
other transactions with affiliates, and 3. During the BHCs inspection, perform the
violations of the restrictions of sec- following activities:
tions 23A or 23B of the FRA, or Regula- a. Review the bank holding companys
tion W. policies and procedures regarding inter-
b. Review the most current FR Y-8 (The company transactions of subsidiary
Bank Holding Company Report of banks.
Insured Depository Institutions Section b. Determine if the substantive transactions
23A Transactions with Affiliates). of the holding company organization
2. In the officers questionnaire, request a list comply with the restrictions on transac-
of subsidiary IDIs and their subsidiaries tions with affiliates in sections 23A and
transactions with affiliates since the previ- 23B of the FRA and Regulation W.
ous inspection, including the amounts, c. Verify that covered transactions count
types, and any collateral, consisting of against Regulation Ws limits and are
a. loans or extensions of credit to an affili- collateralized when required.
ate, and purchases of extensions of credit (1) Ensure that covered transactions are
from an affiliate; properly valued and adequately
b. a purchase or sale of an investment in collateralized;
securities issued by, or sold to, the affili- (2) Review collateral documentation to
ate, or purchase or sale of other assets, ensure that a lien is adequately per-
including assets subject to an agreement fected and prioritized.
to repurchase; (3) Review all related documentation,
c. the acceptance of securities or other debt terms, conditions, and circumstances
instrument issued by the affiliate as col- for each transaction, including any
lateral security for a loan or extension of resolutions for securities purchased
credit; (or established standards for securi-
d. the issuance of a guarantee, acceptance, ties purchased from affiliates).
or letter of credit, including an endorse- (4) Determine the purpose and use of
ment or standby letter of credit on behalf the transactions proceeds.
of an affiliate; d. Review all outstanding guarantees,
e. a transaction with an affiliate that endorsements, or pledge agreements by
involves the borrowing or lending of the bank to support the affiliates
securities, to the extent that the transac- borrowings.
tion causes an IDI or a subsidiary to e. Review, on a test-sample basis, adver-
have credit exposure to the affiliate; tisements and written agreements to
f. a derivative transaction, as defined in 12 ascertain whether the bank or any sub-
U.S.C. 84(b), with an affiliate, to the sidiary or affiliate of the bank has stated
extent that the transaction causes an IDI or suggested that it shall be responsible
or a subsidiary to have credit exposure to for the obligations of any affiliates in the
the affiliate. holding company organization.
g. the payment of money or the furnishing f. If the BHC engages in derivative trans-
of services to an affiliate under contract, actions with affiliates, review the BHCs
lease, or otherwise; policies and procedures to determine if
credit limits, collateral restrictions, and
h. transactions in which an affiliate acts as
other limitations (each affiliate and all
agent or broker or receives a fee for its
affiliates combined) have been imposed
services to the bank or to any other
on interaffiliate derivative transaction
person;
(IDI) exposures to affiliates.
i. any transaction or series of transactions (1) Determine if the limits are similar to
with a third party if those imposed on nonaffiliated
(1) the affiliate has a financial interest in counterparties.
the third party or g. Review the listed transactions of the
(2) the affiliate is a participant in such BHC or its subsidiary with the affiliates
transactions; and that the IDI claims are exempt under
j. Any transaction by a subsidiary bank or
its subsidiary with any person, if the BHC Supervision Manual July 2014
proceeds of that transaction are used for Page 37
12 C.F.R. 223.42(k) provided in response h. The purchase or acquisition of securities

to the officers questionnaire (item 2). (1) was not approved by a majority of
Determine if the outside board of directors before the
(1) extensions of credit, and purchases IDIs securities were offered for sale to
of extensions of credit, are supported the public and (2) was not, in the absence
by independent credit evaluations of comparable transactions, on terms and
and if advance loan commitments under circumstances, including credit
are provided before the affiliates standards, that in good faith would have
make loans; been offered to, or would have applied
(2) no blank advance purchase commit- to, nonaffiliated companies.
ments exist to purchase loans; and i. The existence of advertisements or
(3) the purchases meet the quantitative agreements that state or suggest that the
restrictions of the exemption. IDI, its subsidiaries, or affiliate will be
4. Give additional attention to the following responsible for the obligations of its
problems involving the BHC and its affiliates.
subsidiaries: 5. Review any checking accounts and IDI
a. The subsidiary IDI would not have made statements to check for overdrafts the par-
the loan or would not have made the ent company or any of its nonbank subsidi-
loan with such favorable terms and con- aries may have with a subsidiary IDI.
ditions, or engaged in any other covered 6. Review the accounts payable to the sub-
transaction, except for the parent holding sidiary IDI and other accounts payable
companys insistence due to the affiliate accounts for servicers, contractors, lessors,
relationship. and other affiliates to determine if they
b. The IDIs condition is weakened due to arose as the equivalent of an extension of
the extension of credit or the nature of credit, purchase of securities or other assets,
the transaction with the affiliate. or as a liability to third parties. Ascertain
c. The affiliate has not provided adequate whether those transactions were listed in
qualifying collateral to support the loan response to the officers questionnaire and
or extension of credit provided by the whether the transactions were in
subsidiary IDI. accordance with the restrictions in sec-
d. The IDI does not have a perfected secu- tions 23A and 23B of the FRA and Regula-
rity interest in the collateral. tion W.
e. The loan, extension of credit, or transac- 7. Review the accounts receivable from the
tion with an affiliate is not in compliance subsidiary IDI and other accounts receiv-
with the limits and restrictions in sec- able of other affiliates for sales of securi-
tions 23A or 23B of the FRA or Regula- ties or other assets and for the payment of
tion W. money or the furnishing of services.
f. Purchases of low-quality assets by a sub- Ascertain whether those transactions were
sidiary bank or its subsidiaries from an reported in response to an officers
affiliate, unless previously exempted by questionnaire and whether they are in
the Boards Regulation W, Board order, accordance with section 23A and 23B of
or unless the IDI subsidiary or subsidiary the FRAs and Regulation Ws restrictions
affiliate, pursuant to an independent placed on transactions with affiliates.
credit evaluation, had committed itself to 8. Ascertain if the IDIs credit limits, collat-
purchase the low-quality assets before eral requirements, and monitoring of its
the time such asset was acquired by the exposures to affiliates are at least as strict as
affiliate. those it imposes on unaffiliated companies.
g. During the existence of any underwriting 9. Determine if the IDI has policies and proce-
or selling syndicate, a subsidiary IDI or dures to monitor and control its intraday
its subsidiary has purchased or acquired credit exposure to each affiliate and to all
a security from an IDI affiliate or bank affiliates in the aggregate.
holding company affiliate, including an 10. Determine if the IDIs intraday extensions
affiliated broker-dealer, and the principal of credit to affiliates are on comparable
underwriter of that security is an affiliate market terms and if they comply with sec-
of the IDI. tion 23B of the FRA.
11. Review all other transactions that the hold-
BHC Supervision Manual July 2014 ing company organization has engaged in
Page 38 with its affiliated IDIs and their subsidi-
aries, including lease arrangements, to the Examiners Comments and Matters

determine whether they are subject to the Requiring Special Board Attention page
restrictions in sections 23A and 23B and or section of the inspection report for
Regulation W, and, if so, whether they are causing the bank to be in violation or for
in compliance. engaging in unsafe and unsound prac-
12. Discuss the findings with appropriate senior tices.
management and, if the findings are signifi- b. If loans to or transactions with affiliates
cant, the board of directors. within the holding company organiza-
13. Determine managements corrective actions tion appear to adversely affect a subsidi-
regarding any comments raised by the ary bank, request managements assess-
banks primary regulator in an examination ment of such effects and its rationale for
report. the transactions. Use of the Examiners
a. If violations are disclosed in a subsidiary Comments and Matters Requiring Spe-
banks examination report or during an cial Board Attention report page or sec-
inspection of the holding company, the tion may be appropriate.
examiner may criticize management on

Page 39
2020.1.18 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS
Subject Laws 1 Regulations 2 FRRS 3 Orders
Regulation W 223
Treatment of transactions 371c(e), FRA 208.73(d) 3-383.1

with financial subsidiaries of section 23A
banks
Limitations on amount 371c, FRA 223.14(b)(i)(C)

loans secured by paper eli- section 23A(c)
gible for rediscount or pur-
chase by a Federal Reserve
Bank
Applicability to FDIC- 1828(j), FDIA 1-398

insured banks section 18(j)
Restrictions on transactions 371c-1, FRA 3-1116

with affiliates section 23B
Market terms requirement 223.33

derivative transactions with
affiliates
Intraday extensions of credit 223.42(l)

by insured depository insti-
tutions to their affiliates
Exemptions-loans and 223.16(c)(3)

extensions of credit by
member bank to a third
party
Securities issued by an 1813, Dodd-Frank

affiliate cannot be used as Act
collateral for a loan to any 371c(c)(4)
affiliate
Credit exposure resulting 371c(b)(7)(G)

from a derivative transaction
with an affiliate is a covered
transaction
1. 12 U.S.C., unless specifically stated otherwise. 3. Federal Reserve Regulatory Service reference.
2. 12 C.F.R., unless specifically stated otherwise.

Page 40
(Loan Participations) Section 2020.2
WHATS NEW IN THIS REVISED purchase of an asset from an affiliate within the
SECTION meaning of section 23A of the Federal Reserve
Act and thus is a covered transaction that is
Effective July 2010, this section was revised to subject to the quantitative limitations and the
include a cross reference to section 2010.2.7 of prohibition against purchasing of low-quality
this manual, which discusses loan participa- assets. Subsidiary banks must make indepen-
tions. References in the table of Laws, Regula- dent judgments as to the quality of such partici-
tions, Interpretations, and Orders have also pations before their purchase to avoid compro-
been updated. mising the asset quality of such banks for the
benefit of other holding company entities. All
It is common practice for a bank to sell to or loans and participations must be purchased on
place with other banks loans that the bank itself market terms.
has made to its customers. A loan participation A banks purchase of a loan or loan participa-
is a share or part of a loan which entitles the tion, on a nonrecourse basis from an affiliate,
holder to a pro rata share of the income deter- may not be a covered transaction under section
mined by the extent of the holders contribution 23A that is subject to the quantitative limita-
to the original loan and a preference ordering tions (12 C.F.R. 223.11- 223.12)), collateral
for repayment. Such loans may be sold outright requirements (12 C.F.R. 223.14), and low-
without liability to the selling bank in case of quality asset prohibition (12 C.F.R. 223.15) if
default by the borrower, or they may be sold
with terms granting the purchasing bank 1. the extension of credit was originated by the
recourse to the selling bank should the loans affiliate;
become uncollectible. Sales to or placement of 2. the member bank makes an independent
loans with other banks are for the accommoda- evaluation of the creditworthiness of the bor-
tion of either the selling or purchasing bank and rower before the affiliate makes or commits
are arranged for purposes of increasing the rate to make the extension of credit;
of return when loan rates differ between banks, 3. the member bank commits to purchase the
achieving diversification of loans by type, and extension of credit before the affiliate makes
altering liquidity positions. It is also common or commits to make the extension of credit;
practice for banks to sell or place with other 4. the member bank does not make a blanket
banks those portions of individual loans that advance commitment to purchase extensions
would be in excess of the banks legal lending of credit from the affiliate; and
limit (overlines) if the total loan were retained. 5. the dollar amount of the extension of credit,
Participations of this type should be placed when aggregated with the dollar amount of
without recourse as a matter of prudent banking all other extensions of credit purchased from
practice; otherwise, the purpose of compliance the affiliate during the preceding 12 calendar
with the legal lending limitations would be months by the member bank and its deposi-
defeated in the event of default. See section tory institution affiliates, does not represent
2010.2.7 of this manual for supervisory and more than 50 percent (or such lower percent
accounting guidance regarding a BHCs or as is imposed by the banks appropriate Fed-
banks use, purchase, or sale of loan participa- eral banking agency) of the dollar amount of
tion agreements. extensions of credit originated by the affiliate
Banks also sell or place loans or participa- during the preceding 12 calendar months.
tions with their parent holding companies or (See 12 C.F.R. 223.42(k).)
nonbank affiliates. A BHCs purchase of loan
participations from its subsidiary bank(s) gener- In some cases, a bank may renew a loan or a
ally constitutes the making of a loan or exten- participation that it purchased from another
sion of credit within the meaning of section affiliated bank even when the original participa-
225.28(b)(1) of Regulation Y, and as such, a tion has become a low-quality asset. In some
BHC needs prior approval to purchase loan par- instances, a banks renewal of a low-quality
ticipations from its subsidiary bank(s). asset, such as a troubled agricultural loan, or an
A bank may participate in or purchase a loan extension of limited amounts of additional credit
originated by its parent holding company or one to such a borrower may enable both the originat-
of its nonbank subsidiaries. A subsidiary banks
purchase, or participation of a loan, note, or BHC Supervision Manual July 2010
other asset from an affiliate is considered a Page 1
Intercompany Transactions (Loan Participations) 2020.2
ing and participating banks to avoid or mini- providing the funding needs of the affiliates,
mize potential losses. It would be inconsistent except within the parameters of sections 23A
with the purposes of section 23A to bar a partici- and 23B of the Federal Reserve Act.
pating bank from using sound banking judg- 3. To assess the impact of any concentrations of
ment to take the steps that it may deem neces- credit on the holding companys overall
sary to protect itself from harm in such a financial position.
situation, so long as the loan was not a low-
quality asset at the time of the original participa-
tion and the participating bank does not assume
more than its original proportionate share of the 2020.2.2 INSPECTION PROCEDURES
credit.
The following factors thus characterize the 1. During the preinspection process, review
situation where it would be reasonable to inter- each subsidiary banks examination report
pret section 23A as not applying to the renewal for comments on participations with affili-
of an otherwise low-quality asset: ates.
2. In the officers questionnaire to the holding
1. the original extension of credit was not a company, request the BHCs policy on loan
low-quality asset at the time the affiliated participation. Request a list of any loan par-
bank purchased its participation, ticipations the holding company or the non-
2. the renewal and/or the extension of addi- bank subsidiaries have with the subsidiary
tional credit has been approved by the board bank(s).
of directors of the participating bank as nec- 3. During the inspection, review the policy
essary to protect the banks investment by statements and each participation the holding
enhancing the ultimate collection of the company or the nonbank subsidiaries have
original indebtedness, and with the subsidiary bank(s). The following
3. the participating banks share of the renewal characteristics should be analyzed:
and/or additional loan will not exceed its a. any repetitive transaction patterns which
proportionate share of the original invest- may indicate policy;
ment by more than 5 percent. In addition, it b. the adequacy of credit information on file;
is expected that, consistent with safe and c. the extent to which the terms of the par-
sound banking practices, the originating bank ticipation including interest rates are
would make its best efforts to obtain handled in an arms-length manner;
adequate collateral for the loan(s) to further d. the degree that the bank is accommodat-
protect the banks from loss. (See 12 C.F.R. ing the funding needs of the nonbank sub-
223.15.) sidiaries or its parent;
e. the impact of these transactions on the
Loans and loan participations by the various subsidiary bank;
members of the holding company family to indi- f. eligibility for exclusion from section 23A
vidual borrowers or to the same or related inter- restrictions and, if applicable, compliance
ests may represent concentrations of credit with such restrictions.
which are large in relation to the holding compa- 4. Review participations among the bank hold-
nys consolidated capital position. These con- ing company, nonbank subsidiaries, and
centrations of credit should be assessed for the subsidiary banks to determine potentially
potentially harmful exposure to the holding adverse concentrations of credit.
companys financial condition. 5. Discuss with management
a. written and verbal policies regarding par-
ticipations both within the holding com-
2020.2.1 INSPECTION OBJECTIVES pany and with nonaffiliated third parties
and
1. To determine the BHCs loan participation b. any adverse findings on intercompany
policy. participations.
2. To assess the impact of a subsidiary banks 6. Comment on policy on the appropriate page
participation in loans with affiliates and to of the inspection report (see section 5010.6).
ensure that the banks financial condition is If any adverse comments on participations
not compromised and that the bank is not with affiliates are contained in a bank subsid-
iarys examination report, comment on their
BHC Supervision Manual July 2010 current status and the BHCs efforts to rem-
Page 2 edy the problem.
Intercompany Transactions (Loan Participations) 2020.2
Subject Laws 1 Regulations 2 Interpretations 3 Orders

Limitations and restrictions 371c, FRA
section 23A(c)
Purchase of extensions of 223.42(k) 31161
credit from affiliates

Page 3
(Sale and Transfer of Assets) Section 2020.3
Sales and transfers of assets between subsidiary the Act, a BHC may transfer from a subsidiary
banks and other entities in a bank holding com- bank an asset to be disposed of pursuant to the
pany organization pose the potential of risk to request of the banks primary regulator. For
the subsidiary banks. Asset purchases are cov- more information on the transfer of such assets
ered by Section 23A and Section 23B of the and the time parameters involved, refer to Man-
Federal Reserve Act. The limitations state that ual section 3030.0.
all covered transactions, including asset pur- The purchase of low-quality assets is prohib-
chases, by a bank with a single affiliate, may not ited by Section 23A of the Federal Reserve Act.
exceed 10 percent of a banks capital and sur- Refer to section 2020.1.1.5 for a listing of trans-
plus, and transactions with all affiliates may not actions that are exempt from the limitations of
exceed 20 percent of the banks capital and Section 23A of the Federal Reserve Act.
surplus. In addition, all transactions must be
conducted on market terms.
A banks purchase of a loan or loan participa- 2020.3.1 INSPECTION OBJECTIVES
tion from a bank holding company or its subsid-
iary may not be a covered transaction under 1. To review intercompany sale and transfer
Section 23A if: of assets to assess the impact on the subsidiary
1. the bank makes an independent credit bank.
evaluation on each loan prior to the affiliate 2. To initiate corrective action to reverse the
making the loan; transaction, if necessary.
2. the bank agrees to purchase the loan prior
to the affiliate making the loan; and
3. the banks purchase of the affiliates loans 2020.3.2 INSPECTION PROCEDURES
is not the primary source of funding for the
affiliate. 1. During the preinspection process, review
Sale and transfer of assets can also occur all notes to financial statements, the FR Y-8
through swaps and spinoffs. Examples of such report, and the examination reports of subsidi-
transactions which may have an adverse effect ary banks to ascertain whether any purchase or
on a bank include the transfer of a profitable transfer of assets has occurred between the sub-
activity or subsidiary from the bank to the hold- sidiary banks and the parent holding company
ing company, or the transfer of an unprofitable or nonbank subsidiaries.
activity or subsidiary from the holding company 2. In the officers questionnaire, request in-
to the bank. In addition, the transfer of a bank formation on any transfer or sale of assets be-
holding company subsidiary to a bank, whereby tween the subsidiary bank and the parent hold-
the bank assumes the liabilities of the affiliate ing company or the nonbank subsidiaries.
raises supervisory concerns and may violate 3. During the inspection, review all facts re-
Sections 23A and 23B of the Federal Reserve garding any sale or transfer of assets transac-
Act. tions and assess their impact on the subsidiary
Another example is the transfer of a subsidi- bank. Examiners should determine:
ary banks deferred taxes, together with an a. Whether the transaction required and
equivalent amount of cash or earning assets, to received the approval of the banks primary
the parent. In such a transaction, a subsidiary regulator; and
banks liquidity position is weakened. All such b. The quality of the assets transferred or
transfers of deferred taxes must be reversed and sold, and whether the sale of the assets was at a
the banks asset and liability accounts restored price significantly higher than would have been
to their level prior to the transfer. For a detailed realized in an arms-length transaction.
discussion on transfers of a banks deferred tax 4. Discuss findings with management
liability, see Manual section 2070.0. including:
A bank holding company may transfer a liqui- a. Apparent prejudicial transactions and
dating asset from a subsidiary bank to a section violations of regulations; and
4(c)(1)(D) liquidating subsidiary of the holding b. Any unsound practices.
company. Also, pursuant to section 4(c)(3) of

Page 1
(Compensating Balances) Section 2020.4
A compensating balance is a deposit maintained amount of a number of deposits of various sub-
by a firm at a bank to compensate the bank for sidiary banks.
loans and lines of credit granted to the firm. The interest rate on the loan to the holding
Often, a commercial bank, when extending company organization may also be helpful in
credit, requires an average deposit balance equal determining the existence of compensating bal-
to a fixed percentage of the outstanding loan ances. Loans below the lending banks normal
balance. Compensating balance requirements rate may indicate that the lending bank is receiv-
vary from informal understandings to formal ing compensation in another form.
contracts. Deposits maintained as compensating At times, excess correspondent balances are
balances may be demand or time, active or maintained to encourage participation relation-
dormant. Frequently, a lending bank will allow ships and for other goodwill reasons. Therefore,
compensating balances to be supplied by a de- the existence of excess balances may not always
positor other than the borrower itself. If com- indicate that there is a compensating balance
pensating balances are maintained by a BHCs agreement.
subsidiary bank on behalf of its parent, the Although a bank holding company may com-
practice is considered a diversion of bank in- pensate its subsidiary banks for the use of the
come (i.e., the bank loses the opportunity to funds, the compensation may not equal the op-
earn income on the balances that could be in- portunity cost associated with providing the
vested elsewhere). In general, this practice is compensating balance. As a result, subsidiary
inappropriate unless the bank is being compen- banks which maintain compensating balances
sated at an appropriate rate of interest. If the for holding company members may forego
bank is not being appropriately reimbursed, the profit opportunities, and this practice may have
practice should be criticized and action taken to a negative impact on the banks earnings and
insure that the bank is compensated for the use capital adequacy. The amount of such compen-
of its funds. sation should be equal to a fair market rate.
BHCs borrow directly from nonaffiliated If the lending bank has the right of offset to
banks, using the proceeds for both bank and compensating balances maintained by the sub-
nonbank operations and investments. Also, bank sidiary bank in case of default by parent or
holding companies seek credit lines from banks nonbank subsidiaries, the subsidiary banks
to back their borrowings in commercial paper funds are jeopardized. Such potential loss of
markets and for other liquidity purposes. Non- funds should be commented on by the examiner.
bank subsidiaries of bank holding companies
borrow from banks to fund activities such as
mortgage banking, leasing and sales finance. In
some cases, when a bank holding company or
its nonbank subsidiaries borrow, the subsidiary
1. To identify compensating balances main-
banks deposit at the lending institution may be
tained by a subsidiary bank for the parent hold-
accepted as a compensating balance for the bor-
ing company or any nonbank affiliate.
rowings of other members of the bank holding
2. To determine whether the subsidiary bank
company organization. Such transactions raise
is adequately reimbursed for the maintenance of
questions under Section 23B of the Federal Re-
any compensating balances.
serve Act regarding the banks compensation
for such services.
Often the distinction between correspondent
balances and compensating balances is not clear. 2020.4.2 INSPECTION PROCEDURES
Occasionally, the rate of the required compen-
sating balance is written into the loan agree- 1. During the preinspection process:
ment; however, informal understandings usually a. Review the subsidiary bank examina-
appear to determine the amount of compensat- tion reports or contact management to determine
ing balance maintained. At times, a balance may whether the non-affiliated banks, lending to the
be identified in the banks books as a compen- holding company organization, are correspon-
sating balance. A compensating balance may dents of the subsidiary banks. Where applicable,
also be identified as an amount above a corre- request detailed loan information which could
spondent balance historically maintained by the
bank. Compensating balances may also appear BHC Supervision Manual December 1992
as a dormant account or may be the aggregate Page 1
Intercompany Transactions (Compensating Balances) 2020.4
provide information on the compensating bal- 4. Request from management information re-
ances terms required by the lending bank. garding compensating balances maintained by
b. Review the notes to the financial state- subsidiary banks for the benefit of other affili-
ments and other available material, such as ates.
10K reports filed with the SEC, which may 5. Review the subsidiary banks historical
describe compensating balance agreements. level of correspondent balances to assess trends.
FR Y8 reports should be reviewed for ques- Compare levels of balances prior to any loan
tions applicable to compensating balances. origination or interest rate changes.
2. Review interbank loan agreements to de- 6. Review intercompany accounts to deter-
termine whether compensating balances are for- mine the amount of compensation paid to the
mally required. Assess the terms of the loan to subsidiary bank for maintaining compensating
determine whether the loan appears to be at fair balances. Assess adequacy of compensation. As-
market rates for this type of credit request. sess impact of practice on the banks financial
3. Request and review the account balance condition.
and monthly account statement provided by the 7. Discuss with management the reasons for
lending bank to identify the amount of compen- any apparent excess balances, and whether com-
sating balances. The statement should be avail- pensating balances are formally or informally
able within the holding company or bank. required.

Page 2
(Dividends) Section 2020.5
WHATS NEW IN THIS REVISED general, to bank payments of funds to service
SECTION holding company debt, even when the debt was
initially incurred to raise equity capital for the
Effective July 2012, this section was revised to subsidiary bank. It is not considered an appro-
update the references within the table of Laws, priate banking practice for the subsidiary bank
Regulations, Interpretations, and Orders. to pay management fees for the purpose of
servicing holding company debt. Funds for ser-
Dividends are a means by which a corporation vicing holding company debt should, as a
distributes earnings or assets to its shareholders. general rule, be upstreamed in the form of
Although the word dividends usually applies dividends.
to funds paid out of net profits or surplus and is
usually thought of in such a context, dividends
can also be made in kind, which means in 2020.5.1 POLICY STATEMENT ON
property or commodities. This section does not CASH DIVIDEND PAYMENTS
discuss stock dividends which represent
transfers from retained earnings to paid-in capi- On November 14, 1985 the Board approved a
tal rather than distributions of earnings. Divi- policy statement on the payment of cash divi-
dends from the subsidiaries, both bank and non- dends by state member banks and bank holding
bank, to the parent company are the means by companies that are experiencing financial diffi-
which a cash return is realized on the invest- culties. The policy statement addresses the fol-
ment in subsidiaries, thus enabling the parent to lowing practices of supervisory concern by
pay dividends to its shareholders and to meet its institutions that are experiencing earnings weak-
debt service requirements and other obligations. nesses, other serious problems, or that have
Dividends paid by any corporation are gener- inadequate capital:
ally limited by certain State laws. Banks, how-
ever, are subject to further legal restrictions on The payment of dividends not covered by
dividends by their chartering authority and other earnings,
regulators. Aside from the statutory limitations, The payment of dividends from borrowed
the primary consideration in this area is the funds,
subsidiarys level of capital and its ability to The payment of dividends from unusual or
meet future capital needs through earnings nonrecurring gains, such as the sale of prop-
retention. erty or other assets.
Although there are no specific regulations
restricting dividend payments by bank holding It is the Federal Reserves view that an orga-
companies other than State corporate laws, nization experiencing earnings weaknesses or
supervisory concern focuses on the holding other financial pressures should not maintain a
companys capital position, its ability to meet its level of cash dividends that exceeds its net
financial obligations as they come due, and its income, that is inconsistent with the organiza-
capacity to act as a source of financial strength tions capital position, or that can only be
to its subsidiaries. Some one-bank holding com- funded in ways that may weaken the organiza-
panies may be restricted in the amount of divi- tions financial health. In some instances, it may
dends they may pay as a result of certain limita- be appropriate to eliminate cash dividends alto-
tions placed on future dividend distributions at gether. The policy statement is as follows:
the time of the holding companys formation.
(see Manual section 2090.2)
When analyzing the dividend practices of the 2020.5.1.1 Policy Statement on the
subsidiaries and the parent company the follow- Payment of Cash Dividends by State
ing must be considered: the present level of Member Banks and Bank Holding
capital in relation to total assets, risk assets, and Companies
classified assets; growth rates and additional
plans for expansion; past earnings performance The Board of Governors of the Federal Reserve
and projections; and the ability to service debt. System considers adequate capital to be critical
Aside from reasonable and timely fees for to the health of individual banking organiza-
services rendered, the most appropriate way for
funds to be paid by the bank to the parent is BHC Supervision Manual July 2012
through dividends. This principle applies, in Page 1
Intercompany Transactions (Dividends) 2020.5
tions and to the safety and stability of the bank- eral Reserves supervision and regulation of
ing system. A major determinant of a banks or bank holding companies is that bank holding
bank holding companys capital adequacy is the companies should serve as a source of manage-
strength of its earnings and the extent to which rial and financial strength to their subsidiary
its earnings are retained and added to capital or banks. The Board believes, therefore, that a
paid out to shareholders in the form of cash bank holding company should not maintain a
dividends. level of cash dividends to its shareholders that
Normally, during profitable periods, divi- places undue pressure on the capital of bank
dends represent an appropriate return of a por- subsidiaries, or that can be funded only through
tion of a banking organizations net earnings to additional borrowings or other arrangements
its shareholders. However, the payment of cash that may undermine the bank holding com-
dividends that are not fully covered by earnings, panys ability to serve as a source of strength.
in effect, represents the return of a portion of an Thus, for example, if a major subsidiary bank
organizations capital at a time when circum- is unable to pay dividends to its parent
stances may indicate instead the need to companyas a consequence of statutory limi-
strengthen capital and concentrate financial tations, intervention by the primary supervisor,
resources on resolving the organizations or noncompliance with regulatory capital
problems. requirementsthe bank holding company
As a matter of prudent banking, therefore, the should give serious consideration to reducing or
Board believes that a bank or bank holding eliminating its dividends in order to conserve its
company generally should not maintain its exist- capital base and provide capital assistance to the
ing rate of cash dividends on common stock subsidiary bank. . . .
unless 1) the organizations net income avail- This statement of principles is not meant to
able to common shareholders over the past year establish new or rigid regulatory standards;
has been sufficient to fully fund the dividends rather, it reiterates what for most banks, and
and 2) the prospective rate of earnings retention businesses in general, constitutes prudent finan-
appears consistent with the organizations capi- cial practice. Boards of directors should continu-
tal needs, asset quality, and overall financial ally review dividend policies in light of their
condition. Any banking organization whose organizations financial condition and compli-
cash dividends are inconsistent with either of ance with regulatory capital requirements, and
these criteria should give serious consideration should ensure that such policies are consistent
to cutting or eliminating its dividends. Such an with the principles outlined above. Federal
action will help to conserve the organizations Reserve examiners will be guided by these prin-
capital base and assist it in weathering a period ciples in evaluating dividend policies and in
of adversity. Once earnings have begun to formulating corrective action programs for
improve, capital can be strengthened by keeping banking organizations that are experiencing
dividends at a level that allows for an increase earnings weaknesses, asset quality problems, or
in the rate of earnings retention until an that are otherwise subject to unusual financial
adequate capital position has been restored. pressures.
The Board also believes it is inappropriate for
a banking organization that is experiencing seri-
ous financial problems or that has inadequate
capital to borrow in order to pay dividends since 2020.5.2 INSPECTION OBJECTIVES
this can result in increased leverage at the very
time the organization needs to reduce its debt or 1. To assure compliance with statutes and the
increase its capital. Similarly, the payment of Boards November 1985, Policy Statement.
dividends based solely or largely upon gains 2. To determine reasonableness of dividend
resulting from unusual or nonrecurring events, payout at both the subsidiary and holding com-
such as the sale of the organizations building or pany levels.
the disposition of other assets, may not be pru- Depending on the type of charter and mem-
dent or warranted, especially if the funds bership in the Federal Reserve, all insured com-
derived from such transactions could be better mercial banks are subject to certain legal restric-
employed to strengthen the organizations finan- tions on dividends. In the case of nonbank
cial resources. subsidiaries and holding companies, there are
A fundamental principle underlying the Fed- no specific federal statutes, other than the policy
statements discussed, which apply to dividend
BHC Supervision Manual July 2012 payments. State corporate laws would apply.
Page 2 One objective of the inspection process is to
check for compliance with these laws and to ments by subsidiaries and the holding company,
follow-up on any violations. the organizations capital adequacy and future
In some cases dividends which comply with capital needs must be judged with the following
the regulations still may not be in the best in mind: the volume of total assets; asset quality
interest of the bank. It is the examiners respon- (the percentage of weighted classified assets to
sibility to assess the reasonableness of dividend gross capital could be used as an indicator of
payments in relation to each subsidiarys capital quality); asset mix and liquidity; asset growth
needs. Evaluation of the holding companys rates and projections; and plans for expansion
dividend policy and payment requires a review and development of new areas. The subsidiarys
at both the parent company and the consolidated or the holding companys ability to augment
levels. On a consolidated basis the holding com- capital through earnings is also important. If a
panys capital level in relation to the quantity bank, nonbank or holding company has a consis-
and quality of total assets, earnings history and tently strong earnings record and its capital posi-
potential, and growth rates are important in the tion is healthy, a higher dividend payout may be
assessment of a reasonable dividend payout. At acceptable than would be otherwise. In analyz-
the parent level, the method of funding divi- ing the strength of earnings both quantity and
dends should be reviewed. For example, a well quality must be considered. The actual quality
capitalized corporation with strong earnings of earnings and earnings potential are related to
might pay dividends which could be considered operating income rather than extraordinary
unreasonable if the organization were in a items, significant capital or securities gains, or
strained liquidity position. substantial increases resulting from tax consid-
erations.
3. Review the funding of dividends paid by
2020.5.3 INSPECTION PROCEDURES the holding company. Analyze the parents cash
flow and income statements in accordance with
1. Review dividend payments by subsidiaries section 4010.0 of this manual. Discuss any inap-
and the parent company. Check for compliance propriate funding with management and com-
with appropriate statutes and the Boards ment on, based on their severity, either on the
November 14, 1985 policy statement on the Cash Flow Statement (Parent), or the Analy-
Payment of Cash Dividends. Discuss violations sis of Financial Factors and the Examiners
with management and comment on the Exam- Comments and Matters Requiring Special
iners Comments and Matters Requiring Special Attention pages.
Attention page. An analysis of the parent companys cash
This step will often require a review of net flow statement supplemented by the income
earnings and changes in the capital accounts in statement will identify the source of cash for
the past years, as legal restrictions on dividends dividend payments. The parent company has
often apply to cumulative income for several cash inflow from various sources including:
years rather than just the year the dividend is dividends from subsidiaries, income from activi-
actually paid. For this reason detailed working ties conducted for its own account, interest
papers are important, as these can help to avoid income on advances to subsidiaries, manage-
duplications of effort at future inspections. In ment and service fees, borrowings, and tax sav-
some situations the regulations provide that ings resulting from filing a consolidated tax
dividends may be paid in excess of current return. Dividends should be internally funded
years earnings. If prior approval from the from dividends paid by the subsidiaries, the
banks primary regulator is necessary, verify parent companys earnings from activities for
that it has been obtained. Any violations of its own account or from interest income on
dividend statutes should be discussed with man- advances to subsidiaries. Should the analysis of
agement and cited in the Examiners Com- the cash flow statement indicate that dividends
ments and Matters Requiring Special Atten- paid by the parent exceed cash inflow from
tion page of the inspection report. these sources, further attention to the area is
2. Analyze dividend payouts of subsidiaries required to determine the actual underlying
and the parent in terms of capital adequacy, source of dividend funding. As discussed in the
earnings and earnings potential. section on management and service fees, these
Discuss excessive dividend payouts at any are properly assessed at market value or cost of
level with management and comment on the services rendered. They are not to be charged
Examiners Comments and Matters Requiring
Special Attention page of the inspection report. BHC Supervision Manual July 2012
In assessing the reasonableness of dividend pay- Page 3
simply to divert income from subsidiaries in paid by bank holding companies; however, the
order to pay dividends. Borrowing to fund divi- Systems cease and desist authority over bank
dends is fundamentally an unsound practice. holding companies does afford the ability to
When dividends paid by the holding com- curb excessive dividend payouts.
pany are funded by the bank subsidiary, it is Whenever the examiner determines that divi-
possible to control indirectly the holding com- dend payments at the subsidiary level or parent
panys dividend payout level when it is deter- level are not reasonable, are not in the best
mined to be detrimental to the bank subsidiary. interest of the organization, or are not funded in
It is important to remember that the primary a proper manner, discussion with management
responsibility of bank regulators is the promo- and a close look at its philosophy are essential.
tion of safe and sound banking operations. Other Remarks on the matter should appear on the
than the mentioned policy statement there are Examiners Comments and Matters Requiring
no specific federal laws restricting dividends Special Attention page of the report.
Dividend limits for national 5199(b)

banks
Dividend limits 5204
Dividend limits for State Section
member banks 9, F.R.
Act
Capital limitations and 208.5 3160
earnings limitations
on the payment of
dividends by state
member banks
Board policy statement on 225 appendix C 4868 1980 FRB 320
assessment of financial
factors, one bank holding
companies (para. 4
dividend restrictions)
Board policy statement on 4877 1986 FRB 26
dividends for banking
organizations having
financial difficulties

Page 4
(Management and Service Fees) Section 2020.6
A bank holding company is permitted to own of the FDIC Improvement Act of 1991 or sec-
nonbank subsidiaries that furnish services to or tion 38 of the FDIC Act).
perform services for its other subsidiaries pursu- Any fee for services to a banking subsidiary
ant to section 4(a)(2)(A), 4(c)(1)(C), or 4(c)(8) should be supported by evidence that the parent
of the BHC Act. Many bank holding companies or other affiliate provided the service. Services
charge fees for providing to their subsidiaries provided by bank holding companies should
services such as management advice, personnel serve the needs of the subsidiary bank; charges
services, data processing, marketing, supply for services that appear to duplicate existing
administration, investment advice, bookkeep- subsidiary-bank functions should be supported
ing, and trust services. The fees for these ser- by a detailed explanation of the net benefit
vices that are assessed against subsidiary banks derived by the subsidiary bank and by an analy-
take many forms and are an area of potential sis of the reasonableness of the fee.
abuse. In addition to direct fees paid to an When it is impractical to allocate expenses on
affiliate, the compensation for providing these a direct-charge basis, bank holding companies
services might take the form of salaries or direc- frequently allocate overhead expenses to subsid-
tors fees paid to the bank holding companys iaries. Although this practice can be considered
management. A holding company should not, acceptable with regard to nonbanking subsidi-
directly or indirectly through other subsidiaries, aries, allocating all bank holding company
burden its bank subsidiaries with excessive expenses to bank subsidiaries is not permitted.
fees or charge for services unrelated to value The parent company should bear a portion of
received in order to fund its debt service, divi- the costs connected with, for example, the hold-
dend payments, or support of other subsidiaries. ing companys investor/shareholder relations,
regulatory reporting requirements, acquisitions,
Examiners should review the fees charged by formations, applications, board of directors, and
a holding companys bank and nonbank subsid- strategic planning. Bank holding companies are,
iaries to any banking subsidiary and judge the however, expected to support their subsidiary
reasonableness of those fees by examining the banks, and expenses incurred to serve the needs
reasonableness of the services provided and the of the subsidiary banks, such as expenses
basis for allocating fees. Fees charged nonbank incurred in raising capital for subsidiary banks,
subsidiaries and independent third parties should can appropriately be allocated to those subsidi-
not be more favorable than fees charged bank- ary banks that benefit from the services pro-
ing subsidiaries. They should be reasonable and vided, in proportion to the benefit received from
justifiable and be based on the fair market value the service.
of services provided or, when there is no market All fees for services rendered should be sup-
established for a particular service, on actual ported by written agreements that describe the
cost plus a reasonable profit. The market value service, the fees to be charged, and the method
of similar services is the preferred basis of fee of allocating the fees among the subsidiaries.
assessment. When fees are based on cost plus a The absence of such contracts between the sub-
reasonable profit, there is less incentive for the sidiaries of the holding company is considered
efficient and effective use of resources, because inappropriate and an unsafe and unsound bank-
a profit margin is built in regardless of the costs ing practice. Supervisory action should be taken,
involved. In many situations, however, the cost in a manner consistent with the financial condi-
method is the only method possible. tion of the holding company and the subsidiary
bank, to eliminate the improper practices. The
Any method of pricing services provided to practices should be criticized in the inspection
bank subsidiaries that is based on anything other report and actions taken to see that the situation
than value received is inappropriate. The fee is satisfactorily resolved. If the practices are
mechanism should not be used to divert income having a serious impact on the bank, or if they
from any bank subsidiary to meet the parents might reasonably be expected to have a severe
financial needs if those needs are unrelated to impact given the banks financial condition, for-
the provision of services to that subsidiary. In mal administrative action should be considered
addition, banks are prohibited from paying man- in order to require the holding company to ter-
agement fees* if it would cause the institution to minate the practices and make restitution to the
become undercapitalized (see title I, section 131 subsidiary bank.
* Management fees does not include fees for such ser- BHC Supervision Manual December 1993
vices as electronic data processing or auditing. Page 1
Intercompany Transactions (Management and Service Fees) 2020.6
A banks prepayment of service fees to the receives a fee for its services. Although transac-
parent company and payment of expenses in- tions between sister banks and banks that are
curred primarily in conjunction with holding part of a chain banking organization are exempt
company activities unconnected with the bank from section 23B, section 23A requires that
also are cause for supervisory concern. In gen- covered transactions between a bank and an
eral, prepayment for services is inappropriate affiliate be conducted at arms length. See sec-
unless the bank holding company can demon- tion 2020.1.2 for other transactions that are cov-
strate that prepayment is standard industry prac- ered by section 23B and the requirements that
tice for nonbanking companies acquiring the pertain to all such transactions. For examples of
same service. Prepayment of sums for services transactions that could violate section 23B, see
that are not to be provided in the immediate section 3700.10, dealing with an application to
future (for example, prepayment of an entire provide armored car services through a bank
years fees for services to be rendered through- holding companys nonbank subsidiary.
out the year) can have an adverse impact on the
bank and is therefore inappropriate. These prac-
tices should be addressed by requiring timely 2020.6.2 INSPECTION OBJECTIVES
and reasonable payments for services and reim-
bursement to the banks for what are essentially 1. To determine whether the holding com-
holding company expenses. If bank expenses pany and its subsidiaries charge fees to bank
are incurred substantially in support of a hold- subsidiaries based on value received and fair
ing company activity, the bank should be reim- market value.
bursed for that portion of its cash outlay that 2. To determine whether the subsidiaries are
benefits the holding company. Reimbursement actually receiving these services.
is necessary to ensure that bank resources are 3. To determine that the timing of fee pay-
not diverted to a holding company affiliate with ments is appropriate.
little or no benefit to the bank. 4. To determine whether there is an agree-
Aside from reasonable and timely fees for ment between the entities relating to specific
services rendered, the most appropriate way, services and fees charged.
from a supervisory standpoint, for funds to be 5. To determine if any fees result in an
paid to the parent company is through divi- unsafe or unsound condition in any subsidiary
dends. This principle applies, in general, to bank bank.
payment of funds to service holding company Once the management policy underlying the
debt, even when the debt was initially incurred fee structure is clearly understood, it is impor-
to raise equity capital for the subsidiary bank. It tant for the examiner to determine that practice
is an inappropriate banking practice for the sub- is consistent with policy. For example, if man-
sidiary bank to pay management fees for the agement indicates that fees charged are based
purpose of servicing holding company debt. on the fair market value of services received but
Funds for servicing holding company debt the fee structure is actually geared to the bank
should, as a general rule, be upstreamed in the subsidiarys asset size, an inconsistency exists.
form of dividends. Assuming either that all of the bank subsidiaries
have access to the same or similar markets for
the services being provided by the bank holding
2020.6.1 TRANSACTIONS SUBJECT company or that cost is used consistently to
TO FEDERAL RESERVE ACT determine pricing, the established pricing struc-
SECTION 23B ture should be used for all subsidiaries. Devia-
tions from established policy intended to
Section 23B of the FRA applies to any covered channel a greater proportion of income from
transaction with an affiliate, as that term is financially sound banks to financially weak ones
defined in section 23A of the FRA. Section 23B should be noted.
also applies to a number of transactions that are When it has been established that the fee
not covered by section 23A, for example, trans- structure is reasonable and is consistently fol-
actions that involve the payment of money or lowed, a final question remains. Are the bank
the furnishing of services to an affiliate under subsidiaries actually receiving the services for
contract, lease, or otherwise, or transactions in which they are charged? This may be difficult to
which an affiliate acts as an agent or a broker or ascertain in many cases, but serious efforts must
be made.
BHC Supervision Manual December 1993 It is important that the basic business princi-
Page 2 ples of an arms-length transaction be applied to
all transactions between banks and their affili- actually based on the valuation of the services
ates. This approach provides protection for all received and consistent with stated policy. Any
the interests involved. In addition, payment variations from the basic structure among the
should be made within a reasonable time of the bank subsidiaries would also require support
rendering of the services. It is inequitable for the from the market or cost data furnished.
bank subsidiary to pay fees far in advance in Once the holding companys policy, valua-
order to suit the parents cash needs. A clearly tion data, and pricing structure are analyzed,
understood agreement between the holding they should be verified. Check the service at the
company and its bank subsidiaries detailing the bank-subsidiary level. The verification process
duties and responsibilities of each party and the can be modified as deemed appropriate by the
method to be used for fee assessment is also examiner.
important to the servicing arrangement. Note the timing of payment for services. Fees
for services should be billed and paid as they are
received, just as they would be with an unaffili-
2020.6.3 INSPECTION PROCEDURES ated servicer. Prepayments are inappropriate in
most cases.
1. Review and analyze the policy regarding Written service agreements should be in
management and other services provided to effect specifically detailing the types and extent
bank subsidiaries and the method of assessing of services being rendered and the method of
fees. pricing. Any significant exceptions found dur-
2. Determine the basis for valuation. ing the verification process merit follow-up and
3. Review the actual pricing structure as it is comments in the report.
applied. Thus far, these inspection procedures for
4. Verify the following: management and service fees have emphasized
a. Fees are charged in accordance with a review of managements stated intent and the
pricing structure. actual fees charged on the individual bank-
b. Pricing structure is consistently applied subsidiary level and have been somewhat ori-
for all bank subsidiaries. ented toward micro-level analysis. An overall
c. Bank subsidiaries are actually receiving view of the parent companys cash flow and
services for which they are assessed. Determine income statements can also provide certain indi-
whether fee payments have caused the institu- cators of appropriateness of fees. The parent
tion to become undercapitalized. company should be servicing its debt and pay-
d. Payments are made in a timely manner. ing dividends from sources other than manage-
5. Review examination reports on bank sub- ment fees and service fees collected from bank
sidiaries for comments on fee assessment. subsidiaries. If the ratio of management and
6. Analyze the parent companys cash flow service fees to parent-company salaries and
and income statements for intercompany fees. other expenses significantly exceeds 100 per-
7. Review recordkeeping. cent, the holding company could be charging
A review of managements written or stated fees that are unrelated to the value of the ser-
policy regarding services provided subsidiaries vice. This situation would call for further
and fee assessment is a logical starting point for investigation.
the analysis of this area. The policy should be
discussed with the holding companys officers
to ensure that the examiner has a clear under-
standing of the purpose and basic underlying
philosophy. Any policy that calls for fee assess-
ment based on standards other than fair market
value or the cost of providing the services
requires discussion with management and com-
ment on page 1 of the report.
The determination of fair market value or
cost of providing services is the responsibility
of the holding company. The examiner should
review the market or cost information used to
justify the pricing of services and be satisfied
that the data presented actually supports the fee
structure. Request a copy of the pricing sched- BHC Supervision Manual December 1993
ule as it is applied, and determine that it is Page 3
Statement of practice and 4876

procedure in reference to
unsound banking
practices; diversion-of-bank-
income practices (SR-79-533,
March 19, 1979)
Potential violations of 1993 FRB 352

section 23B of the
Federal Reserve Act:
1. Proposal by a bank holding

company to provide armored
car services to its banking
subsidiary through a de novo
nonbank subsidiary. The cost
of the service would be more
than the cost of armored car
services currently received
from an unaffiliated provider.
2. Proposal whereby the bank

holding companys de novo
nonbanking subsidiary would
pay a flat fee based on a
percentage of its direct
operating expenses to cover
all the back-office services
provided by the holding
companys banking subsidiary.

Page 4
Intercompany Transactions (Transfer of
Low-Quality Loans or Other Assets) Section 2020.7
The transfer of low-quality loans or other assets should make certain that the assets have been
from one depository institution to another can properly recorded on the books of the acquiring
be reason for supervisory concern. Such trans- institution at fair market value. If the transfer
fers may be made to avoid detection and classi- was with the parent holding company or a non-
fication during regulatory examinations, and bank affiliate, determine that the transaction is
may be accomplished through participations, also properly recorded on the books of the affil-
purchases/sales, and asset swaps with other affiliate. Refer to SR Letter 8324 (FIS).
iated or nonaffiliated financial institutions. Sec-
tion 23A of the Federal Reserve Act prohibits
bank purchases of low-quality assets from an 2020.7.1 INSPECTION OBJECTIVES
affiliate. Examiners should be alert to situations
where an institutions intention appears to be 1. To ensure that loan transfers involving
the concealment of low quality assets for the state member banks, bank holding companies,
purpose of avoiding examination scrutiny and and nonbank affiliates are carefully evaluated to
possible classification. determine if they were carried out to avoid
During bank holding company inspections, classification, and to determine the effect of the
examiners are requested to identify situations transfer on the condition of the institution and to
where low-quality assets have been transferred ascertain whether the transfer was consistent
between the institution being examined and an- with the requirements of Section 23A. Under
other depository institution. Low-quality loans section 23A of the Federal Reserve Act, an asset
broadly defined include loans which are classi- purchase is a covered transaction. All cov-
fied or specially mentioned, or if subjected to ered transactions by a bank with a single affil-
review would most likely be classified or spe- iate and with all affiliates combined may not
cially mentioned, past due loans, nonaccrual exceed 10 percent and 20 percent, respectively,
loans, loans on which the terms have been rene- of a banks capital and surplus.
gotiated because of a borrowers poor financial 2. To ensure that the primary regulator of the
condition, and any other loans which the exam- other financial institution involved in the trans-
iner feels are of questionable quality. Other as- fer is notified.
sets of questionable quality would include de-
preciated or sub-investment grade securities and
other real estate. The transfer of assets to avoid 2020.7.2 INSPECTION PROCEDURES
supervisory review is a highly improper and
unsound banking practice and may be a viola- 1. Investigate any situations where assets
tion of section 23A of the Federal Reserve Act were transferred prior to the date of examination
that should be addressed through formal super- to determine if any were transferred to avoid
visory enforcement action, if necessary. possible criticism during the examination.
Any situations involving the transfer of low- 2. Determine whether any of the loans trans-
quality or questionable assets should be brought ferred were nonperforming at the time of trans-
to the attention of Reserve Bank supervisory fer, classified at the previous examination, or for
personnel who, in turn, should notify the local any other reason were considered to be of ques-
office of the primary Federal regulator(s) of the tionable quality.
other depository institution(s) involved in the 3. Review the policies and procedures to de-
transaction. For example, Reserve Banks should termine whether or not assets or participations
notify the primary Federal regulator of any de- purchased are given an independent, complete
pository institution to whom a State member and adequate credit evaluation. If a bank is a
bank or holding company is transferring or has holding company subsidiary or a member of a
transferred low quality loans. Reserve Banks chain banking organization, review asset pur-
should also notify the primary regulator of any chases or participations from affiliates or other
depository institution from which a State mem- known members of the chain to determine if the
ber bank or holding company is acquiring or has asset purchases are given an arms-length and
acquired low-quality loans. This procedure ap- independent credit evaluation by the purchasing
plies to transfers involving savings and loan bank.
associations and savings banks, as well as com- 4. Determine whether or not any purchases
mercial banking organizations.
If it is determined that a transfer of assets was BHC Supervision Manual December 1992
undertaken for legitimate reasons, the examiner Page 1
Intercompany Transactions (Transfer of Low-Quality Loans or Other Assets) 2020.7
of assets from an affiliate are in conformance 7. If poor quality assets were transferred to
with section 23A which generally prohibits pur- or from another financial institution for which
chases of low-quality assets from an affiliate the Federal Reserve is not the primary regulator,
and limits asset purchases and all other cov- prepare a memorandum to be submitted to the
ered transactions by a bank from a single affil- Reserve Bank supervisory personnel. The Re-
iate and all affiliates combined to 10 percent and serve Bank will then inform the local office of
20 percent, respectively, of a banks capital and the primary Federal regulator of the other insti-
surplus. tution involved in the transfer. The memoran-
5. Determine that any assets purchased are dum should include the following information,
properly reflected at fair market value (while as applicable:
fair market value may be difficult to determine,
it should at a minimum reflect both the rate of Name of originating and receiving institu-
return being earned on such assets and an appro- tions.
priate risk premium). Determine that appropri- Type of assets involved and type of transfer
ate write-offs are taken on any assets sold at less (i.e., participation, purchase/sale, swap).
than book value. Date(s) of transfer.
6. Determine that transactions involving Total number and dollar amount of assets
transfers of low- quality assets to the parent transferred.
holding company or a nonbank affiliate are Status of the assets when transferred (e.g.,
properly reflected at fair market value on the nonperforming, classified, etc.)
books of both the bank and the holding com- Any other information that would be help-
pany affiliate. ful to the other regulator.

Page 2
(Split-Dollar Life Insurance) Section 2020.9
Split-dollar life insurance is a type of life insur- A variation of the endorsement plan is an
ance in which the purchaser of the policy pays arrangement in which the bank pays an annual
at least part of the insurance premiums and is premium towards the policy and the parent hold-
entitled to only a portion of the cash surrender ing company reimburses the bank for a nominal
value, or death benefit, or both. See SR-93-37 amount of the annual premium payments. These
and its attachments for further discussion of the amounts are substantially lower than the pre-
Federal Reserves position on such arrange- mium payments made by the subsidiary bank
ments between bank holding companies and and therefore do not accurately reflect the eco-
their subsidiary banks. nomic benefit derived by the holding company
as primary beneficiary of the insurance policy.
2020.9.1 SPLIT-DOLLAR LIFE

INSURANCE POLICY 2020.9.1.2 Split-Dollar Life Insurance
ARRANGEMENTS Collateral Assignment Plan
Certain split-dollar life insurance policy Under a collateral assignment plan, the parent
arrangements involving banks and their parent bank holding company owns the policy and
bank holding companies raise legal and safety- pays the entire premium. The subsidiary bank
and-soundness concerns. These arrangements makes annual loans to the bank holding com-
fall into two general categories: (1) those in pany in an amount equal to the annual increase
which the subsidiary bank owns the policy, pays in the cash surrender value of the policy (or, in
all or substantially all of the premiums and is some cases, in amounts equal to premiums paid)
reimbursed for the premium payments (if at all) with the policy itself serving as collateral for the
at some time in the future (endorsement plans) loan. The loans are repayable at either the termi-
and (2) those in which the parent holding com- nation of employment or the death of the insured
pany owns the policy, and pays the premium, employee, and will be paid using the death
but uses the insurance policy as collateral for benefits available from the policy.
loans from its subsidiary bank (collateral assign-
ment plans).
2020.9.2 COMPLIANCE WITH
APPLICABLE LAWS
2020.9.1.1 Split-Dollar Life Insurance
Endorsement Plan 2020.9.2.1 Compliance with Sections
23A and 23B of the FRA
Under an endorsement plan, the subsidiary bank
purchases a policy in which its parent bank Both of the aforementioned types of split-dollar
holding company or an officer, director, or prin- life insurance policy arrangements may be inap-
cipal shareholder thereof is the primary benefi- propriate if they are inconsistent with sections
ciary, rather than the bank or one of its officers 23A or 23B of the Federal Reserve Act (FRA).
or directors. In this instance, the subsidiary bank Section 23A places quantitative restrictions and
receives only a limited portion of the death other requirements on certain transactions,
benefitusually an amount equal to its pre- including loans, between banks and their affili-
mium payments plus interest. The primary ben- ates. The statute also requires that loans between
eficiarythe holding company or one of its banks and their affiliates be secured with col-
officers, directors, or principal shareholders lateral having a specified market value that
receives a majority of the insurance proceeds depends on the type of collateral used to secure
but pays little or nothing for the benefit. Many the loan. Under an endorsement plan, where the
of the policies in this category are single- subsidiary bank pays all or substantially all of
premium universal life policies, whereby the the insurance premiums, an unsecured extension
subsidiary bank pays one large lump sum pre- of credit from the subsidiary bank to its parent
mium payment for the policy. Generally, a sub- holding company generally results because the
sidiary bank involved in an endorsement plan subsidiary bank has paid the bank holding com-
records the cash surrender value of the policy as panys portion of the premium, and the bank
an asset on its books; the bank holding company
does not record anything at the parent-only BHC Supervision Manual December 1993
level. Page 1
Intercompany Transactions (Split-Dollar Life Insurance) 2020.9
will not be reimbursed fully for its payment bank receives from the holding company is
until sometime in the future. based on an implied value of the insurance
Under a collateral assignment plan, if the coverage received by the holding company that
insurance policy held by the parent bank hold- is less than the assessments made to the policy
ing company serves as collateral to secure a equity.
loan from its subsidiary bank, the loan may be a In the process of evaluating split-dollar insur-
violation of section 23A unless it meets the ance arrangements, examiners should keep in
quantitative requirements of section 23A and mind the fact that the advances made by a bank
the cash surrender value of the insurance policy to purchase the insurance are the equivalent of a
used as security is equal to 130 percent of the loan to the holding company. Therefore, to com-
amount of the loan. Thus, a bank loan to the ply with section 23B, the terms of the loan, such
parent bank holding company that equals the as its duration and interest rate, must be on
cash surrender value of the insurance policy that market terms.
is serving as collateral would not be adequately
secured under section 23A, unless additional
collateral was provided. 2020.9.2.2 Investment Authority Under
Both categories of split-dollar life insurance the National Bank Act
policy arrangements may also lead to violations
of section 23B of the Federal Reserve Act, Participation by bank holding companies and
which requires that certain transactions involv- their state-chartered and national bank subsidi-
ing a bank and its affiliates be on terms and aries in split-dollar life insurance policy arrange-
under circumstances substantially the same or at ments may also raise concerns whether the poli-
least as favorable to the bank as those prevailing cies are permissible bank investments under
at the time for comparable transactions with or section 24(7) of the National Bank Act. The
involving nonaffiliated companies. Because the Office of the Comptroller of the Currencys
bank holding company is the beneficiary of the interpretation of this provision of the National
life insurance policy, it is a participant in a Bank Act (OCC Banking Circular 249, May 9,
transaction between a bank and a third party; 1991).2 In addition, under section 24 to the
therefore, the split-dollar life insurance transac- Federal Deposit Insurance Act, a state-chartered
tion must meet the standards of section 23B.1 bank generally may not, without the FDICs
In order to conform to the statutory restrictions permission, engage in any activity that is imper-
of section 23B, the return to the bank from missible for a national bank.3
ownership of the policy should be commensu-
rate with the size and nature of its financial
commitment. In most split-dollar insurance 2020.9.3 SAFETY-AND-SOUNDNESS
arrangements, the bank makes an investment in CONCERNS
the policy not for the purpose of insuring itself
against risk but for the purpose of obtaining The purchase of a split-dollar life insurance
insurance for its holding company. The only policy may also constitute an unsafe and
return that the bank will get from its participa- unsound banking practice involving the diver-
tion in ownership of the policy is the return of sion of bank income or assets. If a subsidiary
its initial investment and possibly some interest. bank pays the entire insurance premium but is
However, the insurance company deducts the not the beneficiary, it provides an economic
cost of maintaining the insurance coverage from benefit to its parent holding company or other
interest that would otherwise be credited to the beneficiary for which it is not being adequately
equity in the policy. These costs include policy reimbursed or compensated. In this instance, the
loads, surrender charges, and mortality costs. bank loses the opportunity to use its assets pro-
The holding company should fully reimburse ductively. Generally, the bank pays the premium
the bank for all of these charges. Examiners in return for the insurance companys payment
should carefully evaluate these arrangements of the entire proceeds. When the bank receives
because, in many cases, the reimbursement the less than the entire proceeds, it has, in effect,
2. National banks may not purchase life insurance as an

1. The Federal Deposit Insurance Corporation has taken
investment. See OCC Banking Circular 249, for the tests
the same position in a published interpretive letter, FDIC
under which life insurance may be purchased and held for
92-40, dated June 18, 1992.
noninvestment purposes.
3. SR-92-97 (FIS) and SR-92-98 (FIS), dated December 16
BHC Supervision Manual December 1993 and 21, 1992, respectively, describe the provisions of section
Page 2 24 of the Federal Deposit Insurance Act.
paid a higher than market price for whatever 2. To ascertain whether participation by bank
limited benefit it may receive. This is also the holding companies and their national bank or
case when the primary beneficiary of the policy state-chartered bank subsidiaries is consistent
is an officer, director, or principal shareholder of with section 24(7) of the National Bank Act and
the parent holding company. Such an arrange- section 24 of the Federal Deposit Insurance Act.
ment is not consistent with safe and sound bank- 3. To verify the cash surrender values of
ing practices because the subsidiary bank is split-dollar life insurance policies and to
conferring an economic benefit on an insider of establish whether those values have been
the parent bank holding company without impaired by loans to, liens by, or assignments
receiving adequate compensation. to, third parties or by unauthorized borrowings
or cancellations.
2020.9.4 EXAMINER REVIEW OF

SPLIT-DOLLAR LIFE INSURANCE 2020.9.6 INSPECTION PROCEDURES
Examiners should be fully aware of the prob- 1. Review corporate life insurance policy
lems inherent in split-dollar life insurance pol- arrangements between the parent company and
icy arrangements between bank holding compa- its subsidiary banks.
nies and their subsidiary banks. During the a. Determine if there are split-dollar life
course of all bank examinations and bank hold- insurance arrangements between any subsidiary
ing company inspections, examiners should bank and the parent company or officers or
review corporate life insurance policy arrange- directors of the parent company.
ments for compliance with applicable banking b. If any such insurance arrangement
laws and safety-and-soundness standards.4 If a exists, establish if the plan is either an endorse-
split-dollar life insurance policy arrangement ment plan or a collateral assignment plan.
exists in either a bank holding company or a c. Review arrangements involving a split-
state member bank, it should be reviewed and dollar life insurance policy purchased by the
modified if it does not comply fully with the law parent company.
and principles of safe and sound banking. If a (1) Review external documentation evi-
bank holding company or a state member bank dencing the cash surrender value. If no docu-
fails to take appropriate action to bring its split- mentation exists, ask the audit committee and its
dollar life insurance policy arrangements into internal auditors
compliance, then the Reserve Bank should con- (a) to obtain external documentation
sider appropriate follow-up supervisory action verifying its value and
(including a formal enforcement action) against (b) to verify that there are no out-
the banking organization or its institution- standing loans, liens, or assignments against the
affiliated parties, or both. insurance policies.
(2) Establish whether the parent compa-
nys board of directors has established policies
2020.9.5 INSPECTION OBJECTIVES and implemented procedures for transactions
between the insurance carrier and the parent
1. To determine if split-dollar life insurance company to prevent unauthorized borrowing or
arrangements between the parent holding com- cancellation of any insurance policy that has a
pany and its subsidiary banks are consistent cash surrender value.
with the provisions of sections 23A and 23B of (3) Determine whether the corporate life
the FRA. insurance policy arrangements are consistent
with applicable safety-and-soundness standards.
4. Examiners conducting examinations of U.S. branches (4) Verify that the recorded value of the
and agencies of foreign banks and Edge corporations should respective asset is equal to the unimpaired cash
also be alerted to the problems associated with split-dollar life surrender value of the asset.
insurance arrangements because these institutions could pur-
chase insurance for the benefit of a parent foreign bank or
2. If an endorsement plan arrangement is pur-
company, or one of the parents officers or directors. In chased by a subsidiary bank, establish whether
addition, section 7(h) of the International Banking Act of the bank holding company is the beneficiary. If
1978 prohibits state-licensed branches or agencies from the parent company is the beneficiary, such an
engaging in any activity that is impermissible for a federal
branch unless the Board determines that such activity is
arrangement may result in an unsecured exten-
consistent with sound banking practice and, in the case of
an FDIC-insured branch, the FDIC determines that the activ- BHC Supervision Manual December 1993
ity poses no significant risk to the deposit insurance fund. Page 3
sion of credit when the subsidiary bank pays all ownership of the policy is commensurate with
or substantially all of the insurance premiums the size and nature of the financial commitment,
but is not reimbursed until some time in the including all costs incurred for maintaining the
future. Ascertain if the investment return to the insurance coverage.
bank from ownership of the policy is commen- b. Determine if the terms (duration and
surate with the size and nature of its financial market interest rate) of the advances made to
commitment. purchase the insurance are on market terms.
3. If a collateral assignment plan (when the c. If the bank holding company is the
insurance policy held by the parent company beneficiary of a bank insurance policy and a
serves as collateral to secure a loan from a bank is a participant in the purchase of the
subsidiary bank), ascertain whether the cash sur- insurance from a third party, determine if the
render value of the insurance policy is equal to transaction was on terms and under circum-
130 percent of the amount of the loan. stances that were substantially the same as or at
4. For both types of split-dollar life least as favorable to the bank as those then
insurance: prevailing for comparable transactions with or
a. Determine if the investment return from involving nonaffiliated companies.
Split-dollar life
insurance:
1. Endorsement plan: 371c, FRA
When a subsidiary section 23A
bank has paid all
the BHCs portion
of the premium and
the bank will not be
reimbursed until
some time in the
future, a loan results
that must be secured.
2. Collateral assignment 371c, FRA

plan securing a loan: section 23A
Cash surrender value
must be 130 percent
of the loan.
3. Both plans:
a. Transactions must 371c, FRA
be on terms and section 23B
under circumstances
substantially the
same as those
prevailing for third-
party transactions.

Page 4
b. When the BHC is 371c-1, FRA

the beneficiary, the section 23B
banks investment
return from the split-
dollar life insurance
policy should be
commensurate with
the size and nature
of the financial
commitment.
Split-dollar life Regulation O

insurance premiums staff opinion
paid by a bank on behalf 3-1081.3
of an executive officer of
the bank are not deemed
an extension of credit for
purposes of Regulation O,
if the officer reported the
premiums as taxable
compensation to the IRS.

Page 5
Grandfather RightsRetention and Expansion of Activities
Section 2030.0
The history of bank holding company legisla- 3. The bank holding company was lawfully
tion reflects a principle that banking and com- engaged in such activities as of June 30, 1968
merce should be separated in order to prevent and has been engaged in such activities continu-
abuses in the distribution of credit. The 1956 ously thereafter.
Act generally required companies to divest their A company covered in 1970 is defined in
nonbank activities and shares within two years. section 2(b) of the Act as a company which
In the 1970 Amendments, the same requirement becomes a bank holding company as a result of
applied to companies formed in the future. How- the enactment of the Bank Holding Company
ever, one-bank holding companies in existence Act Amendments of 1970 and which would
at the time of these amendments were given a have been a bank holding company on June 30,
grace period to comply with divestiture 1968, if those amendments had been enacted on
requirements of the legislation. Those compa- that date. The Board has also determined that
nies whose bank and nonbank interests had been the company must have owned at least 25 per-
combined on or before June 30, 1968, were cent of the voting shares of the same subsidiary
permitted to continue the existing combination bank on June 30, 1968, and December 31, 1970,
for an indefinite period (indefinite or permanent in order to qualify as a company covered in
grandfather privileges). But those BHCs which 1970. If a company was not actively engaged in
existed at the time of the 1970 Amendments, but a nonbank activity prior to June 30, 1968, either
whose bank was acquired or whose nonbank
directly, or indirectly through a subsidiary, it
activity was initiated after June 30, 1968, were
may still qualify for indefinite grandfather privi-
permitted to continue their nonbank activities
leges if the company had entered into a binding
for only 10 years until December 31, 1980. An
contract prior to June 30, 1968. The binding
exception to the divestiture deadline existed
with respect to certain real estate holdings. contract must be a written document which
Although indefinitely grandfathered compa- specifies that the company (or its subsidiary) or
nies may continue to engage in nonbanking persons representing the company will purchase
activities, these grandfather privileges are sub- another company which is already engaged in
ject to review by the Federal Reserve Board at the activity.
the time when a companys banking assets Within two years after the subsidiary bank of
exceed $60 million.1 an indefinitely grandfathered company attains
banking assets in excess of $60 million, the
status of the companys grandfather privileges is
subject to review to determine whether the
2030.0.1 INDEFINITE GRANDFATHER rights should remain in effect or be terminated.
PRIVILEGES The Board or Reserve Bank may also review
any companys grandfather privileges and termi-
Under the provisions of section 4(a)(2) of the nate them if it determines that such action is
Act, as amended in 1970, relating to grandfather necessary to prevent (1) undue concentration of
privileges for certain nonbanking activities of resources, (2) decreased or unfair competition,
bank holding companies, the Reserve Banks (3) conflicts of interests, or (4) unsound banking
have been delegated the authority to determine practices. Moreover, when a company applies
that termination of grandfathered activities of a for approval of an acquisition, it may expect the
particular bank holding company is not war- Board or Reserve Bank to review the legitimacy
ranted; provided, the Reserve Bank is satisfied of its grandfather privileges.
that all of the following conditions are met:
1. The company or its successor is a com-
pany covered in 1970;
2. The nonbanking activities for which 2030.0.2 ACTIVITIES AND
indefinite grandfather privileges are being SECURITIES OF NEW BANK
sought do not present any significant unsettled HOLDING COMPANIES
policy issues; and
A company that becomes a bank holding com-
pany may, for a period of two years, engage in
1. Effective October 20, 1981 the Board amended its Rules
Regarding Delegation of Authority to delegate to the Reserve
Banks authority to make these determinations regarding BHC Supervision Manual January 2010
indefinite grandfather privileges. Page 1
Grandfather RightsRetention and Expansion of Activities 2030.0
nonbanking activities and control voting securi- must be satisfied in order for the transaction to
ties or assets of a nonbank subsidiary, if the be in the ordinary course of business, which
bank holding company engaged in such activi- is permissible: (1) less than a substantial amount
ties or controlled such voting securities or assets of the assets of the company to be acquired must
on the date it became a bank holding company. be involved; (2) the operations of the purchased
The Board can grant requests for up to three company must not be terminated or substan-
one-year extensions of the two-year period. This tially discontinued; (3) the assets acquired must
is in accordance with a December 1983 revision not be significant in relation to the size of the
to Regulation Y (12 C.F.R. 225.22(e)). The same line of nonbank activity already in the
regulatory provision implements Section 4(a)(2) holding company (an acquisition is deemed sig-
of the BHC Act. nificant if the book value of the acquired non-
bank assets exceeds 50 percent of the book
value of the nonbank assets of the holding com-
2030.0.3 LIMITATIONS ON pany or nonbank subsidiary comprising the
EXPANSION OF GRANDFATHER same line of activity); (4) if the transaction
RIGHTS FOR INSURANCE AGENCY involves the acquisition of assets for resale, the
NONBANKING ACTIVITIES OF BANK sale must be a nominal business activity of the
HOLDING COMPANIES acquiring company; and (5) the major purpose
of the transaction must not be to hire essentially
Refer to Manual section 3170.0.3.4.1. all of the sellers principal employees who are
expert, skilled and experienced in the business
of the company being acquired. If any of these
2030.0.4 SUCCESSOR RIGHTS five conditions is not satisfied, the transaction
may be considered to be an acquisition of a
When a bank holding company transfers its going concern, which is not permissible without
bank shares to another company in a manner prior approval. Refer to 12 C.F.R. 225.132.
that produces no substantial change in the con-
trol of the bank, the transferee qualifies under
section 2(e) of the Act as a successor. The
successor provision prevents a bank holding 2030.0.6 DIVESTITURES (also see
company from transferring its bank to some Manual section 2090.6)
other organization. A successor is considered a
bank holding company from the date the trans- The act specifies the time in which a company
feror became a bank holding company. Thus, it must divest of any impermissible activity. Any
may hold the same grandfather privileges as its company becoming a bank holding company
predecessor. By the same token, it becomes subsequent to the 1970 Amendments has two
subject to any conditions or restrictions, such as years in which to divest its impermissible activ-
divestiture requirements, imposed by the Sys- ity. The Act allowed a temporarily grandfath-
tem upon its predecessor. For example, an irre- ered company ten years from December 31,
vocable declaration filed by the predecessor 1970, to divest of its impermissible activities,
would be binding upon the successor. except certain real estate holdings discussed ear-
lier; and allows indefinitely grandfathered com-
panies ten years from the date on which grand-
2030.0.5 EXPANSION OF father privileges are terminated by the Board or
GRANDFATHER ACTIVITIES Reserve Bank, should they be terminated for
good cause.
Grandfather privileges apply to activities, not to As mentioned earlier, reviews of a companys
companies. As a general rule, these activities grandfather privileges may be precipitated by
are permitted to be expanded through internal such circumstances as: (1) a subsidiary bank of
growth; however, there are a few exceptions. an indefinitely grandfathered company attaining
See Appendix 1 in this section. assets in excess of $60 million (reviewed within
In Appendix 1 it is important to distinguish two years); (2) a company seeking approval to
between a purchase in the ordinary course of engage in another activity or acquire another
business and a purchase, in whole or in part, of a
going concern. Each of the following conditions

Page 2
bank; (3) a company which violates the Act; or 5. To determine if expansions of grandfath-
(4) a company operating in a manner which ered activities occurred in accordance with the
results in an undue concentration of resources, Act.
decreased or unfair competition, conflicts of
interests, or unsound banking practices.
When a company has filed an application 2030.0.8 INSPECTION PROCEDURES
requiring the Boards or Reserve Banks ap-
proval, the Board or Reserve Bank may approve 1. If necessary, examine the subsidiary
the application subject to the condition that the banks stock certificate book to determine when
company divest of certain grandfathered shares the company acquired 25 percent or more of the
or assets within a specified time period. The bank.
specified time period generally will be shorter 2. Review the minute books and historical
than the aforementioned time periods stipulated financial records of the company and its subsid-
in the Act. iaries for evidence of the date of commence-
The plan of divestiture should have provided ment of any nonbank activity and its continua-
for the removal of any control relationship tion thereafter. In particular, the financial records
between the company and its divested activities. should reflect the activitys impact as either an
These control requirements, as outlined in asset and/or an income item. From these
section 2(g) of the Act, include one or more of records, also determine whether there has been
the following: (1) no interlocking directorates; expansion of the activity and whether such ex-
(2) ownership of less than 25 percent of the pansion complies with the Act.
voting shares by the BHC and related parties; 3. If necessary, review the latest quarterly
(3) no interlocking management positions in Call Report of Condition for the subsidiary bank
policymaking functions; (4) no indebtedness to determine whether total assets exceeded
between the transferor and the transferee; (5) no $60 million. If appropriate, advise management
agreement or understanding which restricts the that its grandfather status is subject to review.
voting privileges of shares. Further discussion 4. If necessary, examine the stock certificate
of these and other control requirements and records and minutes of the bank or BHC to
issues is found in Manual sections 2090.1 and determine if the banks shares have been trans-
2090.6. ferred from one bank holding company to an-
other in such a manner that the transferee quali-
fies as a successor.
2030.0.7 INSPECTION OBJECTIVES 5. Upon review of the aforementioned
records, discuss the status of the companys
1. To determine when the company acquired grandfather privileges with the Reserve Banks
its subsidiary bank. management, if necessary.
2. To determine when the company com- 6. If divestment is required, encourage its
menced its nonbanking activities and whether execution as soon as possible during the divest-
these activities were conducted continuously ment period. Request a divestment plan which
thereafter. specifies the manner by which divestment will
3. To determine if the banking assets of a be accomplished, the specific steps necessary to
bank controlled by a holding company with effect the divestment, and the time schedule for
indefinite grandfather privileges have reached taking such steps. Advise management that fail-
$60 million. ure to divest within the prescribed time period
4. To determine if a change of ownership will be viewed as a violation of the Act.
or control of the company has taken place,
and whether the transferee qualifies as a
successor.

Page 3
Divestment of activities S-2346

which are temporarily February 15,
grandfathered 1977
Escrow agreements used 1976 FRB 151

in divestiture
Companies with 1977 FRB 962

temporarily grandfathered
activities encouraged to
submit plans by June 30,
1978
Divestment policies 4(a)(2) 1977 FRB 263
Denial of grandfather Whitney
rights for activities which Holding
were shifted from Corporation,
subsidiary bank to New Orleans,
nonbank subsidiary Louisiana;
April 27, 1973
Denied continued D.H. Baldwin

ownership of a savings Company,
and loan association, Cincinnati,
despite permanent Ohio;
grandfather rights February 22,
1977
Discussion of indefinite Patagonia

grandfather rights Corporation,
acquired through the Tucson,
indirect power to exercise Arizona;
a controlling influence February 24,
1977
Denial of grandfather Patagonia

rights on additional stock Corporation,
acquired after June 30, Tucson,
1968, for lack of a Arizona;
controlling influence over July 6, 1973
the subsidiary as of June
30, 1968
Successor rights Republic of

Texas
Corporation,
Dallas, Texas;
October 25,
1973

Page 4
Interprets Company American

covered in 1970 and Security
Successor Corporation,
Washington,
D.C.; July 21,
1976
Review of grandfather Colorado
rights as a result of Funding
subsidiary bank reaching Company,
$60 million in total assets Denver,
Colorado;
September 9,
1977
Review of grandfather General
rights as a result of Education
subsidiary bank reaching Fund, Inc.,
$60 million in total Burlington,
assetscharitable trust Vermont;
involved September
13, 1977
Companies going out of Senate Report
business are not going 901084,
concerns page 5524
Failing companies are not 1974 FRB 725
going concerns
Ownership of less than 25 1973 FRB 539
percent of a nonbanking
company represents an
investment rather than a
subsidiary
Divestitures 225.138 and
225.140
Extension of divestiture Monetary

deadline for real estate Control
interests Act of
1980
Section
701(b)
Delegation of authority to 265.2(f)(42) 1981 FRB 856

Reserve Banks re: and 860
Indefinite Grandfathered
activities

Page 5
Activities and securities 225.22(e)

of new bank holding
companies
Denial of a BHC 1984 FRB 667
acquisitionsuccessor
Acquisition of assets 225.132
2030.0.10 APPENDIX 1EXPANSION OF GRANDFATHERED ACTIVITIES
Permissible Type of Expansion Without Approval Requires Approval
FOR COMPANIES WITH AN INDEFINITELY

GRANDFATHERED NONBANK ACTIVITY
1. Opening of additional offices of existing

subsidiary X
2. Acquisition of assets in the ordinary

course of business as defined X
3. Acquisition of a going concern:
a. Additional shares of the grandfathered

nonbanking subsidiary X
b. Additional shares of a nonbanking

company which is regarded as an
investment (generally companies in
which the holding company has an
interest of between 5 and 25 percent) X
c. Initial acquisition of shares of any

other company engaging in the
activity X

Page 6
Commitments to the Federal Reserve
Section 2040.0
Commitments to the Board arise most often the use of cease-and-desist powers to prevent
through the application process. Many commit- evasion of the purposes of the Act. Pursuant to
ments are included within the text of accompa- the Boards request, each Reserve Bank reports
nying Board orders or letters transmitted to the semi-annually on the status of all outstanding
applicants. Commitments can also arise through commitments made by holding companies in its
the supervisory process. Commitments should District.
be specific and furnished in written form.
The most common type involves a commit-
ment to inject capital (either equity or debt 2040.0.1 INSPECTION OBJECTIVES
capital) into the company or subsidiary to be
acquired or possibly into other subsidiaries of 1. To determine that the bank holding com-
the bank holding company. The required injec- pany is taking the necessary steps to fulfill any
tions may be for a specific dollar amount or for outstanding commitments as scheduled.
an unspecified amount necessary to achieve a 2. To determine whether additional commit-
predetermined capital relationship. Determining ments or conditions should be imposed to
compliance with such commitments is generally achieve complete compliance.
not difficult since an agreed upon quantifiable 3. To determine whether a request for an
result must be achieved. extension of time to fulfill any outstanding com-
Types of commitments made to the Board in mitment is warranted.
the past include: divestiture of nonpermissible
stock holdings or activities; introduction of new
services; and reduction or elimination of divi- 2040.0.2 INSPECTION PROCEDURES
dends or management fees from subsidiaries.
Several of the above forms of commitments 1. Review semi-annual commitment reports
are rather difficult to monitor due to their inex- to the Board for commitments fulfilled since the
act nature. The examiner should determine in last inspection. Determine whether such com-
such cases whether good faith compliance ef- mitments were completed as required.
forts have been made. Where an order approv- 2. Review with management any actions
ing an application imposes specific conditions, taken to comply with outstanding commitments
however, compliance is of the utmost impor- or plans to effect fulfillment.
tance since a conditional order is based on the 3. If warranted, initiate action to consider
theory that such conditions were necessary to an extension for compliance on outstanding
eliminate or outweigh adverse factors. Willful commitments.
noncompliance in these cases might necessitate

Page 1
Extensions of Credit to BHC Officials
Section 2050.0
WHATS NEW IN THIS REVISED serving if its terms are unfavorable to the lender,
SECTION or if the credit would not have been extended on
the same terms absent the official relationship;
This section was updated to discuss amendments that is, it would be improbable that each party to
to the Federal Reserve Act regarding insider the credit would have entered into the credit
lending. The definition of extension of credit transaction under the same terms if the relation-
was revised to include an insured depository ship did not exist. When a transaction appears
institutions (IDI) credit exposure to a person questionable, a complete inquiry into the facts
arising from a derivative transaction, repurchase and circumstances should be undertaken so that
agreement, reverse repurchase agreement, secu- a legal determination can be obtained.
rities lending transaction, or securities borrow- In addition to the above supervisory consider-
ing transaction. See the Federal Reserve Act, ations, the Sarbanes-Oxley Act of 2002 (Pub. L.
section 22(h)(9)(D)(i), as amended by the No. 107-204) (the act) imposed certain insider
Dodd-Frank Act, section 614(a). lending restrictions on public companies,
The Federal Deposit Insurance Act was including BHCs that are public companies. A
amended to prohibit the purchase or sale of BHC generally is considered a public company
assets between an IDI and an executive officer, for these purposes if it has a class of securities
director, or principal shareholder of the IDI, registered under section 12 of the Securities
and any related interest of such person, unless Exchange Act of 1934 (the 1934 act) or is
the transaction is on market terms. In addition, required to file reports with the Securities and
if the asset purchase or sale represents more Exchange Commission (SEC) under section 15
than 10 percent of the IDIs capital stock and of the 1934 act. The Sarbanes-Oxley Act1 pro-
surplus, the transaction must be approved in hibits a publicly owned BHC (public BHC) and
advance by a majority of the members of the its subsidiaries from extending credit, or arrang-
board of directors of the IDI who do not have an ing for another entity to extend credit, in the
interest in the transaction. See section 615(1) of form of a personal loan to any director or execu-
the Dodd-Frank Act. tive officer of the public BHC.2 This prohibition
does not apply to any extension of credit made
before July 30, 2002, so long as the loan is not
2050.0.1 BHC OFFICIAL AND renewed or materially modified after that date.
RELATED INTEREST The Sarbanes-Oxley Act includes two excep-
TRANSACTIONS BETWEEN THE tions to this loan prohibition. First and most
PARENT COMPANY OR ITS importantly, the prohibition does not apply to
NONBANK SUBSIDIARIES any loan made by an insured depository institu-
tion that is subject to the insider lending restric-
Business transactions between a parent bank tions of section 22(h) of the Federal Reserve
holding company or its nonbank subsidiary and Act, as implemented by the Boards Regulation
a BHC official or a BHC officials related inter- O. Thus, loans by the insured depository institu-
ests require close supervisory review. Bank tion subsidiaries of a public BHC to a director
holding company official is defined as any or executive officer of the BHC likely are
director, executive officer, or principal share- exempt from the prohibition, although they
holder of the parent company or any of its would be subject to Regulation O as discussed
subsidiaries, excluding the subsidiary banks below. The second exception permits the direc-
nonbank subsidiaries. tors and executive officers of a public BHC to
Most of these transactions are soundly struc- obtain home improvement and manufactured
tured and have a legitimate business purpose home loans, consumer loans, and loans under
that result in equitable treatment for all parties. open-end credit plans or charge cards from the
However, examiners should pay close attention public BHC or its subsidiaries, so long as the
to all extensions of credit by a BHC or its
nonbank subsidiary to a BHC official or related 1. See 15 U.S.C. 78m (section 402 of the act).
2. The act does not restrict lending by a subsidiary of a
interest to ensure that the terms of the credit, public BHC to the subsidiarys own directors and executive
particularly interest-rate and collateral terms, officers, so long as these persons are not also directors or
are not preferential and that the credit does not executive officers of the public BHC.
involve more than a normal risk of repayment.
An extension of credit by a BHC or nonbank BHC Supervision Manual January 2013
subsidiary may be considered abusive or self- Page 1
Extensions of Credit to BHC Officials 2050.0
credit (1) is extended in the ordinary course of may be unique to a given situation and individu-
the companys consumer credit business, (2) is a als. In general, the fair market price of even
kind of credit generally made available to the unique assets or services can be approximated
public, and (3) is made on market terms or on by the cost of the assets or services to the party
terms that are no more favorable than those selling or furnishing them, if appropriate. The
offered to the general public. value of services or properties provided by a
BHC or nonbank subsidiary should be estab-
lished and justified either by policy or on a
case-by-case basis, and appropriate documenta-
2050.0.2 TRANSACTIONS INVOLVING tion should be available to the examiner.
OTHER PROPERTY Services provided by a BHC official or a
OR SERVICES related interest to a BHC or nonbank subsidiary,
while not unusual, may be most difficult to
Other transactions involving BHC officials, their value. In part because of the problem of valua-
related interests, and the BHC and nonbank tion, this type of transaction is among the most
subsidiary that should be reviewed by the exam- susceptible to abuse. The cost of providing ser-
iner include the vices is frequently derived by placing value on
the time of the individuals providing the ser-
1. purchase of assets or services from the BHC vices. When services are provided by a BHC
or nonbank subsidiary, particularly if at a official who normally places a very high billing
discount or on preferential terms; value on time provided, the benefits to the BHC
2. sale of assets or services to the BHC must be assessed in order to form a basis for
or nonbank subsidiary, particularly if at a determining a fair price. The BHC official may
premium; be a highly regarded professional whose time
3. lease of property to or from the BHC or and services have great value to the organiza-
nonbank subsidiary; and tion. However, when the BHC requires routine
4. use of BHC or nonbank subsidiary property clerical services, officials should not charge the
or personnel by a BHC official or related BHC a professional-level rate for such services.
interest. Under these or similar circumstances, the BHC
would be considered imprudent in paying such
As with loans and other extensions of credit rates and could be subject to critical comment.
to BHC officials on preferential terms, abusive
or self-serving insider transactions involving
other property or services deprive the BHC or 2050.0.3 REGULATION O
nonbank subsidiary of higher returns or gains
that may have been achieved had the same For ease of reference, certain Regulation O defi-
transaction been at a fair market price. A fair nitions and limitations, as revised by the Fed-
market price would be that price charged or eral Deposit Insurance Corporation Improve-
received from an unaffiliated party. ment Act of 1991 (FDICIA), are presented here,
The Dodd-Frank Act amended the Federal some in abbreviated form. A thorough review of
Deposit Insurance Act (FDIA) to impose a pro- the entire regulation (found at FRRS 3960),
hibition on asset purchases and between an IDI and the Boards press releases pertaining to
and an executive officer, director, or principal Regulation O, is necessary for a complete
shareholder of the IDI, and any related interest understanding of the regulation. (Note that sec-
of such person, unless the transaction is on tion 108 of the Financial Institutions Regulatory
market terms. In addition, if the asset purchase Act of 1978 amended section 18(j) of the Fed-
or sale represents more than 10 percent of the eral Deposit Insurance Act to make section
IDIs capital stock and surplus, the transaction 22(h) of the Federal Reserve Act applicable to
must be approved in advance by a majority of nonmember insured banks.)
the members of the board of directors of the IDI
Purpose of Regulation O. Regulation O gov-
who do not have an interest in the transaction.
erns any extension of credit by a member bank
See section 18(z) of the FDIA, as amended by
the Dodd-Frank Act, section 615(a). and its subsidiaries (based on amendments con-
A fair market price is often difficult to deter- tained in FDICIA, Regulation O also applies to
mine because the assets or services involved nonmember insured depository institutions) to
an executive officer, director, or principal share-
BHC Supervision Manual January 2013 holder of (1) the member bank, (2) a bank
Page 2 holding company of which the member bank is
a subsidiary, and (3) any other subsidiary of that 1. Aggregate lending limit (section 215.4(d)).
bank holding company. It also applies to any The aggregate limit on the total amount that a
extension of credit by a member bank to (1) a bank can lend to its insiders and their related
company controlled by such a person and (2) a interests as a class was changed. In general, this
political or campaign committee that benefits or amount is equal to the banks unimpaired capi-
is controlled by such a person. tal and unimpaired surplus. The Board also
Supervision of BHCs and their nonbank sub- decided as a one-year interim measure to permit
sidiaries. Regulation O deals exclusively with banks with deposits under $100 million to adopt
extensions of credit by banks and their subsidi- a higher limit, not to exceed 200 percent of the
aries, not extensions of credit by BHCs and their banks unimpaired capital and unimpaired sur-
nonbank subsidiaries. However, because the plus. (This interim period was extended twice
regulations curtail or eliminate abusive transac- by the Board, extending the higher limit through
tions, they can be used as a guide or model in February 18, 1994, when the higher limit
providing standards for the supervisory review became permanent. The board of directors must
of extensions of credit by BHCs and nonbank provide an annual resolution authorizing the use
subsidiaries. Although a direct extension of of this higher limit. Other conditions also apply.)
credit by a BHC could not be determined to be a 2. Lending limits for directors and related
violation of Regulation O, if the credit fails to interests (section 215.4(c)). Loans to directors
(and their related interests) are subject to the
meet the requirements that Regulation O estab-
same lending limit that is applicable to execu-
lishes for banks, it may be possible to conclude
tive officers and principal shareholders (and
that the BHC is engaging in either an unsafe or
their related interests).
unsound practice that exposes the entire banking
3. Credit standards (section 215.4(a)). When
organization to undue risk and exposure to loss.
lending to an insider 2b a bank must follow credit
Regulation O limits credit extensions by a bank underwriting procedures that are as stringent as
to officials of that bank and their related inter- those applicable to comparable transactions by
ests; therefore, examiners should be especially the bank with persons outside the bank.
alert to credit extensions from BHCs and non- 4. Definition of principal shareholder (sec-
bank subsidiaries. If credit extensions appear to tion 215.2(m)(1)). The definition of principal
circumvent the intent of Regulation O, they shareholder was tightened for banks located in
should be identified and discussed with manage- small communities. The previously existing
ment and noted in the inspection report for 10 percent limitation was made applicable to all
follow-up review and possible formal corrective banks, regardless of the size of the communities
action by regulatory authorities. in which they were located.3
5. Definition of member bank (section
215.2(j)). The term member bank was redefined
2050.0.3.1 FDICIA and BHC Inspection to include any subsidiary of the member bank.
Guidance for Regulation O This revision clarified that an extension of credit
from a subsidiary of a member bank is subject
On April 22, 1992, the Board adopted amend-
ments to Regulation O, effective May 18, 1992,
to implement the changes required by section 2b. The term insider refers to an executive officer, director,
or principal shareholder, and includes any related interest of
306 of FDICIA. Section 306 amended section such a person.
22(h) of the Federal Reserve Act and replaced 3. The Board amended the definition of principal share-
the language of section 22(h) with the provi- holder of a member bank, effective December 17, 1992, so
that it does not include a company of which a member bank is
sions of the Boards Regulation O. Section 306 a subsidiary. This amendment excludes from Regulation O
also made several substantive modifications to loans to a company that owns, controls, or exercises a control-
section 22(h) that required revisions to Regula- ling influence over a member bank, as those relationships are
tion O. These changes are outlined in the defined in section 2(d) of the Bank Holding Company Act, as
well as the related interests of such a parent bank holding
Boards press release and Federal Register company. The definition of principal shareholder for pur-
notice of May 28, 1992 (57 Fed. Reg. 22,417). poses of reporting obligations under section 215.11 of Regula-
The following are some of the more signifi- tion O was not changed as a result of the Housing and
cant changes that were made effective May 18, Community Development Act of 1992 because those portions
of Regulation O implement provisions of law in addition to
1992: 2a section 22(h) of the Federal Reserve Act.
2a. The Regulation O cites are to the February 18, 1994, BHC Supervision Manual January 2013
amendment. Page 3
to the same insider restrictions as an extension ment or agency of the United States; or
of credit from a member bank itself. c. a segregated deposit account with the
6. Coverage of all companies that own banks lending bank.
(section 215.2(b)). All companies that own An exception is also made for loans arising
banks became subject to Regulation O, regard- from the discount of installment consumer paper
less of whether they are technically bank hold- by an insider with full or partial recourse
ing companies. endorsement or guarantee by the insider, if the
7. Prohibition on knowingly receiving unau- maker of the paper is not an insider and the
thorized extensions of credit (section 215.6). loan was made relying primarily on the maker
Insiders are prohibited from knowingly receiv- and this is properly documented. Such loans
ing (or permitting their related interests to continue to be subject to the prohibitions against
receive) any extension of credit not authorized preferential lending.
by section 22(h) of the Federal Reserve Act. 3. Including closing costs in the refinancing
8. Reporting requirement for certain credit of home mortgage loans (section 215.5(c)(2)).
(section 215.12). Executive officers and direc- Section 22(g) of the Federal Reserve Act allows
tors of member banks that do not have publicly a bank to make a loan to its executive officer,
traded stock are required to report annually to without restrictions on the amount, if the loan is
their institutions the outstanding amount of secured by a first lien on a dwelling that is
any credit secured by shares of the insiders owned and used by the executive officer as a
institution. residence after the loan is made. The Boards
amendment includes the refinancing of home
In a February 18, 1994, press release, the mortgage loans in this category only if the pro-
Federal Reserve Board announced its approval ceeds are used to pay off the previous home
of a final rule that further amended several mortgage loan or for the other purposes listed in
provisions of Regulation O, effective on that this section. The regulation states that closing
date. Some of the provisions carried out or costs can be included as part of the exempt
further refined provisions of FDICIA. The portion of a home mortgage refinancing.
amendments were designed to increase the abil- 4. Alternative recordkeeping procedures
ity of banks to make extensions of credit that (section 215.8). Banks are permitted to follow
pose minimal risk of loss, to eliminate record- alternative recordkeeping procedures on loans
keeping requirements that impose a paperwork to insiders of affiliates. The amendment allows a
burden, and to remove certain transactions from bank to decide on its own how to gather infor-
the regulations coverage consistent with bank mation on related interests, so long as its method
safety and soundness. The amendments were is effective. For example, a nonbank credit card
expected to increase the availability of credit, bank or other bank that does not make commer-
particularly in communities served by small cial loans could decide not to keep records on
banks. The following is a discussion of some of related interests. For banks that make commer-
the rules primary provisions. cial loans, one of two acceptable methods is
1. Aggregate lending limitexception for required, unless a bank can demonstrate that
small, adequately capitalized banks (section another method is equally effective: (a) the sur-
215.4(d)). This revision of Regulation O made vey method or (b) the borrower inquiry
permanent an interim rule increasing the aggre- method. Every bank, regardless of the record-
gate lending limit for small, adequately capital- keeping method it selects, must conduct an
ized banks from 100 percent of the banks unim- annual survey to identify its own insiders, but
paired capital surplus to 200 percent, provided not those of its holding company affiliates.
the bank satisfies three conditional criteria. Every bank is expected to check this short list
2. Exceptions to the general limits on lend- before extending credit, even if it is using the
ing (section 215.4(d)(3)). The Board adopted borrower-inquiry method of recordkeeping for
certain exceptions to the general restrictions on affiliates in lieu of the survey method.
lending to insiders. The exceptions apply to 5. Tangible-economic-benefit rule (section
loans fully secured by 215.3(f)). This rule was similar to a provision
a. obligations of the United States or other in section 23A of the Federal Reserve Act
obligations fully guaranteed as to principal and and was adopted at a time when the Board was
interest by the United States; required by section 22(h) of the Federal Reserve
b. commitments or guarantees of a depart- Act to use the definition of extension of credit
found in section 23A. However, the definition of
BHC Supervision Manual January 2013 extension of credit in section 22(h) is no longer
Page 4 tied to section 23A. The Board has therefore
revised the tangible-economic-benefit rule to than 10 percent of any class of voting securi-
clarify that it does not reach certain transactions ties of the company or bank, and no other
that may benefit an insider. The Board explicitly person owns, controls, or has the power to vote
provided that the rule does not apply to an a greater percentage of that class of voting
arms-length extension of credit by a bank to a securities.
third party where the proceeds of the credit are (3) An individual is not considered to have
used to finance the bona fide acquisition of control, including the power to exercise a con-
property, goods, or services from an insider or trolling influence over the management or poli-
an insiders related interest. cies, of a company or bank solely by virtue of
the individuals position as an officer or director
of the company or bank.
2050.0.3.2 Definitions in Regulation O (d) Director of a company or bank means
(abbreviated listing) any director of the company or bank, whether or
not receiving compensation.3a An advisory
Note: Regulation O definitions, prohibitions, director is not considered a director if the advi-
exceptions, and exemptions are particularly sory director (1) is not elected by the sharehold-
detailed and complex. Therefore, inspection staff ers of the bank or company, (2) is not authorized
should consult with Reserve Bank or Board to vote on matters before the board of directors,
supervisory or legal staff before discussing with and (3) provides solely general policy advice to
management or presenting in an inspection the board of directors.
report any BHC inspection findings that rely (e)(1) Executive officer of a company or
upon Regulation O. bank means a person who participates or has
(a) Affiliate means any company of which authority to participate (other than in the capac-
a member bank is a subsidiary or any other ity of a director) in major policymaking func-
subsidiary of that company. tions of the company or bank, whether or not
(b) Company means any corporation, part- the officer has an official title; the title desig-
nership, trust (business or otherwise), associa- nates the officer an assistant; or the officer is
tion, joint venture, pool syndicate, sole propri- serving without salary or other compensation.4
etorship, unincorporated organization, or any
other form of business entity. The term, how- 3a. Extensions of credit to a director of an affiliate of a
ever, does not include (1) an insured bank (as bank are not subject to the general prohibitions (section
defined in 12 U.S.C. 1813) or (2) a corporation 215.4), the prohibitions on knowingly receiving unauthorized
the majority of the shares of which are owned extensions of credit (section 215.6), and the alternative record-
keeping procedures (section 215.8) if
by the United States or by any state. (1) the director of the affiliate is excluded, by resolution of
(c)(1) Control of a company or bank the board of directors or by the bylaws of the bank, from
means that a person directly or indirectly, or participation in major policymaking functions of the bank,
acting through or in concert with one or more and the director does not actually participate in those
functions;
persons (i) owns, controls, or has the power to (2) the affiliate does not control the bank; and
vote 25 percent or more of any class of voting (3) as determined annually, the assets of the affiliate do not
securities of the company or bank; (ii) controls constitute more than 10 percent of the consolidated assets of
in any manner the election of a majority of the the company that controls the bank and is not controlled by
any other company, and the director of the affiliate is not
directors of the company or bank; or (iii) has the otherwise subject to sections 215.4, 215.6, and 215.8 of
power to exercise a controlling influence over Regulation O.
the management or policies of the company or If the director of the affiliate is excluded, by resolution of
bank. (Note: If a company does not have voting the board of directors or by the bylaws of the bank, from
participation in major policymaking functions of the bank, a
securities (that is, a partnership), review the resolution of the board of directors or a corporate bylaw may
degree of interest in the company to determine (1) include the director (by name or by title) in a list of
control.) persons excluded from participation in such functions or
(2) A person is presumed to have control, (2) not include the director in a list of persons authorized (by
name or by title) to participate in such functions.
including the power to exercise a controlling 4. The term executive officer is not intended to include
influence over the management or policies, of a persons who may have official titles and may exercise a
company or bank if (i) the person is an execu- certain measure of discretion in the performance of their
tive officer or director of the company or bank duties, including discretion in the making of loans, but who
do not participate in determining major policies of the bank or
and directly or indirectly owns, controls, or has company and whose decisions are limited by policy standards
the power to vote more than 10 percent of any fixed by the senior management of the bank or company. For
class of voting securities of the company or
bank or (ii) the person directly or indirectly BHC Supervision Manual January 2013
owns, controls, or has the power to vote more Page 5
The chairman of the board, the president, every single borrower established by section 5200 of
vice president, the cashier, the secretary, and the the Revised Statutes,5 12 U.S.C. 84. This
treasurer of a company or bank are considered amount is 15 percent of the banks unimpaired
executive officers, unless the officer is excluded, capital and unimpaired surplus in the case of
by resolution of the board of directors or by the loans that are not fully secured, and an addi-
bylaws of the bank or company, from participa- tional 10 percent of the banks unimpaired capi-
tion (other than in the capacity of a director) in tal and unimpaired surplus in the case of loans
major policymaking functions of the bank or that are fully secured by readily marketable
company, and the officer does not actually par- collateral having a market value, as determined
ticipate therein. by reliable and continuously available price
(2) Extensions of credit to an executive quotations, at least equal to the amount of the
officer of an affiliate of a member bank (other loan. The lending limit also includes any higher
than a company that controls the bank) are not amounts that are permitted by section 5200 of
subject to sections 215.4, 215.6, and 215.8 of the Revised Statutes for the types of obligations
Regulation O if listed therein as exceptions to the limit.
(i) the executive officer of the affiliate is A member banks unimpaired capital and
excluded, by resolution of the board of directors unimpaired surplus equals the (1) member
or by the bylaws of the bank, from participation banks tier 1 and tier 2 capital included in the
in major policymaking functions of the bank, banks risk-based capital, under the capital
and the executive officer does not actually par- guidelines of the appropriate federal banking
ticipate in those functions; agency, and (2) balance of the member banks
(ii) the affiliate does not control the allowance for loan and lease losses that was not
bank; and included in the banks tier 2 capital. This com-
(iii) as determined annually, the assets putation is based on the banks risk-based capi-
of the affiliate do not constitute more than tal under the capital guidelines of the appropri-
10 percent of the consolidated assets of the ate federal banking agency, based on the banks
company that controls the bank and is not con- most recent consolidated report of condition
trolled by any other company, and the execu- filed under 12 U.S.C. 1817(a)(3).
tive officer of the affiliate is not otherwise (i) Member bank means any banking insti-
subject to sections 215.4, 215.6, and 215.8 of tution that is a member of the Federal Reserve
Regulation O. System, including any subsidiary of a member
If the executive officer of the affiliate is bank. The term does not include any foreign
excluded, by resolution of the board of directors bank that maintains a branch in the United
or by the bylaws of the bank, from participation States, whether or not the branch is insured
in major policymaking functions of the bank, a (within the meaning of 12 U.S.C. 1813(s)) and
resolution of the board of directors or a corpo- regardless of the operation of 12 U.S.C. 1813(h)
rate bylaw may (i) include the executive officer and 12 U.S.C. 1828(j)(3)(B).
(by name or by title) in a list of persons (j) Person means an individual or a
excluded from participation in such functions or company.
(ii) not include the executive officer in a list of (k) Principal shareholder 6 means an indi
persons authorized (by name or by title) to vidual or a company (other than an insured
participate in such functions. bank) that directly or indirectly, or acting
(f) Immediate family means the spouse of through or in concert with one or more persons,
an individual, the individuals minor children, owns, controls, or has the power to vote more
and any of the individuals children (including than 10 percent of any class of voting securities
adults) residing in the individuals home.
(g) Insider means an executive officer, 5. Where state law establishes a lending limit for a state
director, principal shareholder, and any related member bank that is lower than the amount permitted in
section 5200 of the Revised Statutes, the lending limit estab-
interest of such person. lished by the applicable state laws shall be the lending limit
(h) The lending limit for a member bank for the state member bank.
is an amount equal to the limit on loans to a 6. On October 28, 1992, in section 955 of the Housing and
Community Development Act of 1992, Congress amended
section 22(h) of the Federal Reserve Act to exclude from the
example, the term does not include a manager or assistant
definition of principal shareholder a company of which a
manager of a branch of a bank unless that individual partici-
member bank is a subsidiary. Regulation O was amended,
pates, or is authorized to participate, in major policymaking
effective December 17, 1992, to implement this change. As a
functions of the bank or company.
result of the amendment, extensions of credit by a bank to its
holding company and to any related interests of its subsidiary
BHC Supervision Manual January 2013 are governed solely by sections 23A and 23B of the Federal
Page 6 Reserve Act.
of a member bank or company. Shares owned or agreement, reverse repurchase agreement, secu-
controlled by a member of an individuals rities lending transaction, or securities borrowing
immediate family are considered to be held by transaction.
the individual. A principal shareholder of a An extension of credit does not include
member bank includes (1) a principal share- (1) an advance against accrued salary or
holder of a company of which the member bank other accrued compensation, or an advance for
is a subsidiary and (2) a principal shareholder of the payment of authorized travel or other
any other subsidiary of that company, exclusive expenses incurred or to be incurred on behalf
of nonbank subsidiaries of member banks. of the bank;
(l) Related interest means (1) a company (2) a receipt by a bank of a check depos-
that is controlled by a person or (2) a political or ited in or delivered to the bank in the usual
campaign committee that is controlled by a per- course of business unless it results in the carry-
son or the funds or services of which will bene- ing of a cash item for or the granting of an
fit a person. overdraft (other than an inadvertent overdraft in
(m) Subsidiary has the meaning given in a limited amount that is promptly repaid under
section 2(d) of the BHC Act, but does not terms that are not more favorable than those
include a subsidiary of a member bank. offered to the general public).
(3) an acquisition of a note, draft, bill of
exchange, or other evidence of indebtedness
2050.0.3.2.1 Extension of Credit through (i) a merger or consolidation of banks
or a similar transaction by which a bank
For the purposes of Regulation O, an exten- acquires assets and assumes liabilities of another
sion of credit is bank or similar organization or (ii) foreclosure
(a) a making or renewal of any loan, a grant- on collateral or similar proceeding for the pro-
ing of a line of credit, or an extending of tection of the bank, provided that such indebted-
credit in any manner whatsoever and ness is not held for a period of more than three
includes: years from the date of the acquisition, subject to
(1) a purchase under repurchase agree-
ment of securities, other assets, or obligations;
(2) an advance by means of an overdraft,
cash item, or otherwise;
(3) issuance of a standby letter of credit
(or other similar arrangement regardless of name
or description) or an ineligible acceptance;
(4) an acquisition by discount, purchase,
exchange, or otherwise of any note, draft, bill of
exchange, or other evidence of indebtedness
upon which an insider may be liable as maker,
drawer, endorser, guarantor, or surety;
(5) an increase of an existing indebted-
ness, but not if the additional funds are
advanced by the bank for its own protection for
(i) accrued interest or (ii) taxes, insurance, or
other expenses incidental to the existing
indebtedness;
(6) an advance of unearned salary or other
unearned compensation for a period in excess of
30 days; and
(7) any other similar transaction as a result
of which a person becomes obligated to pay
money (or its equivalent) to a bank, whether
the obligation arises directly or indirectly, or
because of an endorsement on an obligation or
otherwise, or by any means whatsoever.
The Dodd-Frank Act added to the definition of
an extension of credit an insured depository
institutions (IDI) credit exposure to a person BHC Supervision Manual January 2013
arising from a derivative transaction, repurchase Page 6.1
extension by the appropriate federal banking (2) the proceeds of the extension of credit
agency for good cause; are used in a bona fide transaction to acquire
(4)(i) an endorsement or guarantee for the property, goods, or services from the insider.
protection of a bank of any loan or other asset
previously acquired by the bank in good faith or
(ii) any indebtedness to a bank for the purpose 2050.0.3.2.2 Insider Use of a
of protecting the bank against loss or of giving Bank-Owned Credit Card
financial assistance to it;
(5) indebtedness of $15,000 or less arising Board staff issued a May 22, 2006, legal opinion
by reason of any general arrangement by which in response to an FDIC request for clarification
a bank (i) acquires charge or time credit on the application of the Boards Regulation O
accounts or (ii) makes payments to or on behalf (12 CFR 215) to credit cards that are issued to
of participants in a bank credit card plan, check bank insiders for the banks business purposes.7
credit plan, or similar open-end credit plan, The FDIC asked whether, and under what cir-
provided cumstances, an insiders use of a bank-owned
credit card would be deemed an extension of
(A) the indebtedness does not involve credit by the bank to the insider for purposes of
prior individual clearance or approval by the Regulation O.
bank other than for the purposes of determining The FDIC indicated that insiders of a bank
authority to participate in the arrangement and often use a bank-owned credit card to purchase
compliance with any dollar limit under the goods and services for the banks business pur-
arrangement, and poses. A bank-owned credit card is a credit card
(B) the indebtedness is incurred under that is issued by a third-party financial institu-
terms that are not more favorable than those tion to a bank to enable the bank (through its
offered to the general public; employees) to finance the purchase of goods
(6) indebtedness of $5,000 or less arising and services for the banks business. Board staff
by reason of an interest-bearing overdraft credit commented that it was understood that (1) a
plan (see Regulation O, section 215.4(e)); or bank that provides a bank-owned credit card to
(7) a discount of promissory notes, bills of its employees typically forbids or discourages
exchange, conditional sales contracts, or similar use of the card by employees for their personal
paper, without recourse. purposes and that an employee who uses the
Non-interest-bearing deposits to the credit of card for personal purposes is obligated to
a bank are not considered loans, advances, or promptly reimburse the bank and (2) a bank is
extensions of credit to the bank of deposit. Also, liable to the card-issuing institution for all
the giving of immediate credit to a bank upon extensions of credit made under the card
collected items received in the ordinary course (whether for the banks business purposes or for
of business is not considered to be a loan, an employees personal purposes)8.
advance, or extension of credit to the depositing Although section 215.3(a) of Regulation O
bank. broadly defines an extension of credit to include
a making or renewal of a loan, a granting of a
An extension of credit by a member bank (for line of credit, or an extending of credit in any
the purposes of section 215.4 of Regulation O) manner whatsoever, the rule also provides sev-
is considered to have been made at the time the eral important exceptions to the definition that
bank enters into a binding commitment to make are relevant to the FDICs inquiry. Section
the extension of credit. A participation without 215.3(b)(1) of Regulation O excludes from the
recourse is considered to be an extension of
credit by the participating bank, not by the origi-
nating bank. 7. The provisions of Regulation O apply to a bank holding
company of which a member bank is a subsidiary, and any
Tangible-economic-benefit rule. In general, an other subsidiary of that bank holding company. (See
extension of credit is considered made to an 2050.0.3.)
insider to the extent that the proceeds are trans- 8. In the responding letter, Board legal staff notes that it
was understood that some banks directly issue credit cards to
ferred to the insider or are used for the tangible their employees to enable the employees to finance the pur-
economic benefit of the insider. An extension of chase of goods and services for the banks business (bank-
credit is not considered made to an insider if issued credit cards). Also, the letter states that the principles
set forth with regard to bank-owned credit cards also would
(1) the credit is extended on terms that apply to bank-issued credit cards.
would satisfy the standard set forth in section
215.4(a) of Regulation O for extensions of credit BHC Supervision Manual January 2007
to insiders and Page 7
definition of extension of credit any advance by tial terms in connection with uses of the card for
a bank to an insider for the payment of autho- personal purposes). Nonetheless, use of a bank-
rized or other expenses incurred or to be owned credit card by an insider for personal
incurred on behalf of the bank. Also, section purposes may violate the market- terms require-
215.3(b)(5) of Regulation O excludes from the ment of Regulation O if the card carries a lower
definition of extension of credit indebtedness of interest rate or permits a longer repayment
up to $15,000 incurred by an insider with a bank period than comparable consumer credit offered
under an ordinary credit card. by the bank.
Considering the provisions of Regulation O The Board staffs legal opinion applies only
and the purposes of the insider lending restric- to the specific issues and circumstances
tions in the Federal Reserve Act, Board legal described in the letter and does not address any
staff opined that a bank does not make an exten- other issues or circumstances.
sion of credit to an insider for purposes of
Regulation O at the time of issuance of a bank-
owned credit card to the insider (regardless of 2050.0.3.3 General Prohibitions and
whether the line of credit associated with the Limitations of Regulation O
card is greater than $15,000). The opinion states
also that a bank does not extend credit to an (a) Terms and creditworthiness. No member
insider for the purposes of Regulation O when bank may extend credit to any insider of the
the insider uses the card to purchase goods or bank or insider of its affiliates unless the exten-
services for the banks business purposes. How- sion of credit (1) is made on substantially the
ever, when an insider uses the card to purchase same terms (including interest rates and collat-
goods or services for the insiders personal pur- eral) as, and following credit-underwriting pro-
poses, the bank may be making an extension of cedures that are not less stringent than, those
credit to the insider. The opinion states that an prevailing at the time for comparable transac-
extension of credit would occur for the purposes tions by the bank with other persons that are not
of Regulation O ifand to the extent thatthe covered by Regulation O and who are not
amount of outstanding personal charges made to employed by the bank and (2) does not involve
the card, when aggregated with all other indebt- more than the normal risk of repayment or
edness of the insider that qualifies for the credit present other unfavorable features.
card exception in section 215.3(b)(5) of Regula- Nothing stated above (as to terms and cred-
tion O, exceeds $15,000. itworthiness) should prohibit any extension of
The FDIC also asked whether incidental per- credit made in accordance with a benefit or
sonal expenses charged by an insider to a bank- compensation program that
owned credit card are per se violations of the 1. is widely available to employees of the
market-terms requirement in section 215.4(a) of member bank, and in the case of extensions of
Regulation O because non-insiders do not have credit to an insider of its affiliates, is widely
access to this form of credit from the bank. In available to employees of the affiliates at which
response, Board staff stated that section 215.4(a) that person is an insider and
requires extensions of credit by a bank to its 2. does not give preference to any insider
insiders to (1) be on substantially the same of the member bank over other employees of the
terms (including interest rates and collateral) as, member bank and, in the case of extensions of
and subject to credit underwriting standards that credit to an insider of its affiliates, does not give
are not less stringent than, those prevailing at preference to any insider of its affiliates over
the time for comparable transactions with non- other employees of the affiliates of which that
insiders and (2) not involve more than the nor- person is an insider.
mal risk of repayment or other features unfavor- (b) Prior approval. A member bank may not
able to the bank. extend credit (including granting a line of credit)
The opinion states that a bank may be able to to any insider of the bank or insider of its
satisfy the market-terms requirement, however, affiliates in an amount that, when aggregated
if the bank approves an insider for use of a with the amount of all other extensions of credit
bank-owned credit card only (1) if the insider to that person and to all related interests of that
meets the banks normal credit underwriting person, exceeds the higher of $25,000 or 5 per-
standards and (2) the card does not have prefer- cent of the member banks unimpaired capital
ential terms (or the card does not have preferen- and unimpaired surplus, but in no event can it
exceed $500,000. This provision applies unless
BHC Supervision Manual January 2007 (1) the extension of credit or line of credit has
Page 8 been approved in advance by a majority of the
entire board of directors of that bank and (2) the most recent bank examination report.
interested party has abstained from participating If a member bank has adopted a resolu-
directly or indirectly in the voting. tion authorizing a higher limit and subsequently
The board of directors approval is not fails to meet the above-listed requirements, the
required for an extension of credit that is made member bank cannot extend any additional
pursuant to a line of credit that was approved by credit (including a renewal of any existing
the board of directors within 14 months of the extension of credit) to any insider of the bank or
date of the extension of credit. Participation in its affiliates unless the extension or renewal is
the discussion, or any attempt to influence the consistent with the general limit.
voting, by the board of directors regarding an (3) Exceptions to the general limit. Effec-
extension of credit constitutes indirect participa- tive May 3, 1993, the general limit, described in
tion in the voting by the board of directors on an manual section 2050.0.3.3 (paragraph d) and
extension of credit. specified in section 215.4(d)(1) of the Boards
(c) Individual lending limit. A member bank Regulation O does not apply to
may not extend credit to any insider of the bank (i) extensions of credit secured by a per-
or insider of its affiliates in an amount that, fected security interest in bonds, notes, certifi-
when aggregated with the amount of all other cates of indebtedness, or Treasury bills of the
extensions of credit by the member bank to that United States or in other such obligations fully
person and to all related interests of that person, guaranteed as to principal and interest by the
exceeds the lending limit described above in United States;
section 2050.0.3.2 (paragraph h). This prohibi- (ii) extensions of credit to or secured by
tion does not apply to an extension of credit by a unconditional takeout commitments or guaran-
member bank to a company of which the mem- tees of any department, agency, bureau, board,
ber bank is a subsidiary or to any other subsidi- commission, or establishment of the United
ary of that company. States or any corporation wholly owned directly
(d) Aggregate lending limit. or indirectly by the United States;
(1) General limit. A member bank may (iii) extensions of credit secured by a
not extend credit to any insider of the bank or perfected security interest in a segregated
insider of its affiliates unless the extension of deposit account in the lending bank; or
credit is in an amount that, when aggregated (iv) extensions of credit arising from the
with all outstanding extensions of credit to all discount of negotiable installment consumer
such insiders, would exceed the banks unim- paper that is acquired from an insider and
paired capital and unimpaired surplus as defined carries a full or partial recourse endorsement or
in section 215.2(i) of Regulation O (see section guarantee by the insider,9 provided that
2050.0.3.2, paragraph h). (A) the financial condition of each
(2) A member bank with deposits of less maker of such consumer paper is reasonably
than $100,000,000 may, by an annual resolution documented in the banks files or known to its
of its board of directors, increase the general officers;
limit (specified above) to a level that does not (B) an officer of the bank designated
exceed two times the banks unimpaired capital for that purpose by the board of directors of the
and unimpaired surplus if the board of directors bank certifies in writing that the bank is relying
determines that such higher limit is consistent primarily upon the responsibility of each maker
with prudent, safe, and sound banking practices for the payment of the obligation and not upon
in light of the banks experience in lending to its any endorsement or guarantee by the insider;
insiders and is necessary to attract or retain and
directors or to prevent the restriction of the (C) the maker of the instrument is not
availability of credit in small communities. an insider.
The board of directors resolution must (e) Overdrafts. A member bank may not pay
set forth the facts and reasoning on which it an overdraft of an executive officer or director
bases its finding, including the amount of the of the bank10 on an account at the bank, unless
banks lending to its insiders as a percentage of
the banks unimpaired capital and unimpaired 9. The exceptions to the aggregate lending limit pertaining
surplus as of the date of the resolution. In addi- to extensions of credit secured in the manner described above
(i through iii) apply only to the amounts of such extensions of
tion, the bank must meet or exceed, on a fully credit that are secured in such manner.
phased-in basis, all applicable capital require- 10. This prohibition does not apply to the payment by a
ments established by the appropriate federal
banking agency. The bank would also have had BHC Supervision Manual January 2007
to receive a satisfactory composite rating in its Page 9
the payment of funds is made in accordance owned (or expected to be owned after the exten-
with (1) a written, preauthorized, interest- sion of credit) by the executive officer; and
bearing extension of credit plan that specifies a (ii) in the case of refinancing, that only the
method of repayment or (2) a written, preautho- amount used to repay the original extension of
rized transfer of funds from another account of credit, together with the closing costs of the
the account holder at the bank. refinancing, and any additional amount thereof
The prohibition above does not apply to used for any of the purposes enumerated in
payment of inadvertent overdrafts on an account item 2 above, are included within this category
in an aggregate amount of $1,000 or less, proof credit;
vided (1) the account is not overdrawn for more (3) in any amount, if the extension of credit
than five business days and (2) the member is secured in a manner described in the first
bank charges the executive officer or director three exceptions to the general limit of the
the same fee charged any other customer of the aggregate lending limit (see section 2050.0.3.3,
bank in similar circumstances.11 paragraph d, subparagraphs i to iii); and
(4) for any other purpose (not specified in
items 1 through 3 above), if the aggregate
2050.0.3.4 Additional Restrictions amount of loans to that executive officer does
on Loans to Executive Officers not exceed, at any one time, the higher of
of Member Banks 2.5 percent of the banks unimpaired capital and
unimpaired surplus or $25,000, but in no event
The following restrictions on extensions of more than $100,000.
credit by a member bank to any of its executive Any extension of credit by a member bank to
officers are in addition to any restrictions on any of its executive officers must be
extensions of credit by a member bank to insid- (1) promptly reported to the member banks
ers of itself or its affiliates. The restrictions board of directors,
listed below apply only to the executive officers
of the member bank and not to the executive (2) in compliance with the general prohibi-
officers of its affiliates. tions of section 215.4 of Regulation O (manual
A member bank may not extend credit to any section 2050.0.3.3),
of its executive officers, and no executive officer (3) preceded by the submission of a current
of a member bank can borrow from or otherwise detailed financial statement of the executive
become indebted to the bank, except in the officer, and
amounts, for the purposes, and upon the condi- (4) made subject to the condition in writing
tions specified in items 3 and 4 below. that the extension of credit will, at the option of
A member bank is authorized to extend credit the member bank, become due and payable at
to any executive officer of the bank any time that the officer is indebted to any other
(1) in any amount to finance the education of bank or banks in an aggregate amount greater
the executive officers children; than the amount specified for a category of
(2) in any amount to finance or refinance credit that may be made available by a member
the purchase, construction, maintenance, or bank to any of its executive officers.
improvement of a residence of the executive No member bank may extend credit in an
officer, provided aggregate amount greater than the amount per-
(i) the extension of credit is secured by a mitted for general-purpose loans to an executive
first lien on the residence and the residence is officer (section 215.5(c)(4) of Regulation O) to
a partnership in which one or more of the banks
member bank of an overdraft of a principal shareholder of the executive officers are partners and, either indi-
member bank, unless the principal shareholder is also an
executive officer or director. This prohibition also does not vidually or together, hold a majority interest.
apply to the payment by a member bank of an overdraft of a The total amount of credit extended by a mem-
related interest of an executive officer, director, or principal ber bank to such partnership is considered to be
shareholder of the member bank. extended to each executive officer of the mem-
11. The requirement that the member bank charge the
executive officer or director the same fee charged any other ber bank who is a member of the partnership.
customer of the bank in similar circumstances does not pro- Prohibition on knowingly receiving unautho-
hibit the member bank from charging a fee provided for in a rized extensions of credit. Insiders are prohib-
benefit or compensation program that satisfies the require-
ments detailed in section 2050.0.3.3, item (a). ited from knowingly receiving (or permitting
their related interests to receive) any extensions
BHC Supervision Manual January 2007 of credit not authorized by section 22(h) of the
Page 10 Federal Reserve Act and by Regulation O.
2050.0.3.5 Grandfathering Provisions the outstanding amount of any credit that was
extended to the executive officer or director that
(a) Under FDICIA. FDICIA provided that is secured by shares of the member bank. (See
the amendments to Regulation O would not also Regulation Y section 225.4(f) for the iden-
affect extensions of credit entered into on or tical restriction on executive officers and direc-
before the effective date of the regulation. tors of a bank holding company with loans
Therefore, extensions of credit, including lines secured by shares of the bank holding company.)
of credit, made on or before May 18, 1992,
are not required to comply with either the
individual-borrower limit made applicable to 2050.0.3.7 Report on Credit
directors and their related interests, or with the to Executive Officers
aggregate limit on all loans to insiders. All
extensions of credit, loan renewals, and loan Each member bank must include with (but not
rollovers made after May 18, 1992, must com- as part of) each report of condition (and copy
ply with all of the provisions of Regulation O. thereof) filed pursuant to 12 U.S.C. 1817(a)(3) a
In other words, banks cannot make new loans or report of all extensions of credit made by the
renew outstanding extensions of credit in member bank to its executive officers since the
amounts that, when aggregated with all other date of the banks previous report of condition.
outstanding loans to insiders, would exceed
either of the new limits.
(b) Extensions of credit outstanding on 2050.0.3.8 Disclosure of Credit from
March 10, 1979. Any extension of credit that Member Banks to Executive Officers and
was outstanding on March 10, 1979, and that Principal Shareholders
would have, if made on or after March 10, 1979,
violated the individual lending limit, had to be (a) Definitions. For the purposes of this sec-
reduced in amount by March 10, 1980, to be in tion, the following definitions apply:
compliance with the aggregate lending limit of (1) Principal shareholder of a member
Regulation O. Any renewal or extension of such bank means a person (individual or a com-
a credit extension on or after March 10, 1979, pany), other than an insured bank, or branch or
must have been made only on terms that would representative office of a foreign bank as defined
have brought it into compliance with the aggre- in 12 U.S.C. 3101(7)12 that, directly or indi-
gate lending limit by March 10, 1980. However, rectly, or acting through or in concert with one
any extension of credit made before March 10, or more persons, owns, controls, or has power to
1979, that bears a specific maturity date of vote more than 10 percent of any class of voting
March 10, 1980, or later, had to be repaid in securities of the member bank or company. The
accordance with the repayment schedule in term includes an individual or company that
existence on or before March 10, 1979. controls a principal shareholder (for example, a
person that controls a bank holding company).
Shares of a bank (including a foreign bank),
2050.0.3.6 Reports by Executive Officers bank holding company, or other company
owned or controlled by a member of an indi-
Each executive officer of a member bank who viduals immediate family are considered to be
becomes indebted to any other bank or banks in held or controlled by the individual for the
an aggregate amount greater than the amount purposes of determining principal shareholder
specified for a category of credit in section status.13
215.5(c) of Regulation O (manual section
2050.0.3.4) must make a written report to the 12. A foreign bank means any company organized under
board of directors of the officers bank within the laws of a foreign country, a territory of the United States,
10 days of the date the indebtedness reaches Puerto Rico, Guam, American Samoa, or the Virgin Islands
that engages in the business of banking, or any subsidiary or
such a level. The report must state the lenders affiliate, organized under such laws, of any such company.
name, the date and amount of each extension of This includes foreign commercial banks, foreign merchant
credit, any security for it, and the purposes for banks, and other foreign institutions that engage in banking
which the proceeds have been or are to be used. activities usual in connection with the business of banking in
the countries where such foreign institutions are organized or
Report on credit secured by BHC stock. In operating.
addition to the report required above, each 13. See footnote 3.
executive officer or director of a member bank
the shares of which are not publicly traded must BHC Supervision Manual January 2007
report annually to the banks board of directors Page 11
(2) Related interest means (i) any com- 2050.0.3.10 Records of Member Banks
pany controlled by a person; or (ii) any political (and BHCs)
or campaign committee the funds or services of
which will benefit a person or that is controlled To help inspection and examination personnel
by a person. A related interest does not include identify BHC officials, Regulation O requires
a bank or a foreign bank (as defined in 12 U.S.C. each member bank to maintain records neces-
3101(7)). sary to monitor compliance with this regulation.
(b) Public disclosure. Upon receipt of a writ- BHCs and nonbank subsidiaries should be
ten request from the public, a member bank given access to the records identifying bank
shall make available the names of each of its officials. Each state member bank is required
executive officers (with the exception of any to (1) identify, through an annual survey, all
executive officer of a bank holding company of insiders of the bank itself; and (2) maintain
which the member bank is a subsidiary or of any records of all extensions of credit to insiders of
other subsidiary of that bank holding company the bank itself, including the amount and terms
unless the executive officer is also an executive of each such extension of credit.
officer of the member bank) and each of its
principal shareholders to whom, or to whose
related interests, the member bank had outstand- 2050.0.3.10.1 Recordkeeping for Insiders
ing at the end of the latest previous quarter of of the Member Banks Affiliates
the year, an extension of credit that, when aggre-
gated with all other outstanding extensions of A member bank is required to maintain records
credit at that time from the member bank to of extensions of credit to insiders of the member
such person and to all related interests of such banks affiliates by
person, equaled or exceeded 5 percent of the (1) a survey method, which identifies,
member banks capital and unimpaired surplus through an annual survey, each of the insiders of
or $500,000, whichever amount is less. No dis- the member banks affiliates. Under the survey
closure under this paragraph is required if the method, the member bank must maintain
aggregate amount of all extensions of credit records of the amount and terms of each exten-
outstanding at that time from the member bank sion of credit by the member bank to such
to the executive officer or principal shareholder insiders or
of the member bank and to all related interests (2) a borrower inquiry method, which
of such a person does not exceed $25,000. requires, as part of each extension of credit, the
A member bank is not required to disclose borrower to indicate whether the borrower is an
the specific amounts of individual extensions of insider of an affiliate of the member bank.
credit. Under this method, the member bank must
maintain records that identify the amount and
(c) Maintaining records. Each member bank terms of each extension of credit by the member
is required to maintain records of all requests bank to borrowers so identifying themselves.
for the information described above and the
disposition of the requests. These records may Alternative recordkeeping method for insid-
be disposed of two years after the date of the ers of affiliates. A member bank may use a
request. recordkeeping method other than those identi-
fied above if the appropriate federal banking
agency determines that the banks method is at
least as effective.
2050.0.3.9 Civil Penalties of
Regulation O
2050.0.3.10.2 Special Rule for
Any member bank, or any officer, director, Noncommercial Lenders
employee, agent, or other person participating in
the conduct of the affairs of the bank, that A member bank that is prohibited by law or by
violates any provision of Regulation O is sub- an express resolution of the banks board of
ject to a civil penalty, as specified in section 29 directors from making an extension of credit to
of the Federal Reserve Act. any company, or other entity that is covered by
Regulation O as a company, is not required to
maintain any records of the related interests of
BHC Supervision Manual January 2007 the insiders of the bank or its affiliates. The
Page 12 bank is also not required to inquire of borrowers
whether they are related interests of the insiders 5. To determine that the BHC has arranged to
of the bank or its affiliates. make available, upon request, a listing or
some other form of information sufficient to
identify all BHC officials and to make
2050.0.3.11 Section 23A Ramifications certain that such information is available to
the bank subsidiaries in particular.
Loans to a holding company parent and its
affiliates are governed by section 23A of the
Federal Reserve Act and are not subject to
Regulation O. 2050.0.6 INSPECTION PROCEDURES
1. Review the balance sheets and other records

2050.0.4 REMEDIAL ACTION of the parent-only and nonbank subsidiaries
to determine if there are any loans or other
Self-serving and abusive transactions deprive a extensions of credit to BHC officials.
BHC of opportunities and benefits that may 2. Review the income statements and support-
otherwise have been available and may strip a ing records of the parent-only and nonbank
BHC of its ability to serve as a source of finan- subsidiaries to determine if any interest
cial and managerial strength to its subsidiary income, other income, or expense is associ-
banks. Even if not extended on preferential ated with a transaction with a BHC official or
terms, self-serving loans and other extensions of a related interest.
credit to insiders may be an imprudent business 3. Ask management to identify all such
practice and may reduce the lenders liquidity or transactions and to provide supporting
otherwise overextend the BHC. In such situa- documentation.
tions, formal or informal remedial measures by 4. Review managements familiarity with
the Federal Reserve may be necessary. Formal Regulation Os limitations and the steps they
enforcement action is provided for in the 1974 have taken to establish policies for the inter-
amendments to the Financial Institutions Super- nal administration of their subsidiary banks
visory Act of 1966 (12 U.S.C. 1818), which extensions of credit to BHC officials.
grant the Board authority to issue cease-and- 5. Review any information prepared by man-
desist orders in appropriate situations. For com- agement that presents a listing of all BHC
plete details on formal corrective actions, see officials and their related interests.
section 2110.0. 6. Review any corporate resolutions declaring
an individual not to be an executive officer
for purposes of Regulation O and, if neces-
2050.0.5 INSPECTION OBJECTIVES sary, confirm the individuals nonparticipa-
tion in the formulation of corporate policy.
1. To determine if any transactions between 7. As the provision of Regulation O apply to
BHC officials, their related interests, and the the BHC and its subsidiaries, determine if
BHC or its nonbank subsidiaries are based the BHC provides employees or other insid-
on preferential treatment. ers with extensions of credit, including BHC-
2. To determine if any transactions between owned or BHC-issued credit cards. Find out
BHC officials, their related interests, and the if any of the credit cards are used to conduct
BHC or its nonbank subsidiaries result in the BHCs business.
any undue loss exposure to the BHC or its a. Verify that the BHC has a written policy
subsidiaries. that forbids or discourages an employee
3. To determine if any BHC or nonbank or other insider from using a BHC-owned
extension of credit to a BHC official or or BHC-issued credit card for the insid-
related interest is in the spirit of Regulation ers personal purposes and that the policy
Os requirements or whether it is an attempt obligates the insider to promptly make
to circumvent Regulation Os prohibition on reimbursement to the BHC.
various bank extensions of credit to similar b. Determine the BHCs compliance with
parties. Regulation O regarding its extensions of
4. To determine that BHC officials are aware of credit (including BHC-owned or BHC-
Regulation Os limitations and prohibitions issued credit card loans) to insiders.
and have established internal policies and
procedures for the bank subsidiaries to BHC Supervision Manual July 2007
ensure compliance by the banks. Page 13
Verify that the BHC monitors the amount or use BHC-owned or BHC-issued
of personal charges outstanding on its credit cards for personal purposes, to
BHC-owned or BHC-issued credit cards meet the BHCs normal credit under-
that are held by insiders so that the out- writing standards and
standing charges, when aggregated with the BHC has verified that the insiders
all of an insiders other indebtedness extensions of credit (or BHC-owned
owed to the BHC, do not exceed $15,000. or BHC-issued credit cards) do not
c. Verify the BHCs compliance with the have more preferential terms (for
market-terms requirement of Regulation example, a lower interest rate or a
O. Determine if longer repayment period) than the con-
the BHC requires employees and other sumer credit cards offered by the BHC.
insiders who have extensions of credit,
Loans and extensions 375a and 215.4

of credit to executive 375b 215.5
officers, directors, and (sections 22(g) (Reg. O)
principal shareholders and 22(h) of
F.R. Act)
Granting of below- 1972(2) 4514

market interest rate 31094
mortgage loans to
executives of BHC
subsidiaries as
compensation
Restrictions on 1972 (2)

loans to insiders
of a bank or its
correspondent
bank
Board staff interpretation 31081.5

on the use of bank-
owned or bank-issued
credit cards by bank
insiders

Page 14
Management Information Systems
(General) Section 2060.0
Management Information Systems refers to the tives and procedures to be used by Federal
policies and operating procedures, including Reserve Bank examiners when conducting
systems of internal control, that the board of inspections of bank holding companies.
directors of a bank holding company initiates to
monitor and ensure control of its operations and See 2060.05 Internal Audit Function
activities, while maintaining and improving the and Its Outsourcing
financial strength and objectives of the overall 2060.1 Audit
organization. These policies should focus on the 2060.2 Budget
overall organizational structure with respect to 2060.3 Records and Statements
identifying, monitoring, and managing risks. 2060.4 Reporting
Subsequent sections of the manual focus on the 2060.5 Insurance
essential elements of various management infor- 5052.0 Targeted MIS Inspection
mation systems. Included are inspection objec-

Page 1
Policy Statement on the Internal Audit Function and Its
Outsourcing (Management Information Systems) Section 2060.05
WHATS NEW IN THIS REVISED the system of internal control so that manage-
SECTION ment can take prompt, remedial action. The
federal banking agencies 3 (agencies) long-
Effective January 2014, this section was revised standing inspection policies call for examiners
to include new and revised inspection objectives to review an institutions internal audit function
and inspection procedures for both the 2003 and recommend improvements, if needed. In
interagency guidance, Policy Statement on the addition, pursuant to section 39 of the Federal
Internal Audit Function and its Outsourcing, Deposit Insurance Act (FDI Act) (12 U.S.C.
and the January 23, 2013, Federal Reserve 1831p-1), the agencies have adopted Inter-
Supplemental Policy Statement on Internal agency Guidelines Establishing Standards for
Audit Function and its Outsourcing. Refer to Safety and Soundness that apply to insured
SR-03-5 and SR 13-1/CA 13-1 and Manual sec- depository institutions.4 Under these guidelines
tion 2060.07. and policies, each institution should have an
internal audit function that is appropriate to its
size and the nature and scope of its activities.
2060.05.01 AN EFFECTIVE SYSTEM In addressing various quality and resource
OF INTERNAL CONTROLS issues, many institutions have been engaging
independent public accounting firms and other
Effective internal control1 is a foundation for the outside professionals (outsourcing vendors) in
safe and sound operation of a financial institu- recent years to perform work that traditionally
tion (institution).2 The board of directors and has been done by internal auditors. These
senior management of an institution are respon- arrangements are often called internal audit
sible for ensuring that the system of internal outsourcing, internal audit assistance, audit
control operates effectively. Their responsibility co-sourcing, and extended audit services
cannot be delegated to others within the institu- (hereafter, collectively referred to as outsourc-
tion or to outside parties. An important element ing). Typical outsourcing arrangements are
in assessing the effectiveness of the internal more fully illustrated in part II below.
control system is an internal audit function. Outsourcing may be beneficial to an institu-
When properly structured and conducted, inter- tion if it is properly structured, carefully con-
nal audit provides directors and senior manage- ducted, and prudently managed. However, the
ment with vital information about weaknesses in agencies have concerns that the structure, scope,
and management of some internal audit out-
1. In summary, internal control is a process designed to sourcing arrangements do not contribute to the
provide reasonable assurance that the institution will achieve
the following internal control objectives: efficient and effec-
institutions safety and soundness. Furthermore,
tive operations, including safeguarding of assets; reliable the agencies want to ensure that these arrange-
financial reporting; and compliance with applicable laws and ments with outsourcing vendors do not leave
regulations. Internal control consists of five components that directors and senior management with the erro-
are a part of the management process: control environment,
risk assessment, control activities, information and communi-
neous impression that they have been relieved
cation, and monitoring activities. The effective functioning of of their responsibility for maintaining an effec-
these components, which is brought about by an institutions tive system of internal control and for oversee-
board of directors, management, and other personnel, is essen- ing the internal audit function.
tial to achieving the internal control objectives. This descrip-
tion of internal control is consistent with the Committee of
The Sarbanes-Oxley Act of 2002 (the act)
Sponsoring Organizations of the Treadway Commission became law on July 30, 2002.5 The act addresses
(COSO) report Internal ControlIntegrated Framework. In weaknesses in corporate governance and the
addition, under the COSO framework, financial reporting is
defined in terms of published financial statements, which, for 3. The Board of Governors of the Federal Reserve System
purposes of this policy statement, encompass both financial (FRS), Federal Deposit Insurance Corporation (FDIC), Office
statements prepared in accordance with generally accepted of the Comptroller of the Currency (OCC), and Office of
accounting principles and regulatory reports (such as the Thrift Supervision (OTS).
Reports of Condition and Income). Institutions are encour- 4. For national banks, appendix A to part 30; for state
aged to evaluate their internal control against the COSO member banks, appendix D-1 to part 208; for insured state
framework. nonmember banks and insured state-licensed branches of for-
2. The term institution includes depository institutions eign banks, appendix A to part 364; for savings associations,
insured by the Federal Deposit Insurance Corporation (FDIC), appendix A to part 570.
U.S. financial holding companies and bank holding companies 5. Pub. L. No. 107-204.
supervised by the Federal Reserve System, thrift holding
companies supervised by the Office of Thrift Supervision
(OTS), and the U.S. operations of foreign banking BHC Supervision Manual January 2014
organizations. Page 1
Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05
accounting and auditing professions, and governance and auditing matters. This review
includes provisions addressing audits, financial should ensure that such policies and procedures
reporting and disclosure, conflicts of interest, are consistent with applicable law, regulations,
and corporate governance at publicly owned and supervisory guidance and remain appropri-
companies. The act, among other things, ate in light of the organizations size, opera-
requires public companies to have an audit com- tions, and resources. Furthermore, the agencies
mittee composed entirely of independent direc- stated that a banking organizations policies and
tors. Public banking organizations that are listed procedures for corporate governance, internal
on the New York Stock Exchange (NYSE) and controls, and auditing will be assessed during
Nasdaq must also comply with those exchanges the supervisory process, and the agencies may
listing requirements, which include audit com- take appropriate supervisory action if there
mittee requirements. are deficiencies or weaknesses in these areas
The act also established a Public Company that are inconsistent with sound corporate-
Accounting Oversight Board (PCAOB) that has governance practices or safety-and-soundness
the authority to set and enforce auditing, attesta- considerations.
tion, quality control, and ethics (including inde-
pendence) standards for auditors of public com-
panies, subject to SEC review. (See SR-02-20.)
Accounting firms that conduct audits of public 2060.05.06 INTERAGENCY POLICY
companies (i.e., registered accounting firms) STATEMENT ON THE INTERNAL
must register with the PCAOB and be subject to AUDIT FUNCTION AND ITS
its supervision. The PCAOB is also empowered OUTSOURCING
to inspect the auditing operations of public
accounting firms that audit public companies, as
The Federal Reserve and other federal banking
well as impose disciplinary and remedial sanc-
agencies 6 adopted on March 17, 2003, an inter-
tions for violations of its rules, securities laws,
agency policy statement addressing the internal
and professional auditing and accounting
audit function and its outsourcing (See SR
standards.
03-5). The policy statement revises and replaces
the former 1997 policy statement and incorpo-
rates recent developments in internal auditing.
[Sections 2060.05.022060.05.04 are In addition, the revised policy incorporates guid-
reserved.] ance on the independence of accountants who
provide institutions with both internal and exter-
nal audit services in light of the Sarbanes-Oxley
2060.05.05 APPLICATION OF THE Act of 2002 and associated SEC rules. (See also
SARBANES-OXLEY ACT TO sections 2124.0.2.4, 2060.1, 3230.0.10.2.5,
NONPUBLIC BANKING 5010.7, and 5030.0 [page 7] pertaining to inter-
ORGANIZATIONS nal and external audits.)
In May 2003, the Federal Reserve, the Office of The act prohibits an accounting firm from
the Comptroller of the Currency, and the Office acting as the external auditor of a public com-
of Thrift Supervision announced that they did pany during the same period that the firm pro-
not expect to take actions to apply the corporate- vides internal audit services to the company.
governance and other requirements of the The policy statement discusses the applicability
Sarbanes-Oxley Act generally to nonpublic of this prohibition to institutions that are public
banking organizations that are not otherwise companies, insured depository institutions with
subject to them. 5a (See SR-03-08.) The agen- assets of $500 million or more that are subject
cies, however, encouraged nonpublic banking to the annual audit and reporting requirements
organizations to periodically review their poli- of section 36 of the Federal Deposit Insurance
cies and procedures relating to corporate- Act, and also nonpublic institutions that are not
subject to section 36.
5a. As discussed below, some aspects of the auditor-
independence rules established by the Sarbanes-Oxley Act
apply to all federally insured depository institutions with $500
million or more in total assets. See part 363 of the FDICs
regulations.

Page 2 6. The FDIC, OCC, and OTS.
2060.05.1 INTERNAL AUDIT controls tested and evaluated by units without

FUNCTION (PART I) business-line responsibilities, such as internal
audit groups.
2060.05.1.1 Director and Senior Directors should be confident that the internal
Management Responsibilities for Internal audit function addresses the risks and meets the
Audit demands posed by the institutions current and
planned activities. To accomplish this objective,
The board of directors and senior management
directors should consider whether their institu-
are responsible for having an effective system of
tions internal audit activities are conducted in
internal control and an effective internal audit
accordance with professional standards, such as
function in place at their institution. They are
the Institute of Internal Auditors (IIA) Stan-
also responsible for ensuring that the impor-
dards for the Professional Practice of Internal
tance of internal control is understood and
Auditing. These standards address indepen-
respected throughout the institution. This over-
dence, professional proficiency, scope of work,
all responsibility cannot be delegated to anyone
performance of audit work, management of
else. They may, however, delegate the design,
internal audit, and quality-assurance reviews.
implementation, and monitoring of specific
Furthermore, directors and senior management
internal controls to lower-level management and
should ensure that the following matters are
the testing and assessment of internal controls to
reflected in their institutions internal audit
others. Accordingly, directors and senior man-
function.
agement should have reasonable assurance that
the system of internal control prevents or detects
significant inaccurate, incomplete, or unautho-
rized transactions; deficiencies in the safeguard- 2060.05.1.1.1 Internal Audit Placement
ing of assets; unreliable financial reporting and Structure Within the Organization
(which includes regulatory reporting); and
Careful thought should be given to the place-
deviations from laws, regulations, and the insti-
ment of the audit function in the institutions
tutions policies.7
management structure. The internal audit func-
Some institutions have chosen to rely on
tion should be positioned so that the board has
so-called management self-assessments or con-
confidence that the internal audit function will
trol self-assessments, wherein business-line
perform its duties with impartiality and not be
managers and their staff evaluate the perfor-
unduly influenced by managers of day-to-day
mance of internal controls within their purview.
operations. The audit committee,8 using objec-
Such reviews help to underscore managements
tive criteria it has established, should oversee
responsibility for internal control, but they are
the internal audit function and evaluate its per-
not impartial. Directors and members of senior
management who rely too much on these
reviews may not learn of control weaknesses 8. Depository institutions subject to section 36 of the FDI
until they have become costly problems, particu- Act and part 363 of the FDICs regulations must maintain an
larly if directors are not intimately familiar with independent audit committee (i.e., consisting of directors who
are not members of management). For institutions with
the institutions operations. Therefore, institu- between $500 million and $1 billion in assets, only a majority,
tions generally should also have their internal rather than all, of the members of the audit committeewho
must be outside directorsmust be independent of manage-
ment. For insured institutions having total assets of more than
7. As noted above, under section 36 of the FDI Act, as
$3 billion, the audit committee must (1) have members with
implemented by part 363 of the FDICs regulations (12 C.F.R.
banking or related financial management expertise, (2) have
363), FDIC-insured depository institutions with total assets of
access to outside legal counsel, and (3) not include any large
$500 million or more must submit an annual management
customers of the institution. The audit committee also may be
report signed by the chief executive officer (CEO) and chief
required to satisfy other audit committee membership criteria
accounting or chief financial officer. This report must contain
(see 12 U.S.C. 831m(g)(1)(c) and section 363.5(b)(12 C.F.R.
the following: (1) a statement of managements responsibili-
363.5(b)). Consistent with the 1999 Interagency Policy State-
ties for preparing the institutions annual financial statements,
ment on External Auditing Programs of Banks and Savings
for establishing and maintaining an adequate internal control
Associations, the agencies also encourage the board of direc-
structure and procedures for financial reporting, and for com-
tors of each depository institution that is not otherwise
plying with designated laws and regulations relating to safety
required to do so to establish an audit committee consisting
and soundness, including managements assessment of the
entirely of outside directors. Where the term audit commit-
institutions compliance with those laws and regulations; and
tee is used in this policy statement, the board of directors
(2) for an institution with total assets of $1 billion or more at
may fulfill the audit committee responsibilities if the institu-
the beginning of the institutions most recent fiscal year, the
tion is not subject to an audit committee requirement.
report should include an assessment by management of the
effectiveness of such internal control structure and procedures
as of the end of such fiscal year. (See 12 C.F.R. 363.2(b) and BHC Supervision Manual July 2008
70 Fed. Reg. 71,232, November 28, 2005.) Page 3
formance.9 The audit committee should assign these monitoring functions, better use available
responsibility for the internal audit function to a resources, and enhance the institutions ability
member of management (that is, the manager of to comprehensively manage risk. Such an
internal audit or internal audit manager) who administrative reporting relationship should be
understands the function and has no responsibil- designed so as to not interfere with or hinder the
ity for operating the system of internal control. manager of internal audits functional reporting
The ideal organizational arrangement is for this to and ability to directly communicate with the
manager to report directly and solely to the institutions audit committee. In addition, the
audit committee regarding both audit issues and audit committee should ensure that efforts to
administrative matters (e.g., resources, budget, coordinate these monitoring functions do not
appraisals, and compensation). Institutions are result in the manager of internal audit conduct-
encouraged to consider the IIAs Practice Advi- ing control activities nor diminish his
sory 2060-2: Relationship with the Audit Com- or her independence with respect to the other
mittee, which provides more guidance on the risk-monitoring functions. Furthermore, the
roles and relationships between the audit com- internal audit manager should have the ability to
mittee and the internal audit manager. independently audit these other monitoring
Many institutions place the manager of inter- functions.
nal audit under a dual reporting arrangement: In structuring the reporting hierarchy, the
functionally accountable to the audit committee board should weigh the risk of diminished inde-
on issues discovered by the internal audit func- pendence against the benefit of reduced admin-
tion, while reporting to another senior manager istrative burden in adopting a dual reporting
on administrative matters. Under a dual report- organizational structure. The audit committee
ing relationship, the board should consider the should document its consideration of this risk
potential for diminished objectivity on the part and mitigating controls. The IIAs Practice
of the internal audit manager with respect to Advisory 1110-2: Chief Audit Executive Report-
audits concerning the executive to whom he or ing Lines provides additional guidance regard-
she reports. For example, a manager of internal ing functional and administrative reporting
audit who reports to the chief financial officer lines.
(CFO) for performance appraisal, salary, and
approval of department budgets may approach 2060.05.1.1.2 Internal Audit
audits of the accounting and treasury operations Management, Staffing, and Audit Quality
controlled by the CFO with less objectivity than
if the manager were to report to the chief execu- In managing the internal audit function, the
tive officer. Thus, the chief financial officer, manager of internal audit is responsible for con-
controller, or other similar officer should ideally trol risk assessments, audit plans, audit pro-
be excluded from overseeing the internal audit grams, and audit reports.
activities even in a dual role. The objectivity
and organizational stature of the internal audit 1. A control risk assessment (or risk-assessment
function are best served under such a dual methodology) documents the internal audi-
arrangement if the internal audit manager tors understanding of the institutions sig-
reports administratively to the CEO. nificant business activities and their associ-
Some institutions seek to coordinate the inter- ated risks. These assessments typically
nal audit function with several risk-monitoring analyze the risks inherent in a given business
functions (for example, loan review, market-risk line, the mitigating control processes, and the
assessment, and legal compliance departments) resulting residual risk exposure of the institu-
by establishing an administrative arrangement tion. They should be updated regularly to
under one senior executive. Coordination of reflect changes to the system of internal con-
these other monitoring activities with the inter- trol or work processes and to incorporate
nal audit function can facilitate the reporting of new lines of business.
material risk and control issues to the audit 2. An internal audit plan is based on the control
committee, increase the overall effectiveness of risk assessment and typically includes a sum-
mary of key internal controls within each
9. For example, the performance criteria could include the
significant business activity, the timing and
timeliness of each completed audit, comparison of overall frequency of planned internal audit work,
performance to plan, and other measures. and a resource budget.
3. An internal audit program describes the
BHC Supervision Manual July 2008 objectives of the audit work and lists the
Page 4
procedures that will be performed during 2060.05.1.1.3 Internal Audit Frequency

each internal audit review. and Scope
4. An audit report generally presents the pur-
pose, scope, and results of the audit, includ- The frequency and extent of internal audit
ing findings, conclusions, and recommenda- review and testing should be consistent with the
tions. Workpapers that document the work nature, complexity, and risk of the institutions
performed and support the audit report on- and off-balance-sheet activities. At least
should be maintained. annually, the audit committee should review and
approve internal audits control risk assessment
Ideally, the internal audit functions only role and the scope of the audit plan, including how
should be to independently and objectively much the manager relies on the work of an
evaluate and report on the effectiveness of an outsourcing vendor. It should also periodically
institutions risk-management, control, and gov- review internal audits adherence to the audit
ernance processes. Internal auditors increas- plan. The audit committee should consider
ingly have taken a consulting role within institu- requests for expansion of basic internal audit
tions on new products and services and on work when significant issues arise or when sig-
mergers, acquisitions, and other corporate reor- nificant changes occur in the institutions envi-
ganizations. This role typically includes helping ronment, structure, activities, risk exposures, or
design controls and participating in the imple- systems.10
mentation of changes to the institutions control
activities. The audit committee, in its oversight
of the internal audit staff, should ensure that the 2060.05.1.1.4 Communication of Internal
functions consulting activities do not interfere Audit Findings to the Directors, Audit
or conflict with the objectivity it should have Committee, and Management
with respect to monitoring the institutions sys-
tem of internal control. In order to maintain its To properly carry out their responsibility for
independence, the internal audit function should internal control, directors and senior manage-
not assume a business-line management role ment should foster forthright communications
over control activities, such as approving or and critical inspection of issues to better under-
implementing operating policies or procedures, stand the importance and severity of internal
including those it has helped design in connec- control weaknesses identified by the internal
tion with its consulting activities. The agencies auditor and operating managements solutions
encourage internal auditors to follow the IIAs
standards, including guidance related to the
internal audit function acting in an advisory
capacity.
The internal audit function should be compe-
tently supervised and staffed by people with
sufficient expertise and resources to identify the
risks inherent in the institutions operations and
assess whether internal controls are effective.
The manager of internal audit should oversee
the staff assigned to perform the internal audit
work and should establish policies and proce-
dures to guide the audit staff. The form and
content of these policies and procedures should
be consistent with the size and complexity of
10. Major changes in an institutions environment and
the department and the institution. Many poli- conditions may compel changes to the internal control system
cies and procedures may be communicated and also warrant additional internal audit work. These include
informally in small internal audit departments, (1) new management; (2) areas or activities experiencing
while larger departments would normally rapid growth or rapid decline; (3) new lines of business,
products, or technologies or disposals thereof; (4) corporate
require more formal and comprehensive written restructurings, mergers, and acquisitions; and (5) expansion
guidance. or acquisition of foreign operations (including the impact
of changes in the related economic and regulatory
environments).

Page 4.1
to these weaknesses. Internal auditors should 2060.05.1.3 Internal Audit Systems and
report internal control deficiencies to the appro- the Audit Function for Small Financial
priate level of management as soon as they are Institutions
identified. Significant matters should be
promptly reported directly to the board of direc- An effective system of internal control and an
tors (or its audit committee) and senior manage- independent internal audit function form the
ment. In periodic meetings with management foundation for safe and sound operations,
and the manager of internal audit, the audit regardless of an institutions size. Each institu-
committee should assess whether management tion should have an internal audit function that
is expeditiously resolving internal control weak- is appropriate to its size and the nature and
nesses and other exceptions. Moreover, the audit scope of its activities. The procedures assigned
committee should give the manager of internal to this function should include adequate testing
audit the opportunity to discuss his or her find- and review of internal controls and information
ings without management being present. systems.
Furthermore, each audit committee should It is the responsibility of the audit committee
establish and maintain procedures for employ- and management to carefully consider the extent
ees of their institution to submit confidentially of auditing that will effectively monitor the
and anonymously concerns to the committee internal control system after taking into account
about questionable accounting, internal account- the internal audit functions costs and benefits.
ing control, or auditing matters.11 In addition, For institutions that are large or have complex
the audit committee should set up procedures operations, the benefits derived from a full-time
for the timely investigation of complaints manager of internal audit or an auditing staff
received and the retention for a reasonable time likely outweigh the cost. For small institutions
period of documentation concerning the com- with few employees and less complex opera-
plaint and its subsequent resolution. tions, however, these costs may outweigh the
benefits. Nevertheless, a small institution with-
out an internal auditor can ensure that it main-
2060.05.1.1.5 Contingency Planning tains an objective internal audit function by
As with any other function, the institution implementing a comprehensive set of indepen-
should have a contingency plan to mitigate any dent reviews of significant internal controls. The
significant discontinuity in audit coverage, par- key characteristic of such reviews is that the
ticularly for high-risk areas. Lack of contin- person(s) directing and/or performing the review
gency planning for continuing internal audit of internal controls is not also responsible for
coverage may increase the institutions level of managing or operating those controls. A person
operational risk. who is competent in evaluating a system of
internal control should design the review proce-
dures and arrange for their implementation. The
2060.05.1.2 U.S. Operations of Foreign person responsible for reviewing the system of
Banking Organizations internal control should report findings directly
to the audit committee. The audit committee
The internal audit function of a foreign banking should evaluate the findings and ensure that
organization (FBO) should cover its U.S. opera- senior management has or will take appropriate
tions in its risk assessments, audit plans, and action to correct the control deficiencies.
audit programs. Its U.S.-domiciled audit func-
tion, head-office internal audit staff, or some
combination thereof normally performs the
internal audit of the U.S. operations. Internal 2060.05.2 INTERNAL AUDIT
audit findings (including internal control defi- OUTSOURCING ARRANGEMENTS
ciencies) should be reported to the senior man- (PART II)
agement of the U.S. operations of the FBO and 2060.05.2.1 Examples of Internal Audit
the audit department of the head office. Signifi- Outsourcing Arrangements
cant adverse findings also should be reported to
the head offices senior management and the An outsourcing arrangement is a contract
board of directors or its audit committee. between an institution and an outsourcing ven-
dor to provide internal audit services. Outsourc-
11. Where the board of directors fulfills the audit commit-
tee responsibilities, the procedures should provide for the BHC Supervision Manual June 2003
submission of employee concerns to an outside director. Page 5
ing arrangements take many forms and are used fully consider its current and anticipated busi-
by institutions of all sizes. Some institutions ness risks in setting each partys internal audit
consider entering into these arrangements to responsibilities. The outsourcing arrangement
enhance the quality of their control environment should not increase the risk that a breakdown of
by obtaining the services of a vendor with the internal control will go undetected.
knowledge and skills to critically assess, and To clearly distinguish its duties from those of
recommend improvements to, their internal con- the outsourcing vendor, the institution should
trol systems. The internal audit services under have a written contract, often taking the form of
contract can be limited to helping internal audit an engagement letter.12 Contracts between the
staff in an assignment for which they lack exper- institution and the vendor typically include pro-
tise. Such an arrangement is typically under the visions that
control of the institutions manager of internal
audit, and the outsourcing vendor reports to him 1. define the expectations and responsibilities
or her. Institutions often use outsourcing ven- under the contract for both parties;
dors for audits of areas requiring more technical 2. set the scope and frequency of, and the fees
expertise, such as electronic data processing and to be paid for, the work to be performed by
capital-markets activities. Such uses are often the vendor;
referred to as internal audit assistance or 3. set the responsibilities for providing and
audit co-sourcing. receiving information, such as the type and
Some outsourcing arrangements may require frequency of reporting to senior manage-
an outsourcing vendor to perform virtually all ment and directors about the status of con-
the procedures or tests of the system of internal tract work;
control. Under such an arrangement, a desig- 4. establish the process for changing the terms
nated manager of internal audit oversees the of the service contract, especially for expan-
activities of the outsourcing vendor and typi- sion of audit work if significant issues are
cally is supported by internal audit staff. The found, and stipulations for default and ter-
outsourcing vendor may assist the audit staff in mination of the contract;
determining risks to be reviewed and may rec- 5. state that internal audit reports are the prop-
ommend testing procedures, but the internal erty of the institution, that the institution
audit manager is responsible for approving the will be provided with any copies of the
audit scope, plan, and procedures to be per- related workpapers it deems necessary, and
formed. Furthermore, the internal audit manager that employees authorized by the institution
is responsible for the results of the outsourced will have reasonable and timely access to
audit work, including findings, conclusions, and the workpapers prepared by the outsourcing
recommendations. The outsourcing vendor may vendor;
report these results jointly with the internal audit 6. specify the locations of internal audit
manager to the audit committee. reports and the related workpapers;
7. specify the period of time (for example,
seven years) that vendors must maintain the
2060.05.2.2 Additional Inspection and workpapers;13
Examination Considerations for Internal 8. state that outsourced internal audit services
Audit Outsourcing Arrangements provided by the vendor are subject to regu-
latory review and that examiners will be
Even when outsourcing vendors provide inter- granted full and timely access to the inter-
nal audit services, the board of directors and nal audit reports and related workpapers
senior management of an institution are respon- prepared by the outsourcing vendor;
sible for ensuring that both the system of inter-
nal control and the internal audit function oper- 12. The engagement letter provisions described are compa-
ate effectively. In any outsourced internal audit rable to those outlined by the American Institute of Certified
arrangement, the institutions board of directors Public Accountants (AICPA) for financial statement audits
(see AICPA Professional Standards, AU section 310). These
and senior management must maintain owner- provisions are consistent with the provisions customarily
ship of the internal audit function and provide included in contracts for other outsourcing arrangements,
active oversight of outsourced activities. When such as those involving data processing and information tech-
negotiating the outsourcing arrangement with an nology. Therefore, the federal banking agencies consider these
provisions to be usual and customary business practices.
outsourcing vendor, an institution should care- 13. If the workpapers are in electronic format, contracts
often call for the vendor to maintain proprietary software that
BHC Supervision Manual June 2003 enables the bank and examiners to access the electronic
Page 6 workpapers for a specified time period.
9. prescribe a process (arbitration, mediation, 2060.05.2.2.3 Competence of Outsourced

or other means) for resolving disputes and Internal Audit Vendor
for determining who bears the cost of con-
sequential damages arising from errors, Before entering an outsourcing arrangement, the
omissions, and negligence; and institution should perform due diligence to sat-
10. state that the outsourcing vendor will not isfy itself that the outsourcing vendor has suffi-
perform management functions, make man- cient staff qualified to perform the contracted
agement decisions, or act or appear to act work. The staffs qualifications may be demon-
in a capacity equivalent to that of a member strated, for example, through prior experience
of management or an employee and, if with financial institutions. Because the outsourc-
applicable, will comply with AICPA, ing arrangement is a personal-services contract,
SEC, PCAOB, or regulatory independence the institutions internal audit manager should
guidance. have confidence in the competence of the staff
assigned by the outsourcing vendor and receive
timely notice of key staffing changes. Through-
2060.05.2.2.1 Management of the out the outsourcing arrangement, management
Outsourced Internal Audit Function should ensure that the outsourcing vendor main-
tains sufficient expertise to effectively perform
Directors and senior management should ensure its contractual obligations.
that the outsourced internal audit function is
competently managed. For example, larger insti-
tutions should employ sufficient competent staff 2060.05.2.2.4 Contingency Planning to
members in the internal audit department to Avoid Discontinuity of Internal Audit
assist the manager of internal audit in oversee- Coverage
ing the outsourcing vendor. Small institutions
When an institution enters into an outsourcing
that do not employ a full-time audit manager
arrangement (or significantly changes the mix of
should appoint a competent employee who ide-
internal and external resources used by internal
ally has no managerial responsibility for the
audit), it may increase its operational risk.
areas being audited to oversee the outsourcing
Because the arrangement may be terminated
vendors performance under the contract. This
suddenly, the institution should have a contin-
person should report directly to the audit com-
gency plan to mitigate any significant disconti-
mittee for purposes of communicating internal
nuity in audit coverage, particularly for high-
audit issues.
risk areas.
2060.05.2.2.2 Communication of 2060.05.3 INDEPENDENCE OF THE

Outsourced Internal Audit Findings to INDEPENDENT PUBLIC
Directors and Senior Management ACCOUNTANT (PART III)
Communication between the internal audit func- The following discussion applies only when a
tion and the audit committee and senior manage- financial institution is considering using a pub-
ment should not diminish because the institution lic accountant to provide both external audit
engages an outsourcing vendor. All work by the and internal audit services to the institution.
outsourcing vendor should be well documented
and all findings of control weaknesses should be When one accounting firm performs both the
promptly reported to the institutions manager external audit and the outsourced internal audit
of internal audit. Decisions not to report the function, the firm risks compromising its inde-
outsourcing vendors findings to directors and pendence. These concerns arise because, rather
senior management should be the mutual deci- than having two separate functions, this out-
sion of the internal audit manager and the outsourcing arrangement places the independent
sourcing vendor. In deciding what issues should public accounting firm in the position of appear-
be brought to the boards attention, the concept ing to audit, or actually auditing, its own work.
of materiality, as the term is used in financial For example, in auditing an institutions finan-
statement audits, is generally not a good indica- cial statements, the accounting firm will con-
tor of which control weakness to report. For sider the extent to which it may rely on the
example, when evaluating an institutions com-
pliance with laws and regulations, any excep- BHC Supervision Manual July 2008
tion may be important. Page 7
internal control system, including the internal hibited nonaudit services to the public company
audit function, in designing audit procedures. audit client. The SECs final rules generally
become effective May 6, 2003, although a one-
year transition period is provided if the accoun-
2060.05.3.1 Applicability of the SECs tant is performing prohibited nonaudit services
Auditor Independence Requirements and actual audit services for a public company
pursuant to a contract in existence on May 6,
2060.05.3.1.1 Institutions That Are Public 2003. The services provided during this transi-
Companies tion period, however, must not have impaired
the auditors independence under the preexist-
To strengthen auditor independence, Congress
ing independence requirements of the SEC, the
passed the Sarbanes-Oxley Act of 2002 (the
Independence Standards Board, and the AICPA.
act). Title II of the act applies to any public
Although the SECs pre-Sarbanes-Oxley inde-
companythat is, any company that has a class
pendence requirements (issued November 2000
of securities registered with the SEC or the
(effective August 2002)) did not prohibit the
appropriate federal banking agency under sec-
outsourcing of internal audit services to a public
tion 12 of the Securities Exchange Act of 1934
companys independent public accountant, they
or that is required to file reports with the SEC
did place conditions and limitations on internal
under section 15(d) of that act.14 The act prohib-
audit outsourcing.
its an accounting firm from acting as the exter-
nal auditor of a public company during the same
period that the firm provides internal audit out- 2060.05.3.1.2 Depository Institutions
sourcing services to the company.15 In addition, Subject to the Annual Audit and
if a public companys external auditor will be Reporting Requirements of Section 36 of
providing auditing services and permissible non- the FDI Act
audit services, such as tax services, the compa-
nys audit committee must preapprove each of Under section 36, as implemented by part 363
these services. of the FDICs regulations, each FDIC-insured
According to the SECs final rules (effective depository institution with total assets of
May 6, 2003) implementing the acts nonaudit $500 million or more is required to have an
service prohibitions and audit committee preap- annual audit performed by an independent pub-
proval requirements, an accountant is not inde- lic accountant.16 The part 363 guidelines address
pendent if, at any point during the audit and the qualifications of an independent public
professional engagement period, the accountant accountant engaged by such an institution by
provides internal audit outsourcing or other pro- stating that [t]he independent public accoun-
tant should also be in compliance with the
AICPAs Code of Professional Conduct and
14. 15 U.S.C. 78l and 78o(d).
15. In addition to prohibiting internal audit outsourcing, meet the independence requirements and inter-
the Sarbanes-Oxley Act (15 U.S.C. 78j-1) also identifies other pretations of the SEC and its staff. 17
nonaudit services that an external auditor is prohibited from Thus, the guidelines provide for each FDIC-
providing to a public company whose financial statements it insured depository institution with $500 million
audits. The legislative history of the act indicates that three
broad principles should be considered when determining or more in total assets, whether or not it is a
whether an auditor should be prohibited from providing a public company, and its external auditor to com-
nonaudit service to an audit client. These principles are that an ply with the SECs auditor independence
auditor should not (1) audit his or her own work, (2) perform requirements that are in effect during the period
management functions for the client, or (3) serve in an advo-
cacy role for the client. To do so would impair the auditors covered by the audit. These requirements
independence. Based on these three broad principles, the other include the nonaudit-service prohibitions and
nonaudit services . . . referred to in this section . . . that an audit committee preapproval requirements
auditor is prohibited from providing to a public company implemented by the SECs January 2003 audi-
audit client include bookkeeping or other services related to
the clients accounting records or financial statements; finan- tor independence rules, once the rules come into
cial information systems design and implementation; appraisal effect.18
or valuation services, fairness opinions, or contribution-in-
kind reports; actuarial services; management functions or
16. 12 C.F.R. 363.3(a). (See FDIC Financial Institutions
human resources; broker or dealer, investment adviser, or
Letter, FIL-17-2003 (Corporate Governance, Audits, and
investment banking services; legal services and expert ser-
Reporting Requirements), Attachment II, March 5, 2003.)
vices unrelated to the audit; and any other service determined
17. Appendix A to part 363, Guidelines and Interpreta-
to be impermissible by the PCAOB.
tions, paragraph 14, Independence.
18. If a depository institution subject to section 36 and
BHC Supervision Manual July 2008 part 363 satisfies the annual independent audit requirement by
Page 8 relying on the independent audit of its parent holding com-
2060.05.3.1.3 Institutions Not Subject to their safety-and-soundness objectives for the

Section 36 of the FDI Act That Are institution.
Neither Public Companies Nor When a small nonpublic institution decides to
Subsidiaries of Public Companies hire the same firm to perform internal and exter-
nal audit work, the audit committee and the
The agencies have long encouraged each institu- external auditor should pay particular attention
tion not subject to section 36 of the FDI Act that to preserving the independence of both the inter-
is neither a public company nor a subsidiary of a nal and external audit functions. Furthermore,
public company 19 to have its financial state- the audit committee should document both that
ments audited by an independent public accoun- it has preapproved the internal audit outsourcing
tant.20 The agencies also encourage each such to its external auditor and has considered the
institution to follow the internal audit outsourc- independence issues associated with this
ing prohibition in the Sarbanes-Oxley Act, as arrangement.21 In this regard, the audit commit-
discussed above for institutions that are public tee should consider the independence standards
companies. As previously mentioned, some described in parts I and II of the policy state-
institutions seek to enhance the quality of their ment, the AICPA guidance discussed below,
control environment by obtaining the services of and the broad principles that the auditor should
an outsourcing vendor who can critically assess not perform management functions or serve in
their internal control system and recommend an advocacy role for the client.
improvements. The agencies believe that a small Accordingly, the agencies will not consider
nonpublic institution with less complex opera- an auditor who performs internal audit outsourc-
tions and limited staff can, in certain circum- ing services for a small nonpublic audit client to
stances, use the same accounting firm to per- be independent unless the institution and its
form both an external audit and some or all of auditor have adequately addressed the associ-
the institutions internal audit activities. These ated independence issues. In addition, the insti-
circumstances include, but are not limited to, tutions board of directors and management
situations where must retain ownership of and accountability for
the internal audit function and provide active
1. splitting the audit activities poses significant oversight of the outsourced internal audit
costs or burden, relationship.
2. persons with the appropriate specialized A small nonpublic institution may be required
knowledge and skills are difficult to locate by another law or regulation, an order, or
and obtain, another supervisory action to have its financial
3. the institution is closely held and investors statements audited by an independent public
are not solely reliant on the audited financial accountant. In this situation, if warranted for
statements to understand the financial posi- safety-and-soundness reasons, the institutions
tion and performance of the institution, and primary federal regulator may require that the
4. the outsourced internal audit services are lim- institution and its independent public accountant
ited in either scope or frequency. comply with the auditor independence require-
ments of the Act.22
In circumstances such as these, the agencies
view an internal audit outsourcing arrangement
between a small nonpublic institution and its 2060.05.3.1.4 AICPA Guidance
external auditor as not being inconsistent with
As noted above, the independent public accoun-
pany, once the SECs January 2003 regulations prohibiting an tant for a depository institution subject to sec-
external auditor from performing internal audit outsourcing tion 36 of the FDI Act also should be in compli-
services for an audit client take effect May 6, 2003, or May 6, ance with the AICPAs Code of Professional
2004, depending on the circumstances, the holding companys
external auditor cannot perform internal audit outsourcing Conduct. This code includes professional ethics
work for that holding company or the subsidiary institution. standards, rules, and interpretations that are
19. FDIC-insured depository institutions with less than
$500 million in total assets are not subject to section 36 of the
21. If a small nonpublic institution is considering having
FDI Act. Section 36 does not apply directly to holding compa-
its external auditor perform other nonaudit services, its audit
nies, but it provides that, for an insured depository institution
committee may wish to discuss the implications of the perfor-
that is a subsidiary of a holding company, its audited financial
mance of these services on the auditors independence.
statements requirement and certain of its other requirements
22. 15 U.S.C. 78j-1.
may be satisfied by the holding company.
20. See, for example, the 1999 Interagency Policy State-
ment on External Auditing Programs of Banks and Savings BHC Supervision Manual June 2003
Institutions. Page 9
binding on all certified public accountants direction of the institution and are respon-
(CPAs) who are members of the AICPA in order sive to its internal control needs;
for the member to remain in good standing. 4. the audit committee promotes the internal
Therefore, this code applies to each member audit managers impartiality and indepen-
CPA who provides audit services to an institu- dence by having him or her directly report
tion, regardless of whether the institution is audit findings to it;
subject to section 36 or is a public company. 5. the internal audit manager is placed in the
The AICPA has issued guidance indicating management structure in such a way that
that a member CPA would be deemed not inde- the independence of the function is not
pendent of his or her client when the CPA acts impaired;
or appears to act in a capacity equivalent to a 6. the institution has promptly responded to
member of the clients management or as a significant identified internal control
client employee. The AICPAs guidance weaknesses;
includes illustrations of activities that would be 7. the internal audit function is adequately
considered to compromise a CPAs indepen- managed to ensure that audit plans are met,
dence. Among these are activities that involve programs are carried out, and results of
the CPA authorizing, executing, or consummat- audits are promptly communicated to senior
ing transactions or otherwise exercising author- management and members of the audit
ity on behalf of the client. For additional details, committee and board of directors;
refer to Interpretation 101-3, Performance of 8. workpapers adequately document the inter-
Other Services, and Interpretation 101-13, nal audit work performed and support the
Extended Audit Services, in the AICPAs Code audit reports;
of Professional Conduct. 9. management and the board of directors use
reasonable standards, such as the IIAs
Standards for the Professional Practice of
Internal Auditing, when assessing the per-
2060.05.4 INSPECTION GUIDANCE formance of internal audit; and
(PART IV) 10. the audit function provides high-quality
2060.05.4.1 Review of the Internal Audit advice and counsel to management and the
Function and Outsourcing Arrangements board of directors on current developments
in risk management, internal control, and
Examiners should have full and timely access to regulatory compliance.
an institutions internal audit resources, includ-
ing personnel, workpapers, risk assessments, The examiner should assess the competence
work plans, programs, reports, and budgets. A of the institutions internal audit staff and man-
delay may require examiners to widen the scope agement by considering the education, profes-
of their inspection work and may subject the sional background, and experience of the princi-
institution to follow-up supervisory actions. pal internal auditors. In addition, when
Examiners should assess the quality and reviewing outsourcing arrangements, examiners
scope of an institutions internal audit function, should determine whether
regardless of whether it is performed by the
institutions employees or by an outsourcing 1. the arrangement maintains or improves the
vendor. Specifically, examiners should consider quality of the internal audit function and the
whether institutions internal control;
2. key employees of the institution and the out-
1. the internal audit functions control risk sourcing vendor clearly understand the lines
assessment, audit plans, and audit programs of communication and how any internal con-
are appropriate for the institutions trol problems or other matters noted by the
activities; outsourcing vendor are to be addressed;
2. the internal audit activities have been ad- 3. the scope of the outsourced work is revised
justed for significant changes in the institu- appropriately when the institutions environ-
tions environment, structure, activities, risk ment, structure, activities, risk exposures, or
exposures, or systems; systems change significantly;
3. the internal audit activities are consistent 4. the directors have ensured that the out-
with the long-range goals and strategic sourced internal audit activities are effec-
tively managed by the institution;
BHC Supervision Manual June 2003 5. the arrangement with the outsourcing vendor
Page 10 satisfies the independence standards
described in this policy statement and parts I and II of the policy statement, whether or
thereby preserves the independence of the not the vendor is an accounting firm, and in
internal audit function, whether or not the part III if the vendor provides both external and
vendor is also the institutions independent internal audit services to the institution. In such
public accountant; and cases, the examiner first should ask the institu-
6. the institution has performed sufficient due tion and the outsourcing vendor how the audit
diligence to satisfy itself of the vendors committee determined that the vendor was inde-
competence before entering into the out- pendent. If the vendor is an accounting firm, the
sourcing arrangement and has adequate pro- audit committee should be asked to demonstrate
cedures for ensuring that the vendor main- how it assessed that the arrangement has not
tains sufficient expertise to perform compromised applicable SEC, PCAOB, AICPA,
effectively throughout the arrangement. or other regulatory standards concerning auditor
independence. If the examiners concerns are
not adequately addressed, the examiner should
2060.05.4.2 Inspection Concerns About discuss the matter with appropriate agency staff
the Adequacy of the Internal Audit prior to taking any further action.
Function If the agency staff concurs that the indepen-
dence of the external auditor or other vendor
If the examiner concludes that the institutions
appears to be compromised, the examiner will
internal audit function, whether or not it is out-
discuss his or her findings and the actions the
sourced, does not sufficiently meet the institu-
agency may take with the institutions senior
tions internal audit needs; does not satisfy the
management, board of directors (or audit com-
Interagency Guidelines Establishing Standards
mittee), and the external auditor or other vendor.
for Safety and Soundness, if applicable; or is
In addition, the agency may refer the external
otherwise inadequate, he or she should deter-
auditor to the state board of accountancy, the
mine whether the scope of the inspection should
AICPA, the SEC, the PCAOB, or other authori-
be adjusted. The examiner should also discuss
ties for possible violations of applicable inde-
his or her concerns with the internal audit man-
pendence standards. Moreover, the agency may
ager or other person responsible for reviewing
conclude that the institutions external auditing
the system of internal control. If these discus-
program is inadequate and that it does not com-
sions do not resolve the examiners concerns, he
ply with auditing and reporting requirements,
or she should bring these matters to the attention
including sections 36 and 39 of the FDI Act and
of senior management and the board of directors
related guidance and regulations, if applicable.
or audit committee. Should the examiner find
material weaknesses in the internal audit func-
tion or the internal control system, he or she
should discuss them with appropriate agency 2060.05.5 INSPECTION OBJECTIVES
staff in order to determine the appropriate
1. To determine with reasonable assurance
actions the agency should take to ensure that the
whether the institution23 has an adequate
institution corrects the deficiencies. These
system of internal controls that ensures effi-
actions may include formal and informal
cient and effective operations, including the
enforcement actions.
safeguarding of assets, reliable financial
The institutions management and composite
reporting, and compliance with applicable
ratings should reflect the examiners conclu-
laws and regulations.
sions regarding the institutions internal audit
2. To determine if the internal audit function
function. The report of inspection should con-
and the internal audit outsourcing arrange-
tain comments concerning the adequacy of this
ments of the banking organizations are
function, significant issues or concerns, and rec-
adequately and competently managed by
ommended corrective actions.
the board of directors and senior manage-
ment.
2060.05.4.3 Concerns About the
Independence of the Outsourcing Vendor 23. The term institution is used to maintain consistency
with the interagency policy statement, but these inspection
objectives and procedures apply to financial holding compa-
An examiners initial review of an internal audit nies, bank holding companies, and their bank and nonbank
outsourcing arrangement, including the actions subsidiaries.
of the outsourcing vendor, may raise questions
about the institutions and its vendors adher- BHC Supervision Manual January 2014
ence to the independence standards described in Page 11
3. To ascertain that the banking organizations 9. To determine whether the internal audit
internal audit function monitors, reviews, function and its processes can be relied
and ensures the continued existence and upon for the current supervisory review
maintenance of sound and adequate internal period.
controls over the management process: the 10. For high risk areas, to make a determination
control environment, risk assessment, con- as to whether additional inspection work is
trol activities, information and communica- needed even when the internal audit may be
tion, and monitoring activities. deemed effective and its work reliable.
4. To make an overall determination as to
whether an institutions internal audit func-
tion and its processes are effective or inef- 2060.05.6 INSPECTION PROCEDURES
fective based on the 2003 interagency pol-
icy statement and the FR supplemental Examiners should obtain assurances from the
policy guidance. audit committee and senior management that
5. To determine whether the internal audit they will have full and timely access to an
function reports vital information about institutions internal audit resources, including
weaknesses in the system of internal control personnel, work papers, risk assessments, work
to the board of directors (or its audit com- plans, programs, reports, and budgets. Examin-
mittee) and senior management and that ers should consider widening the scope of their
expeditious remedial action is taken to inspection work when such assurances are not
resolve the internal control weaknesses as provided or if there are any significant delays in
well as any other exceptions. gaining access to the internal audit resources.
Such a delay may subject the institution to
6. To determine if
follow-up supervisory action.
a. the audit committee has established and This inspection program should include a
maintains procedures for employees of review of audit function and audit outsourcing,
the institution to confidentially and which would include a review of the holding
anonymously submit concerns to the companys internal and external audits and the
committee about questionable account- audit procedures they encompass. The audit
ing, internal control, or auditing matters; guidelines are general and all sections or ques-
and tions may not be applicable to every entity
b. the audit committee has procedures for within the consolidated organization.
the timely investigation of complaints Before reviewing any specific audit proce-
received and the retention, for a reason- dures, the examiner should first determine the
able time period, of documentation con- independence and competence of the auditors. If
cerning the complaint and its subsequent the examiner believes the auditors to be both
resolution. competent and independent, he or she should
7. To determine the adequacy of the internal then determine the effectiveness and adequacy
audit function (including its use of out- of their work, and whether the auditors made an
sourced internal audit vendors) as to organi- assessment as to whether the institutions inter-
zational structure, prudent management, nal audit function incorporated the enhanced
staff having sufficient expertise, audit qual- practices outlined in the FRs Supplemental
ity, and the ability of auditors to directly Policy Statement on Internal Audit Function
and freely communicate internal audit find- and its Outsourcing (Supplemental Guidance).
ings to the board of directors, its audit com- Based on a review of the audit function and
mittee, and senior management. on the auditors work, the examiner must then
8. To review and evaluate internal audit out- determine the scope of the inspection. The pro-
sourcing arrangements and the actions of gram and related supporting documentation
the outsourcing vendor, under standards should be completed in an organized manner
established in the 2003 Interagency Policy and should be retained as part of the inspection
Statement on the Internal Audit Function work papers.
and Its Outsourcing and the 2013 Federal Upon completion of the review of the internal
Reserves Supplemental Policy Statement audit program, the examiner should be able to
on the Internal Audit Function and its Out- formulate a conclusion on the effectiveness of
sourcing. audit processes and coverage. Conclusions
about any weaknesses in the internal or external
BHC Supervision Manual January 2014 audit work performed for the FR supervised
Page 12 bank or savings and loan holding company
should be summarized and included in the identify any knowledge gaps.

inspection report. Matters Requiring Immediate 5. Skills gap assessments. Review how often
Attention (MRIA) or Matters Requiring Atten- they are performed, and how gaps in cover-
tion (MRA) to be included in the inspection age are addressed (e.g. targeted staff hires;
report should be discussed with the audit com- training; business- line rotation programs,
mittee and board of directors, the Chief Audit and co-sourcing/ outsourcing arrange-
Executive, (CAE) and senior bank management. ments).
6. Training. Ensure there is a process in place
to determine and monitor the annual train-
2060.05.6.1 Internal Audit Function ing, typically 40 hours minimum, for each
staff member based on their needs.
The following inspection procedures should 7. Content and use of the audit frequency and
encompass a review of the structure of the inter- scope schedule. Review the methodology
nal audit organization and function: utilized to determine the audit universe and
frequency of coverage per auditable entity.
1. Organizational structure of the audit 8. Audit department participation in systems
department. Review the internal audits design projects. Determine through inter-
charter and its organization chart for direct views and documentation reviews, internal
and indirect reporting lines of the CAE, and audits role in assessing systems change
the minutes of the boards audit or examin- control processes.
ing committee to determine how effectively 9. Internal audit charter. Review the internal
the CAE and board of directors are dis- audit charter to determine its current
charging their responsibility. If the CAE adequacy. Determine whether the CAE
reports to someone other than the chief periodically reviews the current adequacy
executive officer (CEO), determine if the of the charter and makes recommendations
audit committee has documented its ratio- to the audit committee for improving inter-
nale for the reporting structure, including nal audit function and whether outsourcing
any mitigating controls for situations that to external experts may be needed.
could adversely impact the objectivity of 10. Audit manual. Review the audit manual to
the CAE. Determine if the audit committee ensure that it includes all applicable audit
has quarterly, but at least annually, evalu- processes, practices, and procedures, and
ated whether (1) the CAE is impartial and applicable references to Institute of Internal
not unduly influenced by the administrative Auditor (IIA) standards.
reporting line and (2) any conflicts of inter- 11. Maintenance of audit records. Review a
est for the CAE and other audit staff are sample of the audit reports and associated
accompanied by appropriate restrictions to work papers to determine compliance with
mitigate those conflicts. prescribed procedures and proper documen-
2. Independence of the audit function. Inter- tation, including appropriate distribution to
view the CAE and observe the operation of senior managers.
the audit department to determine its func- 12. Audit departments formal reporting proce-
tional responsibilities. dures. Review CAE presentations and MIS
3. CAEs qualifications. Review biographical reporting to the audit or examining commit-
data and interview the CAE to determine tee to ensure the committee is providing
his or her ability to manage the institutions effective oversight of the internal audit
internal audit function and his or her function.
responsibility within the institution (i.e., 13. Issue Tracking Follow-up Processes.
bank holding or savings and loan holding Review processes utilized to validate clo-
company). sure of internal audit findings. Review a
4. Audit staff qualifications. Review the bio- sample of closed issues to ensure that inter-
graphical data and interview the manage- nal audit maintains sufficient documenta-
ment staff of the audit department to deter- tion to validate issue closure.
mine their qualifications commensurate 14. Use and effectiveness of audit computer
with their delegated responsibilities com- programs. Interview the CAE and/or the
pared to the institutions strategy and opera- appropriate staff members regarding the use
tions. Review the educational background, of the computer and access to the files for
professional certifications and relevant
banking and audit experience of staff to BHC Supervision Manual January 2014
assess overall staff qualifications and to Page 13
audit purposes. Obtain a walkthrough of fees to be paid for, the work to be per-
automated auditing systems and methodolo- formed by the vendor;
gies. c. set the responsibilities for providing and
receiving information, such as the type
and frequency of reporting to senior
2060.05.6.2 Other Internal Audit management and directors about the sta-
Function Inspection Procedures tus of contract work;
d. establish the process for changing the
1. Broaden the scope of the inspection if the terms of the service contract, especially
institutions internal audit function, whether for expansion of audit work if significant
or not it is outsourced, does not sufficiently issues are found, and establish stipula-
meet its internal audit needs, does not sat- tions for default and termination of the
isfy the Interagency Guidelines Establish- contract;
ing Standards for Safety and Soundness, or e. state that internal audit reports are the
is otherwise inadequate. property of the institution, that the insti-
2. Discuss supervisory concerns and outstand- tution will be provided with any copies
ing internal-external audit report comments of the related work papers it deems nec-
with the CAE or other person responsible essary, and that employees authorized by
for reviewing the system of internal control. the institution will have reasonable and
If these discussions do not resolve the timely access to the work papers pre-
examiners comments and concerns, bring pared by the outsourcing vendor;
these matters to the attention of senior man- f. specify the locations of internal audit
agement and the board of directors or audit reports and the related work papers;
committee. g. specify the period of time (for example,
3. If material weaknesses in the internal audit seven years) that vendors must maintain
function or the internal control system exist, the work papers;24
discuss them with appropriate Federal h. state that outsourced internal audit ser-
Reserve Bank supervisory staff to deter- vices provided by the vendor are subject
mine the appropriate actions that should be to regulatory review and that examiners
taken to ensure that the institution corrects will be granted full and timely access to
the deficiencies (including formal and infor- the internal audit reports and related
mal enforcement actions). work papers prepared by the outsourcing
4. Incorporate conclusions about the institu- vendor;
tions internal audit function into its man- i. prescribe a process (arbitration, media-
agement and composite supervisory ratings. tion, or other means) for resolving dis-
5. Include in the inspection report comments putes and for determining who bears the
concerning the adequacy of the internal cost of consequential damages arising
audit function, significant issues or con- from errors, omissions, and negligence;
cerns, and recommended corrective actions. and
j. state that the outsourcing vendor will not
perform management functions, make
2065.05.6.3 Additional Aspects of the management decisions, or act or appear
Examiners Review of an Outsourcing to act in a capacity equivalent to that of a
Arrangement member of management or an employee
and, if applicable, will comply with
1. Review the internal audit outsourcing AICPA, SEC, PCAOB, or regulatory
arrangement and determine if the institution independence guidance.
has a written contract or an engagement 3. Determine whether
letter with the vendor. a. the outsourcing arrangement maintains
2. Determine whether the written contract or or improves the quality of the internal
engagement letter includes provisions audit function and the institutions inter-
that nal control;
a. define the expectations and responsibili- b. key employees of the institution and the
ties under the contract for both parties;
b. set the scope and frequency of, and the 24. If the work papers are in electronic format, contracts
often call for the vendor to maintain proprietary software that
BHC Supervision Manual January 2014 enables the banking organization and examiners to access the
Page 14 electronic work papers for a specified time period.
outsourcing vendor clearly understand holding companys CAE and audit com-
the lines of communication and how any mittee how they determined that the ven-
internal control problems or other mat- dor was independent; and
ters noted by the outsourcing vendor are b. if the vendor is an accounting firm, ask
to be addressed; the CAE or audit committee how they
c. the scope of work is revised appropri- assessed that the arrangement had not
ately when the institutions environment, compromised applicable SEC, PCAOB,
structure, activities, risk exposures, or AICPA, or other regulatory standards
systems change significantly; concerning auditor independence.
d. the directors have ensured that the out- 2. If the answers to the above raise supervi-
sourced internal audit function is effec- sory concern, or are not adequately
tively managed by the institution; addressed, discuss the matter with appropri-
e. the arrangement with the outsourcing ate Reserve Bank management and supervi-
vendor satisfies the independence stan- sory staff.
dards described in the Policy Statement 3. If the Reserve Bank management and super-
on the Internal Audit Function and Its visory staff concurs that the independence
Outsourcing and thereby preserves the of the external auditor or other vendor
independence of the internal audit func- appears to be compromised, discuss the
tion, whether or not the vendor is also inspection findings and what appropriate
the institutions independent public supervisory actions the Federal Reserve
accountant; may take with the bank holding or savings
f. the institution has performed sufficient and loan holding companys senior manage-
due diligence to satisfy itself of the ven- ment, board of directors (or audit commit-
dors competence before entering into tee), and the external auditor or other ven-
the outsourcing arrangement and dor.
whether there are adequate procedures
for ensuring that the vendor maintains
sufficient expertise to perform effectively 2060.05.6.5 Supplemental Procedures to
throughout the arrangement; and Evaluate the Effectiveness of the Internal
g. the institution has a contingency plan to Audit Function
ensure continuity in audit coverage,
especially for high-risk areas. 1. Determine whether the internal audit func-
4. Adjust the scope of the inspection if the tion and its processes are effective or inef-
outsourcing arrangement has diminished the fective and whether internal audits work
quality of the institutions internal audit. If can be potentially relied upon as part of the
the quality of the internal audit is dimin- supervisory review process. An institutions
ished, inform senior management and the internal audit function generally would be
board of directors and consider it in the considered effective if the institutions
institutions management and composite internal audit function structure and prac-
ratings. tices are consistent with the 2003 inter-
agency policy statement and the Federal
Reserves 2013 supplemental guidance
2060.05.6.4 Assessment of Auditor (supplemental guidance).
Independence 2. To determine if the institution has incorpo-
rated the Federal Reserves Supplemental
1. The initial review of an internal audit out- Guidance, evaluate whether the factors and
sourcing arrangement, including the actions requirements underpinning the following
of the outsourcing vendor, may raise ques- characteristics and processes are in place:
tions about the institutions and its vendors Attributes
adherence to the independence standards Independence
discussed in parts I, II, and III of the Inter- Competent internal audit staff
agency Policy Statement on the Internal Objectivity and ethics
Audit Function and Its Outsourcing (2003 Governance
Policy Statement) and the Federal Reserv- Role of board of directors
es 2013 Supplemental Guidance. If the Role of audit committee
vendor provides both external and internal
audit services to the institution BHC Supervision Manual January 2014
a. question the bank or savings and loan Page 15
Role of Chief Audit Executive (CAE) the institutions activities.

Audit Processes Continuous monitoring Supplement
Audit methodologyReview the inter- inspection procedures with continuous
nal audits risk-assessment methodol- monitoring and an assessment of key
ogy that drives its risk-assessment pro- elements of internal audit, including:
cess and determine if it represents the the adequacy and independence
audit universe. Determine if the meth- of the audit committee;
odology included a documented analy- the independence, professional
sis of cross-institutional risk and the- competence, and quality of the
matic control issues and the processes internal audit function;
and procedures for evaluating the the quality and scope of the audit
effectiveness of risk-management, con- methodology, audit plan, and risk
trol, and governance processes. Evalu- assessment; and
ate internal audits plan for continuous the adequacy of audit programs
monitoring and in determining and and work paper standards.
evaluating risk. Assess internal audits 1) Review these key elements at least
process for incorporating other risk annually to determine whether there
identification techniques (i.e., risk and have been significant changes in the
control self-assessment) that the insti- internal audit infrastructure or
tutions management utilizes. whether there are potential concerns
Audit universeDetermine if internal regarding their adequacy.
audit has effective processes to identify 2) Make a determination on whether
all auditable entities within the audit the work of internal audit can be
universe. Review the documentation of relied upon when internal audits
the audit universe and verify whether it overall function and related pro-
has been reviewed periodically (e.g., cesses are effective and when recent
during the annual audit planning pro- work was performed by internal
cess) and when significant organiza- audit in an area where examiners
tional changes have occurred. are performing inspection proce-
Risk assessmentReview internal dures.
audits documentation of its under- 3) Evaluate and determine whether
standing of the institutions significant additional inspection work is
business activities and their associated needed in high risk areas even
risks. Verify that internal audit where internal audit has been
includes, at least annually, a review of deemed effective and its work reli-
critical risk-management functions as able.
well as changes in the system of inter- Audit Performance and Monitoring
nal controls, infrastructure, work pro- ScopeAdjust the scope of the inspec-
cesses, new or changed business lines, tion if the bank holding or savings and
or laws and regulations. Review the loan holding companys internal audit
disposition of the results of the overall function does not sufficiently meet the
risk assessment summary and deter- institutions internal audit needs
mine if internal audit gave consider- (whether or not the audit function is
ation to key performance or risk indica- outsourced), or is otherwise ineffec-
tors and the most significant risks tive.
facing the institution, including how Work papersDetermine whether the
the risks are addressed within the inter- internal audit work papers adequately
nal audit plan. document the work program, the work
Audit planVerify that internal audit performed and work paper standards,
develops and periodically revises its including documentation of any obser-
comprehensive audit plan. Determine vations and analysis made, the conclu-
if it verifies that the plan includes audit sions, and audit results.
coverage for all identified, auditable Audit reports:
entities within the audit universe appro- 1) Ascertain whether internal audit has
priate for the size and complexity of effective audit reporting processes
that communicate audit report
BHC Supervision Manual January 2014 issues throughout the institution
Page 16
and they are addressed in a timely vent a similar event from occurring
manner. in the future.
2) Review the inspection periods Quality Assurance
audit reports and verify that they Internal Quality Assurance. Ensure
contain an executive summary that the internal audit function pro-
describing the auditable area, its cess is documented in the audit
conclusions, rationale, key issues, manual. Review samples of work,
and managements documented overall results and status of any
action plans to address audit find- action plans.
ings. External Quality Assurance. Deter-
Audit issues tracking mine whether an independent assess-
1) Verify that internal audit has effec- ment had been performed within the
tive processes in place to track, five-year requirement. Review results
monitor, and follow up on open and action plan status to remediate
audit issues. issues.
2) Determine if the institution con- 1) Assess the quality and scope of
ducts independent quality assurance the internal audit work, regardless
reviews of internal audit work per- of whether it is performed by the
formed. institutions employees or by an
3) Verify that the CAE implements outsourcing vendor. Consider
appropriate improvements in inter- whether
nal audit processes or staff training a. the internal audit functions
through the quality assurance and risk assessment, plans, and pro-
improvement programs. grams are appropriate for the
4) Determine whether the institution institutions activities;
conducts an internal quality assess- b. the internal audit function is
ment at least annually and if the adequately managed to ensure
CAE reports the results and status that audit plans are accom-
of internal assessments to senior plished, programs are carried
management and the audit commit- out, and results of audits are
tee at least annually. promptly communicated to the
5) Discuss supervisory concerns and managers and directors;
outstanding internal-external audit c. the internal audit plan and pro-
report comments with the CAE or gram have been adjusted for
other person responsible for review- significant changes in the insti-
ing the system of internal control. If tutions environment, structure,
these discussions do not resolve the activities, risk exposures, or
examiners comments and concerns, systems;
bring these matters to the attention d. the activities of internal audit
of senior management and the board are consistent with the long-
of directors or the audit committee. range goals of the institution
Retrospective review processes. and are responsive to its inter-
1) Determine if management has con- nal control needs; and
ducted a post-mortem and lessons e. the audit function provides
learned analysis when adverse high-quality advice and coun-
events (fraud or a significant loss) sel to management and the
have occurred. board of directors on current
2) Find out if internal audit function developments in risk manage-
verified that a review took place and ment, internal control, and
that appropriate action was taken to regulatory compliance.
remediate identified issues. 3. If there are deficiencies in any internal audit
3) Ascertain if internal audit function characteristics, use your judgment to:
evaluated managements analysis of evaluate the significance of the deficien-
the reasons for the event and if the cies and their relevance to the institu-
adverse event was the result of a tions safety and soundness or compli-
control break down or failure, and
whether management identified BHC Supervision Manual January 2014
measures to be put in place to pre- Page 17
ance with laws and regulations, and odology, audit plan, and risk assessment;
determine whether these deficiencies and
would preclude overall audit processes The adequacy of audit programs and
from being deemed effective. work paper standards.
2. Review, at least annually, the above key
While the internal audit functions overall elements and determine whether there have
processes could be deemed effective, some been significant changes to the internal
elements of the internal audit function may audit infrastructure or whether there are
require enhancements or improvements, potential concerns regarding their adequacy.
such as documentation with respect to spe-
cific audit processes (for example, risk
assessments or work papers).
4. If examiners find the key elements of the 2060.05.6.7 Evaluating the Ability to
internal audit function to be insufficient, the Rely on Internal Audit
overall effectiveness of the internal audit
function should come into question. Such 1. Consider relying on internal audit at a
findings may be include: supervised institution based on whether:
Lack of an appropriate risk-assessment a. an internal audit was deemed effective at
process the most recent supervisory inspection of
Lack of sufficient and competent internal audit;
resources b. internal audits overall function and
Lack of audit coverage in key areas related processes are considered effec-
Inappropriate classification of audit find- tive and when recent work was per-
ings formed by internal audit in a area where
Insufficient root cause analyses examiners are performing inspection
Numerous work paper deficiencies procedures and the examiners can evalu-
A large number of unresolved control- ation whether they may rely on the work
related issues of internal audit;
5. Internal audit processes may be considered c. an evaluation was performed of the sig-
ineffective if there are significant, unre- nificance and degree of risk of particular
solved supervisory matters requiring imme- activities, business lines or other areas or
diate attention (MRIAs) and/or matters business and if a determination was
requiring attention (MRAs) pertaining to made as to the existence of appropriate
internal audit, or if other supervisory con- internal controls over such risks; and
cerns exist relating to the effectiveness of d. the extent of continuous monitoring
the internal audit function. activities that did not identify any sig-
nificant deficiencies or discover any
adverse changes in audit processes or the
2060.05.6.6 Continuous Monitoring quality of internal audits work.
between Inspections of Internal Audit 2. Leverage off an internal audit functions
assessment of how emerging risks and high-
1. Supplement the inspection procedures risk areas are mitigated within the institu-
through continuous monitoring. Include an tion, including whether appropriate internal
assessment of key elements of internal audit controls are in place over such risks;
during the period following the institutions 3. For emerging risks and high-risk areas,
most recent inspection. The assessment of determine if additional inspection work is
key elements of internal audit should needed, even when internal audit has been
include: deemed effective and its work considered
The adequacy and independence of the reliable.
audit committee; 4. Document the results of the supervisory
The independence, professional compe- review, supporting the basis for a conclu-
tence, and quality of the internal audit sion as to whether the examiners can rely
function; upon internal audit and whether there are
The quality and scope of the audit meth- any specific auditable areas (that is, func-
tion or business line) or elements of internal
BHC Supervision Manual January 2014 audit (e.g. open audit issues) on which the
Page 18 examiners cannot rely.
2060.05.6.8 Considerations for or regulator, or that cut across legal enti-

Consolidated Supervision ties; and
Participate in the exchange of informa-
1. Tailor the nature and scope of the Federal tion among domestic and foreign super-
Reserves supervisory and inspection work visors and functional regulators, consis-
to the organizations legal entity and regula- tent with applicable laws and
tory structure and also the risks associated information-sharing arrangements, pro-
with the organizations activities. Promote viding for the comprehensive, consoli-
effective consolidated supervision by foster- dated supervision of each banking orga-
ing strong, cooperative relationships among nizations global activities.
the Federal Reserve, relevant domestic and 3. The Federal Reserves conduct of consoli-
foreign supervisors, and functional regula- dated supervision is central to and depen-
tors. Achieve this objective while limiting dent on the coordination with, and reliance
the potential for duplication of effort or on, the work of other relevant primary
undue burden on the institution under supervisors and functional regulators. The
review. Federal Reserves direction for achieving
2. Focus on the scope and depth of the other these objectives is closely integrated into
supervisors or regulators internal audit the supervisory framework for consolidated
review. Determine the Federal Reserves bank holding companies and the combined
ability to rely on the work of the relevant U.S. operations of foreign banking organi-
supervisor or functional regulator: zations.
Rely to the fullest extent possible on 4. When the Federal Reserve is not the pri-
assessments and information developed mary supervisor or functional regulator of
by other relevant domestic and foreign all entities consolidated under the holding
supervisors and functional regulators; company, the Federal Reserve will evaluate
Focus Federal Reserve supervisory atten- whether, and the degree to which, the major
tion on material risks from activities that subsidiaries of the holding company imple-
are not supervised by another supervisor mented the supplemental guidance.

Page 19
Supplemental Policy Statement on the Internal Audit Function
and Its Outsourcing Section 2060.07
The Federal Reserve issued this January 23, regulations. Moreover, the overall effectiveness
2013, policy statement to supplement the guid- of an institutions internal audit function will
ance in the 2003 Interagency Policy Statement influence the ability of the Federal Reserve to
on the Internal Audit Function and Its Outsourc- rely upon the work of an institutions internal
ing (referred to as the 2003 Policy Statement).1 audit function.
Federal Reserve staff has identified areas for This supplemental policy statement builds
improving regulated institutions internal audit upon the 2003 Policy Statement, which remains
functions. This supplemental policy statement in effect, and follows the same organizational
addresses the characteristics, governance, and structure, with a new section entitled Enhanced
operational effectiveness of an institutions Internal Audit Practices and updates to Parts
internal audit function. Further, this statement I-IV of the 2003 Policy Statement. Refer to
reflects certain changes in banking regulations SR-13-1/CA13-1 and its attachment. To avoid
that have occurred since the issuance of the historical references and duplication some intro-
2003 Policy Statement. The Federal Reserve is ductory paragraphs and other small phrases are
providing this supplemental guidance to omitted from the policy statement here, as indi-
enhance regulated institutions internal audit cated by a line of asterisks.
practices and to encourage them to adopt profes-
sional audit standards and other authoritative
guidance, including those issued by the Institute * * * * * *
of Internal Auditors (IIA).2
This supplemental statement applies to super-
vised institutions with greater than $10 billion
in total consolidated assets, including state 2060.07.1 SUPPLEMENTAL POLICY
member banks, domestic bank and savings and GUIDANCE
loan holding companies, and U.S. operations of
foreign banking organizations.3 This supple- 2060.07.1.1 Enhanced Internal Audit
mental guidance is also consistent with the Practices
objectives of the Federal Reserves consolidated
supervision framework for large financial insti- An institutions internal audit function should
tutions with total consolidated assets of $50 bil- incorporate the following enhanced practices
lion or more, which promotes an independent into their overall processes:
internal audit function as an essential element
for enhancing the resiliency of supervised
institutions.4 2060.07.1.1.1 Risk Analysis
Assessment of the effectiveness of the internal Internal audit should analyze the effectiveness
audit function. The degree to which an institu- of all critical risk-management functions both
tion implements the internal audit practices out- with respect to individual risk dimensions (for
lined in this policy statement will be considered example, credit risk), and an institutions overall
in the Federal Reserves supervisory assessment risk-management function. The analysis should
of the effectiveness of an institutions internal focus on the nature and extent of monitoring
audit function as well as its safety and sound- compliance with established policies and pro-
ness and compliance with consumer laws and cesses and applicable laws and regulations
within the institution as well as whether moni-
1. Refer to SR-03-5, Amended Interagency Guidance on toring processes are appropriate for the institu-
the Internal Audit Function and Its Outsourcing.
2. In this guidance, references have been provided to the
tions business activities and the associated
IIAs International Standards for the Professional Practice of risks.
Internal Auditing (Standards). Refer to the IIA website at
https://na.theiia.org/standards-guidance/pages/standards-and-
guidance-ippf.aspx.
3. Section 4 of this document, however, clarifies certain 2060.07.1.1.2 Thematic Control Issues
changes to the Federal Deposit Insurance Corporation regula-
tion (12 CFR part 363) on independence standards for inde- Internal audit should identify thematic macro
pendent public accountants at insured depository institutions control issues as part of its risk-assessment pro-
with total assets of $500 million or more, which were adopted
pursuant to 2009 amendments to section 36 of the FDI Act.
4. Refer to SR-12-17/CA letter 12-14, Consolidated BHC Supervision Manual July 2013
Supervision Framework for Large Financial Institutions. Page 1
Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07
cesses and determine the overall impact of such 2060.07.1.1.5 Risk Tolerance
issues on the institutions risk profile. Addi-
tional audit coverage would be expected in busi- Internal audit should understand risks faced by
ness activities that present the highest risk to the the institution and confirm that the board of
institution. Internal audit coverage should reflect directors and senior management are actively
the identification of thematic macro control involved in setting and monitoring compliance
issues across the firm in all auditable areas. with the institutions risk tolerance limits. Inter-
Internal audit should communicate thematic nal audit should evaluate the reasonableness of
macro control issues to senior management and established limits and perform sufficient testing
the audit committee. to ensure that management is operating within
In addition, internal audit should identify pat- these limits and other restrictions.
terns of thematic macro control issues, deter-
mine whether additional audit coverage is
required, communicate such control deficiencies 2060.07.1.1.6 Governance and Strategic
to senior management and the audit committee, Objectives
and ensure management establishes effective
remediation mechanisms. Internal audit should evaluate governance at all
management levels within the institution,
including at the senior management level, and
2060.07.1.1.3 Challenging Management within all significant business lines. Internal
and Policy audit should also evaluate the adequacy and
effectiveness of controls to respond to risks
within the organizations governance, opera-
Internal audit should challenge management to
tions, and information systems in achieving the
adopt appropriate policies and procedures and
organizations strategic objectives. Any con-
effective controls. If policies, procedures, and
cerns should be communicated by internal audit
internal controls are ineffective or insufficient in
to the board of directors and senior
a particular line of business or activity, internal
management.
audit should report specific deficiencies to
senior management and the audit committee
with recommended remediation. Such recom-
mendations may include restricting business 2060.07.1.2 Internal Audit Function (Part
activity in affected lines of business until effec- I of the 2003 Policy Statement)
tive policies, procedures, and controls are
The primary objectives of the internal audit
designed and implemented. Internal audit should
function are to examine, evaluate, and perform
monitor managements corrective action and
an independent assessment of the institutions
conduct a follow-up review to confirm that the
internal control system, and report findings back
recommendations of both internal audit and the
to senior management and the institutions audit
audit committee have been addressed.
committee. An effective internal audit function
within a financial institution is a vital means for
an institutions board of directors to maintain
2060.07.1.1.4 Infrastructure the quality of the internal control environment
and risk-management systems.
When an institution designs and implements The guidance set forth in this section supple-
infrastructure enhancements, internal audit ments the existing guidance in the 2003 Policy
should review significant changes and notify Statement by strongly encouraging internal
management of potential internal control issues. auditors to adhere to professional standards,
In particular, internal audit should ensure that such as the IIA guidance. Furthermore, this sec-
existing, effective internal controls (for exam- tion clarifies certain aspects of the IIA guidance
ple, software applications and management and provides practices intended to increase the
information system reporting) are not rendered safety and soundness of institutions.
ineffective as a result of infrastructure changes
unless those controls are compensated for by
other improvements to internal controls. 2060.07.1.2.1 Attributes of Internal Audit
Independence. Internal audit is an independent
BHC Supervision Manual July 2013 function that supports the organizations busi-
Page 2 ness objectives and evaluates the effectiveness
of risk management, control, and governance U.S. based audit committee that meets U.S. pub-
processes. The 2003 Policy Statement addressed lic company standards for independence or by
the structure of an internal audit function, not- the foreign parent companys internal audit
ing that it should be positioned so that an institu- function.
tions board of directors has confidence that the
internal audit function can be impartial and not Professional competence and staffing. Internal
unduly influenced by managers of day-to-day audit staff should have the requisite collective
operations. Thus, the member of management skill levels to audit all areas of the institution.
responsible for the internal audit function (here- Therefore, auditors should have a wide range of
after referred to as the chief audit executive or business knowledge, demonstrated through
CAE)5 should have no responsibility for operat- years of audit and industry-specific experience,
ing the system of internal control and should educational background, professional certifica-
report functionally to the audit committee. A tions, training programs, committee participa-
reporting arrangement may be used in which the tion, professional associations, and job rota-
CAE is functionally accountable and reports tional assignments. Internal audit should assign
directly to the audit committee on internal audit staff to audit assignments based on areas of
matters (that is, the audit plan, audit findings, expertise and, when feasible, rotate staff within
and the CAEs job performance and compensa- the audit function.
tion) and reports administratively to another Internal audit management should perform
senior member of management who is not knowledge-gap assessments at least annually to
responsible for operational activities reviewed evaluate whether current staff members have the
by internal audit. When there is an administra- knowledge and skills commensurate with the
tive reporting of the CAE to another member of institutions strategy and operations. Manage-
senior management, the objectivity of internal ment feedback surveys and internal or external
audit is served best when the CAE reports quality assurance findings are useful tools to
administratively to the chief executive officer identify and assess knowledge gaps. Any identi-
(CEO). fied knowledge gaps should be filled and may
If the CAE reports administratively to some- be addressed through targeted staff hires, train-
one other than the CEO, the audit committee ing, business line rotation programs, and out-
should document its rationale for this reporting sourcing arrangements. The internal audit func-
structure, including mitigating controls avail- tion should have an effective staff training
able for situations that could adversely impact program to advance professional development
the objectivity of the CAE. In such instances, and should have a process to evaluate and moni-
the audit committee should periodically (at least tor the quality and appropriateness of training
annually) evaluate whether the CAE is impartial provided to each auditor. Internal auditors gen-
and not unduly influenced by the administrative erally receive a minimum of forty hours of
reporting line arrangement. Further, conflicts of training in a given year.
interest for the CAE and all other audit staff
should be monitored at least annually with Objectivity and ethics. Internal auditors should
appropriate restrictions placed on auditing areas be objective, which means performing assign-
where conflicts may occur. ments free from bias and interference. A major
For foreign banking organizations (FBOs), characteristic of objectivity is that the CAE and
the internal audit function for the U.S. opera- all internal audit professional staff avoid any
tions of an FBO should have appropriate inde- conflicts of interest.7 For their first year in the
pendent oversight for the total assets of U.S. internal audit function, internally recruited
operations.6 When there is a resident U.S. audit internal auditors should not audit activities for
function, the CAE of the U.S. audit function which they were previously responsible. More-
should report directly to senior officials of the over, compensation schemes should not provide
internal audit department at the head office such incentives for internal auditors to act contrary to
as the global CAE. If the FBO has separate U.S. the attributes and objectives of the internal audit
subsidiaries, oversight may be provided by a
7. IIA standards define conflict of interest as a situation in
which an internal auditor, who is in a position of trust, has a
5. More recently, this title is used to refer to the person in
competing professional or personal interest. Such competing
charge of the internal audit function. An institution may not
interests can make it difficult for the individual to fulfill his or
have a person at the management level of CAE and instead
her duties impartially.
may have an internal audit manager.
6. This is defined as the combined total assets of U.S.
operations, net of all intercompany assets and claims on BHC Supervision Manual July 2013
U.S.-domiciled affiliates. Page 3
function.8 While an internal auditor may recom- 2060.07.1.2.2 Corporate Governance

mend internal control standards or review man- Considerations
agements procedures before implementation,
objectivity requires that the internal auditor not Board of directors and senior management
be responsible for the design, installation, proce- responsibilities. The board of directors and
dures development, or operations of the institu- senior management are responsible for ensuring
tions internal control systems. that the institution has an effective system of
An institutions internal audit function should internal controls. As indicated in the 2003 Pol-
have a code of ethics that emphasizes the prin- icy Statement, this responsibility cannot be del-
ciples of objectivity, competence, confidential- egated to others within the institution or to
ity, and integrity, consistent with professional external parties. Further, the board of directors
internal audit guidance such as the code of and senior management are responsible for
ethics established by the IIA. ensuring that internal controls are operating
effectively.
Internal audit charter. Each institution should
have an internal audit charter that describes the Audit committee responsibilities. An institu-
purpose, authority, and responsibility of the tions audit committee is responsible for estab-
internal audit function. An audit charter should lishing an appropriate internal audit function
include the following critical components: and ensuring that it operates adequately and
effectively. The audit committee should be con-
fident that the internal audit function addresses
The objectives and scope of the internal audit the risks and meets the demands posed by the
function; institutions current and planned activities.
The internal audit functions management Moreover, the audit committee is expected to
reporting position within the organization, as retain oversight responsibility for any aspects of
well as its authority and responsibilities; the internal audit function that are outsourced to
The responsibility and accountability of the a third party.
CAE; and The audit committee should provide
The internal audit functions responsibility to oversight to the internal audit function. Audit
evaluate the effectiveness of the institutions committee meetings should be on a frequency
risk management, internal controls, and gov- that facilitates this oversight and generally
ernance processes. should be held four times a year at a minimum,
with additional meetings held by audit commit-
The charter should be approved by the audit tees of larger financial institutions. Annually,
committee of the institutions board of directors. the audit committee should review and approve
The charter should provide the internal audit internal audits charter, budget and staffing
function with the authorization to access the levels, and the audit plan and overall risk-
institutions records, personnel, and physical assessment methodology. The committee
properties relevant to the performance of inter- approves the CAEs hiring, annual performance
nal audit procedures, including the authority to evaluation, and compensation.
examine any activities or entities. Periodically, The audit committee and its chairperson
the CAE should evaluate whether the charter should have ongoing interaction with the CAE
continues to be adequate, requesting the separate from formally scheduled meetings to
approval of the audit committee for any revi- remain current on any internal audit department,
sions. The charter should define the criteria for organizational, or industry concerns. In addi-
when and how the internal audit function may tion, the audit committee should have executive
outsource some of its work to external experts. sessions with the CAE without members of
senior management present as needed.
The audit committee should receive appropri-
ate levels of management information to fulfill
its oversight responsibilities. At a minimum, the
audit committee should receive the following
data with respect to internal audit:
8. IIA standards have additional examples of conflict of
interest for consideration. Audit results with a focus on areas rated less
than satisfactory;
BHC Supervision Manual July 2013 Audit plan completion status and compliance
Page 4 with report issuance timeframes;
Audit plan changes, including the rationale Audit methodology. Internal audit should ensure
for significant changes; that it has a well-developed risk-assessment
Audit issue information, including aging, methodology that drives its risk-assessment pro-
past-due status, root-cause analysis, and the- cess. The methodology should include an analy-
matic trends; sis of cross-institutional risk and thematic con-
Information on higher-risk issues indicating trol issues and address its processes and
the potential impact, root cause, and remedia- procedures for evaluating the effectiveness of
tion status; risk management, control, and governance pro-
Results of internal and external quality assur- cesses. The methodology should also address
ance reviews; the role of continuous monitoring in determin-
Information on significant industry and insti- ing and evaluating risk, as well as internal
tution trends in risks and controls; audits process for incorporating other risk iden-
Reporting of significant changes in audit staff- tification techniques that the institutions man-
ing levels; agement utilizes such as a risk and control self-
Significant changes in internal audit pro- assessment (RCSA). The components of an
cesses, including a periodic review of key effective methodology should support the inter-
internal audit policies and procedures; nal audit functions assessment of the control
Budgeted audit hours versus actual audit environment, beginning with an evaluation of
hours; the audit universe.
Information on major projects; and
Opinion on the adequacy of risk-management Audit universe. Internal audit should have effec-
processes, including effectiveness of manage- tive processes to identify all auditable entities
ments self-assessment and remediation of within the audit universe. The number of audit-
identified issues (at least annually). able entities will depend upon whether entities
are captured at individual department levels or
Role of the chief audit executive. In addition to at other aggregated organizational levels. Inter-
communicating and reporting to the audit com- nal audit should use its knowledge of the institu-
mittee on audit-related matters, the CAE is tion to determine whether it has identified all
responsible for developing and maintaining a auditable entities and may use the general led-
quality assurance and improvement program ger, cost centers, new product approval pro-
that covers all aspects of internal audit activity, cesses, organization charts, department listings,
and for continuously monitoring the effective- knowledge of the institutions products and ser-
ness of the audit function. The CAE and/or vices, major operating and application systems,
senior staff should effectively manage and moni- significant laws and regulations, or other data.
tor all aspects of audit work on an ongoing The audit universe should be documented and
basis, including any audit work that is reviewed periodically as significant organiza-
outsourced.9 tional changes occur or at least during the
annual audit planning process.
2060.07.1.2.3 The Adequacy of the Internal audit risk assessment. A risk assess-
Internal Audit Functions Processes ment should document the internal audit staffs
understanding of the institutions significant
Internal audit should have an understanding of business activities and the associated risks.
the institutions strategy and operating processes These assessments typically analyze the risks
as well as the potential impact of current market inherent in a given business line or process, the
and macroeconomic conditions on the financial mitigating control processes, and the resulting
institution. Internal audits risk-assessment residual risk exposure to the institution.
methodology is an integral part of the evalua- A comprehensive risk assessment should
tion of overall policies, procedures, and controls effectively analyze the key risks (and the critical
at the institution and the development of a plan risk-management functions) within the institu-
to test those processes. tion and prioritize audit entities within the audit
universe. The risk-assessment process should be
well documented and dynamic, reflecting
9. The ongoing review of audit work should include risk changes to the system of internal controls, infra-
assessments of audit entities and elements, scope documents,
audit programs, detailed audit procedures and steps (including
structure, work processes, and new or changed
sampling methodologies), audit work papers, audit findings,
and monitoring of the timely and effective resolution of audit BHC Supervision Manual July 2013
issues. Page 5
business lines or laws and regulations. The risk when a significant risk will not be audited in the
assessments should also consider thematic con- specified timeframe and a requirement to notify
trol issues, risk tolerance, and governance the audit committee and seek its approval of any
within the institution. Risk assessments should exception to the framework. Generally, common
be revised in light of changing market condi- practice for institutions with defined audit cycles
tions or laws and regulations and updated dur- is to follow either a three- or four-year audit
ing the year as changes are identified in the cycle; high-risk areas should be audited at least
business activities of the institution or observed every twelve to eighteen months.11
in the markets in which the institution operates, The internal audit plan should consider the
but no less than annually. When the risk assess- risk assessment and internal audits approach to
ment indicates a change in risk, the audit plan audit coverage should be appropriate based on
should be reviewed to determine whether the the risk assessment. An effective plan covers
planned audit coverage should be increased or individual business areas and risk disciplines as
decreased to address the revised assessment of well as cross-functional and cross-institutional
risk. areas.
Risk assessments should be formally docu- The audit planning process should be
mented and supported with written analysis of dynamic, allowing for change when necessary.
the risks.10 There should be risk assessments for The process should include a process for modi-
critical risk-management functions within the fying the internal audit plan to incorporate sig-
institution. Risk assessments may be quantita- nificant changes that are identified either
tive or qualitative and may include factors such through continuous monitoring or during an
as the date of the last audit, prior audit results, audit. Any significant changes should be clearly
the impact and likelihood of an event occurring, documented and included in quarterly commu-
and the status of external vendor relationships. nications to the audit committee. Critical data to
A management RCSA, if performed, may be be reported to the audit committee should
considered by the internal audit function in include deferred or cancelled audits rated high-
developing its independent risk assessment. The risk and other significant additions or deletions.
internal audit risk assessment should also Significant changes to audit budgets and timeli-
include a specific rationale for the overall audit- ness for the completion of audits should be
able entity risk score. The overall disposition of reported to the audit committee with docu-
the risk assessment should be summarized with mented rationale.
consideration given to key performance or risk
indicators and prior audit results. A high-level Internal audit continuous monitoring. Internal
summary or discussion of the risk-assessment audit is encouraged to utilize formal continuous
results should be provided to the audit commit- monitoring practices as part of the functions
tee and include the most significant risks facing risk-assessment processes to support adjust-
the institution as well as how these risks have ments to the audit plan or universe as they
been addressed in the internal audit plan. occur. Continuous monitoring can be conducted
by an assigned group or individual internal audi-
Internal audit plan. Internal audit should develop tors. An effective continuous monitoring pro-
and periodically revise its comprehensive audit cess should include written standards to ensure
plan and ensure that audit coverage for all consistent application of processes throughout
identified, auditable entities within the audit the organization.
universe is appropriate for the size and Continuous monitoring results should be
complexity of the institutions activities. This documented through a combination of metrics,
should be accomplished either through a management reporting, periodic audit summa-
multiyear plan approach, with the plan revised ries, and updated risk assessments to substanti-
annually, or through an approach that utilizes a ate that the process is operating as designed.
framework to evaluate risks annually focusing on Critical issues identified through the monitoring
the most significant risks. In the latter approach, process should be communicated to the audit
there should be a mechanism in place to identify committee. Computer-assisted auditing tech-
niques are useful tools to highlight issues that
warrant further consideration within a continu-
10. For example, risks include credit, market, operational, ous monitoring process.
liquidity, compliance, IT, fraud, political, legal, regulatory,
strategic, and reputational.
11. Regardless of the institutions practice, particular care
should be taken to ensure that higher-risk elements are
BHC Supervision Manual July 2013 reviewed with an appropriate frequency, and not obscured due
Page 6 to their inclusion in a lower risk-rated audit entity.
2060.07.1.2.4 Internal Audit Performance conclusions, the rationale for those conclu-
and Monitoring Processes sions, and key issues. Most audit reports also
include managements action plans to address
Performance. Detailed guidance related to the audit findings. To ensure that identified issues
performance of an internal audit should be docu- are addressed in a timely manner, reports
mented in the audit manual12 and work pro- should be issued to affected business areas,
grams to ensure that audit execution is consis- senior management, and the audit committee
tent across the audit function. Internal audit within an appropriate timeframe after the
policies and procedures should be designed to completion of field work. Compliance with
ensure that audits are executed in a high-quality issuance timeframes should be monitored and
manner, their results are appropriately commu- reported periodically to the audit committee.
nicated, and issues are monitored and appropri- At a minimum, internal audit should ensure
ately resolved. In performing internal audit that management considers the level and sig-
work, an institution should consider the nificance of the risk when assigning resources
following. to address and remediate issues. Management
should appropriately document the action
Internal audit scope: During the audit plan- plans either within the audit report or
ning process, internal audit should analyze the separately.
auditable entitys specific risks, mitigating
controls, and level of residual risk. The infor- Internal audit issues tracking: Internal audit
mation gathered during the audit planning should have effective processes in place to
phase should be used to determine the scope track and monitor open audit issues and to
and specific audit steps that should be per- follow-up on such issues. The timely remedia-
formed to test the adequacy of the design and tion of open audit issues is an essential com-
operating effectiveness of control processes. ponent of an organizations risk reduction
efforts. Internal audit and the responsible
Internal audit work papers: Work papers management should discuss and agree to an
document the work performed, observations appropriate resolution date, based on the level
and analyses made, and support for the con- of work necessary to complete remediation
clusions and audit results. The work papers processes. When an issue owner indicates that
should contain sufficient information regard- work to close an issue is completed, the inter-
ing any scope or audit program modifications nal audit function should perform validation
and waiver of issues not included in the final work prior to closing the issue. The level of
report. Work papers also should document the validation necessary may vary based on the
specific sampling methodology, including issues risk level. For higher-risk issues, inter-
minimum sample sizes, and the rationale for nal audit should perform and document sub-
such methodology. The work papers should stantive testing to validate that the issue has
contain information that reflects all phases of been resolved. Issues should be tested over an
the audit process including planning, field- appropriate period of time to ensure the sus-
work, reporting, and issues tracking and tainability of the remediation.
follow-up. On an ongoing basis, a comprehen-
sive supervisory review should be performed Retrospective review processes. When an
on all audit work, including any outsourced adverse event occurs at an institution (for exam-
internal audit procedures.13 ple, fraud or a significant loss), management
should conduct a post-mortem and lessons
Audit report: Internal audit should have effec- learned analysis. In these situations, internal
tive processes to ensure that issues are com- audit should ensure that such a review takes
municated throughout the institution and audit place and appropriate action is taken to remedi-
issues are addressed in a timely manner. The ate identified issues. The internal audit function
audit report should include an executive sum- should evaluate managements analysis of the
mary that describes the auditable area, audits reasons for the event and whether the adverse
event was the result of a control breakdown or
12. To facilitate effective, efficient, and consistent practice failure, and identify the measures that should be
within the internal audit department, an institution should put in place to prevent a similar event from
develop an audit manual that includes comprehensive policies
and procedures and is made available to all internal audit
occurring in the future. In certain situations, the
staff. The manual should be updated as needed.
13. An experienced audit manager should perform this BHC Supervision Manual July 2013
review. Page 7
internal audit function should conduct its own for maintaining an effective system of internal
post-mortem and a lessons learned analysis controls. Responsibility for maintaining an
outlining the remediation procedures necessary effective system of internal controls cannot be
to detect, correct, and/or prevent future internal delegated to a third party. An institution that
control breakdowns (including improvements in chooses to outsource audit work should ensure
internal audit processes). that the audit committee maintains ownership of
the internal audit function. The institutions
Quality assurance and improvement program. audit committee and CAE should provide active
A well-designed, comprehensive quality assur- and effective oversight of outsourced activities.
ance program should ensure that internal audit Institutions should carefully consider the over-
activities conform to the IIAs professional stan- sight responsibilities that are consequential to
dards and the institutions internal audit policies these types of arrangements in determining
and procedures. The program should include appropriate staffing levels.
both internal and external quality assessments. To distinguish its duties from those of the
The internal audit function should develop outsourcing vendor, the institution should have
and document its internal assessment program a written contract, which may take the form of
to promote and assess the quality and consis- an engagement letter or similar services agree-
tency of audit work across all audit groups with ment. Contracts between the institution and the
respect to policies, procedures, audit perfor- vendor should include a provision stating that
mance, and work papers. The quality assurance work papers and any related non-public confi-
review should be performed by someone inde- dential information and personal information
pendent of the audit work being reviewed. Con- must be handled by the vendor in accordance
clusions reached and recommendations for with applicable laws and regulations. An institu-
appropriate improvement in internal audit pro- tion should periodically confirm that the vendor
cess or staff training should be implemented by continues to comply with the agreed-upon confi-
the CAE through the quality assurance and dentiality requirements, especially for long-term
improvement program. Action plan progress contracts. The audit committee should approve
should be monitored and subsequently closed all significant aspects of outsourcing arrange-
after a period of sustainability. Each institution ments and should receive information on audit
should conduct an internal quality assessment deficiencies in a manner consistent with that
annually and the CAE should report the results provided by the in-house audit department.
and status of internal assessments to senior man-
agement and the audit committee at least
annually. 2060.07.1.3.1 Vendor Competence
The IIA recommends that an external quality
assessment of internal audit be performed by a An institution should have appropriate policies
qualified independent party at least once every and procedures governing the selection and
five years. The review should address compli- oversight of internal audit vendors, including
ance with the IIAs definition of internal audit- whether to continue with an existing outsourced
ing, code of ethics, and standards, as well as arrangement. The audit committee and the CAE
with the internal audit functions charter, poli- are responsible for the selection and retention of
cies and procedures, and any applicable legisla- internal audit vendors and should be aware of
tive and regulatory requirements. The CAE factors that may impact vendors competence
should communicate the results, planned and ability to deliver high-quality audit services.
actions, and status of remediation efforts to
senior management and the audit committee.
2060.07.1.3 Internal Audit Outsourcing An institutions contingency plan should take

Arrangements (Part II of the 2003 Policy into consideration the extent to which the insti-
Statement) tution relies upon outsourcing arrangements.
When an institution relies significantly on the
As stated in the 2003 Policy Statement, an insti- resources of an internal audit service provider,
tutions board of directors and senior manage- the institution should have contingency proce-
ment are charged with the overall responsibility dures for managing temporary or permanent
disruptions in the service in order to ensure that
BHC Supervision Manual July 2013 the internal audit function can meet its intended
Page 8 objectives.
2060.07.1.3.3 Quality of Audit Work Statement on examination guidance and dis-

cusses the overall effectiveness of an institu-
The quality of audit work performed by the tions internal audit function and the examiners
vendor should be consistent with the institu- reliance on internal audit.
tions standards of work expected to be per-
formed by an in-house internal audit depart-
ment. Further, information supplied by the 2060.07.1.5.1 Determining the Overall
vendor should provide the board of directors, its Effectiveness of Internal Audit
audit committee, and senior management with
an accurate report on the control environment, An effective internal audit function is a vehicle
including any changes necessary to enhance to advance an institutions safety and soundness
controls. and compliance with consumer laws and regula-
tions and is therefore considered as part of the
supervisory review process. Federal Reserve
2060.07.1.4 Independence Guidance for examiners will make an overall determination as
the Independent Public Accountant (Part to whether the internal audit function and its
III of the 2003 Policy Statement) processes are effective or ineffective and
whether examiners can potentially rely upon
The following discussion supplements the dis-
internal audits work as part of the supervisory
cussion in Part III of the 2003 Policy Statement
review process. If internal audits overall pro-
and addresses additional requirements regarding
cesses are deemed effective, examiners may be
auditor independence for depository institutions
able to rely on the work performed by internal
subject to section 36 of the FDI Act (as amended
audit depending on the nature and risk of the
in 2009).
functions subject to examination.
The supervisory assessment of internal audit
2060.07.1.4.1 Depository Institutions and its effectiveness will consider an institu-
Subject to the Annual Audit and tions application of the 2003 Policy Statement
Reporting Requirements of Section 36 of and this supplemental guidance. An institutions
the FDI Act internal audit function generally would be con-
sidered effective if the institutions internal audit
The July 2009 amendments to section 36 of the function structure and practices are consistent
FDI Act (applicable to insured depository insti- with the 2003 Policy Statement and this guid-
tutions with total assets of $500 million or more) ance.
require an institutions external auditor to fol- Conversely, an institutions internal audit
low the more restrictive of the independence function that does not follow the enhanced prac-
rules issued by the AICPA, SEC, and PCAOB. tices and supplemental guidance outlined in this
In March 2003, the SEC prohibited a registered policy letter generally will be considered inef-
public accounting firm that is responsible for fective. In such a case, examiners will not rely
furnishing an opinion on the consolidated or on the institutions internal audit function.
separate financial statements of an audit client Examiners will inform the CAE as to whether
from providing internal audit services to that the function is deemed to be effective or ineffec-
same client.14 Therefore, by following the more tive. Internal audits overall processes could be
restrictive independence rules, a depository deemed effective even though some aspects of
institutions external auditor is precluded from the internal audit function may require
performing internal audit services, either on a enhancements or improvements such as addi-
co-sourced or an outsourced basis, even if the tional documentation with respect to specific
institution is not a public company. audit processes (for example, risk assessments
or work papers). In these situations, the required
enhancements or improvements generally
2060.07.1.5 Examination Guidance (Part should not be a critical part of the overall inter-
IV of the 2003 Policy Statement) nal audit function, or the function should be
deemed to be ineffective.
The following discussion supplements the exist-
ing guidance in Part IV of the 2003 Policy
14. See SEC final rule, Strengthening the Commissions

Requirements Regarding Auditor Independence, at 17 CFR BHC Supervision Manual July 2013
parts 210, 240, 249 and 274. Page 9
2060.07.1.5.2 Relying on the Work Examiners may choose to rely on the work of
Performed by Internal Audit internal audit when internal audits overall func-
tion and related processes are effective and
Examiners may rely on internal audit at super- when recent work was performed by internal
vised institutions if internal audit was deemed audit in an area where examiners are performing
effective at the most recent examination of inter- examination procedures. For example, if an
nal audit. In examining an institutions internal internal audit department performs internal audit
audit function, examiners will supplement their work in an area where examiners might also
examination procedures through continuous review controls, examiners may evaluate
monitoring and an assessment of key elements whether they can rely on the work of internal
of internal audit, including (1) the adequacy and audit (and either eliminate or reduce the testing
independence of the audit committee; (2) the scheduled as part of the regulatory examination
independence, professional competence, and processes). In high-risk areas, examiners will
quality of the internal audit function; (3) the consider whether additional examination work
quality and scope of the audit methodology, is needed even where internal audit has been
audit plan, and risk assessment; and (4) the deemed effective and its work reliable.
adequacy of audit programs and work paper
standards. On at least an annual basis, examin-
ers should review these key elements to deter- * * * * * * * * * * *
mine whether there have been significant
changes in the internal audit infrastructure or (End of the January 23, 2013, Supplemental
whether there are potential concerns regarding Policy Statement)
their adequacy.

Page 10
Audit
(Management Information Systems) Section 2060.1
WHATS NEW IN THIS REVISED tional requirements of the job under the guid-
SECTION ance and leadership of the auditor. When evalu-
ating the effectiveness of an internal audit
Effective January 2016, this section has been program, the examiner may want to consider the
revised to incorporate the January 15, 2016 size of audit staffs of banking organizations of a
Interagency Advisory on External Audits of similar size and complexity. To ensure freedom
Internationally Active U.S. Financial Institu- of access to corporate records and complete
tions. The federal banking agencies issued the independence and objectivity in administering
interagency advisory to communicate their sup- the audit program, the auditor should report
port for the principles and expectations set forth directly to the directorate or a committee
in parts 1 and 2 of the Basel Committee on thereof. Administratively, the internal auditor is
Banking Supervisions March 2014 guidance on usually responsible to an officer at a major poli-
External audits of banks. Internationally cymaking level.
Active Banks is defined in the advisory. Refer To supplement the internal audit activities,
to subsection 2060.1.8 and SR-16-2 and its external accountants-auditors may be engaged
attachment. to certify or audit the financial statements or
specified activities of the bank holding company
and its subsidiaries. Each top-tier bank holding
2060.1.1 INTERNAL AND EXTERNAL company with total consolidated assets of $500
AUDIT PROGRAMS AND ACTIVITIES million or more must engage independent pub-
lic accountants to perform audits and report on
Audit is an independent appraisal activity that its annual financial statements in accordance
serves as a managerial control within an organi- with generally accepted accounting principles.
zation. The primary responsibility for the main- The scope of the audit engagement must be
tenance of sound systems of internal controls sufficient to permit such accountant to deter-
and an adequate internal audit program rests mine and report whether the financial statements
with the directorate of the bank holding com- are presented fairly and in accordance with gen-
pany. Included among the objectives of a com- erally accepted accounting principles. Bank
prehensive audit program are the detection of holding companies do not have to submit
irregularities; the determination of compliance audited financial statements as part of the
with applicable laws and regulations; and the requirements for the FR Y-6 annual report. The
appraisal of the soundness and adequacy of Federal Reserve may request audited consoli-
accounting, operating, and administrative con- dated financial statements from any bank hold-
trols designed to ensure prompt and accurate ing company with total consolidated assets of
recording of transactions and proper safeguard- less than $500 million if deemed warranted for
ing of assets. At a minimum, an audit program supervisory purposes.
should ensure that adequate systems of checks The internal and external auditors should
and balances are in effect to deter fraud and work together in establishing the scope and fre-
detect control deficiencies. quency of audits to be performed. In addition to
The size and complexity of a bank holding performing some of the basic functions of the
company operation are major determinants in internal auditor, the external auditor should
the scope and extent of the audit program that is review the internal auditing program to assess
developed. In the smaller, less sophisticated its scope and adequacy. When a bank holding
organizations, such as holding company shells company is perhaps too small to employ an
for small banks, it may not be feasible to employ internal audit staff, but when the complexities
an auditor or implement an audit program. In and activities of the organization suggest the
some cases, such as those in which banking need for an audit, the holding company should
assets represent virtually all of the parent com- consider hiring an external auditor. Indepen-
panys assets and a comprehensive, effective dence and objectivity are mandatory in any audit
audit program is being implemented in the vari- program, and these are difficult to maintain if
ous subsidiaries, neither an internal nor an exter- the audit function is a part-time responsibility.
nal audit program may be necessary at the par- When external auditors are employed to per-
ent company level. form the internal audit function, they should be
The development and implementation of an
internal audit program should be delegated to a BHC Supervision Manual January 2016
qualified staff large enough to meet the func- Page 1
Audit 2060.1
permitted to establish the scope of their audits confidentiality of the reports and other supervi-
and schedule surprise audits. They also should sory communications reviewed as part of their
be given responsibility for suggesting systems engagement. See also the Boards rules on the
and organizational duty assignments for maxi- release of confidential supervisory information
mum control consistent with the size of the (12 C.F.R. 261, subpart C).
organization.
2060.1.3 EXTERNAL AUDITOR

2060.1.2 EXTERNAL AUDITORS AND INQUIRIES
THE RELEASE OF REQUIRED
INFORMATION In some situations, examiners may not be able
to fully respond to external auditors inquiries
The enactment of the Financial Institutions on certain matters relating to examinations still
Reform, Recovery, and Enforcement Act in progress. The examiners findings may be
(FIRREA) on August 9, 1989, requires that incomplete or may be under review by higher
FDIC-insured depository institutions that are supervisory authorities within the Federal
being audited provide their independent auditors Reserve System. In addition, as a general prac-
with information concerning their financial con- tice, examiners will normally only discuss with
dition and any supervisory actions being taken external auditors issues and inspection findings
against them. Specifically, section 36(h)(1) of that have been presented to the bank holding
the Federal Deposit Insurance Act (12 U.S.C. companys management. These situations relate
1831m(h)(1)) (the FDI Act) requires an insured primarily to the timing of the auditors inquiries
depository institution that has engaged the ser- in relation to the stage of inspection work and,
vices of an independent auditor to perform an thus, should not automatically preclude an audi-
audit within the past two years to provide the tor from expressing an opinion on the organiza-
auditor with tions financial statements.
1. a copy of the most recent report of condition

made by the institution (pursuant to the FDI 2060.1.4 UNSAFE AND UNSOUND
Act or any other provision of law) and a USE OF LIMITATION-OF-LIABILITY
copy of the most recent report of examina- PROVISIONS IN EXTERNAL AUDIT
tion received by the institution; ENGAGEMENT LETTERS
2. a copy of any supervisory memorandum of
understanding with such institution and any On February 9, 2006, the Federal Reserve and
written agreement between a federal or state the other financial institution regulatory agen-
banking agency and the depository institu- cies (the agencies)1 issued an interagency advi-
tion that is in effect during the period cov- sory (the advisory) to address safety-and-
ered by the audit; and soundness concerns that may arise when
3. a report of any action initiated or taken by a financial institutions enter into external audit
federal banking agency during the period contracts (typically referred to as engagement
covered by the audit under subsection (a), letters) that limit the auditors liability for audit
(b), (c), (e), (g), (i), (s), or (t) of section 8 of services.2 The advisory informs financial institu-
the FDI Act or of any similar action taken by tions3 boards of directors, audit committees,
a state banking agency under state law, or management, and external auditors of the safety-
any other civil money penalty assessed under and-soundness implications that may arise when
any other provision of law with respect to the the financial institution enters into engagement
depository institution or any affiliated party. letters that contain provisions to limit the audi-
tors liability.
External auditors who are serving as agents The advisory does not apply to previously
of a bank holding company may, with the
approval of the organization, review examina- 1. The Board of Governors of the Federal Reserve System
tion or inspection reports and supervisory corre- (Board), the Office of the Comptroller of the Currency (OCC),
spondence received and communicate with the Federal Deposit Insurance Corporation (FDIC), and the
examiners. Examiners should remind external National Credit Union Administration (NCUA).
2. The advisory is effective for audit engagement letters
auditors of their responsibility to maintain the issued on or after February 9, 2006.
3. As used in this advisory, the term financial institutions
BHC Supervision Manual January 2016 includes bank holding companies, banks, savings associa-
Page 2 tions, and savings and loan holding companies.
Audit 2060.1
executed engagement letters. However, any pendent and objective view of the reliability of a
financial institution subject to a multiyear audit financial institutions financial statements. The
engagement letter containing unsafe and external auditors objective in an audit is to
unsound limitation-of-liability provisions should form an opinion on the financial statements
seek an amendment to its engagement letter to taken as a whole. When planning and perform-
be consistent with the advisory for periods ending the audit, the external auditor considers the
ing in 2007 or later. (See SR-06-4.) financial institutions internal control over
Limits on external auditors liability may financial reporting. Generally, the external audi-
weaken the external auditors objectivity, impar- tor communicates any identified deficiencies in
tiality, and performance and, thus, reduce the internal control to management, which enables
agencies ability to rely on audits. Therefore, management to take appropriate corrective
certain limitation-of-liability provisions action. In addition, certain financial institutions
(described in the advisory and its appendix A; are required to file audited financial statements
see section 2060.1.4.7) are unsafe and unsound. and internal control audit or attestation reports
In addition, such provisions may not be consis- with one or more of the agencies. The agencies
tent with the auditor-independence standards of encourage financial institutions not subject to
the U.S. Securities and Exchange Commission mandatory audit requirements to voluntarily
(SEC), the Public Company Accounting Over- obtain audits of their financial statements. The
sight Board (PCAOB), and the American Insti- FFIECs September 1999 Interagency Policy
tute of Certified Public Accountants (AICPA). Statement on External Auditing Programs of
Banks and Savings Associations4 notes, [a]n
institutions internal and external audit pro-
2060.1.4.1 Scope of the Advisory on grams are critical to its safety and soundness.
Engagement Letters The policy also states that an effective external
auditing program can improve the safety and
The advisory applies to engagement letters soundness of an institution substantially and
between financial institutions and external audi- lessen the risk the institution poses to the insur-
tors with respect to financial-statement audits, ance funds administered by the FDIC.
audits of internal control over financial report- Typically, a written engagement letter is used
ing, and attestations on managements assess- to establish an understanding between the exter-
ment of internal control over financial reporting nal auditor and the financial institution regard-
(collectively, audit or audits). ing the services to be performed in connection
The advisory does not apply to with the financial institutions audit. The
engagement letter commonly describes the
1. nonaudit services that may be performed by objective of the audit, the reports to be prepared,
financial institutions external auditors, the responsibilities of management and the
2. audits of financial institutions 401(k) plans, external auditor, and other significant arrange-
pension plans, and other similar audits, ments (for example, fees and billing). Boards of
3. services performed by accountants who are directors, audit committees, and management
not engaged to perform financial institutions are encouraged to closely review all of the pro-
audits (e.g., outsourced internal audits or visions in the audit engagement letter before
loan reviews), and agreeing to sign. As with all agreements that
4. other service providers (e.g., software con- affect a financial institutions legal rights, the
sultants or legal advisers). financial institutions legal counsel should care-
fully review audit engagement letters to help
While the agencies have observed several ensure that those charged with engaging the
types of limitation-of-liability provisions in external auditor make a fully informed decision.
external audit engagement letters, this advisory The advisory describes the types of objection-
applies to any agreement that a financial institu- able limitation-of-liability provisions and pro-
tion enters into with its external auditor that vides examples.5 Financial institutions boards
limits the external auditors liability with respect
to audits in an unsafe and unsound manner. 4. See 64 Fed. Reg. 52,319 (September 28, 1999).
5. In the majority of external audit engagement letters
reviewed, the agencies did not observe provisions that limited
an external auditors liability. However, for those reviewed
2060.1.4.2 External Audits and Their external audit engagement letters that did have external audi-
Engagement Letters
A properly conducted audit provides an inde- Page 3
Audit 2060.1
of directors, audit committees, and management with $500 million or more in total assets are
should also be aware that certain insurance poli- required to have annual independent audits.6
cies (such as error and omission policies and Furthermore, financial institutions that are pub-
directors and officers liability policies) might lic companies7 must have annual independent
not cover losses arising from claims. audits. Certain savings associations (for exam-
ple, those with a CAMELS rating of 3, 4, or 5)
and savings and loan holding companies are
2060.1.4.3 Limitation-of-Liability also required by OTSs regulations to have
Provisions annual independent audits.8 The agencies rely
on the results of audits as part of their assess-
The provisions of an external audit engagement ment of a financial institutions safety and
letter that the agencies deem to be unsafe and soundness.
unsound can be generally categorized as fol- For audits to be effective, the external audi-
lows: a provision within an agreement between tors must be independent in both fact and
a client financial institution and its external appearance, and they must perform all neces-
auditor that effectively sary procedures to comply with auditing and
attestation standards established by either the
1. indemnifies the external auditor against AICPA or, if applicable, the PCAOB. When
claims made by third parties; financial institutions execute agreements that
2. holds harmless or releases the external audi- limit the external auditors liability, the external
tor from liability for claims or potential auditors objectivity, impartiality, and perfor-
claims that might be asserted by the client mance may be weakened or compromised, and
financial institution, other than claims for the usefulness of the audits for safety-and-
punitive damages; or soundness purposes may be diminished.
3. limits the remedies available to the client By their very nature, limitation-of-liability
financial institution, other than punitive provisions can remove or greatly weaken exter-
damages. nal auditors objective and unbiased consider-
ation of problems encountered in audit engage-
Collectively, these categories of provisions ments and may diminish auditors adherence to
are referred to in this advisory as limitation-of- the standards of objectivity and impartiality
liability provisions. required in the performance of audits. The exis-
Provisions that waive the right of financial tence of such provisions in external audit
institutions to seek punitive damages from their engagement letters may lead to the use of less
external auditor are not treated as unsafe and extensive or less thorough procedures than
unsound under the advisory. Nevertheless, would otherwise be followed, thereby reducing
agreements by clients to indemnify their audi- the reliability of audits. Accordingly, financial
tors against any third-party damage awards, institutions should not enter into external audit
including punitive damages, are deemed unsafe arrangements that include unsafe and unsound
and unsound under the advisory. To enhance limitation-of-liability provisions identified in the
transparency and market discipline, public advisory, regardless of (1) the size of the finan-
financial institutions that agree to waive claims cial institution, (2) whether the financial institu-
for punitive damages against their external audi- tion is public or not, or (3) whether the external
tors may want to disclose annually the nature of audit is required or voluntary.
these arrangements in their proxy statements or
other public reports.
Many financial institutions are required to 2060.1.4.4 Auditor Independence
have their financial statements audited, while
others voluntarily choose to undergo such Currently, auditor-independence standard-setters
audits. For example, federally insured banks include the SEC, PCAOB, and AICPA. Depend-
ing on the audit client, an external auditor is
tor limited-liability provisions, the agencies noted a signifi- subject to the independence standards issued by
cant increase in the types and frequency of the provisions. The one or more of these standard-setters. For all
provisions took many forms, which made it impractical for
the agencies to provide an all-inclusive list. Examples of
6. For banks and savings associations, see section 36 of the
auditor limitation-of-liability provisions are illustrated in the
FDI Act (12 U.S.C. 1831m) and part 363 of the FDICs
advisorys appendix A. See section 2060.1.4.7.
regulations (12 C.F.R. 363).
7. Public companies are companies subject to the reporting
BHC Supervision Manual January 2016 requirements of the Securities Exchange Act of 1934.
Page 4 8. See OTS regulation at 12 C.F.R. 563.4.
Audit 2060.1
nonpublic financial institutions that are not 2060.1.4.5 Alternative Dispute-Resolution

required to have annual independent audits, the Agreements and Jury-Trial Waivers
FDICs rules, pursuant to part 363 (or section
562.4 of the OTSs regulations) require only The agencies observed that a review of the
that an external auditor meet the AICPA inde- engagement letters of some financial institutions
pendence standards. The rules do not require the revealed that they had agreed to submit disputes
financial institutions external auditor to comply over external audit services to mandatory and
with the independence standards of the SEC and binding alternative dispute resolution, binding
the PCAOB. arbitration, or other binding nonjudicial dispute-
In contrast, for financial institutions subject to resolution processes (collectively, mandatory
the audit requirements in part 363 of the FDICs ADR) or to waive the right to a jury trial. By
regulations (or in section 562.4 of the OTS agreeing in advance to submit disputes to man-
regulations), the external auditor should be in datory ADR, financial institutions may waive
compliance with the AICPAs Code of Profes- the right to full discovery, limit appellate
sional Conduct and meet the independence review, or limit or waive other rights and pro-
requirements and interpretations of the SEC and tections available in ordinary litigation
its staff.9 In this regard, in a December 13, 2004, proceedings.
frequently asked question (FAQ) on the applica- Mandatory ADR procedures and jury-trial
tion of the SECs auditor-independence rules, waivers may be efficient and cost-effective tools
the SEC staff reiterated its long-standing posi- for resolving disputes in some cases. Accord-
tion that when an accountant and his or her ingly, the agencies believe that mandatory ADR
client enter into an agreement that seeks to or waiver of jury-trial provisions in external
provide the accountant immunity from liability audit engagement letters do not present safety-
for his or her own negligent acts, the accountant and-soundness concerns, provided that the
is not independent. The SECs FAQ also stated engagement letters do not also incorporate
that including in engagement letters a clause limitation-of-liability provisions. Institutions are
that would release, indemnify, or hold the encouraged to carefully review mandatory ADR
auditor harmless from any liability and costs and jury-trial provisions in engagement letters,
resulting from knowing misrepresentations by as well as review any agreements regarding
management would impair the auditors rules of procedure, and to fully comprehend the
independence. The FAQ is consistent with the ramifications of any agreement to waive any
SECs Codification of Financial Reporting Poli- available remedies. Financial institutions should
cies, section 602.02.f.i, Indemnification by Cli- ensure that any mandatory ADR provisions in
ent. (See section 2060.1.4.8.) audit engagement letters are commercially rea-
On the basis of the SEC guidance and the sonable and
agencies existing regulations, certain limits on
auditors liability are already inappropriate in 1. apply equally to all parties,
audit engagement letters entered into by 2. provide a fair process (for example, neutral
decision makers and appropriate hearing pro-
1. public financial institutions that file reports cedures), and
with the SEC or with the agencies, 3. are not imposed in a coercive manner.
2. financial institutions subject to part 363,10
and
3. certain other financial institutions that are 2060.1.4.6 The Advisorys Conclusion
required to have annual independent audits.
Financial institutions boards of directors, audit
In addition, certain of these limits on audi- committees, and management should not enter
tors liability may violate the AICPA indepen- into any agreement that incorporates limitation-
dence standards. Notwithstanding the potential of-liability provisions with respect to audits. In
applicability of auditor-independence standards, addition, financial institutions should document
the limitation-of-liability provisions discussed their business rationale for agreeing to any other
in the advisory present safety-and-soundness provisions that limit their legal rights.
concerns for all financial institution audits. The inclusion of limitation-of-liability provi-
sions in external audit engagement letters and
9. See part 363 of the FDICs regulation (12 C.F.R. 363),
other agreements that are inconsistent with the
Appendix AGuidelines and Interpretations, Guideline 14,
Role of the Independent Public Accountant-Independence. BHC Supervision Manual January 2016
10. See also the OTSs regulation (12 C.F.R. 562.4). Page 5
Audit 2060.1
advisory will generally be considered an unsafe the extent finally determined to have resulted
and unsound practice. Examiners will consider from the willful misconduct or fraudulent behav-
the policies, processes, and personnel surround- ior of [the audit firm] relating to such services.
ing a financial institutions external auditing
program in determining whether (1) the engage-
ment letter covering external auditing activities 2. No Damages Provision
raises any safety-and-soundness concerns and
(2) the external auditor maintains appropriate In this type of provision, the financial institu-
independence regarding relationships with the tion agrees that in no event will the external
financial institution under relevant professional audit firms liability include responsibility for
standards. The agencies may take appropriate any compensatory (incidental or consequential)
supervisory action if unsafe and unsound damages claimed by the financial institution.
limitation-of-liability provisions are included in
external audit engagement letters or other agree- Example: In no event will [the audit firms]
ments related to audits that are executed liability under the terms of this agreement
(accepted or agreed to by the financial include responsibility for any claimed incidental
institution). or consequential damages.
2060.1.4.7 Examples of Unsafe and 3. Limitation of Period to File Claim

Unsound Limitation-of-Liability Provision
Provisions
In this type of provision, the financial institu-
The following information was contained in tion agrees that no claim will be asserted after a
appendix A of the February 9, 2006, inter- fixed period of time that is shorter than the
agency advisory. applicable statute of limitations, effectively
agreeing to limit the financial institutions rights
Presented below are some of the types of in filing a claim.
limitation-of-liability provisions (with an illus-
trative example of each type) that the agencies Example: It is agreed by the financial institution
observed in financial institutions external audit and [the audit firm] or any successors in inter-
engagement letters. The inclusion in external est that no claim arising out of services ren-
audit engagement letters or agreements related dered pursuant to this agreement by, or on
to audits of any of the illustrative provisions behalf of, the financial institution shall be
(which do not represent an all-inclusive list) or asserted more than two years after the date of
any other language that would produce similar the last audit report issued by [the audit firm].
effects is considered an unsafe and unsound
practice.
4. Losses Occurring During Periods
Audited Provision
1. Release from Liability for Auditor
Negligence Provision In this type of provision, the financial institu-
tion agrees that the external audit firms liability
In this type of provision, the financial institu- will be limited to any losses occurring during
tion agrees not to hold the audit firm liable for periods covered by the external audit, and will
any damages, except to the extent determined to not include any losses occurring in later periods
have resulted from willful misconduct or for which the external audit firm is not engaged.
fraudulent behavior by the audit firm. This provision may not only preclude the collec-
tion of consequential damages for harm in later
Example: In no event shall [the audit firm] be years, but could preclude any recovery at all. It
liable to the financial institution, whether a appears that no claim of liability could be
claim be in tort, contract or otherwise, for any brought against the external audit firm until the
consequential, indirect, lost profit, or similar external audit report is actually delivered. Under
damages relating to [the audit firms] services such a clause, any claim for liability thereafter
provided under this engagement letter, except to might be precluded because the losses did not
occur during the period covered by the external
BHC Supervision Manual January 2016 audit. In other words, it might limit the external
Page 6 audit firms liability to a period before there
Audit 2060.1
could be any liability. Read more broadly, the 7. Indemnification for Management
external audit firm might be liable for losses that Negligence Provision
arise in subsequent years only if the firm contin-
ues to be engaged to audit the clients financial In this type of provision, the financial institu-
statements in those years. tion agrees to protect the external auditor from
third-party claims arising from the external audit
Example: In the event the financial institution is firms failure to discover negligent conduct by
dissatisfied with [the audit firms] services, it is management. It would also reinforce the defense
understood that [the audit firms] liability, if of contributory negligence in cases in which the
any, arising from this engagement will be lim- financial institution brings an action against its
ited to any losses occurring during the periods external auditor. In either case, the contractual
covered by [the audit firms] audit, and shall defense would insulate the external audit firm
not include any losses occurring in later periods from claims for damages even if the reason the
for which is not engaged as auditors. external auditor failed to discover the negligent
conduct was a failure to conduct the external
audit in accordance with generally accepted
5. No Assignment or Transfer auditing standards or other applicable profes-
Provision sional standards.
In this type of provision, the financial institu- Example: The financial institution shall indem-
tion agrees that it will not assign or transfer any nify, hold harmless, and defend and its autho-
claim against the external audit firm to another rized agents, partners, and employees from and
party. This provision could limit the ability of against any and all claims, damages, demands,
another party to pursue a claim against the exter- actions, costs, and charges arising out of, or by
nal auditor in a sale or merger of the financial reason of, the financial institutions negligent
institution, in a sale of certain assets or a line of acts or failure to act hereunder.
business of the financial institution, or in a
supervisory merger or receivership of the finan-
cial institution. This provision may also prevent
the financial institution from subrogating a 8. Damages Not to Exceed Fees Paid
claim against its external auditor to the financial Provision
institutions insurer under its directors and offi-
cers liability or other insurance coverage. In this type of provision, the financial institu-
tion agrees to limit the external auditors liabil-
ity to the amount of audit fees the financial
Example: The financial institution agrees that it
institution paid the external auditor, regardless
will not, directly or indirectly, agree to assign or
of the extent of damages. This may result in a
transfer any claim against [the audit firm] aris-
substantial unrecoverable loss or cost to the
ing out of this engagement to anyone.
financial institution.
Example: [The audit firm] shall not be liable for

6. Knowing Misrepresentations by any claim for damages arising out of or in
Management Provision connection with any services provided herein to
the financial institution in an amount greater
In this type of provision, the financial institu- than the amount of fees actually paid to [the
tion releases and indemnifies the external audit audit firm] with respect to the services directly
firm from any claims, liabilities, and costs attrib- relating to and forming the basis of such
utable to any knowing misrepresentation by claim.11
management.
Example: Because of the importance of oral and

written management representations to an effec-
tive audit, the financial institution releases and
11. The agencies also observed a similar provision that
indemnifies [the audit firm] and its personnel limited damages to a predetermined amount not related to fees
from any and all claims, liabilities, costs, and paid.
expenses attributable to any knowing misrepre-
sentation by management. BHC Supervision Manual January 2016
Page 7
Audit 2060.1
2060.1.4.8 Frequently Asked Questions result in a failure to appraise with professional

on the Application of the SECs acumen the information disclosed by the exami-
Auditor-Independence Rules nation. Consequently, the accountant cannot be
recognized as independent for the purpose of
The following information is contained in certifying the financial statements of the corpo-
appendix B of the February 9, 2006, inter- ration.
agency advisory. The information is derived
from the SECs Office of Chief Accountants
Codification of Financial Reporting Policies. Question
Has there been any change in the commis-
Question12 sions long-standing view (Financial Reporting
PoliciesSection 600602.02.f.i., Indemnifi-
Inquiry was made as to whether an accoun- cation by Client) that when an accountant
tant who certifies financial statements included enters into an indemnity agreement with the
in a registration statement or annual report filed registrant, his or her independence would come
with the commission under the Securities Act or into question?
the Exchange Act would be considered indepen-
dent if he had entered into an indemnity agree-
ment with the registrant. In the particular illus- Answer
tration cited, the board of directors of the
registrant formally approved the filing of a reg- No. When an accountant and his or her client,
istration statement with the commission and directly or through an affiliate, enter into an
agreed to indemnify and save harmless each and agreement of indemnity that seeks to provide
every accountant who certified any part of such the accountant immunity from liability for his or
statement from any and all losses, claims, dam- her own negligent acts, whether of omission or
ages or liabilities arising out of such act or acts commission, the accountant is not independent.
to which they or any of them may become Further, including in engagement letters a clause
subject under the Securities Act, as amended, or that a registrant would release, indemnify, or
at common law, other than for their willful hold harmless from any liability and costs
misstatements or omissions. resulting from knowing misrepresentations by
management would also impair the firms
independence.
Answer
When an accountant and his client, directly or 2060.1.3 INSPECTION OBJECTIVES
through an affiliate, have entered into an agree-
ment of indemnity which seeks to assure to the 1. To review the operations of the bank holding
accountant immunity from liability for his own company to determine if an audit program
negligent acts, whether of omission or commis- exits.
sion, one of the major stimuli to objective and 2. To determine the independence and compe-
unbiased consideration of the problems encoun- tence of those who administer and provide
tered in a particular engagement is removed or the internal and external audit function.
greatly weakened. Such condition must fre- 3. To determine the adequacy of the scope and
quently induce a departure from the standards of frequency of the audit program.
objectivity and impartiality which the concept 4. To determine with reasonable assurance that
of independence implies. In such difficult mat- the bank holding company has adequate
ters, for example, as the determination of the internal audit and external audit functions
scope of audit necessary, existence of such an that ensure efficient and effective operations,
agreement may easily lead to the use of less including the safeguarding of assets, reliable
extensive or thorough procedures than would financial reporting, and compliance with
otherwise be followed. In other cases it may applicable laws and regulations.
5. To ascertain if the bank holding companys
12. The subtitles in this section have been revised for this
internal audit function monitors, reviews, and
manual. ensures the continued existence and mainte-
nance of sound and adequate internal con-
BHC Supervision Manual January 2016 trols over the bank holding companys man-
Page 8 agement processthe control environment,
Audit 2060.1
risk assessment, control activities, informa- procedures, with equal emphasis being placed
tion and communication, and monitoring on the parent, bank, and nonbank subsidiaries,
activities. are recommended as minimum guidelines for
6. To review and evaluate internal audit out- the inspection.
sourcing arrangements and the actions of the 1. Review the parent company and nonbank
outsourcing vendor under the standards operations and the audit comments in
established by the Interagency Policy State- the bank examination reports to ascertain
ment on the Internal Audit Function and Its the adequacy of the existing audit program
Outsourcing. or the need for developing such a program,
7. To consider the policies, processes, and per- if the organization currently lacks one.
sonnel surrounding the bank holding com- 2. Review the scope of the audit function to
panys external auditing program and to ensure that procedures are in place to cover
determine the existence of any unsafe and adequately those areas that may be suscep-
unsound practices or conditions, including tible to exposure. When reviewing the audit
whether scope, determine whether the auditor was
a. any engagement letter or other agreement able to perform all the procedures necessary
related to external audit activities (1) pro- to complete the audit. If not
vides any assurances of indemnification to a. establish whether the scope limita-
the banks external auditors that relieves tions were imposed by the directorship
them of liability for their own negligent or management and
acts (including any losses, claims, dam- b. determine whether the auditor estab-
ages, or other liabilities) or (2) raises any lished and documented the reasons why
other safety-and-soundness concerns; and the scope limitations were imposed.
b. the external auditors have not maintained (1) Was the auditor able to quantify the
appropriate independence in their relation- effects of the scope limitation on the
ships with the bank holding company, in financial statements and the audit
accordance with relevant professional results, and, if not pervasive, was a
standards. qualified opinion or disclaimer of
8. To determine, based on the criteria above, if opinion issued?
the work performed by internal and external (2) Did the auditor evaluate all possible
auditors is reliable. effects on his ability to express an
opinion on the financial statements?
(3) Were there any external circum-
2060.1.6 INSPECTION PROCEDURES stances that imposed limitations on
the audits scope?
The primary thrust of the inspection should be (4) Were alternative procedures used to
directed toward the audit activities that relate to accomplish the same audit objec-
the parent company and all subsidiaries. An tives? If so, did the use of the alterna-
assessment of the audit function as it pertains to tive procedures justify issuance of an
the bank (or banks) is primarily the responsibil- unqualified opinion?
ity of the regulatory agency that examines that 3. Review the audit schedule to determine that
particular bank. The examiner should review the the audits are satisfactorily spaced and that
latest bank examination reports to note com- all functions are audited with adequate
ments and deficiencies cited concerning internal frequency.
controls and the audit function. In addition to 4. Review audit workpapers and reports on a
providing an input into the overall assessment test-check basis for adequacy of content,
of the audit function, review of the bank exami- satisfactory maintenance, and conformance
nation reports may provide a basis for determin- to audit guidelines outlined by the board of
ing areas of investigation during the inspection. directors.
Further, if matters cited in the latest bank exami- 5. Determine the qualifications and back-
nation report are deemed to be significant and ground of the auditor and others participat-
indications are that corrective action has not ing in the audit function.
been taken, the examiner should mention the 6. To establish that the auditor has a direct
facts to senior management of the bank holding communication line to the board of direc-
company and note the details in the inspection tors and freedom of access to all records for
report.
To judge the adequacy of the audit program, BHC Supervision Manual January 2016
including its scope and frequency, the following Page 9
Audit 2060.1
audit purposes, review audit reports and placed on the work of the internal audit
minutes of meetings held by directors or a staff.
committee thereof. 14. Determine if the audit engagement letters or
7. Determine the entity responsible for main- other agreements include possible unsafe
taining the audit function. If a bank pro- and unsound provisions or practices that
vides audit services to affiliates, indicate the a. indemnify the external auditor against
manner in which the bank is reimbursed for all claims made by third parties;
the cost of such services. b. hold harmless, release, or indemnify the
8. Determine whether audit reports are submit- external auditor from liability for claims
ted on a timely basis to or potential claims that the BHC may
a. the directors and senior management and assert, thus providing relief from liabil-
b. management in the area being audited. ity for the auditors own negligent acts,
including any losses, claims, damages,
9. Review responses to exceptions and recom-
or other liabilities, (other than claims for
mendations noted in audit reports.
punitive damages); or
10. Check on the relationship between the inter- c. limit the remedies available to the BHC
nal and any external auditors to determine (other than punitive damages).
whether their activities are coordinated in a 15. Find out whether the BHCs board of direc-
manner that effects comprehensive cover- tors, audit committee, and senior manage-
age of the organization and at the same time ment closely review all of the provisions of
avoids duplication of effort. audit engagement letters or other agree-
11. Review the letter addressed to management ments for providing external auditing ser-
by the external auditor and determine that vices for the bank before agreeing to sign,
steps have been taken to correct any defi- thus indicating the BHCs approval and
ciencies noted. If no deficiencies were noted financial commitment.
in the letter, inquire as to whether such 16. Verify that the BHC has documented its
comments were communicated to manage- business rationale for any engagement letter
ment by any other means. or other agreement provisions with external
12. Ascertain that the audit program is annually audit firms that limit or impair the BHCs
reviewed and approved by the directors. legal rights.
13. If the BHC has engaged any external audit 17. If new external auditors have been engaged,
firms to conduct audits of its financial state- ascertain the reasons for such change.
ments (including their certification), audits 18. Determine if the parent company or non-
of internal control over financial reporting, bank subsidiaries have reported any defal-
attestations on managements assessment of cations. If so, determine if adequate con-
internal control, appraisals of the BHCs trols have been initiated to lessen any
audit function, or any internal audit or audit further risk and exposure.
function or operational review, the exam- 19. Determine if the BHCs external auditors
iner should: received copies of the subsidiary FDIC-
a. Review the engagement letters (includ- insured institutions examination and other
ing past or pending engagement letters) designated supervisory reports and corre-
and any agreements between the board spondence required by section 36(h)(1) of
of directors (and the audit committee) the FDI Act.
and the external auditor, noting any 20. Determine the degree of independence of
qualifications that are contained therein. the external audit firm by reviewing any
b. Review any correspondence exchanged financial ties between the BHC, audit firm,
between the BHC and the external audi- and any of its partners or employees. Also
tor, including any letters requesting opin- review any other relationships or potential
ions from external auditors. Determine if conflicts of interest that may exist.13
BHC management influenced any of the
opinions.
13. The Securities and Exchange Commission (SEC) has
c. Ascertain if any of the engagement let- also released guidance relating to the independence of audi-
ters restricted the scope of the audit in tors for public institutions. According to SEC Rule 101, the
any way, including whether the letters independence of an auditor would be impaired if there are
financial, employment, or business relationships between
limited the degree of reliance to be auditors and audit clients, or if there are relationships between
auditors and audit clients in which the auditors provide certain
BHC Supervision Manual January 2016 nonaudit services to their audit clients. Much of the language
Page 10 found in the SECs independence rules is incorporated in the
Audit 2060.1
The independence of the internal auditor are broadly consistent with the BCBS external
should be evaluated by ascertaining whether the audit guidance. However, because of the legal
following conditions exist: (1) reports are dis- and regulatory framework in the United States,
tributed directly to the board or a committee certain differences exist between the standards
thereof or, less desirably, to an officer not con- and practices followed in the United States and
nected with the area being reviewed; (2) there the principles and expectations in the BCBS
are no relationships within the organization that external audit guidance. These differences are
are incompatible with the internal audit func- addressed in this advisory, which also describes
tion; and (3) severe restrictions are not placed the agencies supervisory expectations for U.S.
on the program or its scheduling by manage- financial institutions within the scope of this
ment. In order to maintain the degree of objec- advisory for incorporating the principles and
tivity essential to the audit function, the exam- expectations in the BCBS external audit guid-
iner should establish that the internal auditor ance into their practices. This advisory also
does not install procedures, originate and outlines examiner responsibilities related to
approve entries, or otherwise engage in any these supervisory expectations.
activity that would be subject to audit review The BCBS external audit guidance is
and appraisal. intended for internationally active banks and
The examiner should consider meeting with is relevant for the management, audit commit-
the audit committee and the auditor and, subse- tees, external auditors, and prudential supervi-
quently, with senior bank holding company sors of such financial institutions. The agencies
management to communicate conclusions con- define internationally active banks in the advi-
cerning the adequacy of the scope and fre- sory. (Refer to SR-16-2 and its attachment.)
quency of the audit program. During the discus-
sions, the examiner should concentrate on
detailing criticisms or deficiencies noted. The
auditor and senior bank holding com-pany man- 2060.1.8.1 Appendix AInteragency
agement should be made fully cognizant of the Advisory on External Audits of
examiners analyses and the comments concern- Internationally Active U.S. Financial
ing the audit function that will appear on the Institutions
relevant pages in the inspection report.
2060.1.7 (reserved for future use) Scope

The BCBS external audit guidance is intended
2060.1.8 OVERVIEW: for internationally active banks and is rel-
INTERAGENCY ADVISORY ON evant for the management, audit committees,
EXTERNAL AUDITS OF external auditors, and prudential supervisors of
INTERNATIONALLY ACTIVE U.S. such financial institutions. For purposes of this
FINANCIAL INSTITUTIONS advisory, the agencies are defining internation-
ally active banks as:
The federal banking agencies (the agencies)14
issued this interagency advisory to communi- Insured depository institutions that meet
cate the agencies support for the principles and either of the following two criteria: (1) con-
expectations set forth in parts 1 and 2, respec- solidated total assets of $250 billion or more;
tively, of the Basel Committee on Banking or (2) consolidated total on-balance sheet for-
Supervisions (the BCBS or the Committee) eign exposure of $10 billion or more (referred
March 2014 guidance on External audits of to as core banks); and
banks (hereafter, referred to as the BCBS U.S. depository institution holding companies
external audit guidance).15 that meet any of the following three criteria:
In supporting these principles and expecta- (1) consolidated total assets (excluding assets
tions, the agencies acknowledge that the exist- held by an insurance underwriting subsidiary)
ing standards and practices in the United States of $250 billion or more; (2) consolidated total
on-balance sheet foreign exposure of $10 bil-
Interagency Policy Statement on the Internal Audit Function lion or more; or (3) have a subsidiary deposi-
and Its Outsourcing. (See section 2060.05.)
14. The Board of Governors of the Federal Reserve Sys-
tory institution that is a core bank.
tem, the Federal Deposit Insurance Corporation, and the
Office of the Comptroller of the Currency. BHC Supervision Manual January 2016
15. See www.bis.org/publ/bcbs280.pdf. Page 11
Audit 2060.1
In the United States, core banks are subject to ment of bank supervisors with external audi-
12 CFR 363, the Federal Deposit Insurance tors and external auditors regulators.
Corporations (FDIC) regulation on Annual Part 2 of the document (expectations) empha-
Independent Audits and Reporting Require- sizes the proper application of existing inter-
ments.16 Core banks typically comply with 12 nationally accepted auditing standards. The
CFR 363 requirements at a holding company BCBS external audit guidance also provides
level. In addition, these holding companies gen- recommendations for procedures that external
erally are public companies that are required to auditors could perform in the execution of
file annual, quarterly, and other periodic reports bank audits to enhance audit quality.18
with the U.S. Securities and Exchange Commis-
sion (SEC). The Public Company Accounting
Supervisory Expectations Regarding the
Oversight Board (PCAOB) regulates the exter-
Differences Between U.S. Standards and
nal auditors of these public companies.
Practices and the BCBS External Audit
Guidance
Background The BCBS external audit guidance builds upon
internationally accepted auditing standards and
In March 2014, the Committee published the sets expectations for institutions and their exter-
BCBS external audit guidance to improve the nal auditors. In the United States, financial insti-
external audit quality of banks and enhance the tutions within the scope of this advisory are
effectiveness of prudential supervision, which directly or indirectly subject to the audit require-
contributes to financial stability. The BCBS ments of 12 CFR 36319 and supervisory guid-
external audit guidance elaborates on Core Prin- ance related to audits of financial institutions.20
ciple 27, Financial Reporting and External In order for a core bank to comply with the
Audit, of the Committees Core Principles for audited financial statements requirement of 12
Effective Banking Supervision17 by providing CFR 363 at a public holding company level, the
guidance related to bank audit committees audit must be performed in accordance with
responsibilities in overseeing the external audit PCAOB standards. The 12 CFR 363 audit
function. This guidance also discusses pruden- requirements, supervisory guidance, and
tial supervisors relationships with external PCAOB standards, collectively, are generally
auditors of banks and audit oversight bodies. consistent with the BCBS external audit guid-
Additionally, the BCBS external audit guidance ance, except for the differences noted below.
includes information relevant to external audits This advisory discusses the agencies supervi-
of financial statements that the Committee sory expectations regarding these differences
believes will enhance the quality of these exter- with reference to the corresponding principles
nal audits. from part 1 and expectations from part 2 of the
The BCBS external audit guidance has two BCBS external audit guidance.
parts:
Part 1, Principle 2: The audit committee should
Part 1 provides guidance (principles) on the monitor and assess the independence of the
roles and responsibilities of audit committees external auditor.
relevant to external audits and the engage-
Paragraph 49 of the BCBS external audit guid-
16. 12 CFR 363 applies to any insured depository institu- ance indicates that an institutions audit commit-
tion with respect to any fiscal year in which its consolidated tee should have a policy in place that stipulates
total assets as of the beginning of such fiscal year are $500
million or more.
the criteria for tendering, i.e., putting its exter-
17. The Committees Core Principles are available at nal audit contract out for bid. This paragraph
www.bis.org/publ/bcbs230.pdf. In particular, Core Principle further states that the policy also should call for
27 states, The supervisor determines that banks and banking
groups maintain adequate and reliable records, prepare finan-
cial statements in accordance with accounting policies and
18. The BCBS external audit guidance acknowledges that
practices that are widely accepted internationally and annu-
the Committee does not have the authority to set professional
ally publish information that fairly reflects their financial
standards for external auditors.
condition and performance and bears an independent external
19. 12 CFR 363.3(f) requires external auditors to comply
auditors opinion. The supervisor also determines that banks
with the independence standards and interpretations of the
and parent companies of banking groups have adequate gover-
American Institute of Certified Public Accountants, the SEC,
nance and oversight of the external audit function.
and the PCAOB.
20. For example, Interagency Policy Statement on Coordi-
BHC Supervision Manual January 2016 nation and Communication Between External Auditors and
Page 12 Examiners (July 23, 1992).
Audit 2060.1
the audit committee to periodically consider framework or by a formal agreement or proto-

whether to put the external audit contract out for col. According to the BCBS external audit guid-
bid. Consistent with 12 CFR 363, the banking ance, [a] matter or group of matters is normally
agencies encourage audit committees to estab- of material significance ... when, due either to
lish policies and procedures addressing the its nature or its potential financial impact, it is
retention and remuneration of the external audi- likely of itself to require investigation by the
tor (independent public accountant).21 In addi- regulator.23
tion, the external auditors of insured depository There is no generally applicable legal or regu-
institutions subject to 12 CFR 363 must comply latory requirement in the United States for exter-
with the SECs rules regarding audit partner nal auditors of banks and holding companies to
rotation. Audit committees are encouraged to report directly to the institutions primary fed-
consider whether their policies should explicitly eral (and, if applicable, state) supervisor matters
address the criteria for tendering the audit con- arising from the audit that may be of material
tract and whether the contract should periodi- significance, nor is there a legal safe harbor to
cally be put out for bid. do so. Insured depository institutions subject to
12 CFR 363 are required to file with appropriate
Part 1, Principle 6: The supervisor and the federal and state supervisors copies of reports
external auditor should have an effective rela- and other written communications issued by the
tionship that includes appropriate communica- external auditor to the institution in connection
tion channels for the exchange of information with the external audit services provided to the
relevant to carrying out their respective statu- institution. Consistent with interagency policy
tory responsibilities. statements24 and practices, the agencies con-
tinue to encourage open and candid communica-
and tion between an institutions external auditor
and the institutions supervisors.
Part 1, Principle 7: The supervisor should
require the external auditor to report to it Part 2, Expectation 5: The external auditor of a
directly on matters arising from an audit that bank should identify and assess the risks of
are likely to be of material significance to the material misstatement in the banks financial
functions of the supervisor. statements, taking into consideration the com-
plexities of the banks activities and the effec-
Paragraphs 95 and 96 of the BCBS external tiveness of its internal control environment.
audit guidance indicate that the auditor may
share information about the external audit of an and
institution that may be of interest to the deposi-
tory institutions supervisor (e.g., significant Part 2, Expectation 6: The external auditor of a
risks of material misstatements, significant or bank should respond appropriately to the sig-
unusual transactions, evidence of management nificant risks of material misstatement in the
bias, significant deficiencies or material weak- banks financial statements.
nesses in internal control over financial report-
ing, and actual or suspected breaches of regula- Paragraphs 157 and 168 of the BCBS external
tions or laws22), either (1) directly with the audit guidance set forth the Committees expec-
supervisor when a safe harbor exists or (2) tations for external auditors to (1) consider regu-
indirectly through the institution to the supervi- latory ratios in the determination of materiality
sor when a legal safe harbor does not exist. for the audit, and (2) evaluate any identified
Paragraph 99 of the BCBS external audit guid- audit differences, errors, and adjustments and
ance provides that the external auditor should their effect on regulatory capital or regulatory
communicate matters arising from the audit that capital ratios. PCAOB standards25 and SEC
may be of material significance to the supervi- Staff Accounting Bulletin Topic 1.M, Material-
sor when required by the legal or regulatory
23. See footnote 9 in the BCBS external audit guidance.
24. See footnote 6 of this advisory.
21. 12 CFR 363.5(a) states, The duties of the audit com-
25. See PCAOB Auditing Standard No. 11, Consideration
mittee shall include the appointment, compensation, and over-
of Materiality in Planning and Performing an Audit, para-
sight of the independent public accountant who performs
graph 6, and PCAOB Auditing Standard No. 14, Evaluating
services required under this part, and reviewing with manage-
Audit Results, appendix B, paragraph B2.
ment and the independent public accountant the basis for the
reports issued under this part.
22. See also paragraphs 90-94 of the BCBS external audit BHC Supervision Manual January 2016
guidance. Page 13
Audit 2060.1
ity, indicate external auditors should consider the institutions internal audit activities are con-
qualitative factors (which include regulatory ducted in accordance with professional stan-
capital, ratios, and disclosures) in determining dards, such as the Institute of Internal Auditors
materiality and when evaluating the effect of (IIA) International Professional Practices
audit differences, errors, and adjustments. Framework (previously known as the Standards
Therefore, the agencies expect institutions audit for the Professional Practice of Internal Audit-
committees will ensure that their external audi- ing). Audit committees may look to the IIAs
tors consider regulatory capital ratios in plan- Framework for guidance for both internal and
ning and performing the audit. In this regard, external assessments of the internal audit func-
audit committees are encouraged to inquire as to tion.
how the external auditors factored these ratios
into their materiality assessments.
Additionally, paragraph 166 of the BCBS Examiner Responsibilities
external audit guidance recommends that the
external auditor provide written feedback about Examiners should evaluate any actions taken by
the audit engagement teams relations with the institutions within the scope of this advisory and
institutions internal audit function, including its their audit committees to ensure such actions
observations on the adequacy of the work of are consistent with the objectives of this advi-
internal audit, to those charged with governance sory and the BCBS external audit guidance.
of the bank. PCAOB Auditing Standard No. 16, Where there are differences between the BCBS
Communications with Audit Committees, external audit guidance and U.S. standards,
requires the external auditor, as part of commu- examiners should encourage institutions audit
nicating the overall audit strategy, to explain the committees to follow the practices identified in
extent to which the auditor plans to use the work this advisory.
of internal audit in an audit of the financial
statements or an audit of internal control over
financial reporting. However, PCAOB standards Conclusion
do not require the external auditor to provide
written feedback about the audit engagement External auditors play an important role in con-
teams relations with the institutions internal tributing to financial stability when they deliver
audit function, including its observations on the quality audits, which foster market confidence
adequacy of the work of internal audit. The in institutions financial statements. Quality
agencies encourage audit committees to con- audits are also a valuable complement to the
sider requesting their external auditor to provide supervisory process. The agencies support the
written feedback about the audit engagement principles and expectations set forth in the
teams relations with internal audit, including its BCBS external audit guidance because
observations on the adequacy of the work of enhanced audit quality is an important factor in
internal audit, as it relates to the audit of the ensuring the safety and soundness of U.S. insti-
financial statements or the audit of internal con- tutions. Institutions and their external auditors
trol over financial reporting. are expected to comply with existing laws, regu-
Furthermore, consistent with the March 2003 lations, and professional standards, as applica-
Interagency Policy Statement on the Internal ble, including those referenced in this advisory.
Audit Function and Its Outsourcing, an institu-
tions audit committee should consider whether

Page 14
(Budget) Section 2060.2
An assessment of managements strategic plans While various individuals may be responsible
and its success in meeting previously estab- for input to the budget process, the chief execu-
lished budgetary goals is one of the factors tive officer typically has the ultimate responsi-
considered in evaluating a BHCs management, bility for preparation and implementation of the
operations, financial condition, and prospects.1 formal budget. The time period covered by a
Through review of the budget figures, insight budget typically encompasses one year,
can be gained concerning an organizations although it often covers longer periods in the
future plans and other matters such as capital larger, more sophisticated bank holding compa-
adequacy, liquidity, sources and applications of nies. The longer the budget period, the greater
funds, level and quality of earnings, and perfor- are the prospects for increased variances from
mance of management. original budget figures. In some cases in which
The budget is a coordinated financial plan four- or five-year projections are made, bank
used to estimate and control all or a few of the holding companies may formulate several fore-
activities of the various divisions or subsidiaries casts based on different sets of assumptions. In
in a bank holding company. Based on an assess- such instances, the examiner should work with
ment of future economic developments and con- the most likely situation that may evolve
ditions, management formulates a plan of action based on economic trends, history, and
and indicates anticipated changes in the balance- experience of the organization, but should also
sheet accounts and profitability (predicated on give serious consideration to the worst-case
implementation of the plan). The budget is a projections.
significant management tool in that it projects Many bank holding companies, particularly
expected results and also serves as an important the smaller organizations, may not have formal
check on management decisions and perfor- written budgets or plans. In small shell compa-
mance by providing a basis for comparison and nies, while it is not essential to have a formal
corrective action on a timely basis. The com- budget, budgeting procedures should be encour-
parison of actual performance to budget allows aged where appropriate. Budgeting at the parent
management to give careful attention to various level could be appropriately limited to debt-
possible courses of action and to choose the servicing and dividend considerations.
course which should result in the greatest bene-
fit. Budgeting is also useful in measuring the
performance of individuals and the departments
they manage. Further, the comparison of budget 2060.2.1 INSPECTION OBJECTIVES
totals to actual changes in activities such as
loans, investments, and deposits assists in deci- 1. To determine the extent of an organiza-
sion making and can promote coordination and tions financial planning and budget program.
cooperation among affiliates. The variance indi- 2. To indicate to management of organiza-
cated by the comparison process may be con- tions that are without formal planning proce-
strued as a measure of managements perfor- dures the advantages of adopting a budget.
mance and planning record and its relationship 3. To understand the institutions decision-
to the organizations goals and objectives. It making process as it relates to the budget.
should be noted that some significant variances 4. To determine the causes of significant
may be caused by factors beyond managements variances between the budget and actual
control or factors that could not reasonably be performance.
anticipated. 5. To assess the reasonableness of projected
figures, including controls over the data
throughout the budgeting process.
6. To assess the impact of the budget on the
1. The stragetic planning process focuses on intermediate present condition and future prospects of the
and long-term strategic goals and is the vehicle used to bank holding company.
determine the overall direction and focus of the organization.
The budgeting process refers to the tactical decisions required
7. To determine whether the plan outlined in
to meet goals and objectives. The budget is a subset of the the budget is supported by the finan-
strategic plan. While smaller bank holding company organiza- cial and managerial resources of the holding
tions may not always have formal written budgets, all organi- company.
zations should have a strategic planning process, which deter-
mines overall corporate direction, general resource allocation,
and balance-sheet relationships with respect to capital needs, BHC Supervision Manual December 1997
growth, asset mix, and risk. Page 1
Management Information Systems (Budget) 2060.2
2060.2.2 INSPECTION PROCEDURES 8. The examiner should determine whether

the accounting principles of major importance
1. Familiarity with a bank holding compa- have been applied consistently and, if not, the
nys financial condition and results of opera- impact of the alternative accounting treatment
tions should begin before the start of the inspec- on the budget totals.
tion with a review of the annual report to 9. The sources of input for the budget should
shareholders, financial reports submitted to the be reviewed and the frequency and procedures
Federal Reserve System, and other financial for effecting revision should be ascertained.
documentation contained in the files. The more 10. When there are significant budget vari-
significant accounts, statistical data, and perti- ances, the examiner should seek documented
nent ratios should be compared on a period-to- explanations. Review any such documentation
period basis to highlight significant changes and to determine if management policy or factors
discern trends. beyond management control were responsible
2. The examiner also should become familiar for the variances.
with current and projected economic conditions, 11. A final summary discussion should be
both nationally and locally, including general held with management to discuss goals which
industry conditions. the examiner believes may be unattainable and
3. Based on a review of the aforementioned to communicate conclusions concerning the
data, the examiner should be in a position to budget. Due consideration should be given to
substantiate the reasonableness of budgeted fig- managements views, whether or not in concur-
ures without a systematic examination of all of rence with the examiners conclusions. If man-
the transactions affecting the figures presented. agement indicates future changes which could
Further, such an analysis provides a better have a significant impact on the organization,
understanding of the operation and highlights the matter should be noted in the inspection
matters of interest and potential problem areas report. Further, managements assessment of the
to be investigated during the inspection. effect of contemplated action on the operations
4. Throughout the review process, the exam- and financial condition of the bank holding com-
iner must maintain a sense of perspective to pany should be noted.
avoid spending excessive time on relatively 12. For those bank holding companies that
immaterial amounts. do not have formal written plans, the examiner
5. The examiner should meet with the officer should obtain from senior management informa-
responsible for the preparation of the budget to tion on their plans for matters such as growth
determine the scope of the organizations finan- and expansion, capital injections, debt retire-
cial plans. The extent of senior managements ment, and changes in sources of funding. Except
and the board of directors involvement in the for small, shell companies, the examiner should
strategic planning and budgeting process should recommend adoption of a budget program and
also be ascertained in this preliminary meeting. emphasize the need for strategic planning by
6. Workpapers which document or illustrate indicating how management methods may be
the rationale for the budget data should be improved as a result of a logically conceived
reviewed and discussed with budget personnel, and properly operated budget. Budgets and plan-
including the existence and extent of internal ning are especially important in cases in which a
controls over the data. bank holding company is losing its share of the
7. The examiner should evaluate plans, pro- market or in which inefficiencies are depressing
jections, and forecasts in light of market-area profitability.
characteristics and the present condition and
history of the organization.

Page 2
(Records and Statements) Section 2060.3
Adequate and accurate records and financial 3. To recommend corrective action when
statements are an integral part of a sound bank policies and procedures employed have resulted
holding company operation. Records should be in inadequate or inaccurate records and financial
maintained to allow preparation of financial statements.
statements in accordance with generally
accepted accounting principles and to ensure
proper accountability for all assets, liabilities, 2060.3.2 INSPECTION PROCEDURES
income, and expenses. Generally, an indepen-
dently certified statement inspires greater confi- 1. The examiner should review the sections
dence than a statement prepared internally. relating to audit and records in the prior inspec-
Moreover, an unqualified, independently certi- tion report and the latest examination reports of
fied statement may act as a check on manage- the subsidiary banks to note any comments or
ment recordkeeping policies and procedures, deficiencies cited concerning records, including
and provide more assurance that transactions are any MIS deficiencies. In addition to providing
being properly recorded and that books accu- an input into the overall assessment of the qual-
rately reflect overall financial condition. ity of records, the review may provide a basis
Management may exercise reasonable discre- for determining areas of emphasis and follow-up
tion in selecting and adopting the type of books during the inspection.
and records it uses and in formulating account- 2. The examiner should discuss recommen-
ing systems and bookkeeping procedures. From dations and criticisms contained in such reports
the examiners viewpoint, the test of a bank with an appropriate officer to ascertain what
holding companys records is one of adequacy, changes, if any, have taken place.
consistency, and accuracy. The financial state- 3. The examiner should review the external
ments of every bank holding company must auditing firms management letter, giving par-
accurately reflect financial condition and operat- ticular attention to comments concerning rec-
ing results. This principle is applicable whether ordkeeping. Determine if any corrective actions
a bank holding company is small and has a were recommended by the external auditors and
relatively simple bookkeeping system or the extent to which the cited items have been
whether it is a larger institution with a fully corrected.
automated system. A recordkeeping system that 4. In those situations when it appears that
is capable of generating a wide variety of perti- records are deficient or financial statements are
nent internal data and other information facili- inaccurate, a thorough investigation of applica-
tates problem solving and decision making and, ble transactions may be required. The purpose
thus, contributes to the efficiency of a bank of the investigation is to obtain information
holding companys operations. Further, such a needed in outlining improved controls over
system serves as a convenient tool to provide MIS, accounting methods, and records so that
directors, stockholders, and other interested par- the financial data presented are in accordance
ties with information on conditions in a bank with generally accepted accounting principles.
holding company. Thus, information is provided which will better
serve bank holding company management. The
investigation should not necessarily involve a
2060.3.1 INSPECTION OBJECTIVES review of every transaction, but should involve
a check of a sufficient number of transactions to
1. To determine whether financial statements ensure the examiner that the records, as
are prepared in accordance with generally checked, reflect an accurate financial condition.
accepted accounting principles and are suffi- The extent of the review will depend largely on
ciently detailed to accurately portray the compa- the procedures and controls over MIS and the
nys financial condition. condition and adequacy of the books and under-
2. To determine that sufficient records are lying records. During the investigative process,
maintained to provide detail on material the examiner should be careful to distinguish
balance-sheet items, income-statement items, between documented facts and statements of
and various contingent liabilities and off- intent or interpretations set forth by company
balance-sheet risks that permit the preparation representatives.
of appropriate financial information.
Page 1
Management of Information Systems
(Structure and Reporting) Section 2060.4
The directorate and management of bank hold- eration is whether each company is providing
ing companies have a responsibility to contrib- sufficient data to keep the interested parties
ute to the health and growth of the organization informed of the financial condition and perfor-
they serve. To carry out this responsibility effec- mance of all the divisions or entities. The fre-
tively, they must be kept fully informed of con- quency of the reporting and the detail of infor-
ditions throughout the organization and trends mation provided can be categorized as being on
within the banking industry. Reporting is the a need-to-know basis. The form of reports
process of developing and communicating infor- ranges from consultations and meetings to sub-
mation internally to directors and management mission of printed material for study and review.
and externally to shareholders and regulatory The scope and size of the operations will have
authorities. Management and the board of direc- an effect on the frequency and detail of the
tors must recognize that as a company develops information submitted. In the larger, more
and grows, its environment, strategic goals, and sophisticated companies, frequent meetings and
information needs change. The guidelines and consultations are held to discuss the perfor-
requirements for reports flowing to management mance of various entities, the impact of perfor-
and the board of directors should be established mance on the organizations goals and objec-
and allow for change, recognizing the fact that tives, and policies and strategies to be followed.
informational needs can vary, including those at Written reports outlining important matters and
different levels of the organization. summarizing various financial data are typically
Informational needs will also be dictated by reviewed and discussed regularly.
the particular type of management structure in The number and variety of reports depends
placecentralized, decentralized, legal entity, on the size and sophistication of the bank hold-
or business line. The ultimate decision-making ing company operation. For smaller bank hold-
responsibility rests with the corporations board ing companies, the extent of their reports may
of directors, and the responsibility for imple- be limited to annual statements, as more fre-
menting their decisions rests with designated quent periodic reports may not be necessary
board committees, executive management, or under normal conditions. The larger holding
other designated management committees or companies normally prepare monthly compara-
individuals. As such, examiners should make an tive balance sheets and income statements cov-
assessment of the qualifications of the persons ering similar periods for two consecutive years.
on the board of directors, executive manage- Thus, any significant deviation from the prior
ment staff, and the board and executive manage- years data can be readily detected. Generally,
ment committees to ensure that they have the reports detailing the extent of delinquent and
necessary knowledge, experience, and expertise nonaccrual loans are prepared monthly. Facts
to understand the information presented and to and figures pertaining to the adequacy of the
act on it constructively. The assessment should loan-loss provision are presented periodically.
include a review of reporting lines to identify Additional reports containing information on
information flows and the various decision- budgets, cash flow, liquidity, and capital
making levels involved or needed. adequacy are prepared to assist management in
All reports flowing to executive management, assessing the organizations overall financial
board committees, and the board of directors condition and performance. Summaries of inter-
should be analyzed for clarity, consistency, nal audit reports and reports of examinations of
timeliness, quality, and coverage of crucial areas subsidiary banks are brought to managements
of the organization. A review of board and attention. Data relative to other bank holding
committee minutes should reveal if participants companies or banks in the same peer groups are
had any questions or whether there were any assembled, when available, so that comparisons
uncertainties as to the meaning of the data with similarly sized organizations are possible.
presented. All of the aforementioned information may be
Each bank holding company prepares various prepared for directors, although not necessarily
reports for submission to its management and in as much detail as that submitted to manage-
directors; an effective internal reporting system ment. On occasion, key management personnel
facilitates their ability to analyze a situation and of the holding company attend directors meet-
to make informed decisions. Although such ings to expand on the topics being discussed.
reports may vary in content from company to
company, emphasis is generally placed on the BHC Supervision Manual December 1997
financial data generated. The important consid- Page 1
Management of Information Systems (Structure and Reporting) 2060.4
Reports to shareholders usually consist of 2060.4.2 INSPECTION PROCEDURES

quarterly and annual reports which detail the
companys financial condition and results of 1. Review the organizational structure to deter-
operations. Additional information may include mine reporting lines and the various levels of
the chief executive officers overall assessment decision making, risk assessment, and
of the company, future plans, and other financial controls.
and analytical data. The financial information is 2. Ascertain whether any corporate policies
used for public disclosure and enables investors, address risk managment or internal reporting
depositors, and creditors to make informed judg- requirements and determine:
ments concerning the financial condition of the a. the types of reports required to be
bank holding company. Bank holding compa- submitted and
nies whose securities have been registered pur- b. the adequacy of such reporting require-
suant to the Securities and Exchange Act of ments in light of a companys particular
1934 are required to prepare various reports circumstances.
containing specific financial information. Comment: In a holding company with a
decentralized system of control over subsid-
iaries, the existence of written policies and
2060.4.1 INSPECTION OBJECTIVES procedures is important since each subsidi-
ary operates as a relatively autonomous unit.
1. To review the organizational structure to
3. Obtain a listing of internal reports that are
determine the various levels of decision-
submitted to corporate executive manage-
making and reporting lines, including board
ment and the board of directors (including
and executive management committees.
packages for the board of directors and
2. To determine whether the bank holding com-
executive committees).
pany has written policies and procedures,
4. Randomly sample, based on a material risk
and internal controls covering the types of
focus, the individual as well as the various
reports required to be submitted to manage-
types of management reports and determine
ment and the directors.
whether they are adequately prepared in
3. To determine that the required reports are
accordance with established policies and pro-
adequate to accurately reflect the financial
cedures and submitted to the appropriate
condition and performance within the organi-
individuals on a timely basis. Determine
zations divisions and units and whether the
whether the management reports are suffi-
reporting systems and reports are adequate to
cient to measure the companys progress in
monitor the risks therein.
achieving its financial and business goals and
4. To evaluate whether the reports and report-
forecasts.
ing systems are adequate to measure and
5. Identify and document management proce-
reflect the companys financial position and
dures for reacting to elevated risk, weak-
performance in all areas, to measure the com-
nesses, or deficiencies disclosed by MIS.
panys progress in meeting its financial and
Also evaluate the ability of the information
business goals, and to monitor inherent risks.
system to handle regulatory and accounting
5. To determine that the contents of the reports
issues and to adapt to change.
are complete and submitted on a timely basis.
6. At the conclusion of the review process, the
6. To recommend corrective action when
examiner should discuss with management,
reporting practices, policies, or procedures
as appropriate, topics such as
are deficient.
a. the lack of established policies and proce-
7. To evaluate managements procedures for
dures and internal controls,
reacting to elevated risk, weaknesses, or defi-
b. inadequate reporting requirements, and
ciencies disclosed by reporting systems, and
c. noncompliance with reporting require-
to evaluate the systems ability to adapt to
ments and/or the untimely submission of
change caused by regulatory and accounting
reports.
issues or other market conditions.

Page 2
Management of Information Systems (Structure and Reporting) 2060.4
Registration, reports, and 225.5

examinations or inspections
Reporting requirements 15 USC 78a
emanating from the et seq.
Securities Exchange Act of
1934

Page 3
(Insurance) Section 2060.5
2060.5.1 INTRODUCTION 2060.5.3 TYPES OF BLANKET BONDS
In establishing an insurance program, a bank While there are several similar forms of blanket
holding company should be aware of where it is bonds in use, those commonly found are the
exposed to loss, the extent to which insurance is Financial Institutions Bond Standard Form No.
available to cover potential losses and the cost 24, the Bankers Blanket Bond Standard Form
of such insurance. These various factors should No. 2, and Lloyds Banks and Trust Compa-
be weighed to determine how much risk the nies Policy HAN Form (C). Under these blan-
bank holding company will assume directly. In ket forms, every employee is usually covered
assessing the extent of risk an organization is for the total amount of the bond. Typically, new
willing to assume, it is important to analyze the employees and new offices are automatically
impact of an uninsured loss not only on the covered and no notice is required for an increase
entity where the loss occurs, but also on the in the number of employees or in the number of
affiliates and the parent. Once appropriate cover- offices established, unless such increases result
age has been acquired, procedures should be from a merger or consolidation with another
established for the periodic review of the pro- institution. The word blanket, however, refers
gram to assure the continuing adequacy of the to the over-all amount that applies to the several
coverage. Particularly for larger BHCs, these specified risks covered under the bond and is
procedures should include at least an annual not intended to mean all risks coverage. A
review of the program by the board of directors most important feature of the bankers blanket
of the parent organization. bond is the discovery rider. The rider, which
Insurance is a highly specialized field and no converts the blanket bond from a loss sus-
attempt is made here to discuss all the various tained basis to a discovery basis, provides
types and forms of insurance coverage that are indemnity against any loss sustained by the in-
available to financial institutions. Examiners are sured entity at any time but discovered after the
not expected to be insurance experts; however, effective date of the bond and prior to the termi-
examiners should recognize that a financial or- nation or cancellation of the bond, even though
ganizations primary defenses against loss in- lower amounts of insurance and more restrictive
clude adequate internal controls and procedures coverage may have been carried when the loss
and that insurance is intended to complement, was actually sustained.
not replace, an effective system of internal con-
trols. Thus, an overall appraisal of the control
environment becomes a significant consider-
ation in assessing the adequacy of the insurance
2060.5.4 DETERMINING THE
program. To the extent controls are lacking, the
COVERAGE NEEDED
need for additional coverage increases.
One of the most difficult insurance problems
management faces is the determination of the
amount of blanket bond coverage that should be
maintained. An estimate of the maximum
2060.5.2 BANKERS BLANKET BOND amount of money and securities that may be lost
through burglary or robbery can be calculated
The most important and comprehensive insur- with reasonable accuracy, but the potential loss
ance coverage available is the bankers blanket resulting from dishonest acts of officers and
bond which is usually extended to encompass employees is not easily measured. The Insur-
all the entities in a bank holding company struc- ance and Protective Committee of the American
ture. Generally, the scope of the blanket bond Bankers Association has conducted several stud-
contract is intended to cover risks of loss due to ies of the problems of determining adequate
criminal acts, such as embezzlement, burglary, coverage and has concluded that total deposits
robbery, theft, larceny, forgery, etc., but in addi- represent the most appropriate item in bank
tion it provides indemnity for loss of property financial statements upon which to base an esti-
through damage, destruction, misplacement and mate of a reasonable or suitable amount of
mysterious, unexplainable disappearance. The blanket bond coverage.
most important item of protection under the
bond, however, is the blanket fidelity coverage BHC Supervision Manual December 1992
for officers and employees. Page 1
Management Information Systems (Insurance) 2060.5
In a bank holding company structure, the 2. To determine the adequacy of insurance

amount of blanket bond coverage is generally coverage after giving due consideration to the
determined by the deposits of the largest bank overall control environment and factors such as
and the amount of suggested coverage in the the organizations claim experience and costs
ABAs schedule. Such an amount is considered associated with various coverages.
to be a minimum and other factors such as a 3. To ascertain that a comprehensive review
rapidly expanding operation, excessive cash on of the insurance program is conducted periodi-
hand, or inferior audit and control practices may cally by management and at least annually by
suggest the need for larger coverage. Since cov- the board of directors and entered into the min-
erages are generally extended to include the utes.
nonbank subsidiaries and such subsidiaries usu- 4. To determine the entity(ies) responsible
ally operate on a smaller scale than their affili- for paying the premiums and the manner in
ated banks, the question concerning the ade- which such payments are allocated among the
quacy of the amount of the blanket bond affiliates that receive the coverage benefits.
coverage for a nonbank subsidiary is more eas- 5. To determine if procedures are in place to
ily addressed and is typically a function of the assure that claims are filed promptly.
parents and the banks coverage.

2060.5.5 NOTIFICATION OF LOSS
1. The prior years inspection report should
When submitting a claim, most blanket bonds be reviewed for comments relative to controls
have provisions which require a report to be and insurance. The examiner should note the
submitted within a specified period after a re- types and extent of coverages, comments con-
portable item comes to the attention of manage- cerning the control environment and any defi-
ment. Occasionally, items are not reported to the ciencies related to the administration of the in-
bonding company because of uncertainty as to surance program and the coverages in force.
whether the incident constitutes a reportable 2. A similar review encompassing the latest
item. Failure to report in a timely manner could examination reports of all major affiliated banks
invalidate the claim and jeopardize existing cov- should be conducted. The review process is
erages. Thus, it should be emphasized to man- intended to provide a basis for determining areas
agement that any questionable items should be of emphasis and follow-up during the inspec-
reported. tion. The examiner need not re-examine the
insurance program or the controls in force in the
individual banks.
2060.5.6 DIRECTORS AND 3. The examiner should meet with the officer
OFFICERS LIABILITY INSURANCE responsible for maintaining the insurance poli-
cies and related documentation and ascertain the
Directors and Officers Liability Insurance location of such policies and documentation.
(DOL Insurance) insures the Directors and Review any independent review of coverages
Officers against personal liability resulting from and any deficiencies that may have been cited
claims of alleged negligence, wrongful acts, er- by the internal or external auditors.
rors and omissions, etc. This insurance is not 4. Review the manner and frequency of pre-
included in the blanket bond or other standard sentations to the board of directors of the insur-
fidelity coverage. ance coverage.

1. To determine the scope and extent of in-
surance coverages for the various entities in the
organization.

Page 2
(Accounting, Reporting, and Disclosure Issues) Section 2065.1
Working with borrowers who are experiencing income on nonaccrual assets (including loans
financial difficulties may involve formally that have been partially charged off), if the
restructuring their loans and taking other mea- remaining book balance of the loan is deemed
sures to conform the repayment terms to the fully collectible. Interest income recognized on
borrowers ability to repay. Such actions, if a cash basis should be limited to that which
done in a way that is consistent with prudent would have been accrued on the recorded bal-
lending principles and supervisory practices, can ance at the contractual rate. Any cash interest
improve the prospects for collection. Generally received over this limit should be recorded as
accepted accounting principles (GAAP) and recoveries of prior charge-offs until these
regulatory reporting requirements provide a charge-offs have been fully recovered.
framework for reporting that may alleviate cer-
tain concerns that lenders may have about work-
ing constructively with borrowers who are hav- 2065.1.2 NONACCRUAL ASSETS
ing financial difficulties. SUBJECT TO FAS 15 AND FAS 114
Interagency policy statements and guidance, RESTRUCTURINGS
issued on March 1, 1991; March 10, 1993; and
June 10, 1993, clarified supervisory policies A loan or other debt instrument that has been
regarding nonaccrual assets, restructured loans, formally restructured to ensure repayment and
and collateral valuation (additional clarification performance need not be maintained in non-
guidance may be found in SR-95-38 and in the accrual status. When the asset is returned to
glossary of the reporting instructions for the accrual status, payment performance that had
bank call report and the FR-Y-9C, the consoli- been sustained for a reasonable time before the
dated bank holding company report). When cer- restructuring may be considered. For example, a
tain criteria1 are met, (1) interest payments on loan may have been restructured, in part, to
nonaccrual assets can be recognized as income reduce the amount of the borrowers contractual
on a cash basis without first recovering any payments. It may be that the amount and fre-
prior partial charge-offs; (2) nonaccrual assets quency of payments under the restructured
can be restored to accrual status when subject to terms do not exceed those of the payments that
formal restructurings, according to Financial the borrower had made over a sustained period,
Accounting Standards Board (FASB) Statement within a reasonable time before the restruc-
Nos. 15 and 114, Accounting by Debtors and turing. In this situation, if the lender is reason-
Creditors for Troubled Debt Restructurings ably assured of repayment and performance
(FAS 15) and Accounting by Creditors for according to the modified terms, the loan can be
Impairment of a Loan (FAS 114); and (3) re- immediately restored to accrual status.
structurings that specify a market rate of interest Clearly, a period of sustained performance,
would not have to be included in restructured whether before or after the date of the restructur-
loan amounts reported in the years after the year ing, is very important in determining whether
of the restructuring. These supervisory policies there is reasonable assurance of repayment
apply to federally supervised financial institu- and performance. In certain circumstances, other
tions. The board of directors and management information may be sufficient to demonstrate an
of bank holding companies should therefore in- improvement in the borrowers condition or in
corporate these policies into the supervision of economic conditions that may affect the bor-
their federally supervised financial institution rowers ability to repay. Such information may
subsidiaries. reduce the need to rely on the borrowers perfor-
mance to date in assessing repayment prospects.
For example, if the borrower has obtained sub-
2065.1.1 CASH-BASIS INCOME stantial and reliable sales, lease, or rental con-
RECOGNITION ON NONACCRUAL tracts or if other important developments are
ASSETS expected to significantly increase the borrow-
ers cash flow and debt-service capacity and
Current regulatory reporting requirements do strength, then the borrowers commitment to
not preclude the cash-basis recognition of repay may be sufficient. A preponderance of
such evidence may be sufficient to warrant
1. A discussion of the criteria is found within the corre- BHC Supervision Manual December 2002
sponding subsections that follow. Page 1
Nonaccrual Loans and Restructured Debt 2065.1
returning a restructured loan to accrual status. ibility. One loan to a borrower being placed
The restructured terms must reasonably ensure in nonaccrual status does not automatically have
performance and full repayment. to result in all other extensions of credit to that
It is imperative that the reasons for restoring borrower being placed in nonaccrual status.
restructured debt to accrual status be docu- When a single borrower has multiple extensions
mented. A restoration should be supported by of credit outstanding and one meets the criteria
a current, well-documented evaluation of the for nonaccrual status, the lender should evalu-
borrowers financial condition and prospects ate the others to determine whether one or more
for repayment. This documentation will be of them should also be placed in nonaccrual
reviewed by examiners. status.
The formal restructuring of a loan or other
debt instrument should be undertaken in ways
that will improve the likelihood that the credit 2065.1.4.1 Troubled-Debt
will be repaid in full in accordance with reason- RestructuringReturning a Multiple-Note
ably restructured repayment terms.2 Regulatory Structure to Accrual Status
reporting requirements and GAAP do not
require a banking organization that restructures On June 10, 1993, interagency guidance was
a loan to grant excessive concessions, forgive issued to clarify a March 10, 1993, interagency
principal, or take other steps not commensurate policy statement on credit availability. The guid-
with the borrowers ability to repay in order to ance addresses a troubled-debt restructuring
use the reporting treatment specified in FAS 15. (TDR) that involves multiple notes (some-
Furthermore, the restructured terms may include times referred to as A/B note structures). An
prudent contingent payment provisions that per- example of a multiple-note structure is when
mit an institution to obtain appropriate recovery the first, or A, note would represent the portion
of concessions granted in the restructuring, if of the original-loan principal amount that would
the borrowers condition substantially improves. be expected to be fully collected along with
contractual interest. The second part of the
restructured loan, or B note, represents the por-
2065.1.3 RESTRUCTURINGS tion of the original loan that has been charged
RESULTING IN A MARKET off.
INTEREST RATE Such TDRs generally may take any of three
forms: (1) In certain TDRs, the B note may be a
A FAS 114 restructuring that specifies an effec- contingent receivable that is payable only if
tive interest rate that is equal to or greater than certain conditions are met (for example, if there
the rate the lending banking organization is will- is sufficient cash flow from the property).
ing to accept at the time of the restructuring, for (2) For other TDRs, the B note may be
a new loan with comparable risk (assuming the contingency-forgiven (note B is forgiven if note
loan is not impaired by the restructuring agree- A is paid in full). (3) In other instances, an
ment), does not have to be reported as institution would have granted a concession (for
a troubled-debt restructuring after the year of example, a rate reduction) to the troubled bor-
restructuring. rower but the B note would remain a contractual
obligation of the borrower. Because the B note
is not reflected as an asset on the institutions
2065.l.4 NONACCRUAL TREATMENT books and is unlikely to be collected, the B note
OF MULTIPLE LOANS TO ONE is viewed as a contingent receivable for report-
BORROWER ing purposes.
Financial institutions may return the A note
As a general principle, whether to place an asset to accrual status provided the following condi-
in nonaccrual status should be determined by an tions are met:
assessment of the individual assets collect-
1. The restructuring qualifies as a TDR as
defined by FAS 15, and there is economic
2. A restructured loan may not be restored to accrual status substance to the restructuring. (Under FAS
unless there is reasonable assurance of repayment and perfor-
mance under its modified terms in accordance with a reason-
15, a restructuring of debt is considered a
able repayment schedule. TDR if the creditor for economic or legal
reasons related to the debtors financial diffi-
BHC Supervision Manual December 2002 culties grants a concession to the debtor that
Page 2 it would not otherwise consider.)
2. The portion of the original loan represented with the contractual terms. When the federal
by the B note has been charged off. The financial institution regulatory reporting criteria
charge-off must be supported by a current, for restoration to accrual status are met, previ-
well-documented evaluation of the borrow- ous charge-offs taken would not have to be fully
ers financial condition and prospects for recovered before such loans are returned to
repayment under the revised terms. The accrual status. Loans that meet this criteria
charge-off must be recorded before or at the should continue to be disclosed as past due as
time of the restructuring. appropriate (for example, 90 days past due and
3. The institution is reasonably assured of still accruing) until they have been brought fully
repayment of the A note and of performance current. (See SR-93-30.)
in accordance with the modified terms.
4. In general, the borrower must have demon-
strated sustained repayment performance 2065.1.5 ACQUISITION OF
(either immediately before or after the NONACCRUAL ASSETS
restructuring) in accordance with the modi-
fied terms for a reasonable period before the Banking organizations (or the receiver of a
date on which the A note is returned to failed institution) may sell loans or debt securi-
accrual status. Sustained payment perfor- ties maintained in nonaccrual status. Such loans
mance generally would be for a minimum of or debt securities that have been acquired from
six months and involve payments in the form an unaffiliated third party should be reported by
of cash or cash equivalents. the purchaser in accordance with AICPA Prac-
tice Bulletin No. 6. When the criteria specified
The A note would be initially disclosed as a in this bulletin are met, these assets may be
TDR. However, if the A note yields a market placed in nonaccrual status.3
rate of interest and performs in accordance with
the restructured terms, the note would not have
to be disclosed as a TDR in the year after the 2065.1.6 TREATMENT OF
restructuring. To be considered a market rate of NONACCRUAL LOANS WITH
interest, the interest rate on the A note at the PARTIAL CHARGE-OFFS
time of the restructuring must be equal to or
greater than the rate that the institution is will- Whether partial charge-offs associated with a
ing to accept for a new receivable with compa- nonaccrual loan that has not been formally
rable risk. (See SR-93-30.) restructured must first be fully recovered before
the loan can be restored to accrual status is an
issue that has not been explicitly addressed by
2065.1.4.2 Nonaccrual Loans That Have GAAP and bank regulatory reporting require-
Demonstrated Sustained Contractual ments. In accordance with the instructions for
Performance the bank call report and the bank holding com-
pany reports (FR-Y series), restoration to
Certain borrowers have resumed paying the full accrual status is permitted when (1) the loan has
amount of scheduled contractual interest and been brought fully current with respect to princi-
principal payments on loans that are past due pal and interest and (2) it is expected that the
and in nonaccrual status. Although prior arrear- full contractual balance of the loan (including
ages may not have been eliminated by payments any amounts charged off) plus interest will be
from the borrowers, some borrowers have dem- fully collectible under the terms of the loan.4
onstrated sustained performance over a time in
accordance with contractual terms. The inter- 3. AICPA Practice Bulletin No. 6, Amortization of Dis-
agency guidance of June 10, 1993, announced counts on Certain Acquired Loans, American Institute of
that such loans may henceforth be returned to Certified Public Accountants, August 1989.
4. The instructions for the call reports and FR-Y reports
accrual status, even though the loans have not discuss the criteria for restoration to accrual status in the
been brought fully current. They may be glossary entries for nonaccrual status. This guidance also
returned to accrual status if (1) there is reason- permits restoration to accrual status for nonaccrual assets that
able assurance of repayment of all principal and are both well secured and in the process of collection. In
addition, this guidance permits restoration to accrual status,
interest amounts contractually due (including when certain criteria are met, of formally restructured debt
arrearages) within a reasonable period and and acquired nonaccrual assets.
(2) the borrower has made payments of cash or
cash equivalents over a sustained period (gener- BHC Supervision Manual December 2002
ally a minimum of six months) in accordance Page 3
Thus, in determining whether a partially 15, a collateral-dependent real estate loan 5

charged-off loan that has been brought fully would be reported as other real estate owned
current can be returned to accrual status, it is (OREO) only if the lender had taken possession
important to determine whether the banking of the collateral. For other collateral-dependent
organization expects to receive the full amount real estate loans, loss recognition would be
of principal and interest called for by the terms based on the fair value of the collateral if fore-
of the loan. closure is probable.6 Such loans would remain
When a loan has been brought fully current in the loan category and would not be reported
with respect to contractual principal and inter- as OREO. For depository institution examina-
est, and when the borrowers financial condition tions, any portion of the loan balance on a
and economic conditions that could affect the collateral-dependent loan that exceeds the fair
borrowers ability to repay have improved to the value of the collateral and that can be identified
point that repayment of the full amount of con- as uncollectible would generally be classified as
tractual principal (including any amounts a loss and be promptly charged off against the
charged off) and interest is expected, the loan ALLL.
may be restored to accrual status even if the A collateralized loan that becomes impaired
charge-off has not been recovered. However, is not considered collateral dependent if
this treatment would not be appropriate if the repayment is available from reliable sources
charge-off reflects continuing doubt about the other than the collateral. Any impairment on
collectibility of principal or interest. Because such a loan may, at the depository institutions
loans or other assets are required to be placed in option, be determined based on the present value
nonaccrual status when full repayment of princi- of the expected future cash flows discounted at
pal or interest is not expected, such loans could the loans effective interest rate or, as a practical
not be restored to accrual status. expedient, based on the loans observable mar-
It is imperative that the reasons for the resto- ket price. (See SR-95-38.)
ration of a partially charged-off loan to accrual Losses must be recognized on real estate
status be supported by a current, well- loans that meet the in-substance foreclosure
documented evaluation of the borrowers finan- criteria with the collateral being valued accord-
cial condition and prospects for full repayment ing to its fair value. Such loans do not have to
of contractual principal (including any amounts be reported as OREO unless possession of the
charged off) and interest. This documentation underlying collateral has been obtained. (See
will be subject to review by examiners. SR-93-30.)
A nonaccrual loan or debt instrument may
have been formally restructured in accordance
with FAS 15 so that it meets the criteria for
2065.1.8 LIQUIDATION VALUES OF
restoration to accrual status presented in section
REAL ESTATE LOANS
2065.1.2 addressing restructured loans. Under In accordance with the March 10, 1993, inter-
GAAP, when a charge-off was taken before the agency policy statement Credit Availability,
date of the restructuring, it does not have to loans secured by real estate should be based on
be recovered before the restructured loan can the borrowers ability to pay over time, rather
be restored to accrual status. When a charge-off than on a presumption of immediate liquidation.
occurs after the date of the restructuring, the Interagency guidance issued on June 10, 1993,
considerations and treatments discussed earlier emphasizes that it is not regulatory policy to
in this section are applicable. value collateral that underlies real estate loans
on a liquidation basis. (See SR-93-30.)
2065.1.7 IN-SUBSTANCE
FORECLOSURES
FAS 114 addresses the accounting for impaired 5. A collateral-dependent real estate loan is a loan for
loans and clarifies existing accounting guidance which repayment is expected to be provided solely by the
for in-substance foreclosures. Under the impair- underlying collateral and there are no other available and
ment standard and related amendments to FAS reliable sources of repayment.
6. The fair value of the assets transferred is the amount that
the debtor could reasonably expect to receive for them in a
BHC Supervision Manual December 2002 current sale between a willing buyer and a willing seller, other
Page 4 than in a forced or liquidation sale.
Determining an Adequate Level for the Allowance for Loan and Lease
Losses (Accounting, Reporting, and Disclosure Issues) Section 2065.2
The adequacy of a banking organizations Examiners will evaluate the methodology and
allowance for loan and lease losses (ALLL) process that management has followed in arriv-
(including amounts based on an analysis of the ing at an overall estimate of the ALLL to ensure
commercial real estate portfolio) must be based that all of the relevant factors affecting the
on a careful, well-documented, and consistently collectibility of the portfolio have been appro-
applied analysis of the loan and lease portfolio.1 priately considered. In addition, the overall esti-
The determination of the adequacy of the ALLL mate of the ALLL and the range of possible
should be based on managements consideration credit losses estimated by management will be
of all current significant conditions that might reviewed for reasonableness in view of these
affect the ability of borrowers (or guarantors, if factors. The examiners analysis will also con-
any) to fulfill their obligations to the institution. sider the quality of the organizations systems
While historical loss experience provides a rea- and management in identifying, monitoring, and
sonable starting point, historical losses or even addressing asset-quality problems. (See sections
recent trends in losses are not sufficient, without 2065.3, 2065.4, and 2128.08.)
further analysis, to produce a reliable estimate The value of the collateral will be considered
of anticipated loss. by examiners in reviewing and classifying a
In determining the adequacy of the ALLL, commercial real estate loan. However, for a
management should consider factors such as performing commercial real estate loan, the
changes in the nature and volume of the port- supervisory policies of the agencies do not
folio; the experience, ability, and depth of lend- require automatic increases to the ALLL solely
ing management and staff; changes in credit because the value of the collateral has declined
standards; collection policies and historical col- to an amount that is less than the loan balance.
lection experience; concentrations of credit risk; In assessing the ALLL, it is important to
trends in the volume and severity of past-due recognize that managements process, method-
and classified loans; and trends in the volume of ology, and underlying assumptions require a
nonaccrual loans, specific problem loans, and substantial degree of judgment. Even when
commitments. In addition, this analysis should an organization maintains sound loan-
consider the quality of the organizations sys- administration and -collection procedures and
tems and management in identifying, monitor- effective internal systems and controls, the esti-
ing, and addressing asset-quality problems. Fur- mation of losses may not be precise due to the
thermore, management should consider external wide range of factors that must be considered.
factors such as local and national economic Further, the ability to estimate losses on specific
conditions and developments, competition, and loans and categories of loans improves over
legal and regulatory requirements, as well as time as substantive information accumulates
reasonably foreseeable events that are likely to regarding the factors affecting repayment pros-
affect the collectibility of the loan portfolio. pects. When management has (1) maintained
Management should adequately document the effective systems and controls for identifying,
factors that were considered, the methodology monitoring, and addressing asset-quality prob-
and process that were used in determining the lems and (2) analyzed all significant factors
adequacy of the ALLL, and the range of pos- affecting the collectibility of the portfolio,
sible credit losses estimated by this process. The examiners should give considerable weight to
complexity and scope of this analysis must be managements estimates in assessing the
appropriate to the size and nature of the organi- adequacy of the overall ALLL.
zation and provide for sufficient flexibility to Examiners and bank holding company man-
accommodate changing circumstances. agement should consider the impact of the
Financial Accounting Standards Boards
(FASB) Statement No. 114, Accounting by
1. The estimation process described in this section permits Creditors for Impairment of a Loan (FAS 114)
a more accurate estimate of anticipated losses than could be (as amended by FASB Statement No. 118,
achieved by assessing the loan portfolio solely on an aggre-
gate basis. However, it is only an estimation process and does
Accounting by Creditors for Impairment of a
not imply that any part of the ALLL is segregated for, or LoanIncome Recognition and Disclosures),
allocated to, any particular asset or group of assets. The on the ALLL-estimating process. FAS 114 sets
ALLL is available to absorb overall credit losses originating forth guidance for estimating the impairment of
from the loan and lease portfolio. The balance of the ALLL is
managements estimation of potential credit losses, synony-
mous with its determination as to the adequacy of the overall BHC Supervision Manual December 2002
ALLL. Page 1
Determining an Adequate Level for the Allowance for Loan and Lease Losses 2065.2
a loan for general financial reporting purposes. 2065.2.2 INSPECTION PROCEDURES

Under FAS 114, a loan is impaired when, based
on current information and events, it is probable 1. Determine whether the banking organization
that a creditor will be unable to collect all has carefully documented and applied an
amounts due (principal and interest) according accurate and consistent method of analysis
to the contractual terms of the loan agreement. for estimating the overall ALLL. When mak-
When a creditor has determined that a loan is ing such a determination, ascertain
impaired, FAS 114 requires that an allowance whether
be established based on the present value of the a. management has considered all significant
expected future cash flows of the loan dis- factors and conditions that might affect
counted at the loans effective interest rate (that the collectibility of the loan, including the
is, the contract rate, as adjusted for any net borrowers repayment practices, the value
deferred loan fees or costs, premiums, or dis- of accessible underlying collateral, and
counts) or, as a practical expedient, at the loans other factors (that is, those factors listed
observable market price or at the fair value of in this section);
the collateral if the loan is collateral dependent. b. management has documented all factors
Since the allowances under FAS 114 apply only that were considered and the methodology
to a subset of loans,2 FAS 114 does not address and process that were used to evaluate the
the adequacy of a creditors overall ALLL or adequacy of the allowance; and
how the creditor should assess the adequacy of c. the complexity and scope of the analysis
its ALLL. Examiners should not focus unduly are appropriate for the size and nature of
on the adequacy of this or any other portion of the organization.
the ALLL established for a subset of loans. 2. Evaluate the methodology and process that
Bank holding companies are required to follow management has followed in arriving at an
FAS 114 (as amended by FAS 118) when report- overall estimate of the ALLL.
ing in the FR Y-9C report for the holding com- 3. Determine the reasonableness of manage-
pany on a consolidated basis. ments consolidated estimate of the ALLL,
including the range of possible credit losses.
Determine whether management has prop-
2065.2.1 INSPECTION OBJECTIVES erly evaluated the overall composition of the
loan portfolio at all organizational levels
1. To evaluate the methodology and process
by
that management employs in compiling an
a. identifying potential problem loans,
overall estimate of the ALLL.
including loans classified by all bank
2. To understand and evaluate the nature of the
regulatory agencies;
external (economic and social climate, the
b. determining trends with respect to loan
extent of competition) and internal (credit
volume (growth (in particular, rapid
strategies, levels of acceptable credit risk,
growth), levels of delinquencies, nonac-
and lending policies and procedures) lending
cruals, and nonperforming loans);
environment and how they might influence
c. considering the previous loss and recovery
managements estimate of the ALLL.
experience including the timeliness of
3. To determine the accuracy and reasonable-
charge-offs;
ness of managements estimate of the overall
d. evaluating the performance of concentra-
ALLL.
tions of credit (related interests, geo-
4. To evaluate the quality of the BHCs systems
graphic regions, industries, lesser-
and management performance in identifying,
developed countries (LDCs), highly
monitoring, and resolving asset-quality
leveraged loans, and the size of credit
problems.
exposures (few large loans versus numer-
ous small loans));
2. The guidance on impairment in FAS 114 does not apply
to large groups of smaller balance homogeneous loans that
e. determining the amount of loans and
are collectively evaluated for impairment, loans that are problem loans (delinquent, nonaccrual,
measured at fair value or at the lower of cost or fair value, or and nonperforming) by lending officer or
leases and debt securities as defined in FAS 115, Accounting committee; and
for Certain Investments in Debt and Equity Securities.
FAS 114 does apply to loans that are restructured in a
f. evaluating the levels and performance of
troubled-debt restructuring involving a modification of terms. loans involving related parties.
4. For each level of the organization, determine
BHC Supervision Manual December 2002 the percentage of past-due loans to the loan
Page 2 portfolio and compare it with prior periods.
Determining an Adequate Level for the Allowance for Loan and Lease Losses 2065.2
The examiner may find it beneficial to com- 6. Compute the percentage of the ALLL to
pute the ratio for groups of loans by type, average outstanding loans and compare those
size, or risk levels. results with those of the previous inspection.
5. Compare the loans classified during reg- Investigate the reasons for variations
ulatory examinations or BHC inspections between those periods.
with the previous examinations or inspec- 7. Assess the quality of the organizations sys-
tions and also with those classified by man- tems and internal controls in identifying,
agement before the regulatory examinations monitoring, and addressing asset-quality
or inspections. Investigate the current status problems.
of previously classified loans.

Page 3
Maintenance of an Appropriate Allowance for Loan and Lease Losses
WHATS NEW IN THIS REVISED loan review systems and controls for identify-
SECTION ing, monitoring, and addressing asset-quality
problems in a timely manner; (2) analyzed all
This section has been fully revised to set forth significant environmental factors that affect the
the 2006 Interagency Policy Statement on the collectibility of the portfolio as of the evaluation
Allowance for Loan and Lease Losses (ALLL), date in a reasonable manner; (3) established an
which was issued on December 13, 2006, by the acceptable ALLL-evaluation process for both
federal bank and thrift regulatory agencies (the individual loans and groups loans that meets the
banking agencies.) (See SR-06-17.) This guid- objectives for an appropriate ALLL; and
ance updates and replaces the 1993 policy state- (4) incorporated reasonable and properly sup-
ment. The policy was revised to ensure consis- ported assumptions, valuations, and judgments
tency with generally accepted accounting into the evaluation process.
principles (GAAP) and recent supervisory guid- The policy also reiterates the points of agree-
ance. The Federal Reserve believes the guid- ment between the Securities and Exchange
ance is broadly applicable to bank holding com- Commission and the banking agencies since
panies. Accordingly, examiners should apply the 1999: (1) the need for management to exercise
policy, as appropriate, during inspections of significant judgment when estimating the
bank holding companies and their nonbank ALLL, (2) the concept of a range of losses, and
subsidiaries. (3) the appropriateness of a properly developed
and documented ALLL. Accordingly, the policy
emphasizes that an institution should provide
2065.3.0 OVERVIEW OF THE ALLL reasonable support and documentation of its
POLICY STATEMENT ALLL estimates, including adjustments to the
allowance for qualitative or environmental fac-
The 2006 policy statement discusses the nature tors and unallocated portions of the allowance.
and purpose of the allowance for loan and lease This emphasis on support and documentation
losses (ALLL); the responsibilities of boards of supplements, but does not replace, the guidance
directors, the institutions management, and the in the 2001 Interagency Policy Statement on the
examiners of banking organizations regarding Allowance for Loan and Lease Losses Method-
the ALLL; factors to be considered in the esti- ologies and Documentation for Banks and Sav-
mation of the ALLL; and the objectives and ings Institutions (see SR-01-17).
elements of an effective loan review system, Additionally, institutions are reminded that
including a sound credit grading system. The the allowance is an institution-specific estimate
statement states that it is the responsibility of and generally should not be based solely on a
the board of directors and management of each standard percentage of loans. While peer
institution to maintain the ALLL at an appropri- group or other benchmark averages are an
ate level. Each institution is responsible for appropriate tool to evaluate the reasonableness
developing, maintaining, and documenting a of the allowance, it is the institutions responsi-
comprehensive, systematic, and consistently bility to analyze the collectibility of the loan
applied process for determining the amounts of portfolio to estimate the allowance. To that end,
the ALLL and the provision for loan and lease the policy statement does not reference stan-
losses. To fulfill this responsibility, each institu- dardized loss estimates (that is, 15 percent for
tion should ensure that controls are in place to loans classified as substandard and 50 percent
consistently determine the ALLL in accordance for loans classified as doubtful).
with GAAP, the institutions stated policies and The policy statement also includes guidance
procedures, managements best judgment, and on SFAS 114, Accounting by Creditors for
relevant supervisory guidance. The policy state- Impairment of a Loan, which describes the
ment also discusses the analysis of the loan and evaluation and measurement of impairment for
lease portfolio, factors to consider in estimating loans that are impaired on an individual basis,
credit losses, and the characteristics of an effec- and SFAS 5, Accounting for Contingencies,
tive loan-review system. which describes the same for pools of loans
The policy statement continues the policy grouped according to risk factors. The relation-
that Federal Reserve examiners will generally ship between the two standards is described as
accept bank managements estimates in their
assessment of the appropriateness of the ALLL BHC Supervision Manual July 2007
when management has (1) maintained effective Page 1
Maintenance of an Appropriate Allowance for Loan and Lease Losses 2065.3
well as the application of each standard in esti- guidance on accounting for impairment in a
mating the ALLL. Lastly, the policy reminds loan portfolio under GAAP are Statement of
institutions that allowances related to off- Financial Accounting Standards No. 5,
balance-sheet financial instruments such as loan Accounting for Contingencies (FAS 5) and
commitments or letters of credit should not be Statement of Financial Accounting Standards
reported as part of the ALLL. Any allowance No. 114, Accounting by Creditors for Impair-
for these types of instruments is recorded as an ment of a Loan (FAS 114). In addition, the
other liability. Financial Accounting Standards Board View-
This policy statement applies to all deposi- points article that is included in Emerging Issues
tory institutions supervised by the banking agen- Task Force Topic D-80 (EITF D-80), Applica-
cies, except for U.S. branches and agencies of tion of FASB Statements No. 5 and No. 114 to a
foreign banks. In addition, the Federal Reserve Loan Portfolio, presents questions and answers
believes the guidance is broadly applicable to that provide specific guidance on the interaction
bank holding companies as well. Accordingly, between these two FASB statements and may be
examiners should apply the policy, as appropri- helpful in applying them.
ate, during inspections of bank holding compa- In July 1999, the banking agencies and the
nies and their nonbank subsidiaries, in addition Securities and Exchange Commission (SEC)
to the examination of state member banks. issued a Joint Interagency Letter to Financial
Although the policy statement discusses key Institutions. The letter stated that the banking
concepts and requirements in GAAP and exist- agencies and the SEC agreed on the following
ing supervisory guidance on the ALLL, the important aspects of loan loss allowance
banking agencies recognized that institutions practices:
may not have had sufficient time to complete
any enhancements needed to bring their ALLL Arriving at an appropriate allowance involves
processes and documentation into full compli- a high degree of management judgment and
ance with the revised guidance for year-end results in a range of estimated losses.
2006 reporting purposes. Nevertheless, such Prudent, conservativebut not excessive
enhancements were to be completed and effec- loan loss allowances that fall within an accept-
tive in the subsequent near term. able range of estimated losses are appropriate.
The text of the interagency policy statement In accordance with GAAP, an institution
follows. (See also sections 2065.1, 2065.2, and should record its best estimate within the
2065.4.) range of credit losses, including when man-
agements best estimate is at the high end of
the range.
2065.3.1 2006 INTERAGENCY POLICY Determining the allowance for loan losses is
STATEMENT ON THE ALLOWANCE inevitably imprecise, and an appropriate
FOR LOAN AND LEASE LOSSES allowance falls within a range of estimated
losses.
This 2006 interagency policy statement1 revises An unallocated loan loss allowance is
and replaces the 1993 policy statement on the appropriate when it reflects an estimate of
ALLL. It reiterates key concepts and require- probable losses, determined in accordance
ments included in generally accepted account- with GAAP, and is properly supported.
ing principles (GAAP) and existing ALLL Allowance estimates should be based on a
supervisory guidance.2 The principal sources of comprehensive, well-documented, and consis-
tently applied analysis of the loan portfolio.
The loan loss allowance should take into con-
1. The policy statement was adopted by, and applies to, all
depository institutions (institutions), except U.S. branches and sideration all available information existing as
agencies of foreign banks, that are supervised by the Board of of the financial statement date, including envi-
Governors of the Federal Reserve System, the Office of the ronmental factors such as industry, geographi-
Comptroller of the Currency, the Federal Deposit Insurance cal, economic, and political factors.
Corporation, the Office of Thrift Supervision (the banking
agencies), and to institutions insured and supervised by the
National Credit Union Administration (NCUA) (collectively, In July 2001, the banking agencies issued the
the agencies). U.S. branches and agencies of foreign banks Policy Statement on Allowance for Loan and
continue to be subject to any separate guidance that has been
issued by their primary supervisory agency.
Purpose of the ALLL within this section, this policy state-
2. As discussed more fully below in the Nature and
ment and the ALLL generally do not address loans carried at
fair value or loans held for sale. In addition, this policy
BHC Supervision Manual July 2007 statement provides only limited guidance on purchased
Page 2 impaired loans.
Lease Losses Methodologies and Documenta- sale,5 off-balance-sheet credit exposures6 (for
tion for Banks and Savings Institutions (2001 example, financial instruments such as off-
policy statement). The policy statement is balance-sheet loan commitments, standby let-
designed to assist institutions in establishing a ters of credit, and guarantees), or general or
sound process for determining an appropriate unspecified business risks.
ALLL and documenting that process in accor- For purposes of this policy statement, the
dance with GAAP.3 (See section 2065.4.1.) term estimated credit losses means an estimate
In March 2004, the agencies also issued the of the current amount of loans that it is probable
Update on Accounting for Loan and Lease the institution will be unable to collect given
Losses. This guidance provided reminders of facts and circumstances since the evaluation
longstanding supervisory guidance as well as a date. Thus, estimated credit losses represent net
listing of the existing allowance guidance that charge-offs that are likely to be realized for a
institutions should continue to apply. loan or group of loans. These estimated credit
losses should meet the criteria for accrual of a
loss contingency (that is, through a provision to
the ALLL) set forth in GAAP.7 When available
2065.3.1.1 Nature and Purpose of the information confirms that specific loans, or por-
ALLL tions thereof, are uncollectible, these amounts
should be promptly charged off against the
The ALLL represents one of the most signifi- ALLL.
cant estimates in an institutions financial state- For purchased impaired loans,8 GAAP pro-
ments and regulatory reports. Because of its
significance, each institution has a responsibility
5. See Interagency Guidance on Certain Loans Held for
for developing, maintaining, and documenting a Sale (March 26, 2001) for the appropriate accounting and
comprehensive, systematic, and consistently reporting treatment for certain loans that are sold directly
applied process for determining the amounts of from the loan portfolio or transferred to a held-for-sale
the ALLL and the provision for loan and lease account. Loans held for sale are reported at the lower of cost
or fair value. Declines in value occurring after the transfer of a
losses (PLLL). To fulfill this responsibility, each loan to the held-for-sale portfolio are accounted for as adjust-
institution should ensure controls are in place to ments to a valuation allowance for held-for-sale loans and not
consistently determine the ALLL in accordance as adjustments to the ALLL.
with GAAP, the institutions stated policies and 6. Credit losses on off-balance-sheet credit exposures
should be estimated in accordance with FAS 5. Any allow-
procedures, managements best judgment, and ance for credit losses on off-balance-sheet exposures should
relevant supervisory guidance. As of the end of be reported on the balance sheet as an other liability, and
each quarter, or more frequently if warranted, not as part of the ALLL.
each institution must analyze the collectibility 7. FAS 5 requires the accrual of a loss contingency when
information available prior to the issuance of the financial
of its loans and leases held for investment4 statements indicates it is probable that an asset has been
(hereafter referred to as loans) and maintain an impaired at the date of the financial statements and the amount
ALLL at a level that is appropriate and deter- of loss can be reasonably estimated. These conditions may be
mined in accordance with GAAP. An appropri- considered in relation to individual loans or in relation to
groups of similar types of loans. If the conditions are met,
ate ALLL covers estimated credit losses on indi- accrual should be made even though the particular loans that
vidually evaluated loans that are determined to are uncollectible may not be identifiable. Under FAS 114, an
be impaired as well as estimated credit losses individual loan is impaired when, based on current informa-
inherent in the remainder of the loan and lease tion and events, it is probable that a creditor will be unable to
collect all amounts due according to the contractual terms of
portfolio. The ALLL does not apply, however, the loan agreement. It is implicit in these conditions that it
to loans carried at fair value, loans held for must be probable that one or more future events will occur
confirming the fact of the loss. Thus, under GAAP, the pur-
pose of the ALLL is not to absorb all of the risk in the loan
portfolio, but to cover probable credit losses that have already
3. See section 2065.4.1 for the 2001 policy statement. The
been incurred.
SEC staff issued parallel guidance in July 2001, which is
8. A purchased impaired loan is defined as a loan that an
found in Staff Accounting Bulletin No. 10, Selected Loan
institution has purchased, including a loan acquired in a
Loss Allowance Methodology and Documentation Issues
purchase business combination, that has evidence of deteriora-
(SAB 102), which has been codified as Topic 6.L. in the
tion of credit quality since its origination and for which it is
SECs Codification of Staff Accounting Bulletins. Both SAB
probable, at the purchase date, that the institution will be
102 and the codification are available on the SECs web site.
unable to collect all contractually required payments. When
4. Consistent with the American Institute of Certified Pub-
reviewing the appropriateness of the reported ALLL of an
lic Accountants (AICPA) Statement of Position 01-6,
institution with purchased impaired loans, examiners should
Accounting by Certain Entities (Including Entities With
consider the credit losses factored into the initial investment
Trade Receivables) That Lend to or Finance the Activities of
Others, loans and leases held for investment are those loans
and leases that the institution has the intent and ability to hold BHC Supervision Manual July 2007
for the foreseeable future or until maturity or payoff. Page 3
hibits carrying over or creating an ALLL in costs, and unamortized premium or discount) in
the initial recording of these loans. However, if, excess of the fair value of the collateral that can
upon evaluation subsequent to acquisition, it is be identified as uncollectible, and is therefore
probable that the institution will be unable to deemed a confirmed loss, should be promptly
collect all cash flows expected at acquisition on charged off against the ALLL.11
a purchased impaired loan (an estimate that All other loans, including individually evalu-
considers both timing and amount), the loan ated loans determined not to be impaired under
should be considered impaired for purposes of FAS 114, should be included in a group of loans
applying the measurement and other provisions that is evaluated for impairment under FAS 5.12
of FAS 5 or, if applicable, FAS 114. While an institution may segment its loan port-
Estimates of credit losses should reflect con- folio into groups of loans based on a variety of
sideration of all significant factors that affect the factors, the loans within each group should have
collectibility of the portfolio as of the evaluation similar risk characteristics. For example, a loan
date. For loans within the scope of FAS 114 that that is fully collateralized with risk-free assets
are individually evaluated and determined to be should not be grouped with uncollateralized
impaired,9 these estimates should reflect consid- loans. When estimating credit losses on each
eration of one of the standards three impair- group of loans with similar risk characteristics,
ment measurement methods as of the evaluation an institution should consider its historical loss
date: (1) the present value of expected future experience on the group, adjusted for changes
cash flows discounted at the loans effective in trends, conditions, and other relevant factors
interest rate,10 (2) the loans observable market that affect repayment of the loans as of the
price, or (3) the fair value of the collateral if the evaluation date.
loan is collateral dependent. For analytical purposes, an institution should
An institution may choose the appropriate attribute portions of the ALLL to loans that it
FAS 114 measurement method on a loan-by- evaluates and determines to be impaired under
loan basis for an individually impaired loan, FAS 114 and to groups of loans that it evaluates
except for an impaired collateral-dependent collectively under FAS 5. However, the ALLL
loan. The agencies require impairment of a is available to cover all charge-offs that arise
collateral-dependent loan to be measured using from the loan portfolio.
the fair value of collateral method. As defined in
FAS 114, a loan is collateral dependent if repay-
ment of the loan is expected to be provided 2065.3.1.2 Responsibilities of the Board
solely by the underlying collateral. In general, of Directors and Management
any portion of the recorded investment in a
collateral-dependent loan (including any capital- 2065.3.1.2.1 Appropriate ALLL Level
ized accrued interest, net deferred loan fees or
Each institutions management is responsible
for maintaining the ALLL at an appropriate
in these loans when determining whether further deterioration level and for documenting its analysis according
(for example, decreases in cash flows expected to be col-
lected) has occurred since the loans were purchased. The to the standards set forth in the 2001 policy
banks Consolidated Report of Condition and Income (Call statement. Thus, management should evaluate
Report) and/or the Consolidated Financial Statement for Bank the ALLL reported on the balance sheet as of
Holding Companies (such as the FR Y-9C), and the disclo- the end of each quarter or more frequently if
sures in the banks financial statements may provide useful
information for examiners in reviewing these loans. Refer to warranted, and charge or credit the PLLL to
the AICPAs Statement of Position 03-3, Accounting for bring the ALLL to an appropriate level as of
Certain Loans or Debt Securities Acquired in a Transfer, for each evaluation date. The determination of the
further guidance on the appropriate accounting. amounts of the ALLL and the PLLL should be
9. FAS 114 does not specify how an institution should
identify loans that are to be evaluated for collectibility nor based on managements current judgments
does it specify how an institution should determine that a loan about the credit quality of the loan portfolio, and
is impaired. An institution should apply its normal loan review
procedures in making those judgments. Refer to the ALLL
11. For further information, refer to the illustration in
interpretations for further guidance.
appendix B of the 2001 policy statement (see the appendix in
10. The effective interest rate on a loan is the rate of
section 2065.4.1.8).
return implicit in the loan (that is, the contractual interest rate
12. An individually evaluated loan that is determined not
adjusted for any net deferred loan fees or costs and any
to be impaired under FAS 114 should be evaluated under FAS
premium or discount existing at the origination or acquisition
5 when specific characteristics of the loan indicate that it is
of the loan).
probable there would be estimated credit losses in a group of
loans with those characteristics. For further guidance, refer to
BHC Supervision Manual July 2007 the frequently asked questions that were distributed with this
Page 4 policy statement.
should consider all known relevant internal and ensure that the resulting loss estimates are
external factors that affect loan collectibility as consistent with GAAP. To demonstrate this
of the evaluation date. Managements evalua- consistency, the institution should document
tion is subject to review by examiners. An insti- its evaluations and conclusions regarding the
tutions failure to analyze the collectibility of appropriateness of estimating credit losses
the loan portfolio and maintain and support an with the models or other estimation tools. The
appropriate ALLL in accordance with GAAP institution should also document and support
and supervisory guidance is generally an unsafe any adjustments made to the models or to the
and unsound practice. output of the models in determining the esti-
In carrying out its responsibility for maintain- mated credit losses.
ing an appropriate ALLL, management is The institution promptly charges off loans, or
expected to adopt and adhere to written policies portions of loans, that available information
and procedures that are appropriate to the size confirms to be uncollectible.
of the institution and the nature, scope, and risk The institution periodically validates the
of its lending activities. At a minimum, these ALLL methodology. This validation process
policies and procedures should ensure the fol- should include procedures for a review, by a
lowing: party who is independent of the institutions
credit approval and ALLL estimation pro-
The institutions process for determining an cesses, of the ALLL methodology and its
appropriate level for the ALLL is based on a application in order to confirm its effective-
comprehensive, well-documented, and consis- ness. A party who is independent of these
tently applied analysis of its loan portfolio.13 processes could be the internal audit staff, a
The analysis should consider all significant risk management unit of the institution, an
factors that affect the collectibility of the port- external auditor (subject to applicable auditor
folio and should support the credit losses esti- independence standards), or another con-
mated by this process. The institution has an tracted third party from outside the institution.
effective loan review system and controls One party need not perform the entire analy-
(including an effective loan classification or sis, as the validation can be divided among
credit grading system) that identify, monitor, various independent parties.
and address asset quality problems in an accu-
rate and timely manner.14 To be effective, the The board of directors is responsible for over-
institutions loan review system and controls seeing managements significant judgments and
must be responsive to changes in internal and estimates pertaining to the determination of an
external factors affecting the level of credit appropriate ALLL. This oversight should
risk in the portfolio. include but is not limited to
The institution has adequate data capture and
reporting systems to supply the information reviewing and approving the institutions
necessary to support and document its esti- written ALLL policies and procedures at least
mate of an appropriate ALLL. annually;
The institution evaluates any loss estimation reviewing managements assessment and jus-
models before they are employed and modi- tification that the loan review system is sound
fies the models assumptions, as needed, to and appropriate for the size and complexity of
the institution;
13. As noted in the 2001 policy statement, an institution reviewing managements assessment and jus-
with less complex lending activities and products may find it tification for the amounts estimated and
more efficient to combine a number of procedures while reported each period for the PLLL and the
continuing to ensure that the institution has a consistent and ALLL; and
appropriate ALLL methodology. Thus, much of the support-
ing documentation required for an institution with more com- requiring management to periodically validate
plex products or portfolios may be combined into fewer and, when appropriate, revise the ALLL meth-
supporting documents in an institution with less complex odology.
products or portfolios.
14. Loan review and loan classification or credit grading
systems are discussed in attachment 1 of this policy statement. For purposes of the Consolidated Reports of
In addition, state member banks and savings associations Condition and Income (Call Report) and/or the
should refer to the asset quality standards in the Interagency Consolidated Financial Statement for Bank
Guidelines Establishing Standards for Safety and Soundness,
which were adopted by the Federal Reserve Board (see appen-
Holding Companies (such as the FR Y-9C) an
dix D-1, 12 C.F.R. 208). For national banks, see appendix A
to Part 30; for state nonmember banks, appendix A to Part BHC Supervision Manual July 2007
364; and for savings associations, appendix A to Part 570. Page 5
appropriate ALLL (after deducting all loans and tions should maintain appropriate documenta-
portions of loans confirmed loss) should consist tion to support the identified range and the ratio-
only of the following components (as appli- nale used for determining the best estimate from
cable),15 the amounts of which take into account within the range of loan losses.
all relevant facts and circumstances as of the As discussed more fully in attachment 1 of
evaluation date: this policy statement, it is essential that institu-
tions maintain effective loan review systems.
For loans within the scope of FAS 114 that are An effective loan review system should work to
individually evaluated and found to be ensure the accuracy of internal credit classifica-
impaired, the associated ALLL should be tion or grading systems and, thus, the quality of
based upon one of the three impairment mea- the information used to assess the appropriate-
surement methods specified in FAS 114.16 ness of the ALLL. The complexity and scope of
For all other loans, including individually an institutions ALLL evaluation process, loan
evaluated loans determined not to be impaired review system, and other relevant controls
under FAS 114,17 the associated ALLL should should be appropriate for the size of the institu-
be measured under FAS 5 and should provide tion and the nature of its lending activities. The
for all estimated credit losses that have been evaluation process should also provide for suffi-
incurred on groups of loans with similar risk cient flexibility to respond to changes in the
characteristics. factors that affect the collectibility of the
For estimated credit losses from transfer risk portfolio.
on cross-border loans, the impact to the ALLL Credit losses that arise from the transfer risk
should be evaluated individually for impaired associated with an institutions cross-border
loans under FAS 114 or evaluated on a group lending activities require special consideration.
basis under FAS 5. See this policy statements In particular, for banks with cross-border lend-
attachment 2 for further guidance on considering exposure, management should determine
ations of transfer risk on cross-border loans. that the ALLL is appropriate to cover estimated
For estimated credit losses on accrued interest losses from transfer risk associated with this
and fees on loans that have been reported as exposure over and above any minimum amount
part of the respective loan balances on the that the Interagency Country Exposure Review
institutions balance sheet, the associated Committee requires to be provided in the Allo-
ALLL should be evaluated under FAS 114 or cated Transfer Risk Reserve (or charged off
FAS 5 as appropriate, if not already included against the ALLL). These estimated losses
in one of the preceding components. should meet the criteria for accrual of a loss
contingency set forth in GAAP. (See attachment
Because deposit accounts that are overdrawn 2 for factors to consider.)
(that is, overdrafts) must be reclassified as loans
on the balance sheet, overdrawn accounts should
be included in one of the first two components 2065.3.1.2.2 Factors to Consider in the
above, as appropriate, and evaluated for esti- Estimation of Credit Losses
mated credit losses.
Determining the appropriate level for the Estimated credit losses should reflect consider-
ALLL is inevitably imprecise and requires a ation of all significant factors that affect the
high degree of management judgment. Manage- collectibility of the portfolio as of the evaluation
ments analysis should reflect a prudent, conser- date. Normally, an institution should determine
vative, but not excessive ALLL that falls within the historical loss rate for each group of loans
an acceptable range of estimated credit losses. with similar risk characteristics in its portfolio
When a range of losses is determined, institu- based on its own loss experience for loans in
that group. While historical loss experience pro-
vides a reasonable starting point for the institu-
15. A component of the ALLL that is labeled unallo-
cated is appropriate when it reflects estimated credit losses
tions analysis, historical lossesor even recent
determined in accordance with GAAP and is properly sup- trends in lossesdo not by themselves form a
ported and documented. sufficient basis to determine the appropriate
16. As previously noted, the use of the fair value of collat- level for the ALLL. Management also should
eral method is required for an individually evaluated loan that
is impaired if the loan is collateral dependent.
consider those qualitative or environmental fac-
17. See footnote 12. tors that are likely to cause estimated credit
losses associated with the institutions existing
BHC Supervision Manual July 2007 portfolio to differ from historical loss experi-
Page 6 ence, including but not limited to
changes in lending policies and procedures, on groups of loans with similar risk characteris-
including changes in underwriting standards tics in accordance with FAS 5, a widely used
and collection, charge-off, and recovery prac- method is based on each groups historical net
tices not considered elsewhere in estimating charge-off rate adjusted for the effects of the
credit losses; qualitative or environmental factors discussed
changes in international, national, regional, previously. As the first step in applying this
and local economic and business conditions method, management generally bases the his-
and developments that affect the collectibility torical net charge-off rates on the annualized
of the portfolio, including the condition of historical gross loan charge-offs, less recoveries,
various market segments;18 recorded by the institution on loans in each
changes in the nature and volume of the port- group.
folio and in the terms of loans; Methodologies for determining the historical
changes in the experience, ability, and depth net charge-off rate on a group of loans with
of lending management and other relevant similar risk characteristics under FAS 5 can
staff; range from the simple average of, or a determi-
changes in the volume and severity of past nation of the range of, an institutions annual net
due loans, the volume of nonaccrual loans, charge-off experience to more complex tech-
and the volume and severity of adversely clas- niques, such as migration analysis and models
sified or graded loans;19 that estimate credit losses.20 Generally, institu-
changes in the quality of the institutions loan tions should use at least an annualized or
review system; 12-month average net charge-off rate that will
changes in the value of underlying collateral be applied to the groups of loans when estimat-
for collateral-dependent loans; ing credit losses. However, this rate could vary.
the existence and effect of any concentrations For example, loans with effective lives longer
of credit, and changes in the level of such than 12 months often have workout periods over
concentrations; and an extended period of time, which may indicate
the effect of other external factors such as that the estimated credit losses should be greater
competition and legal and regulatory require- than that calculated based solely on the annual-
ments on the level of estimated credit losses ized net charge-off rate for such loans. These
in the institutions existing portfolio. groups may include certain commercial loans as
well as groups of adversely classified loans.
In addition, changes in the level of the ALLL Other groups of loans may have effective lives
should be directionally consistent with changes shorter than 12 months, which may indicate that
in the factors, taken as a whole, that evidence the estimated credit losses should be less than
credit losses, keeping in mind the characteristics that calculated based on the annualized net
of an institutions loan portfolio. For example, if charge-off rate.
declining credit quality trends relevant to the Regardless of the method used, institutions
types of loans in an institutions portfolio are should maintain supporting documentation for
evident, the ALLL level as a percentage of the
portfolio should generally increase, barring 20. Annual charge-off rates are calculated over a specified
unusual charge-off activity. Similarly, if improv- time period (for example, three years or five years), which can
ing credit quality trends are evident, the ALLL vary based on a number of factors including the relevance of
past periods experience to the current period or point in the
level as a percentage of the portfolio should credit cycle. Also, some institutions remove loans that become
generally decrease. adversely classified or graded from a group of nonclassified or
nongraded loans with similar risk characteristics in order to
evaluate the removed loans individually under FAS 114 (if
deemed impaired) or collectively in a group of adversely
2065.3.1.2.3 Measurement of Estimated classified or graded loans with similar risk characteristics
Credit Losses under FAS 5. In this situation, the net charge-off experience
on the adversely classified or graded loans that have been
FAS 5. When measuring estimated credit losses removed from the group of nonclassified or nongraded loans
should be included in the historical loss rates for that group of
loans. Even though the net charge-off experience on adversely
classified or graded loans is included in the estimation of the
18. Credit loss and recovery experience may vary signifi-
historical loss rates that will be applied to the group of
cantly depending upon the stage of the business cycle. For
nonclassified or nongraded loans, the adversely classified or
example, an overreliance on credit loss experience during a
graded loans themselves are no longer included in that group
period of economic growth will not result in realistic esti-
for purposes of estimating credit losses on the group.
mates of credit losses during a period of economic downturn.
19. For banks and savings associations, adversely classi-
fied or graded loans are loans rated substandard (or its BHC Supervision Manual July 2007
equivalent) or worse under its loan classification system. Page 7
the techniques used to develop the historical tors affected the analysis and the impact of those
loss rate for each group of loans. If a range of factors on the loss measurement. Support and
historical loss rates is developed instead for a documentation includes descriptions of each
group of loans, institutions should maintain factor, managements analysis of how each fac-
documentation to support the identified range tor has changed over time, which loan groups
and the rationale for determining which rate is loss rates have been adjusted, the amount by
the best estimate within the range of loss rates. which loss estimates have been adjusted for
The rationale should be based on managements changes in conditions, an explanation of how
assessment of which rate is most reflective of management estimated the impact, and other
the estimated credit losses in the current loan available data that supports the reasonableness
portfolio. of the adjustments. Examples of underlying sup-
After determining the appropriate historical porting evidence could include, but are not lim-
loss rate for each group of loans with similar ited to, relevant articles from newspapers and
risk characteristics, management should con- other publications that describe economic events
sider those current qualitative or environmental affecting a particular geographic area, economic
factors that are likely to cause estimated credit reports and data, and notes from discussions
losses as of the evaluation date to differ from the with borrowers.
groups historical loss experience. Institutions There may be times when an institution does
typically reflect the overall effect of these fac- not have its own historical loss experience upon
tors on a loan group as an adjustment that, as which to base its estimate of the credit losses in
appropriate, increases or decreases the historical a group of loans with similar risk characteris-
loss rate applied to the loan group. Alterna- tics. This may occur when an institution offers a
tively, the effect of these factors may be new loan product or when it is a newly estab-
reflected through separate stand-alone adjust- lished (that is, de novo) institution. If an institu-
ments within the FAS 5 component of the tion has no experience of its own for a loan
ALLL.21 Both methods are consistent with group, reference to the experience of other
GAAP, provided the adjustments for qualitative enterprises in the same lending business may be
or environmental factors are reasonably and appropriate, provided the institution demon-
consistently determined, are adequately docu- strates that the attributes of the group of loans in
mented, and represent estimated credit losses. its portfolio are similar to those of the loan
For each group of loans, an institution should group in the portfolio providing the loss experi-
apply its adjusted historical loss rate, or its ence. An institution should only use another
historical loss rate and separate stand-alone enterprises experience on a short-term basis
adjustments, to the recorded investment in the until it has developed its own loss experience
group when determining its estimated credit for a particular group of loans.
losses.
Management must exercise significant judg- FAS 114. When determining the FAS 114 com-
ment when evaluating the effect of qualitative ponent of the ALLL for an individually
factors on the amount of the ALLL because data impaired loan,22 an institution should consider
may not be reasonably available or directly estimated costs to sell the loans collateral, if
applicable for management to determine the pre- any, on a discounted basis, in the measurement
cise impact of a factor on the collectibility of the of impairment if those costs are expected to
institutions loan portfolio as of the evaluation reduce the cash flows available to repay or
date. Accordingly, institutions should support otherwise satisfy the loan. If the institution bases
adjustments to historical loss rates and explain its measure of loan impairment on the present
how the adjustments reflect current information, value of expected future cash flows discounted
events, circumstances, and conditions in the loss at the loans effective interest rate, the estimates
measurements. Management should maintain of these cash flows should be the institutions
reasonable documentation to support which fac- best estimate based on reasonable and support-
21. An overall adjustment to a portion of the ALLL that is

22. As noted in FAS 114, some individually impaired
not attributed to specific segments of the loan portfolio is
loans have risk characteristics that are unique to an individual
often labeled unallocated. Regardless of what a component
borrower and the institution will apply the measurement meth-
of the ALLL is labeled, it is appropriate when it reflects
ods on a loan-by-loan basis. However, some impaired loans
estimated credit losses determined in accordance with GAAP
may have risk characteristics in common with other impaired
and is properly supported.
loans. An institution may aggregate those loans and may use
historical statistics, such as average recovery period and aver-
BHC Supervision Manual July 2007 age amount recovered, along with a composite effective inter-
Page 8 est rate as a means of measuring impairment of those loans.
able assumptions and projections. All available 2065.3.1.2.5 Estimated Credit Losses in
evidence should be considered in developing the Credit-Related Accounts
estimate of expected future cash flows. The
weight given to the evidence should be com- Typically, institutions evaluate and estimate
mensurate with the extent to which the evidence credit losses for off-balance-sheet credit expo-
can be verified objectively. The likelihood of the sures at the same time that they estimate credit
possible outcomes should be considered in losses for loans. While a similar process should
determining the best estimate of expected future be followed to support loss estimates related to
cash flows. off-balance-sheet exposures, these estimated
credit losses are not recorded as part of the
ALLL. When the conditions for accrual of a loss
2065.3.1.2.4 Analyzing the Overall under FAS 5 are met, an institution should main-
Measurement of the ALLL tain and report as a separate liability account, an
allowance that is appropriate to cover estimated
Institutions also are encouraged to use ratio credit losses on off-balance-sheet loan commit-
analysis as a supplemental tool for evaluating ments, standby letters of credit, and guarantees.
the overall reasonableness of the ALLL. Ratio In addition, recourse liability accounts (that
analysis can be useful in identifying divergent arise from recourse obligations on any transfers
trends (compared with an institutions peer of loans that are reported as sales in accordance
group and its own historical experience) in the with GAAP) should be reported in regulatory
relationship of the ALLL to adversely classified reports as liabilities that are separate and dis-
or graded loans, past due and nonaccrual loans, tinct from both the ALLL and the allowance for
total loans, and historical gross and net charge- credit losses on off-balance-sheet credit
offs. Based on such analysis, an institution may exposures.
identify additional issues or factors that previ- When accrued interest and fees are reported
ously had not been considered in the ALLL separately on an institutions balance sheet from
estimation process, which may warrant adjust- the related loan balances (that is, as other
ments to estimated credit losses. Such adjust- assets), the institution should maintain an appro-
ments should be appropriately supported and priate valuation allowance, determined in accor-
documented. dance with GAAP, for amounts that are not
While ratio analysis, when used prudently, likely to be collected unless management has
can be helpful as a supplemental check on the placed the underlying loans in nonaccrual status
reasonableness of managements assumptions and reversed previously accrued interest and
and analyses, it is not a sufficient basis for fees.24
determining the appropriate amount for the
ALLL. In particular, because an appropriate
ALLL is an institution-specific amount, such 2065.3.1.3 Examiner Responsibilities
comparisons do not obviate the need for a com-
prehensive analysis of the loan portfolio and the Examiners should assess the credit quality of an
factors affecting its collectibility. Furthermore, institutions loan portfolio, the appropriateness
it is inappropriate for the board of directors or of its ALLL methodology and documentation,
management to make adjustments to the ALLL and the appropriateness of the reported ALLL in
when it has been properly computed and sup-
ported under the institutions methodology for not simply default to a peer ratio or a standard percentage
the sole purpose of reporting an ALLL that after determining an appropriate level of ALLL under its
corresponds to the peer group median, a target methodology. However, there may be circumstances when an
institutions ALLL methodology and credit risk identification
ratio, or a budgeted amount. Institutions that systems are not reliable. Absent reliable data of its own,
have high levels of risk in the loan portfolio or management may seek data that could be used as a short-term
are uncertain about the effect of possible future proxy for the unavailable information (for example, an indus-
events on the collectibility of the portfolio try average loss rate for loans with similar risk characteris-
tics). This is only appropriate as a short-term remedy until the
should address these concerns by maintaining institution creates a viable system for estimating credit losses
higher equity capital and not by arbitrarily within its loan portfolio.
increasing the ALLL in excess of amounts sup- 24. See instructions for the Call Report or the Consolidated
ported under GAAP.23 Financial Statement for Bank Holding Companies (such as
the FR Y- 9C) for further guidance on placing a loan in
nonaccrual status.
23. It is inappropriate to use a standard percentage as
the sole determinant for the amount to be reported as the BHC Supervision Manual July 2007
ALLL on the balance sheet. Moreover, an institution should Page 9
the institutions regulatory reports. In their ness of the overall level of the ALLL. In some
review and classification or grading of the loan instances this may include a quantitative
portfolio, examiners should consider all signifi- analysis (for example, using the types of ratio
cant factors that affect the collectibility of the analysis previously discussed) as a prelimi-
portfolio, including the value of any collateral. nary check on the reasonableness of the
In reviewing the appropriateness of the ALLL, ALLL. This quantitative analysis should dem-
examiners should do the following: onstrate whether changes in the key ratios
from prior periods are reasonable based on the
Consider the effectiveness of board oversight examiners knowledge of the collectibility of
as well as the quality of the institutions loan loans at the institution and its current
review system and management in identify- environment.
ing, monitoring, and addressing asset quality Review the ALLL amount reported in the
problems. This will include a review of the institutions regulatory reports and financial
institutions loan review function and credit statements and ensure these amounts recon-
grading system. Typically, this will involve cile to its ALLL analyses. There should be no
testing a sample of the institutions loans. The material differences between the consolidated
sample size generally varies and will depend loss estimate, as determined by the ALLL
on the nature or purpose of the examination.25 methodology, and the final ALLL balance
Evaluate the institutions ALLL policies and reported in the financial statements. Inquire
procedures and assess the methodology that about reasons for any material differences
management uses to arrive at an overall esti- between the results of the institutions ALLL
mate of the ALLL, including whether man- analyses and the institutions reported ALLL
agements assumptions, valuations, and judg- to determine whether the differences can be
ments appear reasonable and are properly satisfactorily explained.
supported. If a range of credit losses has been Review the adequacy of the documentation
estimated by management, evaluate the rea- and controls maintained by management to
sonableness of the range and managements support the appropriateness of the ALLL.
best estimate within the range. In making Review the interest and fee income accounts
these evaluations, examiners should ensure associated with the lending process to ensure
that the institutions historical loss experience that the institutions net income is not materi-
and all significant qualitative or environmen- ally misstated.26
tal factors that affect the collectibility of the
portfolio (including changes in the quality of As noted in the Responsibilities of the Board
the institutions loan review function and the of Directors and Management section of this
other factors previously discussed) have been policy statement, when assessing the appropri-
appropriately considered and that manage- ateness of the ALLL, it is important to recog-
ment has appropriately applied GAAP, includ- nize that the related process, methodology, and
ing FAS 114 and FAS 5. underlying assumptions require a substantial
Review managements use of loss estimation degree of management judgment. Even when an
models or other loss estimation tools to ensure institution maintains sound loan administration
that the resulting estimated credit losses are in and collection procedures and an effective loan
conformity with GAAP. review system and controls, its estimate of credit
Review the appropriateness and reasonable- losses is not a single precise amount due to the
wide range of qualitative or environmental fac-
tors that must be considered.
25. In an examiners review of an institutions loan review An institutions ability to estimate credit
system, the examiners loan classifications or credit grades
may differ from those of the institutions loan review system. losses on specific loans and groups of loans
If the examiners evaluation of these differences indicates should improve over time as substantive infor-
problems with the loan review system, especially when the mation accumulates regarding the factors affect-
loan classification or credit grades assigned by the institution ing repayment prospects. Therefore, examiners
are more liberal than those assigned by the examiner, the
institution would be expected to make appropriate adjust- should generally accept managements estimates
ments to the assignment of its loan classifications or credit
grades to the loan portfolio and to its estimated credit losses.
26. As noted previously, accrued interest and fees on loans
Furthermore, the institution would be expected to improve its
that have been reported as part of the respective loan balances
loan review system. (This policy statements attachment 1
on the institutions balance sheet should be evaluated for
discusses effective loan review systems.)
estimated credit losses. The accrual of the interest and fee
income should also be considered. Refer to GAAP and the
BHC Supervision Manual July 2007 agencies regulatory reporting instructions for further guid-
Page 10 ance on income recognition.
when assessing the appropriateness of the insti- 2065.3.1.5 Appendix 1Loan Review
tutions reported ALLL, and not seek adjust- Systems
ments to the ALLL, when management has
The nature of loan review systems may vary
maintained effective loan review systems and based on an institutions size, complexity, loan
controls for identifying, monitoring, and types, and management practices.27 For
addressing asset quality problems in a timely example, a loan review system may include
manner; components of a traditional loan review func-
analyzed all significant qualitative or environ- tion that is independent of the lending function,
mental factors that affect the collectibility of or it may place some reliance on loan officers.
the portfolio as of the evaluation date in a In addition, the use of the term loan review
reasonable manner; system can refer to various responsibilities
established an acceptable ALLL evaluation assigned to credit administration, loan adminis-
process for both individual loans and groups tration, a problem loan workout group, or other
of loans that meets the GAAP requirements areas of an institution. These responsibilities
for an appropriate ALLL; and may range from administering the internal prob-
incorporated reasonable and properly sup- lem loan reporting process to maintaining the
ported assumptions, valuations, and judg- integrity of the loan classification or credit grad-
ments into the evaluation process. ing process (for example, ensuring that timely
and appropriate changes are made to the loan
If the examiner concludes that the reported classifications or credit grades assigned to loans)
ALLL level is not appropriate or determines and coordinating the gathering of the informa-
that the ALLL evaluation process is based on tion necessary to assess the appropriateness of
the results of an unreliable loan review system the ALLL. Additionally, some or all of this
or is otherwise deficient, recommendations for function may be outsourced to a qualified exter-
correcting these deficiencies, including any nal loan reviewer. Regardless of the structure of
examiner concerns regarding an appropriate the loan review system in an institution, an
level for the ALLL, should be noted in the effective loan review system should have, at a
report of examination. The examiners com- minimum, the following objectives:
ments should cite any departures from GAAP
and any contraventions of this policy statement promptly identify loans with potential credit
and the 2001 policy statement, as applicable. weaknesses;
Additional supervisory action may also be taken appropriately grade or adversely classify
based on the magnitude of the observed short- loans, especially those with well-defined
comings in the ALLL process, including the credit weaknesses that jeopardize repayment,
materiality of any error in the reported amount so that timely action can be taken and credit
of the ALLL. losses can be minimized;
identify relevant trends that affect the collect-
ibility of the portfolio and isolate segments of
2065.3.1.4 ALLL Level Reflected in the portfolio that are potential problem areas;
Regulatory Reports
The agencies believe that an ALLL established 27. The loan review function is not intended to be per-
in accordance with this policy statement and the formed by an institutions internal audit function. However, as
2001 policy statement, as applicable, falls within discussed in the banking agencies March 2003 Interagency
Policy Statement on the Internal Audit Function and Its Out-
the range of acceptable estimates determined in sourcing, some institutions seek to coordinate the internal
accordance with GAAP. When the reported audit function with several risk-monitoring functions such as
amount of an institutions ALLL is not appropri- loan review. The policy statement notes that coordination of
ate, the institution will be required to adjust its loan review with the internal audit function can facilitate the
reporting of material risk and control issues to the audit
ALLL by an amount sufficient to bring the committee, increase the overall effectiveness of these monitor-
ALLL reported on its Call Report and/or Con- ing functions, better utilize available resources, and enhance
solidated Financial Statement for Bank Holding the institutions ability to comprehensively manage risk. How-
Companies (such as the FR Y-9C) to an appro- ever, the internal audit function should maintain the ability to
independently audit other risk-monitoring functions, includ-
priate level as of the evaluation date. This ing loan review, without impairing its independence with
adjustment should be reflected in the current respect to these other functions.
period provision or through the restatement of
prior period provisions, as appropriate in the BHC Supervision Manual July 2007
circumstances. Page 11
assess the adequacy of and adherence to inter- a formal loan classification or credit grading
nal credit policies and loan administration system in which loan classifications or credit
procedures and monitor compliance with rel- grades reflect the risk of default and credit
evant laws and regulations; losses and for which a written description is
evaluate the activities of lending personnel maintained, including a discussion of the fac-
including their compliance with lending poli- tors used to assign appropriate classifications
cies and the quality of their loan approval, or credit grades to loans;28
monitoring, and risk assessment; an identification or grouping of loans that
provide senior management and the board of warrant the special attention of management29
directors with an objective and timely assess- or other designated watch lists of loans that
ment of the overall quality of the loan portfo- management is more closely monitoring;
lio; and documentation supporting the reasons why
particular loans merit special attention or
provide management with accurate and timely received a specific adverse classification or
credit quality information for financial and credit grade and managements adherence to
regulatory reporting purposes, including the approved workout plans;
determination of an appropriate ALLL. a mechanism for direct, periodic, and timely
reporting to senior management and the board
of directors on the status of loans identified as
2065.3.1.5.1 Loan Classification or meriting special attention or adversely classi-
Credit Grading Systems fied or graded and the actions taken by man-
agement; and
The foundation for any loan review system is appropriate documentation of the institutions
accurate and timely loan classification or credit historical loss experience for each of the
grading, which involves an assessment of credit groups of loans with similar risk characteris-
quality and leads to the identification of prob- tics into which it has segmented its loan
lem loans. An effective loan classification or portfolio.30
credit grading system provides important infor-
mation on the collectibility of the portfolio for
use in the determination of an appropriate level 2065.3.1.5.2 Elements of Loan-Review
for the ALLL. Systems
Regardless of the type of loan review system
employed, an effective loan classification or Each institution should have a written policy
credit grading framework generally places pri- that is reviewed and approved at least annually
mary reliance on the institutions lending staff by the board of directors to evidence its support
to identify emerging loan problems. However, of and commitment to maintaining an effective
given the importance and subjective nature of loan review system. The loan review policy
loan classification or credit grading, the judg- should address the following elements that are
ment of an institutions lending staff regarding described in more detail below: the qualifica-
the assignment of particular classification or tions and independence of loan review person-
grades to loans should be subject to review by nel; the frequency, scope and depth of reviews;
(1) peers, superiors, or loan committee(s); (2) an
independent, qualified part-time or full-time
28. A bank or savings association may have a loan classifi-
employee(s); (3) an internal department staffed cation or credit grading system that differs from the frame-
with credit review specialists; or (4) qualified work used by the banking agencies. However, each institution
outside credit review consultants. A loan classi- that maintains a loan classification or credit grading system
fication or credit grading review that is indepen- that differs from the banking agencies framework should
maintain documentation that translates its system into the
dent of the lending function is preferred because framework used by the banking agencies. This documentation
it typically provides a more objective assess- should be sufficient to enable examiners to reconcile the totals
ment of credit quality. Because accurate and for the various loan classifications or credit grades under the
timely loan classification or credit grading is a institutions system to the banking agencies categories.
29. For banks and savings associations, loans that have
critical component of an effective loan review potential weaknesses that deserve managements close atten-
system, each institution should ensure that its tion are designated special mention loans.
loan review system includes the following 30. In particular, institutions with large and complex loan
attributes: portfolios are encouraged to maintain records of their histori-
cal loss experience for credits in each of the categories in their
loan classification or credit grading framework. For banks,
BHC Supervision Manual July 2007 these categories should be (1) those used by or (2) categories
Page 12 that can be translated into those used by, the banking agencies.
the review of findings and follow-up; and work- the institution should be mindful of special
paper and report distribution. requirements concerning independence should it
consider outsourcing the credit review function
Qualifications of loan review personnel. Persons to its external auditor.
involved in the loan review or credit grading
function should be qualified based on their level Frequency of reviews. Loan review personnel
of education, experience, and extent of formal should review significant credits31 at least annu-
credit training. They should be knowledgeable ally, upon renewal, or more frequently when
in both sound lending practices and the institu- internal or external factors indicate a potential
tions lending guidelines for the types of loans for deteriorating credit quality in a particular
offered by the institution. In addition, they loan, loan product, or group of loans. Optimally,
should be knowledgeable of relevant laws and the loan review function can be used to provide
regulations affecting lending activities. useful continual feedback on the effectiveness
of the lending process in order to identify any
Independence of loan review personnel. An emerging problems. A system of ongoing or
effective loan review system uses both the ini- periodic portfolio reviews is particularly impor-
tial identification of emerging problem loans by tant to the ALLL determination process because
loan officers and other line staff, and the credit this process is dependent on the accurate and
review of loans by individuals independent of timely identification of problem loans.
the credit approval process. An important
requirement for an effective system is to place Scope of reviews. Reviews by loan review per-
responsibility on loan officers and line staff for sonnel should cover all loans that are significant
continuous portfolio analysis and prompt identi- and other loans that meet certain criteria. Man-
fication and reporting of problem loans. Because agement should document the scope of its
of frequent contact with borrowers, loan officers reviews and ensure that the percentage of the
and line staff can usually identify potential prob- portfolio selected for review provides reason-
lems before they become apparent to others. able assurance that the results of the review
However, institutions should be careful to avoid have identified any credit quality deterioration
overreliance upon loan officers and line staff for and other unfavorable trends in the portfolio and
identification of problem loans. Institutions reflect its quality as a whole. Management
should ensure that loans are also reviewed by should also consider industry standards for loan
individuals who do not have control over the review coverage consistent with the size and
loans they review and who are not part of, and complexity of its loan portfolio and lending
are not influenced by anyone associated with, operations to verify that the scope of its reviews
the loan approval process. is appropriate. The institutions board of direc-
While larger institutions typically establish a tors should approve the scope of loan reviews
separate department staffed with credit review on an annual basis or when any significant
specialists, cost and volume considerations may interim changes to the scope of reviews are
not justify such a system in smaller institutions. made. Reviews typically include
In some smaller institutions, an independent
committee of outside directors may fill this role. loans over a predetermined size;
Whether or not the institution has an indepen- a sufficient sample of smaller loans;
dent loan review department, the loan review past due, nonaccrual, renewed, and restruc-
function should report directly to the board of tured loans;
directors or a committee thereof (although loans previously adversely classified or
senior management may be responsible for graded and loans designated as warranting the
appropriate administrative functions so long as special attention of management32 by the
they do not compromise the independence of institution or its examiners;
the loan review function).
insider loans; and
Some institutions may choose to outsource
the credit review function to an independent loans constituting concentrations of credit risk
outside party. However, the responsibility for
maintaining a sound loan review process cannot
31. Significant credits in this context may or may not be
be delegated to an outside party. Therefore, loans individually evaluated for impairment under FAS 114.
institution personnel who are independent of the 32. See footnote 29.
lending function should assess control risks,
develop the credit review plan, and ensure BHC Supervision Manual July 2007
appropriate follow-up of findings. Furthermore, Page 13
and other loans affected by common repay- on the higher credit quality classification or
ment factors. grade.
Depth of reviews. Reviews should analyze a Workpaper and report distribution. The loan
number of important aspects of the loans review function should prepare a list of all loans
selected for review, including reviewed (including the date of the review) and
documentation (including a summary analysis)
credit quality, including underwriting and bor- that substantiates the grades or classifications
rower performance; assigned to the loans reviewed. A report that
sufficiency of credit and collateral documenta- summarizes the results of the loan review should
tion; be submitted to the board of directors at least
proper lien perfection; quarterly.33 In addition to reporting current
proper approval by the loan officer and loan credit quality findings, comparative trends can
committee(s); be presented to the board of directors that iden-
adherence to any loan agreement covenants; tify significant changes in the overall quality of
compliance with internal policies and proce- the portfolio. Findings should also address the
dures (such as aging, nonaccrual, and classifi- adequacy of and adherence to internal policies
cation or grading policies) and laws and regu- and procedures, as well as compliance with laws
lations; and and regulations, in order to facilitate timely
appropriate identification of individually correction of any noted deficiencies.
impaired loans, measurement of estimated
loan impairment, and timeliness of charge-
offs. 2065.3.1.6 Appendix 2International
Transfer Risk Considerations
Furthermore, these reviews should consider the
appropriateness and timeliness of the identifica- With respect to international transfer risk, an
tion of problem loans by loan officers. institution with cross-border exposures should
support its determination of the appropriateness
Review of findings and follow-up. Loan review of its ALLL by performing an analysis of the
personnel should discuss all noted deficiencies transfer risk, commensurate with the size and
and identified weaknesses and any existing or composition of the institutions exposure to each
planned corrective actions, including time country. Such analyses should take into consid-
frames for correction, with appropriate loan eration the following factors, as appropriate:
officers and department managers. Loan review
personnel should then review these findings and the institutions loan portfolio mix for each
corrective actions with members of senior man- country (for example, types of borrowers, loan
agement. All noted deficiencies and identified maturities, collateral, guarantees, special
weaknesses that remain unresolved beyond the credit facilities, and other distinguishing
scheduled time frames for correction should be factors);
promptly reported to senior management and the institutions business strategy and its debt-
the board of directors. management plans for each country;
Credit classification or grading differences each countrys balance of payments position;
between loan officers and loan review personnel each countrys level of international reserves;
should be resolved according to a prearranged each countrys established payment perfor-
process. That process may include formal mance record and its future debt-servicing
appeals procedures and arbitration by an inde- prospects;
pendent party or may require default to the each countrys sociopolitical situation and its
assigned classification or grade that indicates effect on the adoption or implementation of
lower credit quality. If an outsourced credit economic reforms, in particular those affect-
review concludes that a borrower is less credit- ing debt servicing capacity;
worthy than is perceived by the institution, the each countrys current standing with multilat-
lower credit quality classification or grade eral and official creditors;
should prevail unless internal parties identify the status of each countrys relationships with
additional information sufficient to obtain the other creditors, including institutions; and
concurrence of the outside reviewer or arbiter
BHC Supervision Manual July 2007 33. The board of directors should be informed more fre-
Page 14 quently than quarterly when material adverse trends are noted.
the most recent evaluations distributed by the

banking agencies Interagency Country Expo-
sure Review Committee.

Page 15
ALLL Methodologies and Documentation
WHATS NEW IN THIS REVISED directors, should implement appropriate proce-
SECTION dures and controls to ensure compliance with
the institutions ALLL policies and procedures.
Effective July 2012, this section has been Institution management should (1) segment the
revised to delete a reference to SR-04-5, Inter- portfolio to evaluate credit risks; (2) select loss
agency Update on Accounting for Loan and rates that best reflect the probable loss; and
Lease Losses, deemed inactive by SR-12-6. (3) be responsive to changes in the organization,
Also, certain accounting references have been the economy, or the lending environment by
updated for the Financial Accounting Standards changing the methodology, when appropriate.
Boards (FASBs) Accounting Standards Codifi- Furthermore, supporting information should be
cation (ASC) numbering and referencing system. included on summary schedules, whenever fea-
sible. Under this policy, institutions with less-
A supplemental interagency Policy Statement complex loan products or portfolios, such as
on Allowance for Loan and Lease Losses community banks, may use a more streamlined
(ALLL) Methodologies and Documentation for approach to implement this guidance.
Banks and Savings Institutions1 was issued by The policy statement is consistent with the
the Federal Financial Institutions Examination Federal Reserves long-standing policy to pro-
Council (FFIEC) on July 2, 2001.2 The policy mote strong internal controls over an institu-
statement clarifies the agencies expectations for tions ALLL process. In this regard, the policy
documentation that supports the ALLL method- statement recognizes that determining an appro-
ology. Additionally, the statement emphasizes priate allowance involves a high degree of man-
the need for appropriate ALLL policies and agement judgment and is inevitably imprecise.
procedures, which should include an effective Accordingly, an institution may determine that
loan-review system. The guidance also provides the amount of loss falls within a range. In accor-
examples of appropriate supporting documenta- dance with GAAP, an institution should record
tion, as well as illustrations on how to imple- its best estimate within the range of credit
ment this guidance. (See SR-01-17.) While this losses. (See also sections 2065.2 and 2065.3.)
policy statement, by its terms, applies only to The policy statement is provided below.
depository institutions insured by the Federal Some wording has been slightly modified for
Deposit Insurance Corporation (which includes this manual, as indicated by asterisks or text
state member banks), the Federal Reserve enclosed in brackets. Some footnotes have also
believes this guidance is broadly applicable to been renumbered.
bank holding companies. Accordingly, examin-
ers should apply the policy, as appropriate, in
their inspections of bank holding companies and 2065.4.1 2001 POLICY STATEMENT
their nonbank subsidiaries. This policy, how- ON ALLL METHODOLOGIES AND
ever, does not apply to federally insured DOCUMENTATION
branches and agencies of foreign banks. Feder-
ally insured branches and agencies of foreign Boards of directors of banks * * * are respon-
banks continue to be subject to separate guid- sible for ensuring that their institutions have
ance issued by their primary supervisory agency. controls in place to consistently determine the
The guidance requires that a financial institu- allowance for loan and lease losses (ALLL) in
tions ALLL methodology be in accordance accordance with the institutions stated policies
with generally accepted accounting principles and procedures, GAAP, and ALLL supervisory
(GAAP) and all outstanding supervisory guid- guidance.3 To fulfill this responsibility, boards
ance. An ALLL methodology should be system- of directors instruct management to develop and
atic, consistently applied, and auditable. The maintain an appropriate, systematic, and consis-
methodology should be validated periodically
and modified to incorporate new events or find- 3. [The actual policy statement includes a bibliography]
ings, as needed. The guidance specifies that that lists applicable ALLL GAAP guidance, interagency state-
management, under the direction of the board of ments, and other reference materials that may assist in under-
standing and implementing an ALLL in accordance with
GAAP. See [the appendix] for additional information on
1. See 66 Fed. Reg. 35,62935,639 (July 6, 2001). applying GAAP to determine the ALLL.
2. The guidance was developed in consultation with Secu-
rities and Exchange Commission (SEC) staff, who issued
parallel guidance in the form of Staff Accounting Bulletin No. BHC Supervision Manual July 2012
102. Page 1
ALLL Methodologies and Documentation 2065.4
tently applied process to determine the amounts (FDI Act).7 The interagency asset-quality guide-
of the ALLL and provisions for loan losses. lines and [this guidance will assist] an institu-
Management should create and implement suit- tion in estimating and establishing a sufficient
able policies and procedures to communicate ALLL supported by adequate documentation, as
the ALLL process internally to all applicable required under the FDI Act. Additionally, the
personnel. Regardless of who develops and guidelines require operational and managerial
implements these policies, procedures, and standards that are appropriate for an institutions
underlying controls, the board of directors size and the nature and scope of its activities.
should assure themselves that the policies spe- For financial-reporting purposes, including
cifically address the institutions unique goals, regulatory reporting, the provision for loan and
systems, risk profile, personnel, and other lease losses and the ALLL must be determined
resources before approving them. Additionally, in accordance with GAAP. GAAP requires that
by creating an environment that encourages per- allowances be well documented, with clear
sonnel to follow these policies and procedures, explanations of the supporting analyses and
management improves procedural discipline and rationale.8 This [2001] policy statement
compliance. describes but does not increase the documenta-
The determination of the amounts of the tion requirements already existing within
ALLL and provisions for loan and lease losses GAAP. Failure to maintain, analyze, or support
should be based on managements current judg- an adequate ALLL in accordance with GAAP
ments about the credit quality of the loan port- and supervisory guidance is generally an unsafe
folio, and should consider all known relevant and unsound banking practice.9
internal and external factors that affect loan This guidance [the 2001 policy statement]
collectibility as of the reporting date. The applies equally to all institutions, regardless of
amounts reported each period for the provision the size. However, institutions with less-
for loan and lease losses and the ALLL should complex lending activities and products may
be reviewed and approved by the board of direc- find it more efficient to combine a number of
tors. To ensure the methodology remains appro- procedures (for example, information gathering,
priate for the institution, the board of directors documentation, and internal-approval processes)
should have the methodology periodically vali- while continuing to ensure the institution has a
dated and, if appropriate, revised. Further, the consistent and appropriate methodology. Thus,
audit committee4 should oversee and monitor much of the supporting documentation required
the internal controls over the ALLL- for an institution with more-complex products
determination process.5 or portfolios may be combined into fewer sup-
The [Federal Reserve and other] banking porting documents in an institution with less-
agencies6 have long-standing examination poli- complex products or portfolios. For example,
cies that call for examiners to review an institu- simplified documentation can include spread-
tions lending and loan-review functions and sheets, checklists, and other summary docu-
recommend improvements, if needed. Addition-
ally, in 1995 and 1996, the banking agencies 7. Institutions should refer to the guidelines *** for state
adopted interagency guidelines establishing member banks, appendix D to part 208***.
8. The documentation guidance within this 2001 policy
standards for safety and soundness, pursuant to statement is predominantly based upon the GAAP guidance
section 39 of the Federal Deposit Insurance Act from FASBs ASC section 450-20-25, Contingencies - Loss
Contingencies - Recognition (formerly Statement of Financial
Accounting Standards No. 5, Accounting for Contingen-
4. All institutions are encouraged to establish audit com-
cies); ASC Subtopic 310-10-05, Receivables - Overall (for-
mittees; however, at small institutions without audit commit-
merly Statement of Financial Accounting Standards No. 114,
tees, the board of directors retains this responsibility.
Accounting by Creditors for Impairment of a Loan);
5. Institutions and their auditors should refer to Statement
Emerging Issues Task Force Topic No. D-80 (EITF Topic
on Auditing Standards No. 61, Communication with Audit
D-80 and attachments), Application of FASB Statements No.
Committees (as amended by Statement on Auditing Stan-
5 and No. 114 to a Loan Portfolio (which includes the
dards No. 90, Audit Committee Communications), which
Viewpoints articlean article issued in 1999 by FASB staff
requires certain discussions between the auditor and the audit
providing guidance on certain issues regarding the ALLL,
committee. These discussions should include items, such as
particularly on the application of FAS 5 and FAS 114 and how
accounting policies and estimates, judgments, and uncertain-
these statements interrelate); Chapter 9, Credit Losses, the
ties that have a significant impact on the accounting informa-
American Institute of Certified Public Accountants (AIC-
tion included in the financial statements.
PAs) Audit and Accounting Guide, Depository and Lending
6. The [other] banking agencies are the Federal Deposit
Institutions: Banks and Savings Institutions, Credit Unions,
Insurance Corporation, the Office of the Comptroller of the
Finance Companies and Mortgage Companies, 2008 update;
Currency, and the Office of Thrift Supervision.
and the SECs Financial Reporting Release No. 28 (FRR 28).
9. Failure to maintain adequate supporting documentation
BHC Supervision Manual July 2012 does not relieve an institution of its obligation to record an
Page 2 appropriate ALLL.
ments that many institutions currently use. Illus-

trations A and C provide specific examples of
how less-complex institutions may determine
and document portions of their loan-loss
allowance.
2065.4.1.1 Documentation Standards
Appropriate written supporting documentation

for the loan-loss provision and allowance facili-

Page 2.1
tates review of the ALLL process and reported the description of the institutions systematic
amounts, builds discipline and consistency into methodology, which should be consistent with
the ALLL-determination process, and improves the institutions accounting policies for deter-
the process for estimating loan and lease losses mining its ALLL;11 and
by helping to ensure that all relevant factors are the system of internal controls used to ensure
appropriately considered in the ALLL analysis. that the ALLL process is maintained in accor-
An institution should document the relationship dance with GAAP and supervisory guidance.
between the findings of its detailed review of
the loan portfolio and the amount of the ALLL An internal-control system for the ALLL-
and the provision for loan and lease losses estimation process should
reported in each period.10
At a minimum, institutions should maintain
include measures to provide assurance regard-
written supporting documentation for the fol-
ing the reliability and integrity of information
lowing decisions, strategies, and processes:
and compliance with laws, regulations, and
internal policies and procedures;
policies and procedures
over the systems and controls that main- reasonably assure that the institutions finan-
tain an appropriate ALLL and cial statements (including regulatory reports)
over the ALLL methodology are prepared in accordance with GAAP and
loan-grading system or process ALLL supervisory guidance;12 and
summary or consolidation of the ALLL include a well-defined loan-review process
balance containing
validation of the ALLL methodology an effective loan-grading system that is
periodic adjustments to the ALLL process consistently applied, identifies differing
risk characteristics and loan-quality prob-
lems accurately and in a timely manner,
2065.4.1.2 Policies and Procedures and prompts appropriate administrative
actions;
Financial institutions utilize a wide range of
policies, procedures, and control systems in their sufficient internal controls to ensure that
ALLL process. Sound policies should be appro- all relevant loan-review information is
priately tailored to the size and complexity of appropriately considered in estimating
the institution and its loan portfolio. losses. This includes maintaining appro-
In order for an institutions ALLL methodol- priate reports, details of reviews per-
ogy to be effective, the institutions written poli- formed, and identification of personnel
cies and procedures for the systems and controls involved; and
that maintain an appropriate ALLL should clear formal communication and coordina-
address but not be limited to tion between an institutions credit-
administration function, financial-
the roles and responsibilities of the institu- reporting group, management, board of
tions departments and personnel (including directors, and others who are involved in
the lending function, credit review, financial
reporting, internal audit, senior management,
audit committee, board of directors, and oth- 11. Further explanation is presented in the Methodology
section that appears below.
ers, as applicable) who determine, or review, 12. In addition to the supporting documentation require-
as applicable, the ALLL to be reported in the ments for financial institutions, as described in interagency
financial statements; asset-quality guidelines, public companies are required to
the institutions accounting policies for loans, comply with the books and records provisions of the Securi-
ties Exchange Act of 1934 (Exchange Act). Under sections
[leases, and their loan losses], including the 13(b)(2)(7) of the Exchange Act, registrants must make and
policies for charge-offs and recoveries and for keep books, records, and accounts, which, in reasonable
estimating the fair value of collateral, where detail, accurately and fairly reflect the transactions and dispo-
applicable; sitions of assets of the registrant. Registrants also must main-
tain internal accounting controls that are sufficient to provide
reasonable assurances that, among other things, transactions
are recorded as necessary to permit the preparation of finan-
10. This position is fully described in the SECs FRR 28,
cial statements in conformity with GAAP. See also SEC Staff
in which the SEC indicates that the books and records of
Accounting Bulletin No. 99, Materiality.
public companies engaged in lending activities should include
documentation of the rationale supporting each periods deter-
mination that the ALLL and provision amounts reported were BHC Supervision Manual December 2002
adequate. Page 3
the ALLL-determination or -review pro- for determining and measuring impairment

cess, as applicable (e.g., written policies under FAS 114:
and procedures, management reports, the methods used to identify loans to be
audit programs, and committee minutes). analyzed individually;
for individually reviewed loans that are
impaired, how the amount of any impair-
2065.4.1.3 Methodology ment is determined and measured,
including
An ALLL methodology is a system that an
procedures describing the impairment-
institution designs and implements to reason-
measurement techniques available and
ably estimate loan and lease losses as of the
steps performed to determine which
financial statement date. It is critical that ALLL
technique is most appropriate in a given
methodologies incorporate managements cur-
situation.
rent judgments about the credit quality of the
the methods used to determine whether
loan portfolio through a disciplined and consis-
and how loans individually evaluated
tently applied process.
under FAS 114, but not considered to be
An institutions ALLL methodology is influ-
individually impaired, should be grouped
enced by institution-specific factors, such as an
with other loans that share common char-
institutions size, organizational structure, busi-
acteristics for impairment evaluation
ness environment and strategy, management
under FAS 5.
style, loan-portfolio characteristics, loan-
for determining and measuring impairment
administration procedures, and management
under FAS 5
information systems. However, there are certain
how loans with similar characteristics are
common elements an institution should incorpo-
grouped to be evaluated for loan collect-
rate in its ALLL methodology. A summary
ibility (such as loan type, past-due status,
of common elements is provided in [the
and risk);
appendix].13
how loss rates are determined (e.g., his-
torical loss rates adjusted for environmen-
2065.4.1.3.1 Documentation of ALLL tal factors or migration analysis) and what
Methodology in Written Policies and factors are considered when establishing
Procedures appropriate time frames over which to
evaluate loss experience; and
An institutions written policies and procedures descriptions of qualitative factors (e.g.,
should describe the primary elements of the industry, geographical, economic, and
institutions ALLL methodology, including political factors) that may affect loss rates
portfolio segmentation and impairment mea- or other loss measurements.
surement. In order for an institutions ALLL
methodology to be effective, the institutions The supporting documents for the ALLL may
written policies and procedures should describe be integrated in an institutions credit files, loan-
the methodology review reports or worksheets, board of direc-
tors and committee meeting minutes, computer
for segmenting the portfolio: reports, or other appropriate documents and
how the segmentation process is per- files.
formed (i.e., by loan type, industry, risk
rates, etc.),
when a loan-grading system is used to 2065.4.1.4 ALLL Under FAS 114
segment the portfolio:
the definitions of each loan grade, An institutions ALLL methodology related to
a reconciliation of the internal loan FAS 114 loans begins with the use of its normal
grades to supervisory loan grades, and loan-review procedures to identify whether a
the delineation of responsibilities for the loan is impaired as defined by the accounting
loan-grading system. standard. Institutions should document
13. Also, refer to paragraph 7.05 of the AICPA Audit

the method and process for identifying loans
Guide. to be evaluated under FAS 114 and
the analysis that resulted in an impairment
BHC Supervision Manual December 2002 decision for each loan and the determination
Page 4 of the impairment-measurement method to be
used (i.e., present value of expected future appraisal quality, and the expertise and
cash flows, fair value of collateral less costs to independence of the appraiser.
sell, or the loans observable market price). When using the observable-market-price-of-a-
loan method
Once an institution has determined which of the amount, source, and date of the
the three available measurement methods to use observable market price.
for an impaired loan under FAS 114, it should
maintain supporting documentation as follows: Illustration A describes a practice used by a
small financial institution to document its FAS
When using the present-value-of-expected- 114 measurement of impairment using a com-
future-cash-flows method prehensive worksheet.14 [Examples 1 and 2 pro-
vide examples of applying and documenting
the amount and timing of cash flows, impairment-measurement methods under FAS
the effective interest rate used to discount 114. Some loans that are evauluated individu-
the cash flows, and ally for impairment under FAS 114 may be fully
the basis for the determination of cash collateralized and therefore require no ALLL.
flows, including consideration of current Example 3 presents an institution whose loan
environmental factors and other informa- portfolio includes fully collateralized loans. It
tion reflecting past events and current describes the documentation maintained by that
conditions. institution to support its conclusion that no
When using the fair-value-of-collateral ALLL was needed for those loans.]
method
14. The [referenced] illustrations are presented to assist
how fair value was determined, including institutions in evaluating how to implement the guidance
the use of appraisals, valuation assump- provided in this document. The methods described in the
tions, and calculations, illustrations may not be suitable for all institutions and are not
considered required processes or actions. For additional
the supporting rationale for adjustments to descriptions of key aspects of ALLL guidance, a series of
appraised values, if any, [numbered examples is provided. These examples were
included in appendix A of the policy statement as questions
the determination of costs to sell, if appli- and answers. The wording of the examples has been slightly
cable, and modified for this format.]
Illustration A Example 1: ALLL Under FAS 114

Documenting an ALLL Under Measuring and Documenting Impairment
FAS 114 Facts. Approximately one-third of Institution
Comprehensive worksheet for the impairment- As commercial loan portfolio consists of large-
measurement process balance, nonhomogeneous loans. Due to their
large individual balances, these loans meet the
A small institution utilizes a comprehensive criteria under Institution As policies and proce-
worksheet for each loan being reviewed indi- dures for individual review for impairment
vidually under FAS 114. Each worksheet under FAS 114. Upon review of the large-
includes a description of why the loan was balance loans, Institution A determines that cer-
selected for individual review, the impairment- tain of the loans are impaired as defined by FAS
measurement technique used, the measurement 114.
calculation, a comparison to the current loan
balance, and the amount of the ALLL for that Analysis. For the commercial loans reviewed
loan. The rationale for the impairment- under FAS 114 that are individually impaired,
measurement technique used (e.g., present value Institution A should measure and document the
of expected future cash flows, observable mar- impairment on those loans. For those loans that
ket price of the loan, fair value of the collateral) are reviewed individually under FAS 114 and
is also described on the worksheet. considered individually impaired, Institution A
must use one of the methods for measuring
impairment that is specified by FAS 114 (that is,
the present value of expected future cash flows,

Page 5
the loans observable market price, or the fair ingly, Institution B determines that its loan to
value of collateral). Company X is impaired, as defined by FAS 114.
An impairment-measurement method other Because the loan is collateral dependent, Institu-
than the methods allowed by FAS 114 cannot be tion B measures impairment of the loan based
used. For the loans considered individually on the fair value of the collateral. Institution B
impaired under FAS 114, under the circum- determines that the most recent valuation of the
stances described above, it would not be appro- collateral was performed by an appraiser 18
priate for Institution A to choose a measurement months ago and, at that time, the estimated
method not prescribed by FAS 114. For exam- value of the collateral (fair value less costs to
ple, it would not be appropriate to measure loan sell) was $12 million.
impairment by applying a loss rate to each loan Institution B believes that certain of the
based on the average historical loss percentage assumptions that were used to value the collat-
for all of its commercial loans for the past five eral 18 months ago do not reflect current market
years. conditions and, therefore, the appraisers valua-
Institution A should maintain, as sufficient, tion does not approximate current fair value of
objective evidence, written documentation to the collateral. Several buildings, which are com-
support its measurement of loan impairment parable to the real estate collateral, were
under FAS 114. If it uses the present value of recently completed in the area, increasing va-
expected future cash flows to measure impair- cancy rates, decreasing lease rates, and attract-
ment of a loan, it should document (1) the ing several tenants away from the borrower.
amount and timing of cash flows, (2) the effec- Accordingly, credit-review personnel at Institu-
tive interest rate used to discount the cash flows, tion B adjust certain of the valuation assump-
and (3) the basis for the determination of cash tions to better reflect the current market condi-
flows, including consideration of current envi- tions as they relate to the loans collateral.16
ronmental factors15 and other information After adjusting the collateral-valuation assump-
reflecting past events and current conditions. If tions, the credit-review department determines
Institution A uses the fair value of collateral to that the current estimated fair value of the collat-
measure impairment, it should document eral, less costs to sell, is $8 million. Given that
(1) how it determined the fair value, including the recorded investment in the loan is $10 mil-
the use of appraisals, valuation assumptions and lion, Institution B concludes that the loan is
calculations; (2) the supporting rationale for ad- impaired by $2 million and records an allow-
justments to appraised values, if any, and the ance for loan losses of $2 million.
determination of costs to sell, if applicable;
(3) appraisal quality; and (4) the expertise and Analysis. Institution B should maintain docu-
independence of the appraiser. Similarly, Institu- mentation to support its determination of the
tion A should document the amount, source, and allowance for loan losses of $2 million for the
date of the observable market price of a loan, if loan to Company X. It should document that it
that method of measuring loan impairment is measured impairment of the loan to Company X
used. by using the fair value of the loans collateral,
less costs to sell, which it estimated to be
$8 million. This documentation should include
Example 2: ALLL Under FAS 114 (1) the institutions rationale and basis for the
Measuring Impairment for a $8 million valuation, including the revised valu-
Collateral-Dependent Loan ation assumptions it used; (2) the valuation cal-
Facts. Institution B has a $10 million loan out- culation; and (3) the determination of costs to
standing to Company X that is secured by real sell, if applicable. Because Institution B arrived
estate, which Institution B individually evaluat the valuation of $8 million by modifying an
ates under FAS 114 due to the loans size. earlier appraisal, it should document its ratio-
Company X is delinquent in its loan payments nale and basis for the changes it made to the
under the terms of the loan agreement. Accord- valuation assumptions that resulted in the collat-
eral value declining from $12 million 18 months
ago to $8 million in the current period.17
15. Question 16 in Exhibit D-80A of EITF Topic D-80 and
[its] attachments indicates that environmental factors include
16. When reviewing collateral-dependent loans, Institution
existing industry, geographical, economic, and political
B may often find it more appropriate to obtain an updated
factors.
appraisal to estimate the effect of current market conditions
on the appraised value instead of internally estimating an
BHC Supervision Manual December 2002 adjustment.
Page 6 17. In accordance with the FFIECs Federal Register
Example 3: ALLL Under FAS 114Fully of loans, Institution C must maintain the follow-
Collateralized Loans ing documentation:
Facts. Institution C has $10 million in loans that The management summary of the ALLL must
are fully collateralized by highly rated debt se- include documentation indicating that, in
curities with readily determinable market val- accordance with the institutions ALLL pol-
ues. The loan agreement for each of these loans icy, (1) Institution C has verified the collateral
requires the borrower to provide qualifying col- protection on these loans, (2) no probable loss
lateral sufficient to maintain a loan-to-value ratio has been incurred, and (3) no ALLL is
with sufficient margin to absorb volatility in the necessary.
securities market prices. Institution Cs collat- The documentation in Institution Cs loan files
eral department has physical control of the debt must include (1) the two independent market
securities through safekeeping arrangements. In quotes obtained each quarter for each loans
addition, Institution C perfected its security collateral amount, (2) the documents evidenc-
interest in the collateral when the funds were ing the perfection of the security interest in
originally distributed. On a quarterly basis, Insti- the collateral and other relevant supporting
tution Cs credit-administration function documents, and (3) Institution Cs ALLL pol-
determines the market value of the collateral for icy, including guidance for determining when
each loan using two independent market quotes a loan is considered fully collateralized,
and compares the collateral value to the loan which would not require an ALLL. Institution
carrying value. If there are any collateral defi- Cs policy should require the following fac-
ciencies, Institution C notifies the borrower and tors to be considered and fully documented:
requests that the borrower immediately remedy volatility of the market value of the
the deficiency. Due in part to its efficient opera- collateral
tion, Institution C has historically not incurred recency and reliability of the appraisal or
any material losses on these loans. Institution C other valuation
believes these loans are fully collateralized and recency of the institutions or third partys
therefore does not maintain any ALLL balance inspection of the collateral
for these loans. historical losses on similar loans
confidence in the institutions lien or
Analysis. To adequately support its determina- security position including appropriate
tion that no allowance is needed for this group type of security perfection (e.g., physi-
cal possession of collateral or secured
filing);
notice, Implementation Issues Arising from FASB No. 114, filing of security perfection (i.e., correct
Accounting by Creditors for Impairment of a Loan, pub- documents and with the appropriate
lished February 10, 1995 (60 Fed. Reg. 7966), impaired, officials);
collateral-dependent loans must be reported at the fair value
of collateral, less costs to sell, in regulatory reports. This
relationship to other liens; and
treatment is to be applied to all collateral-dependent loans, other factors as appropriate for the loan
regardless of type of collateral. type.
2065.4.1.5 ALLL Under FAS 5 tions offering a narrow range of loan products.
Larger institutions typically offer a more diverse
2065.4.1.5.1 Segmenting the Portfolio and complex mix of loan products. Such institu-
tions may start by segmenting the portfolio into
For loans evaluated on a group basis under FAS major loan types but typically have more
5, management should segment the loan port- detailed information available that allows them
folio by identifying risk characteristics that are to further segregate the portfolio into product-
common to groups of loans. Institutions typi- line segments based on the risk characteristics
cally decide how to segment their loan port- of each portfolio segment. Regardless of the
folios based on many factors, which vary with segmentation method used, an institution should
their business strategies as well as their informa- maintain documentation to support its conclu-
tion system capabilities. Smaller institutions that sion that the loans in each segment have similar
are involved in less complex activities often attributes or characteristics.
segment the portfolio into broad loan categories.
This method of segmenting the portfolio is BHC Supervision Manual December 2002
likely to be appropriate in only small institu- Page 7
As economic and other business conditions Illustration B presents an example in which an

change, institutions often modify their business institution refined its segmentation method to
strategies, which may result in adjustments to more effectively consider risk factors and main-
the way in which they segment their loan port- tains documentation to support this change.
folio for purposes of estimating loan losses.
Illustration B institution decided to evaluate loss rates on an

individual-product basis (e.g., auto loans, unse-
Documenting Segmenting Practices cured loans, or home equity loans). This analy-
sis disclosed significant differences in the loss
Documenting a refinement in a segmentation
rates on different products. With this additional
method
information, the methodology was amended in
the current period to segment the portfolio by
An institution with a significant portfolio of
product, resulting in a better estimation of the
consumer loans performed a review of its ALLL
loan losses associated with the portfolio. To
methodology. The institution had determined its
support this change in segmentation practice,
ALLL based upon historical loss rates in the
the credit-review committee records contain the
overall consumer portfolio. The ALLL method-
analysis that was used as a basis for the change
ology was validated by comparing actual loss
and the written report describing the need for
rates (charge-offs) for the past two years to the
the change.
estimated loss rates. During this process, the
Institutions use a variety of documents to loss-measurement methods and support its con-
support the segmentation of their portfolios. clusions and rationale with written documenta-
Some of these documents include tion. Regardless of the methods used to measure
losses, an institution should demonstrate and
loan trial balances by categories and types of document that the loss-measurement methods
loans, used to estimate the ALLL for each segment are
management reports about the mix of loans in determined in accordance with GAAP as of the
the portfolio, financial statement date.19
delinquency and nonaccrual reports, and One method of estimating loan losses for
a summary presentation of the results of an groups of loans is through the application of
internal or external loan-grading review. loss rates to the groups aggregate loan bal-
ances. Such loss rates typically reflect the insti-
Reports generated to assess the profitability of a tutions historical loan-loss experience for each
loan-product line may be useful in identifying group of loans, adjusted for relevant environ-
areas in which to further segment the portfolio. mental factors (e.g., industry, geographical, eco-
nomic, and political factors) over a defined
2065.4.1.5.2 Estimating Loss on Groups period of time. If an institution does not have
of Loans loss experience of its own, it may be appropriate
to reference the loss experience of other institu-
Based on the segmentation of the loan portfolio, tions, provided that the institution demonstrates
an institution should estimate the FAS 5 portion that the attributes of the loans in its portfolio
of its ALLL. For those segments that require an segment are similar to those of the loans
ALLL,18 the institution should estimate the loan included in the portfolio of the institution pro-
and lease losses, on at least a quarterly basis, viding the loss experience.20 Institutions should
based upon its ongoing loan-review process maintain supporting documentation for the tech-
and analysis of loan performance. The institu- nique used to develop their loss rates, including
tion should follow a systematic and consistently the period of time over which the losses were
applied approach to select the most appropriate incurred. If a range of loss is determined, institu-
tions should maintain documentation to support
the identified range and the rationale used for
18. An example of a loan segment that does not generally determining which estimate is the best estimate
require an ALLL is loans that are fully secured by deposits
maintained at the lending institution. within the range of loan losses. An example of
BHC Supervision Manual December 2002 19. Refer to paragraph 8(b) of FAS 5***.
Page 8 20. Refer to paragraph 23 of FAS 5.
how a small institution performs a comprehen- lending policies, procedures, and practices
sive historical loss analysis is provided as the experience, ability, and depth of lending man-
first item in illustration C. agement and other relevant staff
Before employing a loss-estimation model, national and local economic trends and
an institution should evaluate and modify, as conditions
needed, the models assumptions to ensure that industry conditions
the resulting loss estimate is consistent with
effects of changes in credit concentrations
GAAP. In order to demonstrate consistency with
GAAP, institutions that use loss-estimation
models typically document the evaluation, the For any adjustment of loss measurements
conclusions regarding the appropriateness of for environmental factors, the institution should
estimating loan losses with a model or other maintain sufficient, objective evidence to
loss-estimation tool, and the support for adjust- support the amount of the adjustment and to
ments to the model or its results. explain why the adjustment is necessary to
In developing loss measurements, institutions reflect current information, events, circum-
should consider the impact of current environ- stances, and conditions in the loss
mental factors and then document which factors measurements.
were used in the analysis and how those factors The second item in illustration C provides an
affected the loss measurements. Factors that example of how an institution adjusts its com-
should be considered in developing loss mea- mercial real estate historical loss rates for
surements include the following:21 changes in local economic conditions. Example
4 provides an example of maintaining support-
levels of and trends in delinquencies and ing documentation for adjustments to portfolio-
impaired loans segment loss rates for an environmental factor
levels of and trends in charge-offs and related to an economic downturn in the bor-
recoveries rowers primary industry. Example 5 describes
trends in volume and terms of loans one institutions process for determining and
effects of any changes in risk-selection and documenting an ALLL for loans that are not
underwriting standards, and other changes in individually impaired but have character-
istics indicating there are loan losses on a group
21. Refer to paragraph 7.13 in the AICPA Audit Guide. basis.
Illustration C Adjustment of loss rates for changes in local

economic conditions
Documenting the Setting of Loss
Rates An institution develops a factor to adjust loss
rates for its assessment of the impact of changes
Comprehensive loss analysis in a small in the local economy. For example, when ana-
institution lyzing the loss rate on commercial real estate
loans, the assessment identifies changes in
A small institution determines its loss rates recent commercial building occupancy rates.
based on loss rates over a three-year historical The institution generally finds the occupancy
period. The analysis is conducted by type of statistics to be a good indicator of probable
loan and is further segmented by originating losses on these types of loans. The institution
branch office. The analysis considers charge- maintains documentation that summarizes the
offs and recoveries in determining the loss rate. relationship between current occupancy rates
The institution also considers the loss rates for and its loss experience.
each loan grade and compares them to historical
losses on similarly rated loans in arriving at the
historical loss factor. The institution maintains Example 4: ALLL Under FAS 5
supporting documentation for its loss-factor Adjusting Loss Rates
analysis, including historical losses by type of
loan, originating branch office, and loan grade Facts. Institution Ds lending area includes a
for the three-year period. metropolitan area that is financially dependent

Page 9
upon the profitability of a number of manufac- ences in similar circumstances. As part of its
turing businesses. These businesses use highly effective ALLL methodology, a summary
specialized equipment and significant quantities should be created of the amount and rationale
of rare metals in the manufacturing process. for the adjustment factor, which management
Due to increased low-cost foreign competition, presents to the audit committee and board for
several of the parts suppliers servicing these their review and approval prior to the issuance
manufacturing firms declared bankruptcy. The of the financial statements.
foreign suppliers have subsequently increased
prices, and the manufacturing firms have suf-
fered from increased equipment maintenance Example 5: ALLL Under FAS 5
costs and smaller profit margins. Additionally, Estimating Losses on Loans Individually
the cost of the rare metals used in the manufac- Reviewed for Impairment but Not
turing process increased and has now stabilized Considered Individually Impaired
at double last years price. Due to these events,
the manufacturing businesses are experiencing Facts. Institution E has outstanding loans of
financial difficulties and have recently $2 million to Company Y and $1 million to
announced downsizing plans. Company Z, both of which are paying as agreed
Although Institution D has yet to confirm an upon in the loan documents. The institutions
increase in its loss experience as a result of ALLL policy specifies that all loans greater than
these events, management knows that it lends to $750,000 must be individually reviewed for im-
a significant number of businesses and individu- pairment under FAS 114. Company Ys finan-
als whose repayment ability depends upon the cial statements reflect a strong net worth, good
long-term viability of the manufacturing busi- profits, and ongoing ability to meet debt-service
nesses. Institution Ds management has identi- requirements. In contrast, recent information
fied particular segments of its commercial and indicates Company Zs profitability is declining
consumer customer bases that include borrow- and its cash flow is tight. Accordingly, this loan
ers highly dependent upon sales or salary from is rated substandard under the institutions loan-
the manufacturing businesses. Institution Ds grading system. Despite its concern, manage-
management performs an analysis of the ment believes Company Z will resolve its prob-
affected portfolio segments to adjust its histori- lems and determines that neither loan is
cal loss rates used to determine the ALLL. In individually impaired as defined by FAS 114.
this particular case, Institution D has experi- Institution E segments its loan portfolio to
enced similar business and lending conditions estimate loan losses under FAS 5. Two of its
in the past that it can compare to current loan portfolio segments are Segment 1 and Seg-
conditions. ment 2. The loan to Company Y has risk charac-
Analysis. Institution D should document its sup- teristics similar to the loans included in Seg-
port for the loss-rate adjustments that result ment 1, and the loan to Company Z has risk
from considering these manufacturing firms characteristics similar to the loans included in
financial downturns. It should document its Segment 2.22
identification of the particular segments of its In its determination of the ALLL under FAS
commercial and consumer loan portfolio for 5, Institution E includes its loans to Company Y
which it is probable that the manufacturing busi- and Company Z in the groups of loans with
ness financial downturn has resulted in loan similar characteristics (i.e., Segment 1 for Com-
losses. In addition, it should document its analy- pany Ys loan and Segment 2 for Company Zs
sis that resulted in the adjustments to the loss loan). Managements analyses of Segment 1 and
rates for the affected portfolio segments. As part Segment 2 indicate that it is probable that each
of its documentation, Institution D should main- segment includes some losses, even though the
tain copies of the documents supporting the losses cannot be identified to one or more spe-
analysis, including relevant newspaper articles, cific loans. Management estimates that the use
economic reports, economic data, and notes of its historical loss rates for these two seg-
from discussions with individual borrowers. ments, with adjustments for changes in
Since Institution D has had similar situations environmental factors, provides a reasonable
in the past, its supporting documentation should estimate of the institutions probable loan losses
also include an analysis of how the current in these segments.
conditions compare to its previous loss experi- 22. These groups of loans do not include any loans that
have been individually reviewed for impairment under FAS
BHC Supervision Manual December 2002 114 and determined to be impaired as defined by FAS 114.
Page 10
Analysis. Institution E should adequately docu- these loans with other loans in Segment 1 and
ment an ALLL under FAS 5 for these loans that Segment 2, respectively. Institution E maintains
were individually reviewed for impairment but documentation to support its method of estimat-
are not considered individually impaired. As ing loan losses for Segment 1 and Segment 2,
part of its effective ALLL methodology, Institu- including the average loss rate used, the analysis
tion E documents the decision to include its of historical losses by loan type and by internal
loans to Company Y and Company Z in its risk rating, and support for any adjustments to
determination of its ALLL under FAS 5. It its historical loss rates. The institution also
should also document the specific characteris- maintains copies of the economic and other
tics of the loans that were the basis for grouping reports that provided source data.
2065.4.1.6 Consolidating the Loss Illustration D describes how an institution docu-

Estimates ments its estimated ALLL by adding compre-
hensive explanations to its summary schedule.
To verify that ALLL balances are presented Generally, an institutions review and
fairly in accordance with GAAP and are audit- approval process for the ALLL relies upon the
able, management should prepare a document data provided in these consolidated summaries.
that summarizes the amount to be reported in There may be instances in which individuals or
the financial statements for the ALLL. The committees that review the ALLL methodology
board of directors should review and approve and resulting allowance balance identify adjust-
this summary. ments that need to be made to the loss estimates
Common elements in such summaries to provide a better estimate of loan losses. These
include changes may be due to information not known
at the time of the initial loss estimate (e.g.,
the estimate of the probable loss or range of information that surfaces after determining and
loss incurred for each category evaluated (e.g., adjusting, as necessary, historical loss rates, or
individually evaluated impaired loans, homo- a recent decline in the marketability of property
geneous pools, and other groups of loans that after conducting a FAS 114 valuation based
are collectively evaluated for impairment); upon the fair value of collateral). It is impor-
the aggregate probable loss estimated using tant that these adjustments are consistent with
the institutions methodology; GAAP and are reviewed and approved by
a summary of the current ALLL balance; appropriate personnel. Additionally, the sum-
the amount, if any, by which the ALLL is to mary should provide each subsequent reviewer
be adjusted;23 and with an understanding of the support behind
depending on the level of detail that supports these adjustments. Therefore, management
the ALLL analysis, detailed subschedules of should document the nature of any adjustments
loss estimates that reconcile to the summary and the underlying rationale for making the
schedule. changes. This documentation should be pro-
vided to those making the final determination
23. Subsequent to adjustments, there should be no material of the ALLL amount. Example 6 addresses
differences between the consolidated loss estimate, as deter-
mined by the methodology, and the final ALLL balance
the documentation of the final amount of the
reported in the financial statements. ALLL.

Page 11
Illustration D estimates. As a result of the adjustments made

by senior management, the total amount of the
Summarizing Loss Estimates ALLL changes. However, senior management
Descriptive comments added to the consolidated (or its designee) does not update the ALLL
ALLL summary schedule summary schedule to reflect the adjustments or
reasons for the adjustments. When performing
To simplify the supporting documentation pro- their audit of the financial statements, the inde-
cess and to eliminate redundancy, an institution pendent accountants are provided with the origi-
adds detailed supporting information to its sum- nal ALLL summary schedule that was reviewed
mary schedule. For example, this institutions by senior management and the credit commit-
board of directors receives, within the body of tee, as well as a verbal explanation of the
the ALLL summary schedule, a brief descrip- changes made by senior management and the
tion of the institutions policy for selecting loans credit committee when they met to discuss the
for evaluation under FAS 114. Additionally, the loan-loss allowance.
institution identifies which FAS 114
impairment-measurement method was used for Analysis. Institution Fs documentation prac-
each individually reviewed impaired loan. Other tices supporting the balance of its loan-loss al-
items on the schedule include a brief description lowance, as reported in its financial statements,
of the loss factors for each segment of the loan are not in compliance with existing documenta-
portfolio, the basis for adjustments to loss rates, tion guidance. An institution must maintain sup-
and explanations of changes in ALLL amounts porting documentation for the loan-loss allow-
from period to period, including cross- ance amount reported in its financial statements.
references to more detailed supporting As illustrated above, there may be instances in
documents. which ALLL reviewers identify adjustments that
need to be made to the loan-loss estimates. The
nature of the adjustments, how they were mea-
Example 6: Consolidating the Loss sured or determined, and the underlying ratio-
EstimatesDocumenting the Reported nale for making the changes to the ALLL bal-
ALLL ance should be documented. Appropriate
documentation of the adjustments should be
Facts. Institution F determines its ALLL using provided to the board of directors (or its desig-
an established systematic process. At the end of nee) for review of the final ALLL amount to be
each period, the accounting department prepares reported in the financial statements. For institu-
a summary schedule that includes the amount of tions subject to external audit, this documenta-
each of the components of the ALLL, as well as tion should also be made available to the inde-
the total ALLL amount, for review by senior pendent accountants. If changes frequently
management, the credit committee, and, ulti- occur during management or credit committee
mately, the board of directors. Members of reviews of the ALLL, management may find it
senior management and the credit committee appropriate to analyze the reasons for the fre-
meet to discuss the ALLL. During these discus- quent changes and to reassess the methodology
sions, they identify changes that are required by the institution uses.
GAAP to be made to certain of the ALLL
2065.4.1.7 Validating the ALLL To verify that the ALLL methodology is valid
Methodology and conforms to GAAP and supervisory guid-
ance, an institutions directors should establish
An institutions ALLL methodology is consid- internal-control policies, appropriate for the size
ered valid when it accurately estimates the of the institution and the type and complexity of
amount of loss contained in the portfolio. Thus, its loan products. These policies should include
the institutions methodology should include procedures for a review, by a party who is
procedures that adjust loss-estimation methods independent of the ALLL-estimation process, of
to reduce differences between estimated losses the ALLL methodology and its application in
and actual subsequent charge-offs, as necessary. order to confirm its effectiveness.
In practice, financial institutions employ
BHC Supervision Manual December 2002 numerous procedures when validating the rea-
Page 12 sonableness of their ALLL methodology and
determining whether there may be deficiencies when the criteria for accrual of a loss contin-
in their overall methodology or loan-grading gency as set forth in GAAP have been met.
process. Examples are Estimating the amount of an ALLL involves a
high degree of management judgment and is
a review of trends in loan volume, delinquen- inevitably imprecise. Accordingly, an institution
cies, restructurings, and concentrations; may determine that the amount of loss falls
a review of previous charge-off and recovery within a range. An institution should record its
history, including an evaluation of the timeli- best estimate within the range of loan losses.25
ness of the entries to record both the charge- Under GAAP, Statement of Financial
offs and the recoveries; Accounting Standards No. 5, Accounting for
a review by a party that is independent of the Contingencies (FAS 5), provides the basic
ALLL-estimation process (this often involves guidance for recognition of a loss contingency,
the independent party reviewing, on a test such as the collectibility of loans (receivables),
basis, source documents and underlying when it is probable that a loss has been incurred
assumptions to determine that the established and the amount can be reasonably estimated.
methodology develops reasonable loss Statement of Financial Accounting Standards
estimates); and No. 114, Accounting by Creditors for Impair-
an evaluation of the appraisal process of the ment of a Loan (FAS 114) provides more
underlying collateral. (This may be accom- specific guidance about the measurement and
plished by periodically comparing the disclosure of impairment for certain types of
appraised value to the actual sales price on loans.26 Specifically, FAS 114 applies to loans
selected properties sold.) that are identified for evaluation on an indi-
vidual basis. Loans are considered impaired
when, based on current information and events,
2065.4.1.7.1 Supporting Documentation it is probable that the creditor will be unable to
for the Validation Process collect all interest and principal payments due
according to the contractual terms of the loan
Management usually supports the validation agreement.
process with the workpapers from the ALLL- For individually impaired loans, FAS 114
review function. Additional documentation provides guidance on the acceptable methods to
often includes the summary findings of the inde- measure impairment. Specifically, FAS 114
pendent reviewer. The institutions board of states that when a loan is impaired, a creditor
directors, or its designee, reviews the findings should measure impairment based on the present
and acknowledges its review in its meeting min- value of expected future principal and interest
utes. If the methodology is changed based upon cash flows discounted at the loans effective
the findings of the validation process, documen- interest rate, except that as a practical expedient,
tation that describes and supports the changes a creditor may measure impairment based on a
should be maintained. loans observable market price or the fair value
of collateral, if the loan is collateral dependent.
When developing the estimate of expected
2065.4.1.8 AppendixApplication of future cash flows for a loan, an institution should
GAAP consider all available information reflecting past
events and current conditions, including the
[This appendix was designated appendix B in
the policy statement.] An ALLL recorded pursu- ances or accounting for assets or portions of assets sold with
ant to GAAP is an institutions best estimate of recourse, which is described in Statement of Financial
the probable amount of loans and lease- Accounting Standards No. 140, Accounting for Transfers
financing receivables that it will be unable to and Servicing of Financial Assets and Extinguishments of
Liabilitiesa Replacement of FASB Statement No. 125
collect based on current information and (FAS 140).
events.24 A creditor should record an ALLL 25. Refer to FASB Interpretation No. 14, Reasonable
Estimation of the Amount of a Loss, and Emerging Issues
Task Force Topic No. D-80, Application of FASB State-
24. This appendix provides guidance on the ALLL and
ments No. 5 and No. 114 to a Loan Portfolio (EITF Topic
does not address allowances for credit losses for off-balance-
D-80).
sheet instruments (e.g., loan commitments, guarantees, and
26. EITF Topic D-80 includes additional guidance on the
standby letters of credit). Institutions should record liabilities
requirements of FAS 5 and FAS 114 and how they relate to
for these exposures in accordance with GAAP. Further guid-
each other.***
ance on this topic is presented in the American Institute of
Certified Public Accountants Audit and Accounting Guide,
Banks and Savings Institutions, 2000 edition (AICPA Audit BHC Supervision Manual December 2002
Guide). Additionally, this appendix does not address allow- Page 13
effect of existing environmental factors. The institution estimating a loans impairment when
following illustration provides an example of an the loan has been partially charged off.
Illustration of the recorded investment deemed to be the

confirmed loss and classified the remaining
Interaction of FAS 114 with an recorded investment as Substandard. For this
Adversely Classified Loan, Partial loan, the amount classified Loss was less
Charge-Off, and the Overall ALLL than the impairment amount (as determined
under FAS 114). The institution charged off the
An institution determined that a collateral- Loss portion of the loan. After the charge-off,
dependent loan, which it identified for evalua- the portion of the ALLL related to this Sub-
tion, was impaired. In accordance with FAS standard loan (1) reflects an appropriate mea-
114, the institution established an ALLL for the sure of impairment under FAS 114, and (2) is
amount that the recorded investment in the loan included in the aggregate FAS 114 ALLL for all
exceeded the fair value of the underlying collat- loans that were identified for evaluation and
eral, less costs to sell. individually considered impaired. The aggre-
Consistent with relevant regulatory guidance, gate FAS 114 ALLL is included in the institu-
the institution classified as Loss, the portion tions overall ALLL.
Large groups of smaller-balance homoge- While different institutions may use different
neous loans that are collectively evaluated for methods, there are certain common elements
impairment are not included in the scope of FAS that should be included in any loan-loss allow-
114.27 Such groups of loans may include, but ance methodology. Generally, an institutions
are not limited to, credit card, residential mort- methodology should
gage, and consumer installment loans. FAS 5
addresses the accounting for impairment of include a detailed analysis of the loan port-
these loans. Also, FAS 5 provides the account- folio, performed on a regular basis;
ing guidance for impairment of loans that are consider all loans (whether on an individual
not identified for evaluation on an individual or group basis);
basis and loans that are individually evaluated identify loans to be evaluated for impairment
but are not individually considered impaired. on an individual basis under FAS 114 and
Institutions should ensure that they do not layer segment the remainder of the portfolio into
their loan-loss allowances. Layering is the inap- groups of loans with similar risk charac-
propriate practice of recording in the ALLL teristics for evaluation and analysis under
more than one amount for the same probable FAS 5;
loan loss. Layering can happen when an institu- consider all known relevant internal and
tion includes a loan in one segment, determines external factors that may affect loan
its best estimate of loss for that loan either collectibility;
individually or on a group basis (after taking be applied consistently but, when appropriate,
into account all appropriate environmental fac- be modified for new factors affecting
tors, conditions, and events), and then includes collectibility;
the loan in another group, which receives an consider the particular risks inherent in differ-
additional ALLL amount.28 ent kinds of lending;
consider current collateral values (less costs
27. In addition, FAS 114 does not apply to loans measured to sell), where applicable;
at fair value or at the lower of cost or fair value, leases, or require that analyses, estimates, reviews, and
debt securities. other ALLL methodology functions be
28. According to the Federal Financial Institutions Exami- performed by competent and well-trained
nation Councils Federal Register notice, Implementation
Issues Arising from FASB Statement No. 114, Accounting personnel;
by Creditors for Impairment of a Loan, published February be based on current and reliable data;
10, 1995, institution-specific issues should be reviewed when be well documented, in writing, with clear
estimating loan losses under FAS 114. This analysis should be explanations of the supporting analyses and
conducted as part of the evaluation of each individual loan
reviewed under FAS 114 to avoid potential ALLL layering. rationale; and
include a systematic and logical method to
BHC Supervision Manual December 2002 consolidate the loss estimates and ensure the
Page 14
ALLL balance is recorded in accordance with 2065.4.3 INSPECTION PROCEDURES

GAAP.29
1. Determine if the board of directors has
A systematic methodology that is properly developed and maintained an appropriate,
designed and implemented should result in an systematic, and consistently applied process
institutions best estimate of the ALLL. Accord- to determine the amounts of the ALLL and
ingly, institutions should adjust their ALLL bal- provision for loan losses, or if it has
ance, either upward or downward, in each instructed management to do so. Determine
period for differences between the results of the if the ALLL policies specifically address the
systematic determination process and the unad- BHCs goals, risk profile, personnel, and
justed ALLL balance in the general ledger.30 other resources.
2. Determine if the board of directors has
approved the written ALLL policy.
2065.4.2 INSPECTION OBJECTIVES 3. Determine if the BHCs loan-loss estimate,
in accordance with its methodology, is con-
1. To evaluate internal controls over the loan- sistent with generally accepted accounting
loss estimation process by evaluating the principles and supervisory guidance. Addi-
ALLL written policy and the process used to tionally, ensure that the BHCs loan-loss esti-
create and maintain the policy, loan-grading mate is materially consistent with the
systems, and other associated internal con- reported balance of the BHCs ALLL
trols over credit risk. account.
2. To determine the existence of an ALLL bal- 4. Determine if the ALLL methodology is peri-
ance and review the summary schedule sup- odically validated by an independent party
porting it. and, if appropriate, revised.
3. To analyze and review the evaluation for 5. Ascertain whether the audit committee is
Statement of Financial Accounting Standards overseeing and monitoring the internal con-
No. 114 (FAS 114) (for individually listed trols over the ALLL-documentation process.
loans). 6. Ascertain that the BHC maintains adequate
4. To analyze and review the evaluation for written documentation of its ALLL, includ-
Statement of Financial Accounting Standards ing clear explanations of the supporting
No. 5 (FAS 5) (for groups of loans). analyses and rationale. The documentation
5. To determine if the BHC has adequately should consist of
developed a range of loss and a margin for policies and procedures over the systems
imprecision. and controls that maintain an appropriate
6. To determine that the ALLL reflects esti- ALLL and over the ALLL methodology,
mated credit losses for specifically identified the loan-grading system or process,
loans (or groups of loans) and any estimated a summary or consolidation (including
probable credit losses inherent in the remain- losses) of the ALLL balance,
der of the loan portfolio at the balance-sheet a validation of the ALLL methodology,
date. and
7. To analyze and review the ALLL- periodic adjustments to the ALLL process.
documentation support. 7. Determine if the amount reported for the
8. To determine the adequacy of the BHCs ALLL for each period and the provisions for
process to evaluate the ALLL methodology loan and leases losses are reviewed and
and to adjust the methodology, as needed. approved by the board of directors.
29. Refer to paragraph 7.05 of the AICPA Audit Guide.

30. Institutions should refer to the guidance on materiality BHC Supervision Manual December 2002
in SEC Staff Accounting Bulletin No. 99, Materiality. Page 15
ALLL Estimation Practices for Loans Secured by Junior Liens
Section 2065.5
The federal banking agencies1 issued, in Janu- 2065.5.1 ALLL ESTIMATION
ary 2012, Interagency Supervisory Guidance PRACTICES FOR LOANS AND LINES
on Allowance for Loan and Lease Losses Esti- OF CREDIT SECURED BY JUNIOR
mation Practices for Loans and Lines of Credit LIENS ON 14 FAMILY RESIDENTIAL
Secured by Junior Liens on 14 Family Resi- PROPERTIES
dential Properties. The guidance applies to all
banking organizations with junior-lien loans. It Amidst continued uncertainty in the economy
was issued to address the allowance for loan and and the housing market, federally regulated
lease losses (ALLL) estimation practices for financial institutions are reminded to monitor all
junior-lien loans and lines of credit (collec- credit quality indicators relevant to credit port-
tively, junior liens). (See SR-12-3.) folios, including junior liens. While the follow-
Domestic banking organizations that are ing guidance specifically addresses junior liens,
supervised by the Federal Reserve are reminded it contains principles that apply to estimating
to consider all credit quality indicators relevant the ALLL for all types of loans. Institutions also
to their junior liens. Generally, this information are reminded to follow appropriate risk-
should include the delinquency status of senior management principles in managing junior-lien
liens associated with the institutions junior liens loans and lines of credit, including those in the
and whether the senior lien has been modified. May 2005 guidance.
Institutions should ensure that during the ALLL The December 2006 Interagency Policy
estimation process, sufficient information is Statement on the Allowance for Loan and Lease
gathered to adequately assess the probable loss Losses (IPS) states: Estimates of credit losses
incurred within junior-lien portfolios. should reflect consideration of the significant
This 2012 ALLL guidance applies to institu- factors that affect the collectibility of the port-
tions of all sizes. The guidance states that an folio as of the evaluation date. (See section
institution should use reasonably available tools 2065.3.)
to determine the payment status of senior liens The Interagency Credit Risk Management
associated with its junior liens, such as credit Guidance for Home Equity Lending states:
reports, third-party services, or, in certain cases, Financial institutions should establish an
a proxy. It is expected that large, complex insti- appropriate ALLL and hold capital commensu-
tutions would find most tools reasonably avail- rate with the riskiness of portfolios. In determin-
able and would use proxies in limited ing the ALLL adequacy, an institution should
circumstances. consider how the interest-only and draw fea-
The guidance does not add or modify existing tures of home equity lines of credit (HELOCs)
regulatory reporting requirements issued by the during the lines revolving periods could affect
agencies or current generally accepted account- the loss curves for the HELOC portfolio. Those
ing principles (GAAP). This guidance reiterates institutions engaging in programmatic subprime
key concepts included in GAAP and existing home equity lending or institutions that have
supervisory guidance related to the ALLL. (See, higher risk products are expected to recognize
for example, SR-06-17 (section 2065.3) and the elevated risk of the activity when assessing
SR-01-17 (section 2065.4) and their capital and ALLL adequacy.
attachments. While the 2012 ALLL guidance specifically
Institutions also are reminded to follow addresses junior liens, it contains principles that
appropriate risk-management principles in man- apply to estimating the ALLL for all types of
aging junior-lien loans and lines of credit, loans.
including the May 2005 Interagency Credit
Risk Management Guidance for Home Equity
Lending. (See SR-05-11 and section 2010.2.4.)
1. The federal banking agencies are the Board of Gover-

nors of the Federal Reserve System (Federal Reserve Board),
the Federal Deposit Insurance Corporation (FDIC), the Office
of the Comptroller of the Currency (OCC), and the National BHC Supervision Manual July 2012
Credit Union Administration (NCUA). Page 1
ALLL Estimation Practices for Loans Secured by Junior Liens 2065.5
2065.5.1.1 Responsibilities of Institutions routinely gather information for

Management credit-risk management purposes, but some may
not fully use that information in the allowance
2065.5.1.1.1 Consideration of All estimation process. Institutions should consider
Significant Factors all reasonably available and relevant informa-
tion in the allowance estimation process, includ-
Institutions should ensure that during the ALLL ing information obtained for credit-risk manage-
estimation process sufficient information is gath- ment purposes. Financial Accounting Standards
ered to adequately assess the probable loss Board Accounting Standards Codification
incurred within junior-lien portfolios. Generally, (ASC) Topic 450 states that losses should be
this information should include the delinquency accrued by a charge to income if information
status of senior liens associated with the institu- available prior to issuance of the financial state-
tions junior liens and whether the senior-lien ments indicates that it is probable that an asset
loan has been modified. Institutions with signifi- has been impaired. The 2006 IPS states, ...esti-
cant holdings of junior liens should gather and mates of credit losses should reflect consider-
analyze data on the associated senior-lien loans ation of all significant factors. (See SR-06-17
it owns or services. When an institution does not and its attachment.) Consequently, it is consid-
own or service the associated senior-lien loans, ered inconsistent with both GAAP and supervi-
it should use reasonably available tools to deter- sory guidance to fail to gather and consider
mine the payment status of the senior-lien loans. reasonably available and relevant information
Such tools include obtaining credit reports or that would significantly affect managements
data from third-party services to assist in match- judgment about the collectibility of the
ing an institutions junior liens with its associ- portfolio.2
ated senior liens. Additionally, an institution
may, as a proxy, use the relevant performance
data on similar senior liens it owns or services. 2065.5.1.1.2 Adequate Segmentation
An institution with an insignificant volume of
junior-lien loans and lines of credit may use Institutions normally segment their loan port-
judgment when determining what information folio into groups of loans based on risk charac-
about associated senior liens not owned or ser- teristics as part of the ALLL estimation pro-
viced is reasonably available. cess. Institutions with significant holdings of
Institutions with significant holdings of junior junior liens should ensure adequate segmenta-
liens should also periodically refresh other tion within their junior-lien portfolio to appro-
credit quality indicators the organization has priately estimate the allowance for high-risk
deemed relevant about the collectibility of its segments within this portfolio. A lack of seg-
junior liens, such as borrower credit scores and mentation can result in an allowance estab-
combined loan-to-value ratios (CLTVs), which lished for the entire junior-lien portfolio that is
include both the senior and junior liens. An lower than what the allowance would be if
institution should refresh relevant credit qual- high-risk loans were segregated and grouped
ity indicators as often as necessary considering together for evaluation in one or more separate
economic and housing market conditions that segments. The following credit quality indica-
affect the institutions junior-lien portfolio. As tors may be appropriate for use in identifying
noted in SR-06-17, changes in the level of the high-risk junior-lien portfolio segments:
ALLL should be directionally consistent with
changes in the factors, taken as a whole, that delinquency and modification status of an
evidence credit losses. For example, if declin- institutions junior liens
ing credit quality trends in the factors relevant delinquency and modification status of senior-
to either junior liens or their associated senior- lien loans associated with an institutions
lien loans are evident, the ALLL level as a junior liens
percentage of the junior-lien portfolio should
2. Portfolio refers to loans collectively evaluated for
generally increase, barring unusual charge-off impairment under ASC Topic 450; this supervisory guidance
activity. Similarly, if improving credit quality may also be applicable to junior-lien loans that are subject to
trends are evident, the ALLL level as a percent- measurement for impairment under ASC Subtopic 310-10,
age of the junior-lien portfolio should gener- Receivables - Overall (formerly Statement of Financial
Accounting Standards No. 114, Accounting by Creditors for
ally decrease. Impairment of a Loan) and ASC Subtopic 310-30, Loans and
Debt Securities Acquired with Deteriorated Credit Quality
BHC Supervision Manual July 2012 (formerly AICPA Statement of Position 03-3, Accounting for
Page 2 Certain Loans or Debt Securities Acquired in a Transfer).
current borrower credit score increases or decreases the historical loss rate
current CLTV applied to the loan group. Alternatively, the
origination channel effect of these factors may be reflected through
documentation type separate standalone adjustments within the ASC
property type (for example, investor owned or Subtopic 450-20 component of the ALLL.
owner-occupied) When an institution uses qualitative or envi-
geographic location of property ronmental factors to estimate probable losses
origination vintage related to individual high-risk segments within
HELOCs where the borrower is making only the junior-lien portfolio, any adjustment to the
the minimum payment due historical loss rate or any separate standalone
HELOCs where current information and con- adjustment should be supported by an analysis
ditions indicate that the borrower will be sub- that relates the adjustment to the characteristics
ject to payment shock of and trends in the individual risk segments. In
addition, changes in the allowance allocation for
In particular, institutions should ensure their junior liens should be directionally consistent
ALLL methodology adequately incorporates the with changes in the factors taken as a whole that
elevated borrower default risk associated with evidence credit losses on junior liens, keeping in
payment shocks due to (1) rising interest rates mind the characteristics of the institutions
for adjustable rate junior liens, including junior-lien portfolio.
HELOCs,3 or (2) HELOCs converting from
interest-only to amortizing loans. If the default
rate of junior liens that have experienced pay- 2065.5.1.1.4 Charge-Off and Nonaccrual
ment shock is higher than the default rate of Policies
junior liens that have not experienced payment
shock, an institution should determine whether Banking institutions should ensure that their
it has a significant number of junior liens charge-off policy on junior liens is in accor-
approaching their conversion to amortizing dance with the June 2000 Uniform Retail Credit
loans or approaching an interest rate adjustment Classification and Account Management Policy.
date. If so, to ensure the institutions estimate of (See SR-00-8 and the appendix of section
credit losses is not understated, it would be 2241.0.1.) As stated in SR-06-17, when avail-
necessary to adjust historical default rates on able information confirms that specific loans, or
these junior liens to incorporate the effect of portions thereof, are uncollectible, these
payment shocks that, based on current informa- amounts should be promptly charged off against
tion and conditions, are likely to occur. the ALLL.
Adequate segmentation of the junior-lien Institutions also should ensure that income-
portfolio by risk factors should facilitate an recognition practices related to junior liens are
institutions ability to track default rates and appropriate. Consistent with GAAP and regula-
loss severity for high-risk segments and its abil- tory guidance, institutions are expected to have
ity to appropriately incorporate these data into revenue recognition practices that do not result
the allowance estimation process. in overstating income. Placing a junior lien on
nonaccrual, including a current junior lien, when
payment of principal or interest in full is not
2065.5.1.1.3 Qualitative or expected is one appropriate method to ensure
Environmental Factor Adjustments that income is not overstated. An institutions
income-recognition policy should incorporate
As noted in SR-06-17, institutions should adjust managements consideration of all reasonably
a loan groups historical loss rate for the effect available information including, for junior liens,
of qualitative or environmental factors that are the performance of the associated senior liens as
likely to cause estimated credit losses as of the well as trends in other credit quality indicators.
evaluation date to differ from the groups his- The policy should require that consideration of
torical loss experience. Institutions typically these factors takes place before foreclosure on
reflect the overall effect of these factors on a the senior lien or delinquency of the junior lien.
loan group as an adjustment that, as appropriate, The policy should also explain how manage-
ments consideration of these factors affects
3. Forecasts of future interest rate increases should not be
included in the determination of the ALLL. However, if rates
income recognition prior to foreclosure on the
have risen since the last rate adjustment, the effect of the
increase on the amount of the payment at the next rate BHC Supervision Manual July 2012
adjustment should be considered. Page 3
senior lien or delinquency of the junior lien to If the examiner concludes that the reported
ensure income is not overstated. ALLL for junior liens is not appropriate or
determines that the ALLL evaluation process is
deficient, recommendations for correcting these
2065.5.1.1.5 Responsibilities of deficiencies, including any examiner concerns
Examiners regarding an appropriate level for the ALLL,
should be noted in the inspection report. Exam-
To the extent an institution has significant hold- iners should cite any departures from GAAP
ings of junior liens, examiners should assess the and regulatory guidance, as applicable. Addi-
appropriateness of the institutions ALLL meth- tional supervisory action may also be taken
odology and documentation related to these based on the magnitude of the observed short-
loans, and the appropriateness of the level of the comings in the ALLL process.
ALLL established for this portfolio. As noted in
SR-06-17, for analytical purposes, an institution
should attribute portions of the ALLL to loans 2065.5.2 INSPECTION OBJECTIVES
that it individually evaluates and determines to
be impaired under ASC Subtopic 310-10 and to The inspection objectives for an institution that
groups of loans that it evaluates collectively has significant holdings of loans secured by
under ASC Subtopic 450-20. However, the junior liens are as follows:
ALLL is available to cover all charge-offs that
arise from the loan portfolio. 1. To evaluate the appropriateness of the institu-
Consistent with SR-06-17, in their review of tions methodology and documentation of
the junior-lien portfolio, examiners should con- the ALLL related to these loans.
sider all significant factors that affect the collect- 2. To ascertain whether the institutions poli-
ability of the portfolio. Examiners should take cies, practices, procedures, and internal con-
the following steps when reviewing the appro- trols regarding the ALLL estimation prac-
priateness of an institutions allowance that is tices for loans secured by junior liens are
established for junior liens: sufficient.
3. To determine whether the level of the ALLL
Evaluate the institutions ALLL policies and is reasonable and adequate for the institu-
procedures and assess the methodology that tions volume of such loans outstanding.
management uses to arrive at an overall esti- 4. To evaluate if the institution has fully consid-
mate of the ALLL for junior liens. This should ered and accounted for all significant qualita-
include whether all significant qualitative or tive or environmental factors that affect the
environmental factors that affect the collect- collectability of such loans.
ability of the portfolio (including those factors 5. To ascertain whether the portfolio has been
previously discussed) have been appropriately properly accounted in accordance with
considered in accordance with GAAP. GAAP and whether all applicable supervi-
Review managements use of loss-estimation sory and regulatory guidance, as well as
models or other loss estimation tools to ensure statutory and regulatory requirements, have
that the resulting estimated credit losses are in been adhered to.
conformity with GAAP.
Review managements support for any quali-
tative or environmental factor adjustments to 2065.5.3 INSPECTION PROCEDURES
the allowance related to junior liens. Examin-
ers should ensure that all relevant qualitative 1. To the extent an institution has significant
or environmental factors were considered and holdings of loans secured by junior liens,
adjustments to historical loss rates for specific assess the appropriateness of the institutions
risk segments within the junior-lien portfolio a. ALLL methodology and documentation
are supported by an analysis that relates the related to these loans, and
adjustments to the characteristics of and b. ALLL level established for this portfolio.
trends in the individual risk segments. 2. During the inspections review of the of the
Review the interest income accounts associ- junior-lien portfolio, consider all significant
ated with junior liens to ensure that the institu- qualitative or environmental factors that
tions net income is not overstated. affect the collectibility of the junior-lien
portfolio and whether they have been
BHC Supervision Manual July 2012 appropriately considered in accordance with
Page 4 GAAP.
3. Perform the following steps when reviewing and adjustments to historical loss rates for
the appropriateness of the institutions ALLL specific risk segments within the junior-
that is established for junior liens: lien portfolio are supported by an analysis
a. Evaluate the institutions ALLL policies that relates the adjustment to the charac-
and procedures and assess the methodol- teristics of and trends in the individual
ogy that management uses to arrive at an risk segments.
overall estimate of the ALLL for junior d. Review the interest income accounts asso-
liens. ciated with junior liens to ensure that the
b. Review managements use of loss- institutions net income is not overstated.
estimation models or other loss-estimation 4. Provide comments in the inspection report
tools to ensure that the resulting estimated when the ALLL for junior liens is not appro-
credit losses are in conformity with priate or if the ALLL evaluation process is
GAAP. deficient. Include recommendations for cor-
c. Review managements support for any recting these deficiencies and any concerns
qualitative or environmental factor adjust- regarding an appropriate level for the ALLL.
ments to the ALLL related to junior liens. 5. Cite in the inspection report any departures
Ensure that all relevant qualitative or from GAAP and regulatory guidance, as
environmental factors were considered applicable.

Page 5
Sound Incentive Compensation Policies
Section 2068.0
Incentive compensation practices in the finan- soundness. Accordingly, the Federal Reserve
cial industry were one of many factors that expects banking organizations to maintain
contributed to the financial crisis that began in incentive compensation practices that are con-
mid-2007. Banking organizations too often sistent with safety and soundness, even when
rewarded employees for increasing the organiza- these practices go beyond those needed to align
tions revenue or short-term profit without shareholder and employee interests.
adequate recognition of the risks the employees To be consistent with safety and soundness,
activities posed to the organization.1 These prac- incentive compensation arrangements4 at a
tices exacerbated the risks and losses at a num- banking organization should:
ber of banking organizations and resulted in the
misalignment of the interests of employees with 1. Provide employees incentives that appropri-
the long-term well-being and safety and sound- ately balance risk and reward;
ness of their organizations. This section pro- 2. Be compatible with effective controls and
vides guidance on sound incentive compensa- risk-management; and
tion practices to banking organizations 3. Be supported by strong corporate gover-
supervised by the Federal Reserve (also the nance, including active and effective over-
Office of the Comptroller of the Currency, the sight by the organizations board of directors.
Federal Deposit Insurance Corporation, and the
Office of Thrift Supervision (collectively, the These principles, and the types of policies, pro-
Agencies)).2 This guidance is intended to cedures, and systems that banking organiza-
assist banking organizations in designing and tions should have to help ensure compliance
implementing incentive compensation arrange- with them, are discussed later in this guidance.
ments and related policies and procedures that The Federal Reserve expects banking organi-
effectively consider potential risks and risk zations to regularly review their incentive com-
outcomes.3 pensation arrangements for all executive and
Alignment of incentives provided to employ- non-executive employees who, either individu-
ees with the interests of shareholders of the ally or as part of a group, have the ability to
organization often also benefits safety and expose the organization to material amounts of
soundness. However, aligning employee incen- risk, as well as to regularly review the risk-
tives with the interests of shareholders is not management, control, and corporate governance
always sufficient to address safety-and- processes related to these arrangements. Bank-
soundness concerns. Because of the presence of ing organizations should immediately address
the federal safety net, (including the ability of any identified deficiencies in these arrangements
insured depository institutions to raise insured or processes that are inconsistent with safety
deposits and access the discount window and and soundness. Banking organizations are
payment services of the Federal Reserve), share- responsible for ensuring that their incentive
holders of a banking organization in some cases compensation arrangements are consistent with
may be willing to tolerate a degree of risk that is the principles described in this guidance and
inconsistent with the organizations safety and that they do not encourage employees to expose
the organization to imprudent risks that may
pose a threat to the safety and soundness of the
1. Examples of risks that may present a threat to the organization.
organizations safety and soundness include credit, market,
liquidity, operational, legal, compliance, and reputational
risks. 4. In this guidance, the term incentive compensation
2. As used in this guidance, the term banking organiza- refers to that portion of an employees current or potential
tion includes national banks, state member banks, state compensation that is tied to achievement of one or more
nonmember banks, savings associations, U.S. bank holding specific metrics (e.g., a level of sales, revenue, or income).
companies, savings and loan holding companies, Edge and Incentive compensation does not include compensation that is
agreement corporations, and the U.S. operations of foreign awarded solely for, and the payment of which is solely tied to,
banking organizations (FBOs) with a branch, agency, or com- continued employment (e.g., salary). In addition, the term
mercial lending company in the United States. If the Federal does not include compensation arrangements that are deter-
Reserve is referenced, the reference is intended to also include mined based solely on the employees level of compensation
the other supervisory Agencies. and does not vary based on one or more performance metrics
3. This guidance (see 75 Fed. Reg. 36395, June 25, 2010, (e.g., a 401(k) plan under which the organization contributes a
for the entire text) and the principles reflected herein are set percentage of an employees salary).
consistent with the Principles for Sound Compensation Prac-
tices issued by the Financial Stability Board (FSB) in April
2009, and with the FSBs Implementation Standards for those BHC Supervision Manual July 2010
principles, issued in September 2009. Page 1
Sound Incentive Compensation Policies 2068.0
The Federal Reserve recognizes that incen- malized policies, procedures, and processes.
tive compensation arrangements often seek to These are considered important in ensuring that
serve several important and worthy objectives. incentive compensation arrangements for all
For example, incentive compensation arrange- covered employees are identified and reviewed
ments may be used to help attract skilled staff, by appropriate levels of management (including
induce better organization-wide and employee the board of directors where appropriate and
performance, promote employee retention, pro- control units), and that they appropriately bal-
vide retirement security to employees, or allow ance risks and rewards. In several places, this
compensation expenses to vary with revenue on guidance specifically highlights the types of
an organization-wide basis. Moreover, the policies, procedures, and systems that LCBOs
analysis and methods for ensuring that incentive should have and maintain, but that generally are
compensation arrangements take appropriate not expected of smaller, less complex organiza-
account of risk should be tailored to the size, tions. LCBOs warrant the most intensive super-
complexity, business strategy, and risk tolerance visory attention because they are significant
of each organization. The resources required users of incentive compensation arrangements
will depend upon the complexity of the firm and and because flawed approaches at these organi-
its use of incentive compensation arrangements. zations are more likely to have adverse effects
For some, the task of designing and implement- on the broader financial system. The Federal
ing compensation arrangements that properly Reserve will work with LCBOs as necessary
offer incentives for executive and non-executive through the supervisory process to ensure that
employees to pursue the organizations long- they promptly correct any deficiencies that may
term well-being and that do not encourage be inconsistent with the safety and soundness of
imprudent risk-taking is a complex task that will the organization.
require the commitment of adequate resources. The policies, procedures, and systems of
While issues related to designing and imple- smaller banking organizations that use incentive
menting incentive compensation arrangements compensation arrangements7 are expected to be
are complex, the Federal Reserve is committed less extensive, formalized, and detailed than
to ensuring that banking organizations move those of LCBOs. Supervisory reviews of incen-
forward in incorporating the principles tive compensation arrangements at smaller, less-
described in this guidance into their incentive complex banking organizations will be con-
compensation practices.5 ducted by the Federal Reserve as part of the
As discussed further below, because of the evaluation of those organizations risk-
size and complexity of their operations, Large management, internal controls, and corporate
complex banking organizations (LCBOs)6 governance during the regular, risk-focused
should have and adhere to systematic and for- examination process. These reviews will be tai-
lored to reflect the scope and complexity of an
organizations activities, as well as the preva-
5. In December 2009 the Federal Reserve, working with lence and scope of its incentive compensation
the other Agencies, initiated a special horizontal review of
incentive compensation arrangements and related risk- arrangements. Little, if any, additional examina-
management, control, and corporate governance practices of tion work is expected for smaller banking orga-
large banking organizations (LBOs). This initiative was nizations that do not use, to a significant extent,
designed to spur and monitor the industrys progress towards incentive compensation arrangements.8
the implementation of safe and sound incentive compensation
arrangements, identify emerging best practices, and advance For all banking organizations, supervisory
the state of practice more generally in the industry. findings related to incentive compensation will
6. For supervisory purposes, the Federal Reserve (as well be communicated to the organization and
as the other federal bank regulatory agencies) segments the included in the relevant report of examination or
organizations it supervises into different supervisory port-
folios based on, among other things, size, complexity, and risk inspection. In addition, these findings will be
profile. For purposes of this guidance, the LBOs referred to in incorporated, as appropriate, into the organiza-
the guidance are identified in this section as large complex
banking organizations to be consistent with the Federal
7. This guidance does not apply to banking organizations
Reserves other supervisory policies. LBOs are designated by
that do not use incentive compensation.
(1) the OCC as the largest and most complex national banks
8. To facilitate these reviews, where appropriate, a smaller
as defined in the Large Bank Supervision booklet of the
banking organization should review its compensation arrange-
Comptrollers Handbook; (2) the FDIC, large, complex
ments to determine whether it uses incentive compensation
insured depository institutions (IDIs); and (3) the OTS, the
arrangements to a significant extent in its business operations.
largest and most complex savings associations and savings
A smaller banking organization will not be considered a
and loan holding companies.
significant user of incentive compensation arrangements sim-
ply because the organization has a firm-wide profit-sharing or
BHC Supervision Manual July 2010 bonus plan that is based on the banks profitability, even if the
Page 2 plan covers all or most of the organizations employees.
tions rating component(s) and subcomponent(s) arrangements for executive officers as well as
relating to risk-management, internal controls, for non-executive personnel who have the abil-
and corporate governance under the relevant ity to expose a banking organization to material
supervisory rating system, as well as the organi- amounts of risk may, if not properly structured,
zations overall supervisory rating. pose a threat to the organizations safety and
The Federal Reserve (or the organizations soundness. Accordingly, this guidance applies
appropriate federal supervisor) may take to incentive compensation arrangements for:
enforcement action against a banking organiza-
tion if its incentive compensation arrangements 1. Senior executives and others who are respon-
or related risk-management, control, or gover- sible for oversight of the organizations firm-
nance processes pose a risk to the safety and wide activities or material business lines;10
soundness of the organization, particularly when 2. Individual employees, including non-
the organization is not taking prompt and effec- executive employees, whose activities may
tive measures to correct the deficiencies. For expose the organization to material amounts
example, the appropriate federal supervisor may of risk (e.g., traders with large position limits
take an enforcement action if material deficien- relative to the organizations overall risk tol-
cies are found to exist in the organizations erance); and
incentive compensation arrangements or related 3. Groups of employees who are subject to the
risk-management, control, or governance pro- same or similar incentive compensation
cesses, or the organization fails to promptly arrangements and who, in the aggregate, may
develop, submit, or adhere to an effective plan expose the organization to material amounts
designed to ensure that its incentive compensa- of risk, even if no individual employee is
tion arrangements do not encourage imprudent likely to expose the organization to material
risk-taking and are consistent with principles of risk (e.g., loan officers who, as a group,
safety and soundness. As provided under sec- originate loans that account for a material
tion 8 of the Federal Deposit Insurance Act (12 amount of the organizations credit risk).
U.S.C. 1818), an enforcement action may,
among other things, require an organization to For ease of reference, these executive and
take affirmative action, such as developing a non-executive employees are collectively
corrective action plan that is acceptable to the referred to hereafter as covered employees or
appropriate federal supervisor to rectify safety- employees. Depending on the facts and cir-
and-soundness deficiencies in its incentive com- cumstances of the individual organization, the
pensation arrangements or related processes. types of employees or categories of employees
Where warranted, the appropriate federal super- that are outside the scope of this guidance
visor may require the organization to take addi- because they do not have the ability to expose
tional affirmative action to correct or remedy the organization to material risks would likely
deficiencies related to the organizations incen- include, for example, tellers, bookkeepers, cou-
tive compensation practices. riers, or data processing personnel.
Effective and balanced incentive compensa- In determining whether an employee, or
tion practices are likely to evolve significantly group of employees, may expose a banking
in the coming years, spurred by the efforts of organization to material risk, the organization
banking organizations, supervisors, and other
stakeholders. The Federal Reserve will review with the FBOs group-wide policies developed in accordance
and update this guidance as appropriate to incor- with the rules of the FBOs home country supervisor. The
porate best practices that emerge from these policies of the FBOs U.S. operations should also be consis-
efforts. tent with the FBOs overall corporate and management struc-
ture, as well as its framework for risk-management and inter-
nal controls. In addition, the policies for the U.S. operations of
FBOs should be consistent with this guidance.
2068.0.1 SCOPE OF APPLICATION 10. Senior executives include, at a minimum, executive
officers within the meaning of the Federal Reserves Regula-
tion O (see 12 CFR 215.2(e)(1)) and, for publicly traded
The incentive compensation arrangements and companies, named officers within the meaning of the Secu-
related policies and procedures of banking orga- rities and Exchange Commissions rules on disclosure of
nizations should be consistent with principles of executive compensation (see 17 CFR 229.402(a)(3)). Savings
safety and soundness.9 Incentive compensation associations should also refer to OTSs rule on loans by
saving associations to their executive officers, directors, and
principal shareholders. (12 CFR 563.43).
9. In the case of the U.S. operations of FBOs, the organiza-
tions policies, including management, review, and approval BHC Supervision Manual July 2010
requirements for its U.S. operations, should be coordinated Page 3
should consider the full range of inherent risks procedures and risk controls that ordinarily limit
arising from, or generated by, the employees risk-taking do not obviate the need for incentive
activities, even if the organization uses risk- compensation arrangements to properly balance
management processes or controls to limit the risk-taking incentives.
risks such activities ultimately may pose to the
organization. Moreover, risks should be consid-
ered to be material for purposes of this guidance 2068.0.2 PRINCIPLES OF A SOUND
if they are material to the organization, or are INCENTIVE COMPENSATION
material to a business line or operating unit that SYSTEM
is itself material to the organization.11
For purposes of illustration, assume that a 2068.0.2.1 Principle 1: Balanced
banking organization has a structured-finance Risk-Taking Incentives
unit that is material to the organization. A group
of employees within that unit who originate Incentive compensation arrangements should
structured-finance transactions that may expose balance risk and financial results in a manner
the unit to material risks should be considered that does not encourage employees to expose
covered employees for purposes of this guid- their organizations to imprudent risks.
ance even if those transactions must be
approved by an independent risk function prior Incentive compensation arrangements typically
to consummation, or the organization uses other attempt to encourage actions that result in
processes or methods to limit the risk that such greater revenue or profit for the organization.
transactions may present to the organization. However, short-run revenue or profit can often
Strong and effective risk-management and diverge sharply from actual long-run profit
internal control functions are critical to the because risk outcomes may become clear only
safety and soundness of banking organizations. over time. Activities that carry higher risk typi-
However, irrespective of the quality of these cally yield higher short-term revenue, and an
functions, poorly designed or managed incen- employee who is given incentives to increase
tive compensation arrangements can themselves short-term revenue or profit, without regard to
be a source of risk to a banking organization. risk, will naturally be attracted to opportunities
For example, incentive compensation arrange- to expose the organization to more risk.
ments that provide employees strong incentives An incentive compensation arrangement is
to increase the organizations short-term rev- balanced when the amounts paid to an employee
enues or profits, without regard to the short- or appropriately take into account the risks (includ-
long-term risk associated with such business, ing compliance risks), as well as the financial
can place substantial strain on the risk- benefits, from the employees activities and the
management and internal control functions of impact of those activities on the organizations
even well-managed organizations. safety and soundness. As an example, under a
Moreover, poorly balanced incentive compen- balanced incentive compensation arrangement,
sation arrangements can encourage employees two employees who generate the same amount
to take affirmative actions to weaken or circum- of short-term revenue or profit for an organiza-
vent the organizations risk-management or tion should not receive the same amount of
internal control functions, such as by providing incentive compensation if the risks taken by the
inaccurate or incomplete information to these employees in generating that revenue or profit
functions, to boost the employees personal differ materially. The employee whose activities
compensation. Accordingly, sound compensa- create materially larger risks for the organiza-
tion practices are an integral part of strong risk- tion should receive less than the other employee,
management and internal control functions. A all else being equal.
key goal of this guidance is to encourage bank- The performance measures used in an incen-
ing organizations to incorporate the risks related tive compensation arrangement have an impor-
to incentive compensation into their broader tant effect on the incentives provided employees
risk-management framework. Risk-management and, thus, the potential for the arrangement to
encourage imprudent risk-taking. For example,
if an employees incentive compensation pay-
11. Thus, risks may be material to an organization even if
they are not large enough themselves to threaten the solvency
ments are closely tied to short-term revenue or
of the organization. profit of business generated by the employee,
without any adjustments for the risks associated
BHC Supervision Manual July 2010 with the business generated, the potential for the
Page 4 arrangement to encourage imprudent risk-taking
may be quite strong. Similarly, traders who ated with subprime loans versus prime loans).12
work with positions that close at year-end could In addition, some risks (or combinations of risky
have an incentive to take large risks toward the strategies and positions) may have a low prob-
end of a year if there is no mechanism for ability of being realized, but would have highly
factoring how such positions perform over a adverse effects on the organization if they were
longer period of time. The same result could to be realized (bad tail risks). While share-
ensue if the performance measures themselves holders may have less incentive to guard against
lack integrity or can be manipulated inappropri- bad tail risks because of the infrequency of their
ately by the employees receiving incentive realization and the existence of the federal
compensation. safety net, these risks warrant special attention
On the other hand, if an employees incentive for safety-and-soundness reasons given the
compensation payments are determined based threat they pose to the organizations solvency
on performance measures that are only distantly and the federal safety net.
linked to the employees activities (e.g., for Banking organizations should consider the
most employees, organization-wide profit), the full range of current and potential risks associ-
potential for the arrangement to encourage the ated with the activities of covered employees,
employee to take imprudent risks on behalf of including the cost and amount of capital and
the organization may be weak. For this reason, liquidity needed to support those risks, in devel-
plans that provide for awards based solely on oping balanced incentive compensation arrange-
overall organization-wide performance are ments. Reliable quantitative measures of risk
unlikely to provide employees, other than senior and risk outcomes (quantitative measures),
executives and individuals who have the ability where available, may be particularly useful in
to materially affect the organizations overall developing balanced compensation arrange-
risk profile, with unbalanced risk-taking ments and in assessing the extent to which
incentives. arrangements are properly balanced. However,
Incentive compensation arrangements should reliable quantitative measures may not be avail-
not only be balanced in design, they also should able for all types of risk or for all activities, and
be implemented so that actual payments vary their utility for use in compensation arrange-
based on risks or risk outcomes. If, for example, ments varies across business lines and employ-
employees are paid substantially all of their ees. The absence of reliable quantitative mea-
potential incentive compensation even when risk sures for certain types of risks or outcomes does
or risk outcomes are materially worse than not mean that banking organizations should
expected, employees have less incentive to ignore such risks or outcomes for purposes of
avoid activities with substantial risk. assessing whether an incentive compensation
arrangement achieves balance. For example,
while reliable quantitative measures may not
Banking organizations should consider the exist for many bad-tail risks, it is important that
full range of risks associated with an employ- such risks be considered given their potential
ees activities, as well as the time horizon effect on safety and soundness. As in other
over which those risks may be realized, in risk-management areas, banking organizations
assessing whether incentive compensation should rely on informed judgments, supported
arrangements are balanced. by available data, to estimate risks and risk
outcomes in the absence of reliable quantitative
The activities of employees may create a wide risk measures.
range of risks for a banking organization, such Large complex banking organizations. In
as credit, market, liquidity, operational, legal, designing and modifying incentive compensa-
compliance, and reputational risks, as well as tion arrangements, LCBOs should assess in
other risks to the viability or operation of the advance of implementation whether such
organization. Some of these risks may be real-
ized in the short term, while others may become
apparent only over the long term. For example, 12. Importantly, the time horizon over which a risk out-
come may be realized is not necessarily the same as the stated
future revenues that are booked as current maturity of an exposure. For example, the ongoing reinvest-
income may not materialize, and short-term ment of funds by a cash management unit in commercial
profit-and-loss measures may not appropriately paper with a one-day maturity not only exposes the organiza-
reflect differences in the risks associated with tion to one-day credit risk, but also exposes the organization
to liquidity risk that may be realized only infrequently.
the revenue derived from different activities
(e.g., the higher credit or compliance risk associ- BHC Supervision Manual July 2010
Page 5
arrangements are likely to provide balanced outcomes either formulaically or judgmen-

risk-taking incentives. Simulation analysis of tally, subject to appropriate oversight. To be
incentive compensation arrangements is one most effective, the deferral period should be
way of doing so. Such analysis uses forward- sufficiently long to allow for the realization
looking projections of incentive compensation of a substantial portion of the risks from
awards and payments based on a range of per- employee activities, and the measures of loss
formance levels, risk outcomes, and levels of should be clearly explained to employees
risks taken. This type of analysis, or other analy- and closely tied to their activities during the
sis that results in assessments of likely effective- relevant performance period.
ness, can help an LCBO assess whether incen- 3. Longer Performance Periods: The time
tive compensation awards and payments to an period covered by the performance measures
employee are likely to be reduced appropriately used in determining an employees award is
as the risks to the organization from the employ- extended (for example, from one year to two
ees activities increase. or more years). Longer performance periods
and deferral of payment are related in that
An unbalanced arrangement can be moved both methods allow awards or payments to
toward balance by adding or modifying fea- be made after some or all risk outcomes are
tures that cause the amounts ultimately realized or better known.
received by employees to appropriately reflect 4. Reduced Sensitivity to Short-Term Perfor-
risk and risk outcomes. mance: The banking organization reduces
the rate at which awards increase as an
If an incentive compensation arrangement employee achieves higher levels of the rel-
may encourage employees to expose their bank- evant performance measure(s). Rather than
ing organization to imprudent risks, the organi- offsetting risk-taking incentives associated
zation should modify the arrangement as needed with the use of short-term performance mea-
to ensure that it is consistent with safety and sures, this method reduces the magnitude of
soundness. Four methods are often used to make such incentives. This method also can
compensation more sensitive to risk. These include improving the quality and reliability
methods are: of performance measures in taking into
account both short-term and long-term risks,
1. Risk Adjustment of Awards: The amount of for example improving the reliability and
an incentive compensation award for an accuracy of estimates of revenues and long-
employee is adjusted based on measures that term profits upon which performance mea-
take into account the risk the employees sures depend.14
activities may pose to the organization. Such
measures may be quantitative, or the size of These methods for achieving balance are not
a risk adjustment may be set judgmentally, exclusive, and additional methods or variations
subject to appropriate oversight. may exist or be developed. Moreover, each
2. Deferral of Payment: The actual payout of method has its own advantages and disadvan-
an award to an employee is delayed signifi- tages. For example, where reliable risk mea-
cantly beyond the end of the performance sures exist, risk adjustment of awards may be
period, and the amounts paid are adjusted for more effective than deferral of payment in
actual losses or other aspects of performance reducing incentives for imprudent risk-taking.
that are realized or become better known This is because risk adjustment potentially can
only during the deferral period.13 Deferred take account of the full range and time horizon
payouts may be altered according to risk of risks, rather than just those risk outcomes that
occur or become more evident during the defer-
13. The deferral-of-payment method is sometimes referred ral period. On the other hand, deferral of pay-
to in the industry as a clawback. The term clawback also ment may be more effective than risk adjust-
may refer specifically to an arrangement under which an ment in mitigating incentives to take hard-to-
employee must return incentive compensation payments pre-
viously received by the employee (and not just deferred) if measure risks (such as the risks of new activities
certain risk outcomes occur. Section 304 of the Sarbanes-
Oxley Act of 2002 (15 U.S.C. 7243), which applies to chief
14. Performance targets may have a material effect on
executive officers and chief financial officers of public bank-
risk-taking incentives. Such targets may offer employees
ing organizations, is an example of this more specific type of
greater rewards for increments of performance that are above
clawback requirement.
the target or may provide that awards will be granted only if a
target is met or exceeded. Employees may be particularly
BHC Supervision Manual July 2010 motivated to take imprudent risk in order to reach perfor-
Page 6 mance targets that are aggressive, but potentially achievable.
or products, or certain risks such as reputational sation arrangements should be tailored to

or operational risk that may be difficult to mea- account for the differences between
sure with respect to particular activities), espe- employeesincluding the substantial differ-
cially if such risks are likely to be realized ences between senior executives and other
during the deferral period. Accordingly, in some employeesas well as between banking
cases two or more methods may be needed in organizations.
combination for an incentive compensation
arrangement to be balanced. Activities and risks may vary significantly
The greater the potential incentives an both across banking organizations and across
arrangement creates for an employee to increase employees within a particular banking organiza-
the risks associated with the employees activi- tion. For example, activities, risks, and incentive
ties, the stronger the effect should be of the compensation practices may differ materially
methods applied to achieve balance. Thus, for among banking organizations based on, among
example, risk adjustments used to counteract a other things, the scope or complexity of activi-
materially unbalanced compensation arrange- ties conducted and the business strategies pur-
ment should have a similarly material impact on sued by the organizations. These differences
the incentive compensation paid under the mean that methods for achieving balanced com-
arrangement. Further, improvements in the qual- pensation arrangements at one organization may
ity and reliability of performance measures not be effective in restraining incentives to
themselves, for example improving the relia- engage in imprudent risk-taking at another orga-
bility and accuracy of estimates of revenues and nization. Each organization is responsible for
profits upon which performance measures ensuring that its incentive compensation
depend, can significantly improve the degree of arrangements are consistent with the safety and
balance in risk-taking incentives. soundness of the organization.
Where judgment plays a significant role in Moreover, the risks associated with the activi-
the design or operation of an incentive compen- ties of one group of non-executive employees
sation arrangement, strong policies and proce- (e.g., loan originators) within a banking organi-
dures, internal controls, and ex post monitoring zation may differ significantly from those of
of incentive compensation payments relative to another group of non-executive employees (e.g.,
actual risk outcomes are particularly important spot foreign exchange traders) within the orga-
to help ensure that the arrangements as imple- nization. In addition, reliable quantitative mea-
mented are balanced and do not encourage sures of risk and risk outcomes are unlikely to
imprudent risk-taking. For example, if a bank- be available for a banking organization as a
ing organization relies to a significant degree on whole, particularly a large, complex organiza-
the judgment of one or more managers to ensure tion. This factor can make it difficult for bank-
that the incentive compensation awards to ing organizations to achieve balanced compen-
employees are appropriately risk-adjusted, the sation arrangements for senior executives who
organization should have policies and proce- have responsibility for managing risks on an
dures that describe how managers are expected organization-wide basis solely through use of
to exercise that judgment to achieve balance and the risk-adjustment-of-award method.
that provide for the manager(s) to receive appro-
priate available information about the employ- Furthermore, the payment of deferred incen-
ees risk-taking activities to make informed tive compensation in equity (such as restricted
judgments. stock of the organization) or equity-based instru-
Large complex banking organizations. Meth- ments (such as options to acquire the organiza-
ods and practices for making compensation sen- tions stock) may be helpful in restraining the
sitive to risk are likely to evolve rapidly during risk-taking incentives of senior executives and
the next few years, driven in part by the efforts other covered employees whose activities may
of supervisors and other stakeholders. LCBOs have a material effect on the overall financial
should actively monitor developments in the performance of the organization. However,
field and should incorporate into their incentive equity-related deferred compensation may not
compensation systems new or emerging meth- be as effective in restraining the incentives of
ods or practices that are likely to improve the lower-level covered employees (particularly at
organizations long-term financial well-being large organizations) to take risks because such
and safety and soundness. employees are unlikely to believe that their
The manner in which a banking organization BHC Supervision Manual July 2010
seeks to achieve balanced incentive compen- Page 7
actions will materially affect the organizations compensation to affect the risk-taking behav-
stock price. ior of employees while at the organizations.
Banking organizations should take account of
these differences when constructing balanced Arrangements that provide for an employee
compensation arrangements. For most banking (typically a senior executive), upon departure
organizations, the use of a single, formulaic from the organization or a change in control of
approach to making employee incentive com- the organization, to receive large additional pay-
pensation arrangements appropriately risk- ments or the accelerated payment of deferred
sensitive is likely to result in arrangements that amounts without regard to risk or risk outcomes
are unbalanced at least with respect to some can provide the employee significant incentives
employees.15 to expose the organization to undue risk. For
Large complex banking organizations. Incen- example, an arrangement that provides an
tive compensation arrangements for senior employee with a guaranteed payout upon depar-
executives at LCBOs are likely to be better ture from an organization, regardless of perfor-
balanced if they involve deferral of a substantial mance, may neutralize the effect of any balanc-
portion of the executives incentive compensa- ing features included in the arrangement to help
tion over a multi-year period in a way that prevent imprudent risk-taking.
reduces the amount received in the event of Banking organizations should carefully
poor performance, substantial use of multi-year review any such existing or proposed arrange-
performance periods, or both. Similarly, the ments (sometimes called golden parachutes)
compensation arrangements for senior execu- and the potential impact of such arrangements
tives at LCBOs are likely to be better balanced on the organizations safety and soundness. In
if a significant portion of the incentive compen- appropriate circumstances an organization
sation of these executives is paid in the form of should consider including balancing features
equity-based instruments that vest over multiple such as risk adjustment or deferral requirements
years, with the number of instruments ulti- that extend past the employees departurein
mately received dependent on the performance the arrangements to mitigate the potential for
of the organization during the deferral period. the arrangements to encourage imprudent risk-
The portion of the incentive compensation of taking. In all cases, a banking organization
other covered employees that is deferred or paid should ensure that the structure and terms of any
in the form of equity-based instruments should golden parachute arrangement entered into by
appropriately take into account the level, nature, the organization do not encourage imprudent
and duration of the risks that the employees risk-taking in light of the other features of the
activities create for the organization and the employees incentive compensation arrange-
extent to which those activities may materially ments.
affect the overall performance of the organiza- Large complex banking organizations. Provi-
tion and its stock price. Deferral of a substantial sions that require a departing employee to for-
portion of an employees incentive compensa- feit deferred incentive compensation payments
tion may not be workable for employees at may weaken the effectiveness of the deferral
lower pay scales because of their more limited arrangement if the departing employee is able to
financial resources. This may require increased negotiate a golden handshake arrangement
reliance on other measures in the incentive com- with the new employer.16 This weakening effect
pensation arrangements for these employees to can be particularly significant for senior execu-
achieve balance. tives or other skilled employees at LCBOs
whose services are in high demand within the
Banking organizations should carefully con- market.
sider the potential for golden parachutes Golden handshake arrangements present spe-
and the vesting arrangements for deferred cial issues for LCBOs and supervisors. For
example, while a banking organization could
adjust its deferral arrangements so that depart-
15. For example, spreading payouts of incentive compen-
sation awards over a standard three-year period may not ing employees will continue to receive any
appropriately reflect the differences in the type and time accrued deferred compensation after departure
horizon of risk associated with the activities of different
groups of employees, and may not be sufficient by itself to
balance the compensation arrangements of employees who
16. Golden handshakes are arrangements that compensate
may expose the organization to substantial longer-term risks.
an employee for some or all of the estimated, non-adjusted
value of deferred incentive compensation that would have
BHC Supervision Manual July 2010 been forfeited upon departure from the employees previous
Page 8 employment.
(subject to any clawback or malus17), these 2068.0.2.2 Principle 2: Compatibility

changes could reduce the employees incentive with Effective Controls and
to remain at the organization and, thus, weaken Risk-Management
an organizations ability to retain qualified tal-
ent, which is an important goal of compensa- A banking organizations risk-management pro-
tion, and create conflicts of interest. Moreover, cesses and internal controls should reinforce
actions of the hiring organization (which may or and support the development and maintenance
may not be a supervised banking organization) of balanced incentive compensation arrange-
ultimately may defeat these or other risk- ments.
balancing aspects of a banking organizations
deferral arrangements. LCBOs should monitor In order to increase their own compensation,
whether golden handshake arrangements are employees may seek to evade the processes
materially weakening the organizations efforts established by a banking organization to achieve
to constrain the risk-taking incentives of balanced compensation arrangements. Similarly,
employees. The Federal Reserve will continue an employee covered by an incentive compensa-
to work with banking organizations and others tion arrangement may seek to influence, in ways
to develop appropriate methods for addressing designed to increase the employees pay, the
any effect that such arrangements may have on risk measures or other information or judgments
the safety and soundness of banking organiza- that are used to make the employees pay sensi-
tions. tive to risk.
Such actions may significantly weaken the
Banking organizations should effectively com- effectiveness of an organizations incentive
municate to employees the ways in which compensation arrangements in restricting impru-
incentive compensation awards and payments dent risk-taking. These actions can have a par-
will be reduced as risks increase. ticularly damaging effect on the safety and
soundness of the organization if they result in
In order for the risk-sensitive provisions of the weakening of risk measures, information, or
incentive compensation arrangements to affect judgments that the organization uses for other
employee risk-taking behavior, the organiza- risk-management, internal control, or financial
tions employees need to understand that the purposes. In such cases, the employees actions
amount of incentive compensation that they may may weaken not only the balance of the organi-
receive will vary based on the risk associated zations incentive compensation arrangements,
with their activities. Accordingly, banking orga- but also the risk-management, internal controls,
nizations should ensure that employees covered and other functions that are supposed to act as a
by an incentive compensation arrangement are separate check on risk-taking. For this reason,
informed about the key ways in which risks are traditional risk-management controls alone do
taken into account in determining the amount of not eliminate the need to identify employees
incentive compensation paid. Where feasible, an who may expose the organization to material
organizations communications with employees risk, nor do they obviate the need for the incen-
should include examples of how incentive com- tive compensation arrangements for these
pensation payments may be adjusted to reflect employees to be balanced. Rather, a banking
projected or actual risk outcomes. An organiza- organizations risk-management processes and
tions communications should be tailored appro- internal controls should reinforce and support
priately to reflect the sophistication of the rel- the development and maintenance of balanced
evant audience(s). incentive compensation arrangements.
Banking organizations should have appropri-

ate controls to ensure that their processes for
achieving balanced compensation arrange-
ments are followed and to maintain the integ-
rity of their risk-management and other func-
17. A malus arrangement permits the employer to prevent tions.
vesting of all or part of the amount of a deferred remuneration
award. Malus provisions are invoked when risk outcomes are To help prevent damage from occurring, a
worse than expected or when the information upon which the
award was based turns out to have been incorrect. Loss of
banking organization should have strong con-
unvested compensation due to the employee voluntarily leav-
ing the firm is not an example of malus as the term is used in BHC Supervision Manual July 2010
this guidance. Page 9
trols governing its process for designing, imple- they achieve balance over time requires an
menting, and monitoring incentive compensa- understanding of the risks (including compli-
tion arrangements. Banking organizations ance risks) and potential risk outcomes associ-
should create and maintain sufficient documen- ated with the activities of the relevant employ-
tation to permit an audit of the effectiveness of ees. Accordingly, banking organizations should
the organizations processes for establishing, have policies and procedures that ensure that
modifying, and monitoring incentive compensa- risk-management personnel have an appropriate
tion arrangements. Smaller banking organiza- role in the organizations processes for design-
tions should incorporate reviews of these pro- ing incentive compensation arrangements and
cesses into their overall framework for for assessing their effectiveness in restraining
compliance monitoring (including internal imprudent risk-taking.18 Ways that risk manag-
audit). ers might assist in achieving balanced compen-
Large complex banking organizations. sation arrangements include, but are not limited
LCBOs should have and maintain policies and to
procedures that (1) identify and describe the
role(s) of the personnel, business units, and con- 1. reviewing the types of risks associated with
trol units authorized to be involved in the the activities of covered employees;
design, implementation, and monitoring of 2. approving the risk measures used in risk
incentive compensation arrangements; (2) iden- adjustments and performance measures, as
tify the source of significant risk-related inputs well as measures of risk outcomes used in
into these processes and establish appropriate deferred-payout arrangements; and
controls governing the development and 3. analyzing risk-taking and risk outcomes rela-
approval of these inputs to help ensure their tive to incentive compensation payments.
integrity; and (3) identify the individual(s) and
control unit(s) whose approval is necessary for Other functions within an organization, such
the establishment of new incentive compensa- as its control, human resources, or finance func-
tion arrangements or modification of existing tions, also play an important role in helping
arrangements. ensure that incentive compensation arrange-
An LCBO also should conduct regular inter- ments are balanced. For example, these func-
nal reviews to ensure that its processes for tions may contribute to the design and review of
achieving and maintaining balanced incentive performance measures used in compensation
compensation arrangements are consistently fol- arrangements or may supply data used as part of
lowed. Such reviews should be conducted by these measures.
audit, compliance, or other personnel in a man-
ner consistent with the organizations overall Compensation for employees in risk-
framework for compliance monitoring. An management and control functions should be
LCBOs internal audit department also should sufficient to attract and retain qualified per-
separately conduct regular audits of the organi- sonnel and should avoid conflicts of interest.
zations compliance with its established policies
and controls relating to incentive compensation The risk-management and control personnel
arrangements. The results should be reported to involved in the design, oversight, and operation
appropriate levels of management and, where of incentive compensation arrangements should
appropriate, the organizations board of have appropriate skills and experience needed to
directors. effectively fulfill their roles. These skills and
experiences should be sufficient to equip the
Appropriate personnel, including risk- personnel to remain effective in the face of
management personnel, should have input challenges by covered employees seeking to
into the organizations processes for design- increase their incentive compensation in ways
ing incentive compensation arrangements and that are inconsistent with sound risk-
assessing their effectiveness in restraining management or internal controls. The compen-
imprudent risk-taking. sation arrangements for employees in risk-
management and control functions thus should
Developing incentive compensation arrange- be sufficient to attract and retain qualified per-
ments that provide balanced risk-taking incen-
18. Involvement of risk-management personnel in the
tives and monitoring arrangements to ensure design and monitoring of these arrangements also should help
ensure that the organizations risk-management functions can
BHC Supervision Manual July 2010 properly understand and address the full range of risks facing
Page 10 the organization.
sonnel with experience and expertise in these sound compensation practices, including active
fields that is appropriate in light of the size, and effective oversight by the board of directors.
activities, and complexity of the organization.
In addition, to help preserve the indepen- Given the key role of senior executives in man-
dence of their perspectives, the incentive com- aging the overall risk-taking activities of an
pensation received by risk-management and organization, the board of directors of a banking
control personnel staff should not be based sub- organization should directly approve the incen-
stantially on the financial performance of the tive compensation arrangements for senior
business units that they review. Rather, the per- executives.19 The board also should approve
formance measures used in the incentive com- and document any material exceptions or adjust-
pensation arrangements for these personnel ments to the incentive compensation arrange-
should be based primarily on the achievement ments established for senior executives and
of the objectives of their functions (e.g., adher- should carefully consider and monitor the
ence to internal controls). effects of any approved exceptions or adjust-
ments on the balance of the arrangement, the
Banking organizations should monitor the risk-taking incentives of the senior executive,
performance of their incentive compensation and the safety and soundness of the
arrangements and should revise the arrange- organization.
ments as needed if payments do not appropri- The board of directors of an organization
ately reflect risk. also is ultimately responsible for ensuring that
the organizations incentive compensation
Banking organizations should monitor incen- arrangements for all covered employees are
tive compensation awards and payments, risks appropriately balanced and do not jeopardize
taken, and actual risk outcomes to determine the safety and soundness of the organization.
whether incentive compensation payments to The involvement of the board of directors in
employees are reduced to reflect adverse risk oversight of the organizations overall incen-
outcomes or high levels of risk taken. Results tive compensation program should be scaled
should be reported to appropriate levels of man- appropriately to the scope and prevalence of
agement, including the board of directors where the organizations incentive compensation
warranted and consistent with Principle 3 below. arrangements.
The monitoring methods and processes used by Large complex banking organizations and
a banking organization should be commensurate organizations that are significant users of incen-
with the size and complexity of the organiza- tive compensation. The board of directors of an
tion, as well as its use of incentive compensa- LCBO or other banking organization that uses
tion. Thus, for example, a small, noncomplex incentive compensation to a significant extent
organization that uses incentive compensation should actively oversee the development and
only to a limited extent may find that it can operation of the organizations incentive com-
appropriately monitor its arrangements through pensation policies, systems, and related control
normal management processes. processes. The board of directors of such an
A banking organization should take the organization should review and approve the
results of such monitoring into account in estab- overall goals and purposes of the organizations
lishing or modifying incentive compensation incentive compensation system. In addition, the
arrangements and in overseeing associated con- board should provide clear direction to manage-
trols. If, over time, incentive compensation paid ment to ensure that the goals and policies it
by a banking organization does not appropri- establishes are carried out in a manner that
ately reflect risk outcomes, the organization
should review and revise its incentive compen- 19. As used in this guidance, the term board of directors
sation arrangements and related controls to is used to refer to the members of the board of directors who
ensure that the arrangements, as designed and have primary responsibility for overseeing the incentive com-
implemented, are balanced and do not provide pensation system. Depending on the manner in which the
board is organized, the term may refer to the entire board of
employees incentives to take imprudent risks. directors, a compensation committee of the board, or another
committee of the board that has primary responsibility for
overseeing the incentive compensation system. In the case of
FBOs, the term refers to the relevant oversight body for the
2068.0.2.3 Principle 3: Strong Corporate firms U.S. operations, consistent with the FBOs overall
Governance corporate and management structure.
Banking organizations should have strong and BHC Supervision Manual July 2010
effective corporate governance to help ensure Page 11
achieves balance and is consistent with safety Large complex banking organizations and
and soundness. organizations that are significant users of incen-
The board of directors of such an organiza- tive compensation. The board of an LCBO or
tion also should ensure that steps are taken so other organization that uses incentive compensa-
that the incentive compensation system tion to a significant extent should receive and
including performance measures and targetsis review, on an annual or more frequent basis, an
designed and operated in a manner that will assessment by management, with appropriate
achieve balance. input from risk-management personnel, of the
effectiveness of the design and operation of the
The board of directors should monitor the organizations incentive compensation system
performance, and regularly review the design in providing risk-taking incentives that are con-
and function, of incentive compensation sistent with the organizations safety and sound-
arrangements. ness. These reports should include an evaluation
of whether or how incentive compensation prac-
To allow for informed reviews, the board tices may increase the potential for imprudent
should receive data and analysis from manage- risk-taking.
ment or other sources that are sufficient to allow The board of such an organization also should
the board to assess whether the overall design receive periodic reports that review incentive
and performance of the organizations incentive compensation awards and payments relative to
compensation arrangements are consistent with risk outcomes on a backward-looking basis to
the organizations safety and soundness. These determine whether the organizations incentive
reviews and reports should be appropriately compensation arrangements may be promoting
scoped to reflect the size and complexity of the imprudent risk-taking. Boards of directors of
banking organizations activities and the preva- these organizations also should consider periodi-
lence and scope of its incentive compensation cally obtaining and reviewing simulation analy-
arrangements. sis of compensation on a forward-looking basis
The board of directors of a banking organiza- based on a range of performance levels, risk
tion should closely monitor incentive compensa- outcomes, and the amount of risks taken.
tion payments to senior executives and the sen-
sitivity of those payments to risk outcomes. In The organization, composition, and resources
addition, if the compensation arrangement for a of the board of directors should permit effec-
senior executive includes a clawback provision, tive oversight of incentive compensation.
then the review should include sufficient infor-
mation to determine if the provision has been The board of directors of a banking organiza-
triggered and executed as planned. tion should have, or have access to, a level of
The board of directors of a banking organiza- expertise and experience in risk-management
tion should seek to stay abreast of significant and compensation practices in the financial ser-
emerging changes in compensation plan mecha- vices industry that is appropriate for the nature,
nisms and incentives in the marketplace as well scope, and complexity of the organizations
as developments in academic research and regu- activities. This level of expertise may be present
latory advice regarding incentive compensation collectively among the members of the board,
policies. However, the board should recognize may come from formal training or from experi-
that organizations, activities, and practices ence in addressing these issues, including as a
within the industry are not identical. Incentive director, or may be obtained through advice
compensation arrangements at one organization received from outside counsel, consultants, or
may not be suitable for use at another organiza- other experts with expertise in incentive com-
tion because of differences in the risks, controls, pensation and risk-management. The board of
structure, and management among organiza- directors of an organization with less complex
tions. The board of directors of each organiza- and extensive incentive compensation arrange-
tion is responsible for ensuring that the incen- ments may not find it necessary or appropriate
tive compensation arrangements for its to require special board expertise or to retain
organization do not encourage employees to and use outside experts in this area.
take risks that are beyond the organizations In selecting and using outside parties, the
ability to manage effectively, regardless of the board of directors should give due attention to
practices employed by other organizations. potential conflicts of interest arising from other
dealings of the parties with the organization or
BHC Supervision Manual July 2010 for other reasons. The board also should exer-
Page 12 cise caution to avoid allowing outside parties to
obtain undue levels of influence. While the tion disclosed by the organization should be
retention and use of outside parties may be tailored to the nature and complexity of the
helpful, the board retains ultimate responsibility organization and its incentive compensation
for ensuring that the organizations incentive arrangements.22
compensation arrangements are consistent with
safety and soundness. Large complex banking organizations should
Large complex banking organizations and follow a systematic approach to developing a
organizations that are significant users of incen- compensation system that has balanced incen-
tive compensation. If a separate compensation tive compensation arrangements.
committee is not already in place or required by
other authorities,20 the board of directors of an At banking organizations with large numbers
LCBO or other banking organization that uses of risk-taking employees engaged in diverse
incentive compensation to a significant extent activities, an ad hoc approach to developing
should consider establishing such a balanced arrangements is unlikely to be reliable.
committeereporting to the full boardthat Thus, an LCBO should use a systematic
has primary responsibility for overseeing the approachsupported by robust and formalized
organizations incentive compensation systems. policies, procedures, and systemsto ensure
A compensation committee should be composed that those arrangements are appropriately bal-
solely or predominantly of non-executive direc- anced and consistent with safety and soundness.
tors. If the board does not have such a compen- Such an approach should provide for the organi-
sation committee, the board should take other zation effectively to:
steps to ensure that non-executive directors of
the board are actively involved in the oversight 1. Identify employees who are eligible to
of incentive compensation systems. The com- receive incentive compensation and whose
pensation committee should work closely with activities may expose the organization to
any board-level risk and audit committees where material risks. These employees should
the substance of their actions overlap. include
a. senior executives and others who are
A banking organizations disclosure prac- responsible for oversight of the organiza-
tices should support safe and sound incentive tions firm-wide activities or material
compensation arrangements. business lines;
b. individual employees, including non-
If a banking organizations incentive compen- executive employees, whose activities
sation arrangements provide employees incen- may expose the organization to material
tives to take risks that are beyond the tolerance amounts of risk; and
of the organizations shareholders, these risks c. groups of employees who are subject to
are likely to also present a risk to the safety and the same or similar incentive compensa-
soundness of the organization.21 To help pro- tion arrangements and who, in the aggre-
mote safety and soundness, a banking organiza- gate, may expose the organization to
tion should provide an appropriate amount of material amounts of risk;
information concerning its incentive compensa- 2. Identify the types and time horizons of risks
tion arrangements for executive and non- to the organization from the activities of
executive employees and related risk- these employees;
management, control, and governance processes 3. Assess the potential for the performance
to shareholders to allow them to monitor and, measures included in the incentive compen-
where appropriate, take actions to restrain the sation arrangements for these employees to
potential for such arrangements and processes encourage the employees to take imprudent
that encourage employees to take imprudent risks;
risks. Such disclosures should include informa- 4. Include balancing elements, such as risk
tion relevant to employees other than senior
executives. The scope and level of the informa- 22. A banking organization also should comply with the
incentive compensation disclosure requirements of the federal
securities law and other laws as applicable. See, for example,
20. See New York Stock Exchange Listed Company
Proxy Disclosure Enhancements, SEC Release Nos. 33-9089,
Manual Section 303A.05(a); Nasdaq Listing Rule 5605(d);
34-61175, 74 F.R. 68334 (Dec. 23, 2009) (to be codified at 17
Internal Revenue Code section 162(m) (26 U.S.C. 162(m)).
C.F.R. 229 and 249).
21. On the other hand, as noted previously, compensation
arrangements that are in the interests of the shareholders of a
banking organization are not necessarily consistent with safety BHC Supervision Manual July 2010
and soundness. Page 13
adjustments or deferral periods, within the behavior and are consistent with the safety and
incentive compensation arrangements for soundness of the organization. The Federal
these employees that are reasonably designed Reserve expects banking organizations to take
to ensure that the arrangement will be bal- prompt action to address deficiencies in their
anced in light of the size, type, and time incentive compensation arrangements or related
horizon of the inherent risks of the employ- risk-management, control, and governance
ees activities; processes.
5. Communicate to the employees the ways in The Federal Reserve intends to actively moni-
which their incentive compensation awards tor the actions taken by banking organizations
or payments will be adjusted to reflect the in this area and will promote further advances in
risks of their activities to the organization; designing and implementing balanced incentive
and compensation arrangements. Where appropri-
6. Monitor incentive compensation awards, ate, the Federal Reserve will take supervisory or
payments, risks taken, and risk outcomes for enforcement action to ensure that material defi-
these employees and modify the relevant ciencies that pose a threat to the safety and
arrangements if payments made are not soundness of the organization are promptly
appropriately sensitive to risk and risk addressed. The Federal Reserve also will update
outcomes. this guidance as appropriate to incorporate best
practices as they develop over time.
2068.0.3 CONCLUSION ON SOUND

INCENTIVE COMPENSATION
Banking organizations are responsible for ensur-
ing that their incentive compensation arrange-
ments do not encourage imprudent risk-taking

Page 14
Taxes (Consolidated Tax Filing)
Section 2070.0
WHATS NEW IN THIS REVISED
SECTION Parent Non- Non- Consoli-
Only Bank bank A bank B dated
Effective July 2014, this section is revised to
Contribution to
include a June 13, 2014, interagency Addendum consolidated net
to the 1998 Interagency Policy Statement on taxable income
Income Tax Allocation in a Holding Company (loss): $(100) $2,000 $500 $(50) $2,350
Structure (Addendum). The Board of Gover- Assumed tax
rate 40% 40% 40% 40% 40%
nors of the Federal Reserve System, Federal
Deposit Insurance Corporation, and the Office Tax payment/
of the Comptroller of the Currency (Agencies) (benefit) $(40) $ 800 $200 $(20) $ 940
announced the issuance of the Addendum to
ensure that insured depository institutions (IDIs)
in a consolidated group maintain an appropri- In this example, the parent, as the representa-
ate relationship regarding the payment of taxes tive of the consolidated group to the Internal
and treatment of tax refunds. The purpose of the Revenue Service, would collect $800 from the
Addendum is to ensure that tax allocation agree- bank subsidiary and $200 from Nonbank Sub-
ments expressly acknowledge an agency rela- sidiary A, and pay $20 to Nonbank Subsidiary
tionship between a holding company1 and its B. In return, the parent would remit to the tax
subsidiary IDI to protect the IDIs ownership authorities $940, resulting in a net cash reten-
rights in tax refunds. State member banks and tion of $40 by the parent.
holding companies should implement the guid- Bank holding companies employ numerous
ance as soon as reasonably possible, which the methods to determine the amount of estimated
Agency expect would not be later than October payments to be received from their subsidiaries.
31, 2014. This Addendum clarifies and supple- Although the tax-accounting methods to be used
ments but does not replace the 1998 Interagency by bank holding companies are not prescribed
Policy Statement. (Refer to SR-14-6.) by the Federal Reserve System, the method
employed must afford subsidiaries equitable
A holding company and its depository institu- treatment compared with filing separate returns.
tion subsidiaries may generally file a consoli- In general terms, tax transactions between any
dated group income tax return. For bank regula- subsidiary and its parent should be conducted as
tory purposes, however, each depository though the subsidiary was dealing directly with
institution is viewed as, and reports as, a sepa- state or federal taxing authorities.
rate legal and accounting entity. Each holding The tax structure of holding companies
company subsidiary that participates in filing a becomes more complicated when deferred taxes
consolidated tax return should record its tax are considered in the intercorporate tax settle-
expenses or tax benefits as though it had filed a ments.2 Deferred taxes occur when taxable
tax return as a separate entity. The amount and income, for financial reporting purposes, differs
timing of any intercompany payments or from taxable income as reported to the taxing
refunds to the subsidiary that result from its authorities. This difference is due to timing dif-
being a part of the consolidated return group ferences between financial-statement income
should be no more favorable than if the subsidi- and tax income for loan-loss provisions and
ary was a separate taxpayer. A consolidated other items, such as foreign tax credits. In addi-
return permits the parents and other subsidi- tion, differences result from the use of the cash
aries taxable losses to be offset against other basis of accounting for tax purposes, as opposed
subsidiaries taxable income, with the parent to the accrual basis of accounting used in finan-
most often providing the principal loss. This can
be illustrated with the following example: 2. The issue becomes more complex because of GAAP-
based tax expenses versus actual taxes paid under relevant tax
laws (the difference between the two expenses is either a
deferred tax liability or asset on the balance sheet). If the
sharing agreement is based on the tax expense on the state-
ment of income, more funds may be transferred to the paying
agent than are required to settle the actual taxes owed.
1. For the purpose of this guidance, the term, holding
company refers to a bank holding company or a savings and BHC Supervision Manual July 2014
loan holding company. Page 1
Taxes (Consolidated Tax Filing) 2070.0
cial reporting. The different bases are chosen by March 15 Due date for income tax
management. return for U.S. corporations
An example of deferred income taxes fol- or foreign corporations with
lows, using an estimated tax rate of 40 percent. offices in the United States.
Last day for filing for the auto-
Financial Tax matic six-month extension.
Reporting Return September 15 Due date of return if six-month
extensions were granted.
Pre-tax income $200 $150
Bank holding companies have engaged in
Currently payable 60 60 intercorporate income tax settlements that have
Deferred portion 20
the effect of transferring assets and income from
TOTAL 80 60 a bank subsidiary to the parent company. The
Net income $120 $90 Board will apply appropriate supervisory rem-
edies to situations that are considered inequi-
table or improper. These remedies may include,
The deferred portion represents the tax effect of under certain circumstances, the Boards cease-
delaying the recognition of income or taking and-desist powers.
more of a deduction for tax-return purposes On occasion, bank holding companies have
(40% x $50). This is a temporary difference used deferred tax assets as a vehicle to transfer
since over the life of the holding company, cash or other earning assets of subsidiaries, prin-
income and deductions should theoretically cipally from the bank, into the parent company.
equalize for both book and tax purposes. The Boards opinion is that each deferred tax
Financial Accounting Standards Board asset or liability must remain on the books of
Accounting Standards Codification 740-10 the subsidiary. If deferred tax assets have been
Statement No. 109 (FAS 109), Accounting for transferred to the parent, regardless of when the
Income Taxes, provides guidance on many transfer may have occurred, immediate arrange-
aspects of accounting for income taxes, includ- ments must be made to return the asset to the
ing the accounting for deferred tax liabilities appropriate subsidiary. Instances of transferring
and assets. FAS 109 describes how a bank hold- deferred tax assets to the parent are worthy of
ing company should record (1) taxes payable or inclusion in the Examiners Comments and Mat-
refundable for the current year and (2) deferred ters Requiring Special Board Attention section
tax liabilities and assets for the future tax conse- or page of the inspection report.
quences of events that have been recognized in
the banking organizations financial statements
or tax returns.
Generally, all bank and other holding compa- 2070.0.1 INTERAGENCY POLICY
nies file annual income tax returns. The holding STATEMENT ON INCOME TAX
company pays the entire amount of tax (that is, ALLOCATION IN A HOLDING
the amount still due after estimated tax pay- COMPANY STRUCTURE
ments) on or before the due date for filing, or it
can elect to pay by the extension deadline if one In 1998, the federal bank and savings associa-
is granted. Bank holding companies may receive tions regulatory agencies (the agencies) issued
extensions from taxing authorities to file their the following policy statement to provide guid-
returns later. For the federal tax return, a six- ance to banking organizations and savings asso-
month extension may be granted. ciations regarding the allocation and payment of
Bank holding companies generally pay esti- taxes among a holding company and its subsidi-
mated taxes throughout the year. The most com- aries. A holding company and its subsidiaries
mon payment dates will be as follows (assum- will often file a consolidated group income tax
ing calendar period): return. However, for bank regulatory purposes,
each depository institution of the consolidated
April 15 first estimate (25%) group is viewed as, and reports as, a separate
June 15 second estimate (25%) legal and accounting entity. Accordingly, each
September 15 third estimate (25%) depository institutions applicable income taxes,
December 15 fourth estimate (25%) reflecting either an expense or benefit, should be
recorded as if the institution had filed as a
Page 2
separate tax-paying entity.3 The amount and tim- -refund status. Certain adjustments for statutory
ing of payments or refunds should be no less tax considerations that arise in a consolidated
favorable to a subsidiary than if it was a sepa- return, e.g., application of graduated tax rates,
rate taxpayer. Any practice that is not consistent may be made to the separate-entity calculation
with this policy statement may be viewed as an as long as they are made on a consistent and
unsafe and unsound practice prompting either equitable basis among the holding company
informal or formal corrective action. See SR-98- affiliates.
38. In addition, when an organizations consoli-
dated income tax obligation arising from the
alternative minimum tax (AMT) exceeds its
2070.0.1.1 Tax-Sharing Agreements regular tax on a consolidated basis, the excess
should be consistently and equitably allocated
A holding company and its subsidiary institu- among the members of the consolidated group.
tions are encouraged to enter into a written The allocation method should be based upon the
comprehensive tax-allocation agreement tai- portion of tax preferences, adjustments, and
lored to their specific circumstances. The agree- other items generated by each group member
ment should be approved by the respective which causes the AMT to be applicable at the
boards of directors. Although each agreement consolidated level.
will be different, tax-allocation agreements usu-
ally address certain issues common to consoli-
dated groups. 2070.0.1.3 Tax Payments to the Parent
Therefore, such an agreement should Company
1. require a subsidiary depository institution to Tax payments from a subsidiary institution to
compute its income taxes (both current and the parent company should not exceed the
deferred) on a separate-entity basis; amount the institution has properly recorded as
2. discuss the amount and timing of the institu- its current tax expense on a separate-entity basis.
tions payments for current tax expense, Furthermore, such payments, including esti-
including estimated tax payments; mated tax payments, generally should not be
3. discuss reimbursements to an institution made before the institution would have been
when it has a loss for tax purposes; and obligated to pay the taxing authority had it filed
4. prohibit the payment or other transfer of as a separate entity. Payments made in advance
deferred taxes by the institution to another may be considered extensions of credit from the
member of the consolidated group. subsidiary to the parent and may be subject to
affiliate transaction rules, i.e., sections 23A and
23B of the Federal Reserve Act.
2070.0.1.2 Measurement of Current and A subsidiary institution should not pay its
Deferred Income Taxes deferred tax liabilities or the deferred portion of
its applicable income taxes to the parent. The
Generally accepted accounting principles, deferred tax account is not a tax liability
instructions for the preparation of the federally required to be paid in the current reporting
supervised bank Consolidated Reports of Condi- period. As a result, the payment of deferred
tion and Income, and other guidance issued by income taxes by an institution to its holding
the agencies require depository institutions to company is considered a dividend subject to
account for their current and deferred tax liabil- dividend restrictions,4 not the extinguishment of
ity or benefit. a liability. Furthermore, such payments may
When the depository-institution members of a constitute an unsafe and unsound banking prac-
consolidated group prepare separate bank regu- tice.
latory reports, each subsidiary institution should
record current and deferred taxes as if it files its
4. These restrictions include the prompt-corrective-action
tax returns on a separate-entity basis, regardless provisions of section 38(d)(1) of the Federal Deposit Insur-
of the consolidated groups tax-paying or ance Act (12 U.S.C. 1831o(d)(1)) and its implementing regu-
lations: for insured state nonmember banks, 12 CFR 325,
subpart B; for national banks, 12 CFR section 6.6; for savings
3. Throughout the policy statement, the terms separate
associations, 12 CFR 565; and for state member banks, 12
entity and separate taxpayer are used synonymously. When
CFR 208.45.
a depository institution has subsidiaries of its own, the institu-
tions applicable income taxes on a separate-entity basis
include the taxes of the subsidiaries of the institution that are BHC Supervision Manual July 2014
included with the institution in the consolidated group return. Page 3
2070.0.1.4 Tax Refunds from the Parent 2070.0.1.5 Income-Tax-Forgiveness

Company Transactions
An institution incurring a loss for tax purposes A parent company may require a subsidiary
should record a current income tax benefit and institution to pay it less than the full amount of
receive a refund from its parent in an amount no the current income tax liability that the institu-
less than the amount the institution would have tion calculated on a separate-entity basis. Pro-
been entitled to receive as a separate entity. The vided the parent will not later require the institu-
refund should be made to the institution within a tion to pay the remainder of the current tax
reasonable period following the date the institu- liability, the amount of this unremitted liability
tion would have filed its own return, regardless should be accounted for as having been paid
of whether the consolidated group is receiving a with a simultaneous capital contribution by the
refund. If a refund is not made to the institution parent to the subsidiary.
within this period, the institutions primary fed- In contrast, a parent cannot make a capital
eral regulator may consider the receivable as contribution to a subsidiary institution by for-
either an extension of credit or a dividend from giving some or all of the subsidiarys deferred
the subsidiary to the parent. A parent company tax liability. Transactions in which a parent for-
may reimburse an institution more than the gives any portion of a subsidiary institutions
refund amount it is due on a separate-entity deferred tax liability should not be reflected in
basis. Provided the institution will not later be the institutions regulatory reports. These trans-
required to repay this excess amount to the actions lack economic substance because each
parent, the additional funds received should be member of the consolidated group is jointly and
reported as a capital contribution. severally liable for the groups potential future
If the institution, as a separate entity, would obligation to the taxing authorities. Although
not be entitled to a current refund because it has the subsidiaries have no direct obligation to
no carry-back benefits available on a separate- remit tax payments to the taxing authorities,
entity basis, its holding company may still be these authorities can collect some or all of a
able to utilize the institutions tax loss to reduce group liability from any of the group members
the consolidated groups current tax liability. In if tax payments are not made when due.
this situation, the holding company may reim-
burse the institution for the use of the tax loss. If
the reimbursement will be made on a timely 2070.0.1.6 Appendix 2014 Addendum
basis, the institution should reflect the tax bene- to 1998 Interagency Policy Statement on
fit of the loss in the current portion of its appli- Income Tax Allocation in a Holding
cable income taxes in the period the loss is Company Structure
incurred. Otherwise, the institution should not
recognize the tax benefit in the current portion Since the issuance of the 1998 Interagency Pol-
of its applicable income taxes in the loss year. icy Statement, courts have reached varying con-
Rather, the tax loss represents a loss carry- clusions regarding whether tax allocation agree-
forward, the benefit of which is recognized as a ments create a debtor-creditor relationship
deferred tax asset, net of any valuation allow- between a holding company and its IDI.6 Some
ance. courts have found that the tax refunds in ques-
Regardless of the treatment of an institutions tion were the property of the holding company
tax loss for regulatory reporting and supervisory in bankruptcy (rather than property of the sub-
purposes, a parent company that receives a tax sidiary IDI) and held by the holding company as
refund from a taxing authority obtains these
funds as agent for the consolidated group on
behalf of the group members.5 Accordingly, an
6. Case law on this issue is mixed. Compare Zucker v.
organizations tax-allocation agreement or other FDIC, as Receiver for BankUnited, 727 F.3d 1100, 1108-09
corporate policies should not purport to charac- (11th Cir. Aug. 15, 2013) (The relationship between the
terize refunds attributable to a subsidiary deposi- Holding Company and the Bank is not a debtor-creditor
relationship. When the Holding Company received the tax
tory institution that the parent receives from a refunds it held the funds intactas if in escrowfor the
taxing authority as the property of the parent. benefit of the Bank and thus the remaining members of the
Consolidated Group.) with F.D.I.C. v. Siegel (In re IndyMac
Bancorp, Inc.), F. Appx , 2014 WL 1568759, *2
5. See 26 CFR 1.1502-77(a).
(9th Cir. Apr. 21, 2014) (per curiam) (The TSA does not
create a trust relationship. The absence of language creating a
BHC Supervision Manual July 2014 trust relationship is explicitly an indication of a debtor-
Page 4 creditor relationship in California).
the IDIs debtor.7 or similar language to acknowledge that an

On June 13, 2014, an Addendum to the 1998 agency relationship exists for purposes of the
Interagency Policy Statement (Addendum) was Interagency Policy Statement, this Addendum,
issued by the Board of Governors of the Federal and sections 23A and 23B of the FRA.
Reserve System, Federal Deposit Insurance Cor- All tax allocation agreements are subject to
poration, and the Office of the Comptroller of the requirements of section 23B of the FRA, and
the Currency (Agencies). It explains that Con- tax allocation agreements that do not clearly
solidated Groups should review their tax alloca- acknowledge that an agency relationship exists
tion agreements to ensure the agreements may be subject to additional requirements under
achieve the objectives of the Interagency Policy section 23A of the FRA.9 In general, section
Statement. This Addendum also clarifies how 23B requires affiliate transactions to be made on
certain of the requirements of sections 23A and terms and under circumstances that are substan-
23B of the Federal Reserve Act (FRA) apply to tially the same, or at least as favorable to the
tax allocation agreements between IDIs and IDI, as comparable transactions involving non-
their affiliates. affiliated companies or, in the absence of compa-
In reviewing their tax allocation agreements, rable transactions, on terms and circumstances
Consolidated Groups should ensure the agree- that would in good faith be offered to non-
ments: (1) clearly acknowledge that an agency affiliated companies.10 Tax allocation agree-
relationship exists between the holding comments should require the holding company to
pany and its subsidiary IDIs with respect to tax forward promptly any payment due the IDI
refunds, and (2) do not contain other language under the tax allocation agreement and specify
to suggest a contrary intent.8 In addition, all the timing of such payment. Agreements that
Consolidated Groups should amend their tax allow a holding company to hold and not
allocation agreements to include the following promptly transmit tax refunds received from the
paragraph or substantially similar language: taxing authority and owed to an IDI are incon-
sistent with the requirements of section 23B and
The [holding company] is an agent for the subject to supervisory action. However, an
[IDI and its subsidiaries] (the Institution) with Agencys determination of whether such provi-
respect to all matters related to consolidated tax sion, or the tax allocation agreement in total, is
returns and refund claims, and nothing in this consistent with section 23B will be based on the
agreement shall be construed to alter or modify facts and circumstances of the particular tax
this agency relationship. If the [holding com- allocation agreement and any associated refund.
pany] receives a tax refund from a taxing State member banks and holding companies
authority, these funds are obtained as agent for should implement this 2014 Addendum guid-
the Institution. Any tax refund attributable to ance as soon as reasonably possible, which the
income earned, taxes paid, and losses incurred Agencies expect would not be later than Octo-
by the Institution is the property of and owned ber 31, 2014. See 79 Fed. Reg. 35230, June 19,
by the Institution, and shall be held in trust by 2014, and SR-14-6, July 15, 2014, Addendum
the [holding company] for the benefit of the to the Interagency Policy Statement on Income
Institution. The [holding company] shall for- Tax Allocation in a Holding Company Struc-
ward promptly the amounts held in trust to the ture.
Institution. Nothing in this agreement is
intended to be or should be construed to provide
the [holding company] with an ownership inter-
2070.0.2 Qualifying Subchapter S
est in a tax refund that is attributable to income
Corporations
earned, taxes paid, and losses incurred by the The Small Business Job Protection Act of 1996
Institution. The [holding company] hereby made changes to the Internal Revenue Code (the
agrees that this tax sharing agreement does not
give it an ownership interest in a tax refund
9. Section 23A requires, among other things, that loans and
generated by the tax attributes of the Institution. extensions of credit from a bank to its affiliates be properly
collateralized. 12 U.S.C. 371c(c).
Going forward, the Agencies generally will 10. 12 U.S.C. 371c-1(a). Transactions subject to section 23B
deem tax allocation agreements that contain this include the payment of money by a bank to an affiliate under
contract, lease, or otherwise and transactions in which the
affiliate acts as agent of the bank. Id. at 371c-1(a)(2) &
7. See e.g., F.D.I.C. v. Siegel (In re IndyMac Bancorp, Inc.),
(a)(4).
F. Appx , 2014 WL 1568759 (9th Cir. Apr. 21,
2014) (per curiam).
8. This Addendum clarifies and supplements but does not BHC Supervision Manual July 2014
replace the Interagency Policy Statement. Page 5
code). On October 29, 1996, the FFIEC issued a 4. To determine that no deferred tax liability,
bulletin notifying all federally insured banks corresponding asset, or the deferred portion
and thrifts of the impact of these changes. Thrift of its applicable income taxes has been trans-
organizations may qualify for Subchapter S cor- ferred from a bank subsidiary to the parent
poration11 status under the codes revisions and company.
could generally receive pass-through tax treat- 5. To verify that there has been proper account-
ment for federal income tax purposes if certain ability for tax-forgiveness transactions
criteria are met. between the parent company and its financial
The bulletin states that no formal application institution subsidiaries.
is required to be filed with the federal bank and 6. To substantiate that corporate practices are
thrift regulatory agencies merely as a result of consistent with corporate policies.
an election by a bank, thrift, or parent holding
company to become a Subchapter S corporation.
However, if an institution takes certain steps to 2070.0.4 Inspection Procedures
meet the criteria to qualify for this tax status,
particularly the codes limitations on the num- 1. Obtain and discuss with the holding
ber and types of shareholders, applications or companys management its intercorporate
notices to the agencies may be required. income tax policies and tax-sharing agree-
The FFIEC bulletin also states that any distri- ments. Obtain and retain a copy of the inter-
butions made by the Subchapter S banking orga- corporate tax policies and agreements in the
nization to its shareholders, including distribu- workpaper files. Review the written intercor-
tions intended to cover shareholders personal porate tax-settlement policy and ascertain
tax liabilities for their shares of the income of that it includes the following:
the institution, will continue to be regarded as a. a description of the method(s) used in
dividends and subject to any limitations under determining the amount of estimated taxes
relevant banking law. See SR-96-28. paid by each subsidiary to the parent
b. an indication of when payments are to be
made
2070.0.3 Inspection Objectives c. a statement that deferred taxes are main-
tained on the affiliates general ledger
1. To determine whether the supervisory and d. procedures for handling tax claims and
accounting guidance set forth in ASC 740-10 refunds
(FASB 109), other tax-accounting standards, Holding companies of depository institutions
and the 1998 interagency policy statement on should also have written tax-sharing agreements
income tax allocation has been appropriately, with their subsidiaries that specify intercorpo-
equitably, and consistently applied. rate tax-settlement policies. The Board encour-
2. To verify that the parents intercorporate tax ages these holding companies to develop such
policy contains a provision requiring the sub- agreements. For tax-sharing agreements, the fol-
sidiaries to receive an appropriate refund lowing inspection procedures should be fol-
from the parent when they incur a loss, and lowed:
that such a refund would have been receiv- a. Determine whether each subsidiary is
able from the tax authorities if the subsidiary required to compute its income taxes (cur-
was filing a separate return. rent and deferred) on a separate-entity
3. To ascertain that tax payments and tax basis.
refunds between financial institution subsidi- b. Ascertain if the amount and timing of
aries and the parent company have been lim- payments for current tax expense, includ-
ited to no more than what the institution ing estimated tax payments, are discussed.
might have paid to or received from the tax c. Determine if reimbursements are dis-
authorities, if it had filed its tax returns on a cussed when an institution has a loss for
timely, separate-entity basis.12 tax purposes.
d. Determine if there is a prohibition on the
11. Subchapter S corporations are corporations that elect to payment or other transfer of deferred
pass corporate income tax losses, deductions, and credit taxes by an institution to another member
through to their shareholders for federal income tax purposes.
12. The term separate-entity basis recognizes that certain
of the consolidated group.
adjustments, in particular tax elections in a consolidated
return, may, in certain periods, result in higher payments by
BHC Supervision Manual July 2014 the depository institution than would have been made if the
Page 6 depository institution was unaffiliated.
2. Review briefly the parents intercompany its depository institution subsidiaries as

transaction report; general ledger income tax current tax expense on a separate-entity
accounts; cash receipts and disbursements; basis.
and, if necessary, tax-return workpapers and c. Determine that subsidiary institutions are
other pertinent corporate documents. not paying their deferred tax liabilities on
a. Ascertain that the taxes collected by the the deferred portions of their applicable
parent company from each depository income taxes to the parent company.
institution subsidiary do not exceed the d. Ascertain that the parent company is not
amount that would have been paid if a deriving tax monies from depository insti-
separate return had been filed. tution subsidiaries that are used for other
b. When depository institution subsidiaries operating needs.
are making their tax payments directly to 6. When a subsidiary incurs a loss, review the
the taxing authorities, determine whether tax system to determine that bank and non-
other subsidiaries are paying their propor- bank subsidiaries are receiving an appropri-
tionate share. ate refund from the parent company, that is,
3. Review the separate regulatory reports for an amount that is no less than what would
depository institution members of the hold- have been received if the tax return had been
ing company that are included in the filing of filed on a separate-entity basis.
a consolidated tax return. a. Verify that refunds are received no later
a. Verify that each subsidiary institution is than the date the institutions would have
recording current and deferred taxes as if filed their own returns and that no refund
it was filing its own tax returns on a is characterized as the parent companys
separate-entity basis. property.
b. Ascertain that any adjustments for statu- b. If the parent company does not require a
tory tax considerations, arising from filing subsidiary to pay its full amount of cur-
a consolidated return, are also made to the rent tax liability, and the parent will not
separate-entity calculations consistently later require the institution to pay the
and equitably among the holding com- remainder of the current tax liability,
pany affiliates. ascertain that the amount of the tax liabil-
4. Determine if any excess amounts (tax bene- ity is recorded as having been paid and
fits), resulting from the filing of a consoli- that the corresponding credit is recorded
dated return, are consistently and equitably as a capital contribution from the parent
allocated among the members of the consoli- to the subsidiary.
dated group. 7. Determine that the deferred tax accounts of
5. Review the tax payments that are made from each bank subsidiary are maintained on its
the bank and the nonbank subsidiaries to the books and that they are not transferred to the
parent company. parent organization.
a. Determine that payments, including esti- 8. Determine if the Internal Revenue Service or
mated payments that are being requested, other tax authorities have assessed any addi-
do not significantly precede the time that tional tax payments on the consolidated
a consolidated or estimated current tax group, and whether the holding company has
liability would be due and payable by the provided an additional reserve to cover the
parent to the tax authorities. assessment.
b. Verify with management that the tax pay- 9. Complete the Other Supervisory Issues page
ments to the parent company were not in or section of the Report of Bank Holding
excess of the amounts recorded by Company Inspection (FR 1225 or FR 1241).

Page 7
Interagency Policy Statement 4-870 1999 FRB 111

on Income Tax Allocation
in a Holding Company
Structure
2014 Addendum to the

Interagency Policy
Statement on Income
Tax Allocation in a
Holding Company Structure

Page 8
Funding
(Introduction) Section 2080.0
The purpose of this Section is to discuss the ments available for its use, and probably would
types of funding ordinarily found in holding look to local sources for its debt and equity
companies and to analyze their respective char- needs. This would include sale of equity and
acteristics. It is not intended that this section debt instruments to owners of the holding com-
include an analysis of the inter-relationships of pany. The medium-sized holding company has
these factors because that will be addressed in access to public markets through investment
the various subsections of Section 4000 of the bankers and occasionally may issue its own
Manual. corporate notes in the commercial paper market.
The three major types of funding are short- The large holding company has a wide range of
term debt, long-term debt and equity. The ideal choices depending upon its financial condition
hypothetical holding company balance sheet and the economic climate at the time of any
would reflect sufficient equity to fund total bank offering. It also has the ability to place debt
and nonbank capital needs. privately as an alternate to dealing with public
The complexity of the debt and/or equity markets. In summary, the type of financing
financing will depend greatly upon the size and needed by a holding company will vary with the
financial status of the holding company as well size and nature of its banking and nonbanking
as the access to certain capital markets. The operations. The following subsections address
small holding company will be limited in the those issues.
type and/or sophistication of financing instru-

Page 1
Funding (Bank Holding Company Funding
and Liquidity) Section 2080.05
WHATS NEW IN THIS REVISED alternative sources of liquidity or other reliable

SECTION means to refinance or redeem its obligations. In
addition, commercial paper proceeds should not
Effective July 2010, this section was revised to be used to fund corporate dividends or pay
include a cross reference to section 4066.0 of current expenses. Funding mismatches can
this manual, which provides the March 17, exacerbate an otherwise manageable period of
2010, interagency policy statement on Fund- financial stress or, in the extreme, undermine
ing and Liquidity Risk Management. public confidence in an organizations viability.
For this reason, BHCs, in managing their fund-
A key principle underlying the Federal ing positions, should control liquidity risk by
Reserves supervision of bank holding compa- maintaining an adequate cushion of liquid assets
nies (BHCs) is that such companies should be to cover short-term liabilities. Holding compa-
operated in a way that promotes the soundness nies should, at all times, have sufficient liquidity
of their subsidiary banks. Holding companies and funding flexibility to handle any runoff,
are expected to avoid funding strategies or prac- whether anticipated or unforeseen, of commer-
tices that could undermine public confidence in cial paper or other short-term obligations
the liquidity or stability of their banks. Conse- without having an adverse impact on their sub-
quently, BHCs should develop and maintain sidiary banks.
funding programs that are consistent with their This objective can best be achieved by limit-
lending and investment activities and that pro- ing the use of short-term debt to fund assets that
vide adequate liquidity to the parent company can be readily converted to cash without undue
and its nonbank subsidiaries. loss. It should be emphasized, however, that the
For more information regarding the Federal simple matching of the maturity of short-term
Reserves supervisory expectations on liquidity debt with the stated or nominal maturity of
risk management for BHCs, see section 4066.0, assets does not, by itself, adequately ensure an
Consolidated (Funding and Liquidity Risk organizations ability to retire its short-term
Management). This section provides the obligations if the condition of the underlying
March 17, 2010, interagency policy statement assets precludes their timely sale or liquidation.
on Funding and Liquidity Risk Management. In this regard, it is particularly important that
(see also SR-10-6 and its attachment.) parent company advances to subsidiaries be
considered a reliable source of liquidity only to
the extent that they fund assets of high quality
2080.05.1 FUNDING AND LIQUIDITY that can readily be converted to cash. Conse-
quently, effective procedures to monitor and
A principal objective of a parent BHCs funding ensure on an ongoing basis the quality and
strategy should be to support capital invest- liquidity of the assets being funded by short-
ments in subsidiaries and long-term assets with term debt are critical elements of a holding
capital and long-term sources of funds. Long- companys overall funding program.
term or permanent financing not only reduces BHCs should establish and maintain reliable
funding and liquidity risks, but also provides an funding and contingency plans to meet ongoing
organization with investors and lenders that liquidity needs and to address any unexpected
have a long-run commitment to its viability. funding mismatches that could develop over
Long-term financing may take the form of term time. Such plans could include reduced reliance
loans, long-term debt securities, convertible on short-term purchased funds, greater use of
debentures, subordinated debt, and equity. longer-term financing, appropriate internal limi-
In general, liquidity can be measured by the tations on parent company funding of long-term
ability of an organization to meet its maturing assets, and reliable alternate sources of liquidity.
obligations, convert assets into cash with mini- It is particularly important that BHCs have reli-
mal loss, obtain cash from other sources, or roll able plans or backup facilities to refinance or
over or issue new debt obligations. A major redeem their short-term debt obligations in the
determinant of a BHCs liquidity position is the event assets being funded by these obligations
level of liquid assets available to support matur- cannot be liquidated in a timely manner when
ing liabilities. The use of short-term debt, the debt must be repaid. In this connection,
including commercial paper, to fund long-term
assets can result in unsafe and unsound banking BHC Supervision Manual July 2010
conditions, especially if a BHC does not have Page 1
Funding (Bank Holding Company Funding and Liquidity) 2080.05
holding companies relying on backup lines of ciples outlined above, including the need for
credit for contingency plan purposes should appropriate internal limits on the level and type
seek to arrange standby facilities that will be of short-term debt outstanding and the need for
reliable during times of financial stress, rather realistic and reliable contingency plans to meet
than facilities that contain clauses which may any unanticipated runoff of short-term liabilities
relieve the lender of the obligation to fund the without adversely affecting affiliated banks.
borrower in the event of a deterioration in the
borrowers financial condition.
In developing and carrying out funding pro- 2080.05.3 EXAMINERS
grams, BHCs should avoid overreliance or APPLICATION OF PRINCIPLES IN
excessive dependence on any single short-term EVALUATING LIQUIDITY AND IN
or potentially volatile source of funds, such as FORMULATING CORRECTIVE
commercial paper, or any single maturity range. ACTION PROGRAMS
Prudent internal liquidity policies and practices
should include specifying limits for, and moni- Reserve Bank examiners should be guided by
toring the degree of reliance on, particular matu- these principles in evaluating liquidity and in
rity ranges and types of short-term funding. formulating corrective action programs for
Special attention should be given to the use of BHCs that are experiencing earnings weak-
overnight money since a loss of confidence in nesses or asset-quality problems, or that are
the issuing organization could lead to an imme- otherwise subject to unusual liquidity pressures.
diate funding problem. BHCs issuing overnight In particular, BHCs with less than satisfactory
liabilities should maintain, on an ongoing basis, supervisory ratingscomposite (C) and the
a cushion of superior quality assets that can be potential impact (I) of the parent company and
immediately liquidated or converted to cash nondepository entities(that is, 3 or worse), or
with minimal loss. The absence of such a cush- any other holding companies subject to poten-
ion or a clear ability to redeem overnight liabili- tially serious liquidity or funding pressures,
ties when they become due should generally be should be asked to prepare a realistic and spe-
viewed as an unsafe and unsound banking prac- cific action plan for reducing or redeeming
tice. entirely their outstanding short-term obligations
without directly or indirectly undermining the
2080.05.2 ADDITIONAL condition of their affiliated bank(s).1 Such con-
SUPERVISORY CONSIDERATIONS tingency plans should be reviewed and evalu-
ated by Reserve Bank supervisory personnel
BHCs and their nonbank affiliates should main- during or subsequent to on-site inspections. Any
tain sufficient liquidity and capital strength to deficiencies in the plan, if not addressed by
provide assurance that outstanding debt obliga- management, should be brought to the attention
tions issued to finance the activities of these of the organizations board of directors. If the
entities can be serviced and repaid without liquidity or funding position of such a company
adversely affecting the condition of the affiliated appears likely to worsen significantly, or if the
bank(s). In this regard, BHCs should maintain companys financial condition worsens to a suf-
strong capital positions to enable them to with- ficient degree, the company should be expected
stand potential losses that might be incurred in to implement, on a timely basis, its plan to
the sale of assets to retire holding company debt curtail or eliminate its reliance on commercial
obligations. It is particularly important that a paper or other volatile, short-term sources of
BHC not allow its liquidity and funding policies funds. Any decisions or steps taken by Reserve
or practices to undermine its ability to act as a Banks in this regard should be discussed and
source of strength to its affiliated bank(s). coordinated with Board staff.
The principles and guidelines outlined above Reference should also be made to other
constitute prudent financial practices for BHCs manual sections that address funding, cash flow,
and most businesses in general. Holding com- or liquidity (for example, 2010.1, 2080.0,
pany boards of directors should periodically 2080.1, 2080.2, 2080.4, 2080.5, 2080.6, 4010.0,
assure themselves that funding plans, policies, 4010.1, 4010.2, 5010.27, and 5010.28).
and practices are prudent in light of their organi-
zations overall financial condition. Such plans
1. It is important to note that there are securities registra-
and policies should be consistent with the prin- tion requirements under the Securities Act of 1933 related to
the issuance of commercial paper. A BHC should have proce-
BHC Supervision Manual July 2010 dures in place to ensure compliance with all applicable securi-
Page 2 ties and SEC requirements. Refer to manual section 2080.1.
Funding (Commercial Paper and Other Short-term
Uninsured Debt Obligations and Securities) Section 2080.1
Commercial paper is a generic term that is gen- minimum amount of $25,000) as long as the
erally used to describe short-term unsecured note and each investors interest therein, does
promissory notes issued by well-recognized and not exceed nine months. Such master note
generally financially sound corporations. The agreements may permit prepayment by the is-
largest commercial paper issuers are finance suer, or upon demand of the investor, at any
companies and bank holding companies which time.
use the proceeds as a source of funds in lieu of
fixed rate borrowing.
Generally accepted limitations on issuances 2080.1.1.2 Prime Quality
and uses of commercial paper derive from Sec-
tion 3(a)(3) of the Securities Act of 1933 (1933 Most commercial paper is rated by at least one
Act). Section 3(a)(3) exempts from the registra- of five nationally recognized statistical rating
tion requirements of the 1933 Act any note . . . organizations. The SEC has not clearly articu-
which arises out of a current transaction or the lated the line at which it will regard a specific
proceeds of which have been or are to be used rating of commercial paper as being not
for current transactions and which has a matu- prime and, indeed, there is no requirement that
rity at the time of issuance not exceeding nine a rating be obtained at all in order to qualify.
months, exclusive of days of grace, or any re- SEC staff has issued a series of no-action
newal thereof the maturity of which is likewise letters to individual bank holding companies
limited. . . . The Securities and Exchange Com- based on specific facts and circumstances even
mission (SEC) has rulemaking authority over where it does not appear that a rating was ob-
the issuance of commercial paper. tained. However, where commercial paper is
The five criteria, as set forth in an SEC inter- downgraded to below what is generally re-
pretation (SA Release # 334412, September 20, garded as investment quality (ratings of less
1961), that are deemed necessary to qualify than medium graderefer to the Commercial
securities for the commercial paper exemption Bank Examination Manual, section 203.1), or a
are that the commercial paper must: rating is withdrawn, BHCs may not be able to
issue commercial paper based on the Section
Be of prime quality and negotiable; 3(a)(3) exemption, in the absence of a marked
Be of a type not ordinarily purchased by the significant improvement in the issuers financial
general public; condition.
Be issued to facilitate current operational
business requirements;
Be eligible for discounting by a Federal Re- 2080.1.1.3 Current Transactions
serve Bank;
Have a maturity not exceeding nine months. There have been considerable interpretative
problems arising out of the current transactions
concept. The SEC staff has issued a partial
2080.1.1 MEETING THE SEC laundry list of activities which would not be
CRITERIA deemed suitable for investment of commercial
paper proceeds, namely:
The above criteria are discussed below. 1. The discharge of existing indebtedness,
unless such indebtedness is itself exempt under
section 3(a)(3) of the 1933 Act;
2080.1.1.1 Nine-Month Maturity 2. The purchase or construction of a plant or
Standard the purchase of durable machinery or equip-
ment;
Although roll-over of commercial paper pro- 3. The funding of commercial real estate de-
ceeds on maturity is common, the SEC has velopment or financing;
stated that obligations that are payable on de- 4. The purchase of real estate mortgages or
mand or have provisions for automatic roll-over other securities;
do not satisfy the nine-month maturity standard. 5. The financing of mobile homes or home
However, the SEC staff has issued no action improvements; or
letters for commercial paper master note agree-
ments which allow eligible investors to make BHC Supervision Manual December 1992
daily purchases and withdrawals (subject to a Page 1
Funding (Commercial Paper and Other Short-term Uninsured Debt Obligations) 2080.1
6. The purchase or establishment of a busi- of $1 million. The alternative test requires

ness enterprise. $200,000 in income for each of the last two
The SEC has opined that commercial paper, years ($300,000 if the spouses income is in-
which is used as bridge financing by a bank cluded) and a reasonable expectation of reach-
holding company to fund a permanent acquisi- ing the same income level in the current year.
tion within the 270-day maturity period of the For additional information on marketing of
paper, will meet the current transactions crite- commercial paper, see the next subsection.
rion. The amount of a bank holding companys
commercial paper cannot exceed the aggregate
amount of current transactions of the bank 2080.1.2 MARKETING OF
holding company and its subsidiaries on a con- COMMERCIAL PAPER
solidated basis. For this purpose, current
transactions include dividends, interest, taxes The sale of bank holding company (or nonbank
and short-term loan repayments. In summary, in subsidiary) commercial paper by an affiliated
most cases, the current transactions require- bank to depositors or other investors raises a
ment will not be a significant limitation on number of supervisory issues. Of particular con-
issuances of commercial paper by bank holding cern is the possibility that individuals may pur-
companies. chase holding company paper with the misun-
In addition to meeting SEC requirements, a derstanding that it is an insured deposit or
bank holding company must meet funding and obligation of the subsidiary bank. The probabil-
liquidity criteria prescribed by the Board. For a ity of this occurring is increased when a bank
detailed discussion on acceptable use of com- subsidiary is actively engaged in the marketing
mercial paper in connection with a bank holding of the paper of its holding company or nonbank
company overall funding strategies, see Sec- affiliate, or when the holding company or non-
tions 2080.05 and 2080.6. bank affiliate has a name similar to the name of
the commercial bank subsidiary.
It is a long-standing policy of the Federal
2080.1.1.4 Sales to Institutional Investors Reserve (refer to letters SR 9019 and SR620)
that debt obligations of a bank holding company
Commercial paper is generally marketed only to or a nonbank affiliate should not be issued,
institutional investors (corporations, pension marketed or sold in a way that conveys the
funds, insurance companies, etc.) although sales misimpression or misunderstanding that such
to individuals are not prohibited. It is clear, instruments are either: 1) federally-insured de-
however, from the legislative history of the Sec- posits, or 2) obligations of, or guaranteed by, an
tion 3(a)(3) exemption that commercial paper insured depository institution. The purchase of
was not to be marketed for sale to the general such holding company obligations by retail de-
public. Currently, SEC staff will not issue a positors of an affiliated depository institution
no-action letter if the minimum denomination of can, in the event of default, result in losses to
the commercial paper to be issued is less than individuals who believed that they had acquired
$25,000. One of the underlying premises of the federally-insured or guaranteed instruments. In
Section 3(a)(3) exemption is that purchasers of addition to the problems created for these indi-
commercial paper have sufficient financial so- viduals, such a situation could impair public
phistication to make informed investment deci- confidence in the affiliated depository institution
sions without the benefit of the information pro- and lead to unexpected withdrawals or liquidity
vided by a registration statement. It is, therefore, pressures.
generally recognized today that any individual Events surrounding the sale of uninsured debt
purchaser of commercial paper should meet the obligations of holding companies to retail cus-
accredited investor criteria of commercial tomers of affiliated depository institutions have
paper set forth in SEC Regulation D (17 C.F.R focused attention on the potential for problems
230.501(a)). To qualify as an accredited in this area. In view of these concerns, the
investor, an individual can meet one of two Federal Reserve emphasizes that this policy ap-
testsa net worth test or an income test. To plies to the sale of both long- and short-term
qualify under the net worth test, an individual or debt obligations of a bank holding company and
an individual and his or her spouse must have any nonbank affiliate, as well as to the sale of
a net worth at the time of purchase in excess uninsured debt securities issued by a state mem-
ber bank or its subsidiaries. Debt obligations
BHC Supervision Manual December 1992 covered by this supervisory policy include com-
Page 2 mercial paper and all other short-term and long-
term debt securities, such as thrift notes and for monitoring compliance with this supervisory
subordinated debentures. policy; and, as part of the examination of state
Bank holding companies and nondepository member banks and bank holding companies, are
affiliates that have issued or plan to issue unin- expected to continue to review the polices and
sured obligations or debt securities should not internal controls relating to the marketing and
market or sell these instruments in any public sale of debt obligations and securities. Examin-
area of an insured depository institution where ers should determine whether the marketing and
retail deposits are accepted, including any lobby sale of uninsured nondeposit debt obligations
area of the depository institution. Bank holding are sufficiently separated and distinguished from
companies and any affiliates that are engaged in retail banking operations, particularly the
issuing debt obligations should establish appro- deposit-taking function of the insured deposi-
priate policies and controls over the marketing tory affiliate.
and sale of the instruments. In particular, inter- In determining whether the activities are suf-
nal controls should be established to ensure that ficiently separated, examiners should take into
the promotion, sale, and subsequent customer account: 1) whether the sale of uninsured debt
relationship resulting from the sale of uninsured obligations of a holding company affiliate or
debt obligations is separated from the retail uninsured nondeposit debt securities of a state
deposit-taking functions of affiliated depository member bank is physically separated from the
institutions. banks retail-deposit taking function, including
State member banks, including their subsidi- the general lobby area1; 2) whether advertise-
aries, may also be engaged in issuing nonde- ments that promote uninsured debt obligations
posit debt securities (such as subordinated debt), of the holding company also promote insured
and it is equally important to ensure that such deposits of the affiliated depository institution in
securities are not marketed or sold in a manner a way that could lead to confusion; 3) whether
that could give the purchaser the impression that similar names or logos between the insured de-
the obligations are federally-insured deposits. pository institution and the issuing nonbank
Consequently, state member banks and their affiliate are used in a misleading way to promote
subsidiaries that have issued or plan to issue securities of a nonbank affiliate without clearly
nondeposit debt securities should not market or identifying the obligor; 4) whether retail
sell these instruments in any public area of the deposit-taking employees of the insured deposi-
bank where retail deposits are accepted, includ- tory institution are engaged in the promotion or
ing any lobby area of the bank. Consistent with sale of uninsured debt securities of a nonbank
long-standing Federal Reserve policy, debt obli- affiliate; 5) whether information on the sale of
gations of bank holding companies or their non- uninsured debt obligations of a nonbank holding
bank affiliates, including commercial paper and company affiliate is available in the retail bank-
other short- or long-term debt securities, should ing area; and 6) whether retail deposit state-
prominently indicate that: 1) they are not obliga- ments for bank customers also promote informa-
tions of an insured depository institution; and tion on the sale of uninsured debt obligations
2) they are not insured by the Federal Deposit of the bank holding company or a nonbank
Insurance Corporation. In cases where purchas- affiliate.
ers do not take physical possession of the obli- The Boards policy is that the manner in
gation, the purchasers should be provided with a which commercial paper is sold should not lead
printed advice that conveys this information. bank customers or investors to construe com-
Employees engaged in the sale of bank holding mercial paper as an insured obligation or an
company debt obligations should be instructed instrument which may be higher in yield but
to relate this information verbally to potential equal in risk to insured bank deposits. All pur-
purchasers. In addition, with respect to the sale chasers of commercial paper should clearly
of holding company debt obligations, the instru- understand that such paper is an obligation of
ments or related documentation should not dis- the parent company or nonbank subsidiary and
play the name of the affiliated bank in such a not an obligation of the bank and that the quality
way that could create confusion among potential
purchasers about the identity of the obligor. 1. This policy is not intended to preclude the sale of
State member banks involved in the sale of holding company affiliate obligations from a banks money
market desk, provided that the money market function is
uninsured nondeposit debt securities of the bank separate from any public area where retail deposits are ac-
should establish procedures to ensure that poten- cepted, including any lobby area.
tial purchasers understand that the debt security
is not federally-insured or guaranteed. BHC Supervision Manual December 1992
Federal Reserve examiners are responsible Page 3
of the investment depends on the risks and 2080.1.5 CURRENT PORTION OF

operating characteristics associated with the LONG-TERM DEBT
overall holding company and its nonbanking
activities. This type of debt has many of the short-term
characteristics of bank debt, with possibly one
additional important feature. Such debt is usu-
ally tied to a written agreement between creditor
2080.1.3 THRIFT NOTES AND
and debtor, and encompasses certain minimum
SIMILAR DEBT INSTRUMENTS
standards of performance to be adhered to by
the company. The examiner must review the
In the event a bank holding company or non- agreement to determine that the company is
banking affiliate issues thrift notes or other debt operating within the parameters of the cove-
obligations which do not fall within the gener- nants laid out in the agreement. Failure to abide
ally accepted definition of commercial paper, by the covenants can trigger default provisions
examiners should be guided by the Boards of the agreement and escalate the repayment of
1978 position on the issuance of small denomi- the total loan balance outstanding.
nation debt obligations by bank holding compa-
nies and their nonbanking affiliates. At that time,
the Board was considering thrift notes issued by 2080.1.6 INSPECTION OBJECTIVES
a nonbanking subsidiary of a bank holding com-
pany and concluded that such obligations should 1. To determine the companys policy and
prominently indicate in bold type on their face actual practices with respect to the sale of unin-
that the obligations are not obligations of a bank sured debt obligations and securities issued by
and are not FDIC insured. The Board also stated bank holding companies, nonbank affiliates or
that the obligations should not be sold on the State member banks. More often than not, an
premises of affiliated banks. Where there is sub- informal policy evolves from practice. It then
stantial reliance on the sale of thrift notes to becomes important to interview senior officers
fund the operations of a bank holding company in charge of this function to determine if they
or nonbanking subsidiary, other than an indus- are adequately aware of the statutory and regula-
trial bank, a violation of the GlassSteagall Act tory constraints with respect to appropriate us-
may be involved. Such cases should be dis- age of commercial paper.
cussed with Reserve Bank counsel. 2. To review the companys funding and
liquidity strategy with a view to determining
whether it has sufficient liquid assets to support
2080.1.4 OTHER SHORT-TERM maturing liabilities and whether there are any
INDEBTEDNESS funding mismatches. (See Manual sections
2080.05, 4010.2.3, 4010.2.7, and 5010.24.1)
A companys access to bank credit is almost 3. To determine compliance with the Federal
universal, and most small to medium-sized com- Reserve Systems supervisory policy with re-
panies will reflect this type of debt on their gard to the marketing of commercial paper, thrift
balance sheets. An important point to remember notes or similar type debt instruments (refer to
about bank debt is that maturities of the bank Board letter S 2427 dated June 27, 1980, and
notes are usually short-term while the proceeds supervisory letters SR 9019 and SR 620).
of the borrowings are often applied to long-term 4. To identify potential weaknesses in corpo-
assets, that is, investment in the banks capital rate policy and practices.
and/or long-term debt accounts. The note may
be subject to renewal on an annual basis, and
the creditor may have the opportunity to call the 2080.1.7 INSPECTION PROCEDURES
note at renewal if the financial condition of the
company has deteriorated. Rates of interest on 1. Review the bank holding companys pro-
short- term bank notes are usually pegged to the cedures for authorizing the issuance of commer-
creditors prime rate plus some fraction thereof. cial paper and other uninsured debt obligations
The principal is often repaid over a period of and securities of the holding company and/or its
years as the notes are rolled over despite their nonbank affiliates.
short-term maturity. 2. Review the board of directors resolution
authorizing the issuance of commercial paper
BHC Supervision Manual December 1992 and other uninsured debt obligations and
Page 4 securities.
3. Determine whether the company has local market. The smaller company can be con-
sought a no action letter from the SEC. A tent to sell its paper on a local level through its
no action letter indicates the SEC has re- corporate headquarters, knowing its customer
viewed the companys issuance of commercial profile and limiting the amount to any one
paper and plans no action to require the regis- paperholder, thereby limiting its exposure to
tration of the commercial paper as securities. refinancing problems caused by large scale
Some companies rely on the opinion of their redemptions.
own counsel that their paper is not subject to 7. Review for potential weaknesses in corpo-
SEC registration requirements. If the company rate policy and practices. Any amounts in ex-
does not have a no action letter there should cess of 10 percent in the hands of one paper-
be a legal opinion on file from the holding holder should be discussed with management
companys attorney regarding exemption from and noted in the report. A large paperholder
registration under section 5 of the 1933 Act. could refuse to purchase new paper at maturity
4. Obtain a copy of the holding companys (rollover) and place the company in a liquidity
written policy on paper usage to compare with squeeze, requiring sell-off of assets or draw
resolution and practice. down of back-up lines.
5. Review to determine the extent to which Rollovers are prohibited under the 1933
the commercial paper and other uninsured debt Act. The instrument must have a definite date of
obligations are supported by back-up lines of maturity with no automatic provision for rein-
credit provided by unaffiliated banks. These vestment of proceeds. Companies must abide by
lines are established to cover any unexpected the 270-day provision and if the paperholder
run-off of paper at maturity. Commitments for elects to reinvest the funds, a new instrument
lines of credit should be in writing and have should be executed.
expiration dates. Commitment fees substantiate 8. Request a copy of the commercial paper,
the enforceability of the commitment whereas thrift note or similar type instrument, and any
compensating balances tend to indicate that the printed advice to the purchasing customer for
lending commitment is less formal. The exam- review. These documents should be checked for
iner should determine whether material adverse compliance with the standards set forth under
change clauses exist in back-up line of credit the captions Marketing of Commercial Paper
agreements which may affect their reliability. and Thrift Notes and Similar Debt Instru-
Comment if it appears that those provisions ments in this section of the Manual.
might be utilized. 9. If a bank sells the commercial paper and/or
Compensating balance arrangements other uninsured debt obligations of its holding
should be disclosed. A company may commit to company or nonbanking affiliate, review the
a compensating balance, but if it relies on its procedures to separate their sale from the retail
bank subsidiary to provide the funds the bank operations of the bank.
should be compensated for utilization of its This segregation should be reviewed as
funds. part of all holding company inspections. Exam-
Reciprocal back-up lines may be estab- iner judgment must be relied upon, to a large
lished. This may eliminate the need for fees or extent, to determine whether the marketing ac-
compensating balances and may provide a cer- tivities of commercial bank subsidiaries for the
tain comfort level for company management. bank holding companys commercial paper and
6. Obtain a listing of commercial paper and other uninsured debt obligations are sufficiently
other uninsured debt obligation holders from separated and distinguished from retail banking
management to the extent known. In the case of operations, particularly the deposit- taking func-
larger BHCs, there is a choice between issuing tion. In making this determination, the examiner
paper on a local level or placing it nationally should consider whether:
through the auspices of an investment banking a. The sale of uninsured debt obligations
firm. In the latter case, there is likely to be no of a holding company affiliate or uninsured non-
record of who purchases the paper because the deposit debt securities of a state member bank is
paper is usually sold on a bearer basis. Holding physically separated from the banks retail-
companies looking for a wider market, national deposit taking function, including the general
recognition, and higher ratings place their paper lobby area;
through an investment banking firm. However, b. Advertisements that promote uninsured
it should be recognized that the market for com- debt obligations of the holding company also
mercial paper placed in this manner is more
sophisticated and knowledgeable and therefore BHC Supervision Manual December 1992
more sensitive to adverse developments than a Page 5
promote insured deposits of the affiliated depos- that these obligations are not being sold on the
itory institution in a way that could lead to premises of affiliated banks.
confusion; 10. The procedures in Nos. 8 and 9 address
c. Similar names or logos between the in- the manner in which bank holding companies
sured depository institution and the issuing non- (or nonbanking subsidiaries) market their com-
bank affiliate are used in a misleading way to mercial paper, thrift notes or similar type debt
promote securities of a nonbank affiliate without instruments; consequently, implementation will
clearly identifying the obligor; necessitate review of marketing procedures of
d. Retail deposit-taking employees of the all holding companies (or nonbanking subsidi-
insured depository institution are engaged in the aries), regardless of the type of charter or the
promotion or sale of uninsured debt securities of identity of the primary supervisor of the subsid-
a nonbank affiliate; iary (affiliate) bank. Exceptions to the policies
e. Information on the sale of uninsured on the marketing of such paper should be noted
debt obligations of a nonbank holding company on the Commercial Paper and Lines of Credit
affiliate is available in the retail banking area; pages and discussed on the Examiners
and Comments page of the inspection report. The
f. Retail deposit statements for bank cus- managements of all bank holding companies
tomers also promote information on the sale of must be fully informed of the Federal Reserves
uninsured debt obligations of the bank holding policy with respect to the marketing of holding
company or a nonbank affiliate. company debt obligations, as in SR Letter
In those cases where the bank holding 9019, and exceptions should be addressed in
company or nonbanking affiliates issue thrift the supervisory follow-up process.
notes or similar type debt instruments, ascertain

Page 6
Funding
(Long-Term Debt) Section 2080.2
Long-term debt represents an alternative Theoretically, straight debt is a direct se-
financing method to short-term debt and equity cured or unsecured obligation requiring repay-
funds. Before choosing this type of funding the ment at maturity and generally taking a senior
bank holding company will need to determine position in the claim on assets. Principal is
how the advantages and disadvantages of long- sometimes payable in a lump sum, often through
term debt apply to its financial position and the use of a sinking fund, while interest is paid
funding needs. Interest on long-term debt is an at stated periods throughout the life of the note.
expense item and therefore is tax deductible.
The company issuing debt effectively pays
approximately half-price (interest expense
net of tax deduction) on debt while the company 2080.2.1 CONVERTIBLE
issuing equity pays the full dividend rate with- SUBORDINATED DEBENTURE
out a tax benefit. Counterbalancing the tax ad-
vantage is the fact that long-term debt must be A convertible subordinated debenture is an un-
serviced and retired to prevent default and can- secured debt that is subordinate to other debt
not be used as an offset for losses. and convertible to common stock at a certain
The issuance of long-term debt will be rela- date or price. The essential provision of this
tively advantageous to the holding company debt is that it may eventually be retired by
whose price/earnings ratio is low and whose equity and inherently has the potential for dilu-
stock is selling significantly below book value. tion. With this type of financing, the creditor
In this instance, the cost to the company of typically has the right to convert the bond into a
equity funding rises proportionately to the drop stated number of shares of common stock at
in the price of the stock since less funds are some future time. Usually the conversion price
obtained for an equal number of shares, yet the is 10 to 15 percent above the market price of the
dividend per share remains the same. stock. This encourages the bondholder to keep
A major factor influencing a bank holding the bond until the market price meets or sur-
companys decision to issue long-term debt in- passes the conversion price. In many convert-
stead of equity is the dilution impact of new ible debt agreements, the bank holding company
equity. Straight debt will not dilute ownership issuing debt will have the option to call the issue
and is typically retired from cash flow, whereas when the conversion price equals the market
new equity dilutes earnings per share (more so price.
than the impact of the debts interest expense on The bank holding company will issue a con-
earnings). vertible subordinated debenture when its stock
Preferred stock can be retired through a sink- price is depressed. The convertibility provision
ing fund and is sometimes convertible to com- is added as a sweetner to the issue and coun-
mon shares. Convertible stock adds to the dilu- teracts the negative aspect of its subordinated
tion effect when the conversion is exercised and position. The subordinated nature of this issue
prior to conversion, fully diluted earnings per will help a bank holding company with prior
share must be reported that assume full conver- debt which includes covenants that dictate
sion. The bank holding company will consider against additional senior debt.
both stockholder and market reaction to any
dilution effects of long-term financing. The
BHC may view debt financing as the best alter-
native if it feels that a diluted earnings per share 2080.2.2 CONVERTIBLE PREFERRED
would drive down the market price of its stock DEBENTURE
and contribute to stockholder discontent.
Inherent in any financing are intangible costs. This debt instrument is similar to straight
While it is evident that on the surface debt convertible debt except it is convertible into
financing is cheaper than equity financing, it preferred stock. This alternative is open to the
would be hard to quantify the effects of poten- bank holding company which needs to add a
tial missed interest payment or default associ- sweetner to this issue in order to market
ated with debt instruments. The bank holding it, but does not want dilution of common
company also will be concerned with its addi- ownership.
tional debt capacity if the present issuance of
debt pushes the debt/equity ratio beyond accept- BHC Supervision Manual December 1992
able limits. Page 1
Funding (Long-Term Debt) 2080.2
2080.2.3 NEGATIVE COVENANTS 2080.2.5 INSPECTION PROCEDURES
The lender will be concerned with the borrow- 1. Review the parent-only balance sheet and
ers debt structure when offering financing. If income statement for debt and interest expense
the borrowers debt/equity ratio is approaching captions.
an unacceptable level, the lender will try to 2. Review the consolidated balance sheet and
assure that the bank holding company does not income statement for debt and interest expense
overextend itself. While the lender may demand captions.
the right to approve future equity issues, the 3. Review any written policies and proce-
lender is likely to be more willing to give such dures available as part of an overall capital plan.
approval than to allow more debt because the If no plan or policies exist, the examiner should
equity issue adds to the capital base, and this encourage management to develop them, and in
base is a possible source of funds for the pay- large BHCs, to put them in writing.
ment of debt. 4. Determine that the bank holding company
Closely related to the restriction on further does not finance long-term assets with short-
debt is the position of the lender in the liquida- term debt, as this leaves the holding company
tion of assets. The holder of a straight debt issue vulnerable to rising interest rates and the possi-
will usually demand to be senior to other debt bility of a credit crunch. On the other hand, it
holders. This characteristic is particularly suited may be beneficial for the holding company to
to straight debt because straight debt is more finance short-term assets with long-term debt.
vulnerable to default than convertible debt and This is particularly true during periods of rising
doesnt have other sweetners such as a conver- interest rates because the bank holding company
sion right or a right to participate in distribu- can get higher yields on loans financed by lower
tions of earnings. The examiner will want to de- cost long-term debt, than it can with commercial
termine how the covenants affect future paper that has to be turned over at generally
debt financing and if the effect is positive or increasing rates. In any event, the bank holding
negative. company will need to insure that it has ample
The lender is likely to seek to insure that capacity to finance additional long-term assets
neither the structure nor policies of the bank with long-term debt when the opportunity pre-
holding company are altered without its ap- sents itself.
proval during the life of the debt. The lender can 5. Review any sinking fund provisions usu-
insure this through other negative covenants ally found with straight debt and straight pre-
attached to the debt. Some common covenants ferred issues if the issue is not going to be
of this type include (1) limitations on capital refinanced by further debt or by an equity issue.
expenditures and on the sale of assets, (2) re- Since payments to the fund will directly drain
strictions on the BHCs redemption of its own cash reserves, it is imperative that the bank
stock, (3) restrictions on investments in general, holding company have adequate annual cash
(4) restrictions on dividend payment without flow to service both the interest and add to the
prior approval, and (5) the imposition of loan to sinking fund. The larger the debt, the more the
capital ratios, deposit to capital ratios and asset lender will look for a sinking fund feature as a
to capital ratios. means of precluding a default when maturity
occurs and refinancing is not available. When a
sinking fund exists the examiner will need to
2080.2.4 INSPECTION OBJECTIVES analyze the parents cash flow statement to see
that payments do not produce an adverse cash
1. To determine the existence of and adher- drain.
ence to policies on long-term debt.
2. To review the use of long-term funds.
3. To determine the existence of debt cove-
nants and compliance by the holding company.

Page 2
Funding
(Equity) Section 2080.3
The capacity of the holding company to serve as sources, such as convertible securities or subor-
a source of financial strength to its bank subsid- dinated debt.
iaries is a major consideration of the Federal
Reserve Board in supervising a bank holding
company. The cornerstone of this financial
strength is capital adequacy. 2080.3.1 PREFERRED STOCK
The financial structure of banking organiza-
tions allows for the use of substantial leverage. Preferred stock is becoming a more acceptable
If capital is large in relation to debt, additional alternative due to certain advantages. Through
borrowing is relatively inexpensive. However, contracted covenants, it is senior to common
because of added risk to lenders, the cost of stock because it usually has no voting voice in
borrowing increases as new obligations are management as does common stock. Preferred
assumed. At some point, therefore, equity stock usually carries a fixed dividend rate that is
financing becomes less costly and may become either cumulative or noncumulative. Cumula-
the only alternative available for needed funds. tive preferred provides that unpaid dividends in
Basically, a holding companys financial prior years must be paid to preferred sharehold-
structure can be viewed in two ways: the single ers before common dividends can be paid. A
entity approach, whereby the holding company noncumulative feature provides that dividends
is considered an integrated entity and financial foregone during lean years are lost permanently.
strength is assessed on the basis of its consoli- From the viewpoint of the bank holding com-
dated totals, and the building block approach, pany, a noncumulative preferred issue is more
wherein the holding company is seen as a col- desirable, while investors would desire a cumu-
lection of individual components. In the latter lative feature.
view, the companys financial strength is as- Perpetual preferred stock does not have a
sessed primarily in terms of the financial struc- stated maturity date and it may not be redeemed
ture of each component. at the option of the holder. Advantages that
When applying the building block ap- preferred stock can offer the bank holding com-
proach, the liability and capital structure of each pany are (1) avoidance of dilution of earnings
subsidiary is compared to the norm of its par- per common share and (2) absence of voting
ticular industry. The use of the building block rights. On the other hand, dividend payments,
approach has some advantages: particularly cumulative dividends, are expen-
sive since they are not a tax-deductible expense
1. Comparative statistics are usually avail-
as is interest on debt. Cumulative dividends can
able to measure the performance and strength of
be particularly draining on cash when they are
the individual subsidiaries.
declared after several years of suspended divi-
2. It permits comparison of capitalization dends and payment is then made in a lump
between holding companies engaged in differ- sum.
ing activities. Preferred stock is usually retired by refinanc-
3. It identifies the degree of leveraging within ing with debt or through its own conversion
a single subsidiary of a bank holding company. feature. If the bank holding company feels that
The parent should maintain a favorable bal- it can afford an equity issue in the future but not
ance of debt and equity so that it will be able to at present, it can issue a convertible preferred
assist its subsidiaries when necessary through debenture to postpone the equity issue until a
contributions of its own capital or through addi- later date. On the other hand, if debt is the
tional funds generated from debt or equity desired method of financing but the present debt/
financing. equity ratio is not acceptable, the bank holding
At times, however, sale of additional stock company will issue preferred and refinance with
may not be a viable alternative for capital for- debt at a more opportune time. However, the
mation, even when a company can show a Board has expressed concern that in applica-
favorable debt/equity balance. Reluctance to en- tions to form a BHC, preferred stock not be
ter into a new stock offering may stem from a used as a debt substitute resulting in circumven-
desire to avoid further dilution of existing own- tion of its debt guidelines. On applications with
ership interest or from an unfavorable market preferred stock which has debt-like characteris-
price of outstanding stock in relation to book
value. In these instances, long-term quasi-capital BHC Supervision Manual June 1996
funds may sometimes be obtained through other Page 1
Funding (Equity) 2080.3
tics, such stock may be treated as debt in the 3. To review any debt covenants that pertain
financial analysis. to a minimum acceptable capital position.
2080.3.2 INSPECTION OBJECTIVES 2080.3.3 INSPECTION PROCEDURES

1. To determine the existence of and adher- 1. Review any existing BHC policies regard-
ence to parent company policies on capital ade- ing capital adequacy or capital planning.
quacy within the subsidiaries and for the con- 2. Request any plans regarding proposed
solidated organization. capital issues.
2. To review the use of proceeds of equity
capital financings.

Page 2
Funding
(Retention of Earnings) Section 2080.4
Earnings retention provides the most immediate as sections 56 and 60(b)) of the Revised Statutes
source of capital formation and growth. Earn- and accordingly, should be reviewed with regard
ings retained after dividend payout can often be to those limitations. The Federal Reserve Board
sufficient to keep pace with asset growth, amended Regulation H regarding the payment
thereby preserving the balance or relationship of dividends by state member banks on Decem-
between equity capital and total assets. Often ber 20, 1990, [12 C.F.R. 208.19(a) and
referred to as internal funding, earnings reten- 208.19(b)]. The rule was revised, effective Octo-
tion should be carefully reviewed to assure that ber 1, 1998, and replaced as renumbered section
the BHCs capital base is keeping pace with 208.5 (see 12 C.F.R. 208.5), Dividends and
asset growth. other distributions. It sets forth the Limitation
Bank earnings retention should be reviewed on withdrawal of capital by dividend or other-
carefully due to the dividend requirements often wise, in subsection 208.5(d). The regulation
imposed on banks by their parent companies. discusses the elements that are taken into
Although a banks board of directors must account in determining a state member banks
approve the declaration and payment of any dividend paying capacity. Two different calcula-
bank dividend, often the banks board is actu- tions are performed to measure the amount of
ally ratifying a decision determined at the parent dividends that may be paid, a Net Income Test
level. The need for bank retention of earnings is and an Undivided Profits Test.
particularly pronounced either during periods of
expansion or periods of declining earnings or
losses. 2080.4.1.1 Net Income Test
Parent company management may be under
pressure from shareholders or the market to The approval of the Federal Reserve is required
increase dividends or to maintain dividends at for dividends declared by a member bank that in
historic levels despite reversals in consolidated any calendar year exceeds the net income of the
earnings trends. Examiners should be careful to current year, combined with retained net income
point out to management that dividend pres- for the two preceding years (the Net Income
sures often serve to the detriment of the bank Test).
subsidiary(ies) which is often asked to supply
the proceeds via a dividend to the parent com-
pany. As a regulator of banks (and bank holding 2080.4.1.2 Undivided Profits Test
companies), the Federal Reserve System is con-
cerned with the preservation and maintenance A member bank must receive prior approval of
of a sound banking system and in particular, the Federal Reserve, and of at least two-thirds of
soundly capitalized banks. Earnings retention the shareholders of each class of stock outstand-
contributes to capital growth and should be ing, before paying dividends in amounts greater
encouraged. For additional information on earn- than undivided profits.
ings retention and dividends see sections
2020.5.1, 4010.1, 4020.1, and 4060.9. See sec-
tion 4070.1 of the Commercial Bank Examina-
tion Manual.
2080.4.1 PAYMENT OF DIVIDENDS

BY BANK SUBSIDIARIES
Bank dividends can be determined to be exces-
sive if they exceed the limitations imposed by
either section 5199(b) or 5204 (also referred to

Page 1
Funding (Pension Funding and
Employee Stock Option Plans) Section 2080.5
Holding companies have turned to employee amounts contributed to ESOPs. Under limited
pension plans and, to a lesser degree, stock circumstances, lenders to ESOPs may also re-
option plans as ways to provide added capital ceive benefits that result in reduced borrowing
for holding company operations. While there costs to the ESOP. As long as ESOP meets the
may be a number of reasons for implementing IRS requirements for a qualified employee plan,
such programs, one of the by-products is the it may invest up to 100% of its assets in
flow of working capital into the holding com- qualifying employer securities. It is exempt
pany. The program usually involves a pre-tax from some of the self-dealing limitations appli-
contribution by the holding company to an em- cable to most employee benefit plans, as it is
ployee benefit plan (e.g., profit sharing plan) viewed as a means of providing stock owner-
and the resulting purchase by such plan of com- ship interests for employees rather than as
mon or preferred shares of the holding compa- strictly a retirement plan. Furthermore, an ESOP
nys stock. The holding company benefits may purchase the stock either from the em-
through the use of the funds for working capital, ployer company or from shareholders. There-
and the plan provides for retirement benefits for fore, in addition to use as a tool of corporate
employees as shareholders in the company. finance, an ESOP may serve as a ready pur-
Since ESOPs are administered under the Em- chaser for outstanding stock, without a corre-
ployees Retirement Income Security Act of sponding loss of voting control.
1974 (ERISA), the guidelines delineated in ESOPs are in some ways similar to deferred
SR 8521 should be followed in determining profit sharing plans. ESOPs are authorized un-
whether possible ERISA violations exist. Refer- der the same section, namely, section 401 of the
ence should also be made to Manual section Internal Revenue Code. Employer contributions
4010.1.1. (within limits based on a percentage of eligible
payroll) are allowable deductions from the em-
ployers pre-tax income. Contributions are held
2080.5.1 STOCK OPTION PROGRAMS in trust, and benefits when paid out upon an
employees retirement, death, or termination of
Employee stock option programs generate a service, must be paid in company stock. The
nominal percentage of a holding companys distinguishing feature of an ESOP lies in the
financing needs to reward key employees for fact that the direct purpose of the plan is to
service rendered via the reduced price of the invest employer contributions in the stock of the
companys stock. While such programs consti- company.
tute one method of available funding for a hold-
ing company, they generally may not be ex-
pected to add any capital amounts beyond 2080.5.2.1 Accounting Guidelines for
nominal levels. Leveraged ESOP Transactions
Newly issued or existing shares of BHC stock
2080.5.2 EMPLOYEE STOCK are sometimes sold to the ESOP and paid for
OWNERSHIP PLANS (ESOPS) with money borrowed from a third party; these
types of ESOPs are commonly referred to as
Employee Stock Ownership Plans (ESOP) are leveraged ESOPs. The borrowings are gener-
an alternative holding company funding tool. ally serviced with contributions by the em-
An ESOP is a tax-qualified employee benefit ployer, which are a tax deductible expense. The
plan which is designed to be invested primarily borrowing arrangement by the ESOP often in-
in employer stock. The concept of an ESOP is cludes a guarantee or commitment by the em-
to encourage the establishment of employee ployer (the BHC or the subsidiary bank) to
benefit programs which expand the employees make future contributions to the ESOP suffi-
share in company stock ownership. Participa- cient to meet debt service requirements.
tion in an ESOP may also significantly enhance When this occurs, questions arise involving
employee motivation. The essential differences the appropriate accounting for the leveraged
between an ESOP and other qualified stock ESOP transaction. The Accounting Standards
bonus plans are that an ESOP is permitted, in Executive Committee of the American Institute
certain circumstances, to incur liabilities in the
acquisition of employer securities, and that an BHC Supervision Manual December 1992
employer may receive additional tax credits for Page 1
Funding (Pension Funding and Employee Stock Option Plans) 2080.5
of CPAs has issued a Statement of Position Department of Labor. The bank regulatory agen-
(SOP) 723 which discusses ESOP borrowing cies also have some responsibility in their re-
situations. Since the Federal Reserve applies view and examination activities where employee
generally accepted accounting principles, banks benefit plans such as ESOPs are involved. In
and bank holding companies should follow SOP this connection, a Uniform Interagency Referral
763. The SOP statement covers cases where Agreement mandated by statute, has been in
the employer either guarantees the ESOP loan effect since 1980 whereby certain possible vio-
or commits to make future ESOP contributions lations of the provisions of ERISA are referred
sufficient to service the debt. For such cases, the to the DOL by the Division of Banking Supervi-
SOP indicates that the employer should credit a sion and Regulation, pursuant to delegated au-
liability account for the amount of the ESOP thority. SR 81697 (SA) contains the proce-
debt and offset that entry by reducing sharehold- dures for making referrals to the Department of
ers equity. The liability recorded by the em- Labor. Attached to the SR letter is an exhibit,
ployer should be reduced as the ESOP makes ERISA Referral Format, which lists the informa-
payments on the debt. This liability is recorded tion necessary when making referrals. Holding
because the guarantee or commitment is in sub- company examiners can expedite the ERISA
stance the employers debt. When there is no referral process by including that information in
guarantee, the ESOP is treated like any other their reports.
shareholder.
In other words, where there is a leveraged
ESOP which has purchased BHC stock, and 2080.5.3 STATUS OF ESOPS UNDER
there is a guarantee, commitment, or other THE BHC ACT
arrangement which is in effect a guarantee rela-
tive to the debt service of the ESOP, for analyti- On August 6, 1985, the Board determined (1985
cal purposes the amount of ESOP debt will be FRB 804) that an ESOP that controls more than
considered as parent debt and thus parent equity 25 percent of the voting shares of a bank or
will be reduced accordingly. This will affect bank holding company is a bank holding com-
debt to equity ratios as well as consolidated pany. The Board determined that the underlying
capital ratios, where applicable. trust which held the shares of the bank holding
company is a business trust as defined in the
BHC Act and was thus not excluded from the
2080.5.2.2 Fiduciary Standards under definition of a company under the terms of
ERISA Pertaining to ESOPs the Act.
There are also general fiduciary standards under

ERISA pertaining to ESOPs which have been 2080.5.4 INSPECTION
delineated largely through court decisions rather CONSIDERATIONS
than issuance of regulations. Although ex-
empted from ERISAs asset diversification re- Examiners should review unfunded pension lia-
quirement, ESOP transactions are still required bilities of the BHC to determine their potential
to meet fiduciary standards of prudence, and impact on the organization. In addition, examin-
must be designed and administered for the ex- ers should review the soundness of any borrow-
clusive benefit of plan employees. (ERISA ings used to fund ESOP purchases of BHC
404(a) and 29 CFR 2550.407d6). Yet, as stock. ESOP borrowings from an affiliated bank
stated above, ESOPs may have distinct advan- used to purchase BHC shares may result in an
tages which inure primarily to the sponsoring apparent increase in BHC capital which in fact
company, its management and large sharehold- turns out to have been funded with subsidiary
ers. Due to these potential or actual conflicts of bank funds, a practice considered suitable for
interest, it is important that the sponsoring em- in-depth review by examination staff. Section
ployer and any other fiduciaries of a plan under- 401 (of the Internal Revenue Code) plan hold-
take every effort to assure full consideration of ings of BHC stock need to be evaluated under
the best interests of plan employees. the content provisions of the BHC Act,
The safeguarding of the statutory exclusive change in Bank Control Act, and Regulation Y.
interests of plan employees pursuant to ERISA When an ESOP is subject to the Change in
is within the jurisdiction of the IRS and the Bank Control Act, this fact should be brought to
the attention of a BHCs management. Section
BHC Supervision Manual December 1992 225.41 of Regulation Y specifies transactions
Page 2 acquisitionsthat would require providing the
Funding (Pension Funding and Employee Stock Option Plans) 2080.5
Board with 60 days prior written notice before should be made as to whether the ESOP is a
acquiring control of a bank holding company bank holding company. The examiner may also
(or a state member bank), unless the transaction refer to the Financial Accounting Standards
is exempt under section 225.42 of the Regula- Boards Statement No. 87, Employers Ac-
tion. In addition to the above, a determination counting for Pensions.

Page 3
Funding (Bank Holding Company Funding
from Sweep Accounts) Section 2080.6
A key principle underlying the Federal Re- readily marketable, investment grade assets that
serves supervision of bank holding companies can be disposed of with minimal loss of princi-
is that such companies should be operated in a pal.1 Use of such proceeds to finance mis-
way that promotes the soundness of their subsid- matched asset positions, such as those involving
iary banks. Holding companies are expected to leases, loans, or loan participations, can lead to
avoid funding strategies or practices that could liquidity problems at the parent company and
undermine public confidence in the liquidity or are not considered appropriate. The absence of a
stability of their banks. Consequently, bank clear ability to redeem overnight or extremely
holding companies should develop and maintain short-term liabilities when they become due
funding programs that are consistent with their should generally be viewed as an unsafe and
lending and investment activities and that pro- unsound banking activity.
vide adequate liquidity to the parent company Reserve Bank supervisory and examination
and its nonbank subsidiaries. personnel are to ensure that bank holding com-
panies and their state member banks are in
compliance with this section and related super-
2080.6.1 FUNDING BY SWEEPING visory letters addressing the marketing of unin-
DEPOSIT ACCOUNTS sured debt instruments, including master notes
and other sweep arrangements (refer to Manual
A principal objective of a bank holding compa- sections 2080.05 and 2080.1). Banking organi-
nys funding strategy should be to maintain an zations not in compliance should take the neces-
adequate degree of liquidity at the parent com- sary steps to achieve full compliance within a
pany and its subsidiaries. Funding mismatches reasonable period of time. Reserve Banks
can exacerbate an otherwise manageable period should provide copies of the supervisory letter
of financial stress and, in the extreme, under- SR 9031 to any bank holding company en-
mine public confidence in an organizations gaged in sweep arrangements with their subsidi-
viability. In developing and carrying out fund- ary banks, or to any other organization if neces-
ing programs, bank holding companies should sary to facilitate compliance.
give special attention to the use of overnight or
extremely short-term liabilities since a loss of
confidence in the issuing organization could
lead to an immediate funding problem. Accord-
ingly, bank holding companies relying on over-
night or extremely short-term funding sources
should maintain a level of superior quality as-
sets, namely, assets that can be immediately
liquidated or converted to cash with minimal
loss, that is at least equal to the amount of those
funding sources.
A potential source of funding mismatch arises
from the use of what has been commonly re-
ferred to as deposit sweeps. This practice is
based upon an agreement with a subsidiary 1. Some banking organizations have interpreted language
in a 1987 letter signed by the Secretary of the Board as
banks deposit customers (typically corporate condoning funding practices that may not be consistent with
accounts) which permits these customers to re- the principles set forth in this supervisory letter and prior
invest amounts in their deposit accounts above a Board rulings. The 1987 letter involved a limited set of facts
designated level in overnight obligations of the and circumstances that pertained to a particular banking orga-
nization; it did not establish or revise Federal Reserve policies
parent bank holding company. These obliga- on the proper use of the proceeds of short-term funding
tions include such instruments as commercial sources. In any event, banking organizations should no longer
paper, program notes, and master notes. rely on the 1987 letter to justify the manner in which they use
In view of the extremely short-term maturity the proceeds of sweep arrangements. Banking organizations
employing sweep arrangements are expected to ensure that
of most sweep arrangements, banking organiza- these arrangements conform with the policies contained in
tions should exercise great care when investing this section and in the Manual section 2080.05 on bank
the proceeds. Appropriate uses of the proceeds holding company funding.
of deposit sweep arrangements are limited to
short-term bank obligations, short-term U.S. BHC Supervision Manual December 1992
Government securities, or other highly liquid, Page 1
Control and Ownership
(General) Section 2090.0
WHATS NEW IN THIS REVISED 1. a company directly or indirectly or acting
SECTION through one or more other persons owns,
controls, or has power to vote 25 percent or
Effective July 2010, this section has been more of any class of voting securities of a
revised to include a reference to the Boards bank or company or
September 21, 2008, Policy Statement on 2. a company controls in any manner the elec-
Equity Investments in Banks and Bank Holding tion of a majority of the directors or trustees
Companies. (See the Boards September 22, of the bank or company.
2008, press release and section 2090.4.4.) The
policy statement provides additional guidance Acting through one or more other persons
on the Boards position on minority equity could include
investments in banks and bank holding compa-
nies that generally do not constitute control
1. acting through the executive officer of a com-
for purposes of the Bank Holding Company Act.
pany, or a relative or business associate of
This policy updates the guidance found in the
that officer;
Boards July 1982 Policy Statement on Non-
voting Equity Investments by Bank Holding 2. financing the purchase of shares of a bank or
Companies. (See section 2090.4.) company when
a. the amount of credit approximates the
purchase price,
2090.0.05 DEFINITIONS b. there is no definite maturity on the credit
extended,
The control provisions of the Bank Holding c. the credit is obtained at a favorable rate of
Company Act (the act) are found in section interest, and
2(a)(1) and (2) (see 12 U.S.C. 1841(a)) under d. the bank whose shares are held as collat-
the definition of a bank holding company. A eral maintains an excessive balance with
bank holding company is defined as any com- the lending company;
pany which has control over any bank or over
3. by a resolution of a companys board of
any company that is or becomes a bank holding
directors, guaranteeing an individual against
company by virtue of the Act.
any loss in relationship to his ownership in a
The term company means any corporation,
bank or company when such ownership rep-
partnership, business trust, association, or simi-
resents 25 percent or more of any voting
lar organization, or any other trust.1 Any corpo-
class;
ration in which the majority of the shares are
owned by the United States or by any state is 4. recognizing earnings from another company;
not considered a company. or
A company covered in 1970 means a com- 5. participating in policy formation or daily
pany that became a bank holding company as a operations of another company.
result of the enactment of the Bank Holding
Company Act Amendments of 1970 and which The power to vote includes the right to
would have been a bank holding company on vote, to direct the voting of shares, or to imme-
June 30, 1968, if those amendments had been diately transfer shares to the name of the holder
enacted on that date. of such rights or the holders nominee, pursuant
to any proxy, contract, or agreement. However,
when stock is held as collateral for a loan under
2090.0.1 CONCLUSIVE an agreement which enables the lender to trans-
PRESUMPTIONS OF CONTROL fer the stock into the name of the lender or its
nominee without the power to vote, the right to
The conclusive presumptions of control are have the shares transferred does not in itself
established in section 2(a)(2)(A) and (B) of the constitute control. To constitute control, the
act when power to vote must be perfected along with the
transfer of the stock into the name of the lender
or its nominee.
1. Unless the terms of the trust require it to terminate
within 25 years or not later than 21 years and 10 months after
the death of individuals living on the effective date of the BHC Supervision Manual July 2010
trust. Page 1
Control and Ownership (General) 2090.0
2090.0.2 DIRECT CONTROL members, or employees, the shares must be

held as a class.
Direct control exists when a company (as 5. If a trust meets the definition of a company, it
defined in section 2(b) of the act) owns 25 per- is possible for such a trust to be a bank
cent or more of any one class of voting securi- holding company. In addition, it is possible
ties of a bank (as defined in section 2(c) of the for a bank through the administration of a
act) or company. Voting securities includes trust(s)(which does not meet the definition of
potential as well as actual voting authority. a company) to become a bank holding com-
pany (that is, a bank which has control over
various trusts whose shares aggregate to
2090.0.3 INDIRECT CONTROL 25 percent or more of a bank or bank holding
company could be deemed a bank holding
Indirect ownership or control is defined in sec- company; a bank which administers a trust
tion 2(g) of the act in subsections 1 and 2 as that owns 25 percent or more of a bank or
follows: bank holding company (and such trust does
(1) Shares owned or controlled by any subsid- not meet the definition of a company) could
iary of a bank holding company shall be be a bank holding company.
deemed to be indirectly owned or con- In addition to the above determinants involv-
trolled by such bank holding company; ing conclusive presumptions of control, the
and Board has determined that whenever the trans-
(2) Shares held or controlled directly or indi- ferability of 25 percent or more of any class of
rectly by trustees for the benefit of (A) a voting securities of a company is restricted, in
company, (B) the shareholders or mem- any manner, upon the transfer of 25 percent or
bers of a company, or (C) the employees more of any class of voting securities of another
(whether exclusively or not) of a com- company, the holders of the two securities
pany, shall be deemed to be controlled by affected by the restriction constitute a company
such company. for the purposes of the act. This determination
To assist in the interpretation of the above sub- applies unless one of the issuers of such securi-
sections the following explanations are ties is a subsidiary of the other and is so identi-
provided. fied in a Board order or in a registration state-
1. All shares owned by a subsidiary of a bank ment or report accepted by the Board under the
holding company are deemed to be con- act.
trolled by the parents ownership interest in In any administrative or judicial proceedings
the directly owned subsidiary. regarding conclusive presumptions of control, a
2. Shares held in a trust for the benefit of a company would not be considered to control a
company are deemed to be controlled by bank or company at any given time unless that
such company regardless of whether the company, at the time in question, directly or
trustee or company votes the shares. A com- indirectly owned, controlled, or had power to
pany is deemed to be the beneficial owner of vote 5 percent or more of any class of voting
shares which it does not vote if all other securities of the bank or company.
shareholders rights are retained by such
company (that is, dividends, or other rights).
3. Shares owned by a trustee for the benefit of a 2090.0.4 REBUTTABLE
companys subsidiary (or the subsidiarys PRESUMPTIONS OF CONTROL
shareholders, members, or employees) are
deemed to be controlled by both the subsidi- A rebuttable presumption of control exists when
ary and its parent. the Board determines, after notice and opportu-
4. Shares held in a trust for the benefit of nity for hearings, that a company directly or
an individual stockholder, member, or indirectly exercises a controlling influence over
employee are not deemed to be controlled the management or policies of a bank or com-
by a company because such shares are held pany (section 2(a)(2)(C) of the act). With regard
for the individual regardless of his or her to the above, there is a presumption that any
relationship with the company. For a com- company which directly or indirectly owns, con-
pany to have control over the shares held for trols, or has power to vote less than 5 percent of
the benefit of a companys stockholders, any class of voting securities of a given bank or
company does not have control over that bank
BHC Supervision Manual July 2010 or company (section 2(a)(3) of the act). This
Page 2 5 percent presumption does not prohibit the
Board from determining that a company exer- ciated individuals. A company that,
cises a controlling influence when such com- together with its management officials or
pany owns, controls, or has power to vote less principal shareholders (including mem-
than 5 percent of any class of voting securities bers of the immediate families of either
of another company or bank. However, in over- (as defined in 12 C.F.R. 206.2(k)) owns,
coming the presumption, the Board bears the controls, or holds with power to vote
burden of proving that such a controlling influ- 25 percent or more of the outstanding
ence exists. shares of any class of voting securities of
a bank or other company, if the first com-
pany owns, controls, or holds with power
2090.0.4.1 Regulation Y Determinants of to vote more than 5 percent of the out-
Control standing shares of any class of voting
securities of the bank or other company.
The Board has established the following rebut- c. Common management officials. A com-
table presumptions of control in section 225.31 pany that has one or more management
of Regulation Y for use in proceedings: officials in common with a bank or other
company controls the bank or other com-
1. Control of voting securities. pany, if the first company owns, controls,
a. Securities convertible into voting securi- or holds with power to vote more than
ties. A company that owns, controls, or 5 percent of the outstanding shares of any
holds securities that are immediately class of voting securities of the bank or
convertible, at the option of the holder other company, and no other person con-
or owner, into voting securities of a bank trols as much as 5 percent of the outstand-
or other company controls the voting ing shares of any class of voting securities
securities. of the bank or other company.
b. Option or restriction on voting securities. d. Shares held as fiduciary. The pre-
A company that enters into an agreement sumptions of control in paragraphs
or understanding under which the rights 225.31(d)(2)(ii) and (iii) of Regulation Y
of a holder of voting securities of a bank do not apply if the securities are held by
or other company are restricted in any the company in a fiduciary capacity with-
manner controls the securities. This pre- out sole discretionary authority to exer-
sumption does not apply where the agree- cise the voting rights.
ment or understanding
(1) is a mutual agreement among share-
holders granting to each other a right 2090.0.4.2 Other Presumptions of Control
of first refusal with respect to their
shares; In addition to the rebuttable presumptions, there
(2) is incident to a bona fide loan transac- are a number of other circumstances that are
tion; or indicative of control and may call for further
(3) relates to restrictions on transferabil- investigation to uncover facts that support a
ity and continues only for the time determination of control. Such circumstances
necessary to obtain approval from the include the following:
appropriate federal supervisory 1. A company owns at least 10 percent of each
authority with respect to acquisition of two banks or at least 5 percent of each of
by the company of the securities. three or more banks.
2. Control over company. 2. A company owns 5 percent or more of a
a. Management agreement. A company that bank or bank holding company and has been
enters into any agreement or understand- instrumental in the hiring or firing of one or
ing with a bank or other company (other more persons; establishing policies or places
than an investment advisory agreement), for branches; establishing hours of business;
such as a management contract, under deciding on rates, terms, or acceptance of
which the first company or any of its loans or deposits; following uniform adver-
subsidiaries directs or exercises signifi- tising practices or using a common telephone
cant influence over the general manage- system; or any other respects directing the
ment or overall operations of the bank or activities of management or establishing the
other company controls the bank or other
company. BHC Supervision Manual July 2010
b. Shares controlled by company and asso- Page 3
policies of the bank or company. of such a solicitation (section 2(a)(5)(C) of

3. A company lends to a borrower on more the act);
favorable terms than it would have for a 4. . . . shares acquired in securing or collect-
borrower of comparable credit standing to ing a debt previously contracted in good
enable the borrower to acquire voting shares faith, until two years after the date of acquisi-
of a bank or other company. tion (section 2(a)(5)(D) of the act);
If the Board proposes to make a determina- (The Board is authorized upon application by
tion based on the above indicators of control, a company to extend, from time to time for
the Board bears the burden of providing evi- not more than one year at a time, the two-year
dence that such a control situation exists. period referred to herein for disposing of any
shares acquired by a company in the regular
course of securing or collecting a debt previ-
ously contracted in good faith, if, in the
2090.0.5 PROCEDURES FOR Boards judgment, such an extension would
DETERMINING CONTROL not be detrimental to the public interest, but
no such extension shall in the aggregate
The question of whether a control situation exceed three years.)
exists may arise from information coming to the 5. . . . any State-chartered bank or trust com-
Boards attention or from a companys seeking pany which
to obtain the Boards opinion regarding a spe- (i) is wholly owned by thrift institutions or
cific situation. When this question arises, the savings banks; and
Board has instructed each Reserve Bank to (ii) is restricted to accepting
make every effort to resolve the matter with the (I) deposits from thrift institutions or
company without resorting to the procedures savings banks;
outlined in this section. However, if the Reserve (II) deposits arising out of the corporate
Bank is unsuccessful in resolving the matter, it business of thrift insitutions or sav-
is referred to the Board staff. If the Board staff ings banks that own the bank or trust
feels the matter warrants Board consideration, it company; or
will recommend that the Board make a prelimi- (III) deposits of public moneys. (section
nary determination of control based on the avail- 2(a)(5)(E) of the act); and
able facts and so inform the company. (See 6. . . . a single . . . bank, if such . . . com-
section 225.31(a).) Following the preliminary pany is a trust company or mutual savings
determination of control, the company must, bank located in the same State as the bank
within 30 days (or longer as may be permitted and if . . . (i) such ownership or control
by the Board), submit the information required existed on the date of enactment of the Bank
by section 225.31(b). Holding Company Act Amendments of 1970
If the company contests the Boards determi- and is specifically authorized by applicable
nation, it is entitled to a formal hearing at its State law, and (ii) the trust company or
request. (See section 225.31(c).) mutual savings bank does not after that date
Notwithstanding any other provision of the acquire an interest in any company that,
act, a company is not deemed to be a bank together with any other interest it holds in
holding company by virtue of its control of that company, will exceed 5 percentum of
1. . . . shares [held] in a fiduciary capacity, any class of the voting shares of that com-
except as provided in paragraphs (2) and (3) pany, except that this limitation shall not be
of subsection (g) (section 2(a)(5)(A) of the applicable to investments of the trust com-
act); pany or mutual savings bank, direct and indi-
2. . . . shares acquired by it in connection with rect, which are otherwise in accordance with
its underwriting of securities if such shares the limitations applicable to national banks
are held only for such period of time as will under section 5136 of the Revised Statutes
permit the sale thereof on a reasonable basis (12 U.S.C. 24) (section 2(a)(5)(F) of the
(section 2(a)(5)(B) of the act); act).
3. [a] company formed for the sole purpose of
participating in a proxy solicitation if the
voting rights of the shares acquired by such 2090.0.6 INSPECTION OBJECTIVES
company are acquired in the ordinary course
1. To determine whether any change in control
BHC Supervision Manual July 2010 of a bank holding company has resulted in a
Page 4 company (as defined by section 2(b) of the
act) becoming a bank holding company in 2. If there are any subsidiaries that are indi-
violation of section 3(a)(1) of the act. rectly owned or controlled as defined in sec-
2. To ascertain whether an existing bank hold- tion 2(g) of the act, determine if such shares
ing company has acquired either directly or are held in a trust and, if so, whether the trust
indirectly additional banking assets in viola- agreement contains any provisions that could
tion of section 3(a)(3) of the act. potentially expose the holding company or
3. To establish whether a company which has any of its subsidiaries to financial or other
purchased its own stock is in compliance liabilities.
with section 225.4(b) of Regulation Y. (See
section 2090.3.)

1. Review the companys stock records and the
companys investment portfolio.

Regulation Y 225
Direct control voting 1978 FRB 121
securities
Indirect control as trustee Ltr. 1/14/76 to W.
Lloyd, Chicago Fed
Ltr. 10/16/73 to W.
Lloyd, Chicago Fed
Acting through others 1970 FRB 350
1974 FRB 865
1972 FRB 717
1974 FRB 130
1974 FRB 131
Transfer of shares 1974 FRB 875
Rebuttable presumption of
control
nonvoting stock 1972 FRB 487
other indicators of control 136 Fed. Reg.
18945
(Sept. 24, 1971)
Procedures for determining S-2173 Patogonia vs. BOG
control (Sept. 17, 1971) 517 F. 2d 803
(at 4191.1) (9th Cir. 1975)
Nonvoting equity 225.143 4-172.1 1982 FRB 413
investments by BHCs

Page 5

Equity investments in 225.144
banks and BHCs (2008
Policy Statement)

Page 6
(Qualified Family Partnerships) Section 2090.05
WHATS NEW IN THIS REVISED not be obligated on any debt, either directly or
SECTION as a guarantor.4
This section has been revised to include a Board Any partnership requesting qualification as a
staff interpretation, pertaining to a qualified QFP must commit (1) to be subject to Federal
family partnership (QFP), that was issued on Reserve Board examination to ensure compli-
May 10, 2010. The interpretation considered ance with the conditions for eligibility and (2) to
whether a proposed assignment of an economic be treated as a BHC for purposes of enforce-
interest in the partnership interests of a partner- ment actions by the Board. In addition, while a
ship that is a QFP under section 2(o)(10) of the QFP is exempt from the prior-approval require-
Bank Holding Company Act would cause the ments of section 3 of the Act in connection with
partnership to lose its status as a QFP. a bank acquisition, the partnership continues to
be subject to the notice provisions of the Change
in Bank Control Act.
2090.05.1 QUALIFIED FAMILY As noted above, the primary benefits to
PARTNERSHIP EXEMPTION becoming a QFP are (1) exemption from the
capital requirements applicable to BHCs,
Under the Bank Holding Company Act (the (2) exemption from the reporting requirements
Act), any company (including a partnership) applicable to a BHC, and (3) the freedom to
that controls a bank is considered a bank hold- make permissible nonbanking investments with-
ing company (BHC).1 Section 2(o) of the Act out prior Board approval. Because the QFP must
(as amended by section 2610 of the Economic use a single registered BHC to hold all of its
Growth and Regulatory Paperwork Reduction bank investments, there continues to be a BHC
Act of 1996),2 however, provides a limited subject to the requirements of the Act in every
exemption from the definition of company for a case. This structure ensures that the cross-
qualified family partnership (QFP), and guarantee provisions of the Federal Deposit
accordingly, a partnership that qualifies as a Insurance Act continue to apply to all banks
QFP is not considered a BHC under the Act.3 A controlled by a QFP.
QFP, under the Act, is able to own and control a
BHC without the partnership becoming subject
to the registration, source of strength, approval, 2090.05.2 ASSIGNMENT OF
reporting, and other requirements imposed on a ECONOMIC PARTNERSHIP
BHC. INTEREST THAT IS A QFP
In order to qualify for the Acts exemption
for a QFP, all the partners of the QFP must be Board staff issued a May 10, 2010, interpreta-
individuals related to each other by blood, mar- tion on whether a proposed assignment of an
riage, or adoption; or trusts for the primary economic interest in the partnership interests of
benefit of those individuals (collectively, a partnership that is a QFP under section
qualified parties). In addition, the partner- 2(o)(10) of the Act would cause the partnership
ship must to lose its status as a QFP.5 Board staff noted
that the QFP exemption does not distinguish
control any bank (its bank investments) between the legal and beneficial ownership of
through a single registered BHC that remains such partnership interest. An assignment of the
subject to all of the provisions of the Act; economic interests in a QFP interest, especially
control only one registered BHC; in the case of a limited partnership interest,
not engage in any business activity except would effectively give the assignee a beneficial
indirectly through ownership of other busi- interest in the QFP. Where the assignee is not a
ness entities (that is, the partnership must be family member, Board staff believes that such
an investment vehicle for the family and may
not be an operating company);
limit its investments to those permitted for a 4. The QFP also must commit to examination by the Board
and to the notice requirements of the Change in Bank Control
BHC under section 4(c) of the Act; and Act if it acquires an additional bank.
5. 12 U.S.C. 1841(o)(10).
1. 12 U.S.C. 184l(a)(1).
2. Pub. L. 104-2089, section 2610; 110 Stat. 3009. BHC Supervision Manual July 2010
3. 12 U.S.C. 1841(b). Page 1
Control and Ownership (Qualified Family Partnerships) 2090.05
an assignment would undermine the family would be inconsistent with the relationship
relationship requirement of the Act and would requirement of the statute. The partnership
expand the exemption beyond its limited scope. would not be in compliance with the statutory
Accordingly, Board staff believes that an assign- requirements of a QFP and would be required to
ment of the economic interests in the partner- register as a BHC.
ship interest of a QFP to a non-qualified person

Page 2
(Change in Control) Section 2090.1
The Change in Bank Control Act of 1978 (the Board will review each notice to acquire control
CBC Act), title VI of the Financial Institutions of a state member bank or bank holding com-
Regulatory and Interest Rate Control Act of pany and will disapprove transactions that are
1978, gives the federal bank supervisory agen- likely to have serious harmful effects. The
cies the authority to disapprove changes in con- Boards intention is to administer the CBC Act
trol of insured depository institutions.1 The Fed- in a manner that will minimize delays and
eral Reserve Board is the responsible federal government regulation of private-sector
banking agency for changes in control of bank transactions.
holding companies and state member banks, and If the Board disapproves a change-in-control
the Federal Deposit Insurance Corporation and filing, the Board will notify the proposed acquir-
the Office of the Comptroller of the Currency ing party in writing within three days after its
are responsible for insured state nonmember and decision. The notice of disapproval will include
national banks respectively. a statement of the basis for disapproval. The
The CBC Act requires any person (that is, an CBC Act provides that the acquiring party may
individual, a partnership, a corporation, a trust, request a hearing by the Board in the event of a
an association, a joint venture, a pool, a sole disapproval and provides a procedure for further
proprietorship, or an unincorporated organiza- review by the courts.
tion) seeking to acquire control of any insured Forms for filing notices of proposed transac-
depository institution or bank holding company tions covered by the CBC Act are available
to provide 60 days prior written notice to the from the Federal Reserve Banks. Persons con-
appropriate federal banking agency. The act spe- templating an acquisition that would result in a
cifically exempts transactions that are subject to change in control of a BHC or state member
section 3 of the Bank Holding Company Act of bank should request the appropriate forms and
1956 or section 18 of the Federal Deposit Insur- instructions from the Reserve Bank in whose
ance Act because those transactions are covered District the affected institution is located. Forms
by existing regulatory approval procedures. Ac- and instructions may also be accessed from the
cordingly, changes in control due to acquisitions Federal Reserve Boards public web site (www.
by bank holding companies and changes in con- federalreserve.gov). The primary forms to be
trol of insured depository institutions resulting completed are the Interagency Biographical and
from mergers, consolidations, or other similar Financial Report and the Interagency Notice of
transactions are not covered by the CBC Act. Change in Control. Filers are requested to con-
The CBC Act describes the factors that the sult with the appropriate Reserve Bank to con-
Federal Reserve and the other federal banking firm what specific information should be
agencies are to consider in determining whether included in a particular notice. The Reserve
a transaction covered by the CBC Act should be Bank can provide specialized publication mate-
disapproved. These factors include the financial rial that will assist the filers in placing a com-
condition, competence, experience, and integ- plete announcement of the proposed acquisition
rity of the acquiring person (or persons acting in in the appropriate newspaper of general cir-
concert); the effect of the transaction on compe- culation. The Board of Governors also will pub-
tition; whether the acquiring persons have pro- lish the notices in the Federal Register. (See
vided all required information; and whether the SR-03-19.)
proposed transaction would result in an adverse When a substantially complete notice is
effect on the Bank Insurance Fund or the Sav- received by the Federal Reserve Bank, a letter
ings Association Insurance Fund. The Federal of acknowledgment will be sent to the acquiring
Reserve Boards objectives in its administration person indicating the date of receipt. After
of the CBC Act are to enhance and maintain reviewing the submitted information, the Fed-
public confidence in the banking system by pre- eral Reserve may initiate name checks with
venting identifiable, serious adverse effects certain other U.S. government agencies (includ-
resulting from anticompetitive combinations of ing law enforcement) on some or all of the
interests, inadequate financial support, and individuals related to the proposal. The informa-
unsuitable management in the institutions. The tion received from those name checks will be
used to further the assessment of the relevant
statutory factors, including the competence,
1. The term insured depository institution includes any
depository institution holding company and any other com-
pany that controls an insured depository institution. The CBC BHC Supervision Manual June 2004
Act is found in 12 U.S.C. 1817(j)(1)(18). Page 1
Control and Ownership (Change in Control) 2090.1
experience, integrity, and financial ability of the years of financial data from any acquiring per-
individual filers. son. For complete details on the informational
requirements of a change-in-control filing, see
the Boards public web site at www.
2090.1.1 COMMITMENTS AND federalreserve.gov/generalinfo/applications/afi/.
CONDITIONS FOR APPROVAL In particular, review the Systems Form FR
2081a, Interagency Notice of Change in
Approvals granted by the Federal Reserve under Control.
the CBC Act may be subject to commitments or
conditions that require the filer to consult with
appropriate Federal Reserve staff before acquir- 2090.1.4 TRANSACTIONS
ing further shares of the subject banking organi- REQUIRING SUBMISSION
zation. The Board or the Reserve Bank may also OF PRIOR NOTICE
impose restrictions on the acquisition of addi-
tional shares by any person who already con- The CBC Act defines control as the power,
trols an institution. The imposition of such com- directly or indirectly, to vote 25 percent or more
mitments, conditions, or limitations is intended of any class of voting securities or to direct the
to ensure that statutory factors remain consistent management or policies of a bank holding com-
with approval. pany or insured depository institution. There-
fore, unless exempted by the CBC Act, any
transaction that results in the acquiring party
2090.1.2 COMPLETION OF THE having voting control of 25 percent or more of
TRANSACTION any class of voting securities or that results in
The transaction may be completed 61 days after the power to direct the management or policies
the date of receipt stated in the acknowledgment of such an institution would trigger the notice
letter, unless the acquiring person has been noti- requirement. However, any person who on
fied by the Board that the acquisition has been March 9, 1979, controlled a bank holding com-
disapproved or that the 60-day period has been pany or state member bank shall not be required
extended as provided for in subparagraph (j)(1) to file a notice to maintain or increase control
of the CBC Act. To avoid undue interference positions in the same institution. In addition, the
with normal business transactions, the Board Boards regulation on a rebuttable presumption
may issue a notice of its intention not to disap- of control allows persons who on March 9,
prove a proposal, after consulting with the rel- 1979, fell within a presumption to acquire addi-
evant state banking authorities as the CBC Act tional shares of an institution without filing
requires. notice so long as they will not have voting
control of 25 percent or more of the institution
(Regulation Y, 12 C.F.R. 225.41). In connection
2090.1.3 INFORMATION TO BE with transactions that would result in greater
INCLUDED IN NOTICES voting control, such persons may file the
required notice or request that the Board make
The CBC Act requires a person proposing to a determination that they already control the
acquire control of a bank holding company or institution.
state member bank to file a notice with the Section 225.41 of Regulation Y sets forth the
Federal Reserve Board that includes biographi- specific types of transactions that require prior
cal and financial information on the filers; notice under the CBC Act. Prior notice is
details of the proposed acquisition; information required by any person (acting directly or indi-
on any proposed structural, managerial, or rectly) that seeks to acquire control of a state
financial changes that would affect the banking member bank or bank holding company. A per-
organization to be acquired; and other relevant son may include an individual, a group of indi-
information required by the Board. viduals acting in concert, or certain entities (for
A current statement of assets and liabilities, a example, corporations, partnerships, or trusts)
brief income summary, and a statement of any that own shares of banking organizations but
material changes since the effective date of this that do not qualify as bank holding companies.
financial-statement information is required. The A person acquires control of a banking organi-
Board reserves the right to require up to five zation whenever the person acquires ownership,
control, or the power to vote 25 percent or more
BHC Supervision Manual June 2004 of any class of voting securities of the
Page 2 institution.
2090.1.4.1 Rebuttable Presumption of pany Act and, therefore, do not require notices
Control under the CBC Act.
Persons who have the power to vote less than

25 percent of an institutions shares may be 2090.1.4.2 Rebuttable Presumption of
required to file notice under the Boards rebut- Concerted Action
table presumption of control, found in section
225.41 of Regulation Y. The Board presumes The following persons are presumed to be act-
that an acquisition of voting securities of a state ing in concert3 and must file a CBC Act notice if
member bank or bank holding company consti- their share of ownership reaches the required
tutes the acquisition of control under the CBC levels:
Act, requiring prior notice to the Board, if,
immediately after the transaction, the acquiring 1. a company and any controlling shareholder,
person (or persons acting in concert) will own, partner, trustee, or management official of
control, or hold with power to vote 10 percent the company, if both the company and the
or more of any class of voting securities of the person own voting shares of the state mem-
institution, and if ber bank or bank holding company
2. an individual and the individuals immediate
1. the institution has registered securities under family
section 12 of the Securities Exchange Act of 3. companies under common control
1934 (15 U.S.C. 78l); or 4. persons that are parties to an agreement, con-
2. no other person will own, control, or hold the tract, understanding, relationship, or other
power to vote a greater percentage of that arrangement, whether written or otherwise,
class of voting securities immediately after regarding the acquisition, voting, or transfer
the transaction.2 of control of voting securities of a state mem-
ber bank or bank holding company, other
Other transactions resulting in a persons con- than through a revocable proxy
trol of less than 25 percent of a class of voting 5. persons who have made or propose to make a
shares of a bank holding company or state joint filing under sections 13 and 14 of the
member bank would not result in control for Securities Exchange Act of 1934 (15 U.S.C.
purposes of the CBC Act. In addition, custom- 78m), and the rules promulgated thereunder
ary one-time proxy solicitations and the receipt by the Securities and Exchange Commission
of pro rata stock dividends are not subject to the 6. any person and any trust for which the per-
CBC Acts notice requirements. son serves as trustee
In some cases, corporations, partnerships, cer-
tain trusts, associations, and similar organiza- If there is any doubt whether a proposed transac-
tions that are not already bank holding compa- tion requires a notice, the acquiring person
nies may be uncertain whether to proceed under should consult the Federal Reserve Bank for
the CBC Act or under the Bank Holding Com- guidance. The CBC Act places the burden of
pany Act with respect to a particular acquisition. providing notice on the prospective acquiring
These organizations should comply with the person.
notice requirements of the CBC Act if they are
not required to secure prior Board approval
under the Bank Holding Company Act. How- 2090.1.5 TRANSACTIONS NOT
ever, some transactions (described in sections REQUIRING ANY NOTICE
2(a)(5)(D) and 3(a)(5)(A) and (B) of the Bank
Holding Company Act), particularly foreclo- Section 225.42 of Regulation Y sets forth the
sures by institutional lenders, fiduciary acquisi- transactions that do not require any notice under
tions by banks, and increases of majority hold- the CBC Act or that require after-the-fact notice.
ings by bank holding companies, do not require The following transactions do not require any
the Boards prior approval. They are considered notice to the Federal Reserve:
subject to section 3 of the Bank Holding Com-
3. Acting in concert includes knowing participation in a
joint activity or parallel action towards a common goal of
acquiring control of a state member bank or bank holding
2. If two or more persons, not acting in concert, each
company whether or not pursuant to an express agreement.
propose to acquire simultaneously equal percentages of 10
percent or more of a class of voting securities of the state
member bank or bank holding company, each person must file BHC Supervision Manual June 2004
prior notice to the Board. Page 3
1. Existing control relationships. The acquisi- banking organization without submitting the
tion of additional shares if the acquirer is prior or after-the-fact notice required by Regula-
deemed to already have control of the bank- tion Y. These unauthorized or undisclosed
ing organization. changes in bank control may not be known to
2. An increase in previously authorized acquisi- the person, the state member bank, or the bank
tions. The acquisition of additional shares of holding company but are discovered by Reserve
a class of voting securities of a state member Bank examiners during an inspection or exami-
bank or bank holding company by any per- nation of the affected institution. In most cases,
son (or persons acting in concert) who such a violation of the CBC Act is addressed by
acquired and maintained control of the insti- having the person immediately file a notice with
tution after complying with federal the Federal Reserve requesting authority to
requirements. retain the acquired shares.4 The filing should
3. Any acquisition subject to approval under include an explanation of the circumstances that
the Bank Holding Company Act or the Bank resulted in the violation and a description of the
Merger Act. Any acquisition of voting securi- actions that have been (or will be) taken by the
ties subject to approval under section 3 of the filers to ensure no further violations of the stat-
BHC Act or under the Bank Merger Act ute. Although the burden to file a timely change
(section 18(c) of the Federal Deposit Insur- in bank control notice is on the persons who are
ance Act). acquiring control or causing a change in control
4. Transactions exempt under the BHC Act. of a banking organization, an acquired banking
5. A proxy solicitation. Receipt of a revocable organization or a banking organization undergo-
proxy in connection with a proxy solicitation ing a change in control may have better informa-
for the purpose of conducting business at a tion regarding current ownership positions,
regular or special meeting of the institution if including shareholder lists, than the acquiring
the proxy terminates within a reasonable individuals or individuals who propose a change
time. in control. Therefore, it is important that state
6. Stock dividends. Receipt of voting securities member banks and bank holding companies be
as a result of a stock dividend (if the propor- familiar with the regulations and policies gov-
tional interest of the recipient remains sub- erning changes in bank control and, when pos-
stantially the same). sible, share such information with shareholders
7. Acquisition of voting securities of a foreign who have significant ownership positions.
banking organization. The acquisition of vot-
ing securities of a qualifying foreign banking
organization.
2090.1.8 CHANGES OR
REPLACEMENT OF AN
2090.1.6 TRANSACTIONS NOT INSTITUTIONS CHIEF EXECUTIVE
REQUIRING PRIOR NOTICE OFFICER OR ANY DIRECTOR
The transactions that require after-the-fact Institutions must report promptly any changes
notice include the acquisition of voting securi- or replacement of its chief executive officer or
ties (1) through inheritance, (2) as a bona fide of any director, in accordance with paragraph 12
gift, or (3) in satisfaction of a debt previously of the CBC Act. Under section 225.42(a)(7) of
contracted in good faith. In these situations, the Regulation Y, acquisitions of control of foreign
appropriate Reserve Bank must be notified bank holding companies are also exempt from
within 90 days after the acquisition, and the the prior-notice requirements of the CBC Act,
acquirer must provide any relevant information but this exemption does not extend to the reports
requested by the Reserve Bank. and information required under paragraphs 9,
10, and 12 of the act. (See section 2090.1.5.)
2090.1.7 UNAUTHORIZED OR
UNDISCLOSED CHANGES IN BANK 4. A violation may be addressed through two other means.
CONTROL The affected party may either (1) submit, for the Federal
Reserves approval, a specific plan for the prompt termination
of the control relationship or (2) contest the preliminary
In some instances, a person acquires control of a determination of a control relationship by filing a response
that sets forth the facts and circumstances in support of the
BHC Supervision Manual June 2004 partys position that no control exists or, if appropriate, pre-
Page 4 senting such views orally to Federal Reserve staff.
2090.1.9 DISAPPROVAL OF 25 percent or more of a class of voting securi-

CHANGES IN CONTROL ties, which would require the filing of both a
change-in-control and treasury stock notifica-
The CBC Act sets forth various factors to be tion. Furthermore, a stock redemption by a BHC
considered in the evaluation of a proposal. The may result in an existing shareholder (or share-
Board is required to review the competitive holders) owning between 10 percent and 25 per-
impact of the transaction; the financial condition cent of the outstanding shares and being the
of the acquiring person; and the competence, largest shareholder, thereby resulting in a rebut-
experience, and integrity of that person and the table presumption of control. For additional
proposed management of the institution. In information, see section 2090.3 Treasury Stock
assessing the financial condition of the acquir- Redemptions.
ing person, the Board will weigh any debt-
servicing requirements in light of the acquiring
persons overall financial strength and the insti- 2090.1.12 CORRECTIVE ACTION
tutions earnings performance, asset condition,
capital adequacy, and future prospects, as well The Federal Reserve has enforcement jurisdic-
as the likelihood of an acquiring party making tion over those persons who file or should file
unreasonable demands on the resources of the notices under the CBC Act. Accordingly, viola-
institution. tions of the requirement to file a change in bank
control notice may result in the Federal Reserve
taking enforcement action against the relevant
2090.1.10 ADDITIONAL REPORTING persons in appropriate circumstances, including
REQUIREMENTS those involving willful or negligent misconduct.
Paragraph 12 of the CBC Act requires that Violations may result in the persons being sub-
whenever a change in control of a bank holding ject to a variety of sanctions, including the
company occurs, each insured depository insti- assessment of a civil money penalty.
tution is required to report promptly to the Violations of the CBC Act are addressed
appropriate federal banking agency any changes through the same type of investigative and
or replacement of its chief executive officer or enforcement authority and formal corrective
of any director occurring in the next 12-month actions that are used in other administrative
period. A statement of the past and current remedies (12 U.S.C. 1818(b)(n)). The CBC
business and professional affiliations of the new Act also authorizes the assessment of civil
chief executive officer or directors should be money penalties for any violation of the CBC
included in each institutions report. Act (12 U.S.C. 1817(j)(16)) and allows the
Paragraph 9 of the CBC Act indicates that Board to seek divestiture of a BHC or bank
whenever any insured depository institution from any person or company who violates the
makes a loan secured by 25 percent or more of CBC Act (12 U.S.C. 1817(j)(15)).
the outstanding voting stock of an insured
depository institution (or bank holding com-
pany), the president or other chief executive 2090.1.13 INSPECTION OBJECTIVES
officer of the lending bank shall promptly report
such fact to the appropriate federal banking 1. To determine that the BHC has complied
agency of the bank (or bank holding company) with the prior-notification requirements of
whose stock secures the loan. However, no the CBC Act and that changes in ownership
report need be made when the borrower has between 10 percent and 25 percent have been
been the owner of record of the stock for a reviewed for rebuttable presumption
period of one year or more or when the stock is considerations.
that of a newly organized bank before its open- 2. To determine that the BHC has complied
ing. Reports required by this paragraph shall with the reporting requirements of paragraph
contain information similar to the informational 12 of the CBC Act regarding changes in its
requirements of the Notice of Change in board of directors or its chief executive offi-
Control. cer that occur within 12 months of a change
in control.
3. To determine that the BHC has complied
2090.1.11 STOCK REDEMPTIONS with the reporting requirements of paragraph
A stock redemption by a BHC may result in an BHC Supervision Manual June 2004
existing shareholder (or shareholders) owning Page 5
9 of the CBC Act regarding loans made the management of the BHC is still valid.
directly by the BHC secured by 25 percent or When changes in directors or the chief
more of the outstanding voting stock of an executive officer occurred within 12 months
insured depository institution (or bank hold- of the change in control, determine if the
ing company). BHC has reported such changes in compli-
ance with paragraph 12 of the CBC Act.
4. When inspecting a BHC that has redeemed
2090.1.14 INSPECTION PROCEDURES any of its own shares subsequent to March 9,
1979, thereby lowering the number of shares
1. Review the BHCs stock certificate register outstanding, determine whether the holdings
or log to determine if any person (or group of of any individual shareholder have increased
persons acting in concert) has acquired proportionally to greater than 10 percent,
10 percent or more of any class of voting which might trigger the rebuttable presump-
securities. tion of control and may require prior notifica-
2. Review changes in control of between tion of a change in control.
10 percent and 25 percent of any class of 5. Review any loans made directly by the BHC
voting securities to determine if the control- that are secured by 25 percent or more of the
ling party is the single largest shareholder. outstanding shares of a bank (or bank hold-
3. When inspecting a BHC that was the subject ing company) and determine if the BHC has
of a change in control and when a prior complied with the reporting requirements of
notification was filed, review the notification paragraph 9 of the CBC Act.
to determine that information submitted on

Page 6
(BHC Formations) Section 2090.2
WHATS NEW IN THIS REVISED company, either by the formation of a one-bank
SECTION or multibank holding company, section 3(a)(3)
of the act prohibits the direct or indirect acquisi-
Effective July 2015, this revised section incorpo- tion of over 5 percent of any additional banks
rates the Boards May 15, 2015 (effective date) or bank holding companys shares without prior
amendment of the Small Bank Holding Com- Board approval. In addition to the above, sec-
pany Policy Statement to expand the applicabil- tion 3(a)(3) serves to prevent an existing bank
ity of its policy statement to include certain holding company from increasing, without prior
savings and loan holding companies. Board approval, its ownership in an existing
The policy statement facilitates the transfer of subsidiary bank unless the BHC already owns
ownership of small community banks and sav- 50 percent of the shares of the bank (section
ings associations by allowing their holding com- 3(a)(5)(B)). A bank holding company which
panies to operate with higher levels of debt than owns more than 50 percent of a banks shares
would normally be permitted. While holding may buy and sell those shares freely without
companies that qualify for the policy statement Board approval, provided the ownership
are excluded from consolidated capital require- remains above 50 percent. If a bank holding
ments, their depository institution subsidiaries company owns less than 50 percent of a banks
continue to be subject to minimum capital shares, prior Board approval is required before
requirements. each additional acquisition of shares until the
The rule amendment raised the asset thresh- bank holding companys ownership of the bank
old of the policy statement from $500 million to reaches more than 50 percent.
$1 billion in total consolidated assets. All firms
must meet certain qualitative requirements,
including those pertaining to nonbanking activi- 2090.2.2 HISTORY OF THE POLICY
ties, off-balance sheet activities, and publicly STATEMENT ON THE FORMATION
registered debt and equity. See 80 Fed. Reg. OF SMALL BANK HOLDING
2015320158 (April 15, 2015). COMPANIES
The Board issued the policy statement in 1980
2090.2.1 FORMATION OF A BANK to facilitate the transfer of ownership of small
HOLDING COMPANY AND CHANGES community-based banks in a manner consistent
IN OWNERSHIP with bank safety and soundness. The Board has
generally discouraged the use of debt by bank
The formation of a bank holding company and holding companies to finance the acquisition of
certain changes in the ownership of banks banks or other companies because high levels of
owned by a bank holding company come under debt can impair the ability of the holding com-
the provisions of section 3 of the BHC Act. pany to serve as a source of strength to its
Section 3(a)(1) prohibits the formation of a bank subsidiary banks. The Board has recognized,
holding company without prior Board approval. however, that small bank holding companies
A company may receive approval pursuant to have less access to equity financing than larger
section 3(a)(1) to become either a one-bank bank holding companies and that the transfer of
holding company or a multibank holding ownership of small banks often requires the use
company. of acquisition debt. Accordingly, the Board
A primary reason for the formation of a one- adopted the policy statement to permit the for-
bank holding company is to obtain income tax mation and expansion of small bank holding
benefits.1 These benefits include offsetting companies with debt levels that are higher than
operating/capital losses of one corporation typically permitted for larger bank holding com-
against the profits/capital gains of another. panies. The policy statement contains several
Once a company becomes a bank holding conditions and restrictions designed to ensure
that small bank holding companies that operate
1. A domestic corporation may be entitled to a special with the higher levels of debt permitted by the
deduction from gross income for dividends received from a policy statement do not present an undue risk to
taxable domestic corporation. There is (1) a 70 percent deduc- the safety and soundness of their subsidiary
tion for dividends received from a corporation that is less than
20 percent owned; and (2) an 80 percent deduction for divi-
dends received from a corporation that is 20 to less than BHC Supervision Manual July 2015
80 percent owned, subject to certain limits. Page 1
Control and Ownership (BHC Formations) 2090.2
banks. Previously, the policy statement applied debt without straining the capital of their subsid-
only to bank holding companies with pro forma iary banks and, further, that such companies
consolidated assets of less than $500 million restore their ability to serve as a source of
that met the following qualitative requirements: strength for their subsidiary banks within a rela-
(1) were not engaged in significant nonbanking tively short period of time.
activities either directly or through a nonbank In the interest of continuing its policy of
subsidiary; (2) did not conduct significant off- facilitating the transfer of ownership in banks
balance sheet activities (including securitization without compromising bank safety and sound-
and asset management or administration) either ness, the Board has, as described below, adopted
directly or through a nonbank subsidiary; and the following procedures and standards for the
(3) did not have a material amount of debt or formation and expansion of small bank holding
equity securities outstanding (other than trust companies subject to this policy statement.
preferred securities) that are registered with the
Securities and Exchange Commission. The
Board last raised the asset threshold in 2006
when it increased it from $150 million to 2090.2.3.1 Applicability of Policy
$500 million. Statement
The policy statement applies only to BHCs with

pro forma consolidated assets of less than $1
2090.2.3 SMALL BANK HOLDING billion that (1) are not engaged in significant
COMPANY AND SAVINGS AND nonbanking activities either directly or through
LOAN HOLDING COMPANY POLICY a nonbank subsidiary; (2) do not conduct signifi-
STATEMENT cant off-balance-sheet activities (including secu-
ritization and asset management or administra-
In acting on applications filed under the BHC tion) either directly or through a nonbank
Act, the Board has adopted and continues to subsidiary; and (3) do not have a material
follow the principle that bank holding compa- amount of debt or equity securities outstanding
nies should serve as a source of strength for (other than trust preferred securities) that are
their subsidiary banks. When bank holding com- registered with the Securities and Exchange
panies incur debt and rely on the earnings of Commission. The Board may in its discretion
their subsidiary banks as the means of repaying exclude any BHC, regardless of asset size, from
such debt, a question arises as to the probable the policy statement if such action is warranted
effect on the financial condition of the holding for supervisory purposes. With the exception of
company and its subsidiary bank or banks. section 4 (Additional Application Requirements
The Board believes that a high level of debt at for Expedited/Waived Processing), the policy
the parent holding company level impairs the statement applies to savings and loan holding
ability of a bank holding company to provide companies as if they were bank holding compa-
financial assistance to its subsidiary bank(s), nies. While this policy statement primarily
and, in some cases, the servicing requirements applies to the formation of small BHCs, it also
on such debt may be a significant drain on the applies to existing BHCs that wish to acquire an
resources of the bank(s). For these reasons, the additional bank or company and to transactions
Board has not favored the use of acquisition involving changes in control, stock redemp-
debt in the formation of bank holding compa- tions, or other shareholder transactions.2 The
nies or in the acquisition of additional banks. criteria are described below.
Nevertheless, the Board has recognized that the
transfer of ownership of small banks often
requires the use of acquisition debt. The Board
therefore has permitted the formation and
2090.2.3.2 Ongoing Requirements
expansion of small bank holding companies
with debt levels higher than would be permitted The following guidelines must be followed on
for larger bank holding companies. Approval of an ongoing basis for all organizations operating
these applications has been given on the condi- under this policy statement.
tion that the small bank holding companies dem-
onstrate the ability to service the acquisition
2. The appropriate Reserve Bank should be contacted to
BHC Supervision Manual July 2015 determine the manner in which a specific situation may
Page 2 qualify for treatment under this policy statement.
2090.2.3.2.1 Reduction in Parent Department of the Treasury under (1) the

Company Leverage Troubled Asset Relief Program established by
the Emergency Economic Stabilization Act of
Small BHCs are to reduce their parent company 2008. (See 74 Fed. Reg. 26077 (June 1, 2009),
debt consistent with the requirement that all Division A of Public Law 110-343, 122 Stat.
debt be retired within 25 years of being incurred. 3765 (2008)), and (2) the Small Business Lend-
The Board expects that these BHCs reach a ing Fund established by the Small Business Jobs
debt-to-equity ratio of .30 to 1 or less within 12 Act of 2010, title IV of Public Law 111-240,
years after incurrence of the debt.3 The bank 124 Stat. 2504 (2010).
holding company must also comply with debt- The term equity as used in the ratio of debt to
servicing and other requirements imposed by its equity, means the total stockholders equity of
creditors. the BHC, as defined in accordance with gener-
Subordinated debt associated with trust pre- ally accepted accounting principles. In deter-
ferred securities generally would be treated as mining the total amount of stockholders equity,
debt for purposes of paragraphs 2.C. (dividend the BHC should account for its investments in
restrictions), 3.A. (minimum down payment), the common stock of subsidiaries by the equity
4.A.i (expedited treatment of certain filings), method of accounting.
and 4.B.i (stock redemption filing requirements) Ordinarily, the Board does not view redeem-
of the policy statement. A BHC, however, may able preferred stock as a substitute for common
exclude from debt an amount of subordinated stock in a small BHC. Nevertheless, to a limited
debt associated with trust preferred securities degree and under certain circumstances, the
that is up to 25 percent of the bank holding Board will consider redeemable preferred stock
companys equity (as defined below) less good- as equity in the capital accounts of the holding
will on the parent companys balance sheet, in company if the following conditions are met:
determining compliance with the requirements (1) the preferred stock is redeemable only at the
of such paragraphs of the policy statement. In option of the issuer and (2) the debt-to-equity
addition, a BHC subject to the policy statement ratio of the holding company would be at or
that has not issued subordinated debt associated remain below .30:1 following the redemption or
with a new issuance of trust preferred securities retirement of any preferred stock. Preferred
after December 31, 2005, may exclude from stock that is convertible into common stock of
debt any subordinated debt associated with trust the holding company may be treated as equity.
preferred securities until December 31, 2010.
BHCs subject to this policy statement may also
exclude from debt until December 31, 2010, any 2090.2.3.2.2 Capital Adequacy
subordinated debt associated with refinanced
issuances of trust preferred securities originally Each insured depository subsidiary of a small
issued on or prior to December 31, 2005, pro- BHC is expected to be well capitalized. Any
vided that the refinancing does not increase the institution that is not well capitalized is expected
BHCs outstanding amount of subordinated to become well capitalized within a brief period
debt. Subordinated debt associated with trust of time.
preferred securities will not be included as debt
in determining compliance with any other
requirements of this policy statement. 2090.2.3.2.3 Dividend Restrictions
In addition, notwithstanding any other provi-
sion of the policy statement and for purposes of A small bank holding company whose debt to
compliance with paragraphs 2.C., 3.A., 4.A.i., equity ratio is greater than 1.0:1 is not expected
and 4.B.i. of the policy statement, both a BHC to pay corporate dividends until such time as it
that is organized in mutual form and a BHC that reduces its debt to equity ratio to 1.0:1 or less
has made a valid election to be taxed under and other wise meets the criteria set forth in
Subchapter S of Chapter 1 of the U.S. Internal sections 225.14(c)(1)(ii), 225.14(c)(2), and
Revenue Code may exclude from debt subordi- 225.14(c)(7) of Regulation Y.4
nated debentures issued to the United States
4. Dividends may be paid by small bank holding compa-
3. The term debt as used in the ratio of debt to equity,
nies with debt to equity at or below 1.0:1 and otherwise
means any borrowed funds (exclusive of short-term borrow-
meeting the requirements of sections 225.14(c)(1)(ii),
ings that arise out of current transactions, the proceeds of
which are used for current transactions) and any securities
issued by, or obligations of, the holding company that are the BHC Supervision Manual July 2015
functional equivalent of borrowed funds. Page 3
Small bank holding companies formed before the criteria would normally result in denial of an
May 15, 2015 (the effective date of the policy application.
statement), may switch to a plan that adheres to
the intent of the policy statement provided they
comply with the requirements set forth above.
2090.2.3.4 Additional Application
Requirements for Expedited/Waived
2090.2.3.3 Core Requirements for All Processing
Applicants
2090.2.3.4.1 Expedited Notices under
In assessing applications or notices by organiza-
Sections 225.14 and 225.23 of
tions subject to the policy statement, the Board
Regulation Y
will continue to take into account a full range of
financial and other information about the appli- A small BHC proposal will be eligible for the
cant, and its current and proposed subsidiaries, expedited processing procedures set forth in sec-
including the recent trend and stability of earn- tions 225.14 and 225.23 of Regulation Y if
ings, past and prospective growth, asset quality, (1) the BHC is in compliance with the ongoing
the ability to meet debt servicing requirements requirements of this policy statement, (2) the
without placing an undue strain on the resources BHC meets the previously discussed core
of the bank(s), and the record and competency requirements for all applicants noted above, and
of management. In addition, the Board will (3) the following requirements are met:
require applicants to meet the following require-
ments: 1. The parent BHC has a pro forma debt-to-
equity ratio of 1.0:1 or less.
2090.2.3.3.1 Minimum Down Payment 2. The BHC meets all the criteria for expedited
action of sections 225.14 and 225.23 of
The amount of acquisition debt should not Regulation Y.
exceed 75 percent of the purchase price of the
bank(s) or company to be acquired. When the
owner(s) of the holding company incurs debt to 2090.2.3.4.2 Waiver of Stock-Redemption
finance the purchase of the bank(s) or company, Filing
such debt will be considered acquisition debt
even though it does not represent an obligation A small BHC will be eligible for the stock-
of the BHC, unless the owner(s) can demon- redemption filing exemption for well-capitalized
strate that such debt can be serviced without BHCs that is found in section 225.4(b)(6) if the
reliance on the resources of the bank(s) or BHC. following requirements are met:
1. The parent BHC has a pro forma debt-to-

2090.2.3.3.2 Ability to Reduce Parent equity ratio of 1.0:1 or less.
Company Leverage 2. The BHC is in compliance with the ongoing
requirements of this policy statement and
The BHC must clearly be able to reduce its meets the requirements of sections
debt-to-equity ratio and comply with its loan 225.14(c)(1)(ii), 225.14(c)(2), and
agreement(s) as stated within the ongoing 225.14(c)(7) of Regulation Y.
requirements for reduction in parent company
leverage, discussed previously.5 Failure to meet
225.14(c)(2), and 225.14(c)(7) if the dividends are reasonable 2090.2.4 INSPECTION OBJECTIVES
in amount, do not adversely affect the ability of the bank
holding company to service its debt in an orderly manner, and 1. To determine compliance with all commit-
do not adversely affect the ability of the subsidiary banks to
be well-capitalized. It is expected that dividends will be
ments made in the application/notification
eliminated if the holding company is (1) not reducing its debt process.
consistent with the requirement that the debt to equity ration 2. To determine if the BHC or SLHC is in
be reduced to .30:1 within 12 years of consummation of the compliance with the Small Bank Holding
proposal or (2) not meeting the requirements of its loan
agreement(s).
Company and Savings and Loan Holding
5. See section 2090.2.3.2.1. Company Policy Statement (Regulation Y,
appendix C), including whether the BHCs
BHC Supervision Manual July 2015 debt is being reduced within the required or
Page 4 expected time periods.
2090.2.5 INSPECTION PROCEDURES less within 12 years of incurring the

debt.
1. Review all commitments made by the com- 3. Ascertain if the BHC uses a regular periodic
pany and its shareholders to determine com- monitoring process to ensure the full retire-
pliance therewith. ment of the holding companys debt within
2. Determine if the BHC or SLHC is in compli- the above-stated required or expected
ance with the Small Bank Holding Company periods.
and Savings and Loan Holding Company 4. Determine whether the BHC is well capital-
Policy Statement (Regulation Y, appendix C) ized or, if not, whether it will be well capital-
by ized within a brief period of time.
a. verifying that the board of directors and 5. Determine if the payment of corporate
senior management have established and dividends has been restricted until the BHCs
regularly maintain a plan to debt-to-equity ratio is 1.0:1 or less and until
retire the BHCs or the SLHCs debt the BHC otherwise meets the criteria
within 25 years of incurring the debt set forth in sections 225.14(c)(1)(ii),
and 225.14(c)(2), and 225.14(c)(7) of Regula-
reach a debt-to-equity ratio of .30:1 or tion Y.
Capital adequacy guidelines of 217 32100

BHCs, SLHCs, and state member
banks (Regulation Q)
Small BHC and SLHC Policy 225 4868

Statement Regulation Y,
appendix C
Expedited action for 225.14 4024.1

certain acquisitions
by well-run BHCs
Expedited action for 225.23 4037.1

nonbanking proposals
by well-run BHCs
Savings and loan holding 238.9 4750.8

companies (Regulation LL)
Small BHC Policy Statement
1. 12 U.S.C., unless specifically stated otherwise.
3. Federal Reserve Regulatory Service reference.

Page 5
(Treasury Stock Redemptions) Section 2090.3
Bootstrapping is the term generally used to the remaining shareholder(s) increases his pro-
describe a treasury stock transaction in which a portionate ownership. If a persons share
company incurs debt to purchase or redeem its ownership should rise above 25 percent or more
own outstanding shares. Bootstrapping is often of the remaining outstanding shares (subsequent
used to facilitate a change in control whereby a to March 9, 1979), that person would then
shareholder or shareholder group need only buy control the BHC. Under these circumstances,
few or no shares in order to gain control. The a change in control notification would have to
repurchase or redemption is often made in be filed. If the treasury stock redemption is for
accordance with a written agreement made an amount sufficient to trigger the requirement
between a former controlling shareholder(s) and for a prior notification of redemption, then dual
the new controlling shareholder(s). notifications are called for (change in control
Section 225.4(b) of Regulation Y requires a and redemption of treasury shares).
bank holding company to file prior written Similarly, prior notification is also required if
notice with the Board before a purchase or a treasury stock redemption should result in a
redemption of any of its own equity securities if shareholders holdings rising to between 10 per-
the gross consideration for the purchase or cent and 25 percent of the remaining outstand-
redemption, when aggregated with the net con- ing shares, and if (a) that shareholder is the
sideration paid by the company for all such firms largest single shareholder immediately
purchases or redemptions during the preceding after the acquisition; or (b) the institution is
12 months, is equal to 10 percent or more of the registered under section 12 of the Securities
companys consolidated net worth. (Net consid- Exchange Act of 1934 (i.e., corporations having
eration is the gross consideration paid by the assets exceeding $1 million, more than 500
company for all of its equity securities pur- shareholders, and securities that are publicly
chased or redeemed during the period minus the traded). For additional information on change in
gross consideration received for all of its equity control notification requirements, see section
securities sold during the period other than as a 2090.1.
part of a new issue.) Additional notices under the CIBC Act do not
Each notice shall furnish the following have to be filed if regulatory clearance had
information: already been received to acquire 10 percent or
more of the voting shares of a bank holding
The purpose of the transaction, a description company, and subsequent treasury stock re-
of the securities to be purchased or redeemed, demptions resulted in ownership of between 10
the total number of each class outstanding, the and 25 percent of the shares of the bank holding
gross consideration to be paid, and the terms company. Refer to section 225.41(a)(2) of Reg-
of any debt incurred in connection with the ulation Y.1
transaction.
A description of all equity securities redeemed
within the preceding 12 months, the net 2090.3.2 INSPECTION OBJECTIVES
consideration paid, and the terms of any
debt incurred in connection with those 1. To determine that a BHC that has
transactions. redeemed shares of its own stock has complied
A current and pro forma consolidated balance with section 225.4(b) of Regulation Y.
sheet if the bank holding company has total 2. To determine that any new controlling
assets of over $150 million, or a current and shareholder of a BHC that has redeemed shares
pro forma parent-company-only balance sheet of its own stock has complied with section
if the bank holding company has total assets 225.41(a) of Regulation Y.
of $150 million or less. 3. To determine if a treasury stock transac-
tion has taken place for the purpose of depleting
the original 25 percent equity investment in the
2090.3.1 CHANGE IN CONTROL ACT purchase price.
CONSIDERATIONS
As indicated earlier, treasury stock redemptions 1. Revised by the Board, effective November 9, 1990.
are often intended to facilitate a change in con-
trol of a bank holding company. By redeeming BHC Supervision Manual June 1994
the shares held by an existing shareholder(s), Page 1
Control and Ownership (Treasury Stock Redemptions) 2090.3
2090.3.3 INSPECTION PROCEDURES quently, an organization considering such a step

should consult with the Federal Reserve before
1. Review the BHCs reconcilement of stock- redeeming any equity (prior to maturity) if such
holders equity to determine if shares have been redemption could have a material effect on the
redeemed. level or composition of the organizations capi-
2. If shares have been redeemed, review for tal base.
compliance with treasury stock redemption The exemption should not be used by a
approval and reporting requirements. small one-bank holding company if it would
3. Determine whether the BHC is using, increase its debt-to-equity ratios significantly
repeatedly, the less than 10 percent ownership above those relied on by the Board in approving
exemption to avoid notice requirements, thus its application to become a bank holding
undermining the capital position of the banking company.
organization, resulting in an unsafe and unsound 5. If shares have been redeemed, determine if
practice. any shareholders holdings have risen to 25 per-
4. Determine if the less than 10 percent own- cent or more of the outstanding shares.
ership exemption is being used by the bank 6. If shares have been redeemed, determine if
holding company when it does not satisfy the any shareholders holdings have risen to
requirements of the Boards capital guidelines between 10 percent and 25 percent of the out-
for redemptions. standing shares. Furthermore, determine
The exemption should not be used by a whether the shareholder is then the largest
bank holding company that does not meet the shareholder or the institution has registered
Boards capital guidelines for redemptions. securities under section 12 of the Securities
Redemptions of permanent equity or other capi- Exchange Act of 1934.
tal instruments before stated maturity could 7. If a stock redemption occurred recently in
have a significant impact on an organizations a bank holding company, determine if the share-
overall capital structure. Use of the exemption holders have maintained a 25 percent equity
could significantly reduce its capital. Conse- investment.

Page 2
Control and Ownership (Policy Statements on Equity
Investments in Banks and Bank Holding Companies) Section 2090.4
WHATS NEW IN THIS REVISED exercise a controlling influence over the
SECTION management or policies of a banking
organization.2
Effective January 2009, this section has been The text and legislative history of the control
revised to incorporate the Boards September definition in the BHC Act make manifest that
21, 2008, Policy Statement on Equity Invest- possession by an investor of a modicum of
ments in Banks and Bank Holding Companies. influence over a banking organization would not
(See the Boards September 22, 2008, Press amount to a controlling influence. At the same
Release and section 2090.4.4.) The policy state- time, the definition does not require that an
ment provides additional guidance on the investor have absolute control over the manage-
Boards position on minority equity investments ment and policies of a banking organization.
in banks and bank holding companies that gen- Instead, the Act requires that an investor be able
erally do not constitute control for purposes to exercise an amount of influence over a bank-
of the Bank Holding Company Act. This policy ing organizations management or policies that
updates the guidance found in the Boards July is significant but less than absolute control in
1982 Policy Statement on Nonvoting Equity fact of the banking organization. Notably, the
Investments by Bank Holding Companies. primary definition of control in the Act is based
on ownership of 25 percent or more of the
voting shares of a banking organizationan
2090.4.1 OVERVIEW AND GUIDING amount that does not provide an investor in
PRINCIPLES most cases with complete control over decisions
but would allow the investor to play a signifi-
For many years, bank holding companies, cant role in the decision-making process.
nonbank financial companies, private equity In assessing whether an investor has the abil-
funds, and other firms made minority equity ity to exercise a controlling influence over a
investments in banks and bank holding compa- banking organization, the Board has been espe-
nies. These investments often raised questions cially mindful of two key purposes of the BHC
about the extent to which the investment would Act. First, the BHC Act was intended to ensure
cause the investor to become subject to that companies that acquire control of banking
supervision, regulation, and the other require- organizations have the financial and manage-
ments applicable to bank holding companies rial strength, integrity, and competence to
under the Bank Holding Company Act (BHC Act exercise that control in a safe and sound man-
or the Act) and the Boards Regulation Y. In ner. The BHC Act is premised on the principle
general, the BHC Act applies to any company that a company that controls a banking
that controls a bank or bank holding company organization may reap the benefits of its suc-
(banking organization). The BHC Act provides cessful management of the banking organiza-
that a company has control over a banking tion but also must be prepared to provide addi-
organization if (1) the company directly or tional financial and managerial resources to the
indirectly or acting through one or more other banking organization to support the companys
persons owns, controls, or has power to vote exercise of control. In this way, the Act ties the
25 percent or more of any class of voting potential upside benefits of having a control-
securities of the banking organization; (2) the ling influence over the management and poli-
company controls, in any manner, the election of cies of a banking organization to responsibility
a majority of the directors or trustees of the for the potential downside results of exercising
banking organization; or (3) the Board deter- that controlling influence. By tying control and
mines, after notice and opportunity for hearing, responsibility together, the Act ensures that
that the company directly or indirectly exercises
a controlling influence over the management or 2. Contemporaneous minority investments in the same
policies of the banking organization.1 Minority banking organization by multiple different investors also often
equity investments in banking organizations are raise questions about whether the multiple investors are a
designed not to trigger either of the first two group acting in concert for purposes of the Change in Bank
Control Act or are a single association for purposes of the
prongs of the definition of control. These BHC Act. These questions are beyond the scope of the 2008
investments often raised questions, however, Policy Statement.
regarding whether the investor would be able to
1. 12 U.S.C. 1841(a)(2). Page 1
Control and Ownership (Policy Statements on Equity Investments in Banks and Bank Holding Companies) 2090.4
companies have positive incentives to run a suc- prevent another company from acquiring the
cessful banking organization but also bear the banking organization without the permission of
costs of their significant involvement in the the investor.
banking organizations decision-making The 1982 Policy Statement sets out the
process, thus protecting taxpayers from Boards concerns with these investments, the
imprudent risk taking by companies that control considerations the Board will take into account
banking organizations. Minority investors in in determining whether the investments are con-
banking organizations typically seek to limit sistent with the Act, and the general scope of
their potential downside financial exposure in arrangements to be avoided by bank holding
the event of the failure of the banking organiza- companies. The Board recognized that the com-
tion. Concomitantly, the BHC Act requires that plexity of legitimate business arrangements pre-
minority investors seeking this protection limit cludes rigid rules designed to cover all situa-
their influence over the management and poli- tions and that decisions regarding the existence
cies of the banking organization. or absence of control in any particular case must
Second, the BHC Act was intended to limit take into account the effect of the combination
the mixing of banking and commerce. In par- of provisions and covenants in the agreement as
ticular, the Act effectively prevents commercial a whole and the particular facts and circum-
firms and companies with commercial interests stances of each case.
from also exercising a controlling influence over
a banking organization. Many minority inves-
tors in banking organizations own commercial 2090.4.2.1 Statutory and Regulatory
investments that conflict with this limitation. Provisions
Under section 3(a) of the Act, a bank holding
2090.4.2 BOARDS 1982 POLICY company may not acquire direct or indirect
STATEMENT ON NONVOTING ownership or control of more than 5 percent of
EQUITY INVESTMENTS BY BANK the voting shares of a bank without the Boards
HOLDING COMPANIES prior approval (12 U.S.C. 1842(a)(3)). In addi-
tion, this section of the Act provides that a bank
On July 8, 1982, the Board issued a Policy holding company may not, without the Boards
Statement on Nonvoting Equity Investments by prior approval, acquire control of a bank: that is,
Bank Holding Companies (the 1982 Policy in the words of the statute, for any action to be
Statement) to provide guidance on the Boards taken that causes a bank to become a subsidiary
interpretation of the controlling influence of a bank holding company (12 U.S.C.
prong of the control definition in the BHC Act.3 1842(a)(2)). Under the Act, a bank is a subsidi-
That statement for the first time outlined the ary of a bank holding company if
policies that the Board would consider in
reviewing whether a minority investment in a 1. The company directly or indirectly owns,
banking organization would result in the exer- controls, or holds with power to vote 25 per-
cise by the investor of a controlling influence cent or more of the voting shares of the bank;
over the management or policies of the banking 2. The company controls in any manner the
organization. The 1982 Policy Statement election of a majority of the board of direc-
focused on issues of particular concern in the tors of the bank; or
1980s in the context of investments by bank 3. The Board determines, after notice and
holding companies in out-of-state banking orga- opportunity for hearing that the company has
nizations. For example, the 1982 Policy State- the power, directly or indirectly, to exercise a
ment primarily addressed investments that controlling influence over the management
included a long-term merger or stock purchase or policies of the bank (12 U.S.C. 1841(d)).
agreement between the investor and the banking
organization that would be triggered on a
change in the interstate banking laws, and 2090.4.2.2 Review of Agreements
so-called lock-up arrangements designed to
Prior to the permissibility of interstate banking,
3. See 1982 FRB 413, 12 C.F.R. 225.143, or the F.R.R.S at
bank holding companies sought to make sub-
4-172.1. stantial equity investments in other bank hold-
ing companies across state lines, but without
BHC Supervision Manual January 2009 obtaining more than 5 percent of the voting
Page 2 shares or control of the acquiree. These invest-
ments involved a combination of the following the investor on financial matters. By their terms,
arrangements: these covenants suggested control by the invest-
ing company over the management and policies
1. Options on, warrants for, or rights to convert of the acquiree.
nonvoting shares into substantial blocks of Similarly, certain of the agreements deprived
voting securities of the acquiree bank hold- the acquiree bank holding company, by cov-
ing company or its subsidiary bank(s); enant or because of an option, of the right to
2. Merger or asset acquisition agreements with sell, transfer, or encumber a majority or all of
the out-of-state bank or bank holding com- the voting shares of its subsidiary bank(s) with
pany that are to be consummated in the event the aim of maintaining the integrity of the
interstate banking is permitted; investment and preventing takeovers by others.
3. Provisions that limit or restrict major poli- These long-term restrictions on voting shares
cies, operations, or decisions of the acquiree; were within the presumption in the Boards
and Regulation Y that attributes control of shares to
4. Provisions that make acquisitions of the any company that enters into any agreement
acquiree or its subsidiary bank(s) by a third placing long-term restrictions on the rights of a
party either impossible or economically holder of voting securities (12 C.F.R.
impracticable. 225.31(d)(2).
Finally, investors wished to reserve the right
The various warrants, options, and rights to sell their options, warrants or rights to a
were not exercisable by the investing bank hold- person of their choice to prevent being locked
ing company until interstate banking was per- into what may become an unwanted investment.
mitted. They were transferred by the investor The Board took the position that the ability to
either immediately or after the passage of a control the ultimate disposition of voting shares
period of time or upon the occurrence of certain to a person of the investors choice and to
events. secure the economic benefits therefrom indi-
After a careful review of a number of these cates control of the shares under the Act.4 The
arrangements, the Board concluded that invest- Board concluded that the ability to transfer
ments in nonvoting stock, absent other arrange- rights to large blocks of voting shares, even if
ments, could be consistent with the Act. Some nonvoting in the hands of the investing com-
of the agreements reviewed appeared consistent pany, could result in such a substantial position
with the Act because they were limited to of leverage over the management of the acquiree
investments of relatively moderate size in non- as to involve a structure that would inevitably
voting equity that may become voting equity. . . result in control prohibited by the Act.
However, other agreements reviewed by the
Board raised substantial problems of consis-
tency with the control provisions of the Act 2090.4.2.3 Provisions that Avoid Control
because the investors. . . sought to assure the
soundness of their investments, prevent take- In 1982, the context of any particular agree-
overs by others, and allow for sale of their ment, provisions of the type described above
options, warrants, or rights to a person of the were acceptable if combined with other provi-
investors choice in the event a third party sions that serve to preclude control. The Board
obtains control of the acquiree or the investor believed that such agreements would not be
otherwise becomes dissatisfied with its invest- consistent with the Act unless provisions are
ment. Since the Act precludes the investors from included that will preserve managements dis-
protecting their investments through ownership cretion over the policies and decisions of the
or use of voting shares or other exercise of acquiree and avoid control of voting shares.
control, the investors substituted contractual As a first step towards avoiding control, man-
agreements for rights normally achieved through agement had to be free to conduct banking and
voting shares. permissible nonbanking activities. Another step
For example, various covenants in certain of to avoid control included the right of the
the agreements sought to assure the continuing acquiree to call the equity investment and
soundness of the investment by substantially
limiting the discretion of the acquirees manage- 4. See Board letter dated March 18, 1982, to C.A. Caven-
ment over major policies and decisions, includ- des, Sociedad Financiera.
ing restrictions on entering into new banking
activities without the investors approval and BHC Supervision Manual January 2009
requirements for extensive consultations with Page 3
options or warrants to assure that covenants that ing company become nonvoting shares,
may become inhibiting can be avoided by the remain nonvoting shares while held by the
acquiree. This right made such investments or investor, and revert to voting shares when
agreements more like a loan in which the bor- transferred to a third party.
rower has a right to escape covenants and avoid
the lenders influence by prepaying the loan.
A measure to avoid problems of control aris- 2090.4.2.4 Review by the Board
ing through the investors control over the ulti-
mate disposition of rights to substantial amounts The 1982 Policy Statement did not constitute
of voting shares of the acquiree might have the exclusive scope of the Boards concerns, nor
included a provision granting the acquiree a were the considerations with respect to control
right of first refusal before warrants, options, or outlined in this statement an exhaustive catalog
other rights may be sold and requiring a public of permissible or impermissible arrangements.
and dispersed distribution of those rights if the The Board instructed its staff to review agree-
right of first refusal is not exercised. ments of the kind discussed in this statement
The Board concluded that agreements that and to bring to the Boards attention those that
involve rights to less than 25 percent of the raise problems of consistency with the Act.
voting shares, with a requirement for a dis-
persed public distribution in the event of sale,
have a much greater prospect of achieving con- 2090.4.3 ACTIVITIES OF BANKING
sistency with the Act than agreement involving ORGANIZATIONS AND BOARD
a greater percentage. This guideline was drawn DETERMINATIONS SUBSEQUENT TO
by analogy from the provision in the Act that THE 1982 POLICY STATEMENT
ownership of 25 percent or more of the voting
securities of a bank constitutes control of the Many aspects of the 1982 Policy Statement have
bank. broader applicability and have served as the
One effect of the guideline was to hold down foundation for the Boards review more gener-
the size of the nonvoting equity investment by ally of whether a minority investment in a bank-
the investing company relative to the acquirees ing organization would give the investor a con-
total equity, thus avoiding the potential for controlling influence over the management or
trol because the investor holds a very large policies of the banking organization. In this
proportion of the acquirees total equity. Obser- regard, the 1982 Policy Statement identified a
vance of the 25 percent guideline also made number of structural measures that the Board
provisions in agreements providing for a right believed would limit the ability of an investor to
of first refusal or a public and widely dispersed exercise a controlling influence over a banking
offering of rights to the acquirees shares more organization. These included restricting the use
practical and realistic. of covenants that constrain the discretion of
Finally, acquirers were to avoid certain banking organization management, limiting the
arrangements regardless of other provisions in amount of voting and nonvoting shares of the
the agreement that were designed to avoid con- banking organization acquired by the investor,
trol. These are and limiting the ability of the investor to trans-
fer large blocks of voting shares.
1. Agreements that enabled the investing bank The Board made clear in the 1982 Policy
holding company (or its designee) to direct Statement that the complexity of legitimate
in any manner the voting of more than 5 per- business arrangements precluded establishing
cent of the voting shares of the acquiree; rigid rules designed to cover all situations and
2. Agreements whereby the investing company that decisions regarding the presence or absence
had the right to direct the acquirees use of of control must take into account the specific
the proceeds of an equity investment by the facts and circumstances of each case. Accord-
investing company to effect certain actions, ingly, since the 1982 Policy Statement, the
such as the purchase and redemption of the Board has determined whether an equity inves-
acquirees voting shares; and tor in a banking organization has a controlling
3. The acquisition of more than 5 percent of the influence over the management or policies of
voting shares of the acquiree that simulta- the banking organization by considering care-
neously with their acquisition by the invest- fully all the facts and circumstances surrounding
the investors investment in, and relationship
BHC Supervision Manual January 2009 with, the banking organization. Large minority
Page 4 investors in a banking organization typically
have avoided acquiring a controlling influence the board of directors of the banking organiza-
over the banking organization by providing the tion. The principal exception to this guideline has
Board with a set of passivity commitments and been in situations in which the investor owns less
by avoiding certain control-enhancing mecha- than 15 percent of the voting stock of the banking
nisms. Specifically, minority investors have organization and another person (or group of
avoided acquiring control over a banking orga- persons acting together) owns a larger block of
nization by, among other things voting stock of the banking organization.
The Board has reexamined its precedent in
restricting the size of their voting and total this area and, based on its experience with
equity investment in the banking organization; minority investors and director representation,
avoiding covenants that would enable the believes that a minority investor generally
investor to restrict the ability of the banking should be able to have a single representative on
organizations management to determine the the board of directors of a banking organization
major policies and operations of the banking without acquiring a controlling influence over
organization; the management or policies of the banking orga-
not attempting to influence the banking organization. Typically, boards of directors of bank-
nizations process for making decisions about ing organizations have 9 or 10 members.
major policies and operations; Although having a representative on the board
limiting director and officer interlocks with of the banking organization enhances the influ-
the banking organization; and ence of a minority investor, the Boards experi-
limiting business relationships between the ence has shown that, in the absence of other
investor and the banking organization. indicia of control, it would be difficult for a
minority investor with a single board seat to
have a controlling influence over the manage-
2090.4.4 BOARDS 2008 POLICY ment or policies of the banking organization.6
STATEMENT ON EQUITY Moreover, a minority investor that has up to
INVESTMENTS IN BANKS AND two representatives on the board of directors of
BANK HOLDING COMPANIES the banking organization is unlikely, absent other
indicia of control, to be able to exercise a
Since issuing the 1982 Policy Statement, the controlling influence over the banking organiza-
Board has reviewed a significant number of tion when the investors aggregate director
noncontrolling investments in banking organiza- representation is proportionate to its total interest
tions. The Board believed that it would be use- in the banking organization7 but does not exceed
ful and appropriate to update its guidance in this 25 percent of the voting members of the board,8
area and therefore issued its Policy Statement
on Equity Investments in Banks and Bank Hold- 6. In addition to formal representation on the board of
ing Companies (the 2008 Policy Statement) on directors of a banking organization, minority investors also
September 21, 2008. (See the Boards Septem- frequently seek to have a representative attend meetings of the
board of directors of the banking organization in the capacity
ber 22, 2008, Press Release.) of a nonvoting observer. Attendance by a representative of a
minority investor as an observer at meetings of the board of
directors of a banking organization allows the investor access
to information and a mechanism for providing advice to the
2090.4.4.1 Specific Approaches to Avoid banking organization but has not in previous situations
Control allowed the investor to exercise a controlling influence over
the management or policies of the banking organization as
The 2008 Policy Statement discusses the long as the observer does not have any right to vote at
Boards views on specific approaches to avoid meetings of the board.
7. An investors total interest is equal to the greater of the
control.5 investors voting interest or total equity interest in the banking
organization.
8. For example, an investor with a 10 percent voting inter-
est and a 20 percent total equity interest generally could have
2090.4.4.1.1 Director Representation two representatives on the board of directors of the banking
organization if the investors director representation does not
The Board generally has not permitted a exceed 20 percent of the board seats. On the other hand, an
company that acquires between 10 and 24.9 per- investor with a 15 percent voting interest and a 33 percent
cent of the voting stock of a banking organization total equity interest generally could have two representatives
on the board of directors of the banking organization if the
(a minority investor) to have representation on investors director representation does not exceed 25 percent
5. See the 2008 Policy Statement at 12 C.F.R. 225.144, BHC Supervision Manual January 2009
beginning at paragraph (c). Page 5
and another shareholder of the banking voting equity investments that exceed 25 per-
organization is a bank holding company that cent of the total equity of a banking organization
controls the banking organization under the BHC generally raise control issues under the BHC
Act.9 The presence of another larger, controlling Act.10 The Board has recognized in a few lim-
shareholder of the banking organization that has ited circumstances, however, that ownership by
been approved by the Board, is subject to a minority investor of 25 percent or more of a
supervision and regulation by the Board, and is banking organizations total equity may not con-
obligated to serve as a source of strength for the fer a controlling influence, usually in situations
banking organization should serve as a powerful when another controlling investor is present or
countervailing force to whatever influence the other extenuating circumstances indicate that
minority investor may have as a result of the exercise of a controlling influence by the
its investment and proportional director minority investor is unlikely.
representation. The Board continues to believe that an inves-
The Board continues to believe that a repre- tor that makes a very large equity investment in
sentative of a minority investor that serves on a banking organization is likely to have a
the board of directors of the banking organiza- controlling influence over the banking
tion should not serve as the chairman of the organizations management or policies. Inves-
board of the banking organization or as the tors with large equity investments have a
chairman of a committee of the board of the powerful incentive to wield influence over the
banking organization. The Board generally banking organization in which they have
believes, however, that representatives of a non- invested. They have a substantial amount of
controlling minority investor may serve as money at stake in the enterprise, are among the
members of committees of the board of the first to absorb losses if the banking organiza-
banking organization when those representation has financial difficulties, and participate in
tives do not occupy more than 25 percent of the the profits of the banking organization going
seats on any committee and do not have the forward. Moreover, a banking organization is
authority or practical ability unilaterally to make likely to pay heed to its large shareholders to
(or block the making of) policy or other deci- help ensure it has the ability to raise equity
sions that bind the board or management of the capital in the future and to prevent the nega-
banking organization. tive market signal that would be created by the
sale of a large block of equity by an unhappy
existing shareholder.
2090.4.4.1.2 Total Equity On the other hand, the Board recognizes that
nonvoting equity does not provide the holder
The three-prong control test in the BHC Act with voting rights that empower the holder to
makes no explicit reference to nonvoting equity participate directly in the selection of banking
investments. Nevertheless, the Board has long organization management or otherwise in the
subscribed to the view that the overall size of an banking organizations decision-making
equity investment, including both voting and process. Moreover, as noted above, the BHC
nonvoting equity, is an important indicator of Act defines control in terms of ownership of
the degree of influence an investor may have. 25 percent or more of a class of voting securi-
Accordingly, the Board traditionally has taken ties but does not impose an express limit on
account of the presence and size of nonvoting ownership of nonvoting shares. The Board
equity investments in its controlling influence continues to believe that, in most circumstances,
analysis. For example, in the 1982 Policy State- an investor that owns 25 percent or more of the
ment, the Board set forth a guideline that non- total equity of a banking organization owns
enough of the capital resources of a banking
(rather than 33 percent) of the board seats. organization to have a controlling influence over
9. In determining what amount of director representation is the management or policies of the banking
proportional to an investors voting interest in a banking organization. The Board continues to recognize,
organization, the investor should round to the nearest whole
number. For example, the Board would consider a minority however, that the ability of an investor to
investor that owns 15 percent of the voting stock of a banking exercise a controlling influence through nonvot-
organization to have proportionate director representation if it ing equity instruments depends significantly on
had two representatives on a board of directors with 10 or the nature and extent of the investors overall
more members (but not on a board of directors with 9 or fewer
members). investment in the banking organization and on
the capital structure of the banking organization.
Page 6 10. 12 C.F.R. 225.143(d)(4) and (d)(5).
In particular, the Board would not expect that threaten to sell their shares in the banking orga-
a minority investor would have a controlling nization as a method for influencing decisions
influence over a banking organization if the of banking organization management; and not to
investor owns a combination of voting shares solicit proxies on any matter from the other
and nonvoting shares that, when aggregated, shareholders of the banking organization. These
represents less than one-third of the total equity commitments were designed to limit the exer-
of the organization (and less than one-third of cise by a minority investor of a controlling
any class of voting securities, assuming conver- influence over the management or policies of a
sion of all convertible nonvoting shares held by banking organization.
the investor) and does not allow the investor to The Board believes that it would be useful to
own, hold, or vote 15 percent or more of any provide additional guidance on the extent of
class of voting securities of the organization. In communications between a minority investor
these situations, the limitation on voting rights and a banking organizations management that
reduces the potential that the investor may exer- would be consistent with a noncontrol determi-
cise influence that is controlling. nation. The Board believes that a noncontrolling
In previous cases, investors that have minority investor, like any other shareholder,
acquired nonvoting shares often have sought the generally may communicate with banking orga-
right to convert those shares to voting shares nization management about, and advocate with
under various circumstances. The Board contin- banking organization management for changes
ues to believe that nonvoting shares that may be in, any of the banking organizations policies
converted into voting shares at the election of and operations. For example, an investor may,
the holder of the shares, or that mandatorily directly or through a representative on a bank-
convert after the passage of time, should be ing organizations board of directors, advocate
considered voting shares at all times for pur- for changes in the banking organizations divi-
poses of the BHC Act. However, in previous dend policy; discuss strategies for raising addi-
cases, the Board has recognized that nonvoting tional debt or equity financing; argue that the
shares that are convertible into voting shares banking organization should enter into or avoid
carry less influence when the nonvoting shares a new business line or divest a material subsidi-
may not be converted into voting shares in the ary; or attempt to convince banking organiza-
hands of the investor and may only be trans- tion management to merge the banking organi-
ferred by the investor: (1) to an affiliate of the zation with another firm or sell the banking
investor or to the banking organization; (2) in a organization to a potential acquirer. These com-
widespread public distribution; (3) in transfers munications also generally may include advo-
in which no transferee (or group of associated cacy by minority investors for changes in the
transferees) would receive 2 percent or more of banking organizations management and recom-
any class of voting securities of the banking mendations for new or alternative manage-
organization; or (4) to a transferee that would ment.11 Although these types of discussions rep-
control more than 50 percent of the voting secu- resent attempts by an investor to influence the
rities of the banking organization without any management or policies of the banking organi-
transfer from the investor. Ownership of this zation, discussions alone are not the type of
form of nonvoting, convertible shares, within controlling influence targeted by the BHC Act.
the limits discussed above, allows investors to To avoid the exercise of a controlling influ-
provide capital to a banking organization in a ence, in all cases, the decision whether or not to
way that is useful to the organization, minimizes adopt a particular position or take a particular
the opportunity for the investor to exercise a action must remain with the banking organiza-
controlling influence over the organization, and tions shareholders as a group, its board of direc-
allows the investor to exit the investment with- tors, or its management, as appropriate. The role
out conveying control to another party outside of the minority investor in these decisions must
the parameters of the BHC Act. be limited to voting its shares in its discretion at
a meeting of the shareholders of the banking
2090.4.4.1.3 Consultations with 11. As discussed later in the 2008 Policy Statement, a
Management minority investor may not have a contractual right to deter-
mine (or a veto right over) any of the major policies and
operations of the bank or the composition of the banks
In many previous cases, minority investors have management team.
agreed not to attempt to influence the opera-
tions, management, or strategies of the banking BHC Supervision Manual January 2009
organization in which they have invested; not to Page 7
organization (directly or by proxy, including in 2090.4.4.1.4.2 Covenants

connection with a proxy solicitation launched
by another shareholder), and by exercising vot- Because the BHC Act explicitly defines control
ing privileges as a member of the board of (and many of its other thresholds) in terms that
directors of the banking organization (to the include a percentage of voting securities, com-
extent permitted as discussed above). Impor- panies often have structured their investments in
tantly, communications by minority investors banking organizations in the form of nonvoting
should not be accompanied by explicit or securities and have attempted to substitute con-
implicit threats to dispose of shares in the bank- tractual agreements for the rights that normally
ing organization or to sponsor a proxy solicita- are obtained through voting securities. The
tion as a condition of action or non-action by the Board has taken and continues to hold the view
banking organization or its management. that covenants that substantially limit the discre-
tion of a banking organizations management
over major policies and decisions suggest the
2090.4.4.1.4 Other Indicia of Control exercise of a controlling influence.12 In particu-
lar, the Board has been concerned about cov-
2090.4.4.1.4.1 Business Relationships enants or contractual terms that place restric-
tions on, or otherwise inhibit, the banking
The Board traditionally has prohibited a non- organizations ability to make decisions about
controlling minority investor in a banking orga- the following actions: (1) hiring, firing, and
nization from having any material business compensating executive officers; (2) engaging
transactions or relationships with the banking in new business lines or making substantial
organization. The Board historically has taken changes to its operations; (3) raising additional
the view that a major supplier, customer, or debt or equity capital; (4) merging or consolidat-
lender to a banking organization can exercise ing; (5) selling, leasing, transferring, or dispos-
considerable influence over the banking organi- ing of material subsidiaries or major assets; or
zations management and policiesespecially (6) acquiring significant assets or control of
when coupled with a sizeable voting stock another firm.13
investmentby threatening to terminate or On the other hand, the Board generally has
change the terms of the business relationship. not viewed as problematic for control purposes
The Board has recognized over the years, those covenants that give an investor rights per-
however, that not all business relationships missible for a holder of nonvoting securities as
even when accompanied by a material described in section 2(q)(2) of Regulation Y.14
investmentprovide the investor a controlling These would include covenants that prohibit the
influence over the management or policies of banking organization from issuing senior securi-
the banking organization. Accordingly, the ties or borrowing on a senior basis, modifying
Board has frequently allowed business relation- the terms of the investors security, or liquidat-
ships that were quantitatively limited and quali- ing the banking organization. Noncontrolling
tatively nonmaterial, particularly in situations covenants also could include covenants that pro-
where an investors voting securities percentage vide the investor with limited financial informa-
in the banking organization was closer to 10 per- tion rights and limited consultation rights.
cent than 25 percent. The Board continues to
believe that business relationships should
remain limited and will continue to review busi-
ness relationships on a case-by-case basis within
the context of the other elements of the invest-
ment structure. In that review, the Board will
pay particular attention to the size of the pro- 12. See 12 C.F.R. 225.143(d)(2).
posed business relationships and to whether the 13. For an investment to be eligible for inclusion in a
banking organizations regulatory capital, it must not contain
proposed business relationships would be on or be covered by any covenants, terms, or restrictions that
market terms, non-exclusive, and terminable are inconsistent with safe and sound banking practices, see
without penalty by the banking organization. 12 C.F.R. 208, Appendix A, II and 12 C.F.R. 225, Appendix
A, II.(i). As described in 12 C.F.R. 250.166(b)(3), such provi-
sions include terms that could adversely affect the banking
organizations liquidity or unduly restrict managements flex-
ibility to run the organization, particularly in times of finan-
cial difficulty, or that could limit the regulators ability to
BHC Supervision Manual January 2009 resolve problem bank situations.
Page 8 14. 12 C.F.R. 225.2(q)(2).
2090.4.4.2 Conclusion of the 2008 Policy and obligations of the investor and the banking
Statement organization; they also depend on the amount of
influence the investor, in fact, exercises over the
As noted above, whether a minority investor in banking organization. Accordingly, the Board
a banking organization has a controlling influ- has and will continue to monitor carefully
ence over the management or policies of the minority investments in banking organizations
banking organization depends on all the facts to ensure that investors do not, in fact, exercise
and circumstances surrounding the investors a controlling influence over the management or
investment in, and relationship with, the bank- policies of the banking organizations in which
ing organization. This policy statement sets they invest. The Board also continues to evalu-
forth some of the most significant factors and ate its policies in this area and will modify them
principles the Board will consider in determin- as appropriate going forward to ensure that
ing whether investments in a banking organiza- minority investments in banking organizations
tion are noncontrolling for purposes of the BHC remain consistent with the BHC Act.
Act.
Importantly, controlling-influence determina-
tions depend not just on the contractual rights

Page 9
Required Federal Reserve 1842(a)(3)

approval if a BHC acquires
more than 5 percent (direct
or indirect control) of vot-
ing shares of a bank
Federal Reserve approval 1842(a)(2)

of a BHC acquiring control
of a bank
BHCs and direct or indirect 1841(d)

controlling influence over a
bank
Acquiring a bank outside 1842(d)(1)

of the home state of the
investing bank holding
company
Long-term restrictions on 225.31(d)(2)

the rights of a holder of
voting securities
Specific approaches that 225.144(c)

avoid control
Nonvoting equity invest- 225.143(d)(4)

ments as a percent of total and (d)(5)
equity and control issues
Covenants and controlling 225.143(d)(2)

influence issues
Covenants and rights per- 225.2(q)(2)

missible for a holder of
nonvoting securities.
Nonvoting Equity Invest- 225.143 4-172.1

ments by BHCs (1982 Pol-
icy Statement)
Equity investments in 225.144

banks and BHCs (2008
Policy Statement)

Page 10
Control and OwnershipGeneral (Acquisitions of
Bank Shares Through Fiduciary Accounts) Section 2090.5
Pursuant to Section 3 of the Bank Holding Com- old, even though sole discretionary voting
pany Act, a bank holding company, directly or authority is not held:
through its subsidiary banks, may not acquire 1. Shares held by a trust which is a
more than 5 percent of the shares of an addi- company, as defined in Section 2(b) of the
tional bank without the Boards prior approval. Bank Holding Company Act; and,
However, it is recognized that banks acting as 2. Shares held as trustee for the benefit of the
trustee may acquire such shares without prior acquiring bank or bank holding company, or its
notice. Therefore, the Act requires a bank or shareholders, employees or subsidiaries.
banks which are subsidiaries of bank holding A bank holding company should have proce-
companies and acquire in excess of the 5 per- dures for monitoring holdings of the stock of
cent threshold limit, to file an application with other banks and bank holding companies for
the Board within 90 days after the shares ex- compliance with the foregoing application re-
ceeding the limit are acquired. The limit gener- quirements of the Act, for compliance with
ally applies only to other bank shares over which reporting requirements on form Y6, and for
the acquiring fiduciary exercises sole discretion- compliance with certain similar reporting re-
ary voting authority. Nevertheless, the Board quirements under the federal securities laws. A
has waived this application requirement under general 5 percent threshold applies in all three
most circumstances in Section 225.12 of Regu- situations, although differing requirements and
lation Y, unless exemptions apply.
1. the acquiring bank or other company has Examiners specifically trained in trust exami-
sole discretionary authority to vote the securities nations may need to conduct this portion of an
and retains the authority for more than two inspection and, in appropriate circumstances,
years; or the examiner may need to consult with Federal
2. the acquisition is for the benefit of the Reserve Bank legal counsel. Trust examiners
acquiring bank or other company, or its share- routinely review such matters in connection
holders, employees, or subsidiaries. with individual trust examinations. The inspec-
In determining whether the threshold limits tion objectives will be to determine whether the
have been reached, shares acquired prior to Jan- holdings of shares of other banks or bank hold-
uary 1, 1971 can ordinarily be excluded. On the ing companies, in a fiduciary capacity, are ap-
other hand, shares of another bank held under propriately monitored to comply with section
the following circumstances should, in certain 3(a) of the Bank Holding Company Act with
instances, be included in the 5 percent thresh- other reporting requirements for such holdings.

Page 1
(Control Determinants) Section 2090.6
WHATS NEW IN THIS REVISED describe situations which are not as clearly
SECTION defined as the irrebuttable presumptions. For
example, a company which enters into a man-
Effective January 2010, this section was revised agement contract that gives the company signifi-
to delete a discussion of, and references to, cant control over the operations or management
section 2(g)(3) of the BHC Act. Section 2(g)(3) of a bank or other company may be deemed to
was repealed by section 2610 of the Economic exercise a controlling influence over that bank
Growth and Regulatory Paperwork Reduction or other company. Section 225.31(c) of Regula-
Act of 1996 (Public Law No. 104-208). tion Y and section 2(a)(2)(C) of the Act require
a Board determination to establish that a com-
pany directly or indirectly exercises a control-
2090.6.05 CONTROL DETERMINANTS ling influence over the management or policies
of a bank or other company.
The spin-off or sale of property by a bank hold-
ing company may not sever the bank holding
companys control relationship over such prop- 2090.6.1 INSPECTION OBJECTIVES
erty for purposes of the Bank Holding Company
Act. The factors which are normally considered 1. To determine whether or not a significant
in determining whether control has ceased voting or ownership interest exists.
include the presumptions of control listed in 2. To determine whether any rebuttable pre-
section 225.31(a) of Regulation Y and in sec- sumptions of control raise any control issues
tions 2(a)(2) and 2(g) of the Act, and certain (see section 225.31(d) of Regulation Y).
ownership and voting rights. 3. To determine whether section 2(g)(2) of the
Most of the irrebuttable and rebuttable pre- Act or any of the other irrebuttable presump-
sumptions of control were written to establish tions of control listed in section 225.2(e) of
initially a control relationship between two Regulation Y raise any control issues.
companies. All of the presumptions of control
must be considered before presuming that a
divestiture is effective. Irrebuttable control rela- 2090.6.2 INSPECTION PROCEDURES
tionships are established, or continue to be rec-
ognized, when any of the conditions listed in The examiner should review the stock records
section 225.2(e) of Regulation Y or sections of the transferor, the transferee, and the trans-
2(a)(2)(A), 2(a)(2)(B), 2(g)(1), or 2(g)(2) of the ferred entity, if possible. Management contracts,
Act exist. Thus, a company is assumed to have trust agreements, and any pertinent agreements
irrebuttable control over a bank or another com- among these parties also should be reviewed for
pany without a Board determination if: any evidence of a control relationship. When
following these procedures for a bank holding
1. The company directly or indirectly, or acting company which has divested or will divest of
through one or more other persons, owns, property, the examiner should be aware that the
controls, or has power to vote 25 percent or criteria for establishing a continuing control
more of the voting securities of the bank or relationship are more stringent than those for
company; establishing an initial control relationship. Thus,
2. The company controls in any manner the the examiner should review all ownership and
election of a majority of the directors, trust- voting rights rather than just those above 5 or
ees, or general partners (individuals exerciz- 25 percent.
ing similar functions) of the bank or other The examiner should review the records of
company; the bank holding company, its parents, and its
3. The Board determines, after notice and subsidiaries as well as the records of any com-
opportunity for hearing, that the company pany being divested and the company (and its
directly or indirectly exercises a controlling parent and subsidiaries) acquiring divested prop-
influence over the management or policies of erty for evidence of a continuing control rela-
the bank or company. tionship. If the transferee is an individual or if
the records of the transferee are not available,
Rebuttable presumptions of control are listed
in section 225.31(d) of Regulation Y and in BHC Supervision Manual January 2010
sections 2(a)(2)(C) of the Act. These sections Page 1
Control and Ownership (Control Determinants) 2090.6
the examiner should inquire whether any of the indebted to or have common personnel (officers,
specific control relationships exist. Specifically, directors, trustees, beneficiaries, policy making
the examiner should determine whether the employees, consultants, etc.) with the transferor,
transferee, its parent, or its subsidiaries, are its parent, or its subsidiaries.
Presumptions of control Sections 2(g)(1) 225.31(a)

and 2(g)(2) of 225.139
the act
Statement of policy 225.138

concerning divestitures
Rebuttable presumptions 225.31(d)

of control
Requirements placed on Alfred I.

transferee and transferor duPont
to ensure a complete Testamentary
separation Trust;
September 21,
1977
Control is not terminated Alfred I.

if a rebuttable presump- duPont
tion of control is Testamentary
applicable Trust;
October 3, 1977
Explanation of transf- 225.139(c)(1) 1978 FRB 211

eror, transferee,
shares, and procedures
Transferee includes 225.139 Summit Home

individuals (footnote 4) Insurance
Company, Min-
neapolis,
Minnesota;
August 30,
1978
The Moody
Foundation,
Galveston,
Texas;
January 16,
1968

Page 2
Presumption of control 225.139 GATX

through common direc- Corporation,
tors, officers, etc. Chicago,
Illinois;
February 21,
1978
Reduction of ownership Financial

to less than 5 percent of Securities
a subsidiary is an effec- Corporation,
tive divestiture Lake City,
Tennessee;
August 29,
1972
Individual may be a 225.139 Mercantile

transferee; an insignifi- National
cant debt relationship Corporation,
may exist Dallas,
Texas; June 2,
1975
Control terminated Equimark

although shares Corporation,
were pledged as Pittsburgh,
collateral on a note Pennsylvania;
representing part of February 4,
purchase price 1977
Application to retain First Bancorp,

control pursuant to Inc.,
rebuttable presumption; Dallas, Texas;
approved, but company February 22,
not authorized to acquire 1977
additional shares
Application to divest Commanche

control pursuant to Land and
rebuttable presumption; Cattle
approved Company,
Commanche,
Texas;
January 15,
1980
Indebtedness of trans- 225.139(c)(4) 1980 FRB 237

feree to transferor

Page 3
Board staff letter on a Imperial

determination of control Bancorp;
after a spin-off August 19,
transaction 1998

Page 4
(Nonbank Banks) Section 2090.7
WHATS NEW IN THIS REVISED tion, no bank subsidiary of the grandfathered

SECTION company may commence to accept demand
deposits and engage in the business of making
This section has been revised to include a March commercial loans. A bank subsidiary of the
21, 2006, Board staff legal opinion that con- grandfathered company may also not permit an
firms that a direct conversion from a state- overdraft2 (including an interday overdraft) or
chartered bank to a national bank would not, by incur an overdraft on behalf of an affiliate3 at a
itself, cause a parent company to lose its grand- Federal Reserve Bank.4
father rights maintained under section 4(f) of If a grandfathered company no longer quali-
the BHC Act. The BHC Act prevents a grand- fies for an exemption, the company must divest
fathered nonbank BHC from acquiring control control of all the banks it controls within
of an additional bank or thrift as a limited- 180 days after the date that the company
purpose trust company, which would not be a receives notice from the Board that it no longer
bank for the purposes of the BHC Act. qualifies for the exemption. The exemption may
be reinstated if, before the end of the 180-day
notice period, the company (1) corrects the con-
2090.7.1 CEBA AND FIRREA dition or ceases the activity that caused its
PROVISIONS FOR NONBANK BANKS exemption to end or submits a plan to the Board
for approval to correct the condition or cease the
The Competitive Equality Banking Act (CEBA), activity within one year and (2) implements
effective August 10, 1987, amended section 2(c) procedures reasonably adapted to avoid a recur-
of the BHC Act by expanding the definition of rence of the condition or activity.
bank to include all FDIC-insured depository The Board may examine and require reports
institutions. The definition also includes any of grandfathered companies and of the nonbank
other institution that (1) accepts demand depos- banks they control but only to monitor or
its or other deposits that the depositor may make enforce compliance with the grandfather restric-
payable to third parties (demand deposits) and tions. The Board also may use civil enforcement
(2) is engaged in the business of making com- powers, including cease-and-desist orders, to
mercial loans. The new definition covers institu- enforce compliance.
tions that were not previously covered by the Grandfathered companies, their affiliates, and
BHC Act (nonbank banks). Thrift institutions their nonbank banks are also subject to the
that remain primarily residential mortgage lend-
ers continue to be excepted from the definition 2. Section 225.52 of Regulation Y further defines the
of bank. restrictions on overdrafts.
CEBA amended section 4 of the BHC Act by 3. Section 225.52(b)(2)(ii) of Regulation Y provides that a
nonbank bank (or an industrial bank) incurs an overdraft on
adding a grandfather provision that permits a behalf of an affiliate when (1) the nonbank bank holds an
nonbanking company that on March 5, 1987, account at a Federal Reserve bank for an affiliate from which
controlled an institution that became a bank third-party payments can be made and (2) the posting of an
under CEBA to retain the institution and not be affiliates transactions to the nonbank banks or industrial
banks account creates an overdraft or increases the amount of
treated as a bank holding company. A grandfath- an existing overdraft in the account.
ered company will lose its exemption, however, 4. The overdraft prohibition does not apply if the overdraft
if it violates any of several prohibitions govern- (1) results from an inadvertent computer or accounting error
ing its activities. Among these prohibitions, a that is beyond the control of both the bank and the affiliate;
(2) is permitted or incurred on behalf of an affiliate that is
grandfathered company may not acquire control monitored by, reports to, and is recognized as a primary dealer
of an additional bank or a thrift institution or by the Federal Reserve Bank of New York and is fully
acquire more than 5 percent of the assets or secured, as required by the Board, by direct U.S. obligations,
shares of an additional bank or thrift.1 In addi- obligations fully guaranteed as to principal and interest by the
United States, or securities or obligations eligible for settle-
ment by the Federal Reserve book-entry system; or (3) is
permitted or incurred by or on behalf of an affiliate in connec-
1. An exception to this prohibition is made for cases tion with an activity that is financial in nature or incidental to
involving the acquisition of a failing thrift provided that a financial activity and does not cause the bank to violate any
(1) the thrift is acquired in an emergency acquisition and is provision of sections 23A or 23B of the Federal Reserve Act
either located in a state where the grandfathered company directly or indirectly or by virtue of section 18(j) of the
already controls a bank or has total assets of $500 million or Federal Deposit Insurance Act.
more at the time of the acquisition or (2) the thrift is acquired
from the RTC, FDIC, or director of the OTS in an acquisition
in which federal or state authorities find the institution to be in BHC Supervision Manual July 2006
danger of default. Page 1
Control and Ownership (Nonbank Banks) 2090.7
anti-tying restrictions of the BHC Act and to the would not establish, or acquire any shares of, a
insider-lending restrictions of section 22(h) of separate bank or savings association as part of
the FRA and in Regulation O. Thus, for exam- the conversion process. Simultaneously with the
ple, a nonbank bank may not condition a grant conversion process, however, the parent com-
of credit on the purchase of a product or service pany would establish a new, limited-purpose
from its grandfathered holding company, or vice national bank trust company (trust company). It
versa, and it may not extend credit to insiders of was represented that the trust company would
the nonbank bank or its grandfathered holding comply with the limitations and restrictions in,
company on preferential terms. and would qualify for, the trust company excep-
A bank holding company that controls a non- tion from the definition of bank under section
bank bank may retain it as long as the nonbank 2(c)(2)(D) of the BHC Act. (See 12 U.S.C.
bank does not (1) engage in an activity5 that 1841.) The parent company would then cause
would have caused it to be a bank before the the trust company to merge into Bank A, with
effective date of CEBA or (2) increase the num- Bank A being the entity that survives the
ber of locations from which it does business merger. Bank A would then change its name
after March 5, 1987. These limitations do not (new bank) and the location of its headquarters.
apply if (1) the nonbank bank is viewed as an Under the proposed transaction, the parent
additional bank subsidiary of the bank holding company would remain the sole shareholder of
company and (2) the BHCs acquisition of the new bank. It was represented that, prior to its
nonbank bank would be permissible under the merger with Bank A, the trust company would
interstate banking provisions of the BHC Act. not be an operating company and would have no
assets or liabilities. It was also represented that
the proposal would not result in any change in
2090.7.2 RETAINING GRANDFATHER ownership or control of Bank A.
RIGHTS UNDER SECTION 4(F) OF The Boards legal staff concluded that the
THE BHC ACT direct conversion of Bank A from a state-
chartered bank to a national bank would not, by
A state nonmember bank (Bank A) that became itself, cause the parent company to lose its
a bank for purposes of the BHC Act as a grandfather rights under section 4(f) of the BHC
result of CEBA requested a determination that Act.6 Also, the BHC Act would not prevent the
its conversion to a national bank and merger parent company from chartering the trust com-
with a limited-purpose trust company would not pany. Although the BHC Act prevents a grand-
cause its parent company to lose certain grandfathered nonbank bank from acquiring control
father rights that it maintains under section 4(f) of an additional bank or thrift (12 U.S.C.
of the BHC Act. (See 12 U.S.C. 1843(f).) 1843(f)(2)(A)), the trust company as a limited-
The parent company could retain ownership purpose trust company would not be a bank for
of Bank A and not be treated as a bank holding the purposes of the BHC Act.
company, but only if it and Bank A abided by The Boards Legal Division staff stated that it
the conditions set forth in section 4(f) of the would not recommend that the Board determine
BHC Act. One of these conditions generally that the transactions described in the request
prohibits the parent company from acquiring would cause the parent company to lose its
control of more than 5 percent of the shares or grandfather rights under section 4(f) of the BHC
assets of an additional bank or savings associa- Act. New bank is required to comply with the
tion. (See 12 U.S.C. 1843(f)(2)(A)(i) and (ii).) conditions applicable to a nonbank bank and a
The parent company wished to convert Bank grandfathered holding company, respectively,
A into a national bank. The conversion would under the BHC Act. (See the Board staff legal
be effected directly, and the parent company opinion dated March 21, 2006.)
5. Previously, a nonbank bank could accept demand depos-

its or engage in the business of making commercial loans, but
could not engage in both activities.
BHC Supervision Manual July 2006 6. See letter from the general counsel of the Board, dated
Page 2 October 12, 2004.
Control and Ownership (Nonbank Banks) 2090.7
Limitations on nonbank 1843(f) 225.52

banks

Page 3
Control and Ownership (Liability of Commonly
Controlled Depository Institutions) Section 2090.8
The Financial Institutions Reform, Recovery The liability the insured depository institution
and Enforcement Act of 1989 (FIRREA), has to the FDIC is senior to shareholders claims
effective August 9, 1990, provided [12 U.S.C. and any obligation or liability owed to any
1815 (e)] that any insured depository institution affiliate of the depository institution.2 Claims of
will be liable for any actual or reasonably the FDIC against the depository institution are
anticipated loss incurred or to be incurred by the subordinate to any deposit liabilities, secured
FDIC in connection with: obligations and obligations that are subordi-
1. The default of a commonly controlled1 nated to depositors (i.e. subordinated debt).
depository institution; or The FDIC may grant an insured depository
2. Any assistance provided by the FDIC to institution a waiver of the cross-guarantee provi-
any commonly controlled insured depository sions, if it determines that such an exemption is
institution. in the best interests of the either the Bank or
Savings Association Insurance Funds. Limited
partnerships and affiliates of limited partner-
2090.8.1 FIVE YEAR PROTECTION ships (other than an insured depository institu-
FROM LIABILITY (5-YEAR tion, which is a majority owned subsidiary of
TRANSITION RULE) such partnership) may also be exempted from
the provisions, if the limited partnership or its
Sister banks, for five years from the enactment affiliate has filed a registration statement with
of the law, are protected against losses due to the Securities and Exchange Commission, on or
the default of a thrift acquired before enactment. before April 10, 1989. The registration state-
The law also grants a five- year protection to ment must indicate that as of the date of the
thrifts for loss due to the default of a bank filing, the partnership intended to acquire one or
acquired before the laws enactment. more insured depository institutions. If an in-
sured depository institution is granted an ex-
emption from the cross-guarantee provisions,
2090.8.2 CROSS-GUARANTEE then the institution and all of its insured de-
PROVISIONS pository institution affiliates must comply with
the restrictions of sections 23A and 23B of
FIRREA contains cross-guarantee provisions. the Federal Reserve Act without regard to sec-
These provisions enable the FDIC to obtain tion 23A(d)(1) which provides for certain
reimbursement from insured depository institu- exemptions.
tions, in the event that the FDIC incurs a loss
due to any assistance provided to, or a default
of, a commonly controlled bank or thrift. 2090.8.3 EXCLUSION FOR
The FDIC will provide written notice when INSTITUTIONS ACQUIRED IN DEBT
an insured depository institution is being held COLLECTIONS
liable for losses sustained by the FDIC in con-
nection with assistance to a commonly con- FIRREA provides an exclusion from the cross-
trolled bank or thrift. Upon receipt of the written guarantee provisions for an institution acquired
notice from the FDIC, the insured depository in securing or collecting a debt previously con-
institution is required to pay the amount speci- tracted in good faith. However, during the entire
fied. An insured depository institution is not exclusion period, the controlling bank and all of
liable for losses incurred by the FDIC, in con- its insured depository institution affiliates must
nection with a commonly controlled institution, comply with sections 23A and 23B of the Fed-
if the written notice is not received within two eral Reserve Act (FRA),3 for transactions with
years from the date of the FDICs loss. the insured depository institution involving
acquisitions as a result of debts previously con-
tracted in good faith.
1. Depository institutions are commonly controlled if: 2. Does not apply to any obligation to affiliates secured as
a. Such institutions are controlled by the same deposi- of May 1, 1989.
tory institution holding company (including any company, 3. Without regard to section 23A(d)(1) of the FRA.
such as nonbank banks, that are required to file reports under
[12 U.S.C. 1843(f)(6)]; or
b. One depository institution is controlled by another BHC Supervision Manual December 1992
depository institution. Page 1
(Shareholder Protection Arrangements) Section 2093.0
The Federal Reserve has observed an increase 2093.0.1 SHAREHOLDER
in interest by some holding companies to estab- PROTECTION ARRANGEMENTS
lish arrangements that are designed to benefit SUPERVISORY ISSUES
certain shareholders, enhance short-term inves-
tor returns, and/or provide a distinct disincen- Examples of shareholder protection arrange-
tive for investors to acquire or increase owner- ments that have raised supervisory issues
ship in a holding companys common stock and include, but are not limited to, provisions
other capital instruments. In some instances, whereby:
supervisory staff has found that these share-
holder protection arrangements would have The holding company agrees to provide an
negative implications on a holding companys investor with cash payments reflecting the
capital or financial position, limit a holding difference between the price paid by the
companys financial flexibility and capital- investor and a lower price per share paid by
raising capacity, or otherwise impair a holding investors in subsequent transactions;3
companys ability to raise additional capital. The holding company agrees to provide an
These arrangements impede the ability of a investor with additional shares of stock for
holding company to serve as a source of strength minimal or no additional cost in the event that
to its insured depository subsidiaries1 and were the holding company issues shares at a price
considered unsafe and unsound. below the price paid by the investor;
In December 2015, the Federal Reserve Existing shareholders of the holding company
issued the following guidance to explain super- are able to acquire additional shares at signifi-
visory concerns related to arrangements struc- cant discounts to market value in a new offer-
tured by bank and savings and loan holding ing if any shareholder crosses a specific own-
companies (collectively, holding companies) ership threshold;4
to protect the financial investments made by Investors with less-than-majority control are
shareholders (collectively, shareholder protec- granted the contractual right to restrict or
tion arrangements). In particular, such arrange- prevent the holding company from issuing
ments raise concerns because they could have additional shares; or
negative implications on a holding companys The holding companys board of directors has
capital or financial position, or limit the holding
companys ability to raise capital in the future.2 3. Provisions of this type and the next example are often
A holding company, regardless of its asset size, referred to as down-round provisions. Down-round provi-
should be aware that the Federal Reserve may sions can take many forms, but all are designed to protect
object to a shareholder protection arrangement existing shareholders in the event a holding companys stock
price declines in a subsequent effort to raise capital or sell the
based on the facts and circumstances and the holding company.
features of the particular arrangement. There- 4. Provisions of this type are often referred to as poison
fore, a holding company that is engaged in pills and were originally developed as defenses against con-
capital raising efforts or is considering the tested acquisitions. There are multiple common forms, but
these provisions generally operate by increasing the owner-
implementation or modification of a shareholder ship interest of shareholders other than a buyer of a significant
protection arrangement should review this guid- block of shares, thereby diluting the buyer and preventing the
ance to help ensure that supervisory concerns takeover bid.
are addressed. (Refer to SR-15-15) Poison pill structures have also been applied in the context
of tax benefit preservation plans (TBPPs), which, in general
terms, are designed to preserve net operating losses within the
requirements of section 382 of the Internal Revenue Code.
1. Pursuant to section 616(d) of the Dodd-Frank Wall Under section 382, the use of deferred tax assets can be
Street Reform and Consumer Protection Act and the Boards restricted by an ownership change. Thus, TBPPs and poison
Regulations Y and LL, a holding company is required to serve pills use similar mechanisms to restrict changes in ownership,
as a source of financial strength for its insured depository despite different underlying purposes. TBPPs may also take
subsidiaries and should not conduct its operations in an unsafe forms different from traditional poison pills.
or unsound manner. Specifically, a holding company should As an example, a TBPP or poison pill may provide all
stand ready to use available resources to provide adequate shareholders, other than the shareholder crossing the relevant
capital funds to its subsidiary banks and thrifts during periods threshold, the right to acquire shares of the holding company
of financial stress or adversity. See 12 U.S.C. 1831o-1; 12 at a substantial discount, reducing the incentive of sharehold-
C.F.R. 225.4(a); and 12 C.F.R. 238.8(a). ers to acquire more shares at or above the threshold. These
2. As discussed further below, these arrangements may rights may or may not terminate within a set amount of time.
come in many different forms, including all or portions of
agreements between shareholders (or other relevant parties),
company plans, organizing documents, and other contractual BHC Supervision Manual January 2016
provisions that provide shareholder protections. Page 1
Control and Ownership (Shareholder Protection Arrangements) 2093.0
the authority to nullify share purchases under companys management): Federal Reserve
certain circumstances, require the holding staff should incorporate a review of such
company to repurchase the shares of the com- arrangements in the examination scope or
pany from a new owner of the shares, or take supervisory plan for the holding company
other actions that would significantly inhibit and, on limited occasions, in connection with
secondary market transactions in the shares of an application filing.7
the holding company.5
The Federal Reserve may direct a holding
Arrangements of these types (in whatever companys board of directors to modify or
form) have the potential to impose additional remove a shareholder protection arrangement
financial obligations on a holding company or that gives rise to safety-and-soundness con-
restrict in some way the primary or secondary cerns. The corrective actions, if any, will vary
market for the holding companys shares. Often, depending on the facts and circumstances of the
these arrangements serve to protect the value of holding company, as well as applicable state and
the initial investment made by a particular sub- federal laws and regulations, corporate charter
set of shareholders rather than the viability of and by-laws, and other considerations.8 The
the issuing holding company, or, in other ways, Reserve Banks communications with the hold-
provide current shareholders with an advantage ing company should comply with applicable
over future, similarly situated, investors.6 supervisory guidance, including SR-13-13/
CA-13-10, Supervisory Considerations for the
Communication of Supervisory Findings. If a
2093.0.2 SUPERVISORY OVERSIGHT holding company has questions regarding the
removal or modification of a shareholder protec-
If supervisory or applications staff determine tion arrangement, the holding company should
that a particular shareholder protection arrange- consult with the appropriate Federal Reserve
ment impairs the ability of a holding company Bank.
to raise or maintain capital, particularly during a
period of stress on the firm, or that provisions of
the arrangement are in violation of applicable
supervisory enforcement actions, Federal
Reserve staff should consult with appropriate
Federal Reserve Board supervisory staff to
determine the appropriate action. This can occur
when:
Federal Reserve staff become aware of a pro-

posed shareholder protection arrangement 7. This guidance is focused on supervisory actions going
(for example, as part of an effort to raise forward and is not intended to require active confirmation by
capital or a proposal to expand): Federal a holding company or Federal Reserve staff on a routine basis
Reserve staff should incorporate a review of that a shareholder protection issue does not exist. To facilitate
the identification of shareholder protection arrangements that
such arrangements during consideration of raise supervisory concern, the management and other repre-
the specific proposal, whether or not there is a sentatives of holding companies are encouraged to bring all
formal application or other approval require- such existing or proposed arrangements to the attention of
ment. relevant supervisory and applications staff when appropriate.
8. Holding companies subject to the Boards Regulation Q
Federal Reserve staff become aware of an (12 C.F.R. 217) are subject to additional regulatory require-
existing shareholder protection arrangement ments that should be considered in connection with share-
during the course of a supervisory activity holder protection arrangements. In particular, common equity
(for example, in discussions with the holding tier 1 capital instruments and additional tier 1 capital instru-
ments are required to satisfy eligibility criteria that effectively
disqualify instruments with certain features used in some
5. These arrangements could include complete prohibitions
shareholder protection arrangements, such as features that
on share transfers, as well as certain forms of buy-sell agree-
limit or discourage future capital issuances, compensate exist-
ments, rights of first refusal, or similar arrangements that
ing investors if new instruments are issued at a lower price,
sufficiently restrict the transfer of shares as to effectively
create incentives to redeem, or interfere with the full discre-
prohibit most, if not all, transfers.
tion of the issuer to cancel dividend payments except under
6. In general, the right to participate in subsequent offer-
limited circumstances. See 12 C.F.R. 217.20. Further, the
ings to prevent dilution of ownership, when fully paid for, has
Board may require a holding company to exclude capital
not raised concerns.
instruments from regulatory capital if such instruments have
characteristics or terms that diminish the instruments ability
BHC Supervision Manual January 2016 to absorb losses, or otherwise present safety-and-soundness
Page 2 concerns. See 12 C.F.R. 217.1(d)(2).
International Banking Activities
Section 2100.0
WHATS NEW IN THIS REVISED ing organizations to obtain financial and operat-
SECTION ing information and, in some instances, to
evaluate the organizations efforts to implement
Effective July 2010 this section was revised to corrective measures or to test their adherence to
discuss the Federal Reserves supervision and safe and sound banking practices. Examinations
regulation of the international operations of abroad are conducted with the cooperation of
banking organizations headquartered in the the supervisory authorities of the countries in
United States as well as the domestic activities which they take place.
of foreign banking organizations (FBOs). This At the end of 2009, 53 member banks were
includes the number of member banks, Edge Act operating 557 branches in foreign countries and
corporations and agreement corporations oper- overseas areas of the United States; 32 national
ating in foreign countries and overseas areas of banks were operating 503 of these branches, and
the United States and the number of entities 21 state member banks were operating the other
representing FBOs operating in the United 54.
States at the end of 2009.
The Federal Reserve has supervisory and regu- 2100.0.2 EDGE ACT AND
latory responsibility for the international opera- AGREEMENT CORPORATIONS
tions of member banks (national and state mem-
ber banks) and bank holding companies (BHCs). Edge Act corporations are international banking
These responsibilities include organizations chartered by the Federal Reserve
to provide all segments of the U.S. economy
authorizing the establishment of foreign with a means of financing international busi-
branches of national banks and state member ness, especially exports. Agreement corpora-
banks and regulating the scope of their tions are similar organizations, state chartered
activities; or federally chartered, that enter into agree-
chartering and regulating the activities of ments with the Federal Reserve to refrain from
Edge and agreement corporations, which are exercising any power that is not permissible for
specialized institutions used for international an Edge Act corporation.
and foreign business; Sections 25 and 25A of the Federal Reserve
authorizing foreign investments of member Act grant Edge Act and agreement corporations
banks, Edge and agreement corporations, and permission to engage in international banking
BHCs and regulating the activities of foreign and foreign financial transactions. These corpo-
firms acquired by such investors; and rations, most of which are subsidiaries of mem-
establishing supervisory policy and practices ber banks, may (1) make foreign investments
regarding foreign lending by state member that are broader than those permissible for mem-
banks. ber banks, and (2) conduct a deposit and loan
business in states other than that of the parent,
In addition, the Federal Reserve supervises provided that the business is strictly related to
the activities that foreign banking organizations international transactions. Foreign banks may
(FBOs) conduct through entities in the United also own Edge Act and agreement corporations.
States, including branches, agencies, representa- At year-end 2009, 38 U.S. banking organiza-
tive offices, and subsidiaries. tions owned Edge Act or agreement corpora-
tions; foreign banks directly owned an addi-
tional 14; and two were standalone companies.
2100.0.1 FOREIGN OPERATIONS OF These corporations are examined annually.
U.S. BANKING ORGANIZATIONS
In supervising the international operations of 2100.0.3 SUPERVISION OF FOREIGN
state member banks, Edge Act and agreement BANKING ORGANIZATIONS
corporations, and BHCs, the Federal Reserve
generally conducts its examinations or inspec- The Federal Reserve has broad authority for the
tions at the U.S. head offices of these organiza- supervision and regulation of FBOs that engage
tions, where the ultimate responsibility for the
foreign offices lies. When appropriate, examin- BHC Supervision Manual July 2010
ers also visit the overseas offices of U.S. bank- Page 1
International Banking Activities 2100.0
in banking in the United States through dated Supervision of Bank Holding Companies
branches, agencies, representative offices, com- and the Combined U.S. Operations of Foreign
mercial lending companies, Edge Act and agree- Banking Organizations. In particular, see
ment corporations, commercial bank subsidi- attachments B1, Guidance for the Supervision
aries, BHCs, and certain nonbank companies. of the Combined U.S. Operations of Foreign
Under the International Banking Act of 1978, as Banking Organizations that are Large Complex
amended by the Federal Deposit Insurance Cor- Banking Organizations and B2, Guidance for
poration Improvement Act of 1991, the Federal the Supervision of the Combined U.S. Opera-
Reserve is required to approve the establishment tions of Multi-office Foreign Banking
of foreign bank branches, agencies, commercial Organizations.
lending subsidiaries, and representative offices As of December 31, 2009, 176 foreign banks
in the United States and may also terminate, or from 53 countries were operating 204 state-
recommend termination of, the operations of licensed branches and agencies (six of which
foreign banks in the United States under certain were insured by the FDIC) and 50 branches and
conditions. The Federal Reserve is primarily agencies licensed by the Office of the Comptrol-
responsible for supervising the U.S. nonbanking ler of the Currency (four of which were insured
operations of FBOs. by the FDIC). These foreign banks also directly
The Federal Reserve may coordinate the owned three commercial lending companies. In
examinations of foreign bank operations with addition, the foreign banks held a controlling
other state and federal regulators. In most cases, interest in 58 U.S. commercial banks. Alto-
on-site examinations of branches and agencies gether, these foreign banks controlled approxi-
are required to be conducted once during each mately 17 percent of U.S. commercial banking
12-month period, although the period may be assets. These foreign banks also operated 78
extended to 18 months if the branch or agency representative offices; an additional 58 foreign
of the foreign bank meets certain criteria. For banks operated in the United States through a
more information on the Federal Reserves representative office. FBOs are significant par-
supervision of FBOs, see SR-08-9, Consoli- ticipants in the U.S. banking system.

Page 2
Formal Corrective Actions
Section 2110.0
WHATS NEW IN THIS REVISED 4. the elements of a corrective order

SECTION 5. temporary orders
6. written agreements
This section has been updated for the various 7. suspensions and removals
types of formal supervisory actionscorrective 8. enforcement of orders
actions (i.e., cease and desist orders (including 9. civil money penalties
placing limits on the activities or functions of a 10. termination of certain nonbank subsidiary
BHC or institution-affiliated party), written activities or ownership
agreements, suspensions (also removals and
prohibitions), nonbank activity termination, vio-
lations of orders and written agreements, civil- 2110.0.2 TYPES OF CORRECTIVE
money penalties (revised penalty amounts), etc. ACTIONS
In addition, the cease-and-desist order dis-
cussion has been expanded to include what an Generally, under section 8 of the Federal
order may require from a BHC or person, and it Deposit Insurance Act (FDI Act), 12 U.S.C.
provides a discussion of the nature of affirma- 1818(b), the Board may use its cease and desist
tive actions by a BHC or person that may need authority and other enforcement tools against
to be taken to restore the BHC to a safe and (1) a BHC1, (2) a nonbank subsidiary of a BHC,
sound condition. The prohibition and removal and (3) any institution-affiliated party. The term
discussion has been expanded to detail what institution-affiliated party includes any direc-
entities or individuals that the Board may take tor, officer, employee, controlling shareholder
action against. It also discusses the prohibition (other than a BHC), or agent, and any other
against any individual who has been convicted person who has filed or is required to file a
of a crime involving dishonesty, breach of trust, change in control notice. It also includes any
or money laundering, from serving, participat- shareholder, consultant, joint venture partner, or
ing in, or owning or controlling a BHC, bank or any other person who participates in the conduct
nonbank subsidiary, or any affiliate thereof with- of the affairs of a BHC or nonbank subsidiary,
out the prior approval of the FDIC or in certain as well as any independent contractor, including
cases, the Federal Reserve Board. The discus- attorneys, appraisers, and accountants who
sion on indemnifications and payments includes knowingly or recklessly participates in any vio-
a detailed discussion of the provisions of section lation of law or regulation, breach of fiduciary
18(k) of the FDI Act and the FDICs regulation duty, or unsafe or unsound practice that causes
on indemnification agreements and payments. (or is likely to cause) more than a minimal
The definition of a prohibited indemnification financial loss to, or a significant adverse effect
payment is included. on, an institution.2 The Boards jurisdiction over
an institution-affiliated party extends for up to
six years after the partys resignation, termina-
2110.0.1 STATUTORY TOOLS FOR tion of employment, or separation caused by the
FORMAL SUPERVISORY ACTION closing of a financial institution, provided that
any notice (such as a notice of intent to remove
Statutory tools are available to the Federal from office and of prohibition) is served on the
Reserve Board if formal supervisory action is party before the end of a six-year period.
warranted against a bank holding company
(BHC) or nonbank subsidiaries, or against cer-
tain individuals associated with them. The
objective of formal actions is to correct prac-
tices that the regulators believe to be unlawful, 1. The Boards authority under 12 U.S.C. 1818 also extends
unsafe, or unsound. The initial consideration to savings and loan holding companies, their nonbank subsid-
and determination of whether formal action is iaries, and their institution-affiliated parties.
required usually results from an inspection. This 2. The Board is authorized to issue regulations further
defining which individuals should be considered institution-
section discusses the following topics: affiliated parties. Similarly, the Board may determine whether
an individual is an institution-affiliated party on a case-by-
1. Board jurisdiction under the law case basis (see 12 U.S.C. 1813(u)).
2. actions or practices that may trigger the
statutory remedies BHC Supervision Manual January 2013
3. Board staff procedures Page 1
Formal Corrective Actions 2110.0
2110.0.2.1 Cease and Desist Orders notice of charges and of hearing to the entity or
party. The notice of charges contains a detailed
Generally, under 12 U.S.C. 1818(b), the Board statement describing the facts constituting the
may use its cease and desist authority against a alleged violations or unsafe or unsound prac-
BHC and any institution-affiliated party when it tices. The issuance of the notice of charges and
finds that the entity or party is engaging, has of hearing3 starts a formal process that includes
engaged, or is about to engage in (1) a violation the convening of a public administrative hearing
of law, rule, or regulation; (2) a violation of a to be conducted before an administrative law
condition imposed in writing by the Board in judge, appointed by the Board. After the hear-
connection with the granting of any application ing, the judge makes a recommended decision
or any written agreement; or (3) an unsafe or to the Board. A hearing must be held within 30
unsound practice in conducting the business of to 60 days of service of the notice of charges,
the institution. Section 12 U.S.C. 1818(b)(3) unless a later date is set by the administrative
makes clear that the cease and desist authority law judge. After the Board considers the record
applies to BHCs and Edge and agreement corpo- of the proceeding, including the administrative
rations, as well as to all institution-affiliated law judges recommended decision, it deter-
parties associated with them. mines whether to issue a final cease and desist
A cease and desist order may require the order. BHCs and individuals who are subject to
BHC or person subject to the order to (1) cease cease and desist orders that were issued as a
and desist from the practices or violations or result of contested proceedings may appeal the
(2) take affirmative action to correct the viola- Boards issuance of the order to the appropriate
tions or practices. Affirmative actions include federal court of appeals.
actions necessary to restore the BHC to a safe
and sound condition, such as measures to
improve the BHCs consolidated capital, 2110.0.2.2 Temporary Cease and Desist
restricting dividends and new debt to conserve Orders
the BHCs assets so it can serve as a source of
strength to the bank; employ qualified officers If a violation or threatened violation of law,
or employees; and any other action the Board rule, or regulation, or if engaging in an unsafe or
determines to be appropriate. An individual may unsound practice that is specified in the notice
be required to reimburse the company for unau- of charges is likely to cause the insolvency of a
thorized or improper payments received, or BHC or its subsidiary bank, weaken the condi-
both. tion of the BHC, cause a significant dissipation
Most cease and desist orders are issued by in earnings, or otherwise seriously prejudice the
consent. When Board staff, in conjunction with interests of subsidiary banks depositors before
the appropriate Reserve Bank, determines that a the completion of the proceedings (initiated by
cease and desist action is necessary, the BHC or the issuance of the notice of charges), the Board
party is permitted an opportunity to consent to may, in conjunction with issuing a notice of
the issuance of the order without the need for charges, issue a temporary cease and desist
the issuance of a notice of charges and a con- order against the BHC or an institution-affiliated
tested administrative hearing. Board staff drafts party to effect immediate correction (pursuant to
the proposed cease and desist order and, with 12 U.S.C. 1818(c)).
Reserve Bank staff, presents it to the BHC or The Board may also issue a temporary order
individual for consent. BHCs and individuals if it determines that a BHCs or nonbank subsid-
are advised that they may have legal counsel iarys books and records are so incomplete or
present at all meetings with Board or Reserve inaccurate that the Board is unable to determine,
Bank staff concerning formal supervisory through the normal supervisory process, the
actions. If the parties voluntarily agree to settle BHCs or nonbank subsidiarys financial condi-
the case by the issuance of a consent cease and tion or the details or purpose of any transaction
desist order, the proposed consent order will be that may have a material effect on the BHCs
presented to senior Board officials for approval, condition. The temporary order may require the
at which time the order will be final and bind- BHC or nonbank subsidiary to take the same
ing. corrective actions as a cease and desist order.
When a BHC or person fails to consent to a The advantage of issuing a temporary cease and
cease and desist order, the Board may issue a
3. A private hearing may be held if the Board determines
BHC Supervision Manual January 2013 that holding a public hearing would be contrary to the public
Page 2 interest.
desist order is that it is effective immediately violation or practice; and

after it is served on the BHC or individual. 3. such violation, practice, or breach
Within 10 days after being served with a tempo- a. involves personal dishonesty; or
rary order, however, the BHC or individual may b. demonstrates a willful or continuing disre-
appeal to a U.S. district court for relief from the gard for the safety or soundness of the
order. Unless set aside by the district court, the institution.
temporary order stays in effect until the Board
issues a final cease and desist order or dismisses The statute also authorizes the Board to initi-
the action. ate removal or prohibition actions against
(1) any institution-affiliated party who has com-
mitted a violation of any provision of the Bank
2110.0.2.3 Written Agreements Secrecy Act that was not inadvertent or uninten-
tional, (2) any officer or director who has knowl-
When circumstances warrant, a written agree- edge that an institution-affiliated party has vio-
ment may be used. The provisions of a written lated the money-laundering statutes and did not
agreement may relate to any of the problems take appropriate action to stop or prevent the
found at the institution or involving institution- reoccurrence of such a violation, or (3) any
affiliated parties. Written agreements are drafted officer or director who violates the prohibitions
by Board staff, in consultation with Reserve on management interlocks. The removal or pro-
Bank staff, and must be approved by the Boards hibition actions for these violations do not
Director of the Division of Banking Supervision require a finding of gain to the individual, loss
and Regulation. After approval by the General to the institution, personal dishonesty, or willful
Counsel before issuance, the Reserve Bank may or continuing disregard for the safety or sound-
enter into the Written Agreement under del- ness of the institution.4
egated authority (12 C.F.R. 265.11(a)(15)). Like a cease and desist order, a removal or
prohibition order may be issued either by con-
sent or after an administrative process initiated
2110.0.2.4 Prohibition and Removal by the issuance of a notice of intent to remove
Authority and prohibit. If an institution-affiliated partys
actions warrant immediate removal from the
The Board is authorized by 12 U.S.C. 1818(e) to BHC, the Board is authorized to suspend the
remove any current institution-affiliated party of person temporarily from the BHC pending the
a BHC and its nonbank subsidiaries for certain outcome of the complete administrative process.
violations and misconduct and to prohibit per- An institution-affiliated party currently associ-
manently from the banking industry any current ated with a BHC may also be suspended or
or former institution-affiliated party from future removed for cause based on actions taken while
involvement with any insured depository institu- formerly associated with a different insured
tion, bank or thrift holding company, and nondepository institution, BHC, or business institu-
bank subsidiary. The Board is authorized to tion. Business institution is not specifically
initiate removal or prohibition actions when defined in the statute so that it may be inter-
preted to include any other business interests of
1. the institution-affiliated party has directly or the institution-affiliated party.
indirectly Under 12 U.S.C. 1818(g), the Board is autho-
a. violated any law, regulation, cease and rized to suspend from office or prohibit from
desist order, condition imposed in writing, further participation any institution-affiliated
or any written agreement; party charged or indicted for the commission of
b. engaged in any unsafe or unsound prac- a crime involving personal dishonesty or breach
tice; or of trust that is punishable by imprisonment for a
c. breached a fiduciary duty; and term exceeding one year under state or federal
2. the Board determines that, because of the law, if the continued participation might
violation, unsafe or unsound practice, or threaten either the interests of depositors or pub-
breach lic confidence in the institution. The Board may
a. the institution has suffered or will suffer also suspend or prohibit any individual charged
financial loss or other damage;
b. the interests of depositors have been or 4. See 12 U.S.C. 1818(e)(2).
could be prejudiced; or
c. the institution-affiliated party has received BHC Supervision Manual January 2013
financial gain or other benefit from the Page 3
with a violation of the money-laundering stat- 2110.0.2.6 Violations of Final Orders and
utes. The suspension can remain in effect until Written Agreements
the criminal action is disposed of or until the
suspension is terminated by the Board. The When any final order or temporary cease and
Board may also initiate a removal or prohibition desist order has been violated, the Board may
action against an institution-affiliated party who apply to a U.S. district court for enforcement of
has been convicted of, or pleaded to, a crime the action. Violations of final orders and written
involving personal dishonesty or breach of trust agreements may also give rise to the assessment
if his or her continued service would threaten of civil money penalties against the offending
the interests of the depositor or impair public BHC or institution-affiliated parties, as circum-
confidence in the institution. The Board is stances warrant. The civil money penalty is
required to issue such an order against any assessed in the same manner as described in the
institution-affiliated party who has been con- Civil Money Penalties section below. Any
victed of, or pleaded to, a violation of the institution-affiliated party who violates a suspen-
money-laundering statutes. sion or removal order is subject to a criminal
Furthermore, 12 U.S.C. 1829 prohibits any fine of up to $1 million, imprisonment for up to
individual who has been convicted of a crime five years, or both.
involving dishonesty, breach of trust, or money
laundering from (1) serving as an institution-
affiliated party of, (2) directly or indirectly par- 2110.0.2.7 Civil Money Penalties
ticipating in the affairs of, and (3) owning or
controlling, directly or indirectly, an insured The Board may assess civil money penalties of
depository institution without the FDICs prior up to $7,500 per day against any institution or
approval. The statute also prohibits a convicted institution-affiliated party for a violation of
person from holding a position at a BHC or (1) law or regulation; (2) a final cease-and-
nonbank affiliate without the Board of Gover- desist, temporary cease and desist, suspension,
nors of the Federal Reserve Systems prior removal, or prohibition order; (3) a condition
approval. The penalty for violation of this law is imposed in writing by the Board in connection
a potential fine for a knowing violation of up to with the granting of an application or other
$1 million per day, imprisonment for up to five request; and (4) a written agreement.
years, or both. The criminal penalty applies to A fine of up to $37,500 per day can be
both the individual and the employing institu- assessed for a violation, an unsafe or unsound
tion. practice recklessly engaged in, or a breach of
fiduciary duty when the violation, practice, or
breach is part of a pattern of misconduct, causes
2110.0.2.5 Termination of Nonbank or is likely to cause more than a minimal loss, or
Activity results in pecuniary gain or other benefit for the
offender. A civil money penalty of up to $1.375
The Board is authorized by 12 U.S.C. 1844(e) to million per day can be assessed for any knowing
order a BHC to terminate certain activities of its violation, unsafe or unsound practice, or breach
nonbank subsidiary (other than a nonbank sub- of any fiduciary duty when the offender know-
sidiary of a bank) or to sell its shares of the ingly or recklessly caused a substantial loss to
nonbank subsidiary. When the Board has rea- the financial institution or received substantial
sonable cause to believe that the BHCs continu- pecuniary gain or other benefit. Civil money
ation of any activity or ownership or control of penalties may also be assessed, under the three-
any of its nonbank subsidiaries constitutes a tier penalty framework described above, for any
serious risk to the financial safety, soundness, or violation of the Change in Bank Control Act
stability of the BHC, and if the activity, owner- and for violations of the anti-tying provisions of
ship, or control is inconsistent with sound bank- federal banking law, among other provisions
ing principles or inconsistent with the purposes (12 U.S.C. 1972).
of the Bank Holding Company Act (BHC Act) The Board may also assess civil money penal-
or the Financial Institutions Supervisory Act of ties for the submission of any late, false, or
1966, the Board may order the BHC to termi- misleading reports required by the BHC Act and
nate the activity or sell control of the nonbank Regulation Y of the Board. If a BHC maintains
subsidiary. procedures that are reasonably adapted to avoid
inadvertent errors and unintentionally fails to
BHC Supervision Manual January 2013 publish any report, submits any false or mislead-
Page 4 ing report or information, or is minimally late
with the report, it can be assessed a fine of up to in connection with any supervisory matter be
$2,200 per day. The financial institution has the accurate and free of insupportable conclusions
burden of proving that the error was inadvertent or opinions.
under these circumstances. If the error was not
inadvertent, a penalty of up to $32,000 per day
can be assessed for all false or misleading 2110.0.2.8.3 Subpoena Power
reports or information submitted to the Board. If
the submission was done in a knowing manner Under 12 U.S.C. 1818(n), which is made appli-
or with reckless disregard for the law, a fine of cable to BHCs by 12 U.S.C. 1818(b)(3) and
up to $1.375 million or 1 percent of the BHCs 1844(f), the Board has the authority to issue
assets can be assessed for each day of the viola- subpoenas directly or through its delegated rep-
tion. Notwithstanding the above, violations of resentatives, and it has the authority to adminis-
the BHC Act (with the exception of late, false, ter oaths or take depositions in connection with
or inaccurate report violations as described an examination or inspection.
above) may be addressed by the assessment of
civil money penalties of not more than $25,000
per day. 2110.0.3 INDEMNIFICATION
PAYMENTS AND GOLDEN
PARACHUTE PAYMENTS
2110.0.2.8 Administration of Formal
Actions In general, an indemnification payment is a pay-
ment that reimburses an insider for a specified
2110.0.2.8.1 Publication of Final Orders liability or cost that the person incurred in con-
nection with a Federal Reserve investigation or
Under 12 U.S.C. 1818(u), the Board is required enforcement action. Golden parachute payments
to publish and make publicly available any final are severance payments or agreements to make
order issued for any administrative enforcement severance payments that are paid or entered into
proceeding it initiates. These orders include at a time when the BHC or its subsidiary bank is
cease and desist, removal, prohibition, and civil in a troubled condition. These payments require
money penalty assessments. The Board is also the prior written approval of the institutions
required to publish and make publicly available federal primary regulator and the concurrence of
any written agreement or other written state- the FDIC. Although both types of payments fall
ment that it may enforce, unless the Board deter- under the same statute, section 18(k) of the FDI
mines that publication of the order or agreement Act (12 U.S.C. 1828(k)) and the FDICs accom-
would be contrary to the public interest. panying regulations,5 the two types of payments
are quite different and distinct. However, some
of the restrictions on these payments are the
2110.0.2.8.2 Public Hearings same or similar.
Under 12 U.S.C. 1818(u), all formal hearings,

including contested cease and desist, removal, 2110.0.3.1 Indemnification Agreements
and civil money penalty proceedings, are open and Payments
to the public unless the Board determines that a
public hearing would be contrary to the public BHCs may seek to indemnify their officers,
interest. Transcripts of all testimony; copies of directors, and employees from any judgments,
all documents submitted as evidence in the hear- fines, claims, or settlements, whether civil,
ing, which could include examination and criminal, or administrative. The bylaws of some
inspection reports and supporting documents BHCs may have broadly worded indemnifica-
(except those filed under seal); and all other tion provisions, or the BHC may have entered
documents, such as the notice and the adminis- into separate indemnification agreements that
trative law judges recommended decision, are cover the ongoing activities of its own
available to the public. These documents could institution-affiliated parties. Such indemnifica-
include examiners workpapers, file memoran-
dums, reports of examination and inspection, 5. See the FDICs golden parachute regulations in 12
and correspondence between a problem institu- C.F.R. 359.
tion or wrongdoer and the Federal Reserve
Bank. Appropriate actions should always be BHC Supervision Manual January 2013
taken to ensure that all written material prepared Page 5
tion provisions may be inconsistent with federal safety-and-soundness perspective, a BHC

banking law and regulations, as well as with should not divert its assets to pay a fine or other
safe and sound banking practices. final judgment issued against an institution-
Supervisory and examiner staff should be affiliated party for misconduct that presumably
alert to the limitations and prohibitions on violates the BHCs policy of compliance with
indemnification imposed by section 18(k) of the applicable law, especially when the individuals
FDI Act6 and the regulations issued thereunder misconduct has already harmed the BHC.
by the FDIC. The law and regulations apply to BHCs should review their bylaws and any
indemnification agreements and payments made outstanding indemnification agreements, as well
by a BHC to any institution-affiliated party, as insurance policies, to ensure that they con-
regardless of the condition of the BHC. The form with the requirements of federal law and
purpose of the law and regulations is to preserve regulations. If a BHC fails to take appropriate
the deterrent effects of administrative enforce- action to bring its indemnification provisions
ment actions (by ensuring that individuals sub- into compliance with federal laws and regula-
ject to final enforcement actions bear the costs tions, appropriate follow-up supervisory action
of any judgments, fines, and associated legal may be taken. As part of the supervisory pro-
expenses) and to safeguard the assets of finan- cess, which will include merger and acquisition
cial institutions. applications, the Federal Reserves supervisory
A prohibited indemnification payment and examiner staff will review identified agree-
includes any payment (or agreement to make a ments having indemnification-related issues for
payment) by a BHC to an institution-affiliated compliance with federal laws and regulations.
party to pay or reimburse such person for any (See SR-02-17.)
liability or legal expense incurred in any Board
administrative proceeding that results in a final
order or settlement in which the institution- 2110.0.3.2 Golden Parachute Payments
affiliated party is assessed a civil money penalty,
is removed or prohibited from banking, or is The FDICs golden parachute regulations apply
required to cease an action or take any affirma- to a BHC or its insured depository institution
tive action, including making restitution, with subsidiary that is in a troubled condition as
respect to the BHC.7 defined in Regulation Y. The purposes of the
The FDICs regulations provide criteria for law and regulations are to safeguard the assets
making permissible indemnification payments. of financial institutions and limit rewards to
A BHC may make or agree to make a reason- institution-affiliated parties who contributed to
able indemnification payment if all of the fol- the institutions troubled condition.
lowing conditions are met: (i) the institutions In general, the FDICs regulations prohibit
board of directors determines in writing that the BHCs and their insured depository institution
institution-affiliated party acted in good faith subsidiaries from making golden parachute pay-
and the best interests of the institution; (ii) the ments except in certain circumstances. A golden
board of directors determines that the payment parachute payment means any payment in the
will not materially affect the institutions safety nature of compensation (or agreement to make
and soundness; (iii) the payment does not fall such payment) for the benefit of any current or
within the definition of a prohibited indemnifi- former institution-affiliated party of a BHC or
cation payment; and (iv) the institution-affiliated its insured depository institution subsidiary that
party agrees in writing to reimburse the institu- meets three criteria. First, the payment or agree-
tion, to the extent not covered by permissible ment must be contingent on the termination of
insurance, for payments made in the event that the institution-affiliated partys employment or
the institution-affiliated party does not prevail. association. Second, the agreement is made or
The law and the FDICs regulations reinforce the payment received on or after, or made in
the Federal Reserves long-standing policy that contemplation of, among other things, a deter-
an institution-affiliated party who engages in mination that the BHC or its insured depository
misconduct should not be insulated from the institution subsidiary is in a troubled condition
consequences of his or her misconduct. From a under the regulations of the applicable banking
agency.8 Third, the agreement is made or the
6. See 12 U.S.C. 1828(k).
7. See 12 C.F.R. 359.
8. See section 225.71 of Regulation Y (12 C.F.R. 225.71),
which defines a troubled condition for a state member bank
BHC Supervision Manual January 2013 or BHC as an institution that (1) has a composite rating of 4 or
Page 6 5; (2) is subject to a cease and desist order or formal written
payment is payable to an institution-affiliated the proposed payments and demonstrate that the
party when a BHC or its insured depository BHC or state member bank does not possess
institution subsidiary meets certain specific con- and is not aware of any evidence that there is
ditions, including being subject to a determina- reasonable basis to believe, at the time the pay-
tion that it is in a troubled condition. ment is proposed to be made, that (1) the
The definition of a golden parachute payment institution-affiliated party receiving such a pay-
also covers a payment made by a BHC that is ment has committed any fraud, breach of fidu-
not in a troubled condition to an institution- ciary duty, or insider abuse or has materially
affiliated party of an insured depository institu- violated any applicable banking law or regula-
tion subsidiary that is in a troubled condition, if tion that had or is likely to have a material
the other criteria in the definition are met. This adverse effect on the BHC or state member
circumstance may arise when a BHC, as part of bank; (2) the individual is substantially respon-
an agreement to acquire a troubled bank or sible for the institutions insolvency or troubled
savings association, proposes to make payments condition; and (3) the individual has violated
to the troubled institutions institution-affiliated specified banking or criminal laws.
parties that are conditioned on their termination Requests regarding golden parachute pay-
of employment.9 ments or agreements should be forwarded by
A BHC or state member bank may make or the Reserve Bank to appropriate Board staff for
enter into an agreement to make a golden para- a final determination on the permissibility of the
chute payment only (1) if the Federal Reserve, payment. Golden parachute payments or agree-
with the written concurrence of the FDIC, deter- ments must be approved by the Boards Direc-
mines that the payment or agreement is permis- tor of the Division of Banking Supervision and
sible; (2) as part of an agreement to hire compe- Regulation and the General Counsel. Denials
tent management in certain conditions, with the are not delegated by the Board of Governors to
consent of the Federal Reserve and the FDIC as Board or Reserve Bank staffs.
to the amount and terms of the proposed pay- If a state member bank or BHC makes or
ment; or (3) pursuant to an agreement to provide enters into an agreement to make a golden para-
a reasonable severance not to exceed 12 months chute payment without prior regulatory approval
salary in the event of an unassisted change in when such approval is required, appropriate
control of the depository institution, with the follow-up supervisory action should be taken.
consent of the Federal Reserve. In determining This follow-up could include an enforcement
the permissibility of the payment, the Federal action requiring the offending institution-
Reserve may consider a variety of factors, affiliated party to reimburse the institution for
including the individuals degree of managerial the amount of the prohibited payment. When a
responsibilities and length of service, the rea- BHC or state member bank is identified as hav-
sonableness of the payment, and any other facing golden parachute-related issues in the super-
tors or circumstances that would indicate that visory process, those issues should be carefully
the proposed payment would be contrary to the reviewed for compliance with the law and the
purposes of the statute or regulations. FDICs regulations. The appropriate Reserve
A BHC or state member bank requesting Bank supervisory staff and the appropriate staff
approval to make a golden parachute payment of the Boards Division of Banking Supervision
or enter into an agreement to make such a and Regulation and Legal Division should be
payment should submit its request simultane- notified and consulted on the golden parachute-
ously to the appropriate FDIC regional office related issues.
and the Reserve Bank. The request must detail
agreement that requires action to improve the institutions

2110.0.4 DISCIPLINARY ACTIONS
financial condition, unless otherwise informed in writing by AGAINST ACCOUNTANTS AND
the Federal Reserve; or (3) is informed in writing by the ACCOUNTING FIRMS PERFORMING
Federal Reserve that it is in a troubled condition. CERTAIN AUDIT SERVICES
9. The FDICs regulations exclude from the definition of a
golden parachute payment several types of payments, such as
payments made pursuant to a qualified pension or retirement Section 36 of the FDI Act authorizes the federal
plan; a benefit plan or bona fide deferred compensation plan bank regulatory agencies to take disciplinary
(which are further defined in the FDICs regulations); or a actions against independent public accountants
severance plan that provides benefits to all eligible employ-
ees, does not exceed the base compensation paid over the
and accounting firms that perform audit services
preceding 12 months, and otherwise meets the regulatory
definition of nondiscriminatory and other conditions in the BHC Supervision Manual January 2013
FDICs regulations. Page 7
covered by the acts provisions. Section 36, as 2110.0.5 APPOINTMENT OF

implemented by part 363 of the FDICs rules DIRECTORS AND SENIOR
(12 C.F.R. 363), requires that each federally EXECUTIVE OFFICERS
insured depository institution with total assets
of $500 million or more obtain an audit of its Under section 32 of the FDI Act (12 U.S.C.
financial statements and an attestation on man- 1831i) and subpart H of Regulation Y (12 C.F.R.
agements assertions concerning internal con- 225.71 et seq.), any BHC or state member bank
trols over financial reporting performed by an that is in troubled condition, or does not meet
independent public accountant (the accountant). minimum capital standards, must provide 30
The insured depository institution must include days written notice to the Board before appoint-
the accountants audit and attestation reports in ing any new director or senior executive offi-
its annual report. cer,11 or changing the responsibilities of any
The audit requirement can be fulfilled by an senior executive officer so that the officer would
independent audit of a BHC where the insured assume a different senior officer position. Sub-
subsidiary bank (1) has total assets of less than part H of Regulation Y sets forth the procedures
$5 billion or (2) has total assets of $5 billion or for filing and the content of the notice. If a BHC
more and has a composite CAMELS rating of 1 or state member bank that is in a troubled condi-
or 2. tion appoints a director or senior officer without
Section 36 and the rules enacted pursuant the required 30 days prior written notice, appro-
thereto set forth the practices and procedures to priate follow-up supervisory action should be
remove, suspend, or debar, for good cause,10 an taken.
accountant or firm from performing audit and The Board may disapprove a notice if it finds
attestation services for an insured state member that the competence, experience, character, or
bank, or BHC that obtains audit services for an integrity of the proposed individual indicates
insured subsidiary bank. Immediate suspensions that his or her service would not be in the best
are permitted in limited circumstances. Also, an interest of the institutions depositors or the
accountant or accounting firm is prohibited from public. A disapproved individual or the institu-
performing audit services for the covered insti- tion that filed the notice may appeal the Federal
tution if an authorized agency has taken such a Reserves notice of disapproval under the proce-
disciplinary action against the accountant or dures set forth in Regulation Y. While the appeal
firm, or if the U.S. Securities and Exchange is pending, the individual may not serve as a
Commission or the Public Company Account- director or senior executive officer of a BHC or
ing Oversight Board has taken certain disciplin- a state member bank.
ary action against the accountant or firm.
10. The rules provide that certain violations of law, negli-

gent conduct, reckless violations of professional standards, or
lack of qualifications to perform auditing services may be
11. The Board or Reserve Bank, under extraordinary cir-
considered good cause.
cumstances, may permit an individual to serve as a director or
senior executive officer before a notice is provided; however,
BHC Supervision Manual January 2013 this permission does not affect the Federal Reserves authority
Page 8 to disapprove a notice within 30 days of its filing.
Foreign Corrupt Practices Act and
Federal Election Campaign Act Section 2120.0
2120.0.1 INTRODUCTION 2120.0.3 BANKS AND THE FECA
On January 17, 1978, the three federal bank National banks and other federally chartered
supervisory agencies issued a joint policy state- corporations are specifically prohibited from
ment to address their concern with regard to the making contributions or expenditures in connec-
potential for improper payments by banks and tion with any election; other corporations, in-
bank holding companies in violation of the For- cluding banks and bank holding companies, may
eign Corrupt Practices Act and the Federal Elec- not make contributions or expenditures in con-
tion Campaign Act. nection with federal elections. However, corpo-
While not widespread, the federal bank super- rations may establish and solicit contributions
visory agencies were concerned that such prac- to separate segregated funds to be used for
tices could reflect adversely on the banking sys- political purposes; these are discussed in greater
tem and constitute unsafe and unsound banking detail below.
practices in addition to their possible illegality. State member banks and bank holding com-
The potential devices for making political panies may make contributions or expenditures
payments in violation of the law could include that are consistent with state and local law in
compensatory bonuses to employees, designated connection with state or local elections. Because
expense accounts, fees or salaries paid to offi- many states have laws that prohibit or limit
cers, and preferential interest rate loans. In addi- political contributions or expenditures by banks,
tion, political contributions could be made by familiarization with applicable state and local
providing equipment and services without laws is a necessity. According to the joint policy
charge to candidates for office. Refer to F.R.R.S. statement of the three banking agencies, a polit-
at 3447.1 and 4875. ical contribution must meet not only the require-
ment of legality but also the standards of safety
and soundness. Thus, a contribution or expendi-
2120.0.2 SUMMARY OF THE ture, among other things, must be recorded
FEDERAL ELECTION CAMPAIGN properly on the banks books, may not be exces-
ACT sive relative to the banks size and condition,
and may not involve self-dealing.
The Federal Election Campaign Act (FECA), Banks may make loans to political candidates
enacted in 1971, was designed to curb potential provided the loans satisfy the requirements set
abuses in the area of federal election financing. out below.
In general, FECA regulates the making of cam-
paign contributions and expenditures in connec-
tion with primary and general elections to fed- 2120.0.4 CONTRIBUTIONS AND
eral offices. Since 1907, federal law has EXPENDITURES
prohibited national banks from making contribu-
tions in connection with political elections. The words contribution and expenditure
FECA does not specifically address the making are defined broadly by FECA and the Commis-
of contributions and expenditures by banks or sions regulations to include any loan, advance,
other corporations to advocate positions on deposit, purchase, payment, distribution, sub-
issues that are the subjects of public referenda. scription or gift of money or anything of value
As originally enacted, FECA required disclo- which is made for the purpose of influencing the
sure of contributions received or expenditures nomination or election of any person to federal
made; however, amendments to the law in 1974 office. The payment by a third party of compen-
and 1976 imposed additional limitations on con- sation for personal services rendered without
tributions and expenditures as well. The 1974 charge to a candidate or political committee is
amendments also established the Federal Elec- also treated as a contribution by FECA, al-
tion Commission (Commission) to administer though the term does not include the value of
FECAs provisions. The Commission is respon- personal services provided by an individual
sible for adopting rules to carry out FECA, for without compensation on a volunteer basis.
rendering advisory opinions, and for enforcing Although loans are included in the definitions
the Act. The Commission was reorganized as a of contribution and expenditure under FECA, a
result of the FECA Amendments of 1976, and it
has issued regulations interpreting the statute BHC Supervision Manual December 1992
(11 C.F.R.). Page 1
Foreign Corrupt Practices Act and Federal Election Campaign Act 2120.0
specific exemption is provided for bank loans In practice, most corporate segregated funds
made in the ordinary course of business and in are administered by a group of corporate person-
accordance with applicable banking laws and nel, which, if the fund receives any contribu-
regulations. The Commissions regulations pro- tions or makes any expenditures during a calen-
vide, further, that in order for extensions of dar year, constitutes a political committee, as
credit to a candidate, political committee or defined by FECA. As such, it is required to file a
other person in connection with a federal elec- statement of organization with the Commission,
tion to be treated as a loan and not a contribu- to keep detailed records of contributions and
tion, they must be on terms substantially similar expenditures, and to file with the Commission
to those made to non-political debtors and be reports identifying contributions in excess of
similar in risk and amount. The regulations also $200 and candidates who are recipients of con-
provide that a debt may be forgiven only if the tributions from the fund.
creditor has treated it in a commercially reason- Solicitation of contributions to corporate seg-
able manner, including making efforts to collect regated funds by political committees must be
the debt which are similar to the efforts it would accomplished within the precise limits estab-
make with a non-political debtor. In considering lished by FECA. All solicitations directed to
whether a particular transaction is a contribution corporate employees must satisfy the following
or a loan, it is expected that a factor would be requirements: (1) the contribution must be en-
the extent to which the creditor may have de- tirely voluntary; (2) the employee must be in-
parted from its customary credit risk analysis. formed of the political purposes of the fund at
FECA and the implementing regulation per- the time of the solicitation; and (3) the em-
mit certain limited payments to candidates or ployee must be informed of his right to refuse to
their political committees. For example, pay- contribute without reprisal. Beyond those basic
ment of compensation to a regular employee requirements, FECA distinguishes between ex-
who is providing a candidate or political com- ecutive and administrative personnel and other
mittee with legal or accounting services which employees. The former and their families may
are solely for the purpose of compliance with be solicited any number of times, while the
the provisions of the FECA is exempt from the latter and their families may only be solicited
definitions of contribution and expenditure. The through a maximum of two written solicitations
Commissions regulations also permit occa- per year, and these solicitations must be ad-
sional use of a corporations facilities by its dressed to the employees at their homes. Solici-
shareholders and employees for volunteer polit- tations may also be directed to corporate stock-
ical activity; however, reimbursement to the cor- holders and their families in the same manner as
poration is required for the normal rental charge to executive and administrative personnel.
for anything more than occasional or incidental Although a corporation, or a corporation and
use. its subsidiaries, may form several political com-
mittees, for purposes of determining the statu-
tory limitations on contributions and expendi-
2120.0.5 SEPARATE SEGREGATED tures, all committees established by a
FUNDS AND POLITICAL corporation and its subsidiaries are treated as
COMMITTEES one. Thus, the total amount which all political
committees of a corporation and its subsidiaries
FECA allows the establishment and administra- may make to a single candidate is $5,000 in any
tion by corporations of separate segregated federal election (provided that the committees
funds to be utilized for political purposes. are qualified multicandidate committees under
While corporate monies may not be used to FECA).
make political contributions or expenditures,
corporations may bear the costs of establishing
and administering these separate segregated 2120.0.6 INSPECTION OBJECTIVES
funds, including payment of rent for office
space, utilities, supplies and salaries. These 1. To determine if the company has made
costs need not be disclosed under FECA. Com- improper or illegal payments in violation of
mission regulations also permit a corporation to either of these statutes, and regardless of legal-
exercise control over its separate segregated ity, and whether they constitute an unsafe and
fund. unsound banking practice.
2. To determine if controls have been estab-
BHC Supervision Manual December 1992 lished to prevent unproper payments in viola-
Page 2 tion of these statutes.
2120.0.7 INSPECTION PROCEDURES course of business in accordance with applica-

ble laws.
1. Determine whether the company and its b. Income and expense ledger accounts for
nonbank subsidiaries have a policy prohibiting unusual entries including unusual debit entries
improper or illegal payments, bribes, kickbacks, (reductions) in income accounts or unusual
or loans covered by either the Foreign Corrupt credit entries (reductions) in expense accounts,
Practices Act or the Federal Election Campaign significant deviations from the normal amount
Act. of recurring entries, and significant entries from
2. Determine how the policy, if any, has been an unusual source, such as a journal entry.
communicated to officers, employees, or agents Procedure 7, following here, should only be
of the organization. undertaken in cases in which the examiner be-
3. Review any investigation or study per- lieves that there is some sufficient evidence indi-
formed by, or on behalf of, the board of direc- cating that improper or illegal payments have
tors that evaluates policy or operations associ- occurred. Such evidence would justify the imple-
ated with the advancement of funds in possible mentation of these additional procedures.
violation of the statutes mentioned above. In 7. Verification of audit programs and internal
addition, ascertain whether the organization has controls.
been investigated by any other government a. Randomly select charged-off loan files
agency in connection with possible violations of and determine whether any charged-off loans
the statutes and, if this is the case, review avail- were made to (i) foreign government officials or
able materials associated with the investigation. other persons or organizations covered by the
4. Review and analyze any internal or exter- Foreign Corrupt Practices Act, or (ii) persons or
nal audit program employed by the organization organizations covered under the Federal Elec-
to determine whether the internal and external tion Campaign Act.
auditors have established appropriate routines to b. For those significant income and ex-
identify improper or illegal payments under the pense accounts on which verification procedures
statutes. In connection with the evaluation of the have not been performed: (i) prepare an analysis
adequacy of any audit program, the examiner of the account for the period since the last
should: examination, preferably by month, and note any
a. Determine whether the auditor is aware unusual fluctuations for which explanations
of the provisions of the Foreign Corrupt Prac- should be obtained, and (ii) obtain an explana-
tices Act and the Federal Election Campaign tion for significant fluctuations or any unusual
Act and whether audit programs are in place items through discussions with organization per-
which check for compliance with these laws; sonnel and review of supporting documents.
b. Review such programs and the results
of any audits; and
c. Determine whether the program directs 2120.0.8 APPARENT VIOLATIONS OF
the auditor to be alert to unusual entries or THE STATUTES
charges which might indicate that improper or
illegal payments have been made to persons or Where violations of law or unsafe and unsound
organizations covered by the statutes. banking practices result from improper pay-
5. Analyze the general level of internal con- ments, the Federal Reserve System should exer-
trol to determine whether there is sufficient pro- cise its full legal authority, including cease-and-
tection against improper or illegal payments be- desist proceedings and referral to the appropriate
ing irregularly recorded on the organizations law enforcement agency for further action, to
books. ensure that such practices are terminated. In
6. Both the examiner and assistants should appropriate circumstances, the fact that such
be alert in the course of their usual inspection payments have been made may reflect so ad-
procedures for any transactions, or the use of versely on an organizations management as to
organization services or equipment, which be a relevant factor in connection with the con-
might indicate a violation of the statutes. Exam- sideration of applications submitted by the orga-
ination personnel should pay particular attention nization.
to: In addition, the Reserve Bank should forward
a. Commercial and other loans (including any information on apparent violations of the
participations), which may have been made in Federal Election Campaign Act to the Federal
connection with a political campaign, to assure
that any such loans were made in the ordinary BHC Supervision Manual December 1992
Page 3
Election Commission. The Federal Election of $10,000 or 200 percent of the amount of the
Commission is authorized to enforce FECA. illegal payment may be imposed. Knowing and
The Commission may be prompted to investi- willful violations involving over $1,000 may
gate possible illegal payments by either a sworn subject the violator to a fine, up to the greater of
statement submitted by an individual alleging a $25,000 or 300 percent of the illegal payment,
violation of the law, or on its own initiative and imprisonment for up to one year.
based on information it has obtained in the
course of carrying out its supervisory responsi-
bilities. When the Commission determines that 2120.0.9 ADVISORY OPINIONS
there is probable cause to believe a violation has
occurred or is about to occur, it endeavors to Any person, including a bank or a corporation,
enter into a conciliation agreement with the may request an advisory opinion concerning the
violator. If, however, it finds probable cause to application of FECA or of the Commissions
believe that a willful violation has occurred or is regulations to a specific transaction or activity
about to occur, it may refer the matter directly to in which that person wishes to engage. The
the Department of Justice for possible criminal Commission must render such advisory opinion
prosecution, without having first attempted con- within 60 days from receipt of a complete re-
ciliation. quest. Banks or bank employees wishing to
If informal means of conciliation fail, the engage in activity which may be regulated by
Commission may begin civil proceedings to ob- FECA are encouraged to request advisory opin-
tain relief. Should the Commission prevail, a ions from the Commission.
maximum penalty of a fine equal to the greater

Page 4
Internal Credit-Risk Ratings at Large Banking
Organizations Section 2122.0
Techniques, practices, and tools for credit-risk vide information as to the institutions overall
management are evolving rapidly, as are the appetite for risk, giving due consideration to the
challenges that banking organizations face in uncertainties faced by lenders and the long-term
their business-lending activities. For larger insti- viability of the institution. Accordingly, large
tutions, the number and geographic dispersion banking organizations should have strong risk-
of their borrowers make it increasingly difficult rating systems which should take proper account
for such institutions to manage their loan port- of gradations in risk. They should also consider
folios simply by remaining closely attuned to (1) the overall composition of portfolios in
the performance of each borrower. As a result, originating new loans, (2) assessing overall port-
one increasingly important component of the folio risks and concentrations, and (3) reporting
systems for controlling credit risk at larger insti- on risk profiles to directors and management.
tutions is the identification of gradations in Moreover, such rating systems should also play
credit risk among their business loans, and the an important role in (1) establishing an appropri-
assignment of internal credit-risk ratings to ate level for the allowance for loan and lease
loans that correspond to these gradations.1 The losses, (2) conducting internal analyses of loan
use of such an internal rating process is appro- and relationship profitability, (3) assessing capi-
priate and necessary for sound risk management tal adequacy, and possibly (4) administering
at large institutions. See SR-98-25. performance-based compensation.
Certain elements of internal rating systems Examiners should evaluate the adequacy of
are necessary to support sophisticated credit- internal credit-risk-rating systems, including
risk management. Supervisors and examiners, ongoing development efforts, when assessing
both in their on-site inspections and other con- both asset quality and the overall strength of
tacts with banking organizations, need to risk management at large institutions. Recogniz-
emphasize the importance of development and ing that a strong risk-rating system is an impor-
implementation of effective internal credit- tant element of sound credit-risk management
rating systems and the critical role such systems for such institutions, examiners should specifi-
should play in the credit-risk-management pro- cally evaluate the adequacy of internal risk-
cess at sound large institutions. See SR-98-18 rating systems at large institutions as one factor
with regard to lending standards for commercial in determining the strength of credit-risk man-
loans. agement. In doing so, examiners should be cog-
Internal rating systems are currently being nizant that an internal risk-identification and
used at large institutions for a range of purposes. -monitoring system should be consistent with
At one end of this range, they are primarily used the nature, size, and complexity of the banking
to determine approval requirements and identify organizations activities.
problem loans. At the other end, they are an
integral element of credit-portfolio monitoring
and management, capital allocation, the pricing
of credit, profitability analysis, and the detailed 2122.0.1 APPLICATION TO LARGE
analysis to support loan-loss reserving. Internal BANK HOLDING COMPANIES
rating systems being used for these latter pur-
poses should be significantly richer and more The guidance provided in this section should be
robust than systems used for the purposes such applied to all large bank holding companies.
as approval requirements and identifying prob- For this purpose, examiners should treat an insti-
lem loans. tution as being large if its lending activities
As with all material financial institutional are sufficient in scope and diversity such that
activities, a sound risk-management process informal processes that rely on keeping track of
should adequately illuminate the risks being the condition of individual borrowers are inad-
taken. It should also cause management to ini- equate to manage its loan portfolio. In this con-
tiate and apply appropriate controls that will text, those institutions with significant involve-
allow the institution to balance risks against ment in relevant secondary-market credit
returns. Furthermore, the process should pro- activities, such as securitization of business
loans or credit derivatives, should have more
elaborate and formal approaches for managing
1. For information on current practices in risk rating among
large banking organizations, see Credit Risk Rating at Large
U.S. Banks, Federal Reserve Bulletin, November 1998, BHC Supervision Manual December 1998
pp. 897921. Page 1
Internal Credit-Risk Ratings at Large Banking Organizations 2122.0
the risks associated with these activities.2 system itself. Although assigning such risk
Whether or not they are active in such ratingsas with ratings issued by public rating
secondary-market credit activities, however, agenciesnecessarily involves subjective judg-
larger and complex institutions typically would ment and experience, a properly designed rating
require a more structured and sophisticated set system will allow this judgment to be applied in
of arrangements for managing credit risk than a structured, more or less formal manner.
smaller regional or community institutions. In Credit-risk ratings are designed to reflect the
performing their evaluation, examiners should quality of a loan or other credit exposure, and
also consider whether other elements of the thus, explicitly or implicitly, the loss characteris-
risk-management process might compensate for tics of that loan or exposure. Increasingly, large
any specific weaknesses attributable to an inad- institutions link definitions to one or more mea-
equate rating system. surable outcomes such as the probability of a
In addition, examiners should review internal borrowers default or expected loss (which
management information system reports to couples the probability of default with some
determine whether the portion of loans in lower- estimate of the amount of loss to be incurred in
quality pass grades has grown significantly over the event a default occurs). In addition, credit-
time, and whether any such change might have risk ratings may reflect not only the likelihood
negative implications for the adequacy of risk or severity of loss but also the variability of loss
management or capital at the institution. Exam- over time, particularly as this relates to the
iners should also consider whether a significant effect of the business cycle. Linkage to these
shift toward higher-risk pass grades, or an over- measurable outcomes gives greater clarity to
all large proportion of loans in a higher-risk risk-rating analysis and allows for more consis-
pass grade, should have negative implications tent evaluation of performance against relevant
for the institutions asset-quality rating, includ- benchmarks. The degree of linkage varies
ing the adequacy of the loan-loss reserve. To among institutions, however.
some extent, such reviews are already an infor- Although the degree of formality may vary,
mal part of the current inspection process. most institutions distinguish the risks associated
Examiners should also continue the long- with the borrowing entity (essentially default
standing practice of evaluating trends in catego- risk) from the risks stemming from a particular
ries associated with problem assets. transaction or structure (more oriented to loss in
Examiners should discuss these issues, event of default). In documenting their credit-
including plans to enhance existing credit-rating administration procedures, institutions should
systems, with bank management and directors. clearly identify whether risk ratings reflect the
Inspection comments on the adequacy of riskrisk of the borrower or the risk of the specific
rating systems and the credit quality of the pass transaction. In this regard, many large institu-
portfolio should be incorporated within the tions currently assign both a borrower and facil-
inspection report, noting deficiencies where ity rating, requiring explicit analysis of both the
appropriate. loans obligor and how the structure and terms
of the particular loan being evaluated (that is,
collateral or guarantees) might strengthen or
2122.0.2 SOUND PRACTICES IN weaken the quality of the loan.
FUNCTION AND DESIGN OF The rating scale chosen should meaningfully
INTERNAL RATING SYSTEMS distinguish gradations of risk within the institu-
tions portfolio so that there is clear linkage to
A consistent and meaningful internal risk-rating loan quality (and/or loss characteristics), rather
system is a useful means of differentiating the than just to levels of administrative attention.3
degree of credit risk in loans and other sources
of credit exposure. This consistency and mean-
ing is rooted in the design of the risk-grading 3. See the December 1993 Interagency Policy Statement
on the Allowance for Loan and Lease Losses in section
2010.7. The policy does not apply to bank holding companies
2. Secondary-market credit activities generally include
directly. As they supervise their respective FDIC-insured
loan syndications, loan sales and participations, credit deriva-
financial institution subsidiaries, bank holding companies are
tives, and asset securitizations, as well as the provision of
advised to apply this supervisory guidance. Internal risk-
credit enhancements and liquidity facilities to such transac-
rating systems and/or supporting documentation should be
tions. Such activities are described further in section 2129.05
sufficient to enable examiners to reconcile the totals for the
and in SR-97-21.
various internal risk ratings under the institutions system
to the federal banking agencies categories for those loans
BHC Supervision Manual December 1998 graded below pass (that is, loans classified as special
Page 2 mention, substandard, doubtful, or loss).
To do so, the rating system should be designed allow for consistent assignment of risk grades to
to address the range of risks typically encoun- similarly risky transactions. Such criteria should
tered in the underlying businesses involving the include guidance both on the factors that should
institutions loan portfolio. One reflection of be considered in assigning a grade and how
this degree of meaning is that there should be a these factors should be weighed in arriving at a
fairly wide distribution of portfolio outstandings final grade.
or exposure across grades, unless the portfolio is Such criteria can promote consistency in
genuinely homogeneous. Many current rating assessing the financial condition of the borrower
systems include grades intended solely to cap- and other objective indicators of the risk of the
ture credits needing heightened administrative transaction. One vehicle for enhancing the
attention, such as so-called watch grades. degree of consistency and accuracy is the use of
Prompt and systematic tracking of credits in guidance or target financial ratios or other
need of such attention is an essential element of objective indicators of the borrowers financial
managing credit risk. However, to the extent performance as a point of comparison when
that loans in need of attention vary in the risk assigning grades. Banking organizations may
they pose, isolating them in a single grade may also provide explicit linkages between internal
detract from that systems ability to indicate grades and credit ratings issued by external par-
risk. One alternative is the use of separate or ties as a reference point, for example, senior
auxiliary indicators for those loans needing such public debt ratings issued by one or more major
administrative attention. ratings agencies. The use of default probability
Institutions whose risk-rating systems are models, bankruptcy scoring, or other analytical
least effective in distinguishing risk use them tools can also be useful as supporting analysis.
primarily to identify loans that are classified for However, the use of such techniques requires
supervisory purposes or that bank management institutions to identify the probability of default
otherwise believes should be given increased that is typical of each grade. The borrowers
attention (that is, watch loans). Such systems primary industry may also be considered, both
contribute little or nothing to evaluating the in terms of establishing the broad characteristics
bulk of loans in the portfoliothat is, loans for of borrowers in an industry (for example, degree
which no specific difficulties are present or fore- of vulnerability to economic cycles or long-term
seen. In some cases these institutions might also favorable or unfavorable trends in the industry)
establish one or two risk grades for loans having and of a borrowers position within the industry.
very little perceived risk, such as those collater- In addition to quantitative indications and
alized by cash or liquid securities or those to tools, credit policies and ratings definitions
blue-chip private firms. Although the forego- should also cite qualitative considerations that
ing gradations are well-defined in terms of the should affect ratings. These might include fac-
relative credit risk they represent, the conse- tors such as (1) the strength and experience of
quence for these least effective systems is that the borrowers management, (2) the quality of
the bulk of the loan portfolio falls into one or financial information provided, and (3) the
two remaining broad risk gradesrepresenting access of the borrower to alternative sources of
pass loans that are neither extremely low risk funding. Addressing qualitative considerations
nor current or emerging problem creditseven in a structured and consistent manner when
though such grades may encompass many dif- assigning a risk rating can be difficult. It requires
ferent levels of underlying credit risk. experience and business judgment. Nonetheless,
adequate consideration of these factors is impor-
tant to assessing the risk of a transaction appro-
2122.0.3 SOUND PRACTICES IN priately. In this regard, institutions may choose
ASSIGNING AND VALIDATING to cite significant and specific points of compari-
INTERNAL RISK RATINGS son for qualitative factors in describing how
such considerations can affect the rating (for
Experience and judgment, as well as more example, whether a borrowers financial state-
objective elements, are critical both in making ments have been audited or merely compiled by
the credit decision and in assigning internal risk its accountants, or whether collateral has been
grades. Institutions should provide clear and independently valued).
explicit criteria for each risk grade in their credit Although the rating process requires the exer-
policies, as well as other guidance to promote cise of good business judgment and does not
consistency in assigning and reviewing grades.
Criteria should be specified, even when address- BHC Supervision Manual December 1998
ing subjective or qualitative considerations, that Page 3
lend itself to formulaic solutions, some formal- risk makeup, of the portfolio. Such consistency
ization of the process can be helpful in promot- further permits risk grades to become a reliable
ing accuracy and consistency. For example, the input into portfolio credit-risk models.5
use of a risk-ratings analysis form can be
important (1) in providing a clear structure for
identifying and addressing the relevant qualita- 2122.0.4 APPLICATION OF
tive and quantitative elements to be considered INTERNAL RISK RATINGS TO
in determining internal risk grades, and (2) for INTERNAL MANAGEMENT AND
documenting how those grades were set by ANALYSIS
requiring analysis or discussion of key quantita-
tive and qualitative elements of a transaction. As noted earlier, robust internal credit-rating
Risk ratings should be reviewed, if not systems are an important element in several key
assigned, by independent credit-risk manage- areas of the risk-management process. Although
ment or loan-review personnel both at the incep- nearly all large institutions currently use risk
tion of a transaction and periodically over the ratings, many of the institutions need to further
life of the loan.4 Such independent reviewers develop these systems so that they provide accu-
should reflect a level of experience and business rate and consistent indications of risk and suffi-
judgment that is comparable to that of the line cient granularityfiner distinctions among
staff responsible for assigning and reviewing risks, especially for riskier assets. Described
initial risk grades. Among the elements of such below are approaches to risk management and
independent review should be whether risk- analysis that are based on robust internal risk-
rating changes (and particularly downgrades) rating systems and that are currently being used
have been timely and appropriate. Such inde- at some banking organizations. These tech-
pendent reviews of individual ratings support niques appear to be emerging as sound practices
the discipline of the rating assignments by in the use of risk ratings.
allowing management to evaluate the perfor-
mance of those individuals assigning and
reviewing risk ratings. If an institution relies on 2122.0.4.1 Limits and Approval
outside consultants, auditors, or other third par- Requirements
ties to perform all or part of this review role,
such individuals should have a clear understand- Many large institutions have different approval
ing of the institutions credit culture and its requirements and thresholds for different inter-
risk-rating process, in addition to commensurate nal grades, allowing less scrutiny and greater
experience and competence in making credit latitude in decision making for loans with lesser
judgments. risk.6 While this appears reasonable, institutions
Finally, institutions should track performance should also consider whether the degree of
of grades over time to gauge migration, consis- eased approval requirements (or the degree to
tency, and default/loss characteristics to allow which limits are higher) is supported by the
for evaluation of how well risk grades are being degree of reduced risk and uncertainty associ-
assigned. Such tracking also allows for ex post ated with these lower-risk loans. If not, lesser
analysis of the loss characteristics of loans in requirements may provide incentives to rate
each risk grade. loans too favorably, particularly in the current
Because ratings are typically applied to differ- benign economic environment, with resulting
ent types of loansfor example, to both com- underassessment of transaction risks.
mercial real estate and commercial loansit is
important that each grade retains the same
meaning to the institution (in terms of overall
2122.0.4.2 Reporting to Management on
risk) across the exposure types. Such compara-
Credit-Risk Profile of the Portfolio
bility allows management to treat loans in high- As part of reports that analyze the overall credit
risk grades as a potential concentration of credit risk in the institutions portfolio, management
risk and to manage them accordingly. It also
allows management and supervisors to monitor
the overall degree of risk, and changes in the 5. For a discussion of these models and the role played by
internal credit-risk ratings, see the May 1998 Federal Reserve
System report, Credit Risk Models at Major U.S. Banking
4. See section 2010.10 regarding internal loan review. Institutions: Current State of the Art and Implications for
Assessments of Capital Adequacy, prepared by the Federal
BHC Supervision Manual December 1998 Reserve System Task Force on Internal Credit-Risk Models.
6. See section 2160.0 for more general guidance involving
Page 4 risk evaluation and control.
and directors should receive information on the meaningful assessment of the risks inherent in
profile of actual outstanding balances, expo- each transaction and in the portfolio as a whole,
sures, or both by internal risk grade.7 Such can be important tools in avoiding competitive
information can thus be one consideration future excessive practices.
among others, such as concentrations in particu-
lar industries or borrower types, in evaluating an
institutions appetite for originating various 2122.0.4.5 Internal Allocation of Capital
types of new loans. Portfolio analysis may range
from simple tallies of aggregates by risk grade Those institutions that choose to allocate capital
to a formal model of portfolio behavior that may use their internal risk grades as important
incorporates diversification and other elements inputs in identifying appropriate internal capital
of the interaction among individual loan types. allocations. Use of appropriately allocated capi-
In this more complex analysis, gradations of tal in evaluating profitability offers many advan-
risk reflect only one among many dimensions of tages, including the incentive to consider both
portfolio risk, along with potential industry con- risk and return in making lending decisions
centrations, exposure to an unfavorable turn in rather than merely rewarding loan volume and
the business cycle, geographical concentrations, short-term fee revenue. Under appropriate
and other factors. circumstancesthat is, where internal capital
allocations are sufficiently consistent, rigorous,
and well-documentedsuch allocations may
2122.0.4.3 Allowance for Loan and also be considered as a source of input for
Lease Losses supervisory evaluations of capital adequacy.9
The makeup of the loan portfolio and the loss
characteristics of each gradeincluding indi- 2122.0.5 INSPECTION OBJECTIVES
vidual pass gradesshould be considered, along
with other factors, in determining the adequacy 1. To evaluate whether the internal risk-
of an institutions allowance for loan and lease identification and -monitoring systems are
losses.8 consistent with
a. sound practices in the function and design
of internal rating systems;
2122.0.4.4 Pricing and Profitability b. sound practices in assigning and review-
In competitive marketplaces, it is properly the ing internal risk ratings; and
role of bankers rather than supervisors to judge c. the nature, size, and complexity of activi-
the appropriateness of pricing, particularly with ties within the banking organization.
regard to any single transaction or group of 2. To determine whether the level and volume
transactions. One way that some institutions of lower-quality pass grades of loans have
choose to discipline their overall pricing prac- grown significantly over time and whether
tices across their portfolio is by incorporating any such trends should
risk-rating-specific loss factors in the determina- a. have adverse implications for determining
tion of the minimum profitability requirements the adequacy of risk management and
(that is, hurdle rates). Following this practice capital, and
may render such institutions less likely to price b. materially alter the institutions asset-
loans well below the level indicated by the quality ratings and valuations, and the
long-term risk of the transaction. Given that examiners evaluation of the adequacy of
bank lending, particularly pricing, can be highly the allowance for loan and lease losses.
competitive, the application of appropriate disci- 3. To determine whether improvements are
plines to pricing, in conjunction with a clear and needed in the credit-risk-management pro-
cess and to discuss them with the board of
directors and senior management.
7. See section 2010.2 regarding a bank holding companys 4. To document the extent to which the institu-
supervision of its subsidiaries and loan administration. See tion has adopted current and emerging sound
also the more general financial analysis sections 4020.2 and
4060.1 with regard to evaluating the asset quality of subsidi-
ary financial institutions and evaluating the asset quality of
9. See sections 4060.3 and 4060.4 regarding the evaluation
the holding company on a consolidated basis.
of capital adequacy of bank holding companies.
8. See footnote 3. Section 2010.7 emphasizes the bank
holding companys responsibility as it supervises its subsidi-
aries with respect to each entity maintaining an adequate BHC Supervision Manual December 1998
allowance for loan and lease losses. Page 5
practices in the use of internal ratings infor- with respect to

mation in internal risk management and financial analysis, including
analysis. whether reference financial ratios or
5. To incorporate the examiners evaluation of other objective indicators are used
sound credit-risk-rating practices into the to indicate the borrowers financial
assessment of management and capital performance;
adequacy. explicit linkages between the inter-
nal grades assigned and credit rat-
ings issued by external parties (for
2122.0.6 INSPECTION PROCEDURES example, senior public debt ratings
by major rating agencies);
1. Determine whether the institution is consid- default probability models, bank-
ered large for purposes of applying this ruptcy scoring, or other analytical
sections guidance and procedures. tools used;
2. Evaluate the adequacy of internal credit- analysis of a borrowers primary
risk-rating systems, including ongoing devel- industry, considering both the
opment efforts, when assessing the quality broad characteristics of borrowers
and overall strength of risk management. within that industry and the borrow-
Give particular attention to the following ers position within that industry;
practices: and
a. Function and design of internal rating qualitative factors (for example, the
systems. quality of the financial information
Ascertain whether the rating scale that is provided, the borrowers
meaningfully distinguishes gradations access to alternative sources of
of risk within the institutions portfolio funding, whether the financial state-
evidencing clear linkage to loan quality ments were audited or merely com-
and/or loss characteristics. piled, or whether collateral was
Determine if the design of the rat- independently valued).
ing system has an adequate number Determine whether loan policies pro-
of internal ratings to distinguish vide clear and explicit guidance as to
among levels of risks in its port- how these risk factors should be
folio, and whether the grades used weighed in arriving at a final grade.
address the range of risks typically Determine whether the ratings assign-
encountered in the underlying busi- ment is well documented, possibly
nesses of the institution. including the use of a risk-rating form
Determine whether loans or expo- to provide formalization and standard-
sures are broadly distributed across ization of the quantitative and qualita-
the internal grades. tive criteria elements used in rating bor-
Establish if there are watch rowers and/or transactions.
grades that are intended to capture Establish whether risk ratings are inde-
loans needing heightened adminis- pendently reviewed at the inception of a
trative attention, or whether sepa- loan and periodically over the life of a
rate or auxiliary indicators are used loan, and whether risk-rating changes
for such loans. have been timely and appropriate (par-
Determine whether credit-risk-rating ticularly downgrades).
definitions are linked to one or more Ascertain whether the performance of
measurable outcomes (for example, the rating grades is tracked over time to
probability of a borrowers default or evaluate migration, consistency, and
expected loss). default/loss characteristics and trends.
b. Sound practices in assigning internal risk c. Application of internal risk ratings to
ratings. internal management and analysis.
Determine whether loan policies pro- Determine whether loan-approval
vide clear and explicit criteria for each requirements for each grade appear to
risk grade as to the risk factors that are be supported by the degree of risk and
to be considered in assigning a grade uncertainty associated with the respec-
tive loans.
BHC Supervision Manual December 1998 Review internal management informa-
Page 6 tion system reports and determine
whether such reporting is adequate for 5. Determine whether a significant shift toward
the institution. higher-risk pass grades, or an overall large
Ascertain if the risk-rating-specific loss proportion of loans in a higher-risk pass
factors are used to determine risk pric- grade, should have negative implications for
ing, minimum profitability require- the institutions asset-quality rating, includ-
ments, and capital adequacy needs, and ing the adequacy of the loan-loss reserve.
document the institutions progress in 6. Evaluate trends in risk-rating categories asso-
this regard. ciated with problem assets.
3. Determine whether other risk elements may 7. Discuss the results of the evaluations with
compensate for any specific weaknesses management, including whether there are
attributable to an inadequate rating system. any plans to enhance existing credit-rating
systems.
4. Review internal management information 8. Prepare written comments for the inspection
system reports to determine whether the por- report on the adequacy of risk-rating systems
tion of loans in lower-quality pass grades has and the credit quality of the pass portfolio,
grown significantly over time, and whether noting any deficiencies.
any such change might have negative impli-
cations for the adequacy of risk management
or capital at the institution.

Page 7
Risk-Focused Safety-and-Soundness Inspections
Section 2124.0
WHATS NEW IN THIS REVISED onciliations of a bank holding companys gen-

SECTION eral ledger to the FR Y-9C report and other FR
Y-series reports. Other similar procedures typi-
Effective January 2015, footnote 2 was revised cally have been completed to ascertain compli-
to include a reference to SR-14-4, Examiner ance with applicable laws and regulations, to
Loan Sampling Requirements for State Member determine whether the banking and nonbank
Bank and Credit Extending Nonbank Subsidi- subsidiaries are following their internal policies
aries of Banking Organizations with $10$50 and procedures and those of the bank holding
Billion in Total Consolidated Assets. This guid- company, and to evaluate the adequacy of inter-
ance within SR-14-4 supersedes the guidance nal control systems.
within SR-94-13, Loan Review Requirements Transaction testing remains a reliable and
for On-Site Examinations for the specified essential inspection technique for assessing a
banking organizations. banking organizations condition and verifying
its adherence to internal policies, procedures,
and controls. In a highly dynamic banking mar-
2124.0.1 FULL-SCOPE INSPECTIONS ket, however, such testing is not sufficient for
AND TRANSACTION TESTING ensuring continued safe and sound operations.
As evolving financial instruments and markets
Full-scope inspections under a risk-focused have enabled banking organizations to rapidly
approach must be performed to fulfill the objec- reposition their portfolio risk exposures, peri-
tives of a full-scope inspection. Inspections can odic assessments of a banking organizations
be adjusted, depending on the circumstances of condition, based on transaction testing alone,
the banking organization being evaluated. At a cannot keep pace with the moment-to-moment
minimum, full-scope inspections should include changes occurring in financial risk profiles.
sufficient procedures to reach an informed judg- To ensure that banking organizations have in
ment on the assigned ratings for the factors place the processes necessary to identify, mea-
addressed by the bank holding company sure, monitor, and control their risk exposures,
RFI/C(D) rating system. The business of bank- inspections must focus more on evaluating the
ing is fundamentally predicated on taking risks, appropriateness of a very high degree of transac-
and the components of the supervisory rating tion testing. Under a risk-focused approach, the
system are strongly influenced by risk exposure. degree of transaction testing should be reduced
Consequently, the procedures for full-scope when internal risk-management processes are
inspections focus to a large degree on assessing determined to be adequate or risks are consid-
the types and extent of risks to which a bank ered minimal. However, when an organizations
holding company and its subsidiaries are risk-management processes or internal controls
exposed, evaluating the organizations methods are considered inappropriate (such as when there
of managing and controlling its risk exposures, is an inadequate segregation of duties or when
and ascertaining whether management and on-site testing determines that such processes or
directors fully understand and are actively moni- controls are lacking), additional transaction test-
toring the organizations exposure to those risks. ing sufficient to fully assess the degree of risk
Given the Federal Reserves responsibility exposure in that function or activity must be
for ensuring compliance with banking laws performed. In addition, if an examiner believes
and regulations, inspections also include an that a banking organizations management is
appropriate level of compliance testing. (See being less than candid, has provided false or
SR-96-14.) misleading information, or has omitted material
Historically, Federal Reserve examinations information, then substantial on-site transaction
and inspections have placed significant reliance testing should be undertaken and appropriate
on transaction-testing procedures. For exam- follow-up actions should be initiated, including
ple, to evaluate the adequacy of the credit- the requirement of additional audit work and
administration process, assess the quality of appropriate enforcement actions.
loans, and ensure the adequacy of the allowance In most cases, full-scope inspections are con-
for loan and lease losses (ALLL), a high per- ducted on or around a single date. This approach
centage of large loan amounts have traditionally is appropriate for the vast majority of banking
been reviewed individually. Similarly, the
assessment of the accuracy of regulatory report- BHC Supervision Manual January 2015
ing often has involved extensive review of rec- Page 1
Risk-Focused Safety-and-Soundness Inspections 2124.0
organizations supervised by the Federal and provides a foundation from which to deter-
Reserve. However, as the largest banking orga- mine the procedures to be conducted during an
nizations have undergone considerable geo- inspection. Risk assessments identify the finan-
graphic expansion and the range of their prod- cial activities in which a banking organization
ucts has become more diversified, coordinating has chosen to engage, determine the types and
the efforts of the large number of examiners quantities of risks to which these activities
necessary to conduct inspections at a single expose the organization, and consider the qual-
point in time has become more difficult. To ity of management and control of these risks. At
avoid causing undue burden on these banking the conclusion of the risk-assessment process, a
organizations, full-scope inspections for many preliminary supervisory strategy can be formu-
large companies are conducted over the course lated for the bank holding company and its
of a year, rather than over a span of weeks, in a subsidiaries and for each of their major activi-
series of targeted reviews focusing on one or ties. Naturally, those activities that are most
two significant aspects of the bank holding significant to the organizations risk profile or
companys operations. This approach to con- that have inadequate risk-management processes
ducting full-scope inspections provides more- or rudimentary internal controls represent the
continuous supervisory contact with the largest highest risks and should undergo the most rigor-
bank holding companies and facilitates ous scrutiny and testing.
improved coordination of inspection efforts with Identifying the significant activities of a bank
other federal banking agencies. It also provides holding company, including those activities con-
more flexibility in the allocation of examiner ducted off-balance-sheet, should be the first step
resources, which has been especially important in the risk-assessment process. These activities
as the complexity of banking markets and prod- may be identified through the review of prior
ucts has increased and led to the development of bank examination and bank holding company
cadres of examiners with specialized skills. inspection reports and workpapers, surveillance
and monitoring reports generated by Board and
Reserve Bank staffs, Uniform Bank Perfor-
2124.0.2 RISK-FOCUSED mance Reports and Bank Holding Company
INSPECTIONS Performance Reports, regulatory reports (for
example, bank Call Reports and the FR Y-9C
Developments in the business of banking have and FFIEC 002 reports), and other relevant super-
increased the range of banking activities, height- visory materials. When appropriate, the follow-
ening demands on examiner resources and making information should be reviewed: strategic
ing the need for examiners to effectively focus plans and budgets, internal management reports,
their activities on areas of the greatest risk even board of directors information packages, corre-
more crucial. Improved in-office planning can spondence and minutes of meetings between the
result in more efficient and effective on-site bank holding company and the Reserve Bank,
inspections that are focused on risks particular annual reports and quarterly SEC filings, press
to specific organizations of the bank holding releases and published news stories, and stock
company. Such improved planning minimizes analysts reports. In addition, examiners should
supervisory burden and provides for the close hold periodic discussions with management to
coordination of the supervisory efforts of the gain insight into their latest strategies or plans
Federal Reserve with those of the other state for changes in activities or management
and federal banking agencies. Improved plan- processes.
ning also allows information requests to be bet- Once significant activities have been identi-
ter tailored to the specific organizations. fied, the types and quantities of risks to which
these activities expose the bank holding com-
pany should be determined. This allows examin-
2124.0.2.1 Risk Assessment ers to identify high-risk areas that should be
emphasized in conducting inspections. The
To focus procedures on the areas of greatest types of risk that may be encountered in bank-
risk, a risk assessment should be performed ing activities individually or in various combi-
before on-site supervisory activities. The risk- nations include, but are not limited to, credit,
assessment process highlights both the strengths market, liquidity, operational, legal, and reputa-
and vulnerabilities of a bank holding company tional risks.1 For example, lending activities are
a primary source of credit and liquidity risks.
Page 2 1. Appendix A defines these primary risk types.
They may also present considerable market risk these risks should be completed. This evaluation
(if the bank holding company or its subsidiaries should be based on findings from previous
are originating mortgage loans for later resale), examination and inspection activities conducted
interest-rate risk (if fixed-rate loans are being by the Reserve Bank or other banking agencies,
granted), or legal risk (if loans are poorly docu- supplemented by the review of internal policies
mented). Similarly, the asset-liability manage- and procedures, management reports, and other
ment function has traditionally been associated documents that provide information on the
with exposures to interest-rate and liquidity extent and reliability of internal risk-
risks. Operational risks are also associated with management systems. Sound risk-management
many of the transactions undertaken by this processes vary from one banking organization
function, and market risks are associated with to another, but generally include four basic ele-
the investments and hedging instruments comments for each individual financial activity or
monly used by the asset-liability management function and for the organization in aggregate.
function. The quantity of risks associated with a These elements are (1) active board and senior
given activity may be indicated by the volume management oversight; (2) adequate policies,
of assets and off-balance-sheet items that the procedures, and limits; (3) adequate risk-
activity represents or by the portion of revenue measurement, risk-monitoring, and management
for which the activity accounts. Activities that information systems; and (4) comprehensive
are new to an organization or for which expo- internal audits and controls. (See sections
sure is not readily quantified may also represent 4070.1 (SR-95-51) and 4071.0 (SR-16-11).)
high risks that should be evaluated during The preliminary evaluation of the risk-
inspections. management process for each activity or func-
A number of analytical techniques may be tion also helps determine the extent of transac-
used to estimate the quantity of risk exposure, tion testing that should be planned for each area.
depending on the activity or risk type being If the organizations risk-management process
evaluated. For example, to assess the quantity of appears appropriate and reliable, then a limited
credit risk in loans and commitments, the level amount of transaction testing may well suffice.
of past-due loans, internally classified or watch If, on the other hand, the risk-management pro-
list loans, nonperforming loans, and concentra- cess appears inappropriate or inadequate to the
tions of credit exposure to particular industries types and quantities of risk in an activity or
or geographic regions should be considered (see function, examiners should plan a much higher
section 2010.2). In addition, as part of the level of transaction testing. They should also
assessment of credit risk, the adequacy of the plan to conduct the most testing in those areas
overall ALLL can be evaluated by considering that comprise the most significant portions of a
trends in past-due, special-mention, and classi- bank holding companys activities and, thus,
fied loans; historic charge-off levels; and the typically represent high potential sources of risk.
coverage of nonperforming loans by the ALLL.
Analytical techniques for gauging the exposure
of a bank holding company and its subsidiaries
to interest-rate risk, as part of the evaluation of
asset-liability management practices, can 2124.0.2.2 Preparation of a Scope
include a review of the historical performance Memorandum
of net interest margins, as well as the results of
internal projections of future earnings perfor- Once the inspection planning and risk-
mance or net economic value under a variety of assessment processes are completed, a scope
plausible interest-rate scenarios. The measure- memorandum should be prepared. A scope
ment of the quantity of market risk arising from memorandum provides a detailed summary of
trading in cash and derivative instruments may the supervisory strategy for a bank holding com-
take into account the historic volatility of trad- pany and assigns specific responsibilities to
ing revenues, the results of internal models cal- inspection team members. A scope memoran-
culating the level of capital and earnings at risk dum should be tailored to the size and complex-
under various market scenarios, and the market ity of the bank holding company that is subject
value of contracts relative to their notional to review, define the objectives of each inspec-
amounts. tion, and generally include
Once the types and quantities of risk in each
activity have been identified, a preliminary
assessment of the banking organizations pro- BHC Supervision Manual July 2016
cess to identify, measure, monitor, and control Page 3
1. a summary of the results of the prior gauged and evaluated. More-extensive transac-
inspection; tion testing is also generally completed for
2. a summary of the strategy and significant activities that are much more significant to a
activities of the banking organization, includ- bank holding company than is completed for
ing its new products and activities; other areas, although the actual level of testing
3. a description of the bank holding companys for these significant activities may be reduced
organization and management structure; commensurate with the quality of internal risk-
4. a summary of performance since the prior management processes.
inspection; Consider, as an example, the risk exposure
5. a statement of the objectives of the current associated with commercial lending activities.
inspection; Traditionally, examiners have reviewed a rela-
6. an overview of the activities and risks to be tively high number and dollar volume of real
addressed by the inspection; and estateassociated loans.2 If, however, credit-
7. a description of the procedures that are to be administration practices are considered satisfac-
performed at the inspection. tory, fewer loans may need be reviewed to
verify that this is the case (that is, fewer loans
For large complex organizations operating in than would be reviewed if deficiencies in credit-
a number of states or internationally, the plan- administration practices were suspected). This
ning and risk-assessment processes are necessar- review may be achieved through a valid statisti-
ily more complicated. The traditional scope cal sampling technique, when appropriate. It
memorandum may have to be broadened into a should be noted that if credit-administration
more extensive set of planning documents to practices are initially considered sound, but if
reflect the unique requirements of complex bank loans reviewed to verify this raise doubts about
holding companies. Examples of these planning the accuracy of internal assessments or the com-
documents include annual consolidated analy- pliance with internal policies and procedures,
ses, periodic risk assessments, and supervisory the number and volume of loans subject to
plans. review should generally be expanded. Examin-
ers should thus review a sufficient number of
loans in order to ensure that the level of risk is
2124.0.2.3 On-Site Procedures clearly understood, an accurate determination of
the adequacy of the ALLL can be made, and the
The amount of review and transaction testing deficiencies in the credit risk-management pro-
necessary to evaluate particular functions or cess can be comprehensively detailed.
activities of a bank holding company generally
depends on the quality of the process the com-
pany uses to identify, measure, monitor, and 2124.0.2.4 Evaluation of Audit Function
control the risks of an activity. When the risk- as Part of Assessment of Internal Control
management process is considered sound, fur- Structure
ther procedures are limited to a relatively small
number of tests of the integrity of the manage- A bank holding companys internal control
ment system. Once the integrity of the manage- structure is critical to its safe and sound func-
ment system is verified through limited testing, tioning in general and to its risk-management
conclusions on the extent of risks within the system in particular. When properly structured,
function or activity are drawn based on internal internal controls promote effective operations
management assessments of those risks rather and reliable financial and regulatory reporting;
than on the results of more-extensive transaction safeguard assets; and help to ensure compliance
testing by examiners. On the other hand, if with laws, regulations, and internal policies and
initial inquiries into the risk-management procedures. In many banking organizations,
systemor efforts to verify the integrity of the internal controls are tested by an independent
systemraise material doubts as to the systems
2. Guidance on the selection of loans for review is pro-
effectiveness, no significant reliance should be vided in SR-94-13, Loan Review Requirements for On-Site
placed on the system. A more extensive series Examinations. The guidance within SR-94-13 is superseded
of tests should be undertaken to ensure that the by SR-14-4, Examiner Loan Sampling Requirements for
banking organizations exposure to risk from a State Member Bank and Credit Extending Nonbank Subsidi-
aries of Banking Organizations with $10$50 Billion in Total
given function or activity can be accurately Consolidated Assets, but only for these banking organiza-
tions. SR-14-4 clarifies expectations for the assessment of
BHC Supervision Manual July 2016 material retail credit portfolios for these institutions (see
Page 4 appendix 1 at section 2010.2.11).
internal auditor who reports directly to the board ratings encompass evaluations of the quality of
of directors or its audit committee. However, in risk-management processes for all significant
some smaller banking organizations whose size activities and all types of risks. As such, they
and complexity of operations do not warrant an should largely summarize conclusions on the
internal audit department, reviews of internal adequacy of risk-management processes for
controls may be conducted by other personnel each individual function or activity evaluated.
independent of the area subject to review. In assigning risk-management ratings, it is
Because the audit function is an integral part important that examiners consider the quality of
of a bank holding companys assessment of its the risk-management process for the bank hold-
internal control system, examiners must include ing company overall, as well as for each indi-
a review of the organizations control- vidual function. At smaller bank holding compa-
assessment activities in every inspection. Such nies engaged in traditional banking and
reviews help identify significant risks and facili- nonbanking activities, relatively basic risk-
tate a comprehensive evaluation of the organiza- management processes established for each sig-
tions internal control structure and also provide nificant activity, such as lending or asset-
information to determine the inspection proce- liability management, may be adequate to allow
dures that should be completed in assessing senior management to effectively manage the
internal controls for particular functions and organizations overall risk profile. On the other
activities and for the bank holding company hand, at larger bank holding companies that are
overall. When conducting this review, examin- typically engaged in more-complex and widely
ers should evaluate the independence and com- diversified activities, effective risk-management
petence of the personnel conducting control systems must evaluate various functional man-
assessments and the effectiveness of the assess- agement processes in combination so that aggre-
ment program in covering the bank holding gate risk exposures can be identified and moni-
companys significant activities and risks. In tored by senior management. Management
addition, examiners should meet with the inter- information reports should typically be gener-
nal auditors or other personnel responsible for ated for the overall organization, as well as for
evaluating internal controls. Examiners should individual functional areas. Some aggregate or
review internal control risk assessments, work specific company-wide limits may also be
plans, reports, workpapers, and related commu- needed for the principal types of risks that are
nications with the audit committee or board of relevant to the companys activities.
directors. A critical aspect of ensuring that a bank hold-
Depending on the size and complexity of the ing companys risk-management and control
activities conducted by a bank holding com- procedures remain adequate is the ongoing test-
pany, the examiner should also consider con- ing of the strength and integrity of these proce-
ducting a similar review of the work performed dures and the extent to which the procedures are
by the companys external auditors. Such a understood and followed throughout the organi-
review often provides added insight into key zation. When assigning a risk-management rat-
risk areas by detailing the nature and extent of ing, examiners should assess the adequacy of
the external auditors testing of those areas. the companys efforts to ensure that its proce-
dures are being followed. The companys vali-
dation efforts must be conducted by individuals
2124.0.2.5 Evaluation of Overall who have proper levels of organizational inde-
Risk-Management Process pendence and expertise, such as internal or
external auditors, internal risk-management
To highlight the importance of a banking organi- units, or managers or other professionals of the
zations risk-management process, bank holding bank holding company who have no direct con-
companies are assigned a risk-management rat- nection to the activities for which procedures
ing on a five-point scale as a significant part of are being assessed.
the evaluation of the management components
of the bank holding company RFI/C(D) rating
system. (See section 4070.0.) In addition, U.S.
branches and agencies of foreign banking orga- ment, operational controls, compliance, and asset quality,
under guidance included in SR-00-14, Enhancements to the
nizations are assigned a similar rating under the Interagency Program for Supervising the U.S. Operations of
ROCA rating system.3 These risk-management Foreign Banking Organizations.
3. U.S. branches and agencies of foreign banking organiza- BHC Supervision Manual January 2015
tions are assigned separate ROCA ratings for risk manage- Page 5
2124.0.2.6 Evaluation of Compliance 2124.0.3 INSPECTION OBJECTIVES

with Laws and Regulations
1. To ensure that the bank holding company has
Compliance with relevant laws and regula- in place the processes necessary to identify,
tions should be assessed at every inspection. measure, monitor, and control its risk expo-
The steps taken to complete these assessments, sures for each of its activities or functions.
however, will vary depending on the circum- 2. To improve inspection efficiencies by stress-
stances of the bank holding company being ing increased in-office planning of inspec-
reviewed. When an organization has a history of tions, using a risk-focused emphasis.
satisfactory compliance with relevant laws and 3. To identify and assess significant on- and
regulations or an effective compliance function, off-balance-sheet activities and the greatest
only a relatively limited degree of transaction types and quantities of risk exposures and
testing need be conducted to assess compliance. vulnerabilities to the bank holding company,
For example, when evaluating compliance with tailoring the extent of transaction testing to
the appraisal requirements of Regulation Y at a the results of this review and other inspec-
bank holding company with a formal compli- tions findings.
ance function, compliance may be ascertained 4. To review and assess the effectiveness and
by reviewing the scope and findings of internal adequacy of documentation of the bank hold-
and external audit activities, evaluating the ing companys control and assessment activi-
internal appraisal-ordering and -review pro- ties and arrangements, including its internal
cesses, and sampling a selection of appraisals control structure, and the qualifications of
for compliance, as part of the supervisory loan- internal and external auditors and other inde-
review process. On the other hand, at bank pendent personnel involved in the program.
holding companies that have a less satisfactory 5. To emphasize the preparation of a risk-
compliance record or that lack a compliance focused scope memorandum that is tailored
function, more appraisals would naturally need to the size and complexity of the bank hold-
to be tested to assess the overall compliance ing company under inspection.
with the appraisal requirements of Regulation Y. 6. To evaluate compliance with laws and
regulations.
2124.0.2.7 Documentation of Supervisory 7. To adequately document and communicate
Findings inspection supervisory findings, recommen-
dations, and conclusions.
The examiners workpaper documentation of
supervisory findings is necessary for Reserve
Bank management to objectively verify the 2124.0.4 INSPECTION PROCEDURES
inspection work performed. Such documenta-
tion also provides a source of information on the 1. Identify the significant on- and off-balance-
condition and prospects of a bank holding com- sheet activities of the bank holding
pany that is invaluable for planning future company.
reviews. Most important, examiners workpaper a. Review prior inspection reports and
documentation provides support for the conclu- workpapers, surveillance and monitoring
sions and recommendations detailed in the reports generated by the Board and
inspection report. Reserve Bank staff, Uniform Bank Per-
formance Reports and Bank Holding
Company Performance Reports, regula-
2124.0.2.8 Communication of
tory reports (for example, bank Call
Supervisory Findings
Reports and FR Y-series and other
Effective and open communication between FFIEC reports), and other relevant super-
bank supervisory agencies and the board of visory materials.
directors and management of bank holding com- b. Review strategic plans and budgets;
panies is essential to ensuring that the results of internal management reports; board of
inspections are fully understood; the director- directors information packages; corre-
ship and management are aware of any identi- spondence and minutes, including min-
fied deficiencies; and, when necessary, they take utes of meetings held between the bank
appropriate corrective actions. holding company and the Reserve Bank;
annual reports and quarterly SEC filings;
BHC Supervision Manual January 2015 press releases and published news
Page 6 stories; and stock analysts reports.
2. Hold periodic discussions with manage- 8. Assess the adequacy of efforts to ensure
ment to gain insight into recently adopted that the current risk-management and con-
strategies or plans to change activities or trol procedures are being followed.
management processes. 9. Assess compliance with laws and regula-
3. Once the significant activities have been tions, adjusting the extent of transaction
identified, determine and analyze the types testing with the organizations history of
(for example, credit, market, liquidity, satisfactory compliance.
operational, legal, and reputational) and 10. Document all work performed and the
quantities of risks to which those activities supervisory findings. Include information
expose the bank holding company, placing on the condition and prospects of the bank
greater inspection emphasis on the high- holding company and its significant subsid-
risk areas. iaries, as well as the inspections conclu-
4. Develop an assessment of the processes that sions and recommendations.
are used to identify, measure, monitor, and
control the risks. Focus on the extent of
board and senior management oversight; 2124.0.5 APPENDIX ADEFINITIONS
the adequacy of policies, procedures, limits, OF RISK TYPES EVALUATED AT
risk-measurement, risk-monitoring, and INSPECTIONS
management information systems; and the
existence of adequately documented inter- 1. Credit risk arises from the potential that a
nal audits and controls. borrower or counterparty will fail to perform
5. Prepare a scope memorandum tailored to on an obligation.
the size and complexity of the bank holding 2. Market risk is the risk to a bank holding
company under inspection. companys condition resulting from adverse
6. Conduct limited tests of the integrity of the movements in market rates or prices, such as
risk-management system. Conduct more- interest rates, foreign-exchange rates, or
extensive transaction testing for those areas equity prices.
of a bank holding company that are very 3. Liquidity risk is the potential that a bank
significant compared with other areas, holding company will be unable to meet its
adjusting the level of transaction testing to obligations as they come due because of an
the quality of internal risk-management pro- inability to liquidate assets or obtain
cesses. If initial inquiries or efforts to verify adequate funding (referred to as funding
the system raise material doubts as to its liquidity risk) or that it cannot easily
effectiveness, place no reliance on the integ- unwind or offset specific exposures without
rity of the bank holding companys risk- significantly lowering market prices because
management system and conduct more- of inadequate market depth or market disrup-
extensive transaction testing. tions (market liquidity risk).
7. Review the bank holding companys risk- 4. Operational risk arises from the potential
assessment control activities, including an that inadequate information systems, opera-
assessment of internal controls for particu- tional problems, breaches in internal con-
lar functions and activities and for the bank trols, fraud, or unforeseen catastrophes will
holding company overall. result in unexpected losses.
a. Evaluate the independence and compe- 5. Legal risk arises from the potential that unen-
tence of the personnel conducting con- forceable contracts, lawsuits, or adverse
trol assessments and the effectiveness of judgments can disrupt or otherwise nega-
the assessment program in covering the tively affect the operations or condition of a
bank holding companys significant bank holding company.
activities and risks. 6. Reputational risk is the potential that nega-
b. Meet the independent external and inter- tive publicity on a bank holding companys
nal auditors and other personnel respon- business practices, whether true or not, will
sible for evaluating internal controls and cause a decline in the customer base, costly
review the internal control risk assess- litigation, or revenue reductions.
ments, work plans, reports, workpapers,
and related communications with the
audit committee or the board of
directors.
Page 7
Risk-Focused Supervision Framework for Large
Complex Banking Organizations Section 2124.01
WHATS NEW IN THIS REVISED 2. To foster consistency, coordination, and com

SECTION munication among the appropriate supervi-
sors. Seamless supervision, which reduces
Effective January 2016, this section was revised regulatory burden and duplication, is pro-
to (1) include an additional risk-focused super- moted. The supervisory process uses exam-
visory letter to the listing in appendix A (SR- iner resources effectively by using the institu-
07-1) and (2) remove an inactive SR letter from tions internal and external risk-assessment
appendix A (SR-99-18). and risk-monitoring systems; making appro-
priate use of joint and alternating examina-
tions and inspections; and tailoring supervi-
2124.01.1 INSPECTION APPROACH sory activities to an institutions condition,
FOR RISK-FOCUSED SUPERVISION risk profile, and unique characteristics.
3. To promote safety and soundness. The
The inspection approach for large complex supervisory process effectively evaluates the
banking organizations (LCBOs) is a risk- safety and soundness of banking organiza-
focused process that relies on (1) an understand- tions, including the assessment of risk-
ing of the banking organization1 (the institu- management systems, financial condition,
tion), (2) the performance of risk assessments, and compliance with laws and regulations.
(3) the development of a supervisory plan, and 4. To provide a comprehensive assessment of
(4) inspection procedures that are tailored to the the institution. The supervisory process inte-
risk profile. The process for a complex institu- grates specialty areas (for example, informa-
tion relies more heavily on a central point of tion technology systems, trust, capital
contact (CPC), detailed risk assessments, and a markets, and consumer compliance (see
supervisory plan before the on-site inspection. SR-03-22/CA-03-15)) and functional risk
The risk-focused inspection also incorporates assessments and reviews, in cooperation with
the U.S. operations of foreign banking organiza- interested supervisors, into a comprehensive
tions (FBOs), for which the Federal Reserve has assessment of the institution.
overall supervisory authority. See SR-12-17,
SR-97-24, and section 2124.05.
2124.01.1.2 Key Elements of the
Risk-Focused Framework
2124.01.1.1 Risk-Focused Supervisory To meet the established objectives and respond
Objectives to the characteristics of large institutions, the
framework for risk-focused supervision of large
The Federal Reserve is committed to ensuring
complex institutions contains the following key
that the supervisory process for all banking
elements:
organizations under its purview meets the fol-
lowing objectives:
1. Designation of a central point of contact.
Large institutions typically have operations
1. To provide flexible and responsive supervi-
in several jurisdictions, multiple charters, and
sion. The supervisory process is designed to
diverse product lines. Consequently, the pro-
be dynamic and forward-looking so that it
gram requires that a CPC be designated for
responds to technological advances, product
each institution to facilitate coordination and
innovation, and new risk-management
communication among the principal bank
systems and techniques, as well as to
and other regulatory authorities (for exam-
changes in the condition of an individual
ple, securities, insurance, and other nonbank-
financial institution and developments in the
ing supervisory entities). Further, the pro-
market.
gram requires that each CPC and LCBO be
assigned a dedicated supervisory team and
1. For this section, the term banking organization refers to staff with specialized skills, knowledge, and
bank holding companies (BHCs) and their domestic and for- experience tailored to the unique profile of a
eign banking and nonbank subsidiaries. It is used synono- particular institution.
mously with the term institutions. That term, however, has an
even broader meaning since it may include other entities (for
example, Edge Act corporations and foreign branches of state BHC Supervision Manual January 2016
member banks). See section 2124.01.1.3.1. Page 1
Risk-Focused Supervision Framework for Large Complex Banking Organizations 2124.01
2. Review of functional activities. Large institu- internal management and board reports,
tions are generally structured along business internal and external audit reports, and
lines or functions, and some activities are publicly available information will further
managed on a centralized basis. As a result, a supplement existing supervisory processes.
single type of risk may cross several legal Banking organizations are also encouraged
entities. Therefore, the supervisory program to continually review and enhance their
incorporates assessments along functional public disclosures in order to promote
lines to evaluate risk exposure and its impact transparency and to foster and support
on safety and soundness. These functional supervisory processes and effective market
reviews will be integrated into the risk discipline.
assessments for specific legal entities and 6. Emphasis on ongoing supervision. Large
used to support the supervisory ratings for institutions face a rapidly changing environ-
individual legal entities.2 ment. The supervisory program thus empha-
3. Focus on risk-management processes. Large sizes ongoing supervision, monitoring, and
institutions generally have highly developed assessment through increased planning; a no-
risk-management systems, such as internal less-than-quarterly reassessment of the orga-
audit, loan review, and compliance. The nizations profile; and continuous off-site
supervisory program emphasizes each insti- monitoring. Ongoing supervision allows for
tutions responsibility to be the principal timely adjustments to the supervisory strat-
source for detecting and deterring abusive egy as conditions change within the institu-
and unsound practices through adequate tion, enhanced information sharing System-
internal controls and operating procedures. wide and on an interagency basis, and the
The program incorporates an approach that use of information technology platforms that
focuses on and evaluates the institutions foster more-effective collaboration and
risk-management systems, processes, and communication.
core proficiencies for identifying, measur- 7. Effective communication with management.
ing, monitoring, and controlling key risks, An effective program of regular and mean-
including credit, market, and operational ingful contacts with management is neces-
risks. Yet, the program retains transaction sary to maintain a current understanding of
testing and supervisory rating systems, such the institutions risk profile and risk-
as CAMELS, RFI/C(D), and ROCA. This management processes without imposing
diagnostic perspective provides insight into undue burden, interfering with legitimate
how effectively an institution is managing management prerogatives, or compromising
its operations and how well it is positioned the objectivity of the supervisory process.
to meet future business challenges. The pro-
gram places less emphasis on traditional
point-in-time balance-sheet assessments.
4. Tailoring of supervisory activities. Large
institutions are unique, but all possess the 2124.01.1.3 Banking Organizations
ability to quickly change their risk profiles. Covered by the Framework
To deliver effective supervision, the pro-
gram incorporates an approach that tailors For purposes of the risk-focused supervision
supervisory activities to the risk profile of framework, LCBOs generally have a functional-
an institution. By concentrating on an insti- management structure, a broad array of prod-
tutions major risk areas, examiners can ucts, and operations that span multiple supervi-
achieve a more relevant and penetrating un- sory jurisdictions.3 These institutions may be
derstanding of the institutions condition. state member banks, BHCs (including their non-
5. Review of internally and externally gener- bank and foreign subsidiaries), savings and loan
ated management information. A review of holding companies, and branches and agencies
of FBOs. The complex-institution process may
also be appropriate for some organizations.
2. When functions are located entirely in legal entities that LCBOs are larger institutions that have par-
are not primarily supervised by the Federal Reserve, the ticularly complex operations and dynamic risk
results of supervisory activities conducted by the primary profiles. To be effective, a supervisory program
regulator will be used to the extent possible to avoid duplica-
tion of activities.
3. Large institutions are defined differently in other regula-
BHC Supervision Manual January 2016 tory guidance regarding regulatory reports and examination
Page 2 mandates.
for LCBOs requires a heightened level of plan- of state member banks; and (3) subsidiary for-
ning, coordination, and innovative techniques. eign banks of the holding company. The level of
These organizations typically have significant supervisory activity to be conducted for non-
on- and off-balance-sheet risk exposures, offer a bank subsidiaries and foreign branches and sub-
broad range of products and services at the sidiaries of domestic institutions should be
domestic and international levels, are subject to based on their individual risk levels relative to
multiple supervisors in the United States and the consolidated organization. The risk associ-
abroad, and participate extensively in large- ated with significant nonbank subsidiaries or
value payment and settlement systems. branches should be identified as part of the
An important aspect of the LCBO program is consolidated risk-assessment planning process,
the assessment and evaluation of banking prac- and the appropriate level of supervisory cover-
tices across a group of institutions with similar age (whether on- or off-site) should be described
business lines, characteristics, and risk profiles. in the supervisory plan for the organization.
This portfolio approach to supervision will Risk-focused supervisory planning should use
(1) support and enhance timely judgments about the workpaper Nonbank Subsidiary of a Bank
individual institutions, including the identifica- Holding Company Risk-Assessment Question-
tion of possible outliers; (2) facilitate peer- naire (see appendix B). It should be used as a
group assessments; (3) provide an improved guide for (1) determining whether a nonbank
framework for discerning industry trends; subsidiary poses significant risk to the entire
(4) foster more-consistent supervision of institu- LCBO (parent bank holding company) and
tions with similar businesses and risk profiles; (2) determining whether an on-site supervisory
(5) contribute substantially to the maintenance inspection or examination of the entity is
of a highly informed and skilled supervisory needed.4 The supervisory plan for the organiza-
staff; and (6) promote the development and shar- tion should also include a review of the institu-
ing of the best supervisory practices within the tions processes to ensure compliance with sec-
Federal Reserve and the supervisory community tions 23A and 23B of the Federal Reserve Act,
more broadly. Regulation W, and various other regulations and
guidelines that govern transactions between the
bank and nonbank affiliates.
2124.01.1.3.1 Foreign Institutions
U.S. supervisory authorities are host-country 2124.01.1.3.3 Edge Act Corporations
rather than home-country supervisors for most
of the U.S. operations of FBOs; therefore, the Under section 25A, paragraph 17, of the Federal
supervisory focus and objectives are somewhat Reserve Act, Edge Act corporations are subject
different for U.S. operations of FBOs and are to examination once a year and at such other
addressed separately in the FBO supervision times as deemed necessary by the Federal
program. The desired result of a risk-focused Reserve. While Reserve Banks must fulfill this
examination process, however, should be the legal mandate, there is flexibility in determining
same. The framework encompasses the supervi- the extent of examination coverage. The scope
sion and examination processes and procedures of Edge Act corporation examinations should be
relevant to the U.S. operations of FBOs, to the determined through the risk-assessment process.
extent that they are appropriate. Any significant Additionally, separate reports of examination
remaining differences are incorporated in the are not required for Edge Act corporations, pro-
FBO supervision program. vided that all relevant findings are included in
the consolidated report of examination of the
2124.01.1.3.2 Nonbank Subsidiaries of

Domestic Institutions 4. When this workpaper is used, a separate risk assessment
of each nonbank subsidiary of the LCBO (for domestic bank
Nonbank subsidiaries of large complex domes- holding companies) is not required. The separate-risk-
tic institutions are covered by the risk-focused assessment requirements of SR-93-19 are thus partially super-
seded for LCBOs. Nonbank subsidiary risk assessments
supervision program. These subsidiaries include should be reflected in the entire consolidated organizations
(1) nonbank subsidiaries of the parent bank risk assessment.
holding company and those of the subsidiary
state member banks; (2) the significant branch BHC Supervision Manual January 2007
operations, primarily foreign-branch operations, Page 3
parent bank.5 This reporting procedure also objectives of seamless risk-focused supervision,
applies to other nonbank subsidiaries of the the RRB is responsible for designating the CPC
bank or bank holding company. and for ensuring that all aspects of the supervi-
sory process are fully coordinated with LRBs
and home-state supervisors. Close coordination
2124.01.1.3.4 Specialty Areas Covered by among the other appropriate regulators for each
the Framework organization is critical to ensure a consistent
risk-focused approach to supervision.
The Federal Reserve regularly conducts exami-
nations, inspections, or reviews of several spe-
cialty areas. To achieve more-efficient supervi- 2124.01.2.2 RRBs Working with Local
sion and reduce the regulatory burden on Reserve Banks
institutions, steps have been taken to coordinate
these reviews with the annual full-scope inspec- The RRB is accountable for all aspects of the
tion of the consolidated organization. Under the supervision of a fully consolidated banking
risk-focused approach, the specialty areas organization, which includes the supervision of
should be included in the planning process in all the organizations subsidiaries and affiliates
relation to the perceived level of risk to the (domestic, foreign, and Edge corporations) for
consolidated organization or any state member which the Federal Reserve has supervisory over-
bank subsidiary. Reviews of any specialty areas sight responsibility. The RRB is generally
can be performed in conjunction with the annual expected to work with local Reserve Banks
full-scope inspection, or through targeted (LRBs) in conducting examinations (and inspec-
examinations or inspections, at any time during tions) and other supervisory activities, particu-
the supervisory cycle. The findings of all spe- larly where significant banking operations are
cialty reviews should be included in the inspec- conducted in a local District. Thus, for state
tion report for the consolidated organization. member banks, the LRB has an important role
in the supervision of that subsidiary. However,
the RRB retains authority and accountability for
2124.01.2 COORDINATION OF the results of all examinations, inspections, and
SUPERVISORY ACTIVITIES reviews that an LRB may perform on its behalf.
Many large complex institutions have interstate

operations that expand with the continuation of 2124.01.2.2.1 RRB Defined
mergers and acquisitions. In this environment,
close cooperation with the other federal and In general, the RRB for a banking organization
state banking agencies is critical. To facilitate has been the Reserve Bank in the District where
coordination between the Federal Reserve and the banking operations of the organization are
other regulators, district Reserve Banks have principally conducted. For domestic banking
been assigned roles and responsibilities that organizations, the RRB typically will be the
reflect their status as the responsible Reserve Reserve Bank District where the head office of
Bank (RRB). the top-tier organization is located and where its
overall strategic direction is established and
overseen. For foreign banking organizations, the
2124.01.2.1 Responsible Reserve Bank RRB typically will be the Reserve Bank District
where the Federal Reserve has the most direct
The RRB facilitates the increased flexibility, involvement in the day-to-day supervision of
planning, and coordination needed to effectively the U.S. banking operations of the organization.
and efficiently supervise institutions with inter- When necessary, the Boards Division of
state operations. Considering the overriding Banking Supervision and Regulation (BS&R),
in consultation with the Division of Consumer
5. A separate memorandum to the file should be prepared and Community Affairs (C&CA), may desig-
and retained. The memorandum should provide the date of nate an RRB when the general principles set
examination of the Edge Act corporation, a summary of forth above could impede the ability of the
findings, the rating assigned, and a reference to the consoli-
dated report of examination. This information should also be
Federal Reserve to perform its functions under
forwarded to Federal Reserve Board staff. law, do not result in an efficient allocation of
supervisory resources, or are otherwise not
BHC Supervision Manual January 2007 appropriate. When more than one Reserve Bank
Page 4 currently shares supervisory responsibilities for
a consolidated banking organization, Board staff are consistent with the supervisory approach
will work with Reserve Bank staff to determine and message applied across the consolidated
the RRB. organization. If an LRB identifies major issues
in the course of directly conducting supervisory
activities on behalf of an RRB, those issues
2124.01.2.2.2 Duties of RRBs should be brought to the attention of the RRB in
a timely manner.
The RRB develops the consolidated risk assess- If an RRB arranges for an LRB to conduct
ment and supervisory plan and ensures that the supervisory activities on its behalf, the LRB is
scope and timing of planned activities con- responsible for the costs of performing the
ducted by participating Districts and agencies activities. If the LRB is unable to fulfill the
pursuant to the plan are appropriate, given the request from the RRB to perform the specified
consolidated risk assessment. The RRB desig- activities, the RRB should seek System assis-
nates the central point of contact or lead exam- tance, if needed, by contacting Board staff or
iner and ensures that all safety-and-soundness, using other established procedures for coordi-
information technology, trust, consumer compli- nating resources.
ance, Community Reinvestment Act (CRA), and
other specialty examinations (and inspections)
and visitations are conducted and appropriately 2124.01.2.3 Central Point of Contact
coordinated within the System and with other
regulators. In addition, the RRB manages all A CPC is critical to fulfilling the objectives of
formal communications with the foreign and seamless risk-focused supervision. The RRB
domestic supervised entity, including the com- should designate a CPC for each large complex
munication of supervisory assessments, ratings, institution it supervises. Generally, all Federal
and remedial actions.6 Reserve System contacts, activities, and duties,
as well as those conducted with other supervi-
sors, should be coordinated through this contact.
2124.01.2.2.3 Sharing of RRB Duties The CPC should
To take advantage of opportunities to enhance 1. be knowledgeable, on an ongoing basis,
supervisory effectiveness or efficiency, an RRB about the institutions financial condition,
is encouraged to arrange for the LRB to under- management structure, strategic plan and
take on its behalf certain examinations or other direction, and overall operations;
supervisory activities. For example, a local Dis- 2. remain up-to-date on the condition of the
trict may have relationships with local represen- assigned institution and be knowledgeable
tatives of the organization or local supervisors; regarding all supervisory activities, monitor-
leveraging these relationships may reduce cots ing and surveillance information, applica-
or facilitate communication. Additionally, LRBs tions issues, capital-markets activities, meet-
may provide specialty examination resources ings with management, and enforcement
in the case of CRA examinations, LRB staff issues, if applicable;
often provide valuable insights into local com- 3. ensure that the objectives of seamless risk-
munities and lending institutions that should be focused supervision are achieved for each
factored into the CRA assessment. When other institution and that the supervisory products
Reserve Bank Districts conduct examinations, (that is, an institutional overview, a risk
inspections, and other supervisory activities for matrix, a risk assessment, a supervisory plan,
the RRB, substantial reliance should be placed an inspection program, a scope memoran-
on the conclusions and ratings recommended by dum, inspection modules, and an inspection
the participating Reserve Bank(s). report) are prepared in a timely manner;
The RRB retains authority and accountability 4. ensure appropriate follow-up and tracking of
for the results of all examinations and reviews supervisory concerns, corrective actions, or
performed on its behalf and, therefore, must other matters that come to light through
work closely with LRB examination teams to ongoing communications and/or surveil-
ensure that examination scopes and conclusions lance; and
5. participate in the inspection or examination
6. Additional guidance on inter-District coordination and
supervisory responsibilities can be found in section 2124.04;
process, as needed, to (1) ensure consistency
SR-97-24, Risk-Focused Framework for Supervision of
Large Complex Institutions; and SR-96-33, State/Federal BHC Supervision Manual January 2007
Protocol and Nationwide Supervisory Agreement. Page 5
with the institutions supervisory plan and on a functional-business-line approach to super-

effective allocation of resources, including vising institutions, while effectively integrating
coordination of on-site efforts with specialty the functional approach into the legal-entity
examination areas and other supervisors, as assessment. Bank holding companies are
appropriate, and (2) facilitate requests for increasingly being managed on a functional
information from the institution, wherever basis. Functional management allows organiza-
possible. tions to take advantage of the synergies among
their components, deliver better products to the
market, and provide higher returns to stockhold-
2124.01.2.4 Sharing of Information ers. Virtually all of the large bank holding
companies operate as integrated units and are
To further promote seamless risk-focused managed as such. For these companies, the risk-
supervision, information related to a specific management systems are generally organized
institution should be provided, as appropriate, to along business lines on a centralized basis. A
other interested supervisors. Sharing of these key implication of this shift in management
products with the institution, however, should structure is that much of the information and
be carefully evaluated on a case-by-case basis. insight gathered on inspections and examina-
The institutional overview, risk assessment, and tions of individual legal entities can be fully
supervisory plan may not be appropriate for understood only in the context of examination
release if they contain a hypothesis about an findings of other related legal entities or central-
institutions risk rather than assessments veri- ized functions. Developing that understanding
fied through the inspection or examination pro- means adapting some of the same functional-
cess. On the other hand, it may be appropriate to business-line approaches to supervision, includ-
share the inspection program with the institution ing examination processes. Consequently, the
in the interest of better coordination of activities. risk-focused supervision framework incorpo-
rates risk assessments, that is, inspection and
examination procedures that are organized by
2124.01.2.5 Coordination with Other function.
Supervisors The functional approach focuses principally
on the key business activities (for example,
Section 305 of the Riegle Community Develop- lending, treasury, retail banking) rather than
ment and Regulatory Improvement Act of 1994 reviewing the legal entity and its balance sheet.
directed the agencies to coordinate their exami- This does not mean that the responsibility for a
nations, to the extent possible, when they are legal-entity assessment is ignored, nor should
jointly responsible for the examination of vari- the Federal Reserve perform examinations of
ous entities of a bank holding company.7 To institutions for which other regulators have pri-
help achieve the desired degree of coordination, mary supervisory responsibility.8 Rather, Fed-
staffs of the agencies are expected, primarily at eral Reserve examiners should integrate the
the regional level, to discuss examination plans findings of a functional review into the legal-
and coordination issues. The institution involved entity assessment and should coordinate closely
is to be kept fully informed of the coordinated with the primary regulator to gather sufficient
activities planned by the agencies, including a information to form an assessment of the con-
general time frame of when each agency expects solidated organization. Nonetheless, in some
to conduct its examination activities. cases, effective supervision of the consolidated
organization may require Federal Reserve exam-
iners to perform process reviews and, possibly,
2124.01.3 FUNCTIONAL APPROACH transaction testing at all levels of the
AND TARGETED INSPECTIONS organization.
Functional-risk-focused supervision is to be
The framework for risk-focused supervision of achieved by the following actions:
large complex institutions relies more heavily
7. In a December 1996 letter to the House Committee on

Banking and Financial Services, the agencies outlined their
8. With respect to U.S. banks owned by FBOs, it is particu-
cooperative efforts to meet the objectives of section 305.
larly important to review the U.S. bank on a legal-entity basis
and also the risk exposure to the U.S. bank from its parent
BHC Supervision Manual January 2007 foreign bank, as U.S. supervisory authorities do not supervise
Page 6 or regulate the parent bank.
1. Planning and conducting joint inspections 3. Communicated in a formal written report to

and examinations with the primary regulator the institutions management or board of
in areas of mutual interest, such as nonde- directors when significant weaknesses are
posit investment products, interest-rate risk, detected or when the findings result in a
liquidity, and mergers and acquisitions. downgrade of any rating component. Other-
2. Leveraging off, or working from, the work wise, the vehicle for communicating the
performed by the primary regulator and the results is left to the judgment of the Reserve
work performed by the institutions internal Banks management and may either be a
and external auditors by reviewing and using formal report or a supervisory letter.10
their workpapers and conclusions to avoid
duplication of effort and to lessen the burden The functional approach to risk assessments
on the institution. and the planning of supervisory activities should
3. Reviewing inspection and examination include a review of the parent company and its
reports and other communications to the significant nonbank subsidiaries. However, it is
institution that were issued by other anticipated that the level of supervisory activi-
supervisors. ties, on- or off-site, will be appropriate to the
4. Conducting a series of functional reviews or risk profile of the parent company or its non-
targeted inspections or examinations of busi- bank subsidiary in relation to the consolidated
ness lines, relevant risk areas, or areas of organization. Intercompany transactions should
significant supervisory concern during the continue to be reviewed as part of the inspection
supervisory cycle.9 Functional reviews and procedures performed, to ensure that they com-
targeted inspections or examinations are ply with laws and regulations and do not pose
increasingly necessary to evaluate the rel- safety-and-soundness concerns.
evant risk exposure of a large complex insti-
tution and the effectiveness of related risk-
management systems.
2124.01.4 OVERVIEW OF THE
The relevant findings of functional reviews or PROCESS AND PRODUCTS
targeted inspections and examinations should be
handled as outlined below. The risk-focused methodology for the supervi-
sion program for large complex institutions
1. Incorporated into the annual full-scope reflects a continuous and dynamic process. As
inspection. In this context, a full-scope table 1 indicates, the methodology consists of
inspection involves the analysis of data suffi- six key steps, each of which uses certain written
cient to determine the safety and soundness products to facilitate communication and
of the institution and to assign supervisory coordination.
ratings. The inspection or examination proce-
dures required to arrive at those determina-
tions do not necessarily have to be performed
at the time of the annual inspection; they can
be a product of the collective activities per-
formed throughout the supervisory cycle.
However, inspection procedures should
include follow-up for deficiencies noted in
functional reviews or targeted inspections
and examinations. 10. As discussed in SR-99-17, it is Federal Reserve Sys-
2. Conveyed to the institutions management tem practice to update RFI/C(D) ratings between inspections
to keep them current and to ensure that they reflect the latest
during a close-out or exit meeting with the information on the institutions financial condition. For state
relevant areas line management. The need member banks, Reserve Banks are to refrain from revising
to communicate the findings to senior man- CAMELS ratings based on off-site analysis in view of the
agement or the board of directors is left to emphasis being placed on the CAMELS ratings for imple-
menting risk-based insurance assessments and other supervi-
the judgment of Reserve Bank management, sory initiatives. In accordance with SR-99-17 (see also section
based on the significance of the findings. 5010.4), Reserve Banks should notify the institutions man-
agement whenever the rating is changed as a result of off-site
analysis.
9. A supervisory cycle is the period of time from the close
of one annual examination to the close of the following BHC Supervision Manual January 2007
annual examination. Page 7
Table 1Steps and Products Involved in sion program to meet the characteristics of the
the Risk-Focused Supervision Process organization and to adjusting that program on
an ongoing basis as circumstances change. It is
Steps Products* also essential to clearly understand the Federal
Reserves supervisory role in relation to an insti-
1. Understanding 1. Institutional overview tution and its affiliates. For example, the Federal
the institution Reserves role pertaining to an FBO will vary
2. Assessing the 2. Risk matrix depending on whether the Federal Reserve is
institutions risk 3. Risk assessment the home- or host-country supervisor for the
3. Planning and 4. Supervisory plan particular legal entity. Thus, planning and moni-
scheduling 5. Inspection/examination toring are key components.
supervisory program Through increased emphasis on planning and
activities monitoring, supervisory activities can focus on
the significant risks to the institution and on
4. Defining 6. Scope memorandum
related supervisory concerns. Given the techno-
inspection 7. Entry letter
activities logical and market developments within the
financial sector and the speed with which an
5. Performing 8. Functional-inspection institutions financial condition and risk profile
inspection modules can change, it is critical to keep abreast of
procedures
events and changes in risk exposure and strat-
6. Reporting the 9. Inspection report(s) egy. The CPC for each large complex institution
findings should continuously review certain information
* For examples of products 1 through 8, see appendixes D and prepare an institutional overview that will
through K of the Federal Reserves handbook Framework communicate the contacts understanding of that
for Risk-Focused Supervision of Large, Complex Institu- institution.
tions, referred to in SR-97-24. See also appendix B, the bank
holding company nonbank subsidiary risk-assessment ques-
tionnaire, which is discussed in section 2124.01.1.3.2.
2124.01.5.1 Sources of Information
With the exception of the entry letter, the
written products associated with steps 1 through Information generated by the Federal Reserve,
4 are designed to sharpen the supervisory focus other supervisors, the institution, and public
on an institutions business activities that pose organizations may assist the CPC in forming
the greatest risk, as well as to assess the and maintaining an ongoing understanding of
adequacy of the institutions risk-management the institutions risk profile and current condi-
systems to identify, measure, monitor, and con- tion. For example, the Federal Reserve main-
trol risks. The products should be revised as tains a significant amount of financial and struc-
new information is received from such sources ture information in various automated databases.
as the current inspection, recent targeted inspec- In addition, prior inspection and examination
tions and examinations, and periodic reviews of reports are excellent sources of information
regulatory reports. regarding previously identified problems.
The focus of the products should be on fully Each Reserve Bank has various surveillance
achieving a risk-focused, seamless, and coordi- reports that identify outliers when an institution
nated supervisory process. The content and for- is compared with its peer group. The Bank
mat of the products are flexible and should be Holding Company Performance Report and the
adapted to correspond to the supervisory prac- Uniform Bank Performance Report may iden-
tices of the agencies involved and to the struc- tify significant deviations in performance rela-
ture and complexity of the institution. tive to institutions peer groups, currently and
between the inspections and examinations of
those institutions. For branches and agencies,
2124.01.5 UNDERSTANDING THE state member banks, and domestic bank holding
INSTITUTION companies that are part of FBOs, the strength-
of-support assessment (SOSA) rating and rel-
The starting point for risk-focused supervision evant credit assessments from major rating
is developing an understanding of the institu- agencies provide information that needs to be
tion. This step is critical to tailoring the supervi- considered in developing an appropriate super-
visory strategy. For FBOs, the Federal Reserve
BHC Supervision Manual January 2007 has developed automated systems that provide
Page 8 information on foreign financial systems, for-
eign accounting standards, and the financial per- concise document, information demonstrating
formance of FBOs with U.S. operations. an understanding of the institutions present
Leveraging off the work, knowledge, and condition and its current and prospective risk
conclusions of other supervisors is of key profiles. The overview should also highlight key
importance to understanding a large complex issues and past supervisory findings. General
organization. Ongoing contact and the exchange types of information that may be valuable to
of information with other supervisors who have present in the overview are listed below: 10a
responsibilities for a given institution may pro-
vide insights that cannot be obtained from other 1. a brief description of the organizational
sources. Additional information can be obtained structure (with comments on the legal and
from examination reports issued by other super- business units) and changes through merger,
visors and from their databases, for example, acquisition, divestitures, consolidation, or
the OCCs Supervisory Monitoring System charter conversion since the prior review
(SMS) and the FDICs Bank Information Track- 2. a summary of the organizations business
ing System (BITS). strategies, key business lines, product mix,
Using information generated by the institu- marketing emphasis, growth areas, acquisi-
tions management information system tion or divestiture plans, and new products
improves the supervisory process. It provides an introduced since the prior review
efficient way to reduce on-site time, identify 3. key issues for the organization, either from
emerging trends, and remain informed about the external or internal factors (for example, dif-
activities of the institution and financial mar- ficulties in keeping pace with competition or
kets. Information that may be periodically poorly performing business lines)
reviewed by the contact includes the size and 4. an overview of management, commenting on
composition of intra-day balance sheets, inter- the level of board oversight, leadership
nal risk-ratings of loans, internal limits and cur- strengths or weaknesses, policy formulation,
rent risk measures regarding trading activities, and the adequacy of management informa-
and internal limits and measures covering the tion systems (Comments should include
institutions interest-rate and market risk. Addi- anticipated changes in key management,
tionally, functional-organization charts reflect- unusual turnover in line management, and
ing the major lines of business across legal management-succession plans. Key execu-
entities, changes to the organizations strategic tives and the extent of their participation in
plan, and information provided to the board of strategic planning, policy formulation, and
directors and management committees should risk management may also be described.)
be reviewed. 5. a brief analysis of the consolidated financial
The CPC should also hold periodic discus- condition and trends, including earnings,
sions with the institutions management to invested capital, and return on investment by
cover, among other topics, credit-market condi- business line
tions, new products, divestitures, mergers and 6. a description of the future prospects of the
acquisitions, and the results of any recently organization, expectations or strategic fore-
completed internal and external audits. When casts for key performance areas, and budget
other agencies have supervisory responsibilities projections
for the organization, joint meetings should be 7. descriptions of internal and external audit,
considered. including the nature of any special work
Publicly available information may provide performed by external auditors during the
additional insight into an institutions condition. period under review
This information may be particularly valuable in 8. a summary of supervisory activity performed
assessing an organizations ability to raise capi- since the last review, including safety-
tal. Public sources of information include SEC and-soundness inspections, examinations,
reports, press releases, and analyses by private and targeted or specialty inspections or
rating agencies and by securities dealers and
underwriters. 10a. This list is provided in the context of institutions for
which the Federal Reserve is the home-country supervisor. In
the case of an FBO, the analysis should begin with the SOSA
rating and the Summary of Condition of its U.S. operations.
2124.01.5.2 Preparation of the See SR-00-14 and also sections 2124.0.2.5, 2127.0, and
Institutional Overview 3903.0.
The institutional overview should provide an BHC Supervision Manual July 2016
executive summary that communicates, in one Page 9
examinations; supervisory actions and the 6. reputational risk, which is the potential that
institutions degree of compliance; and appli- negative publicity regarding an institutions
cations approved or in process business practices, whether true or not, will
9. considerations for conducting future inspec- cause a decline in the customer base, costly
tions, including the institutions preference litigation, or revenue reductions
for the coordination of specialty inspections
or examinations and combined inspection An institutions business activities present
and examination reports, as well as logistical various combinations and concentrations of the
and timing considerations, including conver- above risks depending on the nature and scope
sion activities, space planning, and manage- of the particular activity. When conducting the
ment availability risk assessment, consideration must be given to
the institutions overall risk environment, the
reliability of its internal risk management, the
2124.01.6 ASSESSING THE adequacy of its information technology systems,
INSTITUTIONS RISKS and the risks associated with each of its signifi-
cant business activities. The preparation of the
In order to focus supervisory activities on the risk matrix provides a structured approach to
areas of greatest risk to an institution, the CPC assessing an institutions risks and is the basis
or designated staff personnel should perform a for preparing the narrative risk assessment. See
risk assessment. The risk assessment highlights sections 4070.1 (SR-95-51) and 4071.0 (SR-16-
both the strengths and vulnerabilities of an insti- 11) for additional guidance on the evaluation of
tution and provides a foundation for determin- an institutions risk management.
ing the supervisory activities to be conducted.
Further, the assessment should apply to the
entire spectrum of risks facing an institution, 2124.01.6.1 Assessment of the Overall
including the following risks: Risk Environment
1. credit risk, which arises from the potential The starting point in the risk-assessment process
that a borrower or counterparty will fail to is an evaluation of the institutions risk toler-
perform on an obligation ance and of managements perception of the
2. market risk, which is the risk to an institu- organizations strengths and weaknesses. Such
tions financial condition resulting from an evaluation should entail discussions with
adverse movements in market rates or prices, management and a review of supporting docu-
such as interest rates, foreign-exchange rates, ments, strategic plans, and policy statements.
or equity prices Management, in general, is expected to have a
3. liquidity risk, which is the potential that an clear understanding of the institutions markets;
institution will be unable to meet its obliga- the general banking, business, and economic
tions as they come due because of an inabil- environment; and how these factors affect the
ity to liquidate assets or obtain adequate institution (in other words, their effect on the
funding (referred to as funding liquidity institutions use of technology, products, and
risk) or because it cannot easily unwind or delivery channels).
offset specific exposures without signifi- The institution should have a clearly defined
cantly lowering market prices because of risk-management structure. This structure may
inadequate market depth or market disrup- be formal or informal, centralized or decentral-
tions (referred to as market liquidity risk) ized. However, the greater the risk assumed by
4. operational risk, which arises from the the institution, the more sophisticated its risk-
potential that inadequate information sys- management system should be. Regardless of
tems, operational problems, breaches in the approach, the types and levels of risk an
internal controls, fraud, or unforeseen catas- institution is willing to accept should reflect the
trophes will result in unexpected losses risk appetite determined by its board of
5. legal risk, which arises from the potential directors.
that unenforceable contracts, lawsuits, or
adverse judgments can disrupt or otherwise
negatively affect the operations or condition 2124.01.6.1.1 Internal-Risk-Management
of a banking organization Evaluation

In assessing the overall risk environment, the
Page 10 CPC should make a preliminary evaluation of
the institutions internal risk management. That range of a banking organizations activities to
includes an assessment of the adequacy of the determine the level and trend of consumer com-
institutions internal audit, loan-review, and pliance risk. To address the risks identified in an
compliance functions. External audits also pro- organizations business activities, the supervi-
vide important information regarding the risk sory team will develop a supervisory plan that
profile and condition of the institution and may includes activities appropriate to the level of the
be used in the risk assessment. In completing organizations consumer compliance risk.
this evaluation, Reserve Banks should consi-
der holding meetings with the external auditor Supervisory framework for consumer compli-
and senior management who are responsible for ance risk. For LCBOs and LBOs that are subject
internal audit, loan review, and compliance, to the Systems continuous supervision pro-
as well as with other key risk managers. gram, safety-and-soundness examiners are to
As appropriate, the meetings should be held incorporate an assessment of consumer compli-
jointly with a representative from other super- ance risk into the overall risk assessment and
visory agencies that have an interest in the planned supervisory activities for these organi-
institution. zations. When performing the consumer compli-
In addition, the CPC or designated staff per- ance risk assessment, consumer compliance
sonnel should consider reviewing risk assess- examiners are to rely, to the extent possible, on
ments developed by the internal audit depart- the work conducted by the dedicated supervi-
ment for significant lines of business, and then sory team or primary bank regulator, and expand
compare their results with the supervisory risk that analysis to focus on consumer compliance
assessment. Further, the CPC should consider risk. The consumer compliance risk assessment
evaluating managements ability to aggregate is to include a determination of the level of
risks on a global basis. Examiners can use this consumer compliance risk (high, moderate, or
preliminary evaluation to determine how much low), taking into consideration the internal con-
they can rely on the institutions internal risk trol and review processes in place to mitigate
management when developing their scope of the inherent risk. In addition, the risk assess-
inspection and examination activities. ment is to include a determination of the direc-
tion of consumer compliance risk (increasing,
stable, or decreasing). The consumer compli-
2124.01.6.1.2 Supervision Program for ance examiner is to discuss the identified areas
Consumer Compliance Risk Assessment at of significant consumer compliance risk with
BHCs the CPC. In addition, in coordination with the
CPC and the supervisory team, the consumer
Changes in the banking and financial services compliance examiner is to evaluate how con-
industry have highlighted the importance of sumer compliance risk affects the reputational,
incorporating an assessment of consumer com- legal, and operational risk profiles of the LCBO
pliance risk into the evaluation of a banking or LBO. The CPC will then incorporate this
organizations overall risk profile. To address information and the assessment of consumer
this need, the Federal Reserve enhanced its bank compliance risk into the LCBOs or LBOs
holding company supervision program to ensure overall risk assessment.
that examiners are focusing appropriately on The consumer compliance examiner and the
consumer compliance riskrelated matters CPC will determine, on a case-by-case basis,
across the broad range of a BHCs activities. whether and what type of supervisory activities
(See SR-03-22.) should be included in the organizations super-
An enhanced supervisory framework for the visory plan. The planned supervisory activities
supervision of consumer compliance risk was will vary depending on the nature and level of
developed for large complex banking organiza- an organizations consumer compliance risk.
tions (LCBOs) and for large banking organiza- The CPC and the consumer compliance
tions (LBOs). 10b Under the framework, con- examiner will coordinate with other regulators
sumer compliance examiners are to assess before communicating their findings to the
consumer compliance risk across the broad banking organizations management. This coor-
dination should help to ensure a seamless pro-
cess in which consistent messages are delivered
10b. The Boards Division of Banking Supervision and
Regulation and its Division of Consumer and Community
to LCBO or LBO management.
Affairs developed the consumer compliance risk assessment
framework. The supervisory approach does not apply to shell BHC Supervision Manual January 2007
BHCs. Page 10.1
2124.01.6.1.3 Adequacy of Information risks, examiners must work with specialists to

Technology Systems assess the adequacy of the information technol-
ogy system and the extent to which it can be
Effective risk monitoring requires institutions to relied upon. Evaluating the integrity of the infor-
identify and measure all material risk exposures. mation in reports for business managers requires
Consequently, risk-monitoring activities must be an understanding of the information flows and
supported by management information systems the control environment for the operation.
(MIS) that provide senior managers and direc- Knowledge of the business application is essen-
tors with timely and reliable reports on the tial to determine whether the information flows
financial condition, operating performance, and are complete, accurate, and appropriate in a
risk exposure of the consolidated organization. particular MIS. In addition, such a determina-
Such systems must also provide managers tion requires an assessment of the extent to
engaged in the day-to-day management of the which the institutions internal audit function
organizations activities with regular and suffi- has procedures in place for reviewing and test-
ciently detailed reports for their areas of respon- ing the effectiveness of the processes and inter-
sibility. Moreover, in most large complex insti- nal controls related to information technology
tutions, MIS not only provides reporting systems.
systems but also supports a broad range of busi-
ness decisions through sophisticated risk-
management and decision tools, such as credit
scoring and asset/liability models and automated
trading systems. Accordingly, the institutions
risk assessment must consider the adequacy of
information technology systems.
Institutions need to determine which business
unit or units are responsible for the development
and operation of the information technology
system. Traditionally, such systems were largely
centered on mainframe computers. However, the
development of increasingly powerful and inex-
pensive personal computers and sophisticated
network communication capabilities has given
institutions more timely access to a greater vol-
ume of information that supports a broader
range of business decisionsmoving some
transaction processing out of the mainframe
environment. Consequently, many large institu-
tions are transferring responsibility for develop-
ment and operation of the hardware (generally, a
local area or wide area network) and the related
operating systems and applications from a
centralized, mainframe function to individual
business units. Many of these institutions are
also integrating the information technology
audit function with the general internal audit
function.
Once it has been determined which business
units are responsible for information technol-
ogy, a fuller understanding of the risk profile of
specific functions and of the consolidated orga-
nization can be gained through close coordina-
tion between information systems specialists
and safety-and-soundness examiners. Since
business managers must have MIS reports that
are sufficient and appropriate for identifying

Page 10.2
2124.01.6.2 Preparation of the Risk 2124.01.6.2.2 Type and Level of Inherent

Matrix Risk of Significant Activities
A risk matrix is used to identify significant After the significant activities are identified, the
activities, the type and level of inherent risks in type and level of risk inherent in those activities
these activities, and the adequacy of risk man- should be determined. Types of risk may be
agement over these activities, as well as to deter- categorized according to section 4070.1.2 and
mine composite risk assessments for each of SR-95-51 (as amended by SR-04-18), or by
these activities and the overall institution. A risk using categories defined either by the institution
matrix can be developed for the consolidated or other supervisory agencies. If the institution
organization, for a separate affiliate, or along uses risk categories that differ from those
functional business lines. The matrix is a flex- defined by the supervisory agencies, the exam-
ible tool that documents the process followed to iner should determine if all relevant types of
assess the overall risk of an institution and is a risk are appropriately captured. If risks are
basis for preparation of the narrative risk appropriately captured by the institution, the
assessment. examiner should use the categories identified by
the institution.
Table 2 illustrates risk types as defined by the
Federal Reserve and the OCC. This table is
designed to show the relationship between the
2124.01.6.2.1 Identification of Significant respective agencies risk categories.
Activities
Activities and their significance can be identi-

fied by reviewing information from the institu- Table 2Types of Risk
tion, the Reserve Bank, or other supervisors.
Information generated by the institution may Federal Reserve OCC
include the balance sheet, off-balance-sheet
Credit Credit
reports, the income statement, management
accounting reports, or any other report that is Market Price
prepared for the institutions board of directors Interest rate
and senior management to monitor performance. Foreign exchange
A detailed income statement is particularly Liquidity Liquidity
informative because it reflects significant activi- Reputational Reputation
ties and their relative importance to the institu- Operational Transaction
tions revenue and net income. The income
statement also yields information regarding the Legal Compliance
relationship between the return on individual Strategic*
assets and the inherent risk associated with these * Elements of strategic risk are reflected in each of the risk
assets, providing an important indicator of the categories as defined by the Federal Reserve.
institutions overall risk appetite.
Off-site surveillance information is another For the identified functions or activities, the
source of information that can be used to iden- inherent risk involved in that activity should be
tify new or expanding business activities. For described as high, moderate, or low for each
example, substantial growth in the loan port- type of risk associated with it. For example, it
folio may indicate that the institution has intro- may be determined that a portfolio of commer-
duced a new lending activity. cial loans in a particular institution has high
In addition to financial factors, information credit risk, moderate market risk, moderate
on strategic plans, new products, and possible liquidity risk, low operational risk, low legal
management changes needs to be considered. risk, and low reputational risk. The following
The competitive climate in which the institution definitions apply:
operates is important and should be assessed in
the identification of significant activities. Indus- 1. High inherent risk exists when (1) the activ-
try segmentation and the position the institution ity is significant or positions are large in
occupies within its markets should also be
considered.
Page 11
relation to the institutions resources or to its strength should be characterized as strong,

peer group, (2) there are a substantial num- acceptable, or weak as defined below:
ber of transactions, or (3) the nature of the
activity is inherently more complex than nor- 1. Strong risk management indicates that man-
mal. Thus, the activity could potentially agement effectively identifies and controls
result in a significant and harmful loss to the all major types of risk posed by the BHCs
organization. activities. Management is fully prepared to
2. Moderate inherent risk exists when (1) posi- address risks emanating from new products
tions are average in relation to the institu- and changing market conditions. The board
tions resources or to its peer group, (2) the and management are forward looking and
volume of transactions is average, and (3) the active participants in managing risk. Man-
activity is more typical or traditional. Thus, agement ensures that appropriate policies and
while the activity could potentially result in a limits exist and are understood, reviewed,
loss to the organization, the loss could be and approved by the board. Policies and lim-
absorbed by the organization in the normal its are supported by risk-monitoring proce-
course of business. dures, reports, and management information
3. Low inherent risk exists when the volume, systems that provide management and the
size, or nature of the activity is such that board with the information and analysis nec-
even if the internal controls have weak- essary to make timely and appropriate deci-
nesses, the risk of loss is remote or, if a loss sions in response to changing conditions.
were to occur, it would have little negative Risk-management practices and the organi-
impact on the institutions overall financial zations infrastructure are flexible and highly
condition. responsive to changing industry practices and
current regulatory guidance. Staff has suffi-
cient experience, expertise, and depth to
It is important to remember that this assessment manage the risks assumed by the institution.
of risk is made without considering manage- Internal controls and audit procedures are
ment processes and controls. Those factors are sufficiently comprehensive and appropriate
considered in evaluating the adequacy of the to the size and activities of the institution.
institutions risk-management systems. There are few noted exceptions to the institu-
tions established policies and procedures,
and none is material. Management effec-
2124.01.6.2.3 Risk-Management tively and accurately monitors the condition
Adequacy Assessment for Significant of the institution consistent with the stan-
Activities dards of safety and soundness and in accor-
dance with internal and supervisory policies
When assessing the adequacy of an institutions and practices. Risk-management processes
risk-management systems for identified func- are fully effective in identifying, monitoring,
tions or activities, the CPC or designated staff and controlling the risks to the institution.
personnel should place primary consideration 2. Acceptable risk management indicates that
on findings related to the following key ele- the institutions management of risk is
ments of a sound risk-management system: largely effective but lacking in some modest
degree. Management demonstrates a respon-
1. active board and senior management over- siveness and ability to cope successfully with
sight existing and foreseeable risks that may arise
2. adequate policies, procedures, and limits in carrying out the institutions business plan.
3. adequate risk-management, risk-monitoring, While the institution may have some minor
and management information systems risk-management weaknesses, these prob-
lems have been recognized and are in the
4. comprehensive internal controls process of being resolved. Overall, board and
senior management oversight, policies and
Taking these key elements into account, the limits, risk-monitoring procedures, reports,
contact should assess the relative strength of the and management information systems are
risk-management processes and controls for considered satisfactory and effective in main-
each identified function or activity. Relative taining a safe and sound institution. Risks are
controlled in a manner that does not require
BHC Supervision Manual July 2005 more-than-normal supervisory attention.
Page 12 The BHCs risk-management practices
and infrastructure are satisfactory and gener- 4070.1.2 (See SR-04-18 and SR-95-51) that
ally are adjusted appropriately in response to examiners are to use to rate an institutions
changing industry practices and current regu- overall risk management. However, unlike the
latory guidance. Staff experience, expertise, overall risk-management rating, the assessment
and depth are generally appropriate to man- of the adequacy of risk-management systems
age the risks assumed by the institution. incorporated into the risk matrix is to be used
Internal controls may display modest primarily for planning supervisory activities. In
weaknesses or deficiencies, but they are cor- addition, because the risk matrix is prepared
rectable in the normal course of business. during the planning process, it generally would
The examiner may have recommendations not be appropriate to make fine gradations in the
for improvement, but the weaknesses noted strength of risk-management systems on a
should not have a significant effect on the function-by-function basis. In particular, for pur-
safety and soundness of the institution. poses of rating an institutions overall risk man-
3. Weak risk management indicates that risk- agement, section 4070.1.2 (SR-04-18 and SR-
management practices are lacking in some 95-51) makes distinctions in degrees of
important ways and, therefore, are a cause weaknessfair, marginal, and unsatisfactory
for more-than-normal supervisory attention. that generally cannot be made appropriately on
One or more of the four elements of sound a function-by-function basis, as called for when
risk management11 (active board and senior preparing the risk matrix. After appropriate
management oversight; adequate policies, inspection and examination procedures are per-
procedures, and limits; adequate risk- formed, the assessment of the institutions risk
management monitoring and management management that was prepared for the risk
information systems; comprehensive internal matrix may be a starting point for assigning
controls) are considered less than acceptable an overall risk-management rating for the
and have precluded the institution from fully institution.
addressing one or more significant risks to its
operations. Certain risk-management prac-
tices are in need of improvement to ensure
that management and the board are able to 2124.01.6.2.4 Composite Risk Assessment
identify, monitor, and control all significant of Significant Activities
risks to the institution. Also, the risk-
management structure may need to be The composite risk for each significant activity
improved in areas of significant business is determined by balancing the overall level of
activity, or staff expertise may not be com- inherent risk of the activity with the overall
mensurate with the scope and complexity of strength of risk-management systems for that
business activities. In addition, manage- activity. For example, commercial real estate
ments response to changing industry prac- loans usually will be determined to be inher-
tices and regulatory guidance may need to ently high risk. However, the probability and the
improve. magnitude of possible loss may be reduced by
The internal control system may be lack- having very conservative underwriting stan-
ing in some important aspects, particularly as dards, effective credit administration, strong
indicated by continued control exceptions or internal loan review, and a good early-warning
by a failure to adhere to written policies and system. Consequently, after accounting for these
procedures. The risk-management weak- mitigating factors, the overall risk profile and
nesses could have adverse effects on the level of supervisory concern associated with
safety and soundness of the institution if commercial real estate loans may be moderate.
corrective action is not taken by Table 3 provides guidance on assessing the com-
management. posite risk of an activity by balancing the
observed quantity and degree of risk with the
The definitions above apply to the risk man- perceived strength of related management pro-
agement of individual functions or activities. cesses and internal controls.
They parallel the definitions set forth in section To facilitate consistency in the preparation of
the risk matrix, general definitions of the com-
posite level of risk for significant activities are
11. See SR-04-18,Bank Holding Company Rating Sys- provided below.
tem, which amended the rating definitions of SR-95-51,
Rating the Adequacy of Risk Management Processes and
Internal Controls at State Member Banks and Bank Holding BHC Supervision Manual July 2005
Companies. Page 13
Table 3Composite Risk for Significant 2124.01.6.2.5 Overall Composite Risk

Activities Assessment
Once the examiner has assessed the composite
Inherent risk of the activity
Risk- risk of each identified significant activity or
management Low Moderate High function, an overall composite risk assessment
systems should be made for off-site analytical and plan-
Composite risk assessment ning purposes. This assessment is the final step
in the development of the risk matrix; the evalu-
Weak Low or Moderate High ation of the overall composite risk is incorpo-
moderate or high rated into the written risk assessment.
Acceptable Low Moderate High
Strong Low Low or Moderate
moderate or high 2124.01.6.2.6 Preparation of the Risk
Assessment
1. A high composite risk generally would be A written risk assessment should be prepared to
assigned to an activity when the risk- serve as an internal supervisory planning tool
management system does not significantly and to facilitate communication with other
mitigate the high inherent risk of the activity. supervisors. A sample risk assessment is pro-
Thus, the activity could potentially result in a vided below. The goal is to develop a document
financial loss that would have a significant that presents a comprehensive risk-focused view
negative impact on the organizations overall of the institution. The risk assessment delineates
conditionin some cases, even where the the areas of supervisory concern and is a plat-
systems are considered strong. For an activ- form for developing the supervisory plan.
ity with moderate inherent risk, a risk- The format and content of the written risk
management system that has significant assessment are flexible and should be tailored to
weaknesses could result in a high composite the individual institution. The risk assessment
risk assessment, because management reflects the dynamics of the institution and,
appears to have an insufficient understanding therefore, should consider the institutions
of the risk and an uncertain capacity to evolving business strategies and be amended as
anticipate and respond to changing significant changes in the risk profile occur. It
conditions. should include input from other affected super-
visors and specialty units to ensure that all sig-
2. A moderate composite risk generally would nificant risks of the institution are identified.
be assigned to an activity with moderate The risk assessment should
inherent risk where the risk-management
systems appropriately mitigate the risk. For 1. include an overall risk assessment of the
an activity with a low inherent risk, signifi- organization;
cant weaknesses in the risk-management 2. describe the types of risks (credit, market,
system may result in a moderate composite liquidity, reputational, operational, legal),
risk assessment. On the other hand, a strong their level (high, moderate, low), and the
risk-management system may reduce the direction (increasing, stable, decreasing) of
risks of an inherently high-risk activity so risks;
that any potential financial loss from the 3. identify all major functions, business lines,
activity would have only a moderate nega- activities, products, and legal entities from
tive impact on the financial condition of the which significant risks emanate, and identify
organization. the key issues that could affect the risk pro-
3. A low composite risk generally would be file;
assigned to an activity that has low inherent 4. consider the relationship between the likeli-
risks. An activity with moderate inherent risk hood of an adverse event and the potential
may be assessed a low composite risk where impact on an institution (for example, the
internal controls and risk-management sys- likelihood of a computer system failure may
tems are strong and effectively mitigate much be remote, but the financial impact could be
of the risk. significant); and
5. describe the institutions risk-management
BHC Supervision Manual July 2005 systems. Reviews and risk assessments per-
Page 14 formed by internal and external auditors
should be discussed, as should the ability of 2124.01.7.1 Preparation of the

the institution to take on and manage risk Supervisory Plan
prospectively.
A comprehensive supervisory plan should be
The CPC should attempt to identify and report developed annually and updated as appropriate
the cause of unfavorable trends, as well as their for the consolidated organization.13 The plan
symptoms. Also, it is very important that the should demonstrate the supervisory concerns
risk assessment reflect a thorough, detailed identified through the risk-assessment process
analysis that supports the conclusions made and how the deficiencies noted in the previous
about the institutions risk profile. inspection or examination are being or will be
addressed. To the extent that the institutions
risk-management systems are adequate, the
level of supervisory activity may be adjusted.
The plan should generally address the following
2124.01.7 PLANNING AND
areas:
SCHEDULING SUPERVISORY
ACTIVITIES
1. All supervisory activities to be conducted,
the scope of those activities (full or targeted),
The supervisory plan is a bridge between the the objectives of those activities (for exam-
institutions risk assessment, which identifies ple, review of specific business lines, prod-
significant risks and supervisory concerns, and ucts, support functions, legal entities), and
the supervisory activities to be conducted. In specific concerns regarding those activities,
developing the supervisory plan and inspection if any. Consideration should be given to
and examination schedules, the CPC should a. prioritizing supervisory resources on areas
minimize disruption to the institution and, of higher risk,
whenever possible, avoid duplicative inspection b. pooling examiner resources to reduce bur-
and examination efforts and requests for infor- den and redundancies,
mation from other supervisors.12 c. maximizing the use of examiners located
The institutions organizational structure and where the activity is being conducted,
complexity are significant considerations in d. coordinating examinations of different
planning the specific supervisory activities to be disciplines,
conducted. Additionally, interstate banking and e. determining compliance with or the
branching activities have implications for plan- potential for supervisory action, and
ning on-site and off-site reviews. The scope and f. balancing mandated requirements with the
location of on-site work for interstate banking objectives of the plan.
operations will depend on the significance and 2. General logistical information (for example,
risk profile of local operations, the location of timetable of supervisory activities, partici-
the supervised entitys major functions, and the pants, and expected resource requirements).
degree of its centralization. Consistent with the 3. The extent to which internal and external
Federal Reserve practice of not examining each audit, internal loan review, compliance, and
branch of an intrastate branching network, the other risk-management systems will be tested
bulk of safety-and-soundness examinations for and relied upon.
branches of an interstate bank would likely be
conducted at the head office or regional offices, The planning horizon to be covered by the
supplemented by periodic reviews of branch plan is generally 18 months for domestic institu-
operations and internal controls. The supervi- tions.14 The overall supervisory objectives and
sory plan should reflect the need to coordinate basic framework need to be outlined by midyear
these reviews of branch operations with other
supervisors.
13. The supervisory plan is a high-level plan of supervi-
sory activities to be conducted in monitoring the consolidated
organization. More-detailed procedures for a specific on-site
inspection are appropriately addressed in a scope memoran-
12. See section 5000.0.8.3 and SR-93-30, Interagency
dum, which is discussed in section 2124.01.8.
Policy Statements on Supervisory Initiatives, and its attach-
14. The examination plans and assessments of condition of
ments for guidance on examination coordination of holding
U.S. operations that are used for FBO supervision use a
company inspections with subsidiary bank and thrift examina-
12-month period.
tions. See SR-00-14, Enhancements to the Interagency Pro-
gram for Supervising the U.S. Operations of Foreign Banking
Organizations, regarding coordination with other agencies as BHC Supervision Manual July 2006
part of the FBO supervision program. Page 15
to facilitate preliminary discussions with other fied in the scope memorandum, should be ori-
supervisors and to coincide with planning for ented to a top-down approach that includes a
the Federal Reserves scheduling conferences. review of the organizations internal risk-
The plan should be finalized by the end of the management systems and an appropriate level
year, for execution in the following year. of transaction testing. The risk-focused method-
ology provides flexibility in the amount of
on-site transaction testing. Although the focus
2124.01.7.2 Preparation of the Inspection of the inspection or examination is on the insti-
or Examination Program tutions processes, an appropriate level of trans-
action testing and asset review will be necessary
The inspection or examination program should to verify the integrity of internal systems. If
provide a comprehensive schedule of inspection internal systems are considered reliable, then
or examination activities for the entire organiza- transaction testing should be targeted to a level
tion and aid in the coordination and communica- sufficient to validate that the systems are effec-
tion of responsibilities for supervisory activities. tive and accurate. Conversely, if internal man-
An inspection or examination program provides agement systems are deemed unreliable or inef-
a comprehensive listing of all inspection and fective, then transaction testing must be adjusted
examination activities to be conducted at an to increase the amount of coverage. The entry
institution for the given planning horizon. To letter identifies the information necessary for the
prepare a complete program and to reflect the successful execution of the on-site inspection or
current conditions and activities of an institution examination procedures.
and the activities of other supervisors, the CPC
needs to be the focal point for communications
on a particular institution, including any com- 2124.01.8.1 Scope Memorandum
munications with the Federal Reserve and the
institutions management and other supervisors. After the areas to be reviewed have been identi-
The inspection or examination program should fied in the supervisory plan, a scope memoran-
generally incorporate the following logistical dum should be prepared that documents specific
elements: objectives for the projected inspection or exami-
nation. This document is of key importance, as
1. a schedule of activities, the duration of time, the scope will likely vary from year to year.
and resource estimates for planned projects Thus, it is necessary to identify the specific
2. an identification of the agencies conducting areas chosen for review and the extent of those
and participating in the supervisory activity reviews. The scope memorandum will help
(when conducted jointly with other agencies, ensure that the supervisory plan for the institu-
indicate the lead agency and the agency tion is executed, and it will define and commu-
responsible for a particular activity) and the nicate those specific objectives to the inspection
resources committed by all participants to or examination staff.
the area(s) under review The scope memorandum should be tailored to
3. the planned product for communicating find- the size, complexity, and current rating of the
ings (indicate whether it will be a formal institution subject to review. For large but less-
report or supervisory memorandum) complex institutions, the scope memorandum
4. the need for special examiner skills and may be combined with the supervisory plan or
the extent of participation by specialty risk assessment. The scope memorandum should
disciplines generally include
1. a statement of the objectives;

2124.01.8 DEFINING INSPECTION OR 2. an overview of the activities and risks to be
EXAMINATION ACTIVITIES evaluated;
3. the level of reliance on internal risk-
The scope memorandum is an integral product management systems and internal or exter-
in the risk-focused methodology. The memoran- nal audit findings;
dum identifies the key objectives of the on-site 4. a description of the procedures that are to be
inspection or examination. The focus of on-site performed, indicating any sampling process
inspection or examination activities, as identi- to be used and the level of transaction test-
ing, when appropriate;
BHC Supervision Manual July 2006 5. identification of the procedures that are
Page 16 expected to be performed off-site; and
6. a description of how the findings of targeted

reviews, if any, will be used on the current
inspection or examination.

Page 16.1
2124.01.8.2 Entry Letter reports should be used in all instances.

If they do not provide sufficient information to
Standardized entry inspection and examination inspect or examine the institution, then it would
letters have been developed that are closely appear that management is not adequately
aligned with the risk-focused approach for large informedthis may well be the first inspection
complex institutions.15 The letters are designed or examination finding. As specific items are
to reduce the institutions paperwork burden. selected for inclusion in the entry letter, the
The entry letters include a core section of following guidelines for items should be
required information that is pertinent to all large considered:
institutions, regardless of size or complexity. In
addition to the core requests, supplementary 1. Reflect risk-focused supervision objectives
questionnaires should be used as needed for the and the inspection or examination scope.
specialized areas such as asset securitization/ Items that are not needed to support selected
sales, information systems, private banking, inspection or examination procedures should
securities clearance/lending, trading activities, not be requested.
and transfer risk. The cover letters must be used 2. Facilitate efficiency in the inspection or
(but can be modified), as they provide specific examination process and lessen the burden
guidance to the inspected or examined on financial institutions. Minimize the num-
institution. ber of requested items and avoid, to the
The entry letters direct management to pro- extent possible, duplicate requests for infor-
vide written responses to questions and to pro- mation already provided to other agencies.
vide copies of specific documents requested, but 3. Limit, to the extent possible, requests for
only if the requested information is new or has special management reports.
changed since the previous examination or 4. Eliminate items used for audit-type proce-
inspection. Examiners should not request that dures. Such procedures (for example, verifi-
management provide them with copies of the cations) are generally performed only when
institutions regulatory reports that are available there is a reason to suspect that significant
within each Federal Reserve Bank or from other problems exist.
bank regulatory agencies, such as regulatory 5. Distinguish information to be mailed to the
inspection and examination reports and various examiner-in-charge for off-site inspection or
financial information (for example, annual examination procedures from information to
reports or Call Reports). These reports should be held at the institution for on-site proce-
be gathered from internal sources during the dures. Information that is not easily repro-
pre-examination planning process. Also, entry duced should be reviewed on-site (for exam-
letters should not request information that is ple, policies, corporate minutes, or audit
regularly provided to designated CPCs. The workpapers).
examiner-in-charge should always review 6. Allow management sufficient lead time to
anticipated information and document needs prepare the requested information.
with the CPC for the inspected or examined
institution before the mailing of any entry letter.
The entry letters should be used as a starting 2124.01.9 PERFORMING
point, or template, in preparing for an examina- INSPECTION OR EXAMINATION
tion or inspection. They should be tailored dur- PROCEDURES
ing the planning process to fit the specific char-
acter and profile of the institution to be Inspection or examination procedures should be
inspected or examined and the scope of the tailored to the characteristics of each institution,
activities to be performed. Thus, the effective keeping in mind its size, complexity, and risk
use of entry letters is highly dependent on the profile. The procedures should focus on devel-
planning and scoping of a risk-focused inspec- oping appropriate documentation to adequately
tion or examination. assess managements ability to identify, mea-
The entry letters request internal management sure, monitor, and control risks. Procedures
information reports for each of the key inspec- should be completed to the degree necessary to
tion or examination areas. Internal management determine whether the institutions management
understands and adequately controls the levels
15. Such entry letters should be used for a (1) combined
and types of risks that are assumed. In terms of
bank holding company inspection and lead state member bank
examination, (2) bank holding company inspection (see BHC Supervision Manual July 2005
appendix B), and (3) state member bank examination. Page 17
transaction testing, the volume of transactions 2124.01.10 REPORTING THE

tested should be adjusted according to manage- FINDINGS
ments ability to accurately identify problem
and potential problem transactions and to mea- After performing the inspection or examination
sure, monitor, and control the institutions risk procedures, examiners should document their
exposure. Likewise, the level of transaction test- overall conclusions. Conclusions, as they relate
ing for compliance with laws, regulations, and to the functional area under review, should
supervisory policy statements should take into clearly communicate the examiners assessment
account the effectiveness of management sys- of the internal risk-management system, the
tems to monitor, evaluate, and ensure financial condition, and compliance with laws
compliance. and regulations.
Most full-scope inspections or examinations Inspection and examination activities should
are expected to include the examiners evalua- be coordinated with the respective state and
tion of 10 functional areas during the supervi- other federal banking authorities, with joint
sory cycle. There may be a need to identify and examinations performed and joint inspection
include additional functional areas. To evaluate and examination reports completed wherever
these functional areas, examiners must perform practicable. The inspection and examination
procedures tailored to fit (1) the risk assessment activities should be planned over the supervi-
prepared for the institution and (2) the scope sory cycle, culminating with an annual full-
memorandum. These functional areas represent scope inspection or examination of the organiza-
the primary business activities and functions of tion. As part of the FBO supervision program,
large complex institutions, as well as common individual examination findings are integrated
sources of significant risk to them. Further, con- into an assessment of the FBOs entire U.S.
sistent with the risk-focused approach, examin- operations.
ers are expected to evaluate other areas that are
The results of a targeted, subsidiary, or spe-
significant sources of risk to an institution or
cialty inspection or examination are usually
that are central to the assignment of CAMELS,
reported to the institutions management in a
RFI/C(D), and ROCA ratings. The identified
separate report or supervisory letter. Therefore,
functional areas include the following:
the report for the annual full-scope inspection of
the consolidated parent organization should
1. loan-portfolio analysis (portfolio manage- include a summary of the relevant results of any
ment, loan review, consumer compliance, preceding supervisory activity. When targeted
allowance for loan and lease losses) or specialty inspections or examinations of
2. treasury activities (asset-liability manage- affiliates are conducted concurrently with the
ment, interest-rate risk, parent company annual full-scope inspection of the consolidated
liquidity, funding, investments, deposits) parent organization, the findings from the tar-
3. trading and capital-markets activities (for- geted, consumer compliance, or specialty
eign exchange, commodities, equities, and examinations (fiduciary, insurance, information
other interest-rate risk; credit risk; and technology, etc.) should be incorporated into the
liquidity risk) parents inspection report in lieu of separate
4. audit and internal control review reports, unless the institutions management
requests separate reports. For organizations in
5. final assessment of supervisory ratings
which the lead bank is a state member bank, the
(CAMELS, RFI/C(D), ROCA, or other)
annual full-scope examination report should be
6. information systems combined with the bank holding company
7. insurance and fiduciary activities inspection report, as appropriate. The bank hold-
8. private banking ing company inspection report, or combined
9. retail banking activities (new products and inspection/examination report, may also include
delivery systems) other bank and nonbank subsidiary
examinations, according to the organizations
10. payments system risk (wire transfers,
supervisory plan.
reserves, settlement)
The contents of the report should clearly and
concisely communicate to the institutions man-
agement or to the directorate any supervisory
issues, problems, or concerns related to the
BHC Supervision Manual July 2005 institution, as well as disclose the assigned
Page 18
supervisory rating.16 The report should also agements ability to identify, measure, monitor,
include appropriate comments regarding defi- and control risks.17 The rating assigned should
ciencies noted in the institutions risk- reflect the adequacy of the institutions risk-
management systems. Accordingly, the descrip- management systems in light of the amount and
tions accompanying each component of the types of risks that the institution has taken on.
CAMELS rating system should emphasize man-
16. See section 5010.4 and SR-96-26 for additional 17. See SR-96-38 for additional information on the revised
information. CAMELS rating system.
2124.01.11 APPENDIX ARISK-FOCUSED SUPERVISORY LETTERS AND BHC

SUPERVISION MANUAL SECTION NUMBERS
BHCSM
SR-letter SR-letter title
section no.
SR-16-11 Supervisory Guidance for Assessing Risk Management at Super- 4071.0

vised Institutions with Total Consolidated Assets Less Than $50
Billion
SR-14-4 Examiner Loan Sampling Requirements for State Member Bank 2010.2
and Credit Extending Nonbank Subsidiaries of Banking
Organizations with $10-$50 Billion in Total Consolidated Assets
SR-14-3 Supervisory Guidance on Dodd-Frank Act Company-Run Stress 4069.1
Testing for Banking Organizations with Total Consolidated Assets
of More Than $10 Billion but Less Than $50 Billion
SR-13-24 Managing Foreign Exchange Settlement Risks for Physically 2124.05
Settled Transactions
SR-13-23 Risk Transfer Considerations When Assessing Capital Adequacy 2124.05
Supplemental Guidance on Consolidated Supervision Framework
for Large Financial Institutions (SR letter 12-17/CA letter 12-14)
SR-13-21 Inspection Frequency and Scope Requirements for Bank Holding 5000.0.4.2
Companies and Savings and Loan Holding Companies with Total
Consolidated Assets of $10 Billion or Less
SR 13-19/CA 13-21 Guidance on Managing Outsourcing Risk 2124.3
SR-13-8/CA-13-5 Extension of the Use of Indicative Ratings for Savings and Loan 5000.0.4.3.1
Holding Companies
SR-13-3 Interagency Guidance on Leveraged Lending 2010.2.3.1
SR-12-17 Consolidated Supervision Framework for Large Financial 2124.05
Institutions
SR-12-15 Investing in Securities without Reliance on Nationally Recognized 2126.2
Statistical Rating Organization Ratings
SR 11-11/CA 11-5 Supervision of Savings and Loan Holding Companies (SLHCs) 2500.0
SR 09-4 Applying Supervisory Guidance and Regulations on the Payment 4060.9
of Dividends, Stock Redemptions, and Stock Repurchases at Bank
Holding Companies
SR-08-9/ Consolidated Supervision of Bank Holding Companies and the 1050.0
CA-08-12 Combined U.S. Operations of Foreign Banking Organizations
SR-08-8/ Compliance Risk-Management Programs and Oversight at 2124.08
CA-08-12 Large Banking Organizations with Complex Compliance Profiles
SR-07-01 Concentrations in Commercial Real Estate, Interagency 2010.2
Guidance on

Page 19
BHCSM
section no.
SR-06-15/ Interagency Guidance on Nontraditional Mortgage Product Risks 3070.3

CA-06-12
SR-05-11 Interagency Credit Risk-Management Guidance for Home Equity 2010.2
Lending
SR-04-18 Bank Holding Company Rating System (Revised) 4070.0
SR-03-22 Framework for Assessing Consumer Compliance Risk at Bank 2124.01.6.1.2
Holding Companies
SR-03-5 Interagency Policy Statement on the Internal Audit Function and 2060.05.06
Its Outsourcing
SR-03-4 Risk Management and Valuation of Mortgage Servicing Assets 3070.0
Arising from Mortgage Banking Activities
SR-02-20 The Sarbanes-Oxley Act of 2002 2060.05
SR-02-5 Interagency Guidance on Country Risk Management 4090.0
SR-00-17 Guidance on the Risk Management of Outsourced Technology 2124.1
Services
SR-00-14 Enhancements to the Interagency Program for Supervising the 2124.0
U.S. Operations of Foreign Banking Organizations
SR-00-13 Framework for Financial Holding Company 3900.0
Supervision
SR-99-37 Risk Management and Valuation of Retained 2128.06
Interests Arising from Securitization Activities
SR-99-17 Supervisory Ratings for State Member Banks, Bank Holding
Companies, and Foreign Banking Organizations, and Related
Requirements for the National Examination Data System
SR-99-6 Subprime Lending 2128.08
SR-99-3 Supervisory Guidance Regarding Counterparty Credit Risk 2126.3
Management
SR-98-18 Lending Standards for Commercial Loans 2122.0
SR-98-12 FFIEC Policy Statement on Investment Securities and End-User 2126.1
Derivatives Activities
SR-98-9 Assessment of Information Technology in the Risk-Focused 2124.1
Frameworks for the Supervision of Community Banks and Large
SR-97-24 Risk-Focused Framework for Supervision of Large Complex 2124.01
Institutions
SR-97-21 Risk Management and Capital Adequacy of Exposures Arising 2129.05
from Secondary Market Credit Activities
SR-96-38 Uniform Financial Institution Rating System (CAMELSadding 4020.9,
the S for risk management) 4070.0.4,
4080.0
SR-96-33 State/Federal Protocol and Nationwide Supervisory Agreement
SR-96-29 Supervisory Program for Risk-Based Inspection of Top 50 Bank
Holding Companies
SR-96-27 Guidance on Addressing Internal Control Weaknesses in U.S.
Branches and Agencies of Foreign Banking Organizations Through
Special Audit Procedures

Page 20
BHCSM
section no.
SR-96-26 Provisions of Individual Components of the Rat- 5010.4

ing System
SR-96-17 Supervisory Guidance for Credit Derivatives 2129.0
SR-96-14 Risk-Focused Safety and Soundness Examinations 2124.0
and Inspections
SR-96-13 Joint Policy Statement on Interest-Rate Risk 2127.0
SR-96-10 Risk-Focused Fiduciary Examinations
SR-95-51 Rating the Adequacy of Risk Management and 4070.1
Internal Controls
at State Member Banks and Bank Holding Com-
panies
SR-93-69 Examining Risk Management and Internal Con- 2125.0
trols for Trading Activities of Banking Organiza-
tions
SR-93-19 Supplemental Guidance for Inspection of Non- 5000.0.4.4
bank Subsidiaries
of Bank Holding Companies

Page 20.1
2124.01.12 APPENDIX BNONBANK SUBSIDIARY RISK-ASSESSMENT

QUESTIONNAIRE
NONBANK SUBSIDIARY OF A BANK HOLDING COMPANY

RISK-ASSESSMENT QUESTIONNAIRE
Name of subsidiary
Name of bank holding company
BHC Consolidated:
Tier 1 capital: $ Total operating revenue*: $
*Defined as the sum of total interest income and total non-interest income, before
extraordinary items.
Subsidiary total assets: $ Subsidiary total operating revenue: $
Questions: (Circle answer.)
1. Are the subsidiarys total assets 10 percent or more of BHC consolidated tier 1 capital?
Yes No
2. Is the subsidiarys total operating revenue 10 percent or more of BHC consolidated

operating revenue? Yes No
3. Does the subsidiary issue debt to unaffiliated parties? Yes No
4. Does the subsidiary rely on affiliated banks for funding debt that is either greater than
$10 million or 5 percent of BHC consolidated tier 1 capital? (See SR-93-19.) Yes No
5. Is the subsidiary involved in asset securitization? Yes No
6. Does the subsidiary generate assets and sell assets to affiliates? Yes No
7. Is the subsidiary a broker-dealer affiliate engaged in underwriting, dealing, or market

making? Yes No
8. Does the subsidiary provide derivative instruments for sale or as a service to

unaffiliated parties? Yes No
9. Has the subsidiary had a significant impact on the BHCs condition

or performance? Yes No
If any question is answered yes, then this subsidiary should be considered for on-site review.
If an on-site review is not being conducted, state the reason below.
Prepared by: Date:

Page 20.2
Risk-Focused Supervision Framework for Large, Complex Banking Organizations 2124.01
2124.01.13 APPENDIX CFEDERAL RESERVE BANK COVER LETTER AND

BHC INSPECTION QUESTIONNAIRE
Federal Reserve Bank

of San Francisco
San Francisco, California 94120
D.F. Roe
Senior Vice President
DEF BanCorp
Greentree Boulevard
Anytown, U.S.A. 11111
Dear Mr. Roe:
In order to facilitate an inspection of DEF BanCorp on a fully consolidated basis, you are
requested to instruct the appropriate staff to provide the information described in this questionnaire.
Unless indicated otherwise, information is requested as of the financial statement date December 31,
20X2. You are asked to provide written responses to questions and copies of specific documents
requested in this questionnaire only if the requested information is new or has changed since the
previous inspection, which was conducted as of December 31, 20X1 (indicate no change where
applicable). For each area covered by this questionnaire, please provide the most recent reports used
by management to identify, measure, monitor, and control risk in the respective areas. Please note
that examiners may make additional requests during the inspection.
Single copies of all submissions in response to the requests will be satisfactory unless otherwise
indicated and should be delivered to the examiner-in-charge or designee. Any requests for clarifica-
tion or definition of terms should also be directed to the examiner-in-charge.
In order to expedite the inspection, each completed schedule and other requested information
should be submitted as soon as prepared and should not be accumulated for submission as a
package. Please respond to every item in the questionnaire, indicating N/A if a question is not
applicable.
Most of the requested data will not be needed until the commencement of the inspection, which is
March 15, 20X3. However, certain information may be needed earlier. Such information and the
date due will be discussed with you.
Federal Reserve examiner-in-charge Examiners telephone number

Page 21
FEDERAL RESERVE BANK

BANK HOLDING COMPANY INSPECTION QUESTIONNAIRE
Please provide the following:
Structure
1. The most recent organization chart

(a) for the holding company and its subsidiaries by legal entity, showing percentage of
ownership if less than 100 percent; and
(b) of management by legal entity and functional business lines, if different, indicating lines of
authority and allocation of duties for all key business lines and support areas of the
organization.
2. List new activities that the bank holding company or nonbank subsidiaries have engaged in
since the previous inspection, either on- or off-balance-sheet, and identify the group responsible
for the management of these activities. How has management identified and evaluated risk in
relation to these new activities? Provide copies of any management reports regarding these
products/activities. Please provide a copy of the companys risk policy statement regarding new
activities.
3. The following on each new subsidiary formed or acquired since the prior inspection and
changes, where applicable, on existing subsidiaries.
(a) name
(b) location
(c) date acquired or formed
(d) percentage of ownership
(e) nature of business or business purpose
(f) list of branch locations by city and state
(g) balance sheet and income statement
(h) off-balance-sheet, asset securitization, and derivatives activities and description of such
(i) list of principal officers
(j) management contact person
4. Since (date), has there been any change in or transfer of functions or responsibilities between
the corporation and its subsidiaries and between subsidiaries and/or their affiliates? If so,
describe fully.
5. Since (date), have there been any sales or other transfers of any assets among the corporation
and its subsidiary banks, affiliates of the banks, and/or other subsidiaries? If so, describe fully
and include details on loan participations purchased and sold.
6. Since (date), have any subsidiaries been deactivated, sold, liquidated, transferred, or disposed of
in some other way? If so, identify the subsidiary, the reason for disposition, and the effective
date of disposition.
7. Has the corporation planned or entered into any new agreements, written or oral, to acquire any
additional entities? If so, give pertinent details, including name, location, type of business, and
purchase terms.

Page 22
Corporate Planning and Policy Information

8. The latest financial projections or business plan(s) for revenues, expenses, assets, liabilities,
capital, and contingent liabilities for the current and next fiscal years. Please include details on
the assumptions used in the preparation of the projections.
9. A copy of the strategic business plan with updates or revisions, if any.
10. If new or amended since the prior inspection, copies of policies for the following:
(a) the level of supervision exercised over subsidiaries
(b) loans and investments of subsidiaries
(c) loan participations by and between subsidiaries
(d) dividends and fees from subsidiaries
(e) dividends paid to stockholders
(f) budgeting and tax planning for subsidiaries
(g) insider transactions
(h) funds, asset-liability, and interest-rate risk management at the parent company and subsidi-
aries
(i) risk identification, evaluation, and control (for example, any credit risks, market risks,
liquidity risks, reputational risks, operational risks, and legal risks)
(j) internal loan-review and -grading system
(k) internal audit
(l) any authorized outstanding commitments to the Federal Reserve
(m) description of any routine tie-in arrangements that are used in providing or contracting for
services
Corporate Financial Information
11. For the consolidated company, provide consolidating balance sheet and income statement,
including schedules of eliminating entries.
12. Full details on unaffiliated borrowings of the consolidated organization. For debt issued since
the prior inspection, please provide the prospectus for public-debt offerings and a summary of
terms for private-debt placements.
13. A copy of the most current periodic financial package prepared for senior management and/or
directors.
Subsidiary Information
14. Consolidating and consolidated balance sheets, including off-balance-sheet items, and income
statements for each nonbank first-tier subsidiary.
15. Details of all capital injections made to subsidiaries or returns of capital from subsidiaries
(excluding normal operating dividends) since the prior inspection. Also provide details on any
advance to a subsidiary which has been reclassified as equity.
16. If subsidiary banks have made any extensions of credit to the bank holding company and/or
other affiliates, give details.

Page 23
17. Describe any services performed by the parent for any subsidiaries or any company in which it
has a 5 percent or greater interest.
Parent Company
18. Details on intercompany payments either (1) from the parent company to affiliates or subsidi-
aries or (2) from subsidiaries or affiliates to the parent company. Segregate into dividends,
interest, management or service fees, expense payments, or other transfers made since the prior
inspection. If a payment is governed by an intercompany agreement, please provide a copy of
the agreement. If not, please provide the basis of the payment made.
19. Internally generated cash-flow statement and liquidity schedule for the latest quarter ending.
Make available supporting documentation. Provide access to the workpapers supporting the
preparation of the Cash-Flow Schedule (schedule PI-A) from the Y-9LP report
20. Full details on new parent companys investments in or advances to subsidiaries, and exten-
sions of credit to and borrowings from subsidiaries (including unused lines of credit) since the
previous inspection.
21. Full details on the terms of any third-party borrowing and credit lines made available since the
previous inspection.
22. If any entities (parent company and/or subsidiaries) maintain compensating balances with third
parties, indicate restrictions, if any.
23. A copy of the contingency funding plan. If such a plan does not exist, please provide a
description of what actions would be taken to meet disruptions in the corporations short-term
liability market.
24. Details on security and other investments held by type; par; book and market values; number of
shares owned; interest rates; maturity dates; and convertibility features, where applicable.
Include a copy of all investment authorization policies and delegations of authority pertaining
thereto.
25. For equity investments or any lending activity, please provide a listing with comments on any
significant items that may not be fully collectible and any other relevant factors.
26. A copy of the capital funding plan or planned changes in equity funding, a financial analysis of
any changes in equity (including any stock redemptions), and any internal financial analysis
used to evaluate capital adequacy.
27. Since the previous inspection, if the corporation has purchased or sold securities or other assets
under an agreement to resell or repurchase, give details.
28. If the corporation has, for its own account, any incomplete purchases or sales of securities
pending, give details.
29. If the parent corporation and/or any nonbank subsidiaries have loans outstanding that are
secured by stock or any obligations of the corporation or any of its subsidiaries, give details.
30. Since the prior inspection, if the corporation, either for its own account or for others, has
guaranteed the payment of any loan or other debt obligation or guaranteed the performance of
any other undertaking, provide details.
Corporate-Debt-Markets Activities
31. The following information on commercial paper:

(a) direct placements outstanding

Page 24
(b) dealer placements outstanding

(c) monthly maturity schedules showing breakdown for direct and dealer placements
(d) a copy of a no action letter, if the SEC has issued one
32. Identify any subsidiary which sells commercial paper for its own use or for its parent.
33. If any commercial paper, stock, and/or convertible debt of the corporation or its subsidiaries is
held by trust departments of subsidiary banks, provide details.
34. If there are any concentrations of commercial paper holdings in excess of 10 percent of the
outstanding commercial paper by any individual or organization, provide details.
Corporate Tax Information

35. If the corporation files a consolidated tax return, on what basis does it determine the amount of
taxes to be paid by subsidiaries? Provide a copy of the tax-sharing agreement with subsidiaries.
36. A schedule detailing the following information for (specify dates)
(a) payments (estimated or otherwise) made by the corporate-tax-paying entity to the taxing
authorities and the dates of such payments; and
(b) payments received by the tax-paying entity from other holding company subsidiaries (or
the tax benefits paid to those subsidiaries) and transaction dates.
37. Provide details of any ongoing IRS audit.
Officers, Directors, and Shareholders

38. For senior officers of the corporation, indicate their title, responsibility, and position(s) held at
subsidiary and/or other organizations.
39. List of directors of the corporation, including
(a) number of shares owned directly and/or indirectly, and
(b) occupation or principal business affiliation.
40. A brief biography of each senior officer appointed and director elected since the prior
inspection. Please include the persons date of birth, business background, education, and
affiliations with any outside organizations. For senior officers, indicate date of hire. For
directors, indicate date of election to board.
41. List of board committees, their memberships, and frequency of meetings.
42. Make available board and committee minutes.
43. Details on fees paid to directors.
44. If the corporation has entered into any contracts or agreements to pay or provide additional
sums or fringe benefits to any director, officer, or employee, provide cost and details.
45. Details on any stock option, incentive, bonus, or performance plans for officers and employees.
46. List of loans made by the parent company and/or nonbank subsidiaries to directors and
executive officers (and their interests) of the parent company and/or subsidiaries. For the
purpose of this request, a directors or executive officers interest refers to a beneficial
ownership, directly or indirectly, amounting to 25 percent or more and also to companies
otherwise controlled by a director or officer.
47. List of investments of the parent and/or subsidiaries in stocks, bonds, or other obligations of

Page 25
corporations in which directors and executive officers have a beneficial interest.

48. List of loans to any borrower that are secured by stocks, bonds, or other obligations of
corporations in which directors and executive officers have a beneficial interest.
49. List of shareholders who own 5 percent or more of any class of voting stock and the percentage
held.
50. List of loans made by the parent company and/or nonbank subsidiaries to shareholders who
own 5 percent or more of the parent companys outstanding shares.
Asset Quality
51. A copy of the latest internal consolidated asset-quality tracking report with aggregate totals of
internally criticized assets and off-balance-sheet items. Identify aggregate exposures by type,
risk rating, and entity where the exposure is booked. Distinguish between direct and indirect
extensions of credit.
52. Details on consolidated loans past due as to principal and/or interest, nonperforming loans and
other real estate owned, and totals of such for each subsidiary.
53. A breakdown of the corporations consolidated and major subsidiaries loan-loss reserves (for
example, the allowance for loan and lease losses), including portions earmarked for the
commercial, consumer, and other segments, with a description of and supporting data for the
methodology used in determining its adequacy.
Audit
(The following information should be requested only if the function resides within the parent
company. If the function is performed at a nonmember lead bank subsidiary, then assess the audit
function through discussions with the banks primary regulator.)
54. A copy of the most recent engagement letters or equivalent information which describes the
scope of external audit activities performed for the corporation and any of its nonbank
subsidiaries. Make available a copy of the audit program.
55. An organization chart which shows the structure and staffing of the audit function.
56. The following information about the auditor and key assistants (if not provided at prior
inspections):
(a) present position and date assumed
(b) date of employment
(c) brief summary of education, experience at this institution, and prior work experience
57. Make available the audit timetable and audit program, workpapers, and procedures used in
conducting audits of the parent company and all subsidiaries.
Miscellaneous
58. A summary schedule of fidelity bond and general liability insurance, listing all areas covered
for loss/liability, and date of board approval.
59. Make available the corporations latest pending litigation report describing any significant
pending or potential litigation or investigations against the organization or any director, officer,
or policy-making employee in their official capacity, with the following information:

Page 26
(a) name(s) of plaintiff

(b) nature of claim and damages requested
(c) current status
(d) an opinion of the probable outcome, including an estimation of the organizations liability

Page 27
Consolidated Supervision Framework for Large Financial
Institutions Section 2124.05
Whats New In This Revised Section Each firm is expected to ensure the sustain-
ability of its critical operations3 and banking
Effective July 2014, this section was revised to offices4 under a broad range of internal or
include Appendix B Managing Foreign external stresses. This requires, among other
Exchange Settlement Risks for Physically Settled things, effective resolution planning that
Transactions. See SR-13-24. This guidance sets addresses the complexity and the interconnec-
forth seven principles or guidelines for man- tivity of the firms operations.
aging foreign exchange transaction settlement
risks. The Federal Reserve supports these prin- These objectives are consistent with key pro-
ciples as part of its continuing effort to promote visions of the 2010 Dodd-Frank Wall Street
the global financial systems ability to withstand Reform and Consumer Protection Act (Dodd-
severe market disruptions. Institutions covered Frank Act). These provisions include enhanced
by SR-13-24 should apply the seven guidelines prudential standards, which provide the Federal
to their foreign exchange activities with the Reserve with the flexibility to tailor the applica-
stated clarifications regarding application of the tion of these standards to individual firms or
guidance in the United States. groups of firms.5 (See SR-12-17/CA-12-14 and
the supplemental guidance in SR-13-23.)
The Federal Reserve adopted a new framework
for the consolidated supervision of large finan-
cial institutions on December 17, 2012.1 The
framework strengthens traditional micropruden- 2124.05.1 FRAMEWORK
tial supervision and regulation to enhance the APPLICABILITY
safety and soundness of individual firms. It also
incorporates macroprudential considerations to The new framework is designed to support a
reduce potential threats to the stability of the tailored supervisory approach that accounts for
financial system and to provide insights into the unique risk characteristics of each firm,
financial market trends. The consolidated super- including the nature and degree of potential
vision framework has two primary objectives: systemic risks inherent in a firms activities and
operations, as well as broader trends across
Enhancing resiliency of a firm to lower the firms. This framework applies to the following
probability of its failure or inability to serve institutions:
as a financial intermediary.
Each firm is expected to ensure that the con- Large Institution Supervision Coordinating
solidated organization (or the combined U.S. Committee (LISCC) firms: the largest, most
operations in the case of foreign banking orga- complex U.S. and foreign financial organiza-
nizations) and its core business lines2 can tions subject to consolidated supervision by
survive under a broad range of internal or the Federal Reserve. Nonbank financial com-
external stresses. This requires financial resil- panies designated by the Financial Stability
ience by maintaining sufficient capital and Oversight Council (FSOC) for supervision by
liquidity, and operational resilience by main- the Federal Reserve are included in the LISCC
taining effective corporate governance, risk portfolio. LISCC firms are considered to pose
management, and recovery planning. the greatest systemic risk to the U.S. econ-
Reducing the impact on the financial system omy.
and the broader economy in the event of a The LISCC is a multidisciplinary body that
firms failure or material weakness.
1. The previous framework, SR-99-15, Risk-Focused 3. Critical operations are those operations (including
Supervision of Large Complex Banking Organizations, is associated services, functions, and support) that if they were
superseded. In addition, for the firms described in subsection to fail or be discontinued could pose a threat to the financial
2124.05.1, Framework Applicability, the framework for stability of the United States.
consolidated supervision set forth in SR-08-9/CA-08-12, 4. Banking offices are defined as U.S. depository institu-
Consolidated Supervision of Bank Holding Companies and tion subsidiaries, as well as the U.S. branches and agencies of
the Combined U.S. Operations of Foreign Banking Organiza- foreign banking organizations.
tions, is no longer applicable. 5. 12 U.S.C. 5365 and 12 U.S.C. 5365(a)(2).
2. Core business lines are those business lines (includ-
ing associated operations, services, functions, and support)
that, in the firms view, upon failure would result in a material BHC Supervision Manual July 2014
loss of revenue, profit, or franchise value. Page 1
Consolidated Supervision Framework for Large Financial Institutions 2124.05
oversees supervision and evaluates conditions supervision requires strong, cooperative rela-
of supervised firms. The committee also tionships between the Federal Reserve and other
develops cross-firm perspectives and monitors bank supervisors and functional regulators. The
interconnectedness and common practices that Federal Reserve generally relies to the fullest
could lead to greater systemic risk. extent possible on the information and assess-
Large Banking Organizations (LBOs): domes- ments provided by other supervisors and regula-
tic bank and savings and loan holding compa- tors to support effective supervision. Supervi-
nies with consolidated assets of $50 billion or sory agencies engaged in the supervision of
more that are not included in the LISCC port- large financial institutions continue to enhance
folio. formal and informal discussions to jointly iden-
Large Foreign Banking Organizations (Large tify and address key vulnerabilities, and to coor-
FBOs): foreign banking organizations with dinate supervisory strategies for these firms.
combined assets of U.S. operations of $50 As a general matter, this framework is appli-
billion or more that are not included in the cable in circumstances when the consolidated
LISCC portfolio. organization and its banking offices are in at
least satisfactory condition and there are no
In certain instances, the framework applies to material weaknesses or risks across these core
the intermediate holding company that is the areas of supervisory focus. The Federal Reserve
primary focus of regulations and supervisory applies additional supervisory expectations, and
activities for the consolidated entity. undertakes related activities, to address identi-
fied concerns including areas subject to formal
or informal enforcement action.
2124.05.2 FRAMEWORK OVERVIEW
The supervisory framework comprises the 2124.05.3 ENHANCING RESILIENCY
frameworks sections A, B, and C. Sections A OF A FIRM
and B specifies the Federal Reserves expecta- 2124.05.3.1 Capital and Liquidity
tions across the following core areas of supervi- Planning and Positions
sory focus:
The financial crisis demonstrated the need for
A. Enhancing Resiliency of a Firm stronger regulatory and supervisory assessments
(1) Capital and Liquidity Planning and Posi- of firms financial resiliency.6 The Federal
tions Reserve noted significant weaknesses in the
(2) Corporate Governance adequacy of firms point-in-time regulatory
(3) Recovery Planning capital to cover accumulated and prospective
(4) Management of Core Business Lines risks, as well as in firms liquidity buffers and
B. Reducing the Impact of a Firms Failure risk-management practices.7 These weaknesses
(1) Management of Critical Operations contributed to the failure or near failure of many
(2) Support for Banking Offices financial firms and exacerbated the crisis. To
(3) Resolution Planning support effective capital and liquidity planning,
(4) Additional Macroprudential Supervisory and the adequacy of capital and liquidity posi-
Approaches to Address Risks to Finan- tions, each firm should:
cial Stability
C. Conduct of Supervisory Activities a) Maintain strong capital and liquidity posi-
tions that not only comply with regulatory
The Federal Reserve may periodically iden- requirements, but also support the firms
tify additional supervisory priorities beyond ongoing ability to meet its obligations to
these core areas of focus as necessary to creditors and other counterparties, as well as
enhance firm-specific supervision and develop continue to serve as a financial intermediary
cross-firm perspectives.
Subsection 2124.05.5, Conduct of Supervi- 6. See the Boards final rule on capital plan requirements
sory Activities, (framework section C) outlines for large bank holding companies (76 Fed. Reg. 74631,
the conduct of supervisory activities used to December 1, 2011); SR-10-6, Interagency Policy Statement
maintain a comprehensive understanding and on Funding and Liquidity Risk Management (75 Fed. Reg.
13656, March 22, 2010); and section 4066.0 of this manual.
assessment of each firm. Effective consolidated 7. The capital components of this framework, including
those related to stress testing, will apply to savings and loan
BHC Supervision Manual July 2014 holding companies after they become subject to minimum
Page 2 regulatory capital requirements.
through periods of stress. tial to sustaining the consolidated

b) Have in place robust internal processes that organization.
enable the firm to maintain capital and b) Ensure that the firms senior management
liquidity commensurate with its unique risks has the expertise and level of involvement
under normal and stressful conditions, and to required to manage the firms core business
provide timely restoration of financial buf- lines, critical operations, banking offices, and
fers in the event of drawdown. other material entities.9 These areas should
c) Maintain processes that enable the identifica- receive sufficient operational support to
tion and measurement of potential risks to remain in a safe and sound condition under a
asset quality, earnings, cash flows, and other broad range of stressed conditions.
primary determinants of capital and liquidity c) Maintain a corporate culture that emphasizes
positions. the importance of compliance with laws and
d) Utilize comprehensive projections of the regulations and consumer protection, as well
level and composition of capital and liquid- as the avoidance of conflicts of interest and
ity resources, supported by rigorous and the management of reputational and legal
regular stress testing to assess the potential risks.
impact of a broad range of expected and d) Ensure the organizations internal audit, cor-
potentially adverse scenarios. porate compliance, and risk management and
e) Maintain sound risk measurement and mod- internal control functions are effective and
eling capabilities, supported by comprehen- independent, with demonstrated influence
sive data collection and analysis, indepen- over business-line decision making that is
dent validation, and effective governance, not marginalized by a focus on short-term
policies, and controls.8 revenue generation over longer-term
f) Establish goals for capital and liquidity posi- sustainability.10
tions that are approved by the firms board of e) Assign senior managers with the responsibil-
directors and reflect the potential impact of ity for ensuring that investments across busi-
legal or regulatory restrictions on the transfer ness lines and operations align with corpo-
of capital or liquidity between legal entities. rate strategies, and that compensation
g) Maintain independent internal audit and arrangements and other incentives are consis-
other review functions with appropriate staff tent with the corporate culture and institu-
expertise, experience, and stature in the orga- tional risk appetite.11
nization to monitor the adequacy of capital f) Ensure that management information sys-
and liquidity risk measurement and manage- tems (MIS) support the responsibilities of the
ment processes. board of directors to oversee the firms core
business lines, critical operations, and other
core areas of supervisory focus.
2124.05.3.2 Corporate Governance
In order for a firm to be sustainable under a 2124.05.3.3 Recovery Planning
broad range of economic, operational, legal or
other stresses, its board of directors (or equiva- Robust recovery planning is central to ensuring
lent for the U.S. operations of FBOs) should the ongoing resiliency of a firms consolidated
provide effective corporate governance with the operations as well as its core business lines,
support of senior management. The board is critical operations, banking offices, and other
expected to establish and maintain the firms material entities. Each firm should plan for
culture, incentives, structure, and processes that potential financial or operational weaknesses
promote its compliance with laws, regulations, and identify actions to correct those weaknesses.
and supervisory guidance. Each firms board of
directors and committees, with support from
9. Material entities are subsidiaries or foreign offices of
senior management, should: the firm that are significant to the activities of a core business
line or critical operation.
a) Maintain a clearly articulated corporate strat- 10. See SR-08-8/CA-08-11, and section 2124.07 of this
egy and institutional risk appetite. The board manual.
11. Refer to Guidance on Sound Incentive Compensation
should set direction and oversight for rev- Policies (75 Fed. Reg. 36395, June 25, 2010) and section
enue and profit generation, risk management 2068.0 of this manual.
and control functions, and other areas essen-
8. See SR-11-7, and section 2126.0 of this manual. Page 3
Therefore, each firm should: fications and experience commensurate with

the size and complexity of related activities
a) Maintain clearly documented quantitative and operations;
and qualitative criteria that would trigger A strategic planning process that ensures areas
timely implementation of specific elements of growth and innovation are effectively
of the firms recovery plan and provide for managed;
more rigorous remediation activities if initial Appropriate compensation and other incen-
actions prove insufficient. tives that are consistent with the institutional
b) Ensure that trigger events reflect a suffi- risk appetite and in compliance with laws and
ciently broad range of market- and firm- regulations;
specific stresses across financial, operational, An independent and strong risk-management
reputational, legal, and compliance risks. framework that supports identification, mea-
c) Ensure that recovery planning reflects a surement, assessment, and control of the full
holistic view of sustainability and resiliency. spectrum of risks; and
Recovery planning should be closely inte- Timely identification and resolution of audit,
grated with resolution planning, capital and compliance, and regulatory issues
liquidity planning, and other aspects of finan-
cial contingency, crisis management, and
business continuity planning.12 2124.05.4 REDUCING THE IMPACT
d) Undertake recovery testing and training exer- OF A FIRMS FAILURE
cises that consider a broad range of internal
and external risk scenarios and account for 2124.05.4.1 Management of Critical
interconnectivities across operations and Operations
legal entities.
e) Ensure that the recovery plan is updated as The failure or discontinuance of any of a firms
needed, and reflects lessons learned from critical operations could weaken the U.S. econ-
reviews of trigger events, testing, and train- omy or pose a threat to the financial stability of
ing exercises. the United States. Each of the supervisory
f) Ensure that recovery planning is sufficiently expectations outlined around management of
integrated into corporate governance struc- core business lines (see subsection 2124.05.3.4,
tures and processes, subject to independent Management of Core Business Lines (frame-
validation, and effectively supported by work section A.4)) applies equally to manage-
related MIS reporting to the board and its ment of critical operations to ensure their finan-
committees. cial and operational resilience. Additionally,
each firm should ensure that critical operations
are sufficiently resilient to be maintained, con-
2124.05.3.4 Management of Core tinued, and funded even in the event of failure
Business Lines or material financial or operational distress.
These expectations should be fully reflected in
Effective management of core business lines is recovery and resolution planning.
essential to ensuring the resilience of the con-
solidated organization, as these activities are the
primary drivers of the firms revenue genera- 2124.05.4.2 Support for Banking Offices
tion, profitability, and franchise value. For this
reason, a firms corporate governance should The Federal Reserves consolidated supervision
extend (as discussed in subsection 2124.05.3.2, program has historically focused on protecting
Corporate Governance (framework section the safety and soundness of U.S. depository
A.2)) to the management of each core business institution subsidiaries of bank holding compa-
line. Each core business line should have: nies and the U.S. branches and agencies of for-
eign banking organizations (collectively defined
Business-line senior management with quali- as banking offices). This is due to the risks
posed by banking offices access to the federal
12. Business continuity expectations include adherence safety net. Specifically, these offices pose risks
with expectations set forth in SR-03-9, including the geo-
graphic diversity and resiliency of data centers and opera-
to the payment system, the Federal Reserves
tions, and testing of recovery and resumption arrangements. discount window, andin the case of most U.S.
depository institutionsfederal deposit insur-
BHC Supervision Manual July 2014 ance funds.
Page 4 A consolidated organization should serve as a
source of financial and managerial strength to 2124.05.4.3 Resolution Planning

its banking offices. The activities of the parent
company and affiliated nondepository subsidi- To promote financial stability, the Dodd-Frank
aries should not present material risks to affili- Act requires each bank holding company with
ated banking offices, the consolidated organiza- consolidated assets of $50 billion or more, as
tion itself, or to the consolidated organizations well as nonbank financial companies designated
ability to support its banking offices.13 Each by the FSOC, to develop and maintain plans for
firm should: rapid and orderly resolution in the event of
material financial distress or failure. These plans
a) Provide for the strength and resiliency of its should be utilized as an element of the firms
banking offices, ensuring prompt financial strategic planning and address the complexity
and operational support so that each office and interconnectivity of the firms operations.15
remains in a safe and sound condition under The Federal Reserve and the FDIC jointly
a broad range of stressed conditions. review a firms resolution plan relative to super-
b) Ensure that the activities of the parent com- visory requirements, including:
pany and nondepository institution subsidi-
aries do not present undue direct or indirect a) The firms strategic analysis describing its
risks to the safety and soundness of banking plans for rapid and orderly resolution under
offices. This includes the transmission of the U.S. Bankruptcy Code (or other relevant
financial, operational, legal, compliance, or insolvency regimes). This strategy must not
reputational risks that may undermine public pose systemic risk and must exclude reliance
confidence in the financial strength of its on extraordinary support from the United
banking offices. States or any other government to prevent
failure of the firm.
c) Maintain sufficient liquidity, cash flow, and b) The firms strategy for maintaining and fund-
capital strength at the parent company and ing material entities, critical operations, and
nondepository institution subsidiaries to ser- core business lines in the event of material
vice debt obligations and cover fixed financial distress.
charges. The parent company needs to con- c) Analysis of potential impediments to resolu-
sider whether there are any legal or regulation, and actions to make the firm more
tory restrictions on financial transfers resolvable or otherwise reduce its complex-
between legal entities within the organiza- ity and interconnectivity.
tion. d) Analysis of whether the failure of a major
d) Implement and maintain effective policies, counterparty would likely result in the mate-
procedures, and systems to ensure compli- rial financial distress or failure of the firm.
ance with applicable laws and regulations. e) The manner and extent to which an insured
This includes compliance with respect to depository subsidiary is adequately protected
covered transactions subject to the Boards from risks arising from the activities of non-
Regulation W, which implements sections depository subsidiaries.
23A and 23B of the Federal Reserve Act and f) For a U.S. firm with foreign operations, its
limits a banks transactions with its affili- strategy for addressing the risks arising from
ates.14 these foreign operations to its U.S. opera-
tions, and its ability to maintain core business
lines and critical operations in foreign juris-
dictions.
13. Due to structural differences, there are important dis- g) Analysis of whether resolution planning is
tinctions in the forms of support provided to U.S. depository sufficiently integrated into corporate gover-
institution subsidiaries versus those provided to the U.S. nance structures and processes, subject to
branches and agencies of foreign banks. For example,
branches/agencies do not hold capital and have differing busi- independent validation, and effectively sup-
ness and liquidity profiles, governance mechanisms, and regu- ported by related MIS reporting to the board
latory requirements than depository institutions. Therefore, of directors and its committees.
the Federal Reserve will consider these differences in its
implementation of this supervisory framework for the U.S.
branches and agencies of FBOs, and expects parent FBOs and
15. Refer to 12 C.F.R. 243 (Federal Reserve) and 12 C.F.R.
their U.S. branches and agencies to do the same. The extent of
381 (FDIC) for the Resolution Plans Required regulations.
supervisory activity undertaken to assess the adequacy of
See also, 76 Fed. Reg. 67323, November 1, 2011.
parent company support for U.S branches and agencies of
FBOs is scaled to the condition, size, and interconnectedness
of these offices. BHC Supervision Manual July 2014
14. See SR-03-2, and section 2020.1 of this manual. Page 5
2125.05.4.4 Additional Macroprudential monitoring of systemic risk.

Supervisory Approaches to Address Risks f) Enhancing international coordination with
to Financial Stability foreign counterparts, including national
supervisors and international bodies such as
The financial crisis demonstrated that too nar- the Basel Committee on Bank Supervision,
row a focus on the safety and soundness of the Financial Stability Board, and the Senior
individual firms can result in a failure to detect Supervisors Group. These activities focus on
and address emerging threats to financial stabil- enhancing oversight of internationally active
ity that arise across many firms. The Dodd- financial firms and markets and on minimiz-
Frank Act requires the Federal Reserve to con- ing the opportunities for firms to take advan-
sider the broader risks to financial stability tage of weaker or inconsistent regulations.
posed by individual companies and through the
interconnectedness among these companies. See
section 1040.0.3 of this manual. 2124.05.5 CONDUCT OF
The Federal Reserve aims to reduce systemic SUPERVISORY ACTIVITIES
risks by increasing the capacity of firms and
markets to absorb shocks when problems occur, The Federal Reserve uses a range of supervisory
and by reducing potential costs in the event of activities to maintain a comprehensive under-
financial distress or failure of a systemically standing and assessment of each firm, including:
important institution. Supervision carried out
under this framework will support a variety of a) Coordinated horizontal reviews involve
macroprudential supervisory approaches beyond examination of several institutions simulta-
those already discussed, including: neously, encompassing firm-specific supervi-
sion and the development of cross-firm per-
a) Using insights developed through micropru- spectives. The Federal Reserve recognizes
dential supervision and related data collec- the priority of these reviews through the
tion and analysis to identify, understand, and dedication of multidisciplinary skills and
assess potential systemic risks. Areas of experienced staff. Examples include analysis
review could include, for example, emerging of capital adequacy and planning via the
trends in critical operations, interconnected- Comprehensive Capital Analysis and Review
ness, rapidly expanding markets, cyclical (CCAR), as well as horizontal evaluations of
industries, and financial products lacking resolution plans and incentive compensation
substitutes or effecting large market seg- practices.
ments. b) Firm-specific examination and continuous
b) Identifying potential risks to financial stabil- monitoring activities16 are undertaken to
ity indicated by the information in supervi- maintain an understanding and assessment
sory stress tests and through trends in sce- across the core areas of supervisory focus for
narios employed by firms in their internal each firm. These activities include review
stress tests. and assessment of changes in strategy, inher-
c) Using comparative and aggregate analysis to ent risks, control processes, and key person-
monitor industry practices, common invest- nel, and follow-up on previously identified
ment or funding strategies, changes in degree concerns (for example, areas subject to
or form of financial interconnectedness, or enforcement actions or other supervisory
other developments with implications for issues, or emerging vulnerabilities).
financial stability. c) In developing and executing a detailed
d) Coordinating with the Federal Reserves supervisory plan for each firm, the Federal
supervision of systemically important finan- Reserve generally relies to the fullest extent
cial market utilities to identify and address possible on the information and assessments
risks related to payment, clearing, and settle- provided by other relevant supervisors and
ment activities, as well as to identify poten- functional regulators. The Federal Reserve
tial structural vulnerabilities. actively participates in interagency informa-
e) Working closely with the FSOC and other
regulators and supervisors to support the des- 16. Continuous monitoring activities include meetings
ignation and supervision of systemically with a banking organizations management; analysis of inter-
nal MIS reports, market indicators, and other internal and
important nonbank firms, and to enhance the external information; review of internal and external audit
findings; and coordination with other relevant supervisors and
BHC Supervision Manual July 2014 functional regulators and utilization of their work as appropri-
Page 6 ate.
tion sharing and coordination, consistent with rise to this concern and on which further guid-
applicable laws, to promote comprehensive ance is needed, including cases in which
and effective supervision and limit unneces-
sary duplication of information requests. A firm transfers the risk of a portfolio to a
Supervisory agencies continue to enhance counterparty (which may be a thinly capital-
formal and informal discussions to jointly ized special purpose vehicle (SPV)) that is
identify and address key vulnerabilities, and unable to absorb losses equal to the risk-based
to coordinate supervisory strategies for large capital requirement for the risk transferred; or
financial institutions. A firm transfers the risk of a portfolio to an
d) In certain instances, supervisors may be able unconsolidated, sponsored affiliate entity
to rely on a firms internal audit or internal of the firm (which also may be an SPV).
control functions in developing a compre-
hensive understanding and assessment. In cases involving unaffiliated counterparties,
while the transactions may result in a significant
reduction in a firms risk-weighted assets and
associated capital requirements under the regu-
2124.05.6 APPENDIX A latory capital framework, the firm may nonethe-
less face residual risks. These residual risks
2124.05.6.1 Risk Transfer Considerations arise because the effectiveness of a firms hedge
When Assessing Capital Adequacy involving a thinly capitalized SPV counterparty
The following discussion, SR-13-23, provides would be limited to the loss absorption capacity
supplemental guidance to SR-12-17/CA letter of the SPV itself. In cases involving unconsoli-
12-14 pertaining to its supervisory focus on an dated sponsored affiliates of the firm, the
institutions capital adequacy and liquidity suffi- residual risk arises from the implicit obligation
ciency. The supplemental guidance centers on the sponsoring firm may have to provide sup-
how certain risk transfer transactions affect port to the affiliate in times of stress. SR-13-23
assessments of capital adequacy at large finan- addresses how the Federal Reserve supervisory
cial institutions (hereafter referred to as firms).17 staff will view such risk-reducing transactions19
It provides clarification on supervisory expecta- in evaluating a firm under the Boards capital
tions when assessing a firms capital adequacy plan rule and the associated annual Comprehen-
in certain circumstances when the risk-based sive Capital Analysis and Review (CCAR).20
capital framework may not fully capture the In the case of a risk transfer transaction with a
residual risks of a transaction.18 non-affiliated, limited-recourse SPV or other
Risk mitigation techniques can reduce a counterparty with limited loss-absorption capac-
firms level of risk. In general, the Federal ity, Federal Reserve supervisory staff will evalu-
Reserve views a firms engagement in risk- ate the difference between the amount of capital
reducing transactions as a sound risk- required for the hedged exposures before the
management practice. There are, however, cer- risk transfer transaction and the counterpartys
tain risk-reducing transactions for which the loss-absorbing resources. When evaluating capi-
risk-based capital framework may not fully tal adequacy, including in the context of CCAR,
capture the residual risks that a firm faces on a supervisory staff will evaluate whether a firm
post-transaction basis. As a result of inquiries holds sufficient capital in addition to its mini-
and discussions with market participants, the mum regulatory capital requirements to cover
Federal Reserve has identified specific charac- this difference.21 In addition, when a firm
teristics of risk transfer transactions that give engages in such a risk transfer transaction, the
19. While the cases described are examples, the principles

set forth should apply to other transactions that call into
17. This guidance applies to large financial institutions that
question the degree to which risk transfer has occurred.
are domestic bank and savings and loan holding companies
20. See 12 CFR 225.8(d)(2)(i). For additional guidance on
with consolidated assets of $50 billion or more and foreign
CCAR, refer to the Federal Reserves website at
banking organizations with combined assets of U.S. opera-
www.federalreserve.gov/bankinforeg/ccar.htm. The capital
tions of $50 billion or more.
plan rule and CCAR apply only to bank holding companies
18. See 12 CFR 217. The risk-based capital framework
with total consolidated assets of $50 billion or more.
establishes risk-based and leverage capital requirements for
21. Supervisory staff may also analyze whether the coun-
banking organizations, including top-tier savings and loan
terparty has liabilities in addition to the specific risk transfer
holding companies, except those that are substantially
transaction.
engaged in insurance underwriting or commercial activities.
This guidance would apply to such entities at such time as
risk-based and leverage capital requirements become applica- BHC Supervision Manual July 2014
ble to them. Page 7
firm should be able to demonstrate that it reflects risk transfer transactions to the attention of their
the residual risk in its internal assessment of senior management and supervisors. Supervi-
capital adequacy and maintains sufficient capital sors will evaluate whether a firm can adequately
to address such risk. In this regard, a commit- demonstrate that the firm has taken into account
ment by a third party to provide additional capi- any residual risks in connection with the trans-
tal in a period of financial stress would not be action.
counted toward the loss-absorbing capacity of
the counterparty.
2124.05.7 APPENDIX BMANAGING
Example: A firm has a $100 portfolio that has FOREIGN EXCHANGE SETTLEMENT
a capital requirement of $8. If the firm under- RISKS FOR PHYSICALLY SETTLED
takes a transaction to transfer the risk of this TRANSACTIONS
portfolio to an unaffiliated SPV with paid-in
capital of $3, then the firm would need to be The Federal Reserve notes that the Basel Com-
able to demonstrate that, in addition to meet- mittee on Banking Supervision (Committee),
ing its minimum regulatory capital require- with input from the Federal Reserve,23 pub-
ments, the firm has sufficient capital to cover lished Supervisory Guidance for Managing
the $5 difference between the SPVs capital Risks Associated with the Settlement of Foreign
and the capital requirement associated with Exchange Transactions (guidance) in February
the portfolio. 2013. This guidance sets forth seven principles
or guidelines for managing foreign exchange
In the case of risk transfer to an unconsoli- transaction-settlement risks. The Federal
dated, sponsored affiliated entity, the nature Reserve considers this guidance on foreign
of the firms relationship with the entity calls exchange settlement risks to be a component of
into question the degree of risk transfer in the its current, broad-based focus on banking insti-
transaction. Firms are discouraged from enter- tutions foreign exchange activities.
ing into such transactions, which generally do The Federal Reserve supports these principles
not involve effective risk transfer because of the as part of its continuing effort to promote the
sponsored entitys ongoing relationship with the global financial systems ability to withstand
firm and, as noted above, the implicit obligation severe market disruptions, and has determined
that the firm may have to provide capital to the that the institutions subject to SR-13-24 (cov-
sponsored entity in a period of financial stress ered institutions)24 should apply the seven
affecting the sponsored entity. Firms engaging guidelines, which are summarized below (see
in such transactions should presume for the pur- sections 3.1 through 3.7 of the guidance), to
pose of their internal capital adequacy assess- their foreign exchange activities, with the fol-
ment as well as for capital planning purposes lowing clarifications regarding application of
that no risk transfer has occurred. the guidance in the United States.25
Supervisors will strongly scrutinize risk trans-
fer transactions that result in substantial reduc-
the entity. In making this determination, the Board may
tions in risk-weighted assets, including in super- require the banking organization to treat the entity as if it were
visors assessment of a firms overall capital consolidated onto the balance sheet of the banking organiza-
adequacy, capital planning, and risk manage- tion for risk-based capital purposes and calculate the appropri-
ment through CCAR. Based on an assessment ate risk-based capital ratios accordingly, all as specified by the
Board. See 12 CFR parts 208 and 225, Appendix A, section I.
of the risks retained by the firm, the Board may 23. This guidance applies to large financial institutions
in particular cases determine not to recognize a supervised by the Federal Reserve, as defined in SR-12-17/
transaction as a risk mitigant for risk-based capi- CA-12-14. This guidance does not apply to community and
tal purposes.22 Firms should bring these types of regional banking organizations, defined as those with less
than $50 billion in total consolidated assets, unless the bank-
ing organization engages in significant foreign exchange
activities.
22. See generally 12 CFR 217.1(d)(1), (d)(3), and (d)(5).
24. While the Committees guidance uses the term bank,
In addition, under the Boards current capital adequacy guide-
for purposes of SR-13-24, covered institutions are those
lines for bank holding companies and state member banks
defined in SR-12-17/CA-12-14 as Large Institution Supervi-
(banking organizations), the Board may determine that the
sion Coordinating Committee (LISCC) firms, large banking
regulatory capital treatment for a banking organizations
organizations (LBOs), and U.S operations of large foreign
exposure or other relationship to an entity not consolidated on
banking Organizations (large FBOs), as well as any other
the banking organizations balance sheet is not commensurate
banking organization that engages in significant foreign
with the actual risk relationship of the banking organization to
exchange activities.
25. The guidance applies to foreign exchange transactions
BHC Supervision Manual July 2014 that consist of two settlement payment flows. This includes
Page 8 spot transactions, forwards, swaps, deliverable options, and
Guideline 1Governance. A bank should Guideline 5Operational risk. A bank should

have strong governance arrangements over its properly identify, assess, monitor, and control
foreign exchange settlement-related risks, its operational risks. A bank should ensure
including a comprehensive risk-management that its systems support appropriate risk-
process and active engagement by the board management controls, and have sufficient
of directors. capacity, scalability, and resiliency to handle
Paragraph 3.1.8 of the guidance states that foreign exchange volumes under normal and
the board of directors of a covered institution stressed conditions.
should oversee the management of the com- Guideline 6Legal risk. A bank should
pliance function associated with settling for- ensure that agreements and contracts are
eign exchange transactions. For purposes of legally enforceable for each aspect of its
the application of the guidelines by covered activities in all relevant jurisdictions.
institutions, senior management should rou- Paragraph 3.6.2 of the guidance states that
tinely communicate significant compliance institutions conducting business in multiple
matters to the board of directors. The board of jurisdictions should identify, measure, moni-
directors may choose to delegate regular over- tor, and control for the risks arising from
sight to a single board member or a committee conflicts of laws across jurisdictions and sug-
of the board. gests accomplishing these objectives by
Guideline 2Principal risk. A bank should obtaining legal opinions from qualified inter-
use financial market infrastructures that pro- nal or external counsel. The Federal Reserve
vide payment-versus-payment settlement to does not expect a covered institution to obtain
eliminate principal risk when settling foreign a legal opinion for every transaction; rather,
exchange transactions. Where payment- management should seek legal advice that
versus-payment settlement is not practicable, addresses standardized terms, master netting
a bank should properly identify, measure, con- and other significant agreements, and indi-
trol, and reduce the size and duration of its vidual transactions as appropriate.
remaining principal risk. Guideline 7Capital for foreign exchange
Guideline 3Replacement-cost risk. A bank transactions. When analyzing capital needs, a
should employ prudent risk-mitigation bank should consider all foreign exchange
regimes to properly identify, measure, moni- settlement-related risks, including principal
tor, and control replacement-cost risk for for- risk and replacement-cost risk. A bank should
eign exchange transactions until settlement ensure that sufficient capital is held against
has been confirmed and reconciled. these potential exposures, as appropriate.
Paragraph 3.3.7 of the guidance refers to
transactions with affiliates. Covered institu- While the Federal Reserve acknowledges the
tions are encouraged to exchange variation principles set forth in section 3.7 of the guid-
margin for inter-affiliate transactions as a mat- ance, and in particular that all risks related to the
ter of sound business practice. settlement of foreign exchange transactions
Guideline 4Liquidity risk. A bank should should be considered in determining capital
properly identify, measure, monitor, and con- needs under the applicable capital framework,
trol its liquidity needs and risks in each cur- the guidance does not and is not intended to
rency when settling foreign exchange transac- modify the calculation of regulatory capital
tions. requirements for covered institutions.
currency swaps involving exchange of principal. It excludes

instruments that involve one-way settlement payments, such
as non-deliverable forwards, non-deliverable options, and
contracts for difference. The Federal Reserve expects that the
guidance will be applied broadly by the covered institutions
and notes that there may be limited instances in which an
institution need not apply this guidance to an insignificant BHC Supervision Manual July 2014
currency exposure. Page 9
Compliance Risk-Management Programs and Oversight at Large Banking
Organizations with Complex Compliance Profiles Section 2124.07
Banking organizations have greatly expanded management programs and oversight in a timely
the scope, complexity, and global nature of their manner.2
business activities. At the same time, compli- The Federal Reserves expectations for all
ance requirements associated with these activi- supervised banking organizations are consistent
ties have become more complex. As a result, with the principles outlined in a paper issued in
organizations have confronted significant risk April 2005 by the Basel Committee on Banking
management and corporate governance chal- Supervision, entitled Compliance and the com-
lenges, particularly with respect to compliance pliance function in banks (Basel compliance
risks that transcend business lines, legal entities, paper). The principles in the Basel compliance
and jurisdictions of operation.1 To address these paper have become widely recognized as global
challenges, many banking organizations have sound practices for compliance risk manage-
implemented or enhanced firmwide compliance ment and oversight, and the Federal Reserve
risk-management programs and program endorses these principles. This section provides
oversight. clarification as to the Federal Reserves views
While the guiding principles of sound risk regarding certain compliance risk management
management are the same for compliance as for and oversight matters with regard to banking
other types of risk, the management and over- organizations with complex compliance profiles
sight of compliance risk presents certain chal- in the specific areas addressed within this sec-
lenges. For example, quantitative limits reflect- tion (see SR-08-8/CA-08-11):
ing the board of directors risk appetite can be
established for market and credit risks, allocated 1. organizations that should implement a firm-
to the various business lines within the organiza- wide approach to compliance risk manage-
tion, and monitored by units independent of the ment and oversight;
business line. Compliance risk does not lend 2. independence of compliance staff;
itself to similar processes for establishing and 3. compliance monitoring and testing; and
allocating overall risk tolerance, in part because 4. responsibilities of boards of directors and
organizations must comply with applicable rules senior management regarding compliance
and standards. Additionally, existing compli- risk management and oversight.
ance risk metrics are often less meaningful in
terms of aggregation and trend analysis as com-
pared with more traditional market- and credit- 2124.07.1 FIRMWIDE COMPLIANCE
risk metrics. These distinguishing characteris- RISK MANAGEMENT AND
tics of compliance risk underscore the need for a OVERSIGHT
firmwide approach to compliance risk manage-
ment and oversight for large, complex organiza-
tions. A firmwide compliance function that 2124.07.1.1 Overview
plays a key role in managing and overseeing
Organizations supervised by the Federal
compliance risk while promoting a strong cul-
Reserve, regardless of size and complexity,
ture of compliance across the organization is
should have effective compliance risk-
particularly important for large, complex organi-
management programs that are appropriately tai-
zations that have a number of separate business
lored to the organizations risk profiles.3 The
lines and legal entities that must comply with a
wide range of applicable rules and standards.
2. Effective compliance risk-management programs incor-
The Federal Reserve strongly encourages porate controls designed to maintain compliance with applica-
large banking organizations with complex ble rules and standards, including safety and soundness and
compliance profiles to ensure that the neces- consumer protection guidance issued by supervisory
sary resources are dedicated to fully implement- authorities.
3. See SR-95-51, Rating the Adequacy of Risk Manage-
ing effective firmwide compliance risk- ment Processes and Internal Controls at State Member Banks
and Bank Holding Companies (section 4070.1). This letter
or section provides general guidance on risk-management
1. Compliance risk is the risk of legal or regulatory sanc- processes and internal controls for consolidated organizations
tions, financial loss, or damage to reputation resulting from and discusses the elements of a sound risk-management sys-
failure to comply with laws, regulations, rules, other regula- tem applicable to all banking organizations for which the
tory requirements, or codes of conduct and other standards of Federal Reserve has supervisory responsibility. SR-95-51
self-regulatory organizations applicable to the banking organi-
zation (applicable rules and standards). (See, generally, Com-
pliance and the compliance function in banks, Basel Commit- BHC Supervision Manual January 2009
tee on Banking Supervision, April 2005, www.bis.org.) Page 1
Compliance Risk-Management Programs and Oversight at Large Banking Organizations with Complex Compliance Profiles 2124.07
manner in which the program is implemented The processes established for managing com-
and the type of oversight needed for that pro- pliance risk on a firmwide basis should be for-
gram can vary considerably, depending upon the malized in a compliance program that estab-
scope and complexity of the organizations lishes the framework for identifying, assessing,
activities, the geographic reach of the organiza- controlling, measuring, monitoring, and report-
tion, and other inherent risk factors. Larger, ing compliance risks across the organization,
more complex banking organizations tend to and for providing compliance training through-
conduct a wide range of business activities that out the organization. A banking organizations
are subject to complex compliance requirements compliance risk-management program should
that frequently transcend business lines and be documented in the form of compliance poli-
legal entities and, accordingly, present risk- cies and procedures and compliance risk-
management and corporate governance chal- management standards.4
lenges. Consequently, these organizations typi-
cally require a firmwide approach to compliance Firmwide compliance oversight refers to the
risk management and oversight that includes a processes established to oversee compliance risk
corporate compliance function. In contrast, management across the entire organization, both
smaller, less-complex banking organizations are within and across business lines, legal entities,
not generally confronted with the types of com- and jurisdictions of operation. In addition to the
pliance risks and challenges that require a com- oversight provided by the board of directors and
prehensive firmwide approach to effectively various executive and management committees
manage and oversee compliance risk. The fol- of an organization, a key component of firm-
lowing discussion, therefore, is not directed at wide compliance oversight in larger, more com-
smaller, less-complex banking organizations. plex banking organizations is a corporate com-
pliance function that has day-to-day
Firmwide compliance risk management re- responsibility for overseeing and supporting the
fers to the processes established to manage implementation of the organizations firmwide
compliance risk across an entire organization, compliance risk-management program, and that
both within and across business lines, support plays a key role in controlling compliance risks
units, legal entities, and jurisdictions of opera- that transcend business lines, legal entities, and
tion. This approach ensures that compliance jurisdictions of operation.
risk management is conducted in a context
broader than would take place solely within
individual business lines or legal entities. The
need for a firmwide approach to compliance
risk management at larger, more complex bank-
ing organizations is well demonstrated in areas
such as anti-money-laundering, privacy, affili-
ate transactions, conflicts of interest, and fair
lending, where legal and regulatory require-
ments may apply to multiple business lines or
legal entities within the banking organization. 4. Compliance policies refer to both (1) firmwide compli-
Certain other compliance risks may also war- ance policies that apply to all employees throughout the
rant a firmwide risk-management approach to organization as they conduct their business and support activi-
address similar rules and standards that apply ties and (2) the more detailed, business-specific policies that
are further tailored to, and more specifically address, compli-
to the organizations operations across different ance risks inherent in specific business lines and jurisdictions
jurisdictions. In all such instances, compliance of operation, and apply to employees conducting business and
risk management benefits from an aggregate support activities for the specific business line and/or jurisdic-
view of the organizations compliance risk tion of operation. Compliance procedures refer to the control
procedures that are designed to implement compliance poli-
exposure and an integrated approach to manag- cies. Compliance risk-management standards refer to policies
ing those risks. and procedures applicable to compliance staff as they fulfill
their day-to-day compliance responsibilities. Compliance
standards should clearly articulate expectations regarding the
processes to be followed in implementing the organizations
states that all bank holding companies should be able to assess
firmwide compliance risk-management program, including
the major risks of the consolidated organization. See also 12
the processes and criteria to be utilized in identifying, assess-
C.F.R. 208, appendix D-1, Interagency Guidelines Establish-
ing, controlling, measuring, monitoring, and reporting compli-
ing Standards for Safety and Soundness.
ance risk, and in providing compliance training. Compliance
standards should also clearly articulate the roles and responsi-
BHC Supervision Manual January 2009 bilities of the various committees, functions, and staff with
Page 2 compliance support and oversight responsibilities.
2124.07.1.2 Federal Reserve Supervisory may be able to effectively manage and oversee
Policies on Compliance Risk Management compliance risk without implementing a com-
and Oversight prehensive firmwide approach. Alternatively,
these organizations may choose to implement a
firmwide approach whose scope is highly risk-
2124.07.1.2.1 Large Banking focused on particular compliance risks that exist
Organizations with Complex Compliance throughout the organization. In lieu of relying
Profiles on a corporate compliance function to play a
key role in providing day-to-day oversight of
Although balance sheet size is not the defining
the compliance program, these organizations
indication of a banking organizations compli-
may rely on executive and management com-
ance risk-management needs, experience has
mittees that are actively involved in providing
demonstrated that banking organizations with
ongoing corporate oversight of the compliance
$50 billion or more in consolidated total assets
risk-management program. An organization that
typically have multiple legal entities that pose
adopts this approach, however, should ensure
the type of compliance risks and challenges that
that its compliance program incorporates con-
call for a comprehensive firmwide approach to
trols that effectively address compliance risks
appropriately control compliance risk and pro-
that transcend business lines, legal entities, and
vide effective oversight. Accordingly, such orga-
jurisdictions of operation; that appropriate firm-
nizations should generally implement firmwide
wide standards are established for the business
compliance risk-management programs and
lines to follow in managing compliance risk and
have a corporate compliance function.
reporting on key compliance matters; and that
Compliance programs at such organizations
the organization is appropriately overseeing the
should include more robust processes for identi-
implementation of its compliance risk-
fying, assessing, controlling, measuring, moni-
management program.
toring, and reporting compliance risk, and for
providing compliance training throughout the
organization in order to appropriately control
the heightened level and complexity of compli- 2124.07.1.2.3 Foreign Banking
ance risk. The corporate compliance function Organizations
should play a key role in overseeing and sup-
Each foreign banking organization supervised
porting the implementation of the compliance
by the Federal Reserve should implement a
risk-management program and in controlling
compliance program that is appropriately tai-
compliance risks that transcend business lines,
lored to the scope, complexity, and risk profile
legal entities, and jurisdictions of operation.5
of the organizations U.S. operations. The pro-
gram should be reasonably designed to ensure
that the organizations U.S. operations comply
2124.07.1.2.2 Large Banking with applicable U.S. rules and standards and
Organizations with Less-Complex should establish effective controls over compli-
Compliance Profiles ance risks that transcend business lines or legal
entities. Foreign banking organizations with
In some instances, banking organizations that
large, complex U.S. operations should imple-
meet the $50 billion asset threshold may have
ment compliance programs for these operations
few legal entities, may be less complex in
that have more robust processes for identifying,
nature, and may engage in only a very limited
assessing, controlling, measuring, monitoring,
range of business activities. Such organizations
and reporting compliance risk, and for provid-
ing compliance training, than would be appro-
5. While the corporate compliance function is generally priate for foreign banking organizations with
responsible for overseeing and supporting the compliance
risk-management program, it is recognized that the board of smaller, less-complex U.S. operations.6
directors may assign primary responsibility for aspects of the
compliance program to other units within the organization
6. Foreign banking organizations with $50 billion or more
(e.g., finance, information technology, human resources, etc.).
in U.S. third-party assets will generally be considered as large
The corporate compliance function, therefore, may or may not
banking organizations with complex compliance profiles for
have responsibility for monitoring and testing the controls
purposes of SR 08-8/CA 08-1, unless their U.S. activities are
over certain compliance activities embedded within these
less complex in nature as described in subsection 2124.07.1.
units, such as those over regulatory reporting and regulatory
The Federal Reserves views on compliance risk-management
capital. Nevertheless, it is important that an organizations
compliance program incorporates appropriate controls over
these risks and that proper oversight of the management of BHC Supervision Manual January 2009
these risks is conducted. Page 3
With respect to oversight, foreign banking for, and remuneration of, all compliance staff.7
organizations should provide effective oversight Compliance independence should not, however,
of compliance risks within their U.S. operations, preclude compliance staff from working closely
including risks that transcend business lines or with the management and staff of the various
legal entities. A foreign banking organization, business lines. To the contrary, compliance
however, has flexibility in organizing its over- functions are generally more effective when
sight structure. Compliance oversight of U.S. strong working relationships between compli-
activities may be conducted in a manner that is ance and business line staff exist.
consistent with the foreign banking organiza- The Federal Reserve recognizes, however,
tions broader compliance risk-management that many large, complex banking organizations
framework. Alternatively, a separate function have chosen to implement an organizational
may be established specifically to provide com- structure in which compliance staff within a
pliance oversight of the organizations U.S. business line have a reporting line into the man-
operations. Regardless of the oversight structure agement of the business. In these circumstances,
utilized by a foreign banking organization, its compliance staff should also have a reporting
established oversight mechanisms, governing line through to the corporate compliance func-
policies and procedures, and supporting infra- tion with respect to compliance responsibilities.
structure for its U.S. operations should be suffi- In addition, a banking organization that chooses
ciently transparent for the Federal Reserve to to implement such a dual reporting structure
assess their adequacy. should ensure that the following minimum stan-
dards are observed in order to minimize poten-
tial conflicts of interest associated with this
approach:
2124.07.2 INDEPENDENCE OF
COMPLIANCE STAFF
1. In organizations with dual reporting-line
Federal Reserve supervisory findings at large, structures, the corporate compliance func-
complex banking organizations consistently re- tion should play a key role in determining
inforce the need for compliance staff to be ap- how compliance matters are handled and in
propriately independent of the business lines personnel decisions and actions (including
for which they have compliance responsibili- remuneration) affecting business-line
ties. Compliance independence facilitates ob- compliance and local compliance staff,
jectivity and avoids inherent conflicts of inter- particularly senior compliance staff.
est that may hinder the effective implementa- Furthermore, the organization should have in
tion of a compliance program. A particular place a process designed to ensure that
challenge for many organizations is attaining disputes between the corporate compliance
an appropriate level of independence with re- function and business-line management
spect to compliance staff operating within the regarding compliance matters are resolved
business lines. objectively. Under such a process, the final
The Federal Reserve does not prescribe a decision-making authority should rest either
particular organizational structure for the com- with the corporate compliance function or
pliance function. Large banking organizations with a member or committee of senior
with complex compliance profiles are encour- management that has no business-line
aged, however, to avoid inherent conflicts of responsibilities.
interest by ensuring that accountability exists 2. Compensation and incentive programs
between the corporate compliance function and should be carefully structured to avoid under-
compliance staff within the business lines. Such mining the independence of compliance staff.
accountability would provide the corporate com- Compliance staff should not be compensated
pliance function with ultimate authority regard- on the basis of the financial performance of
ing the handling of compliance matters, person- the business line. Such an arrangement cre-
nel decisions, and actions relating to compliance ates an improper conflict of interest.
staff, including retaining control over the budget 3. Banking organizations with dual reporting-
line structures should implement appropriate
controls and enhanced corporate oversight to
identify and address issues that may arise
programs apply equally to the large, complex U.S. operations
of foreign banking organizations. from conflicts of interest affecting compli-
BHC Supervision Manual January 2009 7. The reference to all compliance staff includes corporate,
Page 4 business-line, and local compliance staff.
ance staff within the business lines. For ing of compliance controls by compliance staff
example, in these circumstances, the process is strongly encouraged as this practice tends to
for providing corporate oversight of monitor- result in an enhanced level of compliance test-
ing and testing activities performed by coming. If, however, compliance testing is per-
pliance staff within the business lines should formed exclusively by the internal audit func-
be especially robust. tion, particular care should be taken to ensure
that high-risk compliance elements are not oth-
erwise obscured by a lower overall risk rating of
2124.07.3 COMPLIANCE a broadly defined audit entity. Otherwise, the
MONITORING AND TESTING scope and frequency of audit coverage of
higher-risk compliance elements tend to be
Robust compliance monitoring and testing play insufficient.
a key role in identifying weaknesses in exist-
ing compliance risk-management controls and
are, therefore, critical components of an effec- 2124.07.4 RESPONSIBILITIES OF THE
tive firmwide compliance risk-management BOARD OF DIRECTORS AND
program. SENIOR MANAGEMENT
The primary responsibility for complying with
2124.07.3.1 Risk Assessments and applicable rules and standards rests with the
Monitoring and Testing Programs individuals within the organization as they
conduct their day-to-day business and support
Risk assessments are the foundation of an effec- activities. The board, senior management, and
tive compliance monitoring and testing pro- the corporate compliance function are
gram. The scope and frequency of compliance responsible for working together to establish
monitoring and testing activities should be a and implement a comprehensive and effective
function of a comprehensive assessment of the compliance risk-management program and
overall compliance risk associated with a par- oversight framework that is reasonably designed
ticular business activity.8 Large complex bank- to prevent and detect compliance breaches and
ing organizations should ensure that comprehen- issues.
sive risk-assessment methodologies are
developed and fully implemented, and that com-
pliance monitoring and testing activities are 2124.07.4.1 Boards of Directors.9
based upon the resulting risk assessments.
Boards of directors are responsible for setting
an appropriate culture of compliance within
2124.07.3.2 Testing their organizations, for establishing clear poli-
cies regarding the management of key risks, and
Compliance testing is necessary to validate for ensuring that these policies are adhered to in
(1) that key assumptions, data sources, and pro- practice. The following discussion is intended to
cedures utilized in measuring and monitoring clarify existing Federal Reserve supervisory
compliance risk can be relied upon on an ongo- views with regard to responsibilities of the
ing basis and (2) in the case of transaction board related to compliance risk management
testing, that controls are working as intended. and oversight, and to differentiate these
The testing of controls and remediation of defi- responsibilities from those of senior
ciencies identified as a result of testing activities management.
are essential to maintaining an effective internal To achieve its objectives, a sound and effec-
control framework. tive firmwide compliance risk-management pro-
The scope and frequency of compliance test- gram should have the support of the board and
ing activities should be based upon the assess- senior management. As set forth in applicable
ment of the specific compliance risks associated
with a particular business activity. Periodic test- 9. Foreign banking organizations should ensure that, with
respect to their U.S. operations, the responsibilities of the
board described in this section are fulfilled in an appropriate
8. Risk assessments should be based upon firmwide stan-
manner through their oversight structure and risk-management
dards that establish the method for, and criteria to be utilized
framework.
in, assessing risk throughout the organization. Risk assess-
ments should take into consideration both the risk inherent in
the activity and the strength and effectiveness of controls BHC Supervision Manual January 2009
designed to mitigate the risk. Page 5
law and supervisory guidance, the board and The board should be knowledgeable about the
senior management of a banking organization general content of the compliance program and
have different, but complementary, roles in man- exercise appropriate oversight of the program.
aging and overseeing compliance risk.10 Accordingly, the board should review and
The board has the responsibility for promot- approve key elements of the organizations
ing a culture that encourages ethical conduct compliance risk-management program and over-
and compliance with applicable rules and stan- sight framework, including firmwide compli-
dards. A strong compliance culture reinforces ance policies, compliance risk-management
the principle that an organization must conduct standards, and roles and responsibilities of com-
its activities in accordance with applicable rules mittees and functions with compliance oversight
and standards and encourages employees to con- responsibilities. The board should oversee man-
duct all activities in accordance with both the agements implementation of the compliance
letter and the spirit of applicable rules and stan- program and the appropriate and timely resolu-
dards. The board should have an appropriate tion of compliance issues by senior manage-
understanding of the types of compliance risks ment. The board should exercise reasonable due
to which the organization is exposed. The level diligence to ensure that the compliance program
of technical knowledge required of directors to remains effective by at least annually reviewing
fulfill these responsibilities may vary, depend- a report on the effectiveness of the program. The
ing on the particular circumstances at the board may delegate these tasks to an appropriate
organization. board-level committee.
The board should ensure that senior manage-
ment is fully capable, qualified, and properly
motivated to manage the compliance risks aris- 2124.07.4.2 Senior Management
ing from the organizations business activities in
a manner that is consistent with the boards Senior management across the organization is
expectations. The board should ensure that its responsible for communicating and reinforcing
views about the importance of compliance are the compliance culture established by the board
understood and communicated by senior man- and for implementing measures to promote the
agement across, and at all levels of, the organi- culture. Senior management also should imple-
zation through ongoing training and other ment and enforce the compliance policies and
means. The board should ensure that senior compliance risk-management standards that
management has established appropriate incen- have been approved by the board. Senior man-
tives to integrate compliance objectives into the agement of the corporate compliance function
management goals and compensation structure should establish, support, and oversee the orga-
across the organization and that appropriate dis- nizations compliance risk-management pro-
ciplinary actions and other measures are taken gram. The corporate compliance function should
when serious compliance failures are identified. report to the board, or a committee thereof, on
Finally, the board should ensure that the corpo- significant compliance matters and the effective-
rate compliance function has an appropriately ness of the compliance risk-management
prominent status within the organization. Senior program.
management within the corporate compliance Senior management of a foreign banking
function and senior compliance personnel within organizations U.S. operations should provide
individual business lines should have the appro- sufficient information to governance or control
priate authority, independence, and access to functions in its home country and should ensure
personnel and information within the organiza- that responsible senior management, including
tion, and appropriate resources to conduct their in the home country, maintain a thorough under-
activities effectively. standing of the risk and control environment
governing U.S. operations. U.S. management
should assess the effectiveness of established
10. See, for example, the Basel compliance paper; SR- governance and control mechanisms on an
04-18, Bank Holding Company Rating System(section
4070.0); SR-95-51, Rating the Adequacy of Risk Manage- ongoing basis, including processes for reporting
ment Processes and Internal Controls at State Member Banks and escalating areas of concern and implementa-
and Bank Holding Companies(section 4070.1); and the tion of corrective action as necessary.
United States Sentencing Commissions Federal Sentencing
Guidelines Manual, Chapter Eight, Sentencing of
Organizations.

Page 6
Assessment of Information Technology in Risk-Focused
Supervision Section 2124.1
The Federal Reserve had adopted risk-focused address the risks associated with its use of
supervision frameworks for community banks information technology,3 and
and large complex banking organizations, 3. provide a basic framework and a common
including foreign banking organizations. These vocabulary to evaluate the effectiveness of
frameworks incorporate a methodology to assess processes used to manage the risks associ-
an organizations risks and business activities ated with information technology.
and to tailor supervisory activities to its risk
profile. These frameworks aim to sharpen the
focus of supervisory activities on areas that pose 2124.1.1 CHANGING ROLE OF
the greatest risk to the safety and soundness of INFORMATION TECHNOLOGY
banking organizations and on management pro-
cesses to identify, measure, monitor, and control As the automated processing of information has
risks.1 moved beyond centralized mainframe opera-
The Federal Reserve recognizes that the use tions to encompass end-user computer and dis-
of information technology can greatly affect a tributed processing systems, the use of informa-
banking organizations financial condition and tion technology in general has expanded greatly.
operating performance.2 With the increasing In the banking industry, information technology
dependency of banking organizations on the use was once limited to automation of routine trans-
of information technology, the Federal Reserve actions and preparation of financial reports but
expects an organizations management and is now used to automate all levels of a banking
board of directors to effectively manage the organizations operations and information pro-
risks associated with information technology. cessing. Some decision-making processes such
Accordingly, examiners must consider the risks as credit scoring and securities trading have
associated with information technology in their been fully automated. New, complex financial
evaluations of an organizations significant busi- products are possible largely because of valua-
ness activities and assess the effectiveness of the tion models that depend on technology. More-
risk-management process that the organization over, technological advances in communica-
applies to information technology. See SR-98- tions and connectivity have minimized
09. geographic constraints within the industry.
This section supplements further the guidance While information technology enables bank-
on the evaluation of banking organizations risk- ing organizations to carry out their activities
management processes. The primary objectives more efficiently and effectively, information
are to technology also can be a source of risk to the
industry. The operational concerns associated
with information processing, traditionally the
1. highlight the critical dependence of the finan- domain of the back office, have assumed
cial services industry on information technol- critical importance during banking mergers and
ogy and its potential effect on safety and consolidations.
soundness, Banking organizations, recognizing the
2. reinforce the concept that the risk-focused dependency of their operations and decision-
supervisory process and related products making processes on information technology,
(risk assessments, supervisory plans, and have placed increased emphasis on the manage-
scope memoranda) for an organization must ment of this important resource. In large bank-
ing organizations, the positions of the chief
information officer and chief technology officer
have become more visible in the top executive
1. The types of risk may be categorized according to those
presented in the guidelines for rating risk management (that ranks of banking organizations. In addition,
is, credit, market, liquidity, operational, legal, and reputa- managers of activities that rely on end-user
tional) or by categories defined by the institution or other computing and distributed processing systems
supervisory agencies. If the institution uses risk categories
that differ from those defined by the supervisory agencies,
those categories may be used if all relevant types of risks are 3. The supervisory products are described in SR-97-24 for
captured. See SR-95-51, Rating the Adequacy of Risk Man- large complex institutions and SR-97-25 for community
agement Processes and Internal Controls at State Member banks.
Banks and Bank Holding Companies.
2. Information technology refers to a business resource
that is the combination of computers (hardware and software), BHC Supervision Manual December 1998
telecommunications, and information. Page 1
Assessment of Information Technology in Risk-Focused Supervision 2124.1
have been assigned more direct responsibility organization and any unique characteristics
for the information technology used in conduct- or issues.
ing their business. As a result, the management 2. Incorporate an analysis of information tech-
of the risks associated with information technol- nology systems into risk assessments, super-
ogy must be evaluated for each significant visory plans, and scope memoranda. The
business activity as well as for the overall analysis should include identification of criti-
organization. cal information technology systems, related
Notwithstanding the move towards decentral- management responsibility, and the major
ized management of information technology, technology components.4 An organizations
large centralized mainframe computer systems information technology systems should be
are still an integral part of the information tech- considered in relation to the size, activities,
nology on which many large banking organiza- and complexity of the organization, as well
tions rely. This includes systems critical to the as the degree of reliance on these systems.
global payments system and to the transfer and 3. Assess the organizations critical systems,
custody of securities. Similarly, with the contin- that is, those that support its major business
ued growth of outsourcing, many third-party activities, and the degree of reliance those
information technology service centers also per- activities have on information technology
form a vital role in the banking industry. There- systems. The level of review should be suffi-
fore, the review of the effectiveness and relia- cient to determine that the systems are deliv-
bility of the critical mainframe systems and ering the services necessary for the organiza-
third-party processors will continue to be an tion to conduct its business safely and
important part of the Federal Reserves supervi- soundly.
sory activities. 4. Determine whether the board of directors
and senior management are adequately iden-
tifying, measuring, monitoring, and control-
2124.1.2 IMPLICATIONS FOR ling the significant risks associated with
RISK-FOCUSED SUPERVISION information technology for the overall orga-
nization and its major business activities.
The risk-focused supervisory process is evolv-
ing and adapting to the changing role of infor-
mation technology, with a greater emphasis 2124.1.3 FRAMEWORK FOR
being placed on an evaluation of information EVALUATING INFORMATION
technology and an assessment of its effect on an TECHNOLOGY
organizations safety and soundness. Accord-
ingly, examiners should explicitly consider In order to provide a common terminology and
information technology when developing their consistent approach for evaluating the adequacy
risk assessments and supervisory plans. It is of an organizations information technology,
expected that examiners will exercise appropri- five information technology elements are intro-
ate judgment in determining the level of review, duced and defined below. These elements may
given the characteristics, size, and business be used to evaluate the information technology
activities of the organization. Moreover, to processes at the functional business level or for
determine the scope of supervisory activities the organization as a whole. They may also be
close coordination is needed between general applied to a variety of information technology
safety-and-soundness examiners and informa- management structures: centralized, decentral-
tion technology specialists during the risk ized, or outsourced.5
assessment and planning, as well as during the Although deficiencies in information technol-
on-site phase of the examination or inspection. ogy appear to be most directly related to opera-
In general, examiners should take the following tional risk, information technology also can
actions: affect the other business risks (credit, market,
liquidity, legal, and reputational) depending on
1. Develop a broad understanding of the organi-
zations approach, strategy, and structure 4. These components include mainframe, local area net-
with regard to information technology. This work, and personal computers, as well as software applica-
requires a determination of the role and tions.
5. When banking organizations outsource operations, they
importance of information technology to the delegate a certain level of responsibility and authority to an
outside party (depending on the contractual arrangements).
BHC Supervision Manual December 1998 However, ultimate accountability remains with the banking
Page 2 organization.
the specific circumstances. Examiners should management systems, programming lan-

view the information technology elements in an guages, and desktop software. Effective
integrated manner with the overall business architecture meets current and long-term
risks of the organization or business activity; a organizational objectives, addresses capacity
deficiency in any one of the elements could requirements to ensure that systems allow
have a substantive adverse effect on the organi- users to easily enter data at both normal and
zations or activitys business risks. Moreover, peak processing times, and provides satisfac-
the elements below do not replace or indepen- tory solutions to problems that arise when
dently add to the business risks described in information is stored and processed in two or
SR-95-51. Rather, these elements should be more systems that cannot be connected elec-
assessed in relation to all business risks. tronically. In assessing the adequacy of infor-
The elements are to be used as a flexible tool mation technology architecture, examiners
to facilitate consideration and discussion of the should consider the hardwares capability to
risks associated with information technology. run the software, the compatibility and inte-
Where an organization uses different terminol- gration with other systems and sources of
ogy to describe information technology ele- data, the ability to upgrade to higher levels of
ments, examiners may use that terminology pro- performance and capacity, and the adequacy
vided the organization adequately addresses all of controls.
elements. Regardless of the terminology 3. Integrity. Integrity refers to the reliability,
employed, examiners should focus on those sys- accuracy, and completeness of information
tems and issues that are considered critical to delivered to the end-user. An information
the organization. technology system has an effective level of
The five information technology elements are integrity when the resulting information
described below: flows are accurate and complete. Insufficient
integrity in an organizations systems could
1. Management processes. Management pro- adversely affect day-to-day reliability, pro-
cesses6 encompass planning, investment, cessing performance, input and output accu-
development, execution, and staffing of racy, and the ease of use of critical informa-
information technology from a corporate- tion. Examiners should review and consider
wide and business-specific perspective. Man- whether the organization relies upon infor-
agement processes over information technol- mation system audits or independent applica-
ogy are effective when they are adequately tion reviews to ensure the integrity of its
and appropriately aligned with, and support- systems. To assess the integrity of an organi-
ive of, the organizations mission and busi- zations systems, examiners should review
ness objectives. Management processes the reliability, accuracy, and completeness of
include strategic planning, management and information delivered.
reporting hierarchy, management succession, 4. Security. Security refers to the safety afforded
and a regular independent review function. to information assets and their data process-
Examiners should determine if the informa- ing environments, using both physical and
tion technology strategy for the business logical controls to achieve a level of protec-
activity or organization is consistent with the tion commensurate with the value of the
organizations mission and business objec- assets. Information technology has effective
tives and whether the information technol- security when controls prevent unauthorized
ogy function has effective management pro- access; modification; destruction; or disclo-
cesses to execute that strategy. sure of information assets during their cre-
2. Architecture. Architecture7 refers to the ation, transmission, processing, maintenance,
underlying design of an automated informa- or storage. Examiners should ensure that
tion system and its individual components. operating procedures and controls are com-
The underlying design encompasses both mensurate with the potential for and risks
physical and logical architecture, including associated with security breaches, which may
operating environments, as well as the orga- be either physical or electronic, inadvertent
nization of data. The individual components or intentional, or internal or external.
refer to network communications, hardware, 5. Availability. Availability refers to the deliv-
and software, which includes operating sys- ery of information to end-users. Information
tems, communications software, database technology has effective availability when
6. Also referred to as organization or strategic. BHC Supervision Manual December 1998

7. Sometimes referred to as infrastructure. Page 3
information is consistently delivered on a soundness examiners may be better suited to

timely basis in support of business and review management processes related to infor-
decision-making processes. In assessing the mation technology. Development of the overall
adequacy of availability, examiners should supervisory approach for an organization
consider the capability of information tech- requires continuous collaboration between gen-
nology to provide information from either eral safety-and-soundness examiners and infor-
primary or secondary sources to the end- mation technology specialists. Accordingly, a
users, as well as the ability of back-up sys- discussion of information technology should be
tems, presented in contingency plans, to miti- integrated into the supervisory process and
gate business disruption. Contingency plans products. That is, examiners should consider
should set out a process for an organization and comment on the risks associated with infor-
to restore or replace its information- mation technology when developing an under-
processing resources, reconstruct its informa- standing of an organization, assessing an organi-
tion assets, and resume its business activity zations risks, and preparing a scope
from disruption caused by human error or memorandum.
intervention, natural disaster, or infrastruc-
ture failure (including the loss of utilities and
communication lines and operational fail- 2124.1.5 INSPECTION OBJECTIVES
ure of hardware, software, and network
communications). 1. To assess the risks associated with informa-
tion technology when developing the scope
Appendix A provides a table with examples of supervisory plans and activities.
of situations where deficiencies in information 2. To consider the various risks associated with
technology elements potentially have a negative information technology along with the risk
effect on the business risks of an organization. evaluation of the banking organizations
The table also provides possible actions that an business activities.
organization could take in these situations to 3. To assess the effectiveness of the risk-
mitigate its risks. The examples in this table are management process that the banking organi-
representative and should not be viewed as an zation applies to information technology.
exhaustive list of the risks associated with infor- 4. To view the banking organizations informa-
mation technology. tion technology elements in an integrated
manner along with the overall business risks
of the banking organization or its business
2124.1.4 ALIGNING EXAMINER activity, and ascertain if there are any defi-
STAFFING WITH THE TECHNOLOGY ciencies therein.
ENVIRONMENT
While mainframe computer systems are still an 2124.1.6 INSPECTION PROCEDURES
integral part of the information technology for
large organizations, information technology pro- 1. Develop a broad understanding of the organi-
cesses have become embedded in the various zations approach, strategy, and structure
business activities of a banking organization with regard to information technology.
particularly with the increased use of local area 2. Incorporate an analysis of information tech-
network and personal computers. In contrast, nology systems into risk assessments,
many community and regional banks continue supervisory plans, and scope memoranda.
to rely on third-party information technology 3. Assess the banking organizations critical
service centers. Given this variability of infor- systems and the degree of reliance those
mation technology environments, the level of activities have on information technology
technical expertise needed for a particular systems.
examination or inspection will vary and should 4. Determine that the information systems are
be identified during its planning phase. For delivering the services necessary for the or-
example, a specialist in information technology ganization to conduct its business safely and
or the particular business activity may be the soundly.
most appropriate person to review information 5. Determine if the board of directors or senior
technology integrity, while general safety-and- management has conducted an independent
review, either by independent qualified staff
BHC Supervision Manual December 1998 or by an independent third-party consultant,
Page 4 of the current architecture, assessing the risks
associated with the institutions information 7. Review, on a sample basis, the reliability,
technology. Did the review establish whether accuracy, and completeness of processed
the organizations architecture had provided delivered information.
for 8. Determine whether the operating proce-
a. current and long-term organizational dures and controls are commensurate with
objectives, the potential for, and risks associated with,
b. capacity requirements during normal and security breaches, which may be either
peak processing periods, physical or electronic, inadvertent or inten-
tional, or internal or external.
c. solutions when information is stored and 9. Determine whether the board of directors
processed in two or more separate and senior management are adequately
systems, identifying, measuring, monitoring, and
d. the hardwares capability to run the soft- controlling the significant risks associated
ware and its compatibility and integration with information technology for the overall
with other systems and sources of data, banking organization and its major business
e. the ability to upgrade to higher levels of activities.
performance and capacity, and 10. After developing an understanding of the
f. the adequacy of controls. banking organization, assess and comment
6. Determine if the institution relies on informa- on the information technology risks and
tion system audits or independent application management in a scope memorandum.
reviews to determine whether information
flows are accurate and complete.

Page 5
Page 6
BHC Supervision Manual
Assessment of Information Technology in Risk-Focused Supervision

2124.1.7 Appendix AExamples of Information Technology Elements that Should Be Considered in Assessing Business Risks of
Particular Situations
Situation IT elements to be considered Potential effect on business risks Risk mitigants
A bank holding company expands Management processes. Lack of clear, Credit risk. Exposure to less creditwor- Develop a well-thought-out plan for
very rapidly via acquisition into cohesive strategies could result in thy borrowers may increase. integrating acquired systems, mapping
new product lines and geographic dependence on different systems that data flows and sources, and ensuring
areas. are incompatible and fragmented. Liquidity risk. Depositors may with- reliability of systems.
draw funds or close accounts due to
Integrity. Unreliable information could unreliable account information.
be produced due to incompatible
systems. Operational risk. Controls may be
December 1998
inadequate to address the increase in

Availability. Critical information may manual interventions to correct incom-
not be available to management when patibility problems between affiliates
needed. systems, leading to a greater potential
for fraudulent transactions.
A banks consumer loan division Integrity. Billing errors and unwar- Reputational risk. Knowledge of errors Improve policies and procedures related
inputs erroneous entries into the ranted late-payment fees could occur could become widespread resulting in to input of accounting entries.
general-ledger system. due to the inaccurate loan information adverse public opinion.
maintained by the system. Ensure internal audit considers system
Operational risk. Increased expendi- aspects of accounting operations.
tures may be required to resolve
accounting operations problems.
Legal risk. Litigation could arise
because of errors in customer accounts
due to processing deficiencies.
Substantial turnover occurs in Security. Security procedures could be Operational risk. Financial losses Increase and strengthen procedural and
banks wire-transfer department. compromised due to inadequate train- could occur due to fraud or incorrectly access controls for wire operations.
ing and lack of qualified personnel. sent wire transfers.
Implement security measures such as
Integrity. System may not be able to Legal risk. Litigation could arise as a passwords and firewalls.
provide real-time funds availability. result of errors in customer accounts
2124.1
and fraudulent wire transfers. Develop and monitor appropriate audit
trails.
Reputational risk. Knowledge of
fraudulent or erroneous wire operations Provide for adequate training program
could result in adverse public opinion. and staffing levels.
Managing Outsourcing Risk
Section 2124.3
The Federal Reserve issued this guidance to Concentration risks arise when outsourced
assist financial institutions in understanding and services or products are provided by a limited
managing the risks associated with outsourcing number of service providers or are concen-
a bank activity to a service provider to perform trated in limited geographic locations.
that activity. Refer to SR-13-19/CA-13-21. Reputational risks arise when actions or poor
In addition to traditional core bank processing performance of a service provider causes the
and information technology services, financial public to form a negative opinion about a
institutions1 outsource operational activities financial institution.
such as accounting, appraisal management, Country risks arise when a financial institu-
internal audit, human resources, sales and mar- tion engages a foreign-based service provider,
keting, loan review, asset and wealth manage- exposing the institution to possible economic,
ment, procurement, and loan servicing. The Fed- social, and political conditions and events
eral Reserve has issued this guidance to from the country where the provider is
financial institutions to highlight the potential located.
risks that arise from the use of service providers Operational risks arise when a service pro-
and to describe the elements of an appropriate vider exposes a financial institution to losses
service provider risk-management program. due to inadequate or failed internal processes
This guidance supplements existing guidance on or systems or from external events and human
technology service provider (TSP) risk,2 and error.
applies to service provider relationships where Legal risks arise when a service provider
business functions or activities are outsourced. exposes a financial institution to legal
For purposes of this guidance, service provid- expenses and possible lawsuits.
ers is broadly defined to include all entities3
that have entered into a contractual relationship
with a financial institution to provide business 2124.3.2 BOARD OF DIRECTORS
functions or activities. AND SENIOR MANAGEMENT
RESPONSIBILITIES
2124.3.1 RISKS FROM THE USE OF The use of service providers does not relieve a
SERVICE PROVIDERS financial institutions board of directors and
senior management of their responsibility to
The use of service providers to perform opera-
ensure that outsourced activities are conducted
tional functions presents various risks to finan-
in a safe-and-sound manner and in compliance
cial institutions. Some risks are inherent to the
with applicable laws and regulations. Policies
outsourced activity itself, whereas others are
governing the use of service providers should be
introduced with the involvement of a service
established and approved by the board of direc-
provider. If not managed effectively, the use of
tors, or an executive committee of the board.
service providers may expose financial institu-
These policies should establish a service
tions to risks that can result in regulatory action,
provider risk management program that
financial loss, litigation, and loss of reputation.
addresses risk assessments and due diligence,
Financial institutions should consider the fol-
standards for contract provisions and
lowing risks before entering into and while man-
considerations, ongoing monitoring of service
aging outsourcing arrangements.
providers, and business continuity and
contingency planning.
Compliance risks arise when the services,
Senior management is responsible for ensur-
products, or activities of a service provider
ing that board-approved policies for the use of
fail to comply with applicable U.S. laws and
service providers are appropriately executed.
regulations.
This includes overseeing the development and
implementation of an appropriate risk-
1. For purposes of this guidance, a financial institution
refers to state member banks, bank and savings and loan
management and reporting framework that
holding companies (including their nonbank subsidiaries), includes elements described in this guidance.
and U.S. operations of foreign banking organizations. Senior management is also responsible for regu-
2. Refer to the FFIEC Outsourcing Technology Services larly reporting to the board of directors on
Booklet (June 2004) at http://ithandbook.ffiec.gov/it-booklets/
outsourcing-technology-services.aspx.
3. Entities may be a bank or nonbank, affiliated or non- BHC Supervision Manual January 2014
affiliated, regulated or non-regulated, or domestic or foreign. Page 1
Managing Outsourcing Risk Section 2124.3
adherence to policies governing outsourcing A. Risk Assessments

arrangements.
Risk assessment of a business activity and the
implications of performing the activity in-house
or having the activity performed by a service
2124.3.3 SERVICE PROVIDER provider are fundamental to the decision of
RISK-MANAGEMENT PROGRAMS whether or not to outsource. A financial institu-
tion should determine whether outsourcing an
A financial institutions service provider risk- activity is consistent with the strategic direction
management program should be risk-focused and overall business strategy of the organiza-
and provide oversight and controls commensu- tion. After that determination is made, a finan-
rate with the level of risk presented by the cial institution should analyze the benefits and
outsourcing arrangements in which the financial risks of outsourcing the proposed activity as
institution is engaged. It should focus on out- well as the service provider risk, and determine
sourced activities that have a substantial impact cost implications for establishing the outsourc-
on a financial institutions financial condition; ing arrangement. Consideration should also be
are critical to the institutions ongoing opera- given to the availability of qualified and experi-
tions; involve sensitive customer information or enced service providers to perform the service
new bank products or services; or pose material on an ongoing basis. Additionally, management
compliance risk. should consider the financial institutions ability
The depth and formality of the service pro- and expertise to provide appropriate oversight
vider risk-management program will depend on and management of the relationship with the
the criticality, complexity, and number of mate- service provider.
rial business activities being outsourced. A com- This risk assessment should be updated at
munity banking organization may have critical appropriate intervals consistent with the finan-
business activities being outsourced, but the cial institutions service provider risk-
number may be few and to highly reputable management program. A financial institution
service providers. Therefore, the risk- should revise its risk mitigation plans, if appro-
management program may be simpler and use priate, based on the results of the updated risk
less elements and considerations. For those assessment.
financial institutions that may use hundreds or
thousands of service providers for numerous
business activities that have material risk, the
financial institutions may find that they need to
B. Due Diligence and Selections of
use many more elements and considerations of a
Service Providers
service provider risk-management program to
manage the higher level of risk and reliance on A financial institution should conduct an evalua-
service providers. tion of and perform the necessary due diligence
for a prospective service provider prior to
While the activities necessary to implement
engaging the service provider. The depth and
an effective service provider risk-management
formality of the due diligence performed will
program can vary based on the scope and nature
vary depending on the scope, complexity, and
of a financial institutions outsourced activities,
importance of the planned outsourcing arrange-
effective programs usually include the following
ment, the financial institutions familiarity with
core elements:
prospective service providers, and the reputa-
tion and industry standing of the service pro-
risk assessments, due diligence and selection vider. Throughout the due diligence process,
of service providers; financial institution technical experts and key
contract provisions and considerations; stakeholders should be engaged in the review
incentive compensation review; and approval process as needed. The overall due
oversight and monitoring of service provid- diligence process includes a review of the ser-
ers; and vice provider with regard to business back-
ground, reputation, and strategy; financial per-
business continuity and contingency plans.
formance and condition; and operations and
internal controls.
Page 2
1. Business Background, Reputation, and of the financial condition of any subcontrac-

Strategy tors.
Other current issues the service provider may
Financial institutions should review a prospec- be facing that could affect future financial
tive service providers status in the industry and performance.
corporate history and qualifications; review the
background and reputation of the service pro-
vider and its principals; and ensure that the 3. Operations and Internal Controls
service provider has an appropriate background
check program for its employees. Financial institutions are responsible for ensur-
The service providers experience in providing that services provided by service providers
ing the proposed service should be evaluated in comply with applicable laws and regulations
order to assess its qualifications and competen- and are consistent with safe-and-sound banking
cies to perform the service. The service provid- practices. Financial institutions should evaluate
ers business model, including its business strat- the adequacy of standards, policies, and proce-
egy and mission, service philosophy, quality dures. Depending on the characteristics of the
initiatives, and organizational policies should be outsourced activity, some or all of the following
evaluated. Financial institutions should also may need to be reviewed:
consider the resiliency and adaptability of the
service providers business model as factors in 1. internal controls;
assessing the future viability of the provider to 2. facilities management (such as access
perform services. requirements or sharing of facilities);
Financial institutions should check the ser- 3. training, including compliance training for
vice providers references to ascertain its perfor- staff;
mance record, and verify any required licenses 4. security of systems (for example, data and
and certifications. Financial institutions should equipment);
also verify whether there are any pending legal 5. privacy protection of the financial institu-
or regulatory compliance issues (for example, tions confidential information;
litigation, regulatory actions, or complaints) that 6. maintenance and retention of records;
are associated with the prospective service pro- 7. business resumption and contingency plan-
vider and its principals. ning;
8. systems development and maintenance;
9. service support and delivery;
2. Financial Performance and Condition 10. employee background checks; and
11. adherence to applicable laws, regulations,
Financial institutions should review the finan- and supervisory guidance.
cial condition of the service provider and its
closely related affiliates. The financial review
may include: C. Contract Provisions and
The service providers most recent financial Considerations
statements and annual report with regard to
outstanding commitments, capital strength, Financial institutions should understand the ser-
liquidity, and operating results. vice contract and legal issues associated with
The service providers sustainability, includ- proposed outsourcing arrangements. The terms
ing factors such as the length of time that the of service agreements should be defined in writ-
service provider has been in business and the ten contracts that have been reviewed by the
service providers growth of market share for financial institutions legal counsel prior to
a given service. execution. The characteristics of the business
The potential impact of the financial institu- activity being outsourced and the service pro-
tions business relationship on the service providers strategy for providing those services will
viders financial condition. determine the terms of the contract. Elements of
The service providers commitment (both in well-defined contracts and service agreements
terms of financial and staff resources) to pro- usually include:
vide the contracted services to the financial
institution for the duration of the contract. 1. Scope: Contracts should clearly define the
The adequacy of the service providers insur-
ance coverage. BHC Supervision Manual January 2014
The adequacy of the service providers review Page 3
rights and responsibilities of each party, Information security measures for out-
including: sourced functions should be viewed as if
support, maintenance, and customer ser- the activity were being performed by the
vice; financial institution and afforded the same
contract timeframes; protections. Financial institutions have a
compliance with applicable laws, regula- responsibility to ensure service providers
tions, and regulatory guidance; take appropriate measures designed to meet
training of financial institution employ- the objectives of the information security
ees; guidelines within Federal Financial Institu-
the ability to subcontract services; tions Examination Council (FFIEC) guid-
the distribution of any required state- ance,4 as well as comply with section
ments or disclosures to the financial 501(b) of the Gramm-Leach-Bliley Act.
institutions customers; These measures should be mapped directly
insurance coverage requirements; and to the security processes at financial institu-
terms governing the use of the financial tions, as well as be included or referenced
institutions property, equipment, and in agreements between financial institutions
staff. and service providers.
2. Cost and compensation: Contracts should Service agreements should also address
describe the compensation, variable service provider use of financial institution
charges, and any fees to be paid for non- information and its customer information.
recurring items and special requests. Agree- Information made available to the service
ments should also address which party is provider should be limited to what is
responsible for the payment of any legal, needed to provide the contracted services.
audit, and examination fees related to the Service providers may reveal confidential
activity being performed by the service pro- supervisory information only to the extent
vider. Where applicable, agreements should authorized under applicable laws and regu-
address the party responsible for the lations.5
expense, purchasing, and maintenance of If service providers handle any of the
any equipment, hardware, software or any financial institution customers Nonpublic
other item related to the activity being per- Personal Information (NPPI), the service
formed by the service provider. In addition, providers must comply with applicable pri-
financial institutions should ensure that any vacy laws and regulations.6 Financial insti-
incentives (for example, in the form of vari- tutions should require notification from ser-
able charges, such as fees and/or commis- vice providers of any breaches involving
sions) provided in contracts do not provide the disclosure of NPPI data. Generally,
potential incentives to take imprudent risks NPPI data is any nonpublic personally iden-
on behalf of the institution. tifiable financial information; and any list,
3. Right to audit: Agreements may provide for description, or other grouping of consumers
the right of the institution or its representa- (and publicly available information pertain-
tives to audit the service provider and/or to ing to them) derived using any personally
have access to audit reports. Agreements identifiable financial information that is not
should define the types of audit reports the publicly available.7 Financial institutions
financial institution will receive and the fre- and their service providers who maintain,
quency of the audits and reports. store, or process NPPI data are responsible
4. Establishment and monitoring of perfor- for that information and any disclosure of
mance standards: Agreements should it. The security of, retention of, and access
define measurable performance standards to NPPI data should be addressed in any
for the services or products being provided. contracts with service providers.
5. Confidentiality and security of information: When a breach or compromise of NPPI
Consistent with applicable laws, regula- data occurs, financial institutions have legal
tions, and supervisory guidance, service requirements that vary by state and these
providers should ensure the security and
confidentiality of both the financial institu- 4. For further guidance regarding vendor security prac-
tions confidential information and the tices, refer to the FFIEC Information Security Booklet (July
2006) at http://ithandbook.ffiec.gov/it-booklets/information-
financial institutions customer information. security.aspx.
5. See 12 CFR Part 261.
BHC Supervision Manual January 2014 6. See 12 C.F.R. 1016.
Page 4 7. See 12 U.S.C. 6801(b).
requirements should be made part of the the continuation of the arrangement

contracts between the financial institution between the parties during the dispute reso-
and any service provider that provides stor- lution period.
age, processing, or transmission of NPPI 10. Limits on liability: Service providers may
data. Misuse or unauthorized disclosure of want to contractually limit their liability.
confidential customer data by service pro- The board of directors and senior manage-
viders may expose financial institutions to ment of a financial institution should deter-
liability or action by a federal or state regu- mine whether the proposed limitations are
latory agency. Contracts should clearly reasonable when compared to the risks to
authorize and disclose the roles and respon- the institution if a service provider fails to
sibilities of financial institutions and service perform.9
providers regarding NPPI data. 11. Insurance: Service providers should have
6. Ownership and license: Agreements should adequate insurance and provide financial
define the ability and circumstances under institutions with proof of insurance. Fur-
which service providers may use financial ther, service providers should notify finan-
institution property inclusive of data, hard- cial institutions when there is a material
ware, software, and intellectual property. change in their insurance coverage.
Agreements should address the ownership 12. Customer complaints: Agreements should
and control of any information generated by specify the responsibilities of financial insti-
service providers. If financial institutions tutions and service providers related to
purchase software from service providers, responding to customer complaints. If ser-
escrow agreements may be needed to ensure vice providers are responsible for customer
that financial institutions have the ability to complaint resolution, agreements should
access the source code and programs under provide for summary reports to the financial
certain conditions.8 institutions that track the status and resolu-
7. Indemnification: Agreements should pro- tion of complaints.
vide for service provider indemnification of 13. Business resumption and contingency plan
financial institutions for any claims against of the service provider: Agreements should
financial institutions resulting from the ser- address the continuation of services pro-
vice providers negligence. vided by service providers in the event of
8. Default and termination: Agreements operational failures. Agreements should
should define events of a contractual address service provider responsibility for
default, list of acceptable remedies, and pro- backing up information and maintaining
vide opportunities for curing default. Agree- disaster recovery and contingency plans.
ments should also define termination rights, Agreements may include a service provid-
including change in control, merger or ers responsibility for testing of plans and
acquisition, increase in fees, failure to meet providing testing results to financial institu-
performance standards, failure to fulfill the tions.
contractual obligations, failure to provide 14. Foreign-based service providers: For agree-
required notices, and failure to prevent vio- ments with foreign-based service providers,
lations of law, bankruptcy, closure, or insol- financial institutions should consider
vency. Contracts should include termination including express choice of law and juris-
and notification requirements that provide dictional provisions that would provide for
financial institutions with sufficient time to the adjudication of all disputes between the
transfer services to another service pro- two parties under the laws of a single, spe-
vider. Agreements should also address a cific jurisdiction. Such agreements may be
service providers preservation and timely subject to the interpretation of foreign
return of financial institution data, records, courts relying on local laws. Foreign law
and other resources. may differ from U.S. law in the enforcement
9. Dispute resolution: Agreements should of contracts. As a result, financial institu-
include a dispute resolution process in order
to expedite problem resolution and address 9. Refer to SR-06-4, Interagency Advisory on the Unsafe
and Unsound Use of Limitations on Liability Provisions in
External Audit Engagement Letters, regarding restrictions
8. Escrow agreements are established with vendors when
on the liability limitations for external audit engagements or
buying or leasing products that have underlying proprietary
section 2060.1.
software. In such agreements, an organization can only access
the source program code under specific conditions, such as
discontinued product support or financial insolvency of the BHC Supervision Manual January 2014
vendor. Page 5
tions should seek legal advice regarding the E. Oversight and Monitoring of Service
enforceability of all aspects of proposed Providers
contracts with foreign-based service provid-
ers and the other legal ramifications of such To effectively monitor contractual requirements,
arrangements. financial institutions should establish acceptable
15. Subcontracting: If agreements allow for performance metrics that the business line or
subcontracting, the same contractual provi- relationship management determines to be
sions should apply to the subcontractor. indicative of acceptable performance levels.
Contract provisions should clearly state that Financial institutions should ensure that person-
the primary service provider has overall nel with oversight and management responsibili-
accountability for all services that the ser- ties for service providers have the appropriate
vice provider and its subcontractors pro- level of expertise and stature to manage the
vide. Agreements should define the services outsourcing arrangement. The oversight pro-
that may be subcontracted, the service process, including the level and frequency of man-
viders due diligence process for engaging agement reporting, should be risk-focused.
and monitoring subcontractors, and the Higher risk service providers may require more
notification and approval requirements frequent assessment and monitoring and may
regarding changes to the service providers require financial institutions to designate indi-
subcontractors. Financial institutions should viduals or a group as a point of contact for those
pay special attention to any foreign subcon- service providers. Financial institutions should
tractors, as information security and data tailor and implement risk mitigation plans for
privacy standards may be different in other higher risk service providers that may include
jurisdictions. Additionally, agreements processes such as additional reporting by the
should include the service providers pro- service provider or heightened monitoring by
cess for assessing the subcontractors finan- the financial institution. Further, more frequent
cial condition to fulfill contractual obliga- and stringent monitoring is necessary for service
tions. providers that exhibit performance, financial,
compliance, or control concerns. For lower risk
service providers, the level of monitoring can be
lessened.
D. Incentive Compensation Review Financial condition: Financial institutions
should have established procedures to monitor
Financial institutions should also ensure that an the financial condition of service providers to
effective process is in place to review and evaluate their ongoing viability. In performing
approve any incentive compensation that may these assessments, financial institutions should
be embedded in service provider contracts, review the most recent financial statements and
including a review of whether existing gover- annual report with regard to outstanding com-
nance and controls are adequate in light of risks mitments, capital strength, liquidity, and operat-
arising from incentive compensation arrange- ing results. If a service provider relies signifi-
ments. As the service provider represents the cantly on subcontractors to provide services to
institution by selling products or services on its financial institutions, then the service providers
behalf, the institution should consider whether controls and due diligence regarding the subcon-
the incentives provided might encourage the tractors should also be reviewed.
service provider to take imprudent risks. Inap- Internal controls: For significant service pro-
propriately structured incentives may result in vider relationships, financial institutions should
reputational damage, increased litigation, or assess the adequacy of the providers control
other risks to the financial institution. An exam- environment. Assessments should include
ple of an inappropriate incentive would be one reviewing available audits or reports such as the
where variable fees or commissions encourage American Institute of Certified Public Accoun-
the service provider to direct customers to prod- tants Service Organization Control 2 report.10
ucts with higher profit margins without due con- If the service provider delivers information tech-
sideration of whether such products are suitable nology services, the financial institution can
for the customer. request the FFIEC Technology Service Provider
examination report from its primary federal
regulator. Security incidents at the service pro-
vider may also necessitate the institution to
Page 6 10. Refer to www.AICPA.org.
elevate its monitoring of the service provider. G. Additional Risk Considerations

Escalation of oversight activities: Financial
institutions should ensure that risk-management Suspicious Activity Report (SAR) reporting func-
processes include triggers to escalate oversight tions: The confidentiality of suspicious activity
and monitoring when service providers are fail- reporting makes the outsourcing of any SAR-
ing to meet performance, compliance, control, related function more complex. Financial insti-
or viability expectations. These procedures tutions need to identify and monitor the risks
should include more frequent and stringent associated with using service providers to per-
monitoring and follow-up on identified issues, form certain suspicious activity reporting func-
on-site control reviews, and when an institution tions in compliance with the Bank Secrecy Act
should exercise its right to audit a service pro- (BSA). Financial institution management should
viders adherence to the terms of the agreement. ensure they understand the risks associated with
Financial institutions should develop criteria for such an arrangement and any BSA-specific
engaging alternative outsourcing arrangements guidance in this area.
and terminating the service provider contract in Foreign-based service providers: Financial
the event that identified issues are not institutions should ensure that foreign-based ser-
adequately addressed in a timely manner. vice providers are in compliance with applicable
U.S. laws, regulations, and regulatory guidance.
Financial institutions may also want to consider
F. Business Continuity and Contingency laws and regulations of the foreign-based pro-
Considerations viders country or regulatory authority regard-
ing the financial institutions ability to perform
Various events may affect a service providers on-site review of the service providers opera-
ability to provide contracted services. For exam- tions. In addition, financial institutions should
ple, services could be disrupted by a providers consider the authority or ability of home coun-
performance failure, operational disruption, try supervisors to gain access to the financial
financial difficulty, or failure of business conti- institutions customer information while exam-
nuity and contingency plans during operational ining the foreign-based service provider.
disruptions or natural disasters. Financial insti- Internal audit: Financial institutions should
tution contingency plans should focus on criti- refer to existing guidance on the engagement of
cal services provided by service providers and independent public accounting firms and other
consider alternative arrangements in the event outside professionals to perform work that has
that a service provider is unable to perform.11 been traditionally carried out by internal audi-
When preparing contingency plans, financial tors.12 The Sarbanes-Oxley Act of 2002 specifi-
institutions should cally prohibits a registered public accounting
firm from performing certain non-audit services
ensure that a disaster recovery and business for a public company client for whom it per-
continuity plan exists with regard to the conforms financial statement audits.
tracted services and products; Risk-management activities: Financial institu-
assess the adequacy and effectiveness of a tions may outsource various risk-management
service providers disaster recovery and busi- activities, such as aspects of interest rate risk and
ness continuity plan and its alignment to their model risk management. Financial institutions
own plan; should require service providers to provide
document the roles and responsibilities for information that demonstrates developmental
maintaining and testing the service providers evidence explaining the product components,
business continuity and contingency plans; design, and intended use, to determine whether
test the service providers business continuity
and contingency plans on a periodic basis to 12. Refer to SR-13-1, Supplemental Policy Statement on
ensure adequacy and effectiveness; and the Internal Audit Function and Its Outsourcing, specifically
maintain an exit strategy, including a pool of the section titled, Depository Institutions Subject to the
Annual Audit and Reporting Requirements of Section 36 of
comparable service providers, in the event the FDI Act. See section 2060.07 of this manual. Refer also
that a contracted service provider is unable to to SR-03-5, Amended Interagency Guidance on the Internal
perform. Audit Function and its Outsourcing, particularly the section
titled,Institutions Not Subject to Section 36 of the FDI Act
that are Neither Public Companies nor Subsidiaries of Public
11. For further guidance regarding business continuity
Companies. See section 2060.05 of this manual.
planning with service providers, refer to the FFIEC Business
Continuity Booklet (March 2008) at http://
ithandbook.ffiec.gov/it-booklets/business-continuity- BHC Supervision Manual January 2014
planning.aspx. Page 7
the products and/or services are appropriate for providers offering model risk-management
the institutions exposures and risks.13 Financial services, such as validation, do so in a way that
institutions should also have standards and is consistent with existing model risk-
processes in place for ensuring that service management guidance.
13. Refer to SR-11-7, Guidance on Model Risk Manage-

ment or section 2126.0 which informs financial institutions
of the importance and risk to the use of models and the
supervisory expectations that financial institutions should
adhere to.

Page 8
Information Security Standards
Section 2124.4
WHATS NEW IN THIS REVISED information security standards include standards

SECTION for the proper disposal of consumer and cus-
tomer information and guidance on response
Effective July 2012, this section was revised to programs for unauthorized access to customer
remove references to SR-97-32, Sound Prac- information. (See SR-05-23/CA-05-10.) See
tices Guidance for Information Security Net- sections 2124.4.1.1 and 2124.4.2.
works and SR-00-4, Outsourcing of Informa- Under the information security standards,
tion and Transaction Processing, which were each bank holding company falling within the
deemed inactive by SR-12-6. A reference to inac- scope of the standards must implement a com-
tive SR-03-12, Revisions to the Suspicious prehensive, written information security pro-
Activity Report Form, was also removed. gram.4 A bank holding companys board of
directors, or an appropriate committee of the
board, must oversee the companys develop-
2124.4.1 INTERAGENCY GUIDELINES ment, implementation, and maintenance of the
ESTABLISHING INFORMATION information security programthis board over-
SECURITY STANDARDS sight includes assigning specific responsibility
for the programs implementation and review-
The federal banking agencies jointly issued ing reports received from management. The
interagency guidelines establishing information information security program should include
security standards (the information security administrative, technical, and physical safe-
standards), which became effective July 1, guards appropriate to the size and complexity of
2001.1 (See appendix A, section 2124.4.5.) The the bank holding company and the nature and
Board of Governors of the Federal Reserve Sys- scope of its activities.
tem approved amendments to the standards on While all parts of a bank holding company
December 16, 2004 (effective July 1, 2005). The are not required to implement a uniform infor-
amended information security standards imple- mation security program and set of policies, all
ment sections of 501 and 505 of the Gramm- elements of the information security program
Leach-Bliley Act (15 U.S.C. 6801 and 6805) must be coordinated. A bank holding company
and section 216 of the Fair and Accurate Credit must ensure that each of its subsidiaries is sub-
Transactions Act of 2003 (15 U.S.C. 1681w). ject to a comprehensive information security
The Gramm-Leach-Bliley Act requires the agen- program. It may fulfill this requirement either
cies to establish information standards consist- 1) by including a subsidiary within the scope of
ing of administrative, technical, and physical the banks holding companys comprehensive
safeguards for customer records and informa- information security program or (2) by having
tion. (See SR-01-15.) Bank holding companies the subsidiary implement a separate comprehen-
and financial holding companies must comply sive information security program in accordance
with the information security standards (see with the information security standards and pro-
appendix F for Regulation Y).2 The information cedures of appendix F, Regulation Y.
security standards apply to customer informa- A bank holding companys information secu-
tion maintained by or on behalf of state member rity program must be designed to (1) ensure the
banks, bank holding companies, and the non- security and confidentiality of customer infor-
bank subsidiaries or affiliates of each.3 The mation,5 (2) protect against anticipated threats
1. The 2001 information security standards were titled 4. The information security standards apply to customer
Interagency Guidelines Establishing Standards for Safeguard- information; as a result, a bank holding company that does not
ing Customer Information. See 66 Fed. Reg. 8,6168,641 maintain any customer information is not subject to the infor-
(February 1, 2001); 69 Fed. Reg. 7,6107,621 (December 28, mation security standards. In addition, when customer infor-
2004); and Regulation H, 12 CFR 208, appendix D-2; Regula- mation is maintained only in the banking subsidiaries or
tion K, 12 CFR 211.9 and 211.24; and Regulation Y, 12 CFR functionally regulated nonbank subsidiaries of the holding
225, appendix F. company, examiners generally may rely on the primary super-
2. The discussion in this section applies equally to finan- visors assessment of the subsidiaries information security
cial holding companies and bank holding companies. programs, if applicable, to determine the holding companys
3. The information security standards do not apply to bro- compliance with the information security standards.
kers, dealers, investment companies, and investment advisers, 5. Customer information is defined to include any record,
or to persons providing insurance under the applicable state whether in paper, electronic, or other form, containing non-
insurance authority of the state in which the person is domi-
ciled. The appropriate federal agency or state insurance
authority regulates these insurance entities under sections 501 BHC Supervision Manual July 2012
and 505 of the Gramm-Leach-Bliley Act. Page 1
Information Security Standards 2124.4
or hazards to the security or integrity of such its activities. The measures that a bank holding
information, (3) protect against unauthorized company must consider and may adopt include
access to or use of customer information that access controls, access restrictions, encryption
could result in substantial harm or inconve- of electronic customer information, dual control
nience to any customer, and (4) ensure the procedures, segregation of duties, and employee
proper disposal of customer information and background checks for employees who have
consumer information.6 Each bank holding com- responsibilities for or access to customer infor-
pany must identify reasonably foreseeable inter- mation. In addition, a bank holding company
nal and external threats that could result in must have monitoring systems and response
unauthorized disclosure, misuse, alteration, or programs and measures to protect against
destruction of customer information or customer destruction, loss, or damage of customer infor-
information systems. An assessment must be mation due to potential environmental hazards,
made of the (1) likelihood and potential damage such as fire and water damage or technological
of these threats, taking into consideration the failures. Training and testing, are critical com-
sensitivity of the customer information, and ponents to implement an effective information
(2) sufficiency of policies, procedures, customer security program. Each bank holding company
information systems, and other arrangements must regularly test the key controls, systems,
that are in place to control risks. and procedures. Tests should be conducted or
Appropriate policies, procedures, training, reviewed by independent third parties or by staff
and testing must be implemented to manage and who are independent of the individuals who
control identified risks. Management must also develop or maintain the security program.
report at least annually to the board of directors The Federal Reserve recognizes that banking
or an appropriate committee of the board. Man- organizations are highly sensitive to the impor-
agements reports should describe the overall tance of safeguarding customer information and
status of the information security program and the need to maintain effective information secu-
the bank holding companys compliance with rity programs. Existing examination and inspec-
the information security standards. The reports tion procedures and supervisory processes
should discuss material matters related to the already address information security. As a result,
BHCs information security program, address- most banking organizations may not need to
ing issues such as risk assessment, risk- implement any new controls and procedures.
management and -control decisions, service- Examiners should assess compliance with the
provider arrangements, results of testing, information security standards during each
security breaches or violations and manage- safety-and-soundness inspection, which may
ments responses to them, and recommenda- include targeted reviews of information technol-
tions for changes in the information security
program.
The information security standards outline
specific information security measures that bank
holding companies must consider in implement-
ing an information security program. A bank
holding company should adopt appropriate mea-
sures to manage and control identified risks,
commensurate with the sensitivity of the infor-
mation as well as the complexity and scope of
public personal information, as defined in Regulation P, about

a financial institutions customer that is maintained by or on
behalf of the bank holding company.
6. A customer is defined in the same manner in Regulation
Pa consumer who has established a continuing relationship
with a bank holding company, under which the bank holding
company provides one or more financial products or services
to the consumer to be used primarily for personal, family, or
household purposes. The definition of customer does not
include a business, nor does it include a consumer who has
not established an ongoing relationship with the bank holding
company.

Page 2
ogy. Ongoing compliance with the information BHC is required to properly dispose of con-
security standards should be monitored as sumer information in accordance with 16 C.F.R.
needed during the risk-focused inspection pro- 682. To address the risks associated with iden-
cess. Material instances of noncompliance tity theft, a BHC and its nonbank subsidiaries
should be noted in the inspection report. and affiliates (a financial institution) is generally
Bank holding companies are required to over- required to develop, implement, and maintain,
see their service-provider arrangements in order as part of its existing information security pro-
to (1) protect the security of customer informa- gram, appropriate measures to properly dispose
tion maintained or processed by their service of consumer information derived from con-
providers; (2) ensure that their service providers sumer reports.
properly dispose of customer and consumer Consumer information is defined as any
information; and (3) whenever warranted, moni- record about an individual, whether in paper,
tor their service providers to confirm that a electronic, or other form, that is a consumer
provider has satisfied its contractual obligations. report or is derived from a consumer report and
A bank holding company must use appropri- that is maintained or otherwise possessed by or
ate due diligence in selecting its service provid- on behalf of the banking organization for a
ers. Bank holding companies should review a business purpose. Consumer information also
potential service providers information security means a compilation of such records.
program or the measures the service provider The following are examples of consumer
will use to protect the bank holding companys information:
customer information.7 All contracts must
require that the service provider implement
appropriate measures designed to meet the 1. a consumer report that a bank obtains
objectives of the information security standards. 2. information from a consumer report that the
When indicated by the bank holding compa- bank obtains from its affiliate after the con-
nys risk assessment, the performance of its sumer has been given a notice and has
service providers must be monitored to confirm elected not to opt out of that sharing
that they have satisfied their obligations under 3. information from a consumer report that the
the information security program. A bank hold- bank obtains about an individual who applies
ing companys methods for overseeing its ser- for but does not receive a loan, including any
vice providers may differ depending on the type loan sought by an individual for a business
of services, the service provider, or the level of purpose
risk to the customer information. For example, 4. information from a consumer report that the
if a service provider is subject to regulations or bank obtains about an individual who guar-
a code of conduct that imposes a duty to protect antees a loan (including a loan to a business
customer information consistent with the objec- entity)
tives of the information security standards, a 5. information from a consumer report that the
bank holding company may consider that duty bank obtains about an employee or prospec-
in exercising its due diligence and oversight of tive employee
the service provider. If a service provider hires a
subservicer (that is, subcontracts), the subser-
vicer would not be considered a service pro- Consumer information does not include any
vider under the guidelines. record that does not personally identify an indi-
vidual, nor does it include the following:
2124.4.1.1 Disposal of Customer and 1. aggregate information, such as the mean

Consumer Information credit score, derived from a group of con-
sumer reports
The information security standards address stan- 2. blind data, such as payment history on
dards for the proper disposal of consumer infor- accounts that are not personally identifiable,
mation, pursuant to sections 621 and 628 of the that may be used for developing credit scor-
Fair Credit Reporting Act (15 U.S.C. 1681s and ing models or for other purposes
1681w). Under section 225.4 of Regulation Y, a
7. A service provider is deemed to be a person or entity

that maintains, processes, or is otherwise permitted access to
customer information through its direct provision of services BHC Supervision Manual January 2006
directly to the bank holding company. Page 3
2124.4.2 RESPONSE PROGRAMS FOR When evaluating the adequacy of an institu-

UNAUTHORIZED ACCESS TO tions required information security program,
CUSTOMER INFORMATION AND examiners are to consider whether the institu-
CUSTOMER NOTICE tion has developed and implemented a response
program equivalent to the guidance. At a mini-
The information security standards list measures mum, an institutions response program should
to be included in a bank holding companys contain procedures for (1) assessing the nature
information security program. These measures and scope of an incident, and identifying what
include response programs that specify actions customer information systems and types of cus-
to be taken when the bank suspects or detects tomer information have been accessed or mis-
that unauthorized individuals have gained access used; (2) notifying its primary federal regulator
to customer information systems, including as soon as possible when the institution becomes
appropriate reports to regulatory and law aware of an incident involving unauthorized
enforcement agencies.8 A response program is access to or use of sensitive customer informa-
the principal means for a financial institution to tion, as defined later in the guidance; (3) imme-
protect against the unauthorized use of cus- diately notifying law enforcement in situations
tomer information that could lead to substan- involving federal criminal violations requiring
tial harm or inconvenience for its customer. immediate attention; (4) taking appropriate steps
For example, customer notification is an impor- to contain and control the incident to prevent
tant tool that enables a customer to take steps to further unauthorized access to or use of cus-
prevent identity theft, such as by arranging to tomer information, such as by monitoring, freez-
have a fraud alert placed in his or her credit file. ing, or closing affected accounts, while
Prompt action by both the institution and the preserving records and other evidence; and
customer following any unauthorized access to (5) notifying customers when warranted.
customer information is crucial to preventing or The guidance does not apply to a financial
limiting damages from identity theft. As a result, institutions foreign offices, branches, or affili-
every financial institution should develop and ates. However, a financial institution subject to
implement a response program appropriate to its the information security standards is responsible
size and complexity and to the nature and scope for the security of its customer information,
of its activities. The program should be designed whether the information is maintained within or
to address incidents of unauthorized access to outside of the United States, such as by a ser-
customer information. vice provider located outside of the United
The Interagency Guidance on Response Pro- States.
grams for Unauthorized Access to Customer The guidance also applies to customer infor-
Information and Customer Notice9 (the guid- mation, meaning any record containing nonpub-
ance) interprets section 501(b) of the Gramm- lic personal information about a financial insti-
Leach-Bliley Act (the GLB Act) and the infor- tutions customer, whether in paper, electronic,
mation security standards.10 The guidance or other form, that is maintained by or on behalf
describes the response programs, including cus- of the institution.11 (See the Boards privacy
tomer notification procedures, that a financial rule, Regulation P, at section 216.3(n)(2) (12
institution should develop and implement to C.F.R. 216.3(n)(2).) Consequently, the guidance
address unauthorized access to or use of cus- applies only to information that is within the
tomer information that could result in substan- control of the institution and its service provid-
tial harm or inconvenience to a customer. ers. The guidance would not apply to informa-
tion directly disclosed by a customer to a third
party, for example, through a fraudulent web
8. See the information security standards, 12 CFR 225, site.
appendix F, supplement A. The guidance also does not apply to informa-
9. The guidance was jointly issued on March 23, 2005 tion involving business or commercial accounts.
(effective March 29, 2005), by the Board of Governors of the Instead, the guidance applies to nonpublic per-
Federal Reserve System, the Federal Deposit Insurance Cor-
poration, the Office of the Comptroller of the Currency, and sonal information about a customer as that
the Office of Thrift Supervision. term is used in the information security stan-
10. See 12 C.F.R. 225, appendix F. The Interagency Guide- dards, namely, a consumer who obtains a finan-
lines Establishing Information Security Standards were for- cial product or service from a financial institu-
merly known as the Interagency Guidelines Establishing Stan-
dards for Safeguarding Customer Information. tion to be used primarily for personal, family, or
BHC Supervision Manual January 2006 11. See the information security standards, 12 C.F.R. 225,
Page 4 appendix F, section I.C.2.c.
household purposes, and who has a continuing 2124.4.2.1.1 Components of a Response

relationship with the institution.12 Program
At a minimum, an institutions response pro-
gram should contain procedures for the
2124.4.2.1 Response Programs following:
Financial institutions should take preventive 1. assessing the nature and scope of an incident,
measures to safeguard customer information and identifying what customer information
against attempts to gain unauthorized access to systems and types of customer information
the information. For example, financial institu- have been accessed or misused
tions should place access controls on customer 2. notifying its primary federal regulator as
information systems and conduct background soon as possible when the institution
checks on employees who are authorized to becomes aware of an incident involving
access customer information.13 However, every unauthorized access to or use of sensitive
financial institution should also develop and customer information, as defined below
implement a risk-based response program to 3. consistent with the Suspicious Activity
address incidents of unauthorized access to cus- Report (SAR) regulations,15 notifying appro-
tomer information in customer information sys- priate law enforcement authorities, in addi-
tems14 that occur nonetheless. A response pro- tion to filing a timely SAR in situations
gram should be a key part of an institutions involving federal criminal violations requir-
information security program. The program ing immediate attention, such as when a
should be appropriate to the size and complexity reportable violation is ongoing
of the institution and the nature and scope of its 4. taking appropriate steps to contain and con-
activities. trol the incident to prevent further unauthor-
In addition, each institution should be able to ized access to or use of customer informa-
address incidents of unauthorized access to cus- tion, for example, by monitoring, freezing, or
tomer information in customer information sys- closing affected accounts, while preserving
tems maintained by its domestic and foreign records and other evidence
service providers. Therefore, consistent with the 5. notifying customers when warranted
obligations in the information security standards
that relate to these arrangements and with exist- As noted above for the second component, a
ing guidance on this topic issued by the agen- financial institution and a bank holding com-
cies, an institutions contract with its service pany are to notify its primary federal regulator
provider should require the service provider to of a security breach involving sensitive cus-
take appropriate actions to address incidents of tomer information, whether or not it notifies its
unauthorized access to the financial institutions customers. The banking organization experienc-
customer information. These actions include ing such a breach should promptly notify its
notifying the institution as soon as possible of supervisory central point of contact at its
any such incident, which enables the institution Reserve Bank and provide information on the
to expeditiously implement its response nature of the incident and on whether law
program. enforcement authorities were notified or a SAR
was or will be filed. When reporting security
breaches involving sensitive customer informa-
tion, the institution should provide the central
point of contact with information on the steps
taken to contain and control the incident, the
12. See the information security standards, 12 C.F.R. 225,
appendix F, at section I.C.2.b. and the Boards Privacy Rule
(Regulation P), section 216.3(h) (12 C.F.R. 216.3(h)).
15. An institutions obligation to file a SAR is set out in
13. Institutions should also conduct background checks on
the SAR regulations and supervisory guidance. See 12 C.F.R.
employees to ensure that they do not violate 12 U.S.C. 1829,
208.62 (state member banks); 12 C.F.R. 211.5(k) (Edge and
which prohibits an institution from hiring an individual con-
agreement corporations); 12 C.F.R. 211.24(f) (uninsured state
victed of certain criminal offenses or who is subject to a
branches and agencies of foreign banks); and 12 C.F.R.
prohibition order under 12 U.S.C. 1818(e)(6).
225.4(f) (bank holding companies and their nonbank subsidi-
14. Under the information security standards, an institu-
aries). See also SR-01-11, Identity Theft and Pretext
tions customer information systems consist of all the methods
Calling.
used to access, collect, store, use, transmit, protect, or dispose
of customer information, including the systems maintained by
its service providers. See the information security standards, BHC Supervision Manual July 2012
12 C.F.R. 225, appendix F, section I.C.2.d. Page 5
number of customers potentially affected, tigation and provides the institution with a writ-
whether customer notification is warranted, and ten request for the delay. However, the institu-
whether a service provider was involved. A tion should notify its customers as soon as
banking organization should not delay provid- notification will no longer interfere with the
ing prompt initial notification to its central point investigation.
of contact. (See SR-05-23/CA-05-10.)
If an incident of unauthorized access to cus-
tomer information involves customer informa- 2124.4.2.2.2 Sensitive Customer
tion systems maintained by an institutions ser- Information
vice providers, the financial institution is
responsible for notifying its customers and regu- Under the information security standards, an
lator. However, an institution may authorize or institution must protect against unauthorized
contract with its service provider to notify the access to or use of customer information that
institutions customers or regulator on its behalf. could result in substantial harm or inconve-
nience to any customer. Substantial harm or
inconvenience is most likely to result from
2124.4.2.2 Customer Notice improper access to sensitive customer informa-
tion because this type of information is most
Financial institutions have an affirmative duty to likely to be misused, as in the commission of
protect their customers information against identity theft.
unauthorized access or use. Notifying customers For purposes of the guidance, sensitive cus-
of a security incident involving the unauthorized tomer information means a customers name,
access or use of the customer information, in address, or telephone number, in conjunction
accordance with the standard set forth below, is with the customers Social Security number,
a key part of that duty. drivers license number, account number, credit
Timely notification of customers is important or debit card number, or with a personal identifi-
to managing an institutions reputation risk. cation number or password that would permit
Effective notice also may reduce an institutions access to the customers account. Sensitive cus-
legal risk, assist in maintaining good customer tomer information also includes any combina-
relations, and enable the institutions customers tion of components of customer information that
to take steps to protect themselves against the would allow someone to log on to or access the
consequences of identity theft. When customer customers account, such as a user name and
notification is warranted, an institution may not password or a password and an account number.
forgo notifying its customers of an incident
because the institution believes that it may be
potentially embarrassed or inconvenienced by
2124.4.2.2.3 Affected Customers
doing so.
If a financial institution, on the basis of its
investigation, can determine from its logs or
2124.4.2.2.1 Standard for Providing other data precisely which customers informa-
Notice tion has been improperly accessed, it may limit
notification to those customers for whom the
When a financial institution becomes aware of
institution determines that misuse of their infor-
an incident of unauthorized access to sensitive
mation has occurred or is reasonably possible.
customer information, the institution should
However, there may be situations in which an
conduct a reasonable investigation to promptly
institution determines that a group of files has
determine the likelihood that the information
been accessed improperly but is unable to iden-
has been or will be misused. If the institution
tify which specific customers information has
determines that misuse of its information about
been accessed. If the circumstances of the unau-
a customer has occurred or is reasonably pos-
thorized access lead the institution to determine
sible, it should notify the affected customer as
that misuse of the information is reasonably
soon as possible.
possible, it should notify all customers in the
Customer notice may be delayed if an appro-
group.
priate law enforcement agency determines that
notification will interfere with a criminal inves-

Page 6
2124.4.2.2.4 Content of Customer Notice Financial institutions are encouraged to notify

the nationwide consumer reporting agencies
Customer notice should be given in a clear and before sending notices to a large number of
conspicuous manner. The notice should describe customers when those notices include contact
the incident in general terms and the type of information for the reporting agencies.
customer information that was the subject of
unauthorized access or use. The notice should
also generally describe what the institution has 2124.4.2.2.5 Delivery of Customer Notice
done to protect the customers information from
further unauthorized access, and include a tele- Customer notice should be delivered in any
phone number that customers can call for fur- manner designed to ensure that a customer can
ther information and assistance.16 The notice reasonably be expected to receive it. For exam-
should remind customers of the need to remain ple, the institution may choose to contact all
vigilant over the next 12 to 24 months, and to affected customers by telephone, by mail, or
promptly report incidents of suspected identity by electronic mail in the case of customers
theft to the institution. The notice should include for whom it has a valid e-mail address and
the following additional items, when who have agreed to receive communications
appropriate: electronically.
1. a recommendation that the customer review

account statements and immediately report
any suspicious activity to the institution 2124.4.3 Inspection Objective
2. a description of fraud alerts and an explana-
tion of how the customer may place a fraud 1. To review and assess the bank holding com-
alert in his or her consumer reports to put the panys compliance with the Interagency
customers creditors on notice that the cus- Guidelines Establishing Information Security
tomer may be a victim of fraud Standards, which include standards for safe-
guarding customer information (the examin-
3. a recommendation that the customer periodi- ers should thus review the BHCs informa-
cally obtain credit reports from each nation- tion security program, including its response
wide credit reporting agency and have infor- program for unauthorized access to customer
mation relating to fraudulent transactions information and customer notice and its
deleted guidelines on the proper disposal of cus-
4. an explanation of how the customer may tomer information and consumer informa-
obtain a credit report free of charge tion) and all other applicable laws, rules, and
5. information about the availability of the Fed- regulations.
eral Trade Commission (FTC) online guid-
ance regarding steps consumers can take to
protect themselves against identity theft (The
notice should encourage the customer to 2124.4.4 Inspection Procedures
report any incidents of identity theft to the
FTC and should provide the FTCs web site 1. Referencing the Establishment of Informa-
address and toll-free telephone number that tion Security Standards section of the inter-
customers may use to obtain the identity nal control questionnaire in section 4060.4 of
theft guidance and to report suspected inci- the Systems Commercial Bank Examination
dents of identity theft.)17 Manual, assess the BHCs compliance with
the Interagency Guidelines Establishing
Information Security Standards including its
standards for safeguarding customer
information.
16. The institution should, therefore, ensure that it has
reasonable policies and procedures in place, including trained
2. Conduct a review that is a sufficient basis for
personnel, to respond appropriately to customer inquiries and evaluating the BHCs overall information
requests for assistance. security program and its compliance with the
17. The FTC web site for the ID theft brochure and the information security standards.
FTC hotline phone number are www.ftc.gov/bcp/
consumer.shtm and 1-877-IDTHEFT. The institution may also
refer customers to any materials developed pursuant to section
151(b) of the FACT Act (educational materials developed by BHC Supervision Manual July 2012
the FTC to teach the public how to prevent identity theft). Page 7
2124.4.5 APPENDIX A B. Objectives

INTERAGENCY GUIDELINES
ESTABLISHING INFORMATION A bank holding companys information security
SECURITY STANDARDS program shall be designed to
Sections II and III of the information security 1. ensure the security and confidentiality of cus-
standards are provided below. For more infor- tomer information;
mation, see the Interagency Guidelines Estab- 2. protect against any anticipated threats or
lishing Information Security Standards in Regu- hazards to the security or integrity of such
lation Y, section 225, appendix F (12 C.F.R. information;
225, appendix F). The guidelines were previ- 3. protect against unauthorized access to or use
ously titled Interagency Guidelines Establishing of such information that could result in sub-
Standards for Safeguarding Customer Informa- stantial harm or inconvenience to any cus-
tion. The information security standards were tomer; and
amended, effective July 1, 2005, to implement 4. ensure the proper disposal of customer infor-
section 216 of the Fair and Accurate Credit mation and consumer information.
Transactions Act of 2003 (the FACT Act). To
address the risks associated with identity theft,
the amendments generally require financial
institutions to develop, implement, and main-
tain, as part of their existing information secu- III. Development and Implementation Of
rity program, appropriate measures to properly Information Security Program
dispose of consumer information derived from
consumer reports. The term consumer informa- A. Involve the Board of Directors
tion is defined in the revised rule.
The board of directors or an appropriate com-
mittee of the board of each bank holding com-
pany is to
II. Standards for Safeguarding Customer
Information 1. approve the bank holding companys written
information security program; and
A. Information Security Program
2. oversee the development, implementation,
and maintenance of the bank holding com-
Each bank holding company is to implement a
panys information security program, includ-
comprehensive, written information security
ing assigning specific responsibility for its
program that includes administrative, technical,
implementation and reviewing reports from
and physical safeguards appropriate to the size
management.
and complexity of the bank holding company
and the nature and scope of its activities. While
all parts of the bank holding company are not
required to implement a uniform set of policies,
B. Assess Risk
all elements of the information security program
are to be coordinated. A bank holding company
Each bank holding company is to
is also to ensure that each of its subsidiaries is
subject to a comprehensive information security
program. The bank holding company may fulfill 1. identify reasonably foreseeable internal and
this requirement either by including a subsidiary external threats that could result in unauthor-
within the scope of the bank holding companys ized disclosure, misuse, alteration, or
comprehensive information security program or destruction of customer information or cus-
by causing the subsidiary to implement a sepa- tomer information systems;
rate comprehensive information security pro- 2. assess the likelihood and potential damage of
gram in accordance with the standards and pro- these threats, taking into consideration the
cedures in sections II and III that apply to bank sensitivity of customer information;
holding companies. 3. assess the sufficiency of policies, procedures,
customer information systems, and other
arrangements in place to control risks; and
BHC Supervision Manual July 2012 4. ensure the proper disposal of customer infor-
Page 8 mation and consumer information.
C. Manage and Control Risk procedures of the information security pro-

gram. The frequency and nature of such tests
Each bank holding company is to should be determined by the bank holding
companys risk assessment. Tests should be
1. Design its information security program to conducted or reviewed by independent third
control the identified risks, commensurate parties or staff independent of those that
with the sensitivity of the information as well develop or maintain the security programs.
as the complexity and scope of the bank 4. Develop, implement, and maintain, as part of
holding companys activities. Each bank its information security program, appropriate
holding company must consider whether the measures to properly dispose of customer
following security measures are appropriate information and consumer information in
for the bank holding company and, if so, accordance with each of the requirements in
adopt those measures the bank holding com- this section III.
pany concludes are appropriate:
a. access controls on customer information
systems, including controls to authenti- D. Oversee Service-Provider
cate and permit access only to authorized Arrangements
individuals and controls to prevent
employees from providing customer Each bank holding company is to
information to unauthorized individuals
who may seek to obtain this information 1. exercise appropriate due diligence in select-
through fraudulent means ing its service providers;
b. access restrictions at physical locations 2. require its service providers by contract to
containing customer information, such as implement appropriate measures designed to
buildings, computer facilities, and records meet the objectives of the information secu-
storage facilities to permit access only to rity standards; and
authorized individuals; 3. where indicated by the bank holding compa-
c. encryption of electronic customer infor- nys risk assessment, monitor its service pro-
mation, including while in transit or in viders to confirm that they have satisfied
storage on networks or systems to which their obligations with regard to the require-
unauthorized individuals may have access ments for overseeing provider arrangements.
d. procedures designed to ensure that cus- As part of this monitoring, a bank holding
tomer information system modifications company should review audits, summaries of
are consistent with the bank holding com- test results, or other equivalent evaluations of
panys information security program its service providers.
e. dual control procedures, segregation of
duties, and employee background checks
for employees with responsibilities for or E. Adjust the Program
access to customer Information
f. monitoring systems and procedures to Each bank holding company is to monitor,
detect actual and attempted attacks on or evaluate, and adjust, as appropriate, the informa-
intrusions into customer information tion security program in light of any relevant
systems changes in technology, the sensitivity of its cus-
g. response programs that specify actions to tomer information, internal or external threats to
be taken when the bank holding company information, and the bank holding companys
suspects or detects that unauthorized indi- own changing business arrangements, such as
viduals have gained access to customer mergers and acquisitions, alliances and joint
information systems, including appropri- ventures, outsourcing arrangements, and
ate reports to regulatory and law enforce- changes to customer information systems.
ment agencies
h. measures to protect against destruction,
loss, or damage of customer information F. Report to the Board
due to potential environmental hazards,
such as fire and water damage or techno- Each bank holding company is to report to its
logical failures board or an appropriate committee of the board
2. Train staff to implement the bank holding
companys information security program. BHC Supervision Manual January 2006
3. Regularly test the key controls, systems, and Page 9
at least annually. This report should describe the and managements responses; and recommenda-
overall status of the information security pro- tions for changes in the information security
gram and the bank holding companys compli- program.
ance with the information security standards.
The reports should discuss material matters
related to its program, addressing issues such as G. Implement the Standards
risk assessment; risk management and control
decisions; service-provider arrangements; For effective dates, see 12 C.F.R. 225, appendix
results of testing; security breaches or violations F, section III.G.

Page 10
Identity Theft Red Flags and Address Discrepancies
Section 2124.5
2124.5.1 IDENTITY THEFT RED Rule (16 CFR 681) and 72 Fed. Reg. 63718-
FLAGS PREVENTION PROGRAM 63775, November 9, 2007.)
This section describes the provisions of the
The federal financial institution regulatory Red Flags Rule and its guidelines (appendix A)
agencies1 and the Federal Trade Commission to be used when examining a BHC and its
(FTC) have issued joint regulations and nonbank subsidiaries over which the Federal
guidelines on the detection, prevention, and Reserve has supervisory authority (collectively
mitigation of identity theft in connection with referred to as BHC). (See SR-08-7/CA-08-10
opening of certain accounts or maintaining and its interagency attachments.)
certain existing accounts in response to the Fair
and Accurate Credit Transactions Act of 2003
(The FACT Act).2 Under the FACT Act, bank
holding companies (BHCs) and their nonbank 2124.5.1.1 Risk Assessment
subsidiaries are subject to the FTCs regula-
tions.3 These regulations require financial Prior to the development of the Program, a
institutions4 or creditors5 that offer or maintain financial institution or creditor must initially
one or more covered accounts to develop and and then periodically conduct a risk assessment
implement a written Identity Theft Prevention to determine whether it offers or maintains cov-
Program (Program). A Program is to be designed ered accounts. It must take into consideration
to detect, prevent, and mitigate identity theft in (1) the methods it provides to open its accounts,
connection with the opening of a covered account (2) the methods it provides to access accounts,
or any existing covered account. The Program and (3) its previous experiences with identity
must be tailored to the entitys size, complexity, theft. If the financial institution or creditor has
and the nature and scope of its operations and covered accounts, it must evaluate its potential
activities. The regulations also require (debit and vulnerability to identity theft. The institution
credit) card issuers to validate notifications of should also consider whether a reasonably fore-
changes of address under certain circumstances. seeable risk of identity theft may exist in con-
The joint final rules and guidelines were nection with the accounts it offers or maintains
effective on January 1, 2008. The mandatory and those that may be opened or accessed
compliance date for the rules was November 1, remotely, through methods that do not require
2008.6 (See section 681 of the FTCs Red Flags face-to-face contact, such as through the Inter-
net or telephone. Financial institutions or credi-
tors that offer or maintain business accounts that
1. The Board of Governors of the Federal Reserve System
(FRB), the Office of the Comptroller of the Currency (OCC),
have been the target of identity theft should
the Office of Thrift Supervision (OTS), the Federal Deposit factor those experiences with identity theft into
Insurance Corporation (FDIC), and the National Credit Union their determination.
Administration (NCUA).
2. Section 111 of the FACT Act defines identity theft as
If the financial institution or creditor deter-
a fraud committed or attempted using the identifying infor- mines that it has covered accounts, the risk
mation of another person. assessment will enable it to identify which of its
3. The FACT Act gives the Board the authority to write accounts the Program must address. If a finan-
rules for state member banks but not BHCs. Nonetheless, the
Board retains its supervisory and enforcement authority over
cial institution or creditor initially determines
BHCs, pursuant to section 1818 of the Federal Deposit Insur- that it does not have covered accounts, it must
ance Act. The Board and FTC Red Flags Rules are substan- periodically reassess whether it must develop
tially the same. and implement a Program in light of changes in
4. For purposes of the rule, the term financial institution
means a State or National bank, a State or Federal savings
the accounts that it offers or maintains.
and loan association, a mutual savings bank . . . or any other
person that, directly or indirectly, holds a transaction account
. . . belonging to a consumer.
5. Under section 111 of the FACT Act, the term creditor
means any person (a natural person, a corporation, govern- (See www2.ftc.gov/opa/2008/10/redflags.shtm.) This delay in
ment or governmental subdivision, trust, estate, partnership, enforcement is limited to the Identity Theft Red Flags Rule
cooperative, or association) who regularly extends, renews, or (16 CFR 681.1), and does not extend to the rule regarding
continues credit; any person who regularly arranges for the changes of address applicable to card issuers (16 C.F.R.
extension, renewal, or continuation of credit; or any assignee 681.2).
or original creditor who participates in the decision to extend,
renew, or continue credit.
6. The FTC subsequently granted a six-month delay of BHC Supervision Manual January 2009
enforcement of its Red Flags Rule until May 1, 2009. Page 1
Identity Theft Red Flags and Address Discrepancies 2124.5
2124.5.1.2 Elements of the Program relevant Red Flags.7 A financial institution or

creditor should include, as appropriate,
The elements of the actual Program will vary 1. alerts, notifications, or other warnings
depending on the size and complexity of the received from consumer reporting agencies
financial institution or creditor. A financial insti- or service providers, such as fraud detection
tution or creditor that determines that it is services;
required to establish and maintain an Identity 2. the presentation of suspicious documents;
Theft Prevention Program must (1) identify rel-
3. the presentation of suspicious personal iden-
evant Red Flags for its covered accounts,
tifying information, such as a suspicious
(2) detect the Red Flags that have been incorpo-
address change;
rated into its Program, and (3) respond appropri-
ately to the detected Red Flags. The Red Flags 4. the unusual use of, or other suspicious activ-
are patterns, practices, or specific activities that ity related to, a covered account; and
indicate the possible existence of identity theft 5. notices received from customers, victims of
or the potential to lead to identity theft. A finan- identity theft, law enforcement authorities, or
cial institution or creditor must ensure (1) that other persons regarding possible identity
its Program is updated periodically to address theft in connection with covered accounts
the changing risks associated with its customers held by the financial institution or creditor.
and their accounts and (2) the safety and sound-
ness of the financial institution or creditor from The above categories do not represent a com-
identity theft. prehensive list of all types of Red Flags that
may indicate the possibility of identity theft.
Institutions must also consider specific business
2124.5.1.3 Guidelines lines and any previous exposures to identity
theft. No specific Red Flag is mandatory for all
Each financial institution or creditor that is financial institutions or creditors. Rather, the
required to implement a written Program must Program should follow the risk-based, nonpre-
consider the Guidelines for Identity Theft scriptive approach regarding the identification
Detection, Prevention, and Mitigation (16 C.F.R. of Red Flags.
681, appendix A of the rule) (the Guidelines)
and include those guidelines that are appropriate
in its Program. Section I of the Guidelines, 2124.5.1.3.3 Detect the Programs Red
The Program, discusses a Programs design Flags
that may include, as appropriate, existing poli-
cies, procedures, and arrangements that control In accordance with Section III of the Guide-
foreseeable risks to the institutions customers lines, each financial institution or creditors Pro-
or to the safety and soundness of the financial gram should address the detection of Red Flags
institution or creditor from identity theft. in connection with the opening of covered
accounts and existing covered accounts. A
financial institution or creditor is required to
2124.5.1.3.1 Identification of Red Flags detect, prevent, and mitigate identity theft in
connection with such accounts. The policies and
A financial institution or creditor should incor- procedures regarding opening a covered account
porate relevant Red Flags into the Program from subject to the Program should explain how an
sources such as (1) incidents of identity theft institution could identify information about, and
that it has experienced, (2) methods of identity verify the identity of, a person opening an
theft that have been identified as reflecting account.8 In the case of existing covered
changes in identity theft risks, and (3) applica- accounts, institutions could authenticate custom-
ble supervisory guidance. ers, monitor transactions, and verify the validity
of change of address requests.
2124.5.1.3.2 Categories of Red Flags

Section II of the Guidelines, Categories of Red
Flags, provides some guidance in identifying
7. Examples of Red Flags from each of these categories are
BHC Supervision Manual January 2009 appended as supplement A to appendix A.
Page 2 8. See 31 U.S.C. 5318(l) and 31 C.F.R. 103.121.
2124.5.1.3.4 Respond Appropriately to including its mergers, acquisitions, joint ven-

any Detected Red Flags tures, and any business arrangements, such
as alliances and service provider
A financial institution or creditor should con- arrangements.
sider precursors to identity theft to stop identity
theft before it occurs. Section IV of the Guide-
lines, Prevention and Mitigation, states that 2124.5.1.4 Administration of Program
an institutions procedures should provide for
appropriate responses to Red Flags that it has A financial institution or creditor that is required
detected that are commensurate with the degree to implement a Program must provide for the
of risk posed. When determining an appropriate continued oversight and administration of its
response, the institution should consider aggra- Program. The following are the steps that are
vating factors that may heighten its risk of iden- needed in the administration of a Red Flags
tity theft. Such factors may include (1) a data Program:
security incident that results in unauthorized
disclosures of nonpublic personal information, 1. Obtain approval from either the institutions
(2) records the institution holds or that are held board of directors or any appropriate com-
by another creditor or third party, or (3) notice mittee of the board of directors of the initial
that the institutions customer has provided written Program;
information related to its covered account to 2. Involve either the board of directors, a desig-
someone fraudulently claiming to represent the nated committee of the board of directors, or
institution or to a fraudulent website. Appropri- a designated senior-management-level
ate responses may include the following: employee in the oversight, development,
(1) monitoring a covered account for evidence implementation, and administration of the
of identity theft; (2) contacting the customer; Program.9 This includes
(3) changing any passwords, security codes, or assigning specific responsibility for the
other security devices that permit access to a Programs implementation,
secured account; (4) reopening a covered reviewing reports prepared by staff regard-
account with a new account number; (5) not ing the institutions compliance (the
opening a new covered account; (6) closing an reports should be prepared at least annu-
existing covered account; (7) not attempting to ally), and
collect on a covered account or not selling a reviewing material changes to the Program
covered account to a debt collector; (8) notify- as necessary to address changing identity
ing law enforcement; or (9) determining that no theft risks.
response is warranted under the particular 3. Train staff. The financial institution or credi-
circumstances. tor must train relevant staff to effectively
implement and monitor the Program. Train-
ing should be provided as changes are made
2124.5.1.3.5 Periodically Updating the to the financial institution or creditors Pro-
Programs Relevant Red Flags gram based on its periodic risk assessment.
4. Exercise appropriate and effective oversight
Section V of the Guidelines, Updating the of service provider arrangements. Section VI
Program, states that a financial institution or of the Guidelines, Methods for Administer-
creditor should periodically update its Program ing the Program, indicates a financial insti-
(including its relevant Red Flags) to reflect any tution or creditor is ultimately responsible
changes in risks to its customers or to the safety for complying with the rules and guidelines
and soundness of the institution from identity for outsourcing an activity to a third-party
theft, based on (but not limited to) factors such
as
9. BHC subsidiaries can use the security program devel-
oped at the holding company level. However, if subsidiary
1. the experiences of the institution with iden- institutions choose to use a security program developed at the
tity theft, holding company level, the board of directors or an appropri-
2. changes in methods of identity theft, ate committee at each subsidiary institution must conduct an
independent review to ensure that the program is suitable and
3. changes in methods to detect, prevent, and complies with the requirements prescribed by its primary
mitigate identity theft, regulator.
4. changes in the types of accounts that the
institution offers or maintains, and BHC Supervision Manual January 2009
5. changes in the institutions structure, Page 3
service provider. Whenever a financial insti- 2. Determine if the BHC has adequately devel-
tution or creditor engages a service provider oped and maintains a written Program that is
to perform an activity in connection with one designed to detect, prevent, and monitor
or more covered accounts, the institution transactions to mitigate identity theft in con-
should ensure that the activity of the service nection with the opening of certain new and
provider is conducted in accordance with existing accounts covered by the FACT Act.
reasonable policies and procedures designed 3. Evaluate whether the Program includes rea-
to detect, prevent, and mitigate the risk of sonable policies and procedures to
identity theft. With regard to the institutions a. identify and detect relevant Red Flags for
oversight of its Program, periodic reports the BHCs covered accounts and whether
from service providers are to be issued on the it incorporated those Red Flags into its
Programs development, implementation, Program,
and administration. b. respond appropriately to any detected Red
Flags to prevent and mitigate identity
theft, and
2124.5.2 INSPECTION OBJECTIVES c. ensure that the Program is updated peri-
odically to reflect changes in identity theft
1. To determine if the BHC has developed, risks to the customers and the safety and
implemented, and maintained a written Pro- soundness of the institution.
gram for new and existing accounts that are 4. If a required Program has been established
covered by the FACT Act and the Federal by the BHC, ascertain if it has provided for
Trade Commissions rules on Fair Credit the Programs continued administration,
Reporting, section 681, Subpart AIdentity including
Theft Red Flags (16 C.F.R. 681, subpart A), a. involving the board of directors, an appro-
which implements provisions of the FACT priate committee thereof, or a designated
Act. employee at the level of senior manage-
2. To make a determination of whether the Pro- ment in the continued oversight, develop-
gram is ment, implementation, and administration
a. designed to detect, prevent, and mitigate of the Program;
identity theft in connection with the open- b. training staff, as necessary, to effectively
ing of a new, or an existing, covered implement the Program; and
account and if the Program includes the c. appropriate and effective oversight of ser-
detection of relevant Red Flags and vice provider arrangements.
b. appropriate to the size and complexity of 5. If the BHC has established and maintains a
the financial institution or creditor required Program that applies to its covered
and the nature and scope of its activities. accounts, determine if the Program includes
3. To ascertain whether the BHC assesses the the relevant and appropriate guidelines
validity of change of address notifications within the rules appendix A (16 C.F.R. 681,
that it receives for the credit and debit cards appendix A).
that it has issued to customers.

1. Verify that the BHC has determined initially,
and periodically thereafter, whether it offers
or maintains accounts covered by the FACT
Act and section 681, Subpart AIdentity
Theft Red Flags (16 C.F.R. 681, subpart A).

Page 4
Trading Activities of Banking Organizations
(Risk Management and Internal Controls) 1 Section 2125.0
The review of risk management and internal involved. As with the inspection of other activi-
controls is an essential element of the inspection ties, examiner judgment plays a key role in
or examination of trading activities. In view of assessing the adequacy and necessary sophisti-
the increasing importance of these activities to cation of a banking organizations risk manage-
the overall risk profile and profitability of cer- ment system for cash and derivative instrument
tain banking organizations,2 this guidance high- trading and hedging activities.
lights key considerations when inspecting or Many of the managerial practices and exam-
examining the risk management and internal iner procedures contained in this guidance are
controls of trading activities in both cash and fundamental and are generally accepted as
derivative instruments.3 sound banking practices for both trading and
The principles set forth in this guidance apply nontrading activities. However, other elements
to the risk management practices of bank hold- may be subject to change, as both supervisory
ing companies, which should manage and con- and bank operating standards evolve in response
trol aggregate risk exposures on a consolidated to new technologies, financial innovations, and
basis while recognizing legal distinctions developments in market and business practices.
among subsidiaries. This guidance is specifi-
cally designed to target trading, market making,
and customer accommodation activities in cash 2125.0.1 OVERSIGHT OF THE RISK
and derivative instruments at state member MANAGEMENT PROCESS
banks, branches and agencies of foreign banks,
and Edge corporations. Many of the principles As is standard practice for most banking activi-
advanced can also be applied to banking organi- ties, banking organizations should maintain
zations use of derivatives as end-users. Exam- written policies and procedures that clearly out-
iners should assess managements application line the organizations risk management guid-
of this guidance to the holding company and ance for trading and derivative activities. At a
to a banking organizations end-user derivative minimum these policies should identify the risk
activities where appropriate, given the nature of tolerances of the board of directors and should
the organizations activities and current account- clearly delineate lines of authority and responsi-
ing standards. bility for managing the risk of these activities.
This examiner guidance is specifically pro- Individuals throughout the trading and deriva-
vided for evaluating the following elements of tives areas should be fully aware of all poli-
an organizations risk management process for cies and procedures that relate to their specific
trading and derivatives activities: duties.
The board of directors, senior-level manage-
Board of directors and management oversight ment, and members of independent risk manage-
The measurement procedures, limit systems, ment functions are all important participants in
and monitoring and review functions of the the risk management process. Examiners should
risk management process ensure that these participants are aware of their
Internal controls and audit procedures responsibilities and that they adequately per-
form their appropriate role in managing the risk
In assessing the adequacy of these elements of trading and derivative activities.
at individual institutions, examiners should
consider the nature and volume of a banking
organizations activities and its overall approach 2125.0.1.1 Board of Directors Approval
toward managing the various types of risks of Risk Management Policies
The board of directors should approve all signif-
1. The following is the text of SR-93-69, adapted for this icant policies relating to the management of
manual. Section numbers have been added for reference. risks throughout the organization. These poli-
2. The term banking organizations refers to institutions
or entities that are directly supervised by the Board of Gover-
cies, which should include those related to trad-
nors of the Federal Reserve System, such as state member ing activities, should be consistent with the
banks and bank holding companies, including the nonbank organizations broader business strategies, capi-
subsidiaries of the holding company. tal adequacy, expertise, and overall willingness
3. In general terms, derivative instruments are bilateral
contracts or agreements whose value derives from the value
of one or more underlying assets, interest rates, exchange BHC Supervision Manual June 1994
rates, commodities, or financial or commodity indexes. Page 1
Trading Activities of Banking Organizations (Risk Management and Internal Controls) 2125.0
to take risk. Accordingly, the board should be nel staffing independent risk management func-
informed regularly of risk exposure and should tions should have a complete understanding of
regularly reevaluate significant risk manage- the risks associated with all traded on- and
ment policies and procedures with special off-balance-sheet instruments. Accordingly,
emphasis placed on those defining the institu- compensation policies for these individuals
tions risk tolerance regarding these activities. should be adequate to attract and retain person-
The board of directors should also conduct and nel qualified to judge these risks. As a matter of
encourage discussions between its members and general policy, compensation policies, espe-
senior management, as well as between senior cially in the risk management, control, and
management and others in the organization, senior management functions, should be struc-
regarding its risk management process and risk tured in a way that avoids the potential incen-
exposure. tives for excessive risk taking that can occur if,
for example, salaries are tied too closely to the
profitability of trading or derivatives activities.
2125.0.1.2 Senior Managements Risk
Management Responsibilities
Senior management is responsible for ensuring
2125.0.2 THE RISK MANAGEMENT
that there are adequate policies and procedures
PROCESS
for conducting trading operations on both a The primary components of a sound risk man-
long-range and day-to-day basis. This responsi- agement process are a comprehensive risk mea-
bility includes ensuring that there are clear surement approach; a detailed structure of lim-
delineations of lines of responsibility for man- its, guidelines, and other parameters used to
aging risk, adequate systems for measuring risk, govern risk taking; and a strong management
appropriately structured limits on risk taking, information system for monitoring and report-
effective internal controls, and a comprehensive ing risks. These components are fundamental to
risk-reporting process. both trading and nontrading activities alike.
Senior management should regularly evaluate Moreover, the underlying risks associated with
the procedures in place to manage risk to ensure these activities, such as credit, market, liquidity,
that those procedures are appropriate and sound. and operating risk, are not new to banking orga-
Senior management should also foster and par- nizations, although their measurement and
ticipate in active discussions with the board, management can be somewhat more complex.
with staff of risk management functions, and Accordingly, the process of risk management
with traders regarding procedures for measuring for trading activities should be integrated into
and managing risk. Management must also the organizations overall risk management sys-
ensure that trading and derivative activities are tem to the fullest extent possible using a concep-
allocated sufficient resources and staff to man- tual framework common to its other activities.
age and control risks. Such a common framework enables the organi-
zation to manage its consolidated risk exposure
2125.0.1.3 Independent Risk more effectively, especially since the various
Management Functions individual risks involved in trading activities
can, at times, be interconnected and can often
The process of measuring, monitoring, and con- transcend specific markets.
trolling risk consistent with the established poli- As is the case with all risk-bearing activities,
cies and procedures should be managed inde- the risk exposures a banking organization
pendently of individuals conducting trading assumes in its trading and derivatives activities
activities, up through senior levels of the institu- should be fully supported by an adequate capital
tion. An independent system for reporting expo- position. Banking organizations should ensure
sures to both senior-level management and to that their capital positions are sufficiently strong
the board of directors is an important element of to support all trading and derivatives risks on a
this process. fully consolidated basis and that adequate capi-
Banking organizations should have highly tal is maintained in all affiliated entities engaged
qualified personnel throughout their trading and in these activities.
derivatives areas, including their risk manage-
ment and internal control functions. The person-
2125.0.2.1 Risk Measurement Systems
Page 2 A banking organizations system for measuring
the various risks of trading and derivatives 2125.0.2.2 Limiting Risks

activities should be both comprehensive and
accurate. Risks should be measured and aggre- A sound system of integrated organizationwide
gated across trading and nontrading activities on limits and risk-taking guidelines is an essential
an organizationwide basis to the fullest extent component of the risk management process.
possible. Such a system should set boundaries for organi-
While examiners should not require the use zational risk-taking and should also ensure that
of a single prescribed risk measurement ap- positions that exceed certain predetermined
proach for management purposes, they should levels receive prompt management attention, so
evaluate the extent to which the organizations that they can be either reduced or prudently
procedures enable management to assess expo- addressed. The limit system should be consis-
sures on a consolidated basis. Examiners should tent with the effectiveness of the organizations
also evaluate whether the risk measures and the overall risk management process and with the
risk measurement process are sufficiently robust adequacy of its capital position. An appropriate
to accurately reflect the multiple types of risks limit system should permit management to
facing the banking organization. Risk measure- control exposures, to initiate discussion about
ment standards should be understood by rele- opportunities and risks, and to monitor actual
vant personnel at all levelsfrom individual risk-taking against predetermined tolerances, as
traders to the board of directorsand should determined by the board of directors and senior
provide a common framework for limiting and management.
monitoring risk-taking activities. Global limits should be set for each major
The process of marking trading and deriva- type of risk involved. These limits should be
tives positions to market is fundamental to mea- consistent with the banking organizations over-
suring and reporting exposures accurately and all risk measurement approach and should be
on a timely basis. Banking organizations active integrated to the fullest extent possible with
in dealing in foreign exchange, derivatives, and organizationwide limits on those risks as they
other traded instruments should have the ability arise in all other activities of the firm. The limit
to monitor credit exposures, trading positions, system should provide the capability to allocate
and market movements at least daily. Some limits down to individual business units.
organizations should also have the capacity, or At times, especially when markets are vola-
at least the goal, of monitoring their more tile, traders may exceed their limits. While such
actively traded products on a real-time basis. exceptions may occur, they should be made
Analyzing stress situations, including combi- known to senior management and approved only
nations of market events that could affect the by authorized personnel. These positions should
banking organization, is also an important also prompt discussions between traders and
aspect of risk measurement. Sound risk mea- management about the consolidated risk-taking
surement practices include identifying possible activities of the firm or the trading unit. The
events or changes in market behavior that could seriousness of individual or continued limit
have unfavorable effects on the organization exceptions depends in large part upon manage-
and assessing its ability to withstand them. ments approach toward setting limits and on
These analyses should consider not only the the actual size of individual and organizational
likelihood of adverse events, reflecting their limits relative to the organizations capacity to
probability, but also plausible worst-case sce- take risk. Banking organizations with relatively
narios. Ideally, such worst-case analysis should conservative limits may encounter more excep-
be conducted on an organizationwide basis by tions to those limits than do organizations where
taking into account the effect of unusual price limits may be less restrictive. Ultimately, exam-
changes or the default of a large counterparty iners should ensure that stated policies are
across both the derivatives and cash-trading enforced and that the level of exposure is man-
portfolios and the loan and funding portfolios. aged prudently.
Such stress tests should not be limited to
quantitative exercises that compute potential
losses or gains. They should also include more 2125.0.2.3 Reporting
qualitative analyses of the actions management
might take under particular scenarios. Contin- An accurate, informative, and timely manage-
gency plans outlining operating procedures and ment information system is essential to the pru-
lines of communication, both formal and infor-
mal, are important products of such qualitative BHC Supervision Manual June 1994
analyses. Page 3
dent operation of a trading or derivatives activ- sider whether existing measures of exposure and
ity. Accordingly, the examiners assessment of limits are appropriate in view of the banking
the quality of the management information sys- organizations past performance and current
tem is an important factor in the overall evalua- capital position.
tion of the risk management process. Examiners The frequency and extent to which banking
should determine the extent to which the risk organizations should reevaluate their risk mea-
management function monitors and reports its surement methodologies and models depends,
measures of trading risks to appropriate levels in part, on the specific risk exposures created by
of senior management and to the board of direc- their trading activities, on the pace and nature of
tors. Exposures and profit and loss statements market changes, and on the pace of innovation
should be reported at least daily to managers with respect to measuring and managing risks.
who supervise but do not, themselves, conduct At a minimum, banking organizations with sig-
trading activities. More frequent reports should nificant trading and derivative activities should
be made as market conditions dictate. Reports to review the underlying methodologies of their
other levels of senior management and the board models at least annuallyand more often as
may occur less frequently, but examiners should market conditions dictateto ensure they are
determine whether the frequency of reporting appropriate and consistent. Such internal evalu-
provides these individuals with adequate infor- ations may, in many cases, be supplemented by
mation to judge the changing nature of the orga- reviews by external auditors or other qualified
nizations risk profile. outside parties, such as consultants who have
Examiners should ensure that the manage- expertise with highly technical models and risk
ment information systems translate the mea- management techniques. Assumptions should be
sured risk from a technical and quantitative for- evaluated on a continual basis.
mat to one that can be easily read and Banking organizations should also have an
understood by senior managers and directors, effective process to evaluate and review the
who may not have specialized and technical risks involved in products that are either new to
knowledge of trading activities and derivative the firm or new to the marketplace and of poten-
products. Risk exposures arising from various tial interest to the firm. In general, a banking
products within the trading function should be organization should not trade a product until
reported to senior managers and directors using senior management and all relevant personnel
a common conceptual framework for measuring (including those in risk management, internal
and limiting risks. control, legal, accounting, and auditing) under-
stand the product and are able to integrate the
product into the banking organizations risk
2125.0.2.4 Management Evaluation and measurement and control systems. Examiners
Review of the Risk Management Process should determine whether the banking organiza-
tion has a formal process for reviewing new
Management should ensure that the various products and whether it introduces new products
components of an organizations risk manage- in a manner that adequately limits potential
ment process are regularly reviewed and evalu- losses.
ated. This review should take into account
changes in the activities of the organization and
in the market environment, since the changes
2125.0.2.5 Managing Specific Risks
may have created exposures that require addi-
tional management and examiner attention. Any
material changes to the risk management system The following discussions present examiner
should also be reviewed. guidance for evaluating the specific components
The independent risk management functions of a firms risk management process in the
should regularly assess the methodologies, mod- context of each of the risks involved in trading
els, and assumptions used to measure risk and to cash and derivatives instruments.
limit exposures. Proper documentation of these
elements of the risk measurement system is
essential for conducting meaningful reviews. 2125.0.2.5.1 Credit Risk
The review of limit structures should compare
limits to actual exposures and should also con- Broadly defined, credit risk is the risk that a
counterparty will fail to perform on an obliga-
BHC Supervision Manual June 1994 tion to the banking organization. Banking orga-
Page 4 nizations should evaluate both settlement and
presettlement credit risk at the customer level personnel who are independent of the trading
across all traded derivative and nonderivative function, that these personnel use standards that
products. On settlement day, the exposure to are consistent with those used for nontrading
counterparty default may equal the full value of activities, and that counterparty credit lines are
any cash flows or securities the banking organi- consistent with the organizations policies and
zation is to receive. Prior to settlement, credit consolidated exposures.
risk is measured as the sum of the replacement Examiners should consider the extent to
cost of the position, plus an estimate of the which credit limits are exceeded and whether
banking organizations potential future expo- exceptions were resolved according to the bank-
sure from the instrument as a result of market ing organizations adopted policies and proce-
changes. Replacement cost should be deter- dures. Examiners should also evaluate whether
mined using current market prices or generally the organizations reports adequately provide
accepted approaches for estimating the present traders and credit officers with relevant, accu-
value of future payments required under each rate, and timely information about the credit
contract, given current market conditions. exposures and approved credit lines.
Potential credit-risk exposure is measured Trading activities that involve cash instru-
more subjectively than current exposure and is ments often involve short-term exposures that
primarily a function of the time remaining to are eliminated at settlement. However, in the
maturity and the expected volatility of the price, case of derivative products traded in over-the-
rate, or index underlying the contract. It is often counter markets, the exposure can often exist
assessed through simulation analysis and option- for a period similar to that commonly associated
valuation models, but can also be addressed by with a loan from a banking organization. Given
using add-ons, such as those included in the this potentially longer-term exposure and the
risk-based capital standard. In either case, exam- complexity associated with some derivative
iners should evaluate the reasonableness of the instruments, banking organizations should con-
assumptions underlying the banking organiza- sider not only the overall financial strength of
tions risk measure and should also ensure that the counterparty and its ability to perform on its
banking organizations that measure exposures obligation, but should also consider the counter-
using a portfolio approach do so in a prudent partys ability to understand and manage the
manner. risks inherent in the derivative product.
Master netting agreements and various credit
enhancements, such as collateral or third-party
guarantees, can be used by banking organiza- 2125.0.2.5.2 Market Risk
tions to reduce their counterparty credit risk. In
such cases, a banking organizations credit Market risk is the risk to a banking organiza-
exposures should reflect these risk-reducing fea- tions financial condition resulting from adverse
tures only to the extent that the agreements and movements in market prices. Accurately mea-
recourse provisions are legally enforceable in all suring a banking organizations market risk
relevant jurisdictions. This legal enforceability requires timely information about the current
should extend to any insolvency proceedings of market values of its assets, liabilities, and off-
the counterparty. Banking organizations should balance-sheet positions. Although there are
be able to demonstrate that they have exercised many types of market risks that can affect a
due diligence in evaluating the enforceability of portfolios value, they can generally be de-
these contracts and that individual transactions scribed as those involving forward risk and
have been executed in a manner that provides those involving options. Forward risks arise
adequate protection. from factors such as changing interest rates and
Credit limits that consider both settlement currency exchange rates, the liquidity of mar-
and presettlement exposures should be estab- kets for specific commodities or financial instru-
lished for all counterparties with whom the ments, and local or world political and eco-
banking organization trades. As a matter of gen- nomic events. Market risks related to options
eral policy, trading with a counterparty should include these factors as well as evolving percep-
not commence until a credit line has been tions of the volatility of price changes, the pas-
approved. The structure of the credit-approval sage of time, and the interactive effect of other
process may differ among organizations, reflect- market risks. All of these sources of potential
ing the organizational and geographic structure market risk can affect the value of the organiza-
of the organization and the specific needs of its
trading activities. Nevertheless, in all cases, it is BHC Supervision Manual June 1994
important that credit limits be determined by Page 5
tion and should be considered in the risk mea- dates. Since neither type of liquidity risk is
surement process. unique to trading activities, management should
Market risk is increasingly measured by mar- evaluate these risks in the broader context of the
ket participants using a value-at-risk approach, organizations overall liquidity. When establish-
which measures the potential gain or loss in a ing limits, organizations should be aware of the
position, portfolio, or organization that is associ- size, depth, and liquidity of the particular mar-
ated with a price movement of a given probabil- ket and establish trading guidelines accordingly.
ity over a specified time horizon. Banking orga- Management should also give consideration to
nizations should revalue all trading portfolios the potential problems associated with replacing
and calculate their exposures at least daily. contracts that terminate early in volatile or
Although banking organizations may use risk illiquid markets.
measures other than value at risk, examiners In developing guidelines for controlling the
should consider whether the measure used is liquidity risks in trading activities, banking
sufficiently accurate and rigorous and whether it organizations should consider the possibility
is adequately incorporated into the banking that they could lose access to one or more
organizations risk management process. markets, either because of concerns about the
Examiners should also ensure that the organi- banking organizations own creditworthiness,
zation compares its estimated market-risk expo- the creditworthiness of a major counterparty, or
sures with actual market-price behavior. In because of generally stressful market condi-
particular, the output of any market-risk models tions. At such times, the banking organization
that require simulations or forecasts of future may have less flexibility in managing its
prices should be compared with actual prices. If market-, credit-, and liquidity-risk exposures.
the projected and actual results differ materially, Banking organizations that make markets in
the models should be modified, as appropriate. over-the-counter derivatives or that dynamically
Banking organizations should establish limits hedge their positions require constant access to
for market risk that relate to their risk measures financial markets, and that need may increase in
and that are consistent with maximum expo- times of market stress. The banking organiza-
sures authorized by their senior management tions liquidity plan should reflect the organiza-
and board of directors. These limits should be tions ability to turn to alternative markets, such
allocated to business units and individual traders as futures or cash markets, or to provide suffi-
and be clearly understood by all relevant parties. cient collateral or other credit enhancements in
Examiners should ensure that exceptions to lim- order to continue trading under a broad range of
its are detected and adequately addressed by scenarios.
management. In practice, some limit systems Examiners should ensure that banking organi-
may include additional elements such as stop- zations that participate in over-the-counter
loss limits and trading guidelines that may play derivative markets adequately consider the po-
an important role in controlling risk at the trader tential liquidity risks associated with the early
and business-unit level; examiners should termination of derivative contracts. Many forms
include them in their review of the limit system. of standardized contracts for derivative transac-
tions allow counterparties to request collateral
or to terminate their contracts early if the bank-
2125.0.2.5.3 Liquidity Risk ing organization experiences an adverse credit
event or a deterioration in its financial condi-
Banking organizations face two types of liquid- tion. In addition, under conditions of market
ity risk in their trading activities: those related stress, customers may ask for the early termina-
to specific products or markets and those related tion of some contracts within the context of the
to the general funding of the banking organiza- dealers market-making activities. In such situa-
tions trading activities. The former is the risk tions, a banking organization that owes money
that a banking organization cannot easily un- on derivative transactions may be required to
wind or offset a particular position at or near the deliver collateral or settle a contract early and
previous market price because of inadequate possibly at a time when the banking organiza-
market depth or because of disruptions in the tion may face other funding and liquidity pres-
marketplace. Funding-liquidity risk is the risk sures. Early terminations may also open up
that the banking organization will be unable to additional, unintended, market positions. Man-
meet its payment obligations on settlement agement and directors should be aware of
these potential liquidity risks and should
BHC Supervision Manual June 1994 address them in the banking organizations
Page 6 liquidity plan and in the broader context of the
banking organizations liquidity management through policies developed by the organiza-

process. In their reviews, examiners should con- tions legal counsel (typically in consultation
sider the extent to which such potential obliga- with officers in the risk management process)
tions could present liquidity risks to the banking that have been approved by the banking organi-
organization. zations senior management and board of direc-
tors. At a minimum, there should be guidelines
and processes in place to ensure the enforceabil-
2125.0.2.5.4 Operational Risk, Legal ity of counterparty agreements. Examiners
Risk, and Business Practices should determine whether a banking organiza-
tion is adequately evaluating the enforceability
Operating risk is the risk that deficiencies in of its agreements before individual transactions
information systems or internal controls will are consummated. Banking organizations should
result in unexpected loss. Legal risk is the risk also ensure that the counterparty has sufficient
that contracts are not legally enforceable or doc- authority to enter into the transaction and that
umented correctly. Although operating and legal the terms of the agreement are legally sound.
risks are difficult to quantify, they can often be Banking organizations should further ascertain
evaluated by examining a series of plausible that their netting agreements are adequately doc-
worst-case or what-if scenarios, such as a umented, that they have been executed properly,
power loss, a doubling of transaction volume, a and that they are enforceable in all relevant
mistake found in the pricing software for collat- jurisdictions. Banking organizations should
eral management, or an unenforceable contract. have knowledge of relevant tax laws and inter-
They can also be assessed through periodic pretations governing the use of these instru-
reviews of procedures, documentation requirements. Knowledge of these laws is necessary
ments, data processing systems, contingency not only for the banking organizations market-
plans, and other operating practices. Such ing activities, but also for its own use of deriva-
reviews may help to reduce the likelihood of tive products.
errors and breakdowns in controls, improve the Sound business practices provide that bank-
control of risk and the effectiveness of the limit ing organizations take steps to ascertain the
system, and prevent unsound marketing prac- character and financial sophistication of counter-
tices and the premature adoption of new prod- parties. This includes efforts to ensure that the
ucts or lines of business. Considering the heavy counterparties understand the nature of and the
reliance of trading activities on computerized risks inherent in the agreed transactions. Where
systems, banking organizations should have the counterparties are unsophisticated, either
plans that take into account potential problems generally or with respect to a particular type of
with their normal processing procedures. transaction, banking organizations should take
Banking organizations should also ensure that additional steps to ensure that counterparties are
trades that are consummated orally are con- made aware of the risks attendant in the specific
firmed as soon as possible. Oral transactions type of transaction. While counterparties are
conducted via telephone should be recorded on ultimately responsible for the transactions into
tape and subsequently supported by written doc- which they choose to enter, where a banking
uments. Examiners should ensure that the orga- organization recommends specific transactions
nization monitors the consistency between the for an unsophisticated counterparty, the banking
terms of a transaction as they were orally agreed organization should ensure that it has adequate
upon and the terms as they were subsequently information regarding its counterparty on which
confirmed. to base its recommendation.
Examiners should also consider the extent to
which banking organizations evaluate and con-
trol operating risks through the use of internal 2125.0.3 INTERNAL CONTROLS AND
audits, stress testing, contingency planning, and AUDITS
other managerial and analytical techniques.
Banking organizations should also have A review of internal controls has long been
approved policies that specify documentation central to the Federal Reserves examination
requirements for trading activities and formal and inspection of trading and derivatives activi-
procedures for saving and safeguarding impor- ties. Policies and related procedures for the
tant documents that are consistent with legal operation of these activities should be an exten-
requirements and internal policies. Relevant per-
sonnel should fully understand the requirements. BHC Supervision Manual June 1994
Legal risks should be limited and managed Page 7
sion of the organizations overall structure of market risk, such as position versus limit reports
internal controls and should be fully integrated and limit overage approval policies and proce-
into routine work-flows. Properly structured, a dures, should also be reviewed. Examiners
system of internal controls should promote should also review the credit approval process
effective and efficient operations, reliable finan- to ensure that the risks of specific products are
cial and regulatory reporting, and compliance adequately captured and that credit approval
with relevant laws, regulations, and banking procedures are followed for all transactions.
organization policies. In determining whether An important step in the process of reviewing
internal controls meet those objectives, examin- internal controls is the examiners appraisal of
ers should consider the overall control environ- the frequency, scope, and findings of indepen-
ment of the organization; the process for iden- dent internal and external auditors and the abil-
tifying, analyzing, and managing risk; the ity of those auditors to review the banking orga-
adequacy of management information systems; nizations trading and derivatives activities.
and adherence to control activities such as Internal auditors should audit and test the risk
approvals, confirmations, and reconciliations. management process and internal controls on a
Assessing the adequacy of internal controls periodic basis, with the frequency based on a
involves a process of understanding, document- careful risk assessment. The depth and fre-
ing, evaluating, and testing an organizations quency of internal audits should be increased if
internal control system. This assessment should weaknesses and significant issues are discov-
include product- or business-line reviews which, ered or if significant changes have been made to
in turn, should start with an assessment of product lines, modeling methodologies, the risk
the lines organizational structure. Examiners oversight process, internal controls, or the over-
should check for adequate separation of duties, all risk profile of the organization.
especially between trading desk personnel and In reviewing the risk management functions
internal control and risk management functions, in particular, internal auditors should thoroughly
adequate oversight by a knowledgeable man- evaluate the effectiveness of internal controls
ager without day-to-day trading responsibilities, relevant to measuring, reporting, and limiting
and the presence of separate reporting lines for risks. Internal auditors should also evaluate
risk management and internal control personnel compliance with risk limits and the reliability
on one side and for trading personnel on the and timeliness of information reported to the
other. Product-by-product reviews of manage- banking organizations senior management and
ment structure should supplement the overall board of directors. Internal auditors are also
assessment of the organizational structure of the expected to evaluate the independence and over-
trading and derivatives areas. all effectiveness of the banking organizations
Examiners are expected to conduct in-depth risk management functions.
reviews of the internal controls of key activities. The level of confidence that examiners place
For example, for transaction recording and pro- in the banking organizations audit programs,
cessing, examiners should evaluate written poli- the nature of the audit findings, and manage-
cies and procedures for recording trades, assess ments response to those findings will influence
the trading areas adherence to policy, and ana- the scope of the current examination of trading
lyze the transaction processing cycle, including and derivatives activities. Even when the audit
settlement, to ensure the integrity and accuracy process and findings are satisfactory, examiners
of the banking organizations records and man- should document, evaluate, and test critical
agement reports. Examiners should review the internal controls.
revaluation process in order to assess the ade- Similar to the focus of internal auditors,
quacy of written policies and procedures for examiners should pay special attention to signif-
revaluing positions and for creating any associ- icant changes in product lines, risk measure-
ated revaluation reserves. Examiners should ment methodologies, limits, and internal con-
review compliance with revaluation policies and trols that have occurred since the last
procedures, the frequency of revaluation, and examination. Meaningful changes in earnings
the independence and quality of the sources of from trading or derivatives activities, or in the
revaluation prices, especially for instruments size of positions or the value at risk associated
traded in illiquid markets. All significant inter- with these activities, should also receive empha-
nal controls associated with the management of sis during the inspection or examination.

Page 8
Model Risk Management
Section 2126.0
Banking organizations should be attentive to the This guidance describes the key aspects of
possible adverse consequences (including finan- effective model risk management. Part II
cial loss) of decisions based on models that are explains the purpose and scope of the guidance,
incorrect or misused and should address those and part III gives an overview of model risk
consequences through active model risk man- management. Part IV discusses robust model
agement. The key aspects of an effective model development, implementation, and use. Part V
risk-management framework are described in describes the components of an effective valida-
more detail below, including robust model tion framework. Part VI explains the salient
development, implementation, and use; effec- features of sound governance, policies, and con-
tive validation; and sound governance, policies, trols over model development, implementation,
and controls. (See SR-11-7.) use, and validation. Part VII concludes.
2126.0.1 INTRODUCTIONPART I 2126.0.2 PURPOSE AND

SCOPEPART II
Banks rely heavily on quantitative analysis and
models in most aspects of financial decision The purpose of this section is to provide com-
making.1 They routinely use models for a broad prehensive guidance for banks on effective
range of activities, including underwriting cred- model risk management. Rigorous model vali-
its; valuing exposures, instruments, and posi- dation plays a critical role in model risk man-
tions; measuring risk; managing and safeguard- agement; however, sound development, imple-
ing client assets; determining capital and reserve mentation, and use of models are also vital
adequacy; and many other activities. In recent elements. Furthermore, model risk management
years, banks have applied models to more com- encompasses governance and control mecha-
plex products and with more ambitious scope, nisms such as board and senior management
such as enterprise-wide risk measurement, while oversight, policies and procedures, controls and
the markets in which they are used have also compliance, and an appropriate incentive and
broadened and changed. Changes in regulation organizational structure.
have spurred some of the recent developments, Previous guidance and other publications
particularly the U.S. regulatory capital rules for issued by the Office of the Comptroller of the
market, credit, and operational risk based on the Currency (OCC) and the Federal Reserve on the
framework developed by the Basel Committee use of models pay particular attention to model
on Banking Supervision. Even apart from these validation.2 Based on supervisory and industry
regulatory considerations, however, banks have experience over the past several years, this
been increasing the use of data-driven, quantita- document expands on existing guidancemost
tive decision making tools for a number of importantly by broadening the scope to include
years. all aspects of model risk management. Many
The expanding use of models in all aspects of banks may already have in place a large portion
banking reflects the extent to which models can of these practices, but all banks should ensure
improve business decisions, but models also that internal policies and procedures are consis-
come with costs. There is the direct cost of
devoting resources to develop and implement 2. For instance, the OCC provided guidance on model risk,
focusing on model validation, in OCC 2000-16 (May 30,
models properly. There are also the potential 2000), other bulletins, and certain subject matter booklets of
indirect costs of relying on models, such as the the Comptrollers Handbook. The Federal Reserve issued
possible adverse consequences (including finan- SR-09-01, Application of the Market Risk Rule in Bank
cial loss) of decisions based on models that are Holding Companies and State Member Banks, which high-
lights various concepts pertinent to model risk management,
incorrect or misused. Those consequences including standards for validation and review, model valida-
should be addressed by active management of tion documentation, and back-testing. The Federal Reserves
model risk. Trading and Capital-Markets Activities Manual also discusses
validation and model risk management. In addition, the
advanced-approaches risk-based capital rules (12 CFR 3,
Appendix C; 12 CFR 208, Appendix F; and 12 CFR 225,
1. Unless otherwise indicated, banks refers to national Appendix G) contain explicit validation requirements for sub-
banks and all other institutions for which the Office of the ject banking organizations.
Comptroller of the Currency is the primary supervisor, and to
bank holding companies, state member banks, and all other
institutions for which the Federal Reserve Board is the pri- BHC Supervision Manual July 2011
mary supervisor. Page 1
Model Risk Management 2126.0
tent with the risk-management principles and quality can be measured in many ways: preci-
supervisory expectations contained in this guid- sion, accuracy, discriminatory power, robust-
ance. Details may vary from bank to bank, as ness, stability, and reliability, to name a few.
practical application of this guidance should be Models are never perfect, and the appropriate
customized to be commensurate with a banks metrics of quality, and the effort that should be
risk exposures, its business activities, and the put into improving quality, depend on the situa-
complexity and extent of its model use. For tion. For example, precision and accuracy are
example, steps taken to apply this guidance at a relevant for models that forecast future values,
community bank using relatively few models of while discriminatory power applies to models
only moderate complexity might be signifi- that rank order risks. In all situations, it is
cantly less involved than those at a larger bank important to understand a models capabilities
where use of models is more extensive or and limitations given its simplifications and
complex. assumptions.
The use of models invariably presents model
risk, which is the potential for adverse conse-
2126.0.3 OVERVIEW OF MODEL RISK quences from decisions based on incorrect or
MANAGEMENTPART III misused model outputs and reports. Model risk
can lead to financial loss, poor business and
For the purposes of this section, the term model strategic decision making, or damage to a banks
refers to a quantitative method, system, or reputation. Model risk occurs primarily for two
approach that applies statistical, economic, reasons:
financial, or mathematical theories, techniques,
and assumptions to process input data into quan- The model may have fundamental errors and
titative estimates. A model consists of three may produce inaccurate outputs when viewed
components: an information input component, against the design objective and intended
which delivers assumptions and data to the business uses. The mathematical calculation
model; a processing component, which trans- and quantification exercise underlying any
forms inputs into estimates; and a reporting model generally involves application of
component, which translates the estimates into theory, choice of sample design and numerical
useful business information. Models meeting routines, selection of inputs and estimation,
this definition might be used for analyzing busi- and implementation in information systems.
ness strategies; informing business decisions; Errors can occur at any point from design
identifying and measuring risks; valuing expo- through implementation. In addition, short-
sures, instruments, or positions; conducting cuts, simplifications, or approximations used
stress testing; assessing adequacy of capital; to manage complicated problems could com-
managing client assets; measuring compliance promise the integrity and reliability of outputs
with internal limits; maintaining the formal con- from those calculations. Finally, the quality of
trol apparatus of the bank; meeting financial or model outputs depends on the quality of input
regulatory reporting requirements; and issuing data and assumptions, and errors in inputs or
public disclosures. The definition of model also incorrect assumptions will lead to inaccurate
covers quantitative approaches whose inputs are outputs.
partially or wholly qualitative or based on expert The model may be used incorrectly or inap-
judgment, provided that the output is quantita- propriately. Even a fundamentally sound
tive in nature.3 model producing accurate outputs consistent
Models are simplified representations of real- with the design objective of the model may
world relationships among observed characteris- exhibit high model risk if it is misapplied or
tics, values, and events. Simplification is inevi- misused. Models by their nature are simplifi-
table, due to the inherent complexity of those cations of reality, and real-world events may
relationships, but also intentional, to focus atten- prove those simplifications inappropriate. This
tion on particular aspects considered to be most is even more of a concern if a model is used
important for a given model application. Model outside the environment for which it was
designed. Banks may do this intentionally as
3. While outside the scope of this guidance, more qualita- they apply existing models to new products or
tive approaches used by banking organizationsi.e., those
not defined as models according to this guidanceshould
markets, or inadvertently as market conditions
also be subject to a rigorous control process. or customer behavior changes. Decision mak-
ers need to understand the limitations of a
BHC Supervision Manual July 2011 model to avoid using it in ways that are not
Page 2 consistent with the original intent. Limitations
come in part from weaknesses in the model model risk management. If at some banks the
due to its various shortcomings, approxima- use of models is less pervasive and has less
tions, and uncertainties. Limitations are also a impact on their financial condition, then those
consequence of assumptions underlying a banks may not need as complex an approach to
model that may restrict the scope to a limited model risk management in order to meet super-
set of specific circumstances and situations. visory expectations. However, where models
and model output have a material impact on
Model risk should be managed like other business decisions, including decisions related
types of risk. Banks should identify the sources to risk management and capital and liquidity
of risk and assess the magnitude. Model risk planning, and where model failure would have a
increases with greater model complexity, higher particularly harmful impact on a banks finan-
uncertainty about inputs and assumptions, cial condition, a banks model risk-management
broader use, and larger potential impact. Banks framework should be more extensive and
should consider risk from individual models and rigorous.
in the aggregate. Aggregate model risk is Model risk management begins with robust
affected by interaction and dependencies among model development, implementation, and use.
models; reliance on common assumptions, data, Another essential element is a sound model
or methodologies; and any other factors that validation process. A third element is gover-
could adversely affect several models and their nance, which sets an effective framework with
outputs at the same time. With an understanding defined roles and responsibilities for clear com-
of the source and magnitude of model risk in munication of model limitations and assump-
place, the next step is to manage it properly. tions, as well as the authority to restrict model
A guiding principle for managing model risk usage. Each of these elements is discussed in the
is effective challenge of models, that is, criti- following sections.
cal analysis by objective, informed parties who
can identify model limitations and assumptions
and produce appropriate changes. Effective
challenge depends on a combination of incen- 2126.0.4 MODEL DEVELOPMENT,
tives, competence, and influence. Incentives to IMPLEMENTATION, AND USE
provide effective challenge to models are PART IV
stronger when there is greater separation of that
challenge from the model development process Model risk management should include disci-
and when challenge is supported by well- plined and knowledgeable development and
designed compensation practices and corporate implementation processes that are consistent
culture. Competence is a key to effectiveness with the situation and goals of the model user
since technical knowledge and modeling skills and with bank policy. Model development is
are necessary to conduct appropriate analysis not a straightforward or routine technical pro-
and critique. Finally, challenge may fail to be cess. The experience and judgment of develop-
effective without the influence to ensure that ers, as much as their technical knowledge,
actions are taken to address model issues. Such greatly influence the appropriate selection of
influence comes from a combination of explicit inputs and processing components. The training
authority, stature within the organization, and and experience of developers exercising such
commitment and support from higher levels of judgment affects the extent of model risk.
management. Moreover, the modeling exercise is often a
Even with skilled modeling and robust valida- multidisciplinary activity drawing on econom-
tion, model risk cannot be eliminated, so other ics, finance, statistics, mathematics, and other
tools should be used to manage model risk fields. Models are employed in real-world mar-
effectively. Among these are establishing limits kets and events and, therefore, should be tai-
on model use, monitoring model performance, lored for specific applications and informed by
adjusting or revising models over time, and business uses. In addition, a considerable
supplementing model results with other analysis amount of subjective judgment is exercised at
and information. Informed conservatism, in various stages of model development, imple-
either the inputs or the design of a model or mentation, use, and validation. It is important
through explicit adjustments to outputs, can be for decision makers to recognize that this sub-
an effective tool, though not an excuse to avoid jectivity elevates the importance of sound
improving models.
As is generally the case with other risks, BHC Supervision Manual July 2011
materiality is an important consideration in Page 3
and comprehensive model risk-management model and its overall functioning are evaluated
processes.4 to determine whether the model is performing
as intended. Model testing includes checking
the models accuracy, demonstrating that the
2126.0.4.1 Model Development and model is robust and stable, assessing potential
Implementation limitations, and evaluating the models behavior
over a range of input values. It should also
An effective development process begins with a assess the impact of assumptions and identify
clear statement of purpose to ensure that model situations where the model performs poorly or
development is aligned with the intended use. becomes unreliable. Testing should be applied
The design, theory, and logic underlying the to actual circumstances under a variety of mar-
model should be well documented and generally ket conditions, including scenarios that are out-
supported by published research and sound side the range of ordinary expectations, and
industry practice. The model methodologies and should encompass the variety of products or
processing components that implement the applications for which the model is intended.
theory, including the mathematical specification Extreme values for inputs should be evaluated
and the numerical techniques and approxima- to identify any boundaries of model effective-
tions, should be explained in detail with particu- ness. The impact of model results on other mod-
lar attention to merits and limitations. Develop- els that rely on those results as inputs should
ers should ensure that the components work as also be evaluated. Included in testing activities
intended, are appropriate for the intended busi- should be the purpose, design, and execution of
ness purpose, and are conceptually sound and test plans, summary results with commentary
mathematically and statistically correct. Com- and evaluation, and detailed analysis of informa-
parison with alternative theories and approaches tive samples. Testing activities should be appro-
is a fundamental component of a sound model- priately documented.
ing process. The nature of testing and analysis will depend
The data and other information used to on the type of model and will be judged by
develop a model are of critical importance; there different criteria depending on the context. For
should be rigorous assessment of data quality example, the appropriate statistical tests depend
and relevance, and appropriate documentation. on specific distributional assumptions and the
Developers should be able to demonstrate that purpose of the model. Furthermore, in many
such data and information are suitable for the cases statistical tests cannot unambiguously
model and that they are consistent with the reject false hypotheses or accept true ones based
theory behind the approach and with the chosen on sample information. Different tests have dif-
methodology. If data proxies are used, they ferent strengths and weaknesses under different
should be carefully identified, justified, and conditions. Any single test is rarely sufficient,
documented. If data and information are not so banks should apply a variety of tests to
representative of the banks portfolio or other develop a sound model.
characteristics, or if assumptions are made to Banks should ensure that the development of
adjust the data and information, these factors the more judgmental and qualitative aspects of
should be properly tracked and analyzed so that their models is also sound. In some cases, banks
users are aware of potential limitations. This is may take statistical output from a model and
particularly important for external data and modify it with judgmental or qualitative adjust-
information (from a vendor or outside party), ments as part of model development. While
especially as they relate to new products, instru- such practices may be appropriate, banks should
ments, or activities. ensure that any such adjustments made as part
An integral part of model development is of the development process are conducted in an
testing, in which the various components of a appropriate and systematic manner and are well
documented.
4. Smaller banks that rely on vendor models may be able to
Models typically are embedded in larger
satisfy the standards in this guidance without an in-house staff information systems that manage the flow of
of technical, quantitative model developers. However, even if data from various sources into the model and
a bank relies on vendors for basic model development, the handle the aggregation and reporting of model
bank should still choose the particular models and variables
that are appropriate to its size, scale, and lines of business and
outcomes. Model calculations should be prop-
ensure the models are appropriate for the intended use. erly coordinated with the capabilities and
requirements of information systems. Sound
BHC Supervision Manual July 2011 model risk management depends on substantial
Page 4 investment in supporting systems to ensure data
and reporting integrity, together with controls sion makers important indications of the mod-
and testing to ensure proper implementation of els accuracy, robustness, and stability as well
models, effective systems integration, and as information on model limitations.
appropriate use. An understanding of model uncertainty and
inaccuracy and a demonstration that the bank is
accounting for them appropriately are important
2126.0.4.2 Model Use outcomes of effective model development,
implementation, and use. Because they are by
Model use provides additional opportunity to definition imperfect representations of reality,
test whether a model is functioning effectively all models have some degree of uncertainty and
and to assess its performance over time as con- inaccuracy. These can sometimes be quantified,
ditions and model applications change. It can for example, by an assessment of the potential
serve as a source of productive feedback and impact of factors that are unobservable or not
insights from a knowledgeable internal constitu- fully incorporated in the model, or by the confi-
ency with strong interest in having models that dence interval around a statistical models point
function well and reflect economic and business estimate. Indeed, using a range of outputs, rather
realities. Model users can provide valuable busi- than a simple point estimate, can be a useful
ness insight during the development process. In way to signal model uncertainty and avoid spu-
addition, business managers affected by model rious precision. At other times, only a qualita-
outcomes may question the methods or assump- tive assessment of model uncertainty and inac-
tions underlying the models, particularly if the curacy is possible. In either case, it can be
managers are significantly affected by, and do prudent for banks to account for model uncer-
not agree with, the outcome. Such questioning tainty by explicitly adjusting model inputs or
can be healthy if it is constructive and causes calculations to produce more severe or adverse
model developers to explain and justify the model output in the interest of conservatism.
assumptions and design of the models. Accounting for model uncertainty can also
However, challenge from model users may be include judgmental conservative adjustments to
weak if the model does not materially affect model output, placing less emphasis on that
their results, if the resulting changes in models models output, or ensuring that the model is
are perceived to have adverse effects on the only used when supplemented by other models
business line, or if change in general is regarded or approaches.5
as expensive or difficult. User challenges also While conservative use of models is prudent
tend not to be comprehensive because they in general, banks should be careful in applying
focus on aspects of models that have the most conservatism broadly or claiming to make con-
direct impact on the users measured business servative adjustments or add-ons to address
performance or compensation, and thus may model risk, because the impact of such conser-
ignore other elements and applications of the vatism in complex models may not be obvious
models. Finally, such challenges tend to be or intuitive. Model aspects that appear conserva-
asymmetric because users are less likely to chal- tive in one model may not be truly conservative
lenge an outcome that results in an advantage compared with alternative methods. For exam-
for them. Indeed, users may incorrectly believe ple, simply picking an extreme point on a given
that model risk is low simply because outcomes modeled distribution may not be conservative if
from model-based decisions appear favorable to the distribution was misestimated or misspeci-
the institution. Thus, the nature and motivation fied in the first place. Furthermore, initially con-
behind model users input should be evaluated servative assumptions may not remain conserva-
carefully, and banks should also solicit constructive over time. Therefore, banks should justify
tive suggestions and criticism from sources and substantiate claims that model outputs are
independent of the line of business using the conservative with a definition and measurement
model. of that conservatism that is communicated to
Reports used for business decision making model users. In some cases, sensitivity analysis
play a critical role in model risk management. or other types of stress testing can be used to
Such reports should be clear and comprehen-
sible and take into account the fact that decision 5. To the extent that models are used to generate amounts
included in public financial statements, any adjustments for
makers and modelers often come from quite model uncertainty must comply with generally accepted
different backgrounds and may interpret the accounting principles.
contents in different ways. Reports that provide
a range of estimates for different input-value BHC Supervision Manual July 2011
scenarios and assumption values can give deci- Page 5
demonstrate that a model is indeed conserva- actions and outcomes, since there may be addi-
tive. Another way in which banks may choose tional ways to ensure objectivity and prevent
to be conservative is to hold an additional cush- bias. As a practical matter, some validation work
ion of capital to protect against potential losses may be most effectively done by model develop-
associated with model risk. However, conserva- ers and users; it is essential, however, that such
tism can become an impediment to proper validation work be subject to critical review by
model development and application if it is seen an independent party, who should conduct addi-
as a solution that dissuades the bank from mak- tional activities to ensure proper validation.
ing the effort to improve the model; in addition, Overall, the quality of the process is judged by
excessive conservatism can lead model users to the manner in which models are subject to criti-
discount the model outputs. cal review. This could be determined by evaluat-
As previously explained, robust model devel- ing the extent and clarity of documentation, the
opment, implementation, and use is important to issues identified by objective parties, and the
model risk management. But it is not enough for actions taken by management to address model
model developers and users to understand and issues.
accept the model. Because model risk is ulti- In addition to independence, banks can sup-
mately borne by the bank as a whole, the bank port appropriate incentives in validation through
should objectively assess model risk and the compensation practices and performance evalu-
associated costs and benefits using a sound ation standards that are tied directly to the qual-
model-validation process. ity of model validations and the degree of criti-
cal, unbiased review. In addition, corporate
culture plays a role if it establishes support for
2126.0.5 MODEL VALIDATION objective thinking and encourages questioning
PART V and challenging of decisions.
Staff doing validation should have the requi-
Model validation is the set of processes and site knowledge, skills, and expertise. A high
activities intended to verify that models are per- level of technical expertise may be needed
forming as expected, in line with their design because of the complexity of many models, both
objectives and business uses. Effective valida- in structure and in application. These staff also
tion helps ensure that models are sound. It also should have a significant degree of familiarity
identifies potential limitations and assumptions with the line of business using the model and
and assesses their possible impact. As with other the models intended use. A models developer
aspects of effective challenge, model validation is an important source of information but cannot
should be performed by staff with appropriate be relied on as an objective or sole source on
incentives, competence, and influence. which to base an assessment of model quality.
All model components, including input, pro- Staff conducting validation work should have
cessing, and reporting, should be subject to vali- explicit authority to challenge developers and
dation; this applies equally to models developed users and to elevate their findings, including
in-house and to those purchased from, or devel- issues and deficiencies. The individual or unit to
oped by, vendors or consultants. The rigor and whom those staff report should have sufficient
sophistication of validation should be commen- influence or stature within the bank to ensure
surate with the banks overall use of models, the that any issues and deficiencies are appropri-
complexity and materiality of its models, and ately addressed in a timely and substantive man-
the size and complexity of the banks opera- ner. Such influence can be reflected in reporting
tions. lines, title, rank, or designated responsibilities.
Validation involves a degree of independence Influence may be demonstrated by a pattern of
from model development and use. Generally, actual instances in which models, or the use of
validation should be done by people who are not models, have been appropriately changed as a
responsible for development or use and do not result of validation.
have a stake in whether a model is determined The range and rigor of validation activities
to be valid. Independence is not an end in itself conducted prior to first use of a model should be
but rather helps ensure that incentives are in line with the potential risk presented by use
aligned with the goals of model validation. of the model. If significant deficiencies are noted
While independence may be supported by sepa- as a result of the validation process, use of the
ration of reporting lines, it should be judged by model should not be allowed or should be per-
mitted only under very tight constraints until
BHC Supervision Manual July 2011 those issues are resolved. If the deficiencies are
Page 6 too severe to be addressed within the models
framework, the model should be rejected. If it is 2126.0.5.1 Key Elements of

not feasible to conduct necessary validation Comprehensive Validation
activities prior to model use because of data
paucity or other limitations, that fact should be An effective validation framework should
documented and communicated in reports to include three core elements:
users, senior management, and other relevant
parties. In such cases, the uncertainty about the Evaluation of conceptual soundness, includ-
results that the model produces should be miti- ing developmental evidence
gated by other compensating controls. This is Ongoing monitoring, including process verifi-
particularly applicable to new models and to the cation and benchmarking
use of existing models in new applications. Outcomes analysis, including back-testing
Validation activities should continue on an
ongoing basis after a model goes into use, to
track known model limitations and to identify 2126.0.5.1.1 Evaluation of Conceptual
any new ones. Validation is an important check Soundness
on model use during periods of benign eco-
nomic and financial conditions, when estimates This first element involves assessing the quality
of risk and potential loss can become overly of the model design and construction. It entails
optimistic, and when the data at hand may not review of documentation and empirical evi-
fully reflect more stressed conditions. Ongoing dence supporting the methods used and vari-
validation activities help to ensure that changes ables selected for the model. Documentation
in markets, products, exposures, activities, cli- and testing should convey an understanding of
ents, or business practices do not create new model limitations and assumptions. Validation
model limitations. For example, if credit risk should ensure that judgment exercised in model
models do not incorporate underwriting changes design and construction is well informed, care-
in a timely manner, flawed and costly business fully considered, and consistent with published
decisions could be made before deterioration in research and with sound industry practice.
model performance becomes apparent. Developmental evidence should be reviewed
Banks should conduct a periodic reviewat before a model goes into use and also as part of
least annually but more frequently if the ongoing validation process, in particular
warrantedof each model to determine whether whenever there is a material change in the
it is working as intended and if the existing model.
validation activities are sufficient. Such a deter- A sound development process will produce
mination could simply affirm previous valida- documented evidence in support of all model
tion work, suggest updates to previous valida- choices, including the overall theoretical con-
tion activities, or call for additional validation struction, key assumptions, data, and specific
activities. Material changes to models should mathematical calculations. As part of model
also be subject to validation. It is generally good validation, those model aspects should be sub-
practice for banks to ensure that all models jected to critical analysis by both evaluating the
undergo the full validation process, as described quality and extent of developmental evidence
in the following section, at some fixed interval, and conducting additional analysis and testing
including updated documentation of all as necessary. Comparison to alternative theories
activities. and approaches should be included. Key
Effective model validation helps reduce assumptions and the choice of variables should
model risk by identifying model errors, correc- be assessed, with analysis of their impact on
tive actions, and appropriate use. It also pro- model outputs and particular focus on any
vides an assessment of the reliability of a given potential limitations. The relevance of the data
model, based on its underlying assumptions, used to build the model should be evaluated to
theory, and methods. In this way, it provides ensure that it is reasonably representative of the
information about the source and extent of banks portfolio or market conditions, depend-
model risk. Validation also can reveal deteriora- ing on the type of model. This is an especially
tion in model performance over time and can set important exercise when a bank uses external
thresholds for acceptable levels of error, through data or the model is used for new products or
analysis of the distribution of outcomes around activities.
expected or predicted values. If outcomes fall Where appropriate to the particular model,
consistently outside this acceptable range, then
the models should be redeveloped.
Page 7
banks should employ sensitivity analysis in part of ongoing monitoring. Monitoring begins
model development and validation to check the when a model is first implemented in production
impact of small changes in inputs and parameter systems for actual business use. This monitoring
values on model outputs to make sure they fall should continue periodically over time, with a
within an expected range. Unexpectedly large frequency appropriate to the nature of the
changes in outputs in response to small changes model, the availability of new data or modeling
in inputs can indicate an unstable model. Vary- approaches, and the magnitude of the risk
ing several inputs simultaneously as part of sen- involved. Banks should design a program of
sitivity analysis can provide evidence of unex- ongoing testing and evaluation of model perfor-
pected interactions, particularly if the mance along with procedures for responding to
interactions are complex and not intuitively any problems that appear. This program should
clear. Banks benefit from conducting model include process verification and benchmarking.
stress testing to check performance over a wide Process verification checks that all model
range of inputs and parameter values, including components are functioning as designed. It
extreme values, to verify that the model is includes verifying that internal and external data
robust. Such testing helps establish the boundar- inputs continue to be accurate, complete, consis-
ies of model performance by identifying the tent with model purpose and design, and of the
acceptable range of inputs as well as conditions highest quality available. Computer code imple-
under which the model may become unstable or menting the model should be subject to rigorous
inaccurate. quality and change control procedures to ensure
Management should have a clear plan for that the code is correct, that it cannot be altered
using the results of sensitivity analysis and other except by approved parties, and that all changes
quantitative testing. If testing indicates that the are logged and can be audited. System integra-
model may be inaccurate or unstable in some tion can be a challenge and deserves special
circumstances, management should consider attention because the model processing compo-
modifying certain model properties, putting less nent often draws from various sources of data,
reliance on its outputs, placing limits on model processes large amounts of data, and then feeds
use, or developing a new approach. into multiple data repositories and reporting sys-
Qualitative information and judgment used in tems. User-developed applications, such as
model development should be evaluated, includ- spreadsheets or ad hoc database applications
ing the logic, judgment, and types of informa- used to generate quantitative estimates, are par-
tion used, to establish the conceptual soundness ticularly prone to model risk. As the content or
of the model and set appropriate conditions for composition of information changes over time,
its use. The validation process should ensure systems may need to be updated to reflect any
that qualitative, judgmental assessments are changes in the data or its use. Reports derived
conducted in an appropriate and systematic from model outputs should be reviewed as part
manner, are well supported, and are of validation to verify that they are accurate,
documented. complete, and informative, and that they contain
appropriate indicators of model performance
and limitations.
2126.0.5.1.2 Ongoing Monitoring Many of the tests employed as part of model
development should be included in ongoing
The second core element of the validation pro- monitoring and be conducted on a regular basis
cess is ongoing monitoring. Such monitoring to incorporate additional information as it
confirms that the model is appropriately imple- becomes available. New empirical evidence or
mented and is being used and is performing as theoretical research may suggest the need to
intended. modify or even replace original methods. Analy-
Ongoing monitoring is essential to evaluate sis of the integrity and applicability of internal
whether changes in products, exposures, activi- and external information sources, including
ties, clients, or market conditions necessitate information provided by third-party vendors,
adjustment, redevelopment, or replacement of should be performed regularly.
the model and to verify that any extension of the Sensitivity analysis and other checks for
model beyond its original scope is valid. Any robustness and stability should likewise be
model limitations identified in the development repeated periodically. They can be as useful
stage should be regularly assessed over time, as during ongoing monitoring as they are during
model development. If models only work well
BHC Supervision Manual July 2011 for certain ranges of input values, market condi-
Page 8 tions, or other factors, they should be monitored
to identify situations where these constraints are parisons help to evaluate model performance by
approached or exceeded. establishing expected ranges for those actual
Ongoing monitoring should include the outcomes in relation to the intended objectives
analysis of overrides with appropriate documen- and assessing the reasons for observed variation
tation. In the use of virtually any model, there between the two. If outcomes analysis produces
will be cases where model output is ignored, evidence of poor performance, the bank should
altered, or reversed based on the expert judg- take action to address those issues. Outcomes
ment of model users. Such overrides are an analysis typically relies on statistical tests or
indication that, in some respect, the model is not other quantitative measures. It can also include
performing as intended or has limitations. Banks expert judgment to check the intuition behind
should evaluate the reasons for overrides and the outcomes and confirm that the results make
track and analyze override performance. If the sense. When a model itself relies on expert
rate of overrides is high, or if the override judgment, quantitative outcomes analysis helps
process consistently improves model perfor- to evaluate the quality of that judgment. Out-
mance, it is often a sign that the underlying comes analysis should be conducted on an ongo-
model needs revision or redevelopment. ing basis to test whether the model continues to
Benchmarking is the comparison of a given perform in line with design objectives and busi-
models inputs and outputs to estimates from ness uses.
alternative internal or external data or models. It A variety of quantitative and qualitative test-
can be incorporated in model development as ing and analytical techniques can be used in
well as in ongoing monitoring. For credit-risk outcomes analysis. The choice of technique
models, examples of benchmarks include mod- should be based on the models methodology,
els from vendor firms or industry consortia and and its complexity, data availability, and the
data from retail credit bureaus. Pricing models magnitude of potential model risk to the bank.
for securities and derivatives often can be com- Outcomes analysis should involve a range of
pared with alternative models that are more tests because any individual test will have weak-
accurate or comprehensive but also too time- nesses. For example, some tests are better at
consuming to run on a daily basis. Whatever the checking a models ability to rank-order or seg-
source, benchmark models should be rigorous, ment observations on a relative basis, whereas
and benchmark data should be accurate and others are better at checking absolute forecast
complete to ensure a reasonable comparison. accuracy. Tests should be designed for each
Discrepancies between the model output and situation, as not all will be effective or feasible
benchmarks should trigger investigation into the in every circumstance, and attention should be
sources and degree of the differences, and paid to choosing the appropriate type of out-
examination of whether they are within an comes analysis for a particular model.
expected or appropriate range given the nature Models are regularly adjusted to take into
of the comparison. The results of that analysis account new data or techniques, or because of
may suggest revisions to the model. However, deterioration in performance. Parallel outcomes
differences do not necessarily indicate that the analysis, under which both the original and
model is in error. The benchmark itself is an adjusted models forecasts are tested against
alternative prediction, and the differences may realized outcomes, provides an important test of
be due to the different data or methods used. If such model adjustments. If the adjusted model
the model and the benchmark match well, that is does not outperform the original model, devel-
evidence in favor of the model, but it should be opers, users, and reviewers should realize that
interpreted with caution so the bank does not get additional changesor even a wholesale
a false degree of comfort. redesignare likely necessary before the
adjusted model replaces the original one.
Back-testing is one form of outcomes
2126.0.5.1.3 Outcomes Analysis analysis; specifically, it involves the comparison
of actual outcomes with model forecasts dur-
The third core element of the validation process ing a sample time period not used in model
is outcomes analysis, a comparison of model development and at an observation frequency
outputs to corresponding actual outcomes. The that matches the forecast horizon or
precise nature of the comparison depends on the performance window of the model. The
objectives of a model and might include an comparison is generally done using expected
assessment of the accuracy of estimates or fore-
casts, an evaluation of rank-ordering ability, or BHC Supervision Manual July 2011
other appropriate tests. In all cases, such com- Page 9
ranges or statistical confidence intervals around These outcomes analysis tools are not substi-
the model forecasts. When outcomes fall tutes for back-testing, which should still be per-
outside those intervals, the bank should analyze formed over the longer time period, but rather
the discrepancies and investigate the causes that are very important complements.
are significant in terms of magnitude or Outcomes analysis and the other elements of
frequency. The objective of the analysis is to the validation process may reveal significant
determine whether differences stem from the errors or inaccuracies in model development or
omission of material factors from the model, outcomes that consistently fall outside the
whether they arise from errors with regard to banks predetermined thresholds of acceptabil-
other aspects of model specification such as ity. In such cases, model adjustment, recalibra-
interaction terms or assumptions of linearity, or tion, or redevelopment is warranted. Adjust-
whether they are purely random and thus ments and recalibration should be governed by
consistent with acceptable model performance. the principle of conservatism and should
Analysis of in-sample fit and of model undergo independent review.
performance in holdout samples (data set aside Material changes in model structure or tech-
and not used to estimate the original model) are nique, and all model redevelopment, should be
important parts of model development but are subject to validation activities of appropriate
not substitutes for back-testing. range and rigor before implementation. At
A well-known example of back-testing is the times, banks may have a limited ability to use
evaluation of value-at-risk (VaR), in which key model validation tools like back-testing or
actual profit and loss is compared with a model sensitivity analysis for various reasons, such as
forecast loss distribution. Significant deviation lack of data or of price observability. In those
in expected versus actual performance and cases, even more attention should be paid to the
unexplained volatility in the profits and losses models limitations when considering the appro-
of trading activities may indicate that hedging priateness of model usage, and senior manage-
and pricing relationships are not adequately ment should be fully informed of those limita-
measured by a given approach. Along with tions when using the models for decision
measuring the frequency of losses in excess of a making. Such scrutiny should be applied to indi-
single VaR percentile estimator, banks should vidual models and models in the aggregate.
use other tests, such as assessing any cluster-
ing of exceptions and checking the distribution
of losses against other estimated percentiles. 2126.0.5.2 Validation of Vendor and
Analysis of the results of even high-quality Other Third-Party Products
and well-designed back-testing can pose chal-
lenges, since it is not a straightforward, The widespread use of vendor and other third-
mechanical process that always produces unam- party productsincluding data, parameter val-
biguous results. The purpose is to test the model, ues, and complete modelsposes unique chal-
not individual forecast values. Back-testing may lenges for validation and other model risk-
entail analysis of a large number of forecasts management activities because the modeling
over different conditions at a point in time or expertise is external to the user and because
over multiple time periods. Statistical testing is some components are considered proprietary.
essential in such cases, yet such testing can pose Vendor products should nevertheless be incor-
challenges in both the choice of appropriate porated into a banks broader model risk-
tests and the interpretation of results; banks management framework, following the same
should support and document both the choice of principles as applied to in-house models,
tests and the interpretation of results. although the process may be somewhat
Models with long forecast horizons should be modified.
back-tested, but given the amount of time it As a first step, banks should ensure that there
would take to accumulate the necessary data, are appropriate processes in place for selecting
that testing should be supplemented by evalua- vendor models. Banks should require the vendor
tion over shorter periods. Banks should employ to provide developmental evidence explaining
outcomes analysis consisting of early warn- the product components, design, and intended
ing metrics designed to measure performance use, to determine whether the model is appropri-
beginning very shortly after model introduction ate for the banks products, exposures, and risks.
and trend analysis of performance over time. Vendors should provide appropriate testing
results that show their product works as
BHC Supervision Manual July 2011 expected. They should also clearly indicate the
Page 10 models limitations and assumptions and where
the products use may be problematic. Banks extent and sophistication of a banks gover-
should expect vendors to conduct ongoing per- nance function is expected to align with the
formance monitoring and outcomes analysis, extent and sophistication of model usage.
with disclosure to their clients, and to make
appropriate modifications and updates over
time. 2126.0.6.1 Board of Directors and Senior
Banks are expected to validate their own use Management
of vendor products. External models may not
allow full access to computer coding and imple- Model risk governance is provided at the high-
mentation details, so the bank may have to rely est level by the board of directors and senior
more on sensitivity analysis and benchmarking. management when they establish a bank-wide
Vendor models are often designed to provide a approach to model risk management. As part of
range of capabilities and so may need to be their overall responsibilities, a banks board and
customized by a bank for its particular circum- senior management should establish a strong
stances. A banks customization choices should model risk-management framework that fits into
be documented and justified as part of valida- the broader risk management of the organiza-
tion. If vendors provide input data or assumption. That framework should be grounded in an
tions, or use them to build models, their rel- understanding of model risknot just for indi-
evance for the banks situation should be vidual models but also in the aggregate. The
investigated. Banks should obtain information framework should include standards for model
regarding the data used to develop the model development, implementation, use, and
and assess the extent to which that data are validation.
representative of the banks situation. The bank While the board is ultimately responsible, it
also should conduct ongoing monitoring and generally delegates to senior management the
outcomes analysis of vendor model performance responsibility for executing and maintaining an
using the banks own outcomes. effective model risk-management framework.
Systematic procedures for validation help the Duties of senior management include establish-
bank to understand the vendor product and its ing adequate policies and procedures and ensur-
capabilities, applicability, and limitations. Such ing compliance, assigning competent staff,
detailed knowledge is necessary for basic con- overseeing model development and
trols of bank operations. It is also very impor- implementation, evaluating model results,
tant for the bank to have as much knowledge ensuring effective challenge, reviewing valida-
in-house as possible, in case the vendor or the tion and internal audit findings, and taking
bank terminates the contract for any reason, or if prompt remedial action when necessary. In the
the vendor is no longer in business. Banks same manner as for other major areas of risk,
should have contingency plans for instances senior management, directly and through
when the vendor model is no longer available or relevant committees, is responsible for regularly
cannot be supported by the vendor. reporting to the board on significant model risk,
from individual models and in the aggregate,
and on compliance with policy. Board members
2126.0.6 GOVERNANCE, POLICIES, should ensure that the level of model risk is
AND CONTROLSPART VI within their tolerance and should direct changes
where appropriate. These actions will set the
Developing and maintaining strong gover- tone for the whole organization about the
nance, policies, and controls over the model importance of model risk and the need for
risk-management framework is fundamentally active model risk management.
important to its effectiveness. Even if model
development, implementation, use, and valida-
tion are satisfactory, a weak governance func- 2126.0.6.2 Policies and Procedures
tion will reduce the effectiveness of overall
model risk management. A strong governance Consistent with good business practices and
framework provides explicit support and struc- existing supervisory expectations, banks should
ture to risk-management functions through formalize model risk-management activities
policies defining relevant risk-management ac- with policies and the procedures to implement
tivities, procedures that implement those poli- them. Model risk-management policies should
cies, allocation of resources, and mechanisms
for evaluating whether policies and procedures BHC Supervision Manual July 2011
are being carried out as specified. Notably, the Page 11
be consistent with this guidance and also be 2126.0.6.3 Roles and Responsibilities
commensurate with the banks relative complex-
ity, business activities, corporate culture, and Conceptually, the roles in model risk manage-
overall organizational structure. The board or its ment can be divided among ownership, con-
delegates should approve model risk- trols, and compliance. While there are several
management policies and review them annually ways in which banks can assign the responsibili-
to ensure consistent and rigorous practices ties associated with these roles, it is important
across the organization. Those policies should that reporting lines and incentives be clear, with
be updated as necessary to ensure that model potential conflicts of interest identified and
risk-management practices remain appropriate addressed.
and keep current with changes in market condi-
Business units are generally responsible for
tions, bank products and strategies, bank expo-
the model risk associated with their business
sures and activities, and practices in the indus-
strategies. The role of model owner involves
try. All aspects of model risk management
ultimate accountability for model use and per-
should be covered by suitable policies, includ-
formance within the framework set by bank
ing model and model risk definitions; assess-
policies and procedures. Model owners should
ment of model risk; acceptable practices for
be responsible for ensuring that models are
model development, implementation, and use;
properly developed, implemented, and used.
appropriate model validation activities; and gov-
The model owner should also ensure that mod-
ernance and controls over the model risk-
els in use have undergone appropriate validation
management process.
and approval processes, promptly identify new
Policies should emphasize testing and analy- or changed models, and provide all necessary
sis and promote the development of targets for information for validation activities.
model accuracy, standards for acceptable levels
Model risk taken by business units should be
of discrepancies, and procedures for review of,
controlled. The responsibilities for risk controls
and response to, unacceptable discrepancies.
may be assigned to individuals, committees, or
They should include a description of the pro-
a combination of the two, and include risk mea-
cesses used to select and retain vendor models,
surement, limits, and monitoring. Other respon-
including the people who should be involved in
sibilities include managing the independent vali-
such decisions.
dation and review process to ensure that
The prioritization, scope, and frequency of effective challenge takes place. Appropriate
validation activities should be addressed in these resources should be assigned for model valida-
policies. They should establish standards for the tion and for guiding the scope and prioritization
extent of validation that should be performed of work. Issues and problems identified through
before models are put into production and the validation and other forms of oversight should
scope of ongoing validation. The policies should be communicated by risk-control staff to rel-
also detail the requirements for validation of evant individuals and business users throughout
vendor models and third-party products. Finally, the organization, including senior management,
they should require maintenance of detailed with a plan for corrective action. Control staff
documentation of all aspects of the model risk- should have the authority to restrict the use of
management framework, including an inventory models and monitor any limits on model usage.
of models in use, results of the modeling and While they may grant exceptions to typical pro-
validation processes, and model issues and their cedures of model validation on a temporary
resolution. basis, that authority should be subject to other
Policies should identify the roles and assign control mechanisms, such as timelines for com-
responsibilities within the model risk- pleting validation work and limits on model use.
management framework with clear detail on Compliance with policies is an obligation of
staff expertise, authority, reporting lines, and model owners and risk-control staff, and there
continuity. They should also outline controls on should be specific processes in place to ensure
the use of external resources for validation and that these roles are being carried out effectively
compliance and specify how that work will be and in line with policy. Documentation and
integrated into the model risk-management tracking of activities surrounding model devel-
framework. opment, implementation, use, and validation are
needed to provide a record that makes compli-
ance with policy transparent.
Page 12
2126.0.6.4 Internal Audit those activities are being conducted in accor-

dance with this guidance.
A banks internal audit function should assess
the overall effectiveness of the model risk-
management framework, including the frame- 2126.0.6.5 External Resources
works ability to address both types of model
risk for individual models and in the aggregate. Although model risk management is an internal
Findings from internal audit related to models process, a bank may decide to engage external
should be documented and reported to the board resources to help execute certain activities
or its appropriately delegated agent. Banks related to the model risk-management frame-
should ensure that internal audit operates with work. These activities could include model vali-
the proper incentives, has appropriate skills, and dation and review, compliance functions, or
has adequate stature in the organization to assist other activities in support of internal audit.
in model risk management. Internal audits role These resources may provide added knowledge
is not to duplicate model risk-management and another level of critical and effective chal-
activities. Instead, its role is to evaluate whether lenge, which may improve the internal model
model risk management is comprehensive, rig- development and risk-management processes.
orous, and effective. To accomplish this evalua- However, this potential benefit should be
tion, internal audit staff should possess suffi- weighed against the added costs for such
cient expertise in relevant modeling concepts as resources and the added time that external par-
well as their use in particular business lines. If ties require to understand internal data, systems,
some internal audit staff perform certain valida- and other relevant bank-specific circumstances.
tion activities, then they should not be involved Whenever external resources are used, the
in the assessment of the overall model risk- bank should specify the activities to be con-
management framework. ducted in a clearly written and agreed-upon
Internal audit should verify that acceptable scope of work. A designated internal party from
policies are in place and that model owners and the bank should be able to understand and evalu-
control groups comply with those policies. Inter- ate the results of validation and risk-control
nal audit should also verify records of model activities conducted by external resources. The
use and validation to test whether validations internal party is responsible for verifying that
are performed in a timely manner and whether the agreed upon scope of work has been com-
models are subject to controls that appropriately pleted; evaluating and tracking identified issues
account for any weaknesses in validation activi- and ensuring they are addressed; and making
ties. Accuracy and completeness of the model sure that completed work is incorporated into
inventory should be assessed. In addition, pro- the banks overall model risk-management
cesses for establishing and monitoring limits on framework. If the external resources are only
model usage should be evaluated. Internal audit utilized to do a portion of validation or compli-
should determine whether procedures for updat- ance work, the bank should coordinate internal
ing models are clearly documented and test resources to complete the full range of work
whether those procedures are being carried out needed. The bank should have a contingency
as specified. Internal audit should check that plan in case an external resource is no longer
model owners and control groups are meeting available or is unsatisfactory.
documentation standards, including risk report-
ing. Additionally, internal audit should perform
assessments of supporting operational systems 2126.0.6.6 Model Inventory
and evaluate the reliability of data used by
models. Banks should maintain a comprehensive set of
Internal audit also has an important role in information for models implemented for use,
ensuring that validation work is conducted prop- under development for implementation, or
erly and that appropriate effective challenge is recently retired. While each line of business
being carried out. It should evaluate the objec- may maintain its own inventory, a specific party
tivity, competence, and organizational standing should also be charged with maintaining a firm-
of the key validation participants, with the ulti- wide inventory of all models, which should
mate goal of ascertaining whether those partici- assist a bank in evaluating its model risk in the
pants have the right incentives to discover and aggregate. Any variation of a model that war-
report deficiencies. Internal audit should review
validation activities conducted by internal and BHC Supervision Manual July 2011
external parties with the same rigor to see if Page 13
rants a separate validation should be included as effective and complete model documentation.
a separate model and cross-referenced with Model developers should have responsibility
other variations. during model development for thorough
While the inventory may contain varying lev- documentation, which should be kept up-to-
els of information, given different model com- date as the model and application environment
plexity and the banks overall level of model changes. In addition, the bank should ensure
usage, the following are some general guide- that other participants in model risk-
lines. The inventory should describe the purpose management activities document their work,
and products for which the model is designed, including ongoing monitoring, process verifica-
actual or expected usage, and any restrictions on tion, benchmarking, and outcomes analysis.
use. It is useful for the inventory to list the type Also, line of business or other decision makers
and source of inputs used by a given model and should document information leading to selec-
underlying components (which may include tion of a given model and its subsequent valida-
other models), as well as model outputs and tion. For cases in which a bank uses models
their intended use. It should also indicate from a vendor or other third party, it should
whether models are functioning properly, pro- ensure that appropriate documentation of the
vide a description of when they were last third-party approach is available so that the
updated, and list any exceptions to policy. Other model can be appropriately validated.
items include the names of individuals respon- Validation reports should articulate model
sible for various aspects of the model develop- aspects that were reviewed, highlighting poten-
ment and validation; the dates of completed and tial deficiencies over a range of financial and
planned validation activities; and the time frame economic conditions, and determining whether
during which the model is expected to remain adjustments or other compensating controls are
valid. warranted. Effective validation reports include
clear executive summaries, with a statement of
model purpose and an accessible synopsis of
2126.0.6.7 Documentation model and validation results, including major
limitations and key assumptions.
Without adequate documentation, model risk
assessment and management will be ineffective.
Documentation of model development and vali-
2126.0.7 CONCLUSIONPART VII
dation should be sufficiently detailed so that This section provides comprehensive guidance
parties unfamiliar with a model can understand on effective model risk management. Many of
how the model operates, its limitations, and its the activities described are common industry
key assumptions. Documentation provides for practice. But all banks should confirm that their
continuity of operations, makes compliance with practices conform to the principles in this guid-
policy transparent, and helps track recommenda- ance for model development, implementation,
tions, responses, and exceptions. Developers, and use, as well as model validation. Banks
users, control and compliance units, and super- should also ensure that they maintain strong
visors are all served by effective documentation. governance and controls to help manage model
Banks can benefit from advances in information risk, including internal policies and procedures
and knowledge management systems and elec- that appropriately reflect the risk-management
tronic documentation to improve the organiza- principles described in this guidance. Details of
tion, timeliness, and accessibility of the various model risk-management practices may vary
records and reports produced in the model risk- from bank to bank, as practical application of
management process. this guidance should be commensurate with a
Documentation takes time and effort, and banks risk exposures, its business activities,
model developers and users who know the and the extent and complexity of its model use.
models well may not appreciate its value. Banks
should therefore provide incentives to produce

Page 14
Investment Securities and End-User Derivatives
Activities Section 2126.1
WHATS NEW IN THIS REVISED managing the interest-rate-risk component of
SECTION market risk, institutions are informed of the
merits of developing internal policies that
Effective January 2013, this section was revised specify the type of pre-acquisition analysis
to acknowledge and to include minor changes (stress testing) that is consistent with the scope,
relating to the issuance of SR-12-15, Investing sophistication, and complexity of their invest-
in Securities without Reliance on Nationally ment securities and end-user derivative hold-
Recognized Statistical Rating Organizations, ings. Such analyses should be conducted for
and its OCC attachment . (See section 2126.2 of certain types of instruments, including those
this manual.) The section also updates the cited that have complex or potentially volatile risk
accounting standards references. profiles. Institutions are advised to periodically
monitor the price sensitivity of their portfolios,
ensuring that they meet the established limits of
2126.1.0 SOUND RISK- the board of directors. Institutions are further
MANAGEMENT PRACTICES FOR advised to fully assess the creditworthiness of
PORTFOLIO INVESTMENT their counterparties, including brokers and issu-
On April 23, 1998, the Federal Financial ers. Institutions are to ensure that they take
Institutions Examination Council (FFIEC) issued proper account of the liquidity of the instru-
a Supervisory Policy Statement on Investment ments held. (See SR-98-12.)
Securities and End-User Derivatives Activities
that became effective on May 25, 1998. The
statement was adopted by the Board of 2126.1.1 SUPERVISORY POLICY
Governors and provides guidance on sound STATEMENT ON INVESTMENT
practices for managing the risks of investment SECURITIES AND END-USER
activities. The guidance focuses on risk- DERIVATIVES ACTIVITIES
management practices of state member banks
and Edge corporations. The basic principles also 2126.1.1.1 Purpose
apply to bank holding companies, which should
manage and control risk exposures on a This policy statement (statement) provides
consolidated basis, recognizing the legal distinc- guidance to financial institutions (institutions) on
tions and potential obstacles to cash movements sound practices for managing the risks of
among subsidiaries. The statements risk- investment securities and end-user derivatives
management principles should also be activities.2 The FFIEC agenciesthe Board of
incorporated into the policies of U.S. branches Governors of the Federal Reserve System, the
and agencies of foreign banks.1 Federal Deposit Insurance Corporation, the
The statements principles set forth sound Office of the Comptroller of the Currency, and
risk-management practices that are relevant to the National Credit Union Administration
most portfolio-management endeavors. The believe that effective management of the risks
statement places greater emphasis on a risk- associated with securities and derivative instru-
focused approach to supervision. Instruments ments represents an essential component of safe
held for end-user reasons are considered, taking and sound practices. This guidance describes the
into consideration a variety of factors such as practices that a prudent manager normally would
managements ability to manage and measure follow and is not intended to be a checklist.
risk within the institutions holdings and the Management should establish practices and
impact of those holdings on aggregate portfolio maintain documentation appropriate to the
risk. institutions individual circumstances, consistent
The statement focuses on managing the mar- with this statement.
ket, credit, liquidity, operational, and legal risks
of investment and end-user activities. When
2. The 1998 statement does not supersede any other

1. Appropriate adaptations should be made to reflect the requirements of the respective agencies statutory rules, regu-
fact that (1) those offices are an integral part of a foreign bank lations, policies, or supervisory guidance.
that must also manage its consolidated risks and recognize
possible obstacles to cash movement among branches and
(2) the foreign bank is subject to overall supervision by its BHC Supervision Manual January 2013
home-country supervisory authority. Page 1
Investment Securities and End-User Derivatives Activities 2126.1
2126.1.1.2 Scope oversight is an integral part of an effective

risk-management program. The board of direc-
This guidance applies to all securities in tors is responsible for approving major policies
held-to-maturity and available-for-sale accounts. for conducting investment activities, including
See FASB Accounting Standards Codification the establishment of risk limits. The board should
section 320-10-35, Investment Debt and Equity ensure that management has the requisite skills to
SecuritiesOverallSubsequent Measure- manage the risks associated with such activities.
ment (formerly FAS 115, Accounting for To properly discharge its oversight responsibili-
Certain Debt and Equity Securities). It also ties, the board should review portfolio activity
applies to certificates of deposit held for and risk levels, and require management to
investment purposes, and end-user derivative demonstrate compliance with approved risk
contracts not held in trading accounts. This limits. Boards should have an adequate
guidance covers all securities used for invest- understanding of investment activities. Boards
ment purposes, including money market instru- that do not should obtain professional advice to
ments, fixed-rate and floating-rate notes and enhance its understanding of investment-activity
bonds, structured notes, mortgage pass-through oversight, so as to enable it to meet its
and other asset-backed securities, and mortgage- responsibilities under this statement.
derivative products. Similarly, this guidance Senior management is responsible for the
covers all end-user derivative instruments used daily management of an institutions invest-
for nontrading purposes, such as swaps, futures, ments. Management should establish and
and options.3 This statement applies to all enforce policies and procedures for conducting
federally insured commercial banks, savings investment activities. Senior management
banks, savings associations, and federally should have an understanding of the nature and
chartered credit unions. level of various risks involved in the institu-
As a matter of sound practice, institutions tions investments and how such risks fit within
should have programs to manage the market, the institutions overall business strategies.
credit, liquidity, legal, operational, and other Management should ensure that the risk-
risks of investment securities and end-user management process is commensurate with the
derivatives activities (investment activities). size, scope, and complexity of the institutions
While risk-management programs will differ holdings. Management should also ensure that
among institutions, there are certain elements the responsibilities for managing investment
that are fundamental to all sound risk- activities are properly segregated to maintain
management programs. These elements include operational integrity. Institutions with signifi-
board and senior management oversight and a cant investment activities should ensure that
comprehensive risk-management process that back-office, settlement, and transaction-
effectively identifies, measures, monitors, and reconciliation responsibilities are conducted and
controls risk. This statement describes sound managed by personnel who are independent of
principles and practices for managing and con- those initiating risk-taking positions.
trolling the risks associated with investment
activities.
Institutions should fully understand and effec- 2126.1.1.4 Risk-Management Process
tively manage the risks inherent in their invest-
ment activities. Failure to understand and An effective risk-management process for
adequately manage the risks in these areas con- investment activities includes (1) policies, pro-
stitutes an unsafe and unsound practice. cedures, and limits; (2) the identification, mea-
surement, and reporting of risk exposures; and
(3) a system of internal controls.
2126.1.1.3 Board and Senior
Management Oversight
2126.1.1.4.1 Policies, Procedures, and
Board of director and senior management Limits
Investment policies, procedures, and limits pro-
3. Natural-person federal credit unions are not permitted to vide the structure to effectively manage invest-
purchase nonresidential mortgage asset-backed securities and
may participate in derivative programs only if authorized by the
ment activities. Policies should be consistent
National Credit Union Administration. with the organizations broader business strate-
gies, capital adequacy, technical expertise, and
BHC Supervision Manual January 2013 risk tolerance. Policies should identify relevant
Page 2 investment objectives, constraints, and guide-
lines for the acquisition and ongoing manage- ultimately responsible for the appropriate per-
ment of securities and derivative instruments. sonnel understanding and managing the risks of
Potential investment objectives include generat- the transaction.
ing earnings, providing liquidity, hedging risk Reports to the board of directors and senior
exposures, taking risk positions, modifying and management should summarize the risks related
managing risk profiles, managing tax liabilities, to the institutions investment activities and
and meeting pledging requirements, if applica- should address compliance with the investment
ble. Policies should also identify the risk charac- policys objectives, constraints, and legal
teristics of permissible investments and should requirements, including any exceptions to estab-
delineate clear lines of responsibility and author- lished policies, procedures, and limits. Reports
ity for investment activities. to management should generally reflect more
An institutions management should under- detail than reports to the board of the institution.
stand the risks and cash-flow characteristics of Reporting should be frequent enough to provide
its investments. This is particularly important timely and adequate information to judge the
for products that have unusual, leveraged, or changing nature of the institutions risk profile
highly variable cash flows. An institution should and to evaluate compliance with stated policy
not acquire a material position in an instrument objectives and constraints.
until senior management and all relevant per-
sonnel understand and can manage the risks
associated with the product. 2126.1.1.4.3 Internal Controls
An institutions investment activities should
be fully integrated into any institution-wide risk An institutions internal control structure is criti-
limits. In so doing, some institutions rely only cal to the safe and sound functioning of the
on the institution-wide limits, while others may organization generally and the management of
apply limits at the investment portfolio, sub- investment activities in particular. A system of
portfolio, or individual instrument level. internal controls promotes efficient operations;
The board and senior management should reliable financial and regulatory reporting; and
review, at least annually, the appropriateness of compliance with relevant laws, regulations, and
its investment strategies, policies, procedures, institutional policies. An effective system of
and limits. internal controls includes enforcing official lines
of authority, maintaining appropriate separation
of duties, and conducting independent reviews
2126.1.1.4.2 Risk Identification, of investment activities.
Measurement, and Reporting For institutions with significant investment
activities, internal and external audits are inte-
Institutions should ensure that they identify and gral to the implementation of a risk-
measure the risks associated with individual management process to control risks in invest-
transactions prior to acquisition and peri- ment activities. An institution should conduct
odically after purchase. This can be done at the periodic independent reviews of its risk-
institutional, portfolio, or individual-instrument management program to ensure its integrity,
level. Prudent management of investment accuracy, and reasonableness. Items that should
activities entails examination of the risk profile be reviewed include
of a particular investment in light of its impact
on the risk profile of the institution. To the 1. compliance with and the appropriateness of
extent practicable, institutions should measure investment policies, procedures, and limits;
exposures to each type of risk, and these 2. the appropriateness of the institutions risk-
measurements should be aggregated and measurement system given the nature, scope,
integrated with similar exposures arising from and complexity of its activities; and
other business activities to obtain the 3. the timeliness, integrity, and usefulness of
institutions overall risk profile. reports to the board of directors and senior
In measuring risks, institutions should con- management.
duct their own in-house pre-acquisition analy-
ses, or to the extent possible, make use of spe- The review should note exceptions to poli-
cific third-party analyses that are independent of cies, procedures, and limits and suggest correc-
the seller or counterparty. Irrespective of any tive actions. The findings of such reviews should
responsibility, legal or otherwise, assumed by a
dealer, counterparty, or financial advisor regard- BHC Supervision Manual January 2013
ing a transaction, the acquiring institution is Page 3
be reported to the board and corrective actions sensitivity limits on their investment portfolio
taken on a timely basis. or on individual securities. These sub-institution
The accounting systems and procedures used limits, if established, should also be consistent
for public and regulatory reporting purposes are with agency guidance.
critically important to the evaluation of an orga- It is a sound practice for an institutions man-
nizations risk profile and the assessment of its agement to fully understand the market risks
financial condition and capital adequacy. associated with investment securities and
Accordingly, an institutions policies should derivative instruments prior to acquisition and
provide clear guidelines regarding the reporting on an ongoing basis. Accordingly, institutions
treatment for all securities and derivatives hold- should have appropriate policies to ensure such
ings. This treatment should be consistent with understanding. In particular, institutions should
the organizations business objectives, generally have policies that specify the types of market-
accepted accounting principles (GAAP), and risk analyses that should be conducted for vari-
regulatory reporting standards. ous types or classes of instruments, including
that conducted prior to their acquisition (pre-
purchase analysis) and on an ongoing basis.
2126.1.1.5 Risks of Investment Activities Policies should also specify any required docu-
mentation needed to verify the analysis.
The following discussion identifies particular It is expected that the substance and form of
sound practices for managing the specific risks such analyses will vary with the type of instru-
involved in investment activities. In addition to ment. Not all investment instruments may need
these sound practices, institutions should follow to be subjected to a pre-purchase analysis. Rela-
any specific guidance or requirements from their tively simple or standardized instruments, the
primary supervisor related to these activities. risks of which are well known to the institution,
would likely require no or significantly less
2126.1.1.5.1 Market Risk analysis than would more volatile, complex
instruments.4
Market risk is the risk to an institutions finan- For relatively more complex instruments, less
cial condition resulting from adverse changes in familiar instruments, and potentially volatile
the value of its holdings arising from move- instruments, institutions should fully address
ments in interest rates, foreign-exchange rates, pre-purchase analyses in their policies. Price-
equity prices, or commodity prices. An institu- sensitivity analysis is an effective way to per-
tions exposure to market risk can be measured form the pre-purchase analysis of individual
by assessing the effect of changing rates and instruments. For example, a pre-purchase analy-
prices on either the earnings or economic value sis should show the impact of an immediate
of an individual instrument, a portfolio, or the parallel shift in the yield curve of plus and
entire institution. For most institutions, the most minus 100, 200, and 300 basis points. Where
significant market risk of investment activities is appropriate, such analysis should encompass a
interest-rate risk. wider range of scenarios, including nonparallel
Investment activities may represent a signifi- changes in the yield curve. A comprehensive
cant component of an institutions overall analysis may also take into account other rel-
interest-rate-risk profile. It is a sound practice evant factors, such as changes in interest-rate
for institutions to manage interest-rate risk on volatility and changes in credit spreads.
an institution-wide basis. This sound practice When the incremental effect of an investment
includes monitoring the price sensitivity of the position is likely to have a significant effect on
institutions investment portfolio (changes in the the risk profile of the institution, it is a sound
investment portfolios value over different practice to analyze the effect of such a position
interest-rate/yield curve scenarios). Consistent on the overall financial condition of the
with agency guidance, institutions should institution.
specify institution-wide interest-rate-risk limits Accurately measuring an institutions market
that appropriately account for these activities risk requires timely information about the cur-
and the strength of the institutions capital posi- rent carrying and market values of its invest-
tion. These limits are generally established for ments. Accordingly, institutions should have
economic value or earnings exposures. Institu- market-risk-measurement systems commensu-
tions may find it useful to establish price-
4. Federal credit unions must comply with the investment-
BHC Supervision Manual January 2013 monitoring requirements of 12 C.F.R. 703.90. See 62 Fed.
Page 4 Reg. 32,989 (June 18, 1997).
rate with the size and nature of these invest- should establish limits on individual counter-
ments. Institutions with significant holdings of party exposures. Policies should also provide
highly complex instruments should ensure that credit-risk and concentration limits. Such limits
they have the means to value their positions. may define concentrations relating to a single or
Institutions employing internal models should related issuer or counterparty, a geographical
have adequate procedures to validate the models area, or obligations with similar characteristics.
and to periodically review all elements of the In managing credit risk, institutions should
modeling process, including its assumptions and consider settlement and presettlement credit
risk-measurement techniques. Managements risk. These risks are the possibility that a coun-
relying on third parties for market-risk- terparty will fail to honor its obligation at or
measurement systems and analyses should before the time of settlement. The selection of
ensure that they fully understand the assump- dealers, investment bankers, and brokers is par-
tions and techniques used. ticularly important in effectively managing these
Institutions should provide reports to their risks. The approval process should include a
boards on the market-risk exposures of their review of each firms financial statements and
investments on a regular basis. To do so, the an evaluation of its ability to honor its commit-
institution may report the market-risk exposure ments. An inquiry into the general reputation of
of the whole institution. Alternatively, reports the dealer is also appropriate. This includes
should contain evaluations that assess trends in review of information from state or federal secu-
aggregate market-risk exposure and the perfor- rities regulators and industry self-regulatory
mance of portfolios in terms of established organizations such as the National Association
objectives and risk constraints. They also should of Securities Dealers concerning any formal
identify compliance with board-approved limits enforcement actions against the dealer, its affili-
and identify any exceptions to established stan- ates, or associated personnel.
dards. Institutions should have mechanisms to The board of directors is responsible for
detect and adequately address exceptions to lim- supervision and oversight of investment port-
its and guidelines. Management reports on mar- folio and end-user derivatives activities, includ-
ket risk should appropriately address potential ing the approval and periodic review of policies
exposures to yield curve changes and other fac- that govern relationships with securities dealers.
tors pertinent to the institutions holdings.
Sound credit-risk management requires that
credit limits be developed by personnel who are
as independent as practicable of the acquisition
2126.1.1.5.2 Credit Risk function. In authorizing issuer and counterparty
credit lines, these personnel should use stan-
Broadly defined, credit risk is the risk that an
dards that are consistent with those used for
issuer or counterparty will fail to perform on an
other activities conducted within the institution
obligation to the institution. For many financial
and with the organizations overall policies and
institutions, credit risk in the investment port-
consolidated exposures.
folio may be low relative to other areas, such as
lending. However, this risk, as with any other
risk, should be effectively identified, measured, 2126.1.1.5.3 Liquidity Risk
monitored, and controlled.
An institution should not acquire investments Liquidity risk is the risk that an institution can-
or enter into derivative contracts without assess- not easily sell, unwind, or offset a particular
ing the creditworthiness of the issuer or counter- position at a fair price because of inadequate
party. The credit risk arising from these posi- market depth. In specifying permissible instru-
tions should be incorporated into the overall ments for accomplishing established objectives,
credit-risk profile of the institution as compre- institutions should ensure that they take into
hensively as practicable. Institutions are to meet account the liquidity of the market for those
certain creditworthiness standards for security instruments and the effect that such characteris-
purchases. Many institutions may maintain and tics have on achieving their objectives. The
update internal credit-rating reports and assess- liquidity of certain types of instruments may
ments that can be supplemented by reports from make them inappropriate for certain objectives.
major external credit-rating services. For non- Institutions should ensure that they consider the
rated securities, institutions should establish effects that market risk can have on the liquidity
guidelines to ensure that the securities meet
legal requirements and that the institution fully BHC Supervision Manual January 2013
understands the risk involved. Institutions Page 5
of different types of instruments under various or illiquid securities, completely independent

scenarios. Accordingly, institutions should pricing may be difficult to obtain. In such
articulate clearly the liquidity characteristics of cases, operational units may need to use
instruments to be used in accomplishing institu- prices provided by the portfolio manager.
tional objectives. For unique instruments where the pricing
Complex and illiquid instruments can often isbeing provided by a single source (e.g., the
involve greater risk than actively traded, more dealer providing the instrument), the institu-
liquid securities. Oftentimes, this higher poten- tion should review and understand the
tial risk arising from illiquidity is not captured assumptions used to price the instrument.
by standardized financial modeling techniques. 2. Personnel. The increasingly complex nature
Such risk is particularly acute for instruments of securities available in the marketplace
that are highly leveraged or that are designed to makes it important that operational personnel
benefit from specific, narrowly defined market have strong technical skills. This will enable
shifts. If market prices or rates do not move as them to better understand the complex finan-
expected, the demand for such instruments can cial structures of some investment
evaporate, decreasing the market value of the instruments.
instrument below the modeled value. 3. Documentation. Institutions should clearly
define documentation requirements for secu-
rities transactions, saving and safeguarding
2126.1.1.5.4 Operational (Transaction) important documents, as well as maintaining
Risk possession and control of instruments
purchased.
Operational (transaction) risk is the risk that
deficiencies in information systems or internal An institutions policies should also provide
controls will result in unexpected loss. Sources guidelines for conflicts of interest for employees
of operating risk include inadequate procedures, who are directly involved in purchasing and
human error, system failure, or fraud. Inaccu- selling securities for the institution from securi-
rately assessing or controlling operating risks is ties dealers. These guidelines should ensure that
one of the more likely sources of problems all directors, officers, and employees act in the
facing institutions involved in investment best interest of the institution. The board may
activities. wish to adopt policies prohibiting these employ-
Effective internal controls are the first line of ees from engaging in personal securities transac-
defense in controlling the operating risks tions with these same securities firms without
involved in an institutions investment activi- specific prior board approval. The board may
ties. Of particular importance are internal con- also wish to adopt a policy applicable to direc-
trols that ensure the separation of duties and tors, officers, and employees restricting or pro-
supervision of persons executing transactions hibiting the receipt of gifts, gratuities, or travel
from those responsible for processing contracts, expenses from approved securities dealer firms
confirming transactions, controlling various and their representatives.
clearing accounts, preparing or posting the
accounting entries, approving the accounting
methodology or entries, and performing 2126.1.1.5.5 Legal Risk
revaluations.
Consistent with the operational support of Legal risk is the risk that contracts are not
other activities within the financial institution, legally enforceable or documented correctly.
securities operations should be as independent Institutions should adequately evaluate the
as practicable from business units. Adequate enforceability of its agreements before indi-
resources should be devoted, such that systems vidual transactions are consummated. Institu-
and capacity are commensurate with the size tions should also ensure that the counterparty
and complexity of the institutions investment has authority to enter into the transaction and
activities. Effective risk management should that the terms of the agreement are legally
also include, at least, the following: enforceable. Institutions should further ascertain
that netting agreements are adequately docu-
1. Valuation. Procedures should ensure inde- mented, executed properly, and are enforceable
pendent portfolio pricing. For thinly traded in all relevant jurisdictions. Institutions should
have knowledge of relevant tax laws and
BHC Supervision Manual January 2013 interpretations governing the use of these
Page 6 instruments.
Investing in Securities without Reliance on Ratings of Nationally
Recognized Statistical Rating Organizations Section 2126.2
On November 15, 2012, state member banks National banks are expected to consider a num-
were advised, effective January 1, 2013, that ber of factors, to the extent appropriate in mak-
they may no longer rely solely on credit ratings ing this determination. While a national bank
issued by nationally recognized statistical rating may continue to take into account external credit
organizations (NRSROs) or external credit rat- ratings and assessments as a valuable source of
ings to determine whether a particular security information, the bank is expected to supplement
is an investment security that is permissible these ratings with a degree of due diligence
for investment by a state member bank. Under processes and additional analyses appropriate
the regulations of the Office of the Comptroller for the banks risk profile and for the size and
of the Currency (OCC), securities qualify for complexity of the instrument.2
investment by national banks only if they are The OCC issued guidance, effective January
determined by the bank to be investment 1, 2013 (OCC investment guidance), to clarify
grade and not predominantly speculative in regulatory expectations with respect to invest-
nature. (See SR-12-15 and its attachment.) The ment purchase decisions and ongoing portfolio
basic sound risk-management principles of this due diligence processes. See appendix 1 below
policy and other referenced guidance that fol- (section 2126.2.1). The guidance clarifies that
lows also applies to bank holding companies generally, investment securities are expected to
(BHCs) and savings and loan holding compa- have good to very strong credit quality. In the
nies (SLHCs). They should manage and control case of structured securities, this determination
their risk exposures on a consolidated basis and may be influenced more by the quality of the
give recognition to the legal distinctions and underlying collateral, the cash flow rules, and
potential obstacles to the cash movements the structure of the security itself than by the
among their financial institution subsidiaries. condition of the issuer.
Since a BHCs structure can include national The OCC also expects national banks to con-
banks, state member banks, and other financial duct an appropriate level of due diligence to
institution subsidiaries, the referenced statutory, understand the inherent risks of a security and
regulatory, and supervisory guidance is pro- determine that it is a permissible investment.
vided. The extent of the due diligence should be suffi-
Under the Federal Reserve Act (12 USC 335) cient to support the institutions conclusion that
and the Federal Reserve (FR)s Regulation H a security meets the investment-grade stan-
(12 CFR 208.21), state member banks are sub- dards. The depth of the due diligence should be
ject to the same limitations and conditions with a function of the securitys credit quality, the
respect to the purchasing, selling, underwriting, complexity of the structure, and the size of the
and holding of investment securities and stock investment. Third-party analytics may be part of
as national banks under the National Banking this analysis, although the national banks man-
Act (12 USC 24 (Seventh)). Therefore, when agement remains responsible for the investment
investing in securities, state member banks must decision and should ensure that prospective
comply with the provisions of the National third parties are independent, reliable, and quali-
Banking Act and the OCC regulations in 12 fied. The guidance also sets forth an expectation
CFR part 1. In addition to this federal require- that the board of directors should oversee man-
ment, a state member bank may purchase, sell, agement to make sure appropriate decisionmak-
underwrite, or hold securities and stock only to ing processes are in place.3
the extent permitted under applicable state law. Investment in securities and stock by state
National banks are to assess a securitys cred- member banks are required under the Federal
itworthiness to determine if it is investment Reserve Act and Regulation H to comply with
grade. A security meets the investment the revised 12 CFR part 1 and should also meet
grade test only if the issuer has an adequate the supervisory expectations set forth in the
capacity to meet its financial commitments OCC investment guidance and this FR guid-
under the security for the projected life of the ance. In addition, state member banks are
asset or exposure. Under this definition, the expected to continue to meet long-established
issuer has an adequate capacity to meet financial
commitments if (1) the risk of default by the 2. See 77 Fed. Reg. 35254 (June 13, 2012).
obligor is low and (2) the full and timely repay- 3. See 77 Fed. Reg. 35259 (June 13, 2012).
ment of principal and interest is expected.1
1. See 77 Fed. Reg. 35257 (June 13, 2012). Page 1
Investing in Securities without Reliance on Ratings of NRSROs 2126.2
supervisory expectations for risk-management expected to take to demonstrate they are in

processes to ensure that the credit risk of the compliance with due diligence requirements
bank, including the credit risk of the investment when purchasing investment securities and con-
portfolio, is effectively identified, measured, ducting ongoing reviews of their investment
monitored, and controlled. portfolios. The standards below describe how
national banks may purchase, sell, deal in,
underwrite, and hold securities consistent with
2126.2.1 APPENDIX 1OCC the authority contained in 12 U.S.C. 24 (Sev-
GUIDANCE ON DUE DILIGENCE enth). The activities of national banks must be
REQUIREMENTS IN DETERMINING consistent with safe and sound banking prac-
WHETHER SECURITIES ARE tices, and this Guidance reminds national banks
ELIGIBLE FOR INVESTMENT of the supervisory risk-management expecta-
tions associated with permissible investment
The guidance below was issued by the Office of portfolio holdings under parts 1 and 160.
the Comptroller of the Currency (OCC) on June
13, 2012, and is being included for ease of
reference. The official guidance was published
in the Federal Register (77 Fed. Reg. 35259),
Background
and is available as an attachment to OCC Bulle-
tin 2012-18. As discussed in SR-12-15, the Fed- Parts 1 and 160 provide standards for determin-
eral Reserve also expects that state member ing whether securities have appropriate credit
banks (SMBs) will meet the supervisory expecta- quality and marketability characteristics to be
tions set forth in the OCC guidance as this purchased and held by national banks. These
guidance provides further clarification to the requirements also establish limits on the amount
OCC rule with which SMBs must comply. (See of investment securities an institution may hold
12 CFR part 1, and 77 Fed. Reg. 35253, June for its own account. As defined in 12 CFR part
13, 2012.) 1, an investment security must be invest-
ment grade. For the purpose of part 1, invest-
ment grade securities are those where the
Purpose issuer has an adequate capacity to meet the
financial commitments under the security for the
The OCC has issued final rules to revise the projected life of the investment. An issuer has
definition of investment grade, as that term is an adequate capacity to meet financial commit-
used in 12 CFR parts 1 and 160 in order to ments if the risk of default by the obligor is low
comply with section 939A of the Dodd-Frank and the full and timely repayment of principal
Act. Institutions, effective January 1, 2013, are and interest is expected. Generally, securities
to ensure that existing investments comply with with good to very strong credit quality will meet
the revised investment grade standard, as this standard. In the case of a structured security
applicable based on investment type, and safety (that is, a security that relies primarily on the
and soundness practices described in 12 CFR cash flows and performance of underlying col-
1.5 and this guidance. This implementation lateral for repayment, rather than the credit of
period also will provide management with time the entity that is the issuer), the determination
to evaluate and amend existing policies and that full and timely repayment of principal and
practices to ensure new purchases comply with interest is expected may be influenced more by
the final rules and guidance. National banks that the quality of the underlying collateral, the cash
have established due diligence review processes, flow rules, and the structure of the security itself
and that have not relied exclusively on external than by the condition of the issuer.
credit ratings, should not have difficulty estab- National banks must be able to demonstrate
lishing compliance with the new standard. that their investment securities meet applicable
The OCC is issuing this guidance (Guidance) credit-quality standards. This Guidance provides
to clarify steps national banks ordinarily are criteria that national banks can use in meeting
expected to take to demonstrate they have prop- part 1 credit-quality standards and that national
erly verified their investments meet the newly banks can use in meeting due diligence
established credit-quality standards under 12 requirements.
CFR part 1 and steps national banks are

Page 2
Determining Whether Securities Are consideration of internal analyses, third party

Permissible Prior to Purchase research and analytics including external credit
ratings, internal risk ratings, default statistics,
The OCCs elimination of references to credit and other sources of information as appropriate
ratings in its regulations, in accordance with the for the particular security. Some institutions may
Dodd-Frank Act, does not substantively change have the resources to do most or all of the
the standards institutions should use when analytical work internally. Some, however, may
deciding whether securities are eligible for pur- choose to rely on third parties for much of the
chase under part 1. The OCCs investment secu- analytical work. While analytical support may
rities regulations generally require a national be delegated to third parties, management may
bank to determine whether or not a security is not delegate its responsibility for decisionmak-
investment grade in order to determine ing and should ensure that prospective third
whether purchasing the security is permissible. parties are independent, reliable, and qualified.
Investments are considered investment grade The board of directors should oversee manage-
if they meet the regulatory standard for credit ment to assure that an appropriate decisionmak-
quality. To meet this standard, a national bank ing process is in place.
must be able to determine that the security has The depth of the due diligence should be a
(1) low risk of default by the obligor and (2) the function of the securitys credit quality, the com-
expectation of full and timely repayment of plexity of the structure, and the size of the
principal and interest over the expected life of investment. The more complex a securitys
the investment. structure, the more credit-related due diligence
For national banks, Type I securities, as an institution should perform, even when the
defined in part 1, generally are government obli- credit quality is perceived to be very high. Man-
gations and are not subject to investment grade agement should ensure it understands the securi-
criteria for determining eligibility to purchase. tys structure and how the security may perform
Typical Type I obligations include U.S. Treasur- in different default environments, and should be
ies, agencies, municipal government general particularly diligent when purchasing structured
obligations, and for well-capitalized institutions, securities.4 The OCC expects national banks to
municipal revenue bonds. While Type I obliga- consider a variety of factors relevant to the
tions do not have to meet the investment grade particular security when determining whether a
criteria to be eligible for purchase, all invest- security is a permissible and sound investment.
ment activities should comply with safe and The range and type of specific factors an institu-
sound banking practices as stated in 12 CFR 1.5 tion should consider will vary depending on the
and in previous regulatory guidance. Under particular type and nature of the securities. As a
OCC rules, Treasury and agency obligations do general matter, a national bank will have a
not require individual credit analysis, but bank greater burden to support its determination if
management should consider how those securi- one factor is contradicted by a finding under
ties fit into the overall purpose, plans, and risk another factor.
and concentration limitations of the investment The following matrix provides examples of
policies established by the board of directors. factors for national banks to consider as part of
Municipal bonds should be subject to an initial a robust credit-risk assessment framework for
credit assessment and then ongoing review con- designated types of instruments. The types of
sistent with the risk characteristics of the bonds securities included in the matrix require a credit-
and the overall risk of the portfolio. focused pre-purchase analysis to meet the
Financial institutions should be well investment grade standard or safety and sound-
acquainted with fundamental credit analysis as ness standards. Again, the matrix is provided as
this is central to a well-managed loan portfolio. a guide to better inform the credit-risk assess-
The foundation of a fundamental credit analysis- ment process. Individual purchases may require
character, capacity, collateral, and covenants- more or less analysis dependent on the securi-
applies to investment securities just as it does to tys risk characteristics, as previously described.
the loan portfolio. Accordingly, the OCC
expects national banks to conduct an appropri-
ate level of due diligence to understand the 4. For example, a national bank should be able to demon-
strate an understanding of the effects on cash flows of a
inherent risks and determine that a security is a structured security assuming varying default levels in the
permissible investment. The extent of the due underlying assets.
diligence should be sufficient to support the
institutions conclusion that a security meets the BHC Supervision Manual January 2013
investment grade standards. This may include Page 3
Key factors Corporate Municipal Revenue Structured

bonds government bonds securities
general
obligations
Confirm spread to U.S. Treasuries is consistent

with bonds of similar credit quality X X X X
Confirm risk of default is low and consistent
with bonds of similar credit quality X X X X
Confirm capacity to pay and assess operating
and financial performance levels and trends
through internal credit analysis and/or other
third party analytics, as appropriate for the
particular security X X X X
Evaluate the soundness of a municipals bud-
getary position and stability of its tax rev-
enues. Consider debt profile and level of
unfunded liabilities, diversity of revenue
sources, taxing authority, and management
experience X
Understand local demographics/economics.
Consider unemployment data, local employ-
ers, income indices, and home values X X
Assess the source and strength of revenue
structure for municipal authorities. Consider
obligors financial condition and reserve lev-
els, annual debt service and debt coverage
ratio, credit enhancement, legal covenants,
and nature of project X
Understand the class or tranche and its relative
position in the securitization structure X
Assess the position in the cash flow waterfall X
Understand loss allocation rules, specific defini-
tion of default, the potential impact of perfor-
mance and market value triggers, and support
provided by credit and/or liquidity
enhancements X
Evaluate and understand the quality of the
underwriting of the underlying collateral as
well as any risk concentrations X
Determine whether current underwriting is
consistent with the original underwriting
underlying the historical performance of the
collateral and consider the effect of any
changes X
Assess the structural subordination and
determine if adequate given current under-
writing standards X
Analyze and understand the impact of collateral
deterioration on tranche performance and
potential credit losses under adverse eco- X
nomic conditions

Page 4
Additional Guidance on Structured including credit risk in the investment portfolio,

Securities Analysis is effectively identified, measured, monitored,
and controlled. The 1998 Interagency Supervi-
The creditworthiness assessment for an invest- sory Policy Statement on Investment Securities
ment security that relies on the cash flows and and End-User Derivatives Activities (Policy
collateral of the underlying assets for repayment Statement) contains risk-management standards
(i.e., a structured security) is inherently different for the investment activities of banks and sav-
from a security that relies on the financial capac- ings associations.5 The Policy Statement empha-
ity of the issuer for repayment. Therefore, a sizes the importance of establishing and main-
financial institution should demonstrate an taining risk processes to manage the market,
understanding of the features of a structured credit, liquidity, legal, operational, and other
security that would materially affect its perfor- risks of investment securities. Other previously
mance and that its risk of loss is low even under issued guidance that supplements OCC invest-
adverse economic conditions. Managements ment standards are OCC 2009-15, Risk Man-
assessment of key factors, such as those pro- agement and Lessons Learned (which high-
vided in this guidance, will be considered a lights lessons learned during the market
critical component of any structured security disruption and re-emphasizes the key principles
evaluation. Existing OCC guidance, including discussed in previously issued OCC guidance
OCC Bulletin 2002-19, Supplemental Guid- on portfolio risk management); OCC 2004-25,
ance, Unsafe and Unsound Investment Portfolio Uniform Agreement on the Classification of
Practices, states that it is unsafe and unsound Securities (which describes the importance of
to purchase a complex high-yield security with- managements credit-risk analysis and its use in
out an understanding of the securitys structure examiner decisions concerning investment secu-
and performing a scenario analysis that evalu- rity risk ratings and classifications); and OCC
ates how the security will perform in different 2002-19, Supplemental Guidance, Unsafe and
default environments. Policies that specifically Unsound Investment Portfolio Practices
permit this type of investment should establish (which alerts banks to the potential risk to future
appropriate limits, and prepurchase due dili- earnings and capital from poor investment deci-
gence processes should consider the impact of sions made during periods of low levels of
such purchases on capital and earnings under a interest rates and emphasizes the importance of
variety of possible scenarios. The OCC expects maintaining prudent credit, interest rate, and
institutions to understand the effect economic liquidity risk-management practices to control
stresses may have on an investments cash risk in the investment portfolio).
flows. Various factors can be used to define the National banks must have in place an appro-
stress scenarios. For example, an institution priate risk-management framework for the level
could evaluate the potential impact of changes of risk in their investment portfolios. Failure to
in economic growth, stock market movements, maintain an adequate investment portfolio risk-
unemployment, and home values on default and management process, which includes under-
recovery rates. Some institutions have the standing key portfolio risks, is considered an
resources to perform this type of analytical work unsafe and unsound practice.
internally. Generally, analyses of the application Having a strong and robust risk-management
of various stress scenarios to a structured securi- framework appropriate for the level of risk in an
tys cash flow are widely available from third institutions investment portfolio is particularly
parties. Many of these analyses evaluate the critical for managing portfolio credit risk. A key
performance of the security in a base case and a role for management in the oversight process is
moderate and severe stress case environment. to translate the board of directors tolerance for
Even under severe stress conditions, the stress risk into a set of internal operating policies and
scenario analysis should determine that the risk procedures that govern the institutions invest-
of loss is low and full and timely repayment of ment activities. Policies should be consistent
principal and interest is expected. with the organizations broader business strate-
gies, capital adequacy, technical expertise, and
Maintaining an Appropriate and Effective

5. On April 23, 1998, the FRB, FDIC, NCUA, and OCC
Portfolio Risk-Management Framework issued the Supervisory Policy Statement on Investment
Securities and End-User Derivatives Activities.
The OCC has had a long-standing expectation
that national banks implement a risk- BHC Supervision Manual January 2013
management process to ensure credit risk, Page 5
risk tolerance. Institutions should ensure that review of similar risk positions.
they identify and measure the risks associated As with pre-purchase analytics, some institu-
with individual transactions prior to acquisition tions may have the resources necessary to do
and periodically after purchase. This can be most or all of their portfolio reviews internally.
done at the institutional, portfolio, or individual However, some may choose to rely on third
instrument level. Investment policies also parties for much of the analytical work. Third-
should provide credit-risk concentration limits. party vendors offer risk analysis and data bench-
Such limits may apply to concentrations relating marks that could be periodically reviewed
to a single or related issuer, a geographical area, against existing portfolio holdings to assess
and obligations with similar characteristics. credit-quality changes over time. Holdings
Safety-and-soundness principles warrant effec- where current financial information or other key
tive concentration risk-management programs analytical data is unavailable should warrant
to ensure that credit exposures do not reach an more frequent analysis. High-quality invest-
excessive level. ments generally will not require the same level
The aforementioned risk-management poli- of review as investments further down the
cies, principles, and due diligence processes credit-quality spectrum. However, any material
should be commensurate with the complexity of positions or concentrations should be identified
the investment portfolio and the materiality of and assessed in more depth and more frequently,
the portfolio to the financial performance and and any system should ensure an accurate and
capital position of the institution. Investment timely risk assessment and reporting process
review processes, following the pre-purchase that informs the board of material changes to the
analysis, may vary from institution to institution risk profile and prompts action when needed.
based on the individual characteristics of the National banks should have investment port-
portfolio, the nature and level of risk involved, folio review processes that effectively assess
and how that risk fits into the overall risk profile and manage the risks in the portfolio and ensure
and operation of the institution. Investment port- compliance with policies and risk limits. Institu-
folio reviews may be risk-based and focus on tions should reference existing regulatory guid-
material positions or specific groups of invest- ance for additional supervisory expectations for
ments or stratifications to enable analysis and investment portfolio risk-management practices.
State member banks are subject to 24 (Sev- 1, 208.21

same limitations and conditions for enth), 335
investments activities as national
banks
Federal financial institution regula- 15 U.S.C.

tory agencies to remove references 780
to, and requirements of reliance on,
external credit ratings in any regu-
lation that requires the assessment
of the creditworthiness of a secu-
rity or money market instrument.
Supervisory and risk expectations 1, 160
Safety and soundness practices 1.5


Page 6
Risk-Focused Supervision (Counterparty Credit Risk
Management Systems) Section 2126.3
Bank holding companies should directly man- 4. The risk-limit and -monitoring systems that
age and control their aggregate risk exposures involve (1) setting meaningful limits on
on a consolidated basis and, if appropriate, for counterparty credit risk, (2) monitoring expo-
individual subsidiaries, in view of the distinct sures against those limits, and (3) initiating
legal existence of various subsidiaries and pos- meaningful risk assessments and risk-
sible obstacles to moving cash, other assets, and controlling actions in the event that expo-
contractual agreements among subsidiaries.1 See sures exceed limits.
SR-99-3.
The confluence of competitive pressures, pur-
suit of earnings, and overreliance on customer
2126.3.1 FUNDAMENTAL ELEMENTS reputation can lead to substantive lapses in fun-
OF COUNTERPARTY CREDIT RISK damental risk-management principles regarding
MANAGEMENT counterparty risk assessment, exposure monitor-
ing, and the management of credit-risk limits.
When conducting bank holding company Policies governing these activities may be
inspections and supervisory contacts, and when unduly general so as to compromise their useful-
monitoring trading and derivatives activities, ness in managing the risks involved with par-
supervisors and examiners should fully eval- ticular types of counterparties. Practices may
uate the integrity of certain key elements of not conform to the stated policies or their intent.
a banking organizations (BO) counterparty Situations may also exist where internal con-
credit risk management process, such as the trols, including documentation and independent
following: review, may be inadequate or lack rigor. For
some larger BOs, regimes for measuring and
1. The BOs assessment of counterparty credit- monitoring counterparty-credit-risk exposure
worthiness, both initially and on an ongoing may be effective in more traditional areas of
basis. A counterpartys creditworthiness can credit extension, but may need enhancements
be evidenced by its capital strength, lev- when used in trading and derivatives activities.
erage, any on- and off-balance-sheet risk
factors, and contingencies. Creditworthiness
can also be evidenced by the counterpartys 2126.3.2 TARGETING SUPERVISORY
liquidity, operating results, reputation, and RESOURCES
ability to understand and manage the risks
inherent in its line of business, as well as the When risk focusing their supervisory initiatives,
risks involved in the particular products and examiners should continue to target those activ-
transactions that define a particular customer ities and areas with significant growth and
relationship. above-normal profitability profilesespecially
2. The standards, methodologies, and tech- in trading and derivatives activities where the
niques used in measuring counterparty- press of business and competitive pressures may
credit-risk exposures on an individual instru- invite a BO to offer new product lines before the
ment, counterparty, and portfolio basis. approval of counterparties and the necessary
3. The use and management of credit enhance- risk-management infrastructure or procedures
ments to mitigate counterparty credit risks, are fully in place. Supervisors and examiners
including collateral arrangements and should encourage a BO to adopt growth, profit-
collateral-management systems, contractual ability, and size criteria for their audit and inde-
downgrades or material-change triggers, and pendent risk-management functions to use in
contractual option-to-terminate or close- targeting their reviews.
out provisions.
2126.3.3 ASSESSMENT OF
1. These basic principles are also to be employed in the COUNTERPARTY
supervision of U.S. branches and agencies of foreign banks, CREDITWORTHINESS
with appropriate adaptations to reflect that (1) those offices
are an integral part of a foreign bank that should be managing Supervisors and examiners should increase their
its risks on a consolidated basis and recognizing possible
obstacles to cash movements among branches, and (2) the
foreign bank is subject to overall supervision by its home- BHC Supervision Manual December 1999
country authorities. Page 1
Counterparty Credit Risk Management Systems 2126.3
focus on the appropriateness, specificity, and enough for it to properly focus its counterparty
rigor of the policies, procedures, and internal risk assessments. Therefore, examiners must
controls that a BO currently uses to assess ensure that the banking organizations policies
the counterparty credit risks arising from its sufficiently address the risk profiles of particular
trading and derivatives activities. BOs should types of counterparties and instruments. The
have extensive written policies covering their policies should specify (1) the types of counter-
assessment of counterparty creditworthiness for parties that may require special consideration;
both the initial due-diligence process (that is, (2) the types and frequency of information to be
before conducting business with a customer) obtained from such counterparties; (3) the types
and for ongoing monitoring. Examiners should and frequency of analyses to be conducted,
focus particular attention on how such policies including the need for and type of any stress-
are structured and implemented. Broadly struc- testing analysis; and (4) how such information
tured, general policies that apply to all types of and analyses appropriately address the risk pro-
counterparties may prove inadequate for direct- file of the particular type of counterparty. This
ing staff in the proper review of the risks posed specificity in credit-assessment policies is par-
by particular types of counterparties. For exam- ticularly important when limited transparency
ple, although most policies call for the assess- may hinder market discipline on the risk-taking
ment and monitoring of the capital strength and activities of counterpartiesas may be the case
leverage of customers, the assessment of hedge- with hedge funds.
fund counterparties should not rely exclusively Examiners should also place increasing
on simple balance-sheet measures and tradi- emphasis on ensuring that a BOs existing prac-
tional assessments of financial condition. This tice conforms both with its stated objectives and
information may be insufficient for those coun- the intent of its established policies. For exam-
terparties whose off-balance-sheet positions are ple, some BOs may not obtain and evaluate all
a source of significant leverage and whose risk the information on the financial strength, condi-
profiles are narrowly based on concentrated tion, and liquidity of some types of counterpar-
business lines (such as with hedge funds and ties that may be required by their own policies.
similar institutional investors). General policies In highly competitive and fast-moving transac-
calling for periodic counterparty credit reviews tion areas, organizations should be sufficiently
over significant intervals (such as annually) are rigorous in conducting the analyses specified
another example of broad policies that may in their policies, such as the review of a counter-
compromise the integrity of the assessment partys ability to manage the risks of its
of individual counterparties or types of business.
counterpartiesa counterpartys risk profile can Necessary internal controls for ensuring that
change significantly over much shorter time practices conform with stated policies include
horizons. actively enforced documentation standards and
Credit-risk-assessment policies should also periodic independent reviews by internal audi-
properly define the types of analyses to be con- tors or other risk-control units, particularly
ducted for particular types of counterparties for business lines, products, and exposures to
based on the nature of their risk profiles. Stress particular groups of counterparties and indi-
testing and scenario analysis may be needed, in vidual customers that exhibit significant growth
addition to customizing fundamental analyses or above-normal profitability. Using targeted
based on industry and business-line charac- inspections and reviews, examiners should
teristics. Customized analyses are particularly evaluate the integrity of a BOs internal con-
important when a counterpartys creditworthi- trols. Examiners should thus conduct their own
ness may be adversely affected by short-term transaction testing of such situations. This test-
fluctuations in financial markets, especially ing should include robust sampling of transac-
when potential credit exposure to a counterparty tions with major counterparties in the targeted
increases at the same time the counterpartys area, as well as sufficient stratification to ensure
credit quality deteriorates. that practices involving smaller relationships
Examiners should continue to pay special also adhere to stated policies.
attention to areas where banking organization
practices may not conform to stated policies.
Such supervisory efforts may be especially diffi- 2126.3.4 CREDIT-RISK-EXPOSURE
cult when the BOs policies are not specificic MEASUREMENT
BHC Supervision Manual December 1999 Financial market turbulence emphasizes the
Page 2 important interrelationships between market
movements and the credit-risk exposures the worst-case value of positions over a time
involved in derivatives activities. Accordingly, horizon of one or two weekstheir estimate
supervisors and examiners should be alert to of a reasonable liquidation period in times of
situations where a BO may need to be more stress. They also perform scenario analyses of
diligent in conducting current computations of counterparty credit exposures. Stress testing and
the loan equivalents and potential future expo- scenario analyses should evaluate the impact
sures (PFE) that are used to measure, monitor, of large market moves on the credit exposure
and control its derivatives counterparty credit to individual counterparties, and they should
exposure. assess the implications inherent in liquidating
Most BOs fully recognize that the credit risk positions under such conditions. Analyses
of derivatives positions includes both the cur- should consider the effects of market liquidity
rent replacement cost of a contract as well as the on the value of positions and any related collat-
contracts PFE. PFEs are generally calculated eral. The use of meaningful scenario analyses is
using statistical techniques to estimate the worst particularly important since stress tests derived
potential loss over a specified time horizon at from simple applications of higher confidence
some specified confidence interval (for exam- intervals or longer time horizons to PFE, value-
ple, 95 percent, 97.5 percent, and 99 percent), at-risk, and other measures may not adequately
which is generally derived in some manner capture the market and exposure dynamics
from historically observed market fluctuations. under turbulent market conditions, particularly
Together with the current replacement cost, such as they relate to the interaction between market,
PFEs are used to convert derivatives contracts credit, and liquidity risk.
to loan equivalents for aggregating credit The results of stress testing and scenario
exposures across products and instruments. analyses should be incorporated into senior
The time horizon used to calculate PFEs can management reports. Such reports should pro-
vary depending on the banking organizations vide sufficient information to ensure an ade-
risk tolerance, collateral protection, and ability quate understanding of the nature of the expo-
to terminate its credit exposure. Some BOs may sure and the analyses conducted. Information
use a time horizon equal to the life of the should also be sufficient to trigger risk-
respective instrument. While such a time hori- controlling actions where necessary.
zon may be appropriate for unsecured positions, Other BOs are moving to build the capability
for collateralized exposures, the use of lifetime, of estimating portfolio-based PFEs by any one
worst-case-estimate PFEs may be ineffective to of several different time horizons or buckets,
measure the true nature of counterparty risk depending on the liquidity and breadth of the
exposure. While life-of-contract PFE measures underlying instrument or risk factor. Based on
provide an objective and conservative long-term managements opinion of the appropriate work-
exposure estimate, they bear little relationship out timeframe, different time horizons can be
to the actual credit exposures typically incurred used for different counterparties, transactions, or
in the case of collateralized relationships. In collateral types to more precisely define expo-
such cases, a banking organizations actual sures. Supervisors and examiners should be alert
credit exposure is the PFE from the time a to situations where collateralized exposures may
counterparty fails to meet a collateral call until be inaccurately estimated, and should encourage
the time the bank liquidates its collateral and management at these BOs to enhance their
closes out the derivative contracta period exposure-measurement systems accordingly.
which is typically much shorter than the con- Supervisors should also be cognizant of the
tracts life. The lack of realism in conservative manner in which the credit exposures are aggre-
measurement can cause managers and traders to gated for individual counterparties. Some BOs
discount them and may result in inappropriate may take a purely transactional approach to
limits being set, thereby compromising the aggregation and not incorporate the netting of
entire risk-management process. long and short derivatives contracts, even when
More realistic measures of collateralized legally enforceable bilateral netting agreements
credit-risk exposures should also take into are available. In such cases, simple sum esti-
account the shorter time horizons over which mates of positive exposures may seriously over-
action can be taken to mitigate losses in times of estimate true credit exposure, and examiners
market stress. These measures should incorpo- should monitor and encourage a BOs move-
rate estimates of collateral-recovery rates given ment toward more realistic measures of counter-
the potential market liquidity impacts of stress
events on collateral values. Some BOs already BHC Supervision Manual December 1999
do stress tests, calculating measures that assess Page 3
party exposure. Other BOs may take a portfolio party characteristics merit special treatmentas
approach, in which information systems allow may be the case with some highly leveraged
and incorporate netting (both within and across counterparties such as hedge funds. Where con-
products, business lines, or risk factors) and sistent with the risk profile of the counterparty
portfolio correlation effects to construct more and instruments involved, policies should
comprehensive counterparty exposure measures. specify when margining requirements based on
In such cases, supervisors should ensure that a estimates of potential future exposures might be
BO has adequate internal controls governing warranted.
exposure estimation, including robust model- Adequate policies should also govern the
review processes and data-integrity checks. use of material-change triggers and closeout
When stratifying samples and selecting the provisions, which should take into account
counterparties and transactions to use for their counterparty-specific situations and risk pro-
targeted testing of practices and internal con- files. For example, closeout provisions based on
trols, supervisors and examiners should incor- annual events or material-change triggers based
porate measures of potential future exposure on long-term performance may prove ineffec-
regardless of the collateralization of current tive for counterparties whose risk profiles can
market-value exposures. As recent events have change rapidly. Also, such material-change trig-
shown, meaningful counterparty credit risks that gers, closeout provisions, and related covenants
surface during periods of stress can go undetec- should be designed to adequately protect against
ted when too much emphasis is placed on collat- deterioration in a counterpartys creditworthi-
eralization of current market values and only ness. They should ensure that a BO is made
unsecured current market exposures are used for aware of adverse financial developments on a
targeting transaction testing. timely basis and should facilitate action as coun-
terparty risk increaseswell in advance of the
time when termination of a relationship is
2126.3.5 CREDIT ENHANCEMENTS appropriate.
Internal assessments of potential risk expo-
BOs continue to rely increasingly on different sures sometimes dictate loss thresholds, margin-
types of credit enhancements to mitigate coun- ing requirements, and closeout provisions with
terparty credit risks. These enhancements some counterparties. Insufficient internal con-
include the use of collateral arrangements, controls may unduly expose certain BOs to these as
tractual downgrades or material-change triggers well as other types of trading and derivatives
that enable the alteration of collateral or margin- counterparties. When evaluating the manage-
ing arrangements, or the activation of contrac- ment of collateral arrangements and other credit
tual option to terminate or closeout provi- enhancements, examiners should not only assess
sions. the adequacy of a banking organizations poli-
CollateraIization of exposures has become an cies but should also determine whether internal
industry standard for many types of counter- controls are sufficient to ensure that practices
parties. Collateralization mitigates but does not comply with these policies. Examiners should
eliminate credit risks. BOs therefore should identify the types of credit enhancements and
ensure that overreliance on collateral does not contractual covenants that are being used when
compromise other elements of sound counter- reviewing areas of counterparty risk manage-
party credit-risk management, such as the due- ment, and then determine whether the banking
diligence process. Clear policies should govern organization has sufficiently assessed the ade-
the determination of loss thresholds and margin- quacy of these enhancements and covenants
ing requirements for derivatives counterparties relative to the risk profile of the counterparty.
of BOs. Such policies should not be so broad
that they compromise the risk-reducing nature
of collateral agreements with specific types of 2126.3.6 CREDIT-RISK-EXPOSURE
counterparties. Policies governing collateral LIMIT-SETTING AND MONITORING
arrangements should specifically define those SYSTEMS
cases in which initial and variation margin is
required, and they should explicitly identify Exposure-monitoring and limit systems are criti-
situations in which the lack of transparency, cal to the effective management of counter-
business-line risk profiles, and other counterparty credit risk. Examiners should focus spe-
cial attention on the policies, practices, and
BHC Supervision Manual December 1999 internal controls employed within such systems
Page 4 at large, complex BOs. An effective exposure-
monitoring system consists of (1) establishing itoring of exposures against meaningful

meaningful limits on the risk exposures a BO is limits.
willing to take, (2) independent, ongoing moni- 4. To ascertain whether the banking organiza-
toring of exposures against such limits, and tion employs policies that are sufficiently
(3) adequate controls to ensure that meaningful calibrated to the risk profiles of particular
risk-controlling action takes place when limits types of counterparties and instruments,
are exceeded. An effective exposure-monitoring which ensures adequate credit-risk assess-
and limit process depends on meaningful ment, exposure measurement, limit setting,
exposure-measurement methodologies, so super- and use of credit enhancements.
visors should closely evaluate measurement 5. To ensure that the banking organizations
methodologies, especially for the estimation of actual business practices conform with
PFEs. Inaccurate measurement can easily com- their stated policies and the intent of these
promise well-structured policies and procedures. policies.
Such situations can lead to limits driven pri- 6. To establish if the banking organization is
marily by customer demand and used only to moving in a timely fashion to enhance its
define and monitor customer facilities, rather measurement of counterparty credit-risk
than limits that serve as strict levels defined exposures, including refining potential future
by credit management and that initiate risk- exposure measures and establishing stress-
controlling actions. testing methodologies to better incorporate
Supervisors and examiners should also assess the interaction of market and credit risks.
the procedures used for controlling credit-risk 7. To accomplish the above inspection objec-
exposures when they become large, when a tives by using sufficient, targeted transaction
counterpartys credit standing weakens, or when testing on those activities, business lines, and
the market comes under stress. Management products experiencing significant growth,
should demonstrate its clear ability to reduce above-normal profitability, or large potential
large positions. Such actions can include cap- future exposures.
ping current exposures, curtailing new busi-
ness, assigning transactions to another counter- 2126.3.8 INSPECTION PROCEDURES
party (where feasible), and restructuring the
transaction to limit potential exposure or make 1. Give increased focus to the adequacy, appro-
it less sensitive to market volatility. BOs can priateness, specificity, and rigor of the poli-
also use various credit-enhancement tools to cies, procedures, and internal controls that a
manage exposures that have become unduly BO currently uses to assess the counterparty
large or highly sensitive to market volatility. credit risks arising from its trading and
derivatives activities.
a. Determine if sufficient written policies
cover the assessment of counterparty
2126.3.7 INSPECTION OBJECTIVES creditworthiness for the initial due-
diligence process (that is, before conduct-
1. To determine if sufficient resources are ing business with a customer) and for
devoted and adequate attention is given to ongoing monitoring.
the management of the risks involved in b. Give particular attention to how such poli-
growing, highly profitable, or potentially cies are structured, their adequacy, and
high-risk activities and product lines. how they are implemented.
2. To ascertain if the banking organizations 2. Focus special attention on areas where a
internal audit and independent risk- BOs practices may not conform to its stated
management functions adequately focus on policies.
growth, profitability, and risk criteria when a. Determine if the banking organizations
targeting their reviews. policies sufficiently address the risk pro-
3. To determine if there is an appropriate files of its particular types of counter-
balance among all elements of credit-risk parties and instruments.
management. This balance includes both quali- b. Ascertain whether existing practices con-
tative and quantitative assessments of coun- form to the stated objectives and the
terparty creditworthiness; measurement and intent of the organizations established
evaluation of on- and off-balance sheet expo- policies.
sures, including potential future exposure;
adequate stress testing; reliance on collateral BHC Supervision Manual December 1999
and other credit enhancements; and the mon- Page 5
3. Evaluate the banking organizations docu- b. Employ sufficient stratification to ensure

mentation standards. that practices involving smaller relation-
4. Determine whether the internal reviews are ships also adhere to stated policies.
adequately conducted for business lines, c. Be alert to situations whereby the current
products, and exposures to particular groups computations of loan equivalents and
of counterparties and individual customers potential exposuresthat are used to
that exhibit significant growth or above- measure, monitor, and control derivatives
normal profitability. counterparty credit exposurescould be
5. Evaluate the integrity of the internal controls deliberately enhanced.
that the banking organization uses to assess 7. Determine if the banking organization needs
its own transaction testing during internal to develop more meaningful measures of
reviews. credit-risk exposures, such as using stress
6. Conduct independent targeted reviews of the testing and scenario analyses, under volatile
internal controls. market conditions.
a. Use robust sampling when testing transac-
tions of major counterparties within a tar-
geted area.

Page 6
Procedures for a Banking Entity to Request an Extended
Transition Period for Illiquid Funds Section 2126.5
The Federal Reserve approved supervisory guid- (CFTC), and the Securities and Exchange Com-
ance on December 9, 2016, to provide banking mission (SEC). The statute also granted exclu-
entities1 with information on the procedures for sively to the Board authority to provide banking
submitting a request for an extended transition entities additional time to conform or divest
period for a hedge fund or private equity fund their activities and investments covered by sec-
(referred to as covered fund) that qualifies as tion 13.
an illiquid fund pursuant to section 13 of the The statute provides that the Board may, by
Bank Holding Company Act of 1956 (BHC rule or order, extend this general conformance
Act).2 Under the statute, a banking entity must period for not more than one year at a time,
apply to the Board for an extended transition up to three times, if in the judgment of the
period for an illiquid fund regardless of the Board, an extension is consistent with the pur-
banking entitys primary financial regulatory poses of section 13 and would not be detrimen-
agency. (Refer to the Boards press release tal to the public interest.5 On July 7, 2016, the
issued December 12, 2016, its attached State- Board issued an order extending the final one-
ment of Policy Regarding Illiquid Fund Invest- year conformance period for banking entities to
ments Under Section 13 of the Bank Holding conform investments in and relationships with
Company Act, and its attached SR letter 16-18.) covered funds and foreign funds that were in
place prior to December 31, 2013 (legacy cov-
ered funds) until July 21, 2017.6
2126.5.1 VOLKER RULES Section 13 also permits the Board, upon the
BACKGROUND application of a banking entity, to provide an
additional transition period of up to five years to
Section 619 of the Dodd-Frank Wall Street conform investments in a limited class of legacy
Reform and Consumer Protection Act added a illiquid funds.7 An illiquid fund is defined by
new section 13 to the BHC Act, also known as the statute as a fund that is principally
the Volcker rule, which generally prohibits any invested in illiquid assets and holds itself out
banking entity from engaging in proprietary as employing a strategy to invest principally in
trading or from acquiring or retaining an owner- illiquid assets.8 The statute provides that this
ship interest in, sponsoring, or having certain extension applies only to the extent that the
relationships with a covered fund, subject to banking entitys retention of the ownership
certain exemptions.3 The restrictions and prohi- interest in the fund, or provision of additional
bitions of section 13 of the BHC Act became capital to the fund, is necessary to fulfill a
effective on July 21, 2012;4 however, the statute contractual obligation of the banking entity that
provided banking entities a period of two years was in effect on May 1, 2010.9 The statute
until July 21, 2014, to conform their activities provides that the Board may grant an extension
and investments to the requirements of the stat- for each illiquid fund only once and for a period
ute and any rule issued by the Board, the Office of up to five years.10 The Boards conformance
of the Comptroller of the Currency (OCC), the rule sets forth provisions governing the submis-
Federal Deposit Insurance Corporation (FDIC),
the Commodity Futures Trading Commission 5. See 12 U.S.C. 1851(c)(2). The Board issued rules imple-
menting the Volcker rule conformance provisions in 2011.
See Conformance Period for Entities Engaged in Prohibited
1. The term banking entity is defined by statute to Proprietary Trading or Private Equity Fund or Hedge Fund
include, with limited exceptions: (i) any insured depository Activities, 76 Fed. Reg. 8265 (February 14, 2011) (confor-
institution (IDI) (as defined in section 3 of the Federal Deposit mance rule).
Insurance Act (12 U.S.C. 1813)); (ii) any company that con- 6. See Board press release, July 7, 2016, at:
trols an IDI (including a bank holding company (BHC), www.federalreserve.gov/newsevents/press/bcreg/
savings and loan holding company (SLHC), and any other 20160707a.htm.
company that controls an insured depository institution but 7. See 12 U.S.C. 1851(c)(3)-(4) and (h)(7).
that is not a BHC or SLHC, such as the parent company of an 8. See12 U.S.C. 1851(h)(7).
industrial loan company); (iii) any company that is treated as 9. See 12 U.S.C. 1851(c)(3)(A). In addition, the statute
a bank holding company for purposes of section 8 of the provides that a banking entity may not engage in a prohibited
International Banking Act of 1978 (for example, any foreign covered fund investment after the date on which the contrac-
bank operating a branch or agency in the United States); and tual obligation to invest in the illiquid fund terminates. See
(iv) any affiliate or subsidiary of any of the foregoing (for 12 U.S.C. 1851(c)(4)(A).
example, a broker-dealer subsidiary of a BHC). 12 U.S.C. 10. See 12 U.S.C. 1851(c)(3)(B).
1851(h)(1).
2. See 12 U.S.C. 1851(c)(3)-(4) and (h)(7).
3. See 12 U.S.C. 1851. BHC Supervision Manual January 2017
4. See 12 U.S.C. 1851(c)(1). Page 1
Procedures for a Banking Entity to Request an Extended Transition Period for Illiquid Funds 2126.5
sion and review of extension requests.11 conformance period and a description of the
In its statement of policy for legacy illiquid banking entitys plan for divesting or con-
covered funds, the Board also generally outlined forming each illiquid fund prior to the end of
a simplified and streamlined process for grant- the requested extension period.
ing extensions of the holding period for illiquid
funds. That process is outlined below. In addition, the Federal Reserve may, on a case-
by-case basis, require a banking entity to pro-
vide a progress report on fund sales, maturities,
2126.5.2 Requirements for Submitting or other conformance efforts as appropriate at
Requests any time during the period that the banking
entity continues to hold illiquid funds in reli-
In filing a request for an extended transition ance on an extension.
period for illiquid funds, a banking entity is A banking entity would not be required to
expected to provide exercise a so-called regulatory out provision13
or otherwise seek consent from third parties (for
a list or simple chart of illiquid funds for example, the general partner or other investors
which an extension is sought. in the fund) to terminate an investment in an
a short description of each fund, including the illiquid fund in order to qualify for the extended
investment strategy and types of investments transition period.
made by each fund, which entity within the
firm holds the investment, the size of each
fund, the total exposure of the banking entity 2126.5.3 Procedures for Filing an
to each fund, the date by which each remain- Extension Request
ing illiquid fund is expected to mature by its
terms or be conformed to section 13 of the A request for an extended transition period for
BHC Act, and the banking entitys relation- illiquid funds should be submitted in writing to
ship with the fund (for example, general part- the Applications Unit of the appropriate Federal
ner, sponsor, investment adviser, and inves- Reserve Bank by the top-tier banking entity in
tor). the district where it is headquartered (referred to
a description of the banking entitys specific as the responsible Federal Reserve Bank).14
efforts to divest or conform its illiquid funds, The request may be submitted at any time at
including a description of the overall covered least 180 days prior to the expiration of the
funds (both liquid and illiquid) that have been general conformance period (that is, at least 180
divested or conformed to date, the progress days prior to July 21, 2017).15 In the case where
that has been made towards divesting or con- the banking entity that sponsors or invests in the
forming the investments for which an exten- illiquid fund is supervised primarily by another
sion is being sought (for example, the number federal banking agency, the SEC, or the CFTC,
of funds sold, the number of funds that con- the top-tier banking entity should also provide a
tinue to be held, and the amount of invest- copy of the extension request to the relevant
ments remaining in each fund and in aggre- agency for the subsidiary banking entity.16 A
gate). banking entity also should provide the name,
a certification by the general counsel or chief phone number, and email address of the banking
compliance officer of the entity that sponsors
or invests in the illiquid funds that each fund 13. So-called regulatory-out provisions are provisions
meets the definition of illiquid funds in sec- whereby a banking entitys contractual obligation to remain
tion 13 of the BHC Act and the Boards invested in a fund may be excused or otherwise terminated if
conformance rule, including that the exten- the banking entitys compliance with the obligation would
cause, or would be reasonably likely to cause, the banking
sion is necessary to fulfill a contractual obliga- entity or the fund to be in violation of applicable laws and
tion of the banking entity that was in effect on regulations.
May 1, 2010.12 14. For banking entities not regulated by the Federal
the length of the requested extension of the Reserve, the following link provides information on each of
the 12 Reserve Banks, including their addresses:
www.federalreserveeducation.org/about-the-fed/structure-
and-functions/districts/. For Federal Reserve regulated bank-
11. See 12 CFR 225.181 and 225.182.
ing entities, notices may also be submitted electronically
12. See 12 U.S.C. 1851(c)(3)-(c)(4) and (h)(7); and
through the Federal Reserve Systems Electronic Applications
12 CFR 225.180(f).
System, E-Apps.
15. See 12 CFR 225.181(c)(1).
BHC Supervision Manual January 2017 16. Refer to the List of Contacts at Other Agencies within
Page 2 the attachment one to SR-16-18.
Procedures for a Banking Entity to Request an Extended Transition Period for Illiquid Funds 2126.5
entitys point of contact to whom Board and include, but would not be limited to, informa-
Reserve Bank staff may submit all inquiries. tion regarding specific bids that have been
Authority to grant (but not to deny) requests sought and other specific actions taken to
has been delegated to the Federal Reserve conform the funds for which an extension is
Banks, in consultation with Board staff. Federal being sought.
Reserve Banks may approve extension requests
if all of the following criteria are met: Consistent with the statute, the extension would
be granted for the shortest of (i) five years from
the extension request relates only to illiquid the date of the expiration of the general confor-
funds; mance period (that is, July 21, 2017), (ii) the
no significant issues have been identified date by which each remaining fund is expected
regarding the firms compliance program to mature by its terms or be conformed to sec-
required under section 248.20(c) of the final tion 13 of the BHC Act, or (iii) a shorter period
rule (this citation applies to entities under determined by the Board. The responsible Fed-
Federal Reserve supervision)17 designed to eral Reserve Bank should expect to act on an
help ensure and monitor compliance with the extension request within 30 days of receiving all
prohibitions and restrictions of the Volcker required information. If the request does not
rule; meet the requirements for delegated action, the
the primary federal agency responsible for Federal Reserve Bank will immediately refer
compliance with the Volcker rule by the bank- the matter to the Board. The Board may then
ing entity that invests in or sponsors the illiq- approve or deny the request based on the rel-
uid fund (if other than the Federal Reserve) evant facts. The Board expects that the illiquid
does not object to the extension; funds of banking entities will generally qualify
the banking entity has made meaningful prog- for extensions, though extensions may not be
ress toward conforming the majority of its granted in certain casesfor example, where
covered fund investments (including funds the banking entity has not demonstrated mean-
other than illiquid funds) as of the date of the ingful progress to conform or divest its illiquid
extension request; and funds, has a deficient compliance program under
the banking entity provides supporting infor- the Volcker rule, or where the Board has con-
mation regarding its efforts to conform the cerns about evasion.
illiquid funds for which an extension is being
sought. Such supporting information could
17. For the other agencies, refer to 12 CFR 44.20(c) (OCC

rule); 12 CFR 351.20(c) (FDIC rule); 17 CFR 75.20(c) (CFTC BHC Supervision Manual January 2017
rule); 17 CFR 255.20(c) (SEC rule). Page 3
Interest-Rate Risk
(Risk Management and Internal Controls) Section 2127.0
WHAT NEW IN THIS REVISED a well-focused assessment of IRR exposure

SECTION before the on-site engagement, a clearly defined
inspection scope, and a comprehensive program
Effective January 2010 this section was revised for following up on inspection findings and
to include a brief overview of the January 6, ongoing monitoring.
2010, interagency advisory on interest-rate risk
management that targets interest-rate risk man-
agement at insured depository institutions. The 2127.0.2 JOINT AGENCY POLICY
advisory does not constitute new guidance. The STATEMENT: INTEREST-RATE RISK
principles and supervisory expectations dis-
cussed within the guidance apply also to bank The Board, together with the Office of the
holding companies, which should manage and Comptroller of the Currency and the Federal
control aggregate risk exposures on a consoli- Deposit Insurance Corporation, adopted a May
dated basis. See SR-10-1. 23, 1996, Joint Agency Policy Statement on
Interest-Rate Risk, effective June 26, 1996. (See
SR-96-13.) It provides guidance to examiners
2127.0.1 ASSESSING THE and bankers on sound practices for managing
MANAGEMENT AND INTERNAL IRR, which form the basis for ongoing evalua-
CONTROLS OVER INTEREST-RATE tion of the adequacy of IRR management at
RISK supervised institutions.
The policy statement outlines fundamental
Interest-rate risk (IRR) is the exposure of a elements of sound management that have been
banking organizations financial condition to identified in prior Federal Reserve guidance and
adverse movements in interest rates. Accepting discusses the importance of these elements in
this risk can be an important source of profit- the context of managing IRR.1 Specifically, the
ability and shareholder value. However, exces- guidance emphasizes the need for active board
sive levels of IRR can pose a significant threat and senior management oversight and a compre-
to a banks or bank holding companys (BHCs) hensive risk-management process that effec-
earnings and capital base. Accordingly, effectively identifies, measures, and controls IRR.
tive risk management that maintains IRR at Although the guidance targets IRR manage-
prudent levels is essential to the organizations ment at commercial banks and Edge Act corpo-
safety and soundness. rations, the basic principles presented in the
Evaluating a BHCs exposure to changes in policy statement are to be applied to bank hold-
interest rates is an important element of any ing companies (BHCs). BHCs should manage
full-scope inspection and may be the sole topic and control aggregate risk exposure on a con-
for specialized or targeted inspections. This solidated basis by recognizing legal distinctions
evaluation includes assessing both the adequacy and possible obstacles to cash movements
of the management process used to control IRR among subsidiaries. The assessment of interest-
and the organizations quantitative level of rate risk management made by examiners in
exposure. When assessing the IRR management accordance with the 1996 Joint Policy State-
process, examiners should ensure that appropri- ment will be incorporated into a BHCs overall
ate policies, procedures, management informa-
tion systems, and internal controls are in place 1. Guidance to examiners identifying fundamental ele-
to maintain IRR at prudent levels with consis- ments of sound risk management includes SR-00-14,
tency and continuity. Evaluating the quantitative Enhancements to the Interagency Program for Supervising
level of IRR exposure requires examiners to the U.S. Operations of Foreign Banking Organizations;
SR-96-14 (see section 2124.0), Risk-Focused Safety and
assess the existing and potential future effects of Soundness Examinations and Inspections; SR-96-13, Joint
changes in interest rates on a BHCs consoli- Policy Statement on Interest-Rate Risk; SR-96-10, Risk-
dated financial condition including its capital Focused Fiduciary Examinations; SR-95-51 (see section
adequacy; earnings; liquidity; and, where appro- 4070.1), Rating the Adequacy of Risk-Management Pro-
cesses and Internal Controls at State Member Banks and Bank
priate, asset quality. To ensure that these assess- Holding Companies; and SR-93-69 (see section 2125.0),
ments are both effective and efficient, examiner Examining Risk Management and Internal Controls for
resources must be appropriately targeted at those Trading Activities of Banking Organizations.
elements of an organizations IRR that pose the
greatest threat to its financial condition. This BHC Supervision Manual January 2010
targeting requires an inspection process built on Page 1
Interest-Rate Risk (Risk Management and Internal Controls) 2127.0
risk-management rating. BHC examiners should ment that each of the regulators has codified in
refer to section 4090.1 of the Commercial Bank its existing guidance, as well as in the inter-
Examination Manual for more detailed inspec- agency guidance on IRR management issued by
tion guidance on the joint policy statement on the banking agencies in SR-96-13. The advisory
IRR. highlights also the need for active board and
senior management oversight and a comprehen-
sive risk-management process that effectively
2127.0.3 INTERAGENCY ADVISORY measures, monitors, and controls IRR.
ON INTEREST RATE RISK The advisory targets IRR management at
MANAGEMENT insured depository institutions. However, the
principles and supervisory expectations articu-
A January 6, 2010, interagency advisory was lated also apply to BHCs, which are reminded
issued by the Board of Governors of the Federal of long-standing supervisory guidance that they
Reserve System and other federal regulators2 should manage and control aggregate risk expo-
that reminds institutions of supervisory expecta- sures on a consolidated basis while recognizing
tions on sound practices for managing IRR. The legal distinctions and possible obstacles to cash
advisory does not constitute new guidance. It movements among subsidiaries. See SR-10-1.
reiterates basic principles of sound IRR manage-
2 The other financial regulators include the Federal

Deposit Insurance Corporation (FDIC), the National Credit
Union Administration (NCUA), the Office of the Comptroller
of the Currency (OCC), the Office of Thrift Supervision
(OTS), and the Federal Financial Institutions Examination
Council (FFIEC) State Liaison Committee (collectively, the
regulators).

Page 2
Structured Notes
WHATS NEW IN THIS REVISED face values. Their customized features and
SECTION embedded options may also make them difficult
to price and can reduce their liquidity. Conse-
Effective July 2009, this section was revised to quently, banking organizations considering the
delete a reference to SR-95-17 that was super- purchase of structured notes should determine
seded by SR-98-12 (see section 2126.1). whether these factors are compatible with their
investment horizons and with their overall port-
folio strategies.
2128.0.1 SUPERVISORY POLICY There are a wide variety of structured notes,
STRUCTURED NOTES with names such as single- or multi-index float-
ers, inverse floaters, index-amortizing notes,
This section discusses supervisory policy with step-up bonds, and range bonds. These simple,
regard to structured notes and their increased though sometimes cryptic, labels can belie the
use by banking organizations. Examiners should potential complexity of these notes and their
be mindful of these instruments, whether they possibly volatile and unpredictable cash flows,
are used in the banking organizations trading, which can involve both principal and interest
investment, or trust activities. Some of these payments. Some notes employ trigger levels
instruments can expose investors to significant at which cash flows can change significantly, or
losses as interest rates, foreign-exchange rates, caps or floors, which can also substantially
and other market indices change. Consequently, affect their price behavior.
during examinations or inspections, examiners The critical factor for examiners to consider
need to ensure that banks and bank holding is the ability of management to understand the
companies that hold structured notes do so risks inherent in these instruments and to satis-
according to their own investment policies and factorily manage the market risks of their insti-
procedures and with a full understanding of the tution. Therefore, examiners should evaluate the
risks and price sensitivity of these instruments appropriateness of these securities institution by
under a broad range of market conditions. institution, with a knowledge of managements
Structured notes, many of which are issued expertise in evaluating such instruments, the
by U.S. government agencies, government- quality of the relevant information systems, and
sponsored entities, and other organizations with the nature of its overall exposure to market risk.
high credit ratings, are debt securities whose This evaluation may include a review of the
cash flows are dependent on one or more indices stress-test capabilities. Failure of management
in ways that create risk characteristics of for- to adequately understand the dimensions of the
wards or options. They tend to have medium- risks in these and similar financial products can
term maturities and reflect a wide variety of constitute an unsafe and unsound practice for
cash-flow characteristics that can be tailored to banking organizations.
the needs of individual investors. When making investment decisions, some
As such, these notes may offer certain advan- banking organizations may focus only on the
tages over other financial instruments used to low credit risk and favorable yields of struc-
manage market risk. In particular, they may tured notes and either overlook or underestimate
reduce counterparty credit risk, offer operating their market and liquidity risks. Consequently,
efficiencies and lower transaction costs, require where these notes are material, examiners
fewer transactions, and more specifically should discuss their role in the organi-
address an institutions risk exposures. Risk to zations risk-management process and assess
principal is typically small. Accordingly, when managements recognition of their potential
structured notes are analyzed and managed volatility.
properly, they can be acceptable investments The risks inherent in such complex instru-
and trading products for banks. ments and relevant risk-management standards
However, structured notes can also have have been addressed in a variety of previously
characteristics that cause them to be inappropri- issued supervisory guidance, including
ate holdings for many banking organizations, SR-letters and supervisory manuals. This guid-
including depository institutions. They can have ance includes SR-90-16, standards for investing
substantial price sensitivity; they can be com- in asset-backed securities (see section 2128.02);
plex and difficult to evaluate; and they may also
reflect high amounts of leverage relative to BHC Supervision Manual July 2009
fixed-income instruments with comparable Page 1
Structured Notes 2128.0
SR-93-69 (see section 2125.0) and SR-98-12 including their potentially reduced liquidity
(see section 2126.1), examination guidance for in secondary markets and the price volatility
reviewing investment securities and end-user that any embedded options, leveraging, or
derivatives activities and the Trading and other characteristics can create
Capital-Markets Activities Manual. Although 3. the need for adequate information systems
these documents may not specifically cite struc- and internal controls for managing the risks
tured notes, they all help to highlight the follow- under changing market conditions
ing important supervisory and risk-management 4. the importance of clear lines of authority for
practices that are relevant to these instruments: making investment decisions and for evaluat-
ing and managing the institutions securities
1. the importance of policies, approved by the activities that involve such instruments
board of directors, that address the goals and
objectives expected to be achieved with such For additional information, see SR-97-21 and
products and that set limits on the amount of SR-91-4. See also sections 3010.3 and 4040.1 of
funds that may be committed to them the Trading and Capital-Markets Activities
2. the need for management to fully understand Manual for more-detailed guidance.
the risks these instruments can present,

Page 2
Asset Securitization
Banking organizations have long been involved To provide examiners with the information
with asset-backed securities (ABS), both as and guidance they need on asset securitization,
investors in such securities and as major partici- the following guidance was developed for
pants in the securitization process. In recent System use. The mechanics of securitiza-
years, banking organizations have stepped up tion and related accounting issues are discussed,
their involvement by increasing their participa- and inspection guidelines, objectives, and
tion in the long-established market for securities procedures are provided.1
backed by residential mortgage loans and by
expanding their securitizing activities to other
types of assets, including credit card receiv- 2128.02.1 OVERVIEW OF ASSET
ables, automobile loans, boat loans, commercial SECURITIZATION
real estate loans, student loans, nonperforming
loans, and lease receivables. Over the past decade, the number of banks and
While the objectives of securitization may bank holding companies (hereafter referred to as
vary from one depository institution to another, banking organizations) that have issued securi-
there are essentially five benefits that can be ties backed by their assets and that have
derived from securitization transactions. First, acquired asset-backed securities as investments
the sale of assets may reduce regulatory costs. has increased markedly. The reason for this
The removal of an asset from an institutions increase is that securitization activities can yield
books reduces capital requirements and reserve significant financial and operational benefits for
requirements on deposits funding the asset. Sec- banking organizations.
ond, securitization provides originators with an In its simplest form, asset securitization
additional source of funding and liquidity. The involves the selling of assets. The process first
process of securitization is basically taking an segregates generally illiquid assets into pools
illiquid asset and converting it into a security and transforms them into capital-market instru-
with greater marketability. Securitized issues ments. The payment of principal and interest on
often carry a higher credit rating than that which these instruments depends on the cash flows
the banking organization itself could normally from the assets in the pool that underlies the
obtain and, consequently, may provide a cheaper new securities. The new securities may have
form of funding. Third, securitization may be denominations, cash flows, and other features
used to reduce interest-rate risk by improving that differ from the pooled assets, which make
the banking organizations asset-liability mix. them more attractive to investors.
This is especially true if the banking organiza- The federal government encouraged the secu-
tion has a large investment in fixed-rate, low- ritization of residential mortgages. In 1970, the
yield assets. Fourth, by removing assets, the Government National Mortgage Association
banking organization enhances its return on (Ginnie Mae or GNMA) created the first pub-
equity and assets. Finally, the ability to sell licly traded mortgage-backed security. Soon, the
these securities worldwide diversifies the bank- Federal National Mortgage Association (Fannie
ing organizations funding base, thereby reduc- Mae) and the Federal Home Loan Mortgage
ing dependence on local economies. Corporation (FHLMC or Freddie Mac), both
It is appropriate for banking organizations to government-sponsored agencies, also developed
engage in securitization activities and to invest mortgage-backed securities. The guarantees that
in ABS, if they do so prudently. Nonetheless, these government or government-sponsored
these activities can significantly affect their entities provide, which assure investors of the
overall risk exposure. It is therefore of great payment of principal and interest, have greatly
importance, particularly given the growth and facilitated the securitization of mortgage assets.
expansion of such activities, for examiners to be
fully informed about the fundamentals of the 1. The Federal Reserve System has developed the follow-
securitization process, various risks that ing three-volume set that contains educational material on the
process of asset securitization and provides examination
securitization and investing in ABS can create guidelines (see SR-90-16):
for banking organizations, and procedures that An Introduction to Asset Securitization
should be followed in examining banks and Accounting Issues Relating to Asset Securitization
inspecting bank holding companies to effec- Examination Guidelines for Asset Securitization
tively assess their exposure to risk and their
management of that exposure. BHC Supervision Manual December 2002
Page 1
Asset Securitization 2128.02
2128.02.2 SECURITIZATION PROCESS the related asset-backed securities (i.e., liabili-

ties) are removed from the balance sheet. The
The asset-securitization process, as depicted in cash proceeds from the securitization transac-
figure 1, begins with the segregation of loans or tions are generally used to originate or acquire
leases into pools that are relatively homoge- additional loans or other assets for securitiza-
neous with respect to credit, maturity, and tion, and the process is repeated. Thus, for the
interest-rate risks. These pools of assets are then same volume of loan originations, securitization
transferred to a trust or other entity known as an results in lower assets and liabilities, compared
issuer because it issues the securities or owner- with traditional lending activities.
ship interests that are acquired by investors. Each issue of asset-backed securities has a
These asset-backed securities may take the form servicer responsible for collecting interest and
of debt, certificates of beneficial ownership, or principal payments on the loans or leases in the
other instruments. The issuer is typically pro- underlying pool of assets and for transmitting
tected from bankruptcy by various structural these funds to investors (or a trustee represent-
and legal arrangements. A sponsor that provides ing them). A trustee monitors the activities of
the assets to be securitized owns or otherwise servicers to ensure that they properly fulfill their
establishes the issuer. role.
Traditional lending activities are generally An investment banking firm or other organi-
funded by deposits or other liabilities, and both zation generally serves as an underwriter for
the assets and related liabilities are reflected on asset-backed securities. In addition, for asset-
the balance sheet. Deposit liabilities must gener- backed issues that are publicly offered, a credit
ally increase to fund additional loans. In con- rating agency will analyze the policies and
trast, the securitization process generally does operations of the originator and servicer, as
not increase on-balance-sheet liabilities in pro- well as the structure, underlying pool of assets,
portion to the volume of loans or other assets expected cash flows, and other attributes of such
securitized. As discussed more fully below, securities. Before assigning a rating to the
when banking organizations securitize their issue, the rating agency will also assess the
assets and these transactions are treated as sales extent of loss protection provided to investors
under Statement of Financial Accounting Stan- by the credit enhancements associated with the
dards No. 140 (FAS 140), both the assets and issue.
Figure 1
Pass-through, asset-backed securities: structure and cash flows
Obligors Forwards Passes through principal and

principal and interest payments
interest Trustee
Remit payments
principal and
interest
Initial cash Initial Initial
payments
proceeds proceeds purchase
Originator/ from from of
securities securities securities
Sponsor/ Trust Underwriter Investors
Servicer Issues Distributes
Transfers
loans on securities securities
Purchases receivables Provides credit
credit enhancement for the
enhancement asset pool, for example,
by a letter of credit
Credit
Enhancer Cash flows
Structure

Page 2
The structure of an asset-backed security and provided for several multiples of the historical
the terms of the investors interest in the collat- losses experienced on the particular asset back-
eral can vary widely, depending on the type of ing the security.
collateral, the desires of investors, and the use One form of credit enhancement is the
of credit enhancements. Securitizations typically recourse provision, or guarantee, that requires
carve up the risk of credit losses from the under- the originator to cover any losses up to an
lying assets and distribute it to different parties. amount contractually agreed upon. Some asset-
The first-dollar, or most subordinate, loss backed securities, such as those backed by
position is first to absorb losses, and the most credit card receivables, typically use a spread
senior investor position is last to absorb losses; account, which is actually an escrow account.
there may also be one or more loss positions in The funds in this account are derived from a
between (second-dollar loss positions). Each portion of the spread between the interest earned
loss position functions as a credit enhancement on the assets in the underlying pool and the
for the more senior positions in the structure. In lower interest paid on securities issued by the
other words, when ABS reallocate the risks in trust. The amounts that accumulate in the
the underlying collateral (particularly credit account are used to cover credit losses in the
risk), the risks are moved into security tranches underlying asset pool up to several multiples of
that match the desires of investors. For example, historical losses on the particular asset collater-
senior-subordinated security structures give alizing the securities.
holders of senior tranches greater credit-risk Overcollateralization, another form of credit
protectionalbeit at lower yieldsthan holders enhancement covering a predetermined amount
of subordinated tranches. Under this structure, of potential credit losses, occurs when the value
at least two classes of asset-backed securities, a of the underlying assets exceeds the face value
senior and a junior or subordinated class, are of the securities. Other forms of credit enhance-
issued in connection with the same pool of ment include standby letters of credit, collateral
collateral. The senior class is structured so that or pool insurance, or surety bonds from third
it has a priority claim on the cash flows from the parties. The sponsor of the asset securitization
underlying pool of assets. The subordinated may provide a portion of the total credit
class must absorb credit losses on the collateral enhancement internally, as part of the securitiza-
before losses can be charged to the senior portion structure, through the use of excess spread
tion. Because the senior class has this priority accounts, overcollateralization, retained subor-
claim, cash flows from the underlying pool of dinated interests, or other similar on-balance-
assets must first satisfy the requirements of the sheet assets. When these or other on-balance-
senior class. Only after these requirements have sheet internal enhancements are provided, the
been met will the cash flows be directed to enhancements are residual interests and are a
service the subordinated class. form of recourse.2 Residual interests (or residu-
als) represent claims on any cash flow after all
obligations to investors and any related
2128.02.3 CREDIT ENHANCEMENT expenses have been met. Such excess cash flows
may arise as a result of overcollateralization or
A guarantor may also be involved to see that from reinvestment income. Residuals can be
investors receive principal and interest pay- retained by sponsors or purchased by investors
ments on a timely basis, even if the servicer in the form of securities.
does not collect these payments from the obli- A seller may also arrange for a third party to
gors. Many issues of mortgage-backed securi- provide credit enhancement in an asset securiti-
ties are either directly guaranteed by GNMA, zation. If the third-party enhancement is pro-
a government agency backed by the full faith vided by another banking organization, it
and credit of the U.S. government, or are guar- assumes some portion of the assets credit risk.
anteed by Fannie Mae or Freddie Mac, which All forms of third-party enhancements, that is,
are government-sponsored agencies that are per- all arrangements in which a banking organiza-
ceived by the credit markets to have the implicit tion assumes credit risk from third-party assets
support of the federal government. Privately
issued mortgage-backed securities and other
2. Under the Federal Reserves capital adequacy guide-
types of asset-backed securities generally lines, purchased credit-enhancing interest-only strips are also
depend on some form of credit enhancement considered residual interests.
provided by the originator or third party to
insulate the investor from some or all of any BHC Supervision Manual December 2002
credit losses. Usually, credit enhancement is Page 3
or other claims that it has not transferred, are underlying pool of assets, and as principal-only
referred to as direct-credit substitutes. The (PO) strips, for which the investor receives all
economic substance of a banking organizations of the principal.
credit risk from providing a direct-credit substi- In addition to these securities, other types of
tute can be identical to its credit risk from financial instruments may arise as a result of
retaining recourse on assets it has transferred. asset securitization. One such instrument is loan-
Many asset securitizations use a combination of servicing rights that are created when organiza-
recourse and third-party enhancements to pro- tions purchase the right to act as servicers for
tect investors from credit risk. When third-party pools of loans. The cost of these purchased
enhancements are not provided, the selling servicing rights may be recorded as an intangi-
banking organization ordinarily retains virtually ble asset when certain criteria are met. Another
all of the credit risk on the assets transferred. financial instrument, excess-servicing-fee receiv-
ables, generally arise when the present value of
any additional cash flows from the underlying
2128.02.4 STRUCTURE OF assets that a servicer expects to receive exceeds
ASSET-BACKED SECURITIES standard normal servicing fees.
Asset securitization involves different kinds of

capital-market instruments. These instruments 2128.02.5 SUPERVISORY
may be structured as pass-throughs or pay- CONSIDERATIONS REGARDING
throughs. Under a pass-through structure, the ASSET SECURITIZATION
cash flows from the underlying pool of assets
are passed through to investors on a pro rata Although banking organizations clearly benefit
basis. This type of security is typically a single- from engaging in securitization activities and
class instrument such as a GNMA pass-through. investing in asset-backed securities, these activi-
The pay-through structure, with multiple ties, if not conducted prudently, can increase a
classes, combines the cash flows from the under- banking organizations overall risk profile. For
lying pool of assets and reallocates them to two the most part, the risks that banking organiza-
or more issues of securities that have different tions encounter in the securitization process are
cash-flow characteristics and maturities. An identical to those that they face in traditional
example is the collateralized mortgage obliga- lending transactions. These involve credit risk,
tion (CMO), which has a series of bond classes, concentration risk, and interest-rate risk
each with its own specified coupon and stated including prepayment risk, operational risk,
maturity. In most cases, the assets that make up liquidity risk, and funding risk. However, since
the CMO collateral pools are pass-through secu- the securitization process separates the tradi-
rities. Scheduled principal payments, and any tional lending function into several limited roles
prepayments, from the underlying collateral go such as originator, servicer, credit enhancer,
first to the earliest maturing class of bonds. This trustee, and investor, the types of risks that a
first class of bonds must be retired before the banking organization will encounter will differ
principal cash flows are used to retire the later depending on the role it assumes.
bond classes. The development of the pay- Investors who invest in asset-backed securi-
through structure resulted from the desire to ties, like investors who invest directly in the
broaden the marketability of these securities to underlying assets, will be exposed to credit risk,
investors who were interested in maturities other that is, the risk that obligors will default on
than those generally associated with pass- principal and interest payments. Investors are
through securities. also subject to the risk that the various parties in
Multiple-class asset-backed securities may the securitization structure, for example, the ser-
also be issued as derivative instruments such as vicer or trustee, will be unable to fulfill their
stripped securities. Investors in each class of contractual obligations. Moreover, investors
a stripped security will receive a different por- may be susceptible to concentrations of risks
tion of the principal and interest cash flows from across various asset-backed security issues
the underlying pool of assets. In their purest through overexposure to an organization per-
form, stripped securities may be issued as forming various roles in the securitization pro-
interest-only (IO) strips, for which the investor cess or as a result of geographic concentrations
receives 100 percent of the interest from the within the pool of assets providing the cash
flows for an individual issue. Also, because the
BHC Supervision Manual December 2002 secondary markets for certain asset-backed
Page 4 securities are thin, investors may encounter
greater-than-anticipated difficulties when seek- 2128.02.6 POLICY STATEMENT ON

ing to sell their securities. Furthermore, certain INVESTMENT SECURITIES AND
derivative instruments, such as stripped asset- END-USER DERIVATIVES
backed securities and residuals, may be ACTIVITIES
extremely sensitive to interest rates and exhibit
a high degree of price volatility. Therefore, these On April 23, 1998, the FFIEC issued a State-
instruments may dramatically affect the risk ment on Investment Securities and End-User
exposure of investors unless they are used in a Derivatives Activities, effective May 25, 1998.
properly structured hedging strategy. The statement was adopted by the Board of
Banking organizations that issue asset-backed Governors and the other federal financial institu-
securities may be subject to pressures to sell tions regulatory agencies. It provides guidance
only their best assets, thus reducing the quality on sound practices for managing the risks of
of their own loan portfolios. On the other hand, investment activities, focusing on sound risk-
some banking organizations may feel pressures management practices that should be used by
to relax their credit standards because they can state member banks and Edge corporations.
sell assets with higher risk than they would The basic principles also apply to bank holding
normally want to retain for their own portfolios. companies, which should manage and control
Banking organizations that service securitiza- risk exposures on a consolidated basis, giving
tion issues must ensure that their policies, opera- recognition to the legal distinctions and poten-
tions, and systems will not permit breakdowns tial obstacles to cash movements among
that may lead to defaults. Issuers and servicers subsidiaries.
may face pressures to provide moral recourse The statements principles set forth risk-
by repurchasing securities backed by loans or management practices that are relevant to most
leases that they have originated and that have portfolio-management endeavors. The statement
deteriorated and have become nonperforming. places greater emphasis on a risk-focused
Funding risk may also be a problem for issuers approach to supervision. Instruments held for
when market aberrations do not permit the issu- end-user reasons are considered, taking into
ance of asset-backed securities that are in the consideration a variety of factors such as man-
securitization pipeline. agements ability to manage and measure risk
within the institutions holdings and the impact
Asset-securitization transactions are fre- of those holdings on aggregate portfolio risk.
quently structured to obtain certain accounting (See section 2126.1 and SR-98-12.4)
treatments, which, in turn, affect reported mea-
sures of profitability and capital adequacy. In
transferring assets into a pool to serve as collat-
eral for asset-backed securities, a key question
2128.02.6.1 Mortgage-Derivative
is whether the transfer should be treated as a
Products
sale of the assets or as a collateralized borrow- Mortgage-derivative products include instru-
ing, that is, as a financing transaction secured by ments such as collateralized mortgage obliga-
assets. Sales treatment results in the removal of tions (CMOs), real estate mortgage investment
the assets from the banking organizations bal- conduits (REMICs), stripped mortgage-backed
ance sheet, thus reducing total assets relative to securities, and CMO and REMIC residuals.
earnings and capital, and thereby producing Supervisory concerns about these instruments
higher performance and capital ratios. Treat- arise from their extreme sensitivity to interest
ment of these transactions as financings, how- rates and the resulting price volatility. This price
ever, means that the assets in the pool remain on volatility is caused in part by the uncertain cash
the balance sheet and are subject to capital flows that result from changes in the prepay-
requirements and the related liabilities to reserve ment rates of the underlying mortgages. A bank-
requirements.3 ing organization that purchases such high-risk
mortgage-derivative securities needs to under-
stand and effectively manage the associated
4. The supervisory policy statement on Investment Securi-

ties and End-User Derivatives Activities is in the Federal
3. Note, however, that the Federal Reserves Regulation D
Reserve Regulatory Service at 31562.
defines what constitutes a reservable liability of a depository
institution. Thus, although a given transaction may qualify as
an asset sale for call report purposes, it nevertheless could BHC Supervision Manual December 2002
result in a reservable liability under Regulation D. Page 5
risks. The levels of activity in such products ments shorten the maturity of mortgages. In
should reasonably be related to the banking contrast, IOs and residuals tend to increase in
organizations capital, capacity to absorb losses, value when interest rates rise because prepay-
and level of in-house management sophistica- ments decline, maturities lengthen, and more
tion and expertise. Appropriate managerial and interest is collected on the underlying
financial controls need to be in place, and the mortgages.
banking organization must analyze, monitor, and When purchasing an IO, PO, or residual,
prudently adjust its holdings of high-risk mort- without offsetting hedges, the investor may be
gage securities in an environment of changing speculating on future interest-rate movements
price and maturity expectations. and how these movements will affect the pre-
Before a banking organization takes a posi- payment of the underlying collateral. Further-
tion in any high-risk mortgage security, manage- more, stripped mortgage-backed securities
ment should conduct an analysis to ensure that that do not have a government agencys or a
the position will reduce the institutions overall government-sponsored agencys guarantee of
interest-rate risk. It should also consider the principal and interest have an added element of
liquidity and price volatility of these products credit risk. The policy statement discusses the
before their purchase. appropriateness of these instruments for deposi-
CMOs and REMICs were developed in tory institutions and the prudential measures
response to investors concerns about the uncer- that a depository institution should take to pro-
tainty of cash flows associated with the prepay- tect itself from undue risk when investing in
ment option of the underlying mortgagor. These them.
securities can be collateralized directly by mort- Residuals represent claims on any cash flows
gages, but more often they are collateralized by from a CMO issue or other asset-backed secu-
mortgage-backed securities issued or guaran- rity remaining after the payments to the holders
teed by GNMA, Fannie Mae, or Freddie Mac of the other classes have been made and after
and held in trust for investors. The cash flow trust-administration expenses are met. The eco-
from the underlying mortgages is segmented nomic value of a residual is a function of the
and paid in accordance with a predetermined present value of the anticipated cash flows.
priority to investors holding various tranches.
By allocating the principal and interest cash
flows from the underlying collateral among the 2128.02.7 RISK-BASED CAPITAL
separate CMO tranches, different classes of PROVISIONS AFFECTING ASSET
bonds are created, each with its own stated SECURITIZATION
maturity, estimated average life, coupon rate,
and prepayment characteristics. It is essential to The risk-based capital framework has three
understand the coupon rates of the underlying main features that will affect the asset-
mortgages of the CMO or REMIC in order to securitization activities of banking organiza-
assess the prepayment sensitivity of the CMO tions. First, the framework assigns risk weights
tranches. to loans, asset-backed securities, and other
Stripped mortgage-backed securities consist assets related to securitization. Second, bank
of two classes of securities, with each class holding companies that transfer assets with
receiving a different portion of the monthly recourse to the seller as part of the securitization
interest and principal cash flows from the under- process are required to hold capital against their
lying mortgage-backed securities (MBS). A off-balance-sheet credit exposures. Third, bank-
stripped mortgage-backed security, in its purest ing organizations that provide credit enhance-
form, is converted into an interest-only (IO) ment to asset-securitization issues through
strip, in which the investor receives all of the standby letters of credit or by other means will
interest cash flows and none of the principal. An have to hold capital against the related off-
investor owning a principal-only (PO) strip rebalance-sheet credit exposure.
ceives all of the principal cash flows and none
of the interest. IOs and POs have highly volatile
price characteristics based, in part, on the pre- 2128.02.7.1 Assigning Risk Weights
payment variability of the underlying mort-
gages. Generally, POs increase in value when The risk weights assigned to an asset-backed
interest rates decline, in part because prepay- security depend on the issuer and whether the
assets that make up the collateral pool are
BHC Supervision Manual December 2002 mortgage-related assets. Asset-backed securities
Page 6 issued by a trust or a single-purpose corporation
and backed by nonmortgage assets are to be 3. The cash flow from the underlying assets of
assigned a risk weight of 100 percent. the security in all cases fully meets the cash-
Securities guaranteed by U.S. government flow requirements of the security without
agencies and those issued by U.S. government undue reliance on any reinvestment income.
sponsored agencies are assigned risk weights of 4. No material reinvestment risk is associated
0 and 20 percent, respectively, because of the with any funds awaiting distribution to the
low degree of credit risk. Accordingly, mort- holders of the security.
gage pass-through securities guaranteed by
GNMA are placed in the risk category of 0 per- Those privately issued mortgage-backed
cent. In addition, securities such as participation securities that do not meet the above criteria
certificates and CMOs issued by Fannie Mae or are to be assigned to the 100 percent risk
Freddie Mac are assigned a 20 percent risk category.
weight. If the underlying pool of mortgage-related
However, several types of securities issued by assets is composed of more than one type of
Fannie Mae and Freddie Mac are excluded from asset, then the entire class of mortgage-backed
the lower risk weight and slotted in the 100 per- securities is assigned to the category appropriate
cent risk category. Residual interests (for exam- to the highest risk-weighted asset in the asset
ple, CMO residuals) and subordinated classes of pool. For example, if the security is backed by a
pass-through securities or CMOs that absorb pool consisting of U.S. governmentsponsored
more than their pro rata share of loss are agency securities (for example, Freddie Mac
assigned to the 100 percent risk-weight cate- participation certificates) that qualify for a
gory. Furthermore, all stripped mortgage-backed 20 percent risk weight and conventional mort-
securities, including IOs, POs, and similar gage loans that qualify for the 50 percent risk
instruments, are assigned to the 100 percent category, then it would receive the 50 percent
risk-weight category because of their extreme risk weight.
price volatility and market risk. As previously mentioned, bank holding com-
A privately issued, mortgage-backed security panies report their activities in accordance with
that meets the criteria listed below is considered generally accepted accounting principles
as a direct or indirect holding of the underlying (GAAP), which permits asset-securitization
mortgage-related assets and is assigned to the transactions to be treated as sales when certain
same risk category as those assets (for example, criteria are met, even when there is recourse to
U.S. government agency securities, U.S. the seller. With the advent of risk-based capital,
governmentsponsored agency securities, FHA- bank holding companies are required to hold
and VA-guaranteed mortgages, and conventional capital against the off-balance-sheet credit expo-
mortgages). However, under no circumstances sure arising from the contingent liability associ-
will a privately issued mortgage-backed security ated with the recourse provisions. This exposure
be assigned to the 0 percent risk category. is considered a direct-credit substitute that
Therefore, private issues that are backed by would be converted at 100 percent to an
GNMA securities will be assigned to the 20 per- on-balance-sheet credit-equivalent amount for
cent risk category as opposed to the 0 percent appropriate risk weighting.
category appropriate to the underlying GNMA The risk-based capital treatment for asset
securities. The criteria that a privately issued securitizations, as discussed in detail in section
mortgage-backed security must meet to be 4060.3, uses, in general, a multilevel, ratings-
assigned the same risk weight as the underlying based approach (effective January 1, 2002) to
assets are as follows: assess the capital requirements on recourse obli-
gations, residual interests (except credit-
enhancing I/O strips), direct-credit substitutes,
1. The underlying assets are held by an inde-
and senior and subordinated securities in asset
pendent trustee, and the trustee has a first-
securitizations, based on their relative exposure
priority, perfected security interest in the
to credit risk. Credit ratings from rating agen-
underlying assets on behalf of the holders of
cies are used to measure relative exposure to
the security.
credit risk and to determine the associated risk-
2. The holder of the security has an undivided based capital requirement. The Federal Reserve
pro rata ownership interest in the underlying is relying on these credit ratings to make deter-
mortgage assets, or the trust or single- minations of credit quality for the regulatory
purpose entity (or conduit) that issues the
security has no liabilities unrelated to the BHC Supervision Manual December 2002
issued securities. Page 7
treatment for loss positions that represent differ- 2128.02.7.2.2 Credit-Equivalent Amounts
ent gradations of risk, the same as investors and and Risk Weights of Recourse Obligations
other market participants. Residual interests, and Direct-Credit Substitutes
however, are subject to (1) a dollar-for-dollar
capital charge and (2) a 25 percent of tier 1 The credit-equivalent amount for a recourse
capital concentration limit on a subset of obligation or direct-credit substitute is the full
residual interests, credit-enhancing I/O strips. amount of the credit-enhanced assets for which
the bank holding company directly or indirectly
retains or assumes credit risk, multiplied by a
100 percent conversion factor. A bank holding
2128.02.7.2 Recourse Obligations company that extends a partial direct-credit sub-
stitute, for example, a financial standby letter of
For regulatory purposes, recourse is generally credit that absorbs the first 10 percent of loss on
defined as an arrangement in which a banking a transaction, must maintain capital against the
organization retains the risk of credit loss in full amount of the assets being supported.
connection with an asset transfer, if the risk of To determine the bank holding companys
credit loss exceeds a pro rata share of its claim risk-weighted assets for an off-balance-sheet
on the assets. In addition to broad contractual recourse obligation, a third-party direct-credit
language that may require the seller to support a substitute, or a letter of credit, the credit-
securitization, recourse can arise from retained equivalent amount is assigned to the risk cate-
interests, retained subordinated security inter- gory appropriate to the obligor in the underlying
ests, the funding of cash-collateral accounts, or transaction, after considering any associated
other forms of credit enhancements that place a guarantees or collateral. For a direct-credit sub-
bank holding companys earnings and capital at stitute that is an on-balance-sheet asset, for
risk. These enhancements should generally be example, a purchased subordinated security, a
aggregated to determine the extent of a bank bank holding company must calculate risk-
holding companys support of securitized assets. weighted assets using the amount of the direct-
Although an asset securitization qualifies for credit substitute and the full amount of the assets
sales treatment under GAAP, the underlying it supports, that is, all the more senior positions
assets may still be subject to regulatory risk- in the structure. This treatment is subject to the
based capital requirements. Assets sold with low-level-exposure rule discussed below.
recourse should generally be risk-weighted as if If a bank holding company has no claim on a
they had not been sold. transferred asset, then the retention of any risk
of credit loss is recourse. A recourse obligation
typically arises when a bank holding company
2128.02.7.2.1 Residuals transfers assets and retains an explicit obligation
to repurchase the assets or absorb losses
For residuals, the risk-based capital treatment because of a default on the payment of principal
is harmonized with the broader capital treat- or interest or because of any other deficiency in
ment for recourse and direct-credit substitutes. the performance of the underlying obligor or
The capital treatment matches the use of the some other party. Recourse may also exist
ratings to the relative risk of loss in asset securi- implicitly if a bank holding company provides
tizations. Highly rated investment-grade posi- credit enhancement beyond any contractual obli-
tions in securitizations receive a favorable (less gation to support assets it has sold. The follow-
than 100 percent) risk weight. Below- ing are examples of recourse arrangements:
investment-grade or unrated positions in securi-
tizations receive a less favorable risk weight 1. credit-enhancing representations and warran-
(generally greater than a 100 percent risk ties made on the transferred assets
weight). Therefore, if the external rating pro- 2. loan-servicing assets retained under an agree-
vided to such a residual interest is investment ment that requires the bank holding company
grade or no more than one category below to be responsible for credit losses associated
investment grade, that residual interest is with the loans being serviced (mortgage-
afforded more favorable capital treatment than servicer cash advances that meet the condi-
the dollar-for-dollar capital requirement other- tions of section III.B.3.a.viii. of the capital
wise required for residuals. adequacy guidelines (12 CFR 225, appendix
A) are not recourse arrangements
BHC Supervision Manual December 2002 3. retained subordinated interests that absorb
Page 8 more than their pro rata share of losses from
the underlying assets ables, as a credit enhancement for the sold or

4. assets sold under an agreement to repur- securitized assets. A spread account is an escrow
chase, if the assets are not already included account that a bank holding company typically
on the balance sheet establishes to absorb losses on receivables it has
5. loan strips sold without contractual recourse sold in a securitization, thereby providing credit
when the maturity of the transferred loan is enhancement to investors in the securities
shorter than the maturity of the commitment backed by the receivables, for example, credit
under which the loan is drawn card receivables. As defined in paragraph 14 of
6. credit derivatives issued that absorb more FAS 140, an I/O strip receivable is the contrac-
than the bank holding companys pro rata tual right to receive some or all of the interest
share of losses from the transferred assets due on a bond, a mortgage loan, or other
7. clean-up calls that, at inception, are greater interest-bearing financial assets. I/O strips are to
than 10 percent of the balance of the original be measured at fair value with gains or losses
pool of transferred loans (Clean-up calls that recognized either in earnings (if classified as
are 10 percent or less of the original pool trading) or a separate component of sharehold-
balance and that are exercisable at the option ers equity (if classified as available-for-sale).
of the bank holding company are not Paragraph 14 of FAS 140 states that I/O
recourse arrangements.) strips, retained interests in securitizations, loans,
other receivables, or other financial assets that
can contractually be prepaid or otherwise settled
2128.02.7.2.3 Low-Level-Recourse in such a way that the holder would not recover
Treatment substantially all of its recorded investment
(except for instruments that are within the scope
Securitization transactions involving recourse of Statement of Financial Accounting Standards
may be eligible for low-level-recourse treat- No. 133 (FAS 133), Accounting for Derivative
ment. A bank holding company that contractu- Instruments and Hedging Activities) shall be
ally limits its maximum off-balance-sheet re- subsequently measured like investments in debt
course obligation or direct-credit substitute securities classified as available-for-sale or trad-
(except credit-enhancing I/O strips) to an ing under Statement of Financial Accounting
amount less than the effective risk-based capital Standards No. 115 (FAS 115), Accounting for
requirement for the enhanced assets is required Certain Investments in Debt and Equity Securi-
to hold risk-based capital equal to the maximum ties. Retained interests that lack objectively
contractual exposure,5 less any recourse liability verifiable support or that fail to meet the super-
established in accordance with GAAP. The low- visory standards (discussed previously in this
level-recourse capital treatment thus applies to section) will be classified as loss and disallowed
transactions accounted for as sales under GAAP. as assets of the bank holding company for regu-
The low-level-exposure rule provides that the latory capital purposes.
dollar amount of risk-based capital required for
assets transferred with recourse should not
exceed the maximum dollar amount for which a 2128.02.7.2.4 Standby Letters of Credit
bank holding company is contractually liable,
less any recourse liability account established in Bank holding companies that issue standby let-
accordance with GAAP. The limitation does not ters of credit as credit enhancements for ABS
apply when the bank holding company provides issues must hold capital against these contingent
credit enhancement beyond any contractual obli- liabilities under the risk-based capital guide-
gation to support assets it has sold. The low- lines. According to the guidelines, financial
level capital treatment applies to low-level- standby letters of credit are direct-credit substi-
recourse transactions involving all types of tutes. A direct-credit substitute is an arrange-
assets, including commercial loans and residen- ment in which a bank holding company as-
tial mortgages. sumes, in form or substance, credit risk
Low-level-recourse transactions can arise associated with an on- or off-balance-sheet
when a bank holding company sells or securi- credit exposure that it did not previously own (a
tizes assets and uses contractual cash flows, third-party asset), and the risk assumed by the
such as spread accounts and I/O strips receiv- bank holding company exceeds the pro rata
share of its interest in the third-party asset. If the
5. For example, the effective risk-based capital require-
ment generally would be 4 percent for residential mortgages BHC Supervision Manual December 2002
and 8 percent for commercial loans. Page 9
bank holding company has no claim on the servicing assets, disallowed purchased credit-
third-party asset, then its assumption of any card relationships, disallowed credit-enhancing
credit risk with respect to the third-party asset is I/O strips, disallowed deferred tax assets, and
a direct-credit substitute. Direct-credit substi- amounts of nonfinancial equity investments re-
tutes are converted in their entirety to credit- quired to be deducted). To determine the amount
equivalent amounts. The credit-equivalent of credit-enhancing I/O strips that fall within the
amounts are then risk-weighted according to concentration limit, the bank holding company
their credit rating, like other direct-credit substi- would multiply the tier 1 capital of $320 by
tutes, and the risk weight for the corresponding 25 percent, which is $80. The amount of credit-
credit rating. enhancing I/O strips that exceeds the concentra-
tion limit, in this case $20, is deducted from tier
1 capital for risk-based and leverage capital
2128.02.8 CONCENTRATION LIMITS calculations and from assets. Credit-enhancing
IMPOSED ON RESIDUAL INTERESTS I/O strips that are not deducted from tier 1
capital (that is, the remaining $80 in the above
The creation of a residual interest (the debit) example), along with all other residual interests
typically results in an offsetting gain on sale not subject to the concentration limit, are sub-
(the credit), and thus the generation of an asset. ject to a dollar-for-dollar capital requirement.
Banking organizations that securitize high- Banks are not required to hold capital for more
yielding assets with long durations may create a than 100 percent of the amount of the residual
residual-interest asset value that exceeds the interest. Credit-enhancing I/O strips are not
risk-based capital charge that would be in place aggregated with any servicing assets or pur-
if it had not sold the assets. Serious problems chased credit-card relationships for purposes of
can arise for those banking organizations that calculating the 25 percent concentration limit.
distribute earnings too generously, only to be Continuing the above illustration for credit-
faced later with a downward valuation and enhancing I/O strips, once a bank holding com-
charge-off of part or all of the residual interests. pany deducts the $20 in disallowed credit-
Under the Federal Reserves capital adequacy enhancing I/O strips, it must hold $80 in total
guidelines, there is a dollar-for-dollar capital capital for the $80 that represents the credit-
charge on residual interests and a concentration enhancing I/O strips not deducted from tier 1
limit on a subset of residual interests, credit- capital. The $20 deducted from tier 1 capital,
enhancing I/O strips. These strips include any plus the $80 in total risk-based capital required
on-balance-sheet assets that represent a contrac- under the dollar-for-dollar treatment, equals
tual right to receive some or all of the interest $100, the face amount of the credit-enhancing
due on transferred assets, after taking into I/O strips. Bank holding companies may apply a
account trustee and other administrative net-of-tax approach to any credit-enhancing I/O
expenses, interest payments to investors, servic- strips that have been deducted from tier 1 capi-
ing fees, reimbursements to investors for losses tal, as well as to the remaining residual interests
attributable to beneficial interests they hold, and subject to the dollar-for-dollar treatment. A bank
reinvestment income and ancillary revenues (for holding company is permitted, but not required,
example, late fees) on the transferred assets. to net the deferred tax liabilities recorded on its
Credit-enhancing I/O strips expose the bank balance sheet, if any, that are associated with the
holding company to more than its pro rata share residual interests. This netting of the deferred
of credit risk and are limited to 25 percent of tier tax liabilities may result in a bank holding com-
1 capital, whether they are retained or pur- panys holding less than 100 percent capital
chased. Any amount of credit-enhancing I/O against residual interests.
strips that exceeds the 25 percent limit will be Normally, a sponsor will eventually receive
deducted from tier 1 capital and assets. An any excess cash flow remaining from securitiza-
example of the concentration calculation tions after investor interests have been met. As
required for bank holding companies that hold previously stated, residual interests are vulner-
credit-enhancing I/O strips is described below. able to sudden and sizeable write-downs that
A bank holding company has purchased and can hinder a bank holding companys access to
retained on its balance sheet credit-enhancing the capital markets; damage its reputation in the
I/O strips with a face amount of $100, and it has marketplace; and, in some cases, threaten its
tier 1 capital of $320 (before any disallowed solvency. A bank holding companys board of
directors and management are expected to
BHC Supervision Manual December 2002 develop and implement policies that limit the
Page 10 amount of residual interests that may be carried
as a percentage of total equity capital, based on for all securitization exposure. Procedures
the results of their valuation and modeling pro- should include thorough and independent
cesses. Well-constructed internal limits also credit assessment of each loan or pool for
lessen the incentives for its personnel to engage which the banking organization has
in activities designed to generate near-term assumed credit risk, followed by periodic
paper profits that may be at the expense of credit reviews to monitor performance
the bank holding companys long-term financial throughout the life of the exposure. If a
position and reputation. banking organization invests in asset-
backed securities, determine whether there
is sole reliance on conclusions of external
2128.02.9 INSPECTION OBJECTIVES rating services when evaluating the
securities.
2. Determine that rigorous credit standards are
1. To determine that securitization activities are
applied regardless of the role the organiza-
integrated into the overall strategic objec-
tion plays in the securitization process, for
tives of the organization.
example, servicer, credit enhancer, or
2. To determine that sources of credit risk are
investor.
understood, properly analyzed, and managed,
3. Determine that major policies and proce-
without excessive reliance on credit ratings
dures, including internal credit-review and
by outside agencies.
-approval procedures and in-house expo-
3. To determine that credit, operational, and
sure limits, are reviewed periodically and
other risks are recognized and addressed
approved by the bank holding companys
through appropriate policies, procedures,
board of directors.
management reports, and other controls.
4. To determine that liquidity and market risks 4. Determine that the banking organization
are recognized and that the organization is uses effective risk-management measures
not excessively dependent on securitization and that those measures are commensurate
as a substitute for funding or as a source of with the nature and volume of its securitiza-
income. tion activities. Verify that the banking orga-
5. To determine that steps have been taken to nization effectively manages the operational
minimize the potential for conflicts of inter- risk associated with credit-enhancing repre-
est from securitization. sentations and warranties as part of its over-
6. To determine that possible sources of struc- all risk-management strategy.
tural failure in securitization transactions are 5. If the banking organization uses computer
recognized and that the organization has software to apply the ratings-based
adopted measures to minimize the impact of approach to its unrated direct-credit substi-
such failures if they occur. tutes in asset-backed commercial paper pro-
7. To determine that the organization is aware grams, determine that the software pro-
of the legal risks and uncertainty regarding duces credit assessments that credibly and
various aspects of securitization. reliably correspond with the ratings of
8. To determine that concentrations of exposure traded positions by the rating agencies.
in the underlying asset pools, in the asset- 6. Determine whether adequate procedures for
backed securities portfolio, or in the struc- evaluating the organizations internal-
tural elements of securitization transactions control procedures and the financial
are avoided. strength of the other institutions involved in
9. To determine that all sources of risk are the securitization process are in place.
evaluated at the inception of each securitiza- 7. Obtain the documentation outlining the
tion activity and are monitored on an ongo- remedies available to provide credit
ing basis. enhancement in the event of a default. Both
originators and purchasers of securitized
assets should have prospectuses on the
issue. (Obtaining a copy of the prospectus
2128.02.10 INSPECTION can be an invaluable source of information
PROCEDURES on credit enhancement, default provisions,
subordination agreements, etc.)
1. Review the parent companys policies and 8. Ensure that, regardless of the role a banking
procedures to ensure that its banking and
nonbanking subsidiaries follow prudent BHC Supervision Manual June 2003
standards of credit assessment and approval Page 11
organization plays in securitization, the adequate audit trails and internal audit
documentation for an asset-backed security coverage should be provided.
clearly specifies the limitations of the bank- 16. Determine that management information
ing organizations legal responsibility to systems provide
assume losses. a. a listing of all securitizations in which
9. Verify whether the banking organization, the organization is involved;
acting as originator, packager, or under- b. a listing of industry and geographic
writer, has written policies addressing the concentration;
repurchase of assets and other reimburse- c. information on total exposure to specific
ment to investors in the event that a originators, servicers, credit enhancers,
defaulted package results in losses exceed- trustees, or underwriters;
ing any contractual credit enhancement. d. information regarding portfolio aging
The repurchase of defaulted assets or pools and performance relative to expecta-
in contradiction of the underlying agree- tions; and
ment in effect sets a standard by which a e. periodic and timely information to senior
banking organization could be found legally management and directors on the organi-
liable for all sold assets. Review and zations involvement in and credit expo-
report any situations in which the organiza- sure arising from securitization.
tion has repurchased or otherwise reim- 17. Ensure that internal auditors examine all
bursed investors for poor-quality assets. facets of securitization regularly.
10. Classify adverse credit risk associated with 18. Review policies and procedures for compli-
the securitization of assets when analyzing ance with applicable state lending limits
the adequacy of an organizations capital or and federal law, such as section 5136 of the
reserve levels. Revised Code. These requirements must be
11. Aggregate securitization exposures with all analyzed to determine whether a particular
loans, extensions of credit, debt and equity asset-backed security issue is considered a
securities, legally binding financial guaran- single investment or a loan to each of the
tees and commitments, and with any other creditors underlying the pool. Collateral-
investments involving the same obligor, ized mortgage obligations may be exempt
when determining compliance with internal from this limitation if they are issued or
credit-exposure limits. guaranteed by an agency or instrumentality
12. Review securitized assets for industrial or of the U.S. government.
geographic concentrations. Excessive expo- 19. Determine whether the underwriting of
sures to an industry or region among the asset-backed securities of affiliates is
underlying assets should be noted in the a. rated by an unaffiliated, nationally recog-
review of the loan portfolio. nized statistical rating organization or
13. Ensure that, in addition to policies limiting b. issued or guaranteed by Fannie Mae,
direct-credit exposure, a banking organiza- Freddie Mac, or GNMA, or represents
tion has developed exposure limits with interests in such obligations.
respect to particular originators, credit 20. If the parent organization or any of its bank-
enhancers, trustees, and servicers. ing and nonbanking subsidiaries invest in
14. Review the policies of the banking organi- high-risk mortgage-derivative securities,
zation engaged in underwriting with regard determine whether management effectively
to situations in which it cannot sell under- manages the associated risks commensurate
written asset-backed securities. Credit with the level of activity.
review, funding capabilities, and approval a. Determine whether the level of activity
limits should allow the banking organiza- is reasonably related to the level of capi-
tion to purchase and hold unsold securities. tal, the organizations ability to absorb
All potential credit exposure should be losses, and the level of in-house manage-
within legal lending limits. ment sophistication and expertise.
15. Ensure that internal systems and controls b. Ascertain whether the appropriate mana-
adequately track the performance and con- gerial and financial controls are required
dition of internal exposures and adequately to be in place, and whether the parent
monitor the organizations compliance with organization analyzes, monitors, and
internal procedures and limits. In addition, prudently adjusts holdings of such high-
risk securities when an environment of
BHC Supervision Manual June 2003 changing price and maturity expecta-
Page 12 tions exists. In that regard, determine to
what extent the organization considers

the liquidity and price volatility of the
high-risk mortgage-derivative products
before their acquistion.

Page 13
Credit-Supported and Asset-Backed Commercial Paper
WHATS NEW IN THIS REVISED arrangement provides borrowers with an alter-

SECTION native source of funding and allows banks to
earn fee income for managing the programs.
Effective July 2015, section 2128.03.3.3 is Fees are earned for providing credit and liquid-
revised to delete a footnote reference to ity enhancements to these programs.
SR-05-13 and its attachment, Interagency Involvement in credit-enhanced and asset-
Guidance on the Eligibility of Asset-Backed backed commercial paper programs, however,
Commercial Paper Program Liquidity Facilities can have potentially significant implications for
and the Resulting Risk-Based Capital Treat- organizations credit- and liquidity-risk expo-
ment, which is superseded by SR-15-6, Inter- sure. Therefore, examiners need to be fully
agency Frequently Asked Questions on the informed on the fundamentals of these pro-
Regulatory Capital Rule. Subsection 2128.03.4 grams, on the risks associated with these pro-
is also revised to delete a reference to SR-05-13. grams, and on the examination and inspection
procedures for banking organizations engaged
in this activity.
2128.03.1 CREDIT-SUPPORTED AND Asset-backed commercial paper programs
ASSET-BACKED COMMERCIAL have been in existence since the early 1980s and
PAPER AS AN ALTERNATIVE have grown substantially since then. These pro-
FUNDING SOURCE grams use a special-purpose entity (SPE) to
acquire receivables generally originated either
The issuance of commercial paper provides an by corporations or sometimes by the advising
alternative to bank borrowing for large corpora- bank itself.3 The SPEs, which are owned by
tions (nonfinancial and financial) and munici- third parties,4 fund their acquisitions of receiv-
palities. Generally, commercial paper issuers are ables by issuing commercial paper that is to be
those with high credit ratings. Some corpora- repaid from the cash flow of the receivables.
tions with lower credit ratings have been able to Bank involvement in an ABCP program can
issue commercial paper by obtaining credit range from advising the program to advising
enhancements1 (credit support from a firm with and providing all of the required credit and li-
a high credit rating) or other high-quality asset quidity enhancements in support of the SPEs
collateral (asset-backed commercial paper) to commercial paper. Typically, the advising bank
allow them to enter the market as issuers. An or an affiliate performs a review to determine if
example of credit-supported commercial paper the receivables of potential program partici-
is one supported by a letter of credit (LOC), the pants (that is, corporate sellers) are eligible for
terms of which specify that the bank issuing the purchase by the SPE. The scope of the review
LOC guarantees that the bank will pay off the is similar to that used in structuring securitiza-
commercial paper if the issuer fails to pay off tions collateralized by credit card receivables
the commercial paper upon maturity.2 A credit or automobile-secured loans.
enhancement could also consist of a surety bond Once the bank (or its affiliate) determines that
from an insurance company. a receivables portfolio has an acceptable credit-
risk profile, it approves the purchase of the
portfolio at a discounted price by the SPE. The
2128.03.2 COMMERCIAL BANK bank or its affiliate may also act as the operating
INVOLVEMENT IN CREDIT- agent for the SPE, which entails structuring the
ENHANCED AND ASSET-BACKED sale of receivable pools to the SPE and then
COMMERCIAL PAPER
A number of commercial banks have become 3. To date, the type of receivables that have been included
in the programs are trade receivables, installment sales con-
involved in credit-enhanced and asset-backed tracts, financing leases, and noncancelable portions of operat-
commercial paper programs. These securitiza- ing leases and credit card receivables.
tion programs enable banks to help arrange 4. Employees of an investment banking firm or some other
third party generally own the equity of the SPE. The advising
short-term financing support for their customers bank can specifically avoid owning the stock if it does not
without having to extend credit directly. This want to raise the issue of whether it must consolidate the SPE
for accounting purposes.
1. This paper is usually called credit-supported commer-

cial paper. BHC Supervision Manual July 2015
2. This arrangement is usually referred to as LOC paper. Page 1
Credit-Supported and Asset-Backed Commercial Paper 2128.03
overseeing the performance of the pools on an from other sources. The obligation to fund may
ongoing basis. be triggered by credit losses, a liquidity short-
The SPE pays for the receivables by issuing fall, or both. In the second, two separate agree-
commercial paper in an amount equal to the ments that jointly cover 100 percent of an SPEs
discounted price paid for the receivables. The outstanding commercial paper are established.
difference between the face value of the receiv- The first agreement, typically an irrevocable
ables and the discounted price paid provides, as letter of credit, is primarily intended to absorb
discussed below, the first level of credit protec- credit losses that exceed the first tier of credit
tion for the commercial paper. The individual enhancement for the commercial paper. The sec-
companies selling their receivables traditionally ond arrangement is a liquidity facility that
act as the servicer for receivables sold to an may or may not provide credit support. This
SPE; that is, they are responsible for collecting second structure will often have a letter of credit
principal and interest payments from the obli- equaling 10 percent to 15 percent of outstand-
gors and passing these funds on to the SPE on a ings, with the liquidity facility covering the
periodic basis. The SPE then distributes the remaining 90 to 85 percent.
proceeds to the holders of the commercial paper.
Asset-backed commercial paper programs
typically have several levels of credit enhance- 2128.03.3 RISK-BASED CAPITAL
ment cushioning the commercial paper pur- ASSET-BACKED COMMERCIAL
chaser from potential loss. As noted above, the PAPER PROGRAM ASSETS
first level of loss protection is provided by the
difference between the face value of the receiv- An asset-backed commercial paper (ABCP) pro-
ables purchased and the discounted price paid gram typically is a program through which a
for them, known as holdback or overcollat- banking organization provides funding to its
eralization. In some cases, the terms of the sale corporate customers by sponsoring and adminis-
also give the SPE recourse back to the seller if tering a bankruptcy-remote special-purpose
there are defaults on the receivables. The entity that purchases asset pools from, or
amount of overcollateralization and recourse extends loans to, those customers.5 The asset
varies from pool to pool and depends, in part, on pools in an ABCP program might include, for
the quality of the receivables in the pool and the example, trade receivables, consumer loans, or
desired credit rating for the paper to be issued. asset-backed securities. The ABCP program
Usually, the level of credit protection provided raises cash to provide funding to the banking
by overcollateralization is specified in terms of organizations customers through the issuance
some multiple of historical loss experience for of externally rated commercial paper into the
similar assets. market. Typically, the sponsoring banking orga-
In addition to overcollateralization and nization provides liquidity and credit enhance-
recourse, secondary credit enhancements are ments to the ABCP program. These enhance-
also customarily provided. Secondary credit ments aid the program in obtaining high credit
enhancements include letters of credit, surety ratings that facilitate the issuance of the com-
bonds, or other backup facilities that obligate a mercial paper.6 (See SR-05-13 and SR-92-11.)
third party to purchase pools of receivables from On June 12, 2009, the Financial Accounting
the SPE at a specified price. In addition to credit Standards Board (FASB) issued Statement of
enhancements, the programs generally have Financial Accounting Standards no. 166,
liquidity enhancements to ensure that the SPE Accounting for Transfers of Financial Assets,
can meet maturing-paper obligations. an Amendment of FASB Statement No. 140
The rating agencies typically require an (FAS 166) and Statement of Financial Account-
SPEs commercial paper to have secondary
enhancements aggregating 100 percent of the 5. The definition of ABCP program generally includes
amount outstanding in order to receive the high- structured investment vehicles (entities that earn a spread by
est credit rating. These enhancements are gener- issuing commercial paper and medium-term notes and using
the proceeds to purchase highly rated debt securities) and
ally structured in one of two ways. In the first, a securities arbitrage programs.
commercial bank enters into a single agreement 6. A bank is considered the sponsor of an ABCP pro-
under which it is unconditionally obligated to gram if it establishes the program; approves the sellers
provide funding for all or any portion of matur- permitted to participate in the program; approves the asset
pools to be purchased by the program; or administers the
ing commercial paper that an SPE cannot pay program by monitoring the assets, arranging for debt place-
ment, compiling monthly reports, or ensuring compliance
BHC Supervision Manual July 2015 with the program documents and with the programs credit
Page 2 and investment policy.
ing Standards no. 167, Amendments to FASB A banking organization that provides liquid-
Interpretation no. 46 (R) (FAS 167). FAS 166 ity facilities to ABCP is exposed to credit risk
and FAS 167 modified the accounting treatment regardless of the term of the liquidity facilities.
under U.S. generally accepted accounting prin- For example, an ABCP program may require a
ciples (GAAP) of certain structured financing liquidity facility to purchase assets from the
transactions involving a special purpose entity. program at the first sign of deterioration in the
Under FAS 167, banking organizations should credit quality of an asset pool, thereby removing
consolidate assets, liabilities, and equity in cer- such assets from the program. In such an event,
tain variable interest entities (VIEs) that were a draw on the liquidity facility exposes the
not consolidated under the standards that FAS banking organization to credit risk.
166 and FAS 167 replaced, or FIN 46 (January Short-term commitments with an original
2003) and FIN 46-R (December 2003).7 The maturity of one year or less expose banking
agencies8 risk-based capital and leverage rules organizations to a lower degree of credit risk
require banking organizations to include con- than longer-term commitments. This difference
solidated assets that are held by VIEs under the in the degree of credit risk is reflected in the
leveraged and risk-based capital rules and, risk-based capital requirement for the different
therefore, included in their leveraged and risk- types of exposures through liquidity facilities.
based capital ratios. FIN 46-R required the con- The Boards risk-based capital guidelines
solidation of many ABCP programs onto the impose a 10 percent credit-conversion factor on
balance sheets of banking organizations. Bank- unused portions of eligible short-term liquidity
ing organizations that are required to consoli- facilities supporting ABCP. A 50 percent credit-
date ABCP program assets must include all of conversion factor applies to eligible ABCP
the program assets (mostly receivables and liquidity facilities having a maturity of greater
securities) and liabilities (mainly commercial than one year. To be an eligible ABCP liquidity
paper) on their balance sheets for purposes of facility and qualify for the 10 or 50 percent
the Consolidated Financial Statements for Bank credit-conversion factor, the facility must be
Holding Companies (FR Y-9C Report) or the subject to an asset-quality test at the time of
bank Reports of Condition and Income (Call inception that does not permit funding against
Reports). (1) assets that are 90 days or more past due,
An ABCP program is defined as a program (2) assets that are in default, and (3) assets or
that primarily issues (that is, more than 50 per- exposures that are externally rated below invest-
cent) externally rated commercial paper backed ment grade at the time of funding if the assets or
by assets or other exposures held in a exposures were externally rated at the inception
bankruptcy-remote, special-purpose entity. of the facility. However, a liquidity facility may
Thus, a banking organization sponsoring a pro- also be an eligible liquidity facility if it funds
gram issuing ABCP must continue to include against assets that are guaranteedeither condi-
the programs assets on a consolidated basis in tionally or unconditionallyby the U.S. govern-
the institutions risk-weighted asset base. ment, U.S. government agencies, or by an
OECD central government, regardless of
2128.03.3.1 Liquidity Facilities whether the assets are 90 days past due, in
Supporting ABCP default, or externally rated investment grade.
The 10 or 50 percent credit-conversion factor
Liquidity facilities supporting ABCP often take applies regardless of whether the structure issu-
the form of commitments to lend to, or to pur- ing the ABCP meets the rules definition of an
chase assets from, the ABCP programs in the ABCP program. For example, a capital charge
event that funds are needed to repay maturing would apply to an eligible short-term liquidity
commercial paper. Typically, this need for facility that provides liquidity support to ABCP
liquidity is due to a timing mismatch between when the ABCP constitutes less than 50 percent
cash collections on the underlying assets in the of the securities issued by the program, thus
program and scheduled repayments of the com- causing the issuing structure not to meet the
mercial paper issued by the program. rules definition of an ABCP program. If a bank-
ing organization (1) does not meet this defini-
tion, it must include the programs assets in its
7. These standards are now included in the FASB Account- risk-weighted asset base or (2) it chooses to
ing Standards Codification Topic 810, Consolidation.
include the programs assets in risk-weighted
the Federal Deposit Insurance Corporation, the Office of the
Comptroller of the Currency, and the Office of Thrift BHC Supervision Manual July 2015
Supervision. Page 3
assets, then no risk-based capital requirement purposes, the banking organization would not
will be assessed against any liquidity facilities be required to hold capital against any credit
provided by the banking organization that sup- enhancements or liquidity facilities that compro-
ports the programs ABCP. Ineligible liquidity mise the same program assets.
facilities will be treated as recourse obligations If different banking organizations have over-
or direct-credit substitutes for the purposes of lapping exposures to an ABCP program, how-
the Boards risk-based capital guidelines. ever, each organization must hold capital against
The resulting credit-equivalent amount would the entire maximum amount of its exposure. As
then be risk-weighted according to the under- a result, while duplication of capital charges
lying assets or the obligor, after considering any will not occur for individual banking organiza-
collateral or guarantees, or external credit rat- tions, some systemic duplication may occur
ings, if applicable. For example, if an eligible where multiple banking organizations have
short-term liquidity facility providing liquidity overlapping exposures to the same ABCP
support to ABCP covered an asset-backed secu- program.
rity (ABS) externally rated AAA, then the
notional amount of the liquidity facility would
be converted at 10 percent to an on-balance- 2128.03.3.3 Asset-Quality Test
sheet credit-equivalent amount and assigned to
the 20 percent risk-weight category appropriate In order for a liquidity facility, either short- or
for AAA-rated ABS.9 long-term, that supports ABCP not to be consid-
ered a recourse obligation or a direct-credit sub-
stitute, it must meet the rules risk-based capital
2128.03.3.2 Overlapping Exposures to an
definition of an eligible ABCP liquidity facility.
ABCP Program
An eligible ABCP liquidity facility must meet a
A banking organization may have multiple over- reasonable asset-quality test that, among other
lapping exposures to a single ABCP program things, precludes funding assets that are 90 days
(for example, both a program-wide credit or more past due or in default. When assets are
enhancement and multiple pool-specific liquid- 90 days or more past due, they typically have
ity facilities to an ABCP program that is not deteriorated to the point where there is an
consolidated for risk-based capital purposes). A extremely high probability of default. Assets
banking organization must hold risk-based capi- that are 90 days past due, for example, often
tal only once against the assets covered by the must be placed on nonaccrual status in accor-
overlapping exposures. Where the overlapping dance with the agencies Uniform Retail Credit
exposures are subject to different risk-based Classification and Account Management Pol-
capital requirements, the banking organization icy.10 Further, they generally must also be classi-
must apply the risk-based capital treatment that fied Substandard under that policy.
results in the highest capital charge to the over- In addition to the above, if the assets covered
lapping portion of the exposures. by the liquidity facility are initially externally
For example, assume a banking organization rated (at the time the facility is provided) the
provides a program-wide credit enhancement facility can be used to fund only those assets
that would absorb 10 percent of the losses in all that are externally rated investment grade at the
of the underlying asset pools in an ABCP pro- time of funding. The practice of purchasing
gram and also provides pool-specific liquidity assets that are externally rated below investment
facilities that cover 100 percent of each of the grade out of an ABCP program is considered to
underlying asset pools. The banking organiza- be the equivalent of providing credit protection
tion would be required to hold capital against to the commercial paper investors. Thus, liquid-
10 percent of the underlying asset pools because ity facilities permitting purchases of below-
it is providing the program-wide credit enhance- investment-grade securities will be considered
ment. The banking organization would also be either recourse obligations or direct-credit
required to hold capital against 90 percent of the substitutes.
liquidity facilities it is providing to each of the However, neither the 90-days-past-due
underlying asset pools. For risk-based capital limitation nor the investment grade limitation
apply to the asset-quality test with respect to
9. See section III.B.3.c. of the guidelines (12 C.F.R. 225,
assets that are conditionally or unconditionally
appendix A). guaranteed by the U.S. government or its agen-
cies or by another OECD central government.
Page 4 10. See 65 Fed. Reg. 36904 (June 12, 2000).
An ABCP liquidity facility is considered to ment to buy back nonperforming or defaulted

be in compliance with the requirement for an loans or downgraded securitiesmay expose
asset-quality test if (1) the liquidity provider has the liquidity provider to an increased level of
access to certain types of acceptable credit credit risk. A decline in the performance of
enhancements and (2) the notional amount of assets sold to an ABCP conduit may signal
such credit enhancements available to the impending difficulties for the seller.
liquidity facility provider exceeds the amount of If the amount of acceptable credit enhance-
underlying assets that are 90 days or more past ment associated with the pool of assets is less
due, defaulted, or below investment grade for than the current amount of assets that are 90
which the liquidity provider may be obligated to days or more past due, in default, or below
fund under the facility. In this circumstance, the investment grade that the liquidity facility pro-
liquidity facility may be considered eligible vider may be obligated to fund against, the
for purposes of the risk-based capital rule liquidity facility should be treated as recourse or
because the provider of the credit enhancement a direct credit substitute. The full amount of
generally bears the credit risk of the assets that assets supported by the liquidity facility would
are 90 days or more past due, in default, or be subject to a 100 percent credit conversion
below investment grade rather than the banking factor.12 The Federal Reserve Board reserves
organization providing liquidity. the right to deem an otherwise eligible liquidity
The following forms of credit enhancements facility to be, in substance, a direct credit substi-
are generally acceptable for purposes of satisfy- tute if a banking organization uses the liquidity
ing the asset quality test: facility to provide credit support.
The banking organization is responsible for
funded credit enhancements that the bank- demonstrating to the Federal Reserve Board
ing organization may access to cover delin- whether acceptable credit enhancements cover
quent, defaulted, or below-investment-grade the 90 days or more past due, defaulted, or
assets, such as overcollateralization, cash below-investment-grade assets that the organi-
reserves, subordinated securities, and funded zation may be obligated to fund against in each
spread accounts; sellers asset pool. If the banking organization
surety bonds and letters of credit issued by a cannot adequately demonstrate satisfaction of
third party with a nationally recognized statis- the conditions in the above-referenced inter-
tical rating organization rating of single A or agency guidance, the Federal Reserve Board
higher that the banking organization may further reserves the right to determine that a
access to cover delinquent, defaulted, or credit enhancement is unacceptable for purposes
below-investment-grade assets, provided that of the requirement for an asset quality test and,
the surety bond or letter of credit is irrevo- therefore, it may deem the liquidity facility to be
cable and legally enforceable; and ineligible.
one months worth of excess spread that the
banking organization may access to cover
delinquent, defaulted, or below-investment- 2128.03.3.4 Market Risk Capital
grade assets if the following conditions are Requirements for ABCP Programs
met: (1) excess spread is contractually
required to be trapped when it falls below Any facility held in the trading book whose
4.5 percent (measured on an annualized basis) primary function, in form or in substance, is to
and (2) there is no material adverse change in provide liquidity to ABCPeven if the facility
the banking organizations ABCP underwrit- does not qualify as an eligible ABCP liquidity
ing standards. The amount of available excess facility under the rulewill be subject to the
spread may be calculated as the average of the banking-book risk-based capital requirements.
current months and the two previous months Specifically, banking organizations are required
excess spread. to convert the notional amount of all trading-
book positions that provide liquidity to ABCP
Recourse directly to the seller, other than the to credit-equivalent amounts by applying the
funded credit enhancements enumerated above, appropriate banking-book credit-conversion fac-
regardless of the sellers external credit rating, tors. For example, the full amount of all eligible
is not an acceptable form of credit enhancement
for purposes of satisfying the asset quality test. 12. See 12 CFR 208, appendix A, section III.B.3.b.i.
Seller recoursefor example, a sellers agree-
11. Reserved footnote. Page 5
ABCP liquidity facilities with an original matu- 1. the characteristics, credit quality, and
rity of one year or less will be subject to a expected performance of the underlying
10 percent conversion factor, regardless of receivables;
whether the facility is carried in the trading 2. the banking organizations ability to meet its
account or the banking book. obligations under the securitization arrange-
ment; and
3. the ability of the other participants in the
2128.03.4 BOARD-OF-DIRECTORS arrangement to meet their obligations.
POLICIES PERTAINING TO CREDIT-
ENHANCED OR ASSET-BACKED Banking organizations providing credit
COMMERCIAL PAPER enhancements and liquidity facilities should
conduct a careful analysis of their funding capa-
A banking organization (that is, a bank or a bilities to ensure that they will be able to meet
bank holding company) participating in an their obligations under all foreseeable circum-
asset-backed commercial paper program should stances. The analysis should include a determi-
ensure that such participation is clearly and logi- nation of the impact that fulfillment of these
cally integrated into its overall strategic objec- obligations would have on their interest-rate risk
tives. Furthermore, management should ensure exposure, asset quality, liquidity position, and
that the risks associated with the various roles capital adequacy.
that the institution may play in such programs Examiners should carefully review the asset-
are fully understood and that safeguards are in backed commercial paper facilities provided by
place to manage the risks properly. banking organizations to ensure that they are
Appropriate policies, procedures, and con- applying, for risk-based capital purposes, the
trols should be established by a banking organi- proper conversion factors to their obligations
zation before it participates in asset-backed supporting asset-backed commercial paper pro-
commercial paper programs. Significant poli- grams. In addition, examiners should determine
cies and procedures should be approved and whether the previously discussed policies are
reviewed periodically by the organizations operative and that institutions are adequately
board of directors. These policies and proce- managing their risk exposure. If not appropriate
dures should ensure that the organization fol- for the open section, a discussion of the size,
lows prudent standards of credit assessment and effectiveness, and risks associated with asset-
approval regardless of the role an institution backed commercial paper programs should be
plays in an asset-backed commercial paper pro- included in the confidential section of the
gram. Such policies and procedures would be examination or inspection report. See SR-92-11.
applicable to all pools of receivables to be pur-
chased by the SPE as well as to the extension of
any credit enhancements and liquidity facilities. 2128.03.5 INSPECTION OBJECTIVES
Procedures should include an initial, thorough
credit assessment of each pool for which the 1. To determine whether the banking organi-
banking organization had assumed credit risk, zation (that is, a bank or a bank holding
followed by periodic credit reviews to monitor company) participating in an asset-backed
performance throughout the life of the exposure. commercial paper program has included
Furthermore, the policies and procedures should this participation in its overall strategic
outline the credit-approval process and establish objectives.
in-house exposure limits, on a consolidated 2. To determine whether management fully
basis, with respect to particular industries or understands the risks associated with the
organizations, that is, companies from which the banking organizations involvement in
SPE purchased the receivables as well as the credit-enhancement and asset-backed com-
receivable obligors themselves. Controls should mercial paper programs and whether appro-
include well-developed management informa- priate safeguards are in place to properly
tion systems and monitoring procedures. manage those risks.
Institutions should analyze the receivables 3. To ascertain that the appropriate policies,
pools underlying the commercial paper as well procedures, and controls have been estab-
as the structure of the arrangement. This analy- lished by the banking organization before
sis should include a review of participating in asset-backed commercial
paper programs.
BHC Supervision Manual July 2015 4. To verify whether existing managerial and
Page 6 internal controls include well-developed
management information systems and moni- lar industries or organizations, that is,
toring procedures. companies from which the SPE purchased
5. To determine whether the banking organiza- the receivables as well as the receivable
tion has conducted a careful analysis of its obligors themselves.
funding capabilities to ensure that it will be c. Determine whether the organization
able to meet its obligations under all foresee- analyzes the receivables pools underlying
able circumstances. the commercial paper as well as analyzes
6. To ensure that all asset-backed securities the structure of the arrangement. Does the
owned, any assets sold with recourse, analysis include a review of
retained interests, and variable interest enti- the characteristics, credit quality, and
ties (VIEs) (for example, asset-backed com- expected performance of the underlying
mercial paper [ABCP] programs, those that receivables;
are defined as VIEs under generally accepted the ability of the banking organization
accounting principles) are properly to meet its obligations under the securi-
accounted for on the banking organizations tization arrangement; and
books and are correctly reported on its regu- the ability of the other participants
latory reports. in the arrangement to meet their
7. To determine that capital is commensurate obligations?
with, and that there are accurate determina- 3. Review the organizations funding obliga-
tions of the risk weights for, the risk expo- tions and commitments, and determine
sures arising from recourse obligations, whether there is sufficient liquidity to satisfy
direct-credit substitutes, asset- and mortgage- those funding requirements. Include a deter-
backed securities, ABCP programs and mination of the impact that fulfillment of
ABCP liquidity facilities, and other asset- these obligations would have on their
securitization transactions. interest-rate risk exposure, asset quality,
liquidity position, and capital adequacy.
4. Review carefully the risk-based capital cal-
2128.03.6 INSPECTION PROCEDURES culations for ABCP facilities to ensure that
they are applying, for risk-based capital pur-
1. Review the minutes of board of directors or poses, the proper conversion factors to their
executive committee meetings. Establish obligations supporting the asset-backed com-
whether the significant policies and proce- mercial paper programs.
dures for credit-enhanced or asset-backed 5. Determine if the banking organization con-
commercial paper have been approved and solidates, in accordance with GAAP, the
reviewed periodically by the organizations assets of any ABCP program or other such
board of directors. program that it sponsors.
a. Determine whether the policies are a. Determine if the banking organizations
operative and whether institutions are ade- ABCP program met the definition of a
quately managing their risk exposure. sponsored ABCP program under the risk-
b. Determine whether the policies and proce- based capital guidelines.
dures are applicable to all pools of receiv- b. Verify that the assets of the banking orga-
ables to be purchased by the SPE as well nizations eligible ABCP program and
as to the extension of any credit any associated minority interest were
enhancements and liquidity facilities. included in the banking organizations
2. Determine if the organization follows pru- calculation of its risk-based capital ratios.
dent standards of credit assessment and c. Ascertain whether the liquidity facilities
approval. the banking organization extends to the
a. Ascertain whether the procedures include ABCP program satisfy the risk-based
an initial, thorough credit assessment of capital requirements, including the appro-
each pool for which the organization had priate asset-quality test, of an eligible
assumed credit risk. The initial review ABCP program liquidity facility. (See
should be followed by periodic credit 12 C.F.R. 225, appendix A, section
reviews to monitor performance through- III.B.3.a.iv.)
out the life of the exposure. d. Determine whether the banking organiza-
b. Determine if the policies and procedures tion applied the correct credit-conversion
outline the credit-approval process and
establish in-house exposure limits, on a BHC Supervision Manual July 2015
consolidated basis, with respect to particu- Page 7
factor to the eligible ABCP liquidity banking organization applied the risk-
facilities when it determined the amount based capital treatment that resulted in the
of risk-weighted assets for its risk-based highest capital charge. (See 12 CFR 225,
capital ratios. (See 12 C.F.R. 225, appen- appendix A, section III.B.6.c.)
dix A, section III.D.) 6. Include in the inspection report a discussion
e. Determine if all ineligible ABCP liquidity of the size, effectiveness, and risks associ-
facilities were treated as either direct- ated with ABCP programs (include the dis-
credit substitutes or as recourse obliga- cussion in the confidential section of the
tions, as required by the risk-based capital inspection report if not appropriate for the
guidelines. open section).
f. If the banking organization had multiple
overlapping exposures, determine if the

Page 8
Implicit Recourse Provided to Asset Securitizations
Implicit recourse arises when a bank holding and, in effect, the risks have not been trans-
company1 provides credit support to one of ferred. Accordingly, examiners must be atten-
more of its securitizations beyond its contractual tive to bank holding companies that provide
obligation. Implicit recourse, like contractual implicit support, given the risk these actions
recourse, exposes a bank holding company to pose to a bank holding companys financial
the risk of loss arising from deterioration in the condition. Increased attention should be given
credit quality of the underlying assets of the to situations where a bank holding company is
securitization. Implicit recourse is of supervi- more likely to provide implicit support.
sory concern because it demonstrates that the Particular attention should be paid to revolv-
securitizing bank holding company is reassum- ing securitizations, such as those used for credit
ing risk associated with the securitized assets card lines and home equity lines of credit, in
risk that the bank holding company initially which receivables generated by the lines are
transferred to the marketplace. For risk-based sold into the securitizations. These securitiza-
capital purposes, bank holding companies tions typically provide that, when certain perfor-
deemed to be providing implicit recourse are mance criteria hit specified thresholds, no new
generally required to hold capital against the receivables can be sold into the securitization,
entire outstanding amount of assets sold, as and the principal on the bonds issued will begin
though the assets remained on the bank holding to pay out. These early-amortization events are
companys books. intended to protect investors from further dete-
Banking organizations have typically pro- rioration in the underlying asset pool. Once an
vided implicit recourse in situations where the early-amortization event has occurred, the bank
originating banking organization perceived that holding company could have difficulties using
the failure to provide this support, even though securitization as a continuing source of funding
not contractually required, would damage its and, at the same time, have to fund the new
future access to the asset-backed securities mar- receivables generated by the lines of credit on
ket. An originating bank holding company can its balance sheet. Thus, bank holding companies
provide implicit recourse in a variety of ways. have an incentive to avoid early amortization by
The ultimate determination as to whether providing implicit support to the securitization.
implicit recourse exists depends on the facts. Examiners should be alert for securitizations
The following actions point to a finding of that are approaching early-amortization triggers,
implicit recourse: such as a decrease in the excess spread3 below a
certain threshold or an increase in delinquencies
1. selling assets to a securitization trust or other beyond a certain rate. Providing implicit
special-purpose entity (SPE) at a discount recourse can pose a degree of risk to a bank
from the price specified in the securitization holding companys financial condition and to
documents, which is typically par value the integrity of its regulatory and public finan-
2. purchasing assets from a trust or other SPE at cial statements and reports. Examiners should
an amount greater than fair value review securitization documents (for example,
3. exchanging performing assets for nonper- pooling and servicing agreements) to ensure that
forming assets in a trust or other SPE the selling institution limits any post-sale sup-
4. funding credit enhancements2 beyond con- port to that specified in the terms and conditions
tractual requirements in the securitization documents. Examiners
should also review a sample of receivables
By providing implicit recourse, a bank hold- transferred between the seller and the trust to
ing company signals to the market that it still ensure that these transfers were conducted in
holds the risks inherent in the securitized assets, accordance with the contractual terms of the
securitization, particularly in cases where the
1. The reference to implicit-recourse activities of bank overall credit quality of the securitized loans or
holding companies is intended to include all of a bank holding receivables has deteriorated. While bank hold-
companys domestic and foreign subsidiaries supervised by ing companies are not prohibited from provid-
the Federal Reserve, as well as its federally insured depository
institutions and other entities that are subject to this interpreta-
tion and guidance of the Federal Financial Institutions Exami- 3. Excess spread generally is defined as finance-charge
nation Council (FFIEC). collections minus certificate interest, servicing fees, and
2. Credit enhancements include retained subordinated charge-offs allocated to the series.
interests, asset-purchase obligations, overcollateralization,
cash-collateral accounts, spread accounts, and interest-only BHC Supervision Manual December 2002
strips. Page 1
Implicit Recourse Provided to Asset Securitizations 2128.04
ing implicit recourse, such support will gener- of the credit card receivables are securitized
ally result in higher capital requirements. through a master-trust structure, the bank hold-
Examiners should recommend that prompt ing company needs to remove the receivables
supervisory action be taken when implicit from the trust. The affected receivables are not
recourse is identified. To determine the appro- experiencing any unusual performance prob-
priate action, examiners need to understand the lems. In that respect, the charge-off and delin-
bank holding companys reasons for providing quency ratios for the receivables to be removed
support and the extent of the impact of this from the trust are substantially similar to those
support on the bank holding companys earn- for the trust as a whole.
ings and capital. As with contractual recourse, The bank holding company enters into a con-
actions involving noncontractual post-sale credit tract to sell the specified credit card accounts
enhancement generally result in the requirement before the receivables are removed from the
that the bank holding company hold risk-based trust. The terms of the transaction are arms
capital against the entire outstanding amount of length, wherein the bank holding company will
the securitized assets. The Federal Reserve may sell the receivables at market value. The bank
require the bank holding company to bring all holding company separately agrees to purchase
assets in existing securitizations back on the the receivables from the trust at this same price.
balance sheet for risk-based capital purposes, as Therefore, no loss is incurred as a result of
well as require the bank holding company to removing the receivables from the trust. The
increase its minimum capital ratios. The Federal bank holding company will remove from the
Reserve may prevent a bank holding company trust only those receivables that are due from
from removing assets from its risk-weighted customers located in the geographic areas where
asset base on future transactions until the bank the bank holding company lacks a significant
holding company demonstrates its intent and market presence, and it will remove all such
ability to transfer risk to the marketplace. The receivables from the trust.
Federal Reserve may consider other actions to
ensure that the risks associated with implicit Analysis. The removal of the above-described
recourse are adequately reflected in the capital receivables from the trust does not constitute
ratios. For example, supervisors may require the implicit recourse for regulatory capital purposes.
bank holding company to deduct residual inter- Supporting factors for this conclusion include
ests from tier 1 capital as well as hold risk-based the following:
capital on the underlying assets. (See SR-02-
15.) 1. The bank holding companys earnings and
The following examples illustrate post-sale capital are not exposed to actual or potential
actions that banking organizations may take risk of loss as a result of removing the receiv-
with respect to assets they have securitized. ables from the trust.
These examples are intended to provide guid- 2. There is no indication that the receivables are
ance on whether these actions would be consid- removed from the trust because of perfor-
ered implicit recourse for risk-based capital and mance concerns.
other supervisory purposes. A key factor in each 3. The bank holding company is removing the
scenario and analysis is the potential risk of loss receivables from the trust for a legitimate
a bank holding companys earnings and capital business purpose other than to systematically
may be exposed to as a result of its actions. improve the quality of the trusts assets. The
legitimate business purpose is evidenced by
Account Removal: Example 1a the bank holding companys prearranged,
arms-length sale agreement that facilitates
Facts. A bank holding company originates and exiting the business in identified geographic
services credit card receivables throughout the locations.
country. The bank holding company decides to
divest those credit card accounts of customers Examiners should review the terms and condi-
who reside in specific geographic areas where tions of the transaction to ensure that the market
the bank holding company lacks a significant value of the receivables is documented and well
market presence. To achieve the maximum sales supported before concluding that this transac-
price, the sale must include both the credit card tion does not represent implicit recourse. Exam-
relationships and the receivables. Because many iners should also ensure that the selling bank
holding company has not provided the pur-
BHC Supervision Manual December 2002 chaser with any guarantees or credit enhance-
Page 2 ments on the sold receivables.
Account Removal: Example 1b company must hold regulatory capital against

the outstanding assets in the trust.
Facts. After the establishment of a master trust
for a pool of credit card receivables, the receiv-
ables in the trust begin to experience adverse Additions of Future Assets or
performance. A combination of lower-than- Receivables: Example 2b
expected yields and higher-than-anticipated
charge-offs on the pool causes spreads to com- Facts. A bank holding company established a
press significantly (although not to zero). The credit card master trust. The receivables from
bank holding companys internally generated the accounts placed in the trust were, on aver-
forecasts indicate that spreads will likely age, of lesser quality than the receivables from
become negative in the near future. Manage- certain affinity accounts retained on the bank
ment takes action to support the trust by pur- holding companys balance sheet. Under the
chasing the low-quality (delinquent) receivables criteria for selecting the receivables to be trans-
from the trust at par, although their market value ferred to the master trust, the bank holding
is less than par. The receivables purchased from company was prevented from including the
the trust represent approximately one-third of better-performing affinity accounts in the initial
the trusts total receivables. This action pool of accounts because the affinity-
improves the overall performance of the trust relationship contract was expiring. The bank
and avoids a potential early-amortization event. holding company and the affinity client subse-
quently revised the terms of their contract,
Analysis. The purchase of low-quality receiv- enabling the affinity accounts to meet the selec-
ables from a trust at par constitutes implicit tion criteria and be included in future securitiza-
recourse for regulatory capital purposes. The tion transactions. Later, rising charge-offs within
purchase of low-quality receivables at an above- the pool of receivables held by the trust caused
market price exposes the bank holding compa- spread compression in the trust. To improve the
nys earnings and capital to potential future performance of the assets in the trust, the bank
losses from assets that had previously been sold. holding company begins to include the better-
Accordingly, the bank holding company is performing and now-eligible receivables from
required to hold risk-based capital for the the affinity accounts among the receivables sold
remaining assets in the trust as if they were to the trust. This action improves the trusts
retained on the balance sheet, as well as hold performance, including its spread levels and
capital for the assets that were repurchased. charge-off ratios. However, the replacement
assets were sold at par in accordance with the
terms of the trust agreement, so no current or
Additions of Future Assets or future charge to the bank holding companys
Receivables: Example 2a earnings or capital will result from these asset
sales. As another result of this action, the perfor-
Facts. Months after the issuance of credit card mance of the trusts assets closely tracks the
asset-backed securities, charge-offs and delin- credit card receivables that remain on the bank
quencies on the underlying pool of receivables holding companys balance sheet.
rise dramatically. A rating agency places the
securities on watch for a potential rating down- Analysis. The actions described above do not
grade. The securitization documents require the constitute implicit recourse for regulatory capi-
bank holding company to transfer new receiv- tal purposes. The bank holding company did not
ables to the securitization trust at par value. incur any additional risk to earnings or capital
However, to maintain the rating on the securi- after the affinity accounts met the selection crite-
ties, the bank holding company begins to sell ria for replacement assets and after the associ-
replacement receivables into the trust at a dis- ated receivables were among the receivables
count from par value. sold to the trust. The replacement assets were
sold at par in accordance with the terms of the
Analysis. The sale of receivables to the trust at a trust agreement, so no future charge to earnings
discount constitutes implicit recourse for regula- or capital will result from these asset sales. The
tory capital purposes. The sale of assets at a sale of replacement assets into a master-trust
discount from the price specified in the securiti- structure is part of normal trust management.
zation documents, par value in this example,
exposes the bank holding companys earnings BHC Supervision Manual December 2002
and capital to future losses. The bank holding Page 3
In this example, the credit card receivables have filed for bankruptcy is changed from
that remain on the bank holding companys criteria that were more conservative than
balance sheet closely track the performance of industry standards, the applicable Federal
the trusts assets. Nevertheless, examiners Reserve classification policy for bank hold-
should ascertain whether a securitizing bank ing companies, and the FFIEC Uniform
holding company sells disproportionately Retail Credit Classification and Account
higher-quality assets into securitizations while Management Policy to criteria that conform
retaining comparatively lower-quality assets on to industry standards, the Federal Reserves
its books. If a bank holding company engages in standards, and the FFIECs policy.
this practice, examiners should consider its 3. Charged-off receivables held by the trust are
effect on the bank holding companys capital sold to a third party. The funds generated by
adequacy. this sale, effectively accelerating the recov-
ery on these receivables, improve the trusts
spread performance.
Additions of Future Assets or
Receivables: Example 2c Analysis. The actions described above do not
constitute implicit recourse for regulatory capi-
Facts. A bank holding company establishes a tal purposes. None of the noncontractual actions
credit card master trust composed of receivables result in a loss or expose the bank holding
from accounts that were generally of lower qual- companys earnings or capital to the risk of loss.
ity than the receivables retained on the bank Because of the margin compression, the bank
holding companys balance sheet. The differ- holding company is obligated to increase the
ence in the two portfolios is primarily due to spread accounts in conformance with the terms
logistical and operational problems that prevent and conditions of the securitization documents.
the bank holding company from including cer- To the extent this results in an increase in the
tain better-quality affinity accounts in the initial value of the subordinated spread accounts
pool from which accounts were selected for (residual interests) on the bank holding compa-
securitization. Rising charge-offs and other fac- nys balance sheet, the bank holding company
tors later result in margin compression on the will need to hold additional capital on a dollar-
assets in the master trust, which causes some for-dollar basis for the additional credit risk it
concern in the market regarding the stability of retains. In contrast, if the bank holding company
the outstanding asset-backed securities. A rating increased the spread accounts beyond its con-
agency places several tranches of the securities tractual obligation under the securitization docu-
on its watch list for a potential rating down- ments, this action would be considered a form
grade. In response to the margin compression, of implicit recourse. None of the other actions
as part of the bank holding companys contrac- the bank holding company took would affect its
tual obligations, spread accounts are increased earnings or capital:
for all classes by trapping excess spread in
conformance with the terms and conditions of 1. Like other additions to credit card trusts, the
the securitization documents. To stabilize the additions of receivables from the new affinity
quality of the receivables in the master trust, as accounts were made at par value, in accor-
well as to preclude a downgrade, the bank hold- dance with the securitization documents.
ing company takes several actions beyond its Therefore, the additions of receivables from
contractual obligations: the new affinity accounts would not affect the
bank holding companys earnings or capital.
1. Affinity accounts are added to the pool of 2. The trusts policy on the timing of charge-
receivables eligible for inclusion in the trust. offs on accounts of cardholders who have
This change results in improved overall trust filed for bankruptcy was changed to meet the
performance. However, these receivables are less stringent standards of the industry and
sold to the trust at par value, consistent with those required under the Federal Reserves
the terms of the securitization documents, so policy in order to improve trust performance,
no current or future charge to the bank hold- at least temporarily. Nonetheless, this would
ing companys earnings or capital will result not affect the bank holding companys earn-
from these asset sales. ings or capital.
2. The charge-off policy for cardholders that 3. In accordance with the securitization docu-
ments, proceeds from recoveries on charged-
BHC Supervision Manual December 2002 off accounts are the property of the trust.
Page 4 These and other proceeds would continue to
be paid out in accordance with the pooling considered implicit recourse because it
and servicing agreement. No impact on the adversely affects the bank holding companys
bank holding companys earnings or capital earnings and capital since the bank holding
would result. company absorbs losses on the loans resulting
from the actions taken by its subsidiary. Further,
no mechanism exists to provide for and ensure
Modification of Loan-Repayment Terms: that the subsidiary will be reimbursed for the
Example 3 payments made to the trust. In addition, examin-
ers will consider any servicer advance a credit
Facts. In performing the role of servicer for its enhancement if the servicer is not entitled to full
securitization, a bank holding company is autho- reimbursement4 or if the reimbursement is sub-
rized under its pooling and servicing agreement ordinate to other claims.
to modify loan-repayment terms when it appears
that this action will improve the likelihood of
repayment on the loan. These actions are part of Reimbursement of Credit Enhancers
the bank holding companys process of working Actual Losses: Example 5
with customers who are delinquent or otherwise
experiencing temporary financial difficulties. All Facts. A bank holding company sponsoring a
of the modifications are consistent with the bank securitization arranges for an unrelated third
holding companys internal loan policy. How- party to provide a first-loss credit enhancement,
ever, in modifying the loan terms, the contrac- such as a financial standby letter of credit, that
tual maturity of some loans may be extended will cover losses up to the first 10 percent of the
beyond the final maturity date of the most junior securitized assets. The bank holding company
class of securities sold to investors. When this agrees to pay a fixed amount as an annual pre-
occurs, the bank holding company repurchases mium for this credit enhancement. The third
these loans from the securitization trust at par. party initially covers actual losses that occur in
the underlying asset pool in accordance with its
Analysis. The combination of the loan-term contractual commitment under the letter of
modification for securitized assets and the sub- credit. Later, the bank holding company agrees
sequent repurchase constitutes implicit recourse not only to pay the credit enhancer the annual
for regulatory capital purposes. While the modi- premium on the credit enhancement, but also to
fication of loan terms is permitted under the reimburse the credit enhancer for the losses it
pooling and servicing agreement, the repurchase absorbed during the preceding year. This reim-
of modified loans with extended maturities at bursement for actual losses was not originally
par exposes the bank holding companys earn- provided for in the contractual arrangement
ings and capital to potential risk of loss. between the bank holding company and the
credit-enhancement provider.
Servicers Payment of Deficiency Analysis. The bank holding companys subse-

Balances: Example 4 quent reimbursement of the credit-enhancement
providers losses constitutes implicit recourse
Facts. A wholly owned subsidiary of a bank because the bank holding companys reimburse-
holding company originates and services a port- ment of losses went beyond its contractual obli-
folio of home equity loans. After liquidation of gations. Furthermore, the Federal Reserve
the collateral for a defaulted loan, the subsidiary would consider any requirement contained in
makes the trust whole in terms of principal and the original credit-enhancement contract that
interest if the proceeds from the collateral are obligates the bank holding company to reim-
not sufficient. However, there is no contractual burse the credit-enhancement provider for its
commitment that requires the subsidiary to sup- losses to be a recourse arrangement.
port the pool in this manner. The payments
made to the trust to cover deficient balances on
the defaulted loans are not recoverable under
the terms of the pooling and servicing 4. A servicer advance will also be considered a form of
credit enhancement if, for any one loan, nonreimbursable
agreement. advances are not contractually limited to an insignificant
amount of that loans outstanding principal.
Analysis. The subsidiarys action constitutes
implicit recourse to the bank holding company BHC Supervision Manual December 2002
for regulatory capital purposes. This action is Page 5
2128.04.1 INSPECTION OBJECTIVES sale support to that specified in the terms and
conditions in the securitization documents.
1. To identify asset-securitization transactions 4. Review a sample of receivables transferred
in which the bank holding company has pro- between the seller and the trust to ensure that
vided implicit recourse. the transfers were conducted in accordance
2. To ascertain whether implicit recourse pro- with the contractual terms of the securitiza-
vided to asset-securitization transactions may tion, particularly in cases where the overall
be detrimental to the bank holding compa- credit quality of the securitized loans or
nys earnings performance, capital adequacy, receivables has deteriorated.
and financial condition. 5. Review the terms and conditions of the secu-
3. To initiate quick supervisory action, which ritization transactions reviewed to ensure that
may include increased minimum-capital the market value of the receivables is docu-
requirements, when implicit recourse is mented and well supported.
identified. 6. Ascertain that the selling bank holding com-
pany has not provided a purchaser with any
guarantees or credit enhancements on the
2128.04.2 INSPECTION PROCEDURES sold receivables.
7. Ascertain whether a securitizing bank hold-
1. Be attentive to situations in which the bank ing company sells disproportionately higher-
holding company may have provided im- quality assets into securitizations while
plicit support to an asset-securitization trans- retaining comparatively lower-quality assets
action. on its books. Evaluate the effect of this prac-
2. Be alert for securitizations that are approach- tice on the bank holding companys earnings
ing early-amortization triggers, such as a and capital adequacy.
decrease in the excess spread below a certain 8. Provide appropriate written documentation
threshold or an increase in delinquencies and recommend that prompt supervisory
beyond a certain rate. action be taken when implicit recourse is
3. Review securitization documents to ensure identified.
that the selling institution limits any post-

Page 6
Securitization Covenants Linked to Supervisory Actions or Thresholds
A bank holding companys board of directors sory information disclosure rules and policies
and senior management are responsible for initi- and may result in follow-up supervisory action.
ating policies and procedures, and for monitor- Because of the supervisory concerns about
ing processes and internal controls, that will covenants that are linked to supervisory actions,
provide reasonable assurance that the bank hold- a federal bank interagency advisory was issued
ing companys contracts and commitments do on May 23, 2002. (See SR-02-14.) The advisory
not include detrimental covenants that affect its emphasizes that a banking organizations man-
safety and soundness. When examiners review a agement and board of directors should ensure
bank holding companys securitization contracts that covenants related to supervisory actions or
and related documentation, they should be alert thresholds are not included in securitization
to any covenants that use adverse supervisory documents. Covenants that provide for the early
actions or the breach of supervisory thresholds termination of the transaction or compel the
as triggers for early-amortization events or the transfer of servicing due, directly or indirectly,
transfer of servicing. Examples of such supervi- to the occurrence of a supervisory action or
sory actions can include a downgrade in the event will be criticized, under appropriate cir-
banking organizations RFI/C(D) or CAMELS cumstances, as an unsafe and unsound banking
rating, an enforcement action, or a downgrade practice. The Federal Reserve (and other super-
in a depository institutions prompt-corrective- visors) may also take other supervisory actions,
action capital category. The inclusion of such as requiring additional capital or denying
supervisory-linked covenants in securitization capital relief for risk-based capital calculations,
documents is considered to be an unsafe and regardless of the treatment under generally
unsound banking practice that undermines the accepted accounting principles (GAAP).
objective of supervisory actions and thresholds. Examiners should consider the potential
An early amortization or transfer of servicing impact of such covenants in existing transac-
triggered by such events can create or exacer- tions when evaluating both the overall condition
bate liquidity and earnings problems for a bank of the bank holding company and the specific
holding company that may lead to further dete- component ratings of capital, liquidity, and man-
rioration in its financial condition. agement. Early-amortization triggers will spe-
Covenants that contain triggers tied, directly cifically be considered in the context of the bank
or indirectly, to supervisory actions or thresh- holding companys overall liquidity position and
olds can also result in the early amortization of a contingency funding plan. For organizations
securitization at a time when the sponsoring with limited access to other funding sources or a
organizations ability to access other funding significant reliance on securitization, the
sources is limited. If an early-amortization event existence of these triggers presents a greater
occurs, investors may lose confidence in the degree of supervisory concern. Any bank hold-
stability of the sponsoring organizations asset- ing company that uses securitization as a fund-
backed securities, thus limiting its ability to ing source should have a viable contingency
raise new funds through securitization. At the funding plan in the event it can no longer access
same time, the organization must fund new the securitization market. Examiners should
receivables on the balance sheet, potentially encourage bank holding company management
resulting in liquidity problems. Moreover, the to amend, modify, or remove covenants linked
existence of a supervisory-linked trigger poten- to supervisory actions from existing transac-
tially could inhibit supervisors from taking tions. Any impediments a bank holding com-
action intended to address problems at a pany may have to taking such actions should be
troubled organization because the action could documented and discussed with the appropriate
trigger an event that worsens its condition or supervisory staff of its responsible Reserve
causes its failure. Bank.
The Federal Reserve is concerned that cov-
enants related to supervisory actions may obli-
gate a bank holding companys management to 2128.05.1 INSPECTION OBJECTIVES
disclose confidential information, such as
RFI/C(D) or CAMELS ratings. Disclosure of 1. During the review of securitization activities
such information by a banking organizations and contracts, to be alert to securitization
directors, officers, employees, attorneys, or in-
dependent auditors, without explicit authoriza- BHC Supervision Manual July 2005
tion by its primary regulator, violates supervi- Page 1
Securitization Covenants Linked to Supervisory Actions or Thresholds 2128.05
documents containing covenants that have 3. If the bank holding company uses securitiza-
triggers tied, directly or indirectly, to supervi- tion as a funding source, determine its over-
sory actions or thresholds. all liquidity position and whether it has an
2. Under appropriate circumstances, to criticize adequate and viable contingency funding
as an unsafe and unsound banking practice plan that can be used if the bank holding
the inclusion of covenants in a securitization- company can no longer access the securitiza-
transaction document when the covenants tion market.
provide for the early termination of the trans- 4. Determine the potential impact of any early-
action or compel the transfer of servicing amortization triggers or transfer of servicing
due, directly or indirectly, to the occurrence within the asset-securitization contracts (any
of a supervisory action or event. covenants that use adverse supervisory
3. To determine if the bank holding company actions or the crossing of supervisory thresh-
has a viable contingency funding plan that it olds as triggers for early-amortization events
can use if it can no longer access the securiti- or the transfer of servicing).
zation market. 5. Encourage bank holding company manage-
ment to amend, modify, or remove from
existing transactions any securitization cov-
2128.05.2 INSPECTION PROCEDURES enants linked to supervisory actions.
6. Report to and consult with Reserve Bank
1. Review a sample of the bank holding compa- supervisory staff on any impediments the
nys securitization contracts and related directors and senior management of the bank
documentation. holding company have to amending, modify-
2. Evaluate the overall condition of the bank ing, or removing any such detrimental securi-
holding company, as well as the specific tization convenants.
component ratings of capital, liquidity, and
management.

Page 2
Valuation of Retained Interests and Risk Management of Securitization
Activities (Risk Management and Internal Controls) Section 2128.06
WHATS NEW IN THIS REVISED ests, for regulatory reporting purposes, should
SECTION not be carried as assets on a BOs books, but
should be charged off. Other supervisory con-
This section has been revised to replace, as cerns include failure to recognize and hold suffi-
appropriate, the references to FAS 125 with cient capital against recourse obligations gener-
either FAS 140 or FAS 157. The Financial ated by securitizations, and the absence of an
Accounting Standards Board (FASB), issued in adequate independent audit function.
September 2000, FAS 140, Accounting for The supervisory guidance focuses on and
Transfers and Servicing of Financial Assets and incorporates important fundamental concepts of
Extinguishments of Liabilities (a replacement of risk-management and risk-focused supervision:
FAS No. 125). FAS 157, Fair Value Measure- active oversight by senior management and the
ments, was issued in September 2006 and was board of directors, the use of effective policies
made effective on November 15, 2007. and limits, accurate and independent procedures
to measure and assess risk, and the maintenance
of strong internal controls.3 The guidance
2128.06.05 RETAINED INTERESTS stresses sound risk-management, modeling,
FROM SECURITIZATION ACTIVITIES valuation, and disclosure practices for asset
securitization; complements previous supervi-
Securitization activities present unique and sory guidance issued on this subject; and supple-
sometimes complex risks that require the atten- ments existing policy statements and
tion of senior management and the board of examination-inspection procedures.4 Emphasis
directors. Retained interests from securitization is placed on the expectation that a BOs
activities, including interest-only strips receiv- securitization-related retained interest must be
able, arise when a banking organization (BO) supported by documentation of the interests
keeps an interest in the assets sold to a securiti- fair value, using reasonable valuation
zation vehicle that, in turn, issues bonds to assumptions that can be objectively verified.
investors.1 Retained interests that lack such objectively
The methods and models BOs use to value verifiable support or that fail to meet these
retained interests and the difficulties in manag- supervisory standards will be classified as loss
ing exposure to these volatile assets can raise and disallowed for inclusion as assets of the BO
supervisory concerns. Under generally accepted for regulatory capital purposes. See SR-99-37
accounting principles (GAAP), a BO recognizes and the more complete text of its referenced
an immediate gain (or loss) on the sale of assets, interagency guidance on the risk mangement
in part, by recording its retained interest at fair and valuation of retained interests arising from
value. The valuation of the retained interest is asset securitization activities. See also SR-03-4
based on the present value of future cash flows and its attachment and section 3071.0.
in excess of the amounts needed to service the Examiners will review a BOs valuation of
bonds and cover credit losses and other fees of retained interests and the concentration of these
the securitization vehicle.2 assets relative to capital. Consistent with exist-
Determinations of fair value should be based ing supervisory authority, BOs may be required,
on reasonable assumptions about factors such as on a case-by-case basis, to hold additional capi-
discount rates, projected credit losses, and pre- tal commensurate with their risk exposures.5 An
payment rates. Bank supervisors expect retained
interests to be supported by verifiable documen- 3. See SR-96-14, Risk-Focused Safety-and-Soundness
tation of fair value in accordance with GAAP. In Examinations and Inspections (section 2124.0 of this
the absence of such support, the retained inter- manual), and SR-95-51, Rating the Adequacy of Risk-
Management Processes and Internal Controls at State Mem-
ber Banks and Bank Holding Companies (section 4070.1 of
1. The term banking organization (BO) refers to any this manual).
federally supervised banking organization. This includes fed- 4. See SR-97-21, Risk Management and Capital
erally insured, federally chartered financial institutions that Adequacy of Exposures Arising from Secondary-Market
are supervised by a federal bank or savings association super- Credit Activities, and SR-96-30, Risk-Based Capital Treat-
visory authority, as well as bank holding companies and their ment for Spread Accounts That Provide Credit Enhancement
nonbank subsidiaries. for Securitized Receivables.
2. See Financial Accounting Standards Board (FASB) 5. For instance, a BO has high concentrations of retained
Statement of Financial Accounting Standard No. 140 (FAS
140), Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities (a replacement of BHC Supervision Manual July 2008
FASB Statement No. 125). Page 1
Valuation of Retained Interests and Risk Management of Securitization Activities 2128.06
excessive dependence on securitizations for day- based on the best information available in the
to-day core funding can present significant circumstances.6 An estimate of fair value must
liquidity problems during times of market turbu- be supported by reasonable and current assump-
lence or if there are difficulties specific to the tions. If a best estimate of fair value is not
BO. practicable, the asset is to be recorded at zero in
financial and regulatory reports. (See FAS 140,
para. 71.)
2128.06.1 ASSET SECURITIZATION Unforeseen market events that affect the dis-
count rate or performance of receivables sup-
Asset securitization typically involves the trans- porting a retained interest can swiftly and dra-
fer of on-balance-sheet assets to a third party or matically alter its value. Without appropriate
trust. In turn, the third party or trust issues internal controls and independent oversight, a
certificates or notes to investors. The cash flow BO that securitizes assets may inappropriately
from the transferred assets supports repayment generate paper profits or mask actual losses
of the certificates or notes. BOs use asset securi- through flawed loss assumptions, inaccurate pre-
tization to access alternative funding sources, payment rates, and inappropriate discount rates.
manage concentrations, improve financial- Liberal and unsubstantiated assumptions can
performance ratios, and more efficiently meet result in material inaccuracies in financial state-
customer needs. Assets typically securitized ments; substantial write-downs of retained inter-
include credit card receivables, automobile ests; and, if retained interests represent an exces-
receivable paper, commercial and residential sive concentration of the sponsoring BOs
first mortgages, commercial loans, home equity capital, the BOs demise. BO managers and
loans, and student loans. directors need to ensure the following:
Senior management and directors must have
the requisite knowledge of the effect of securiti- 1. Independent risk-management processes are
zation on the BOs risk profile and must be fully in place to monitor securitization-pool per-
aware of the accounting, legal, and risk-based formance on an aggregate and individual
capital nuances of this activity. BOs must fully transaction level. An effective risk-
and accurately distinguish and measure the risks management function includes appropriate
that are transferred versus those retained, and information systems to monitor securitiza-
must adequately manage the retained portion. It tion activities.
is essential that BOs engaging in securitization
activities have appropriate front- and back-office 2. Appropriate valuation assumptions and mod-
staffing, internal and external accounting and eling methodologies are used to establish,
legal support, audit or independent review cov- evaluate, and adjust the carrying value of
erage, information systems capacity, and over- retained interests on a regular and timely
sight mechanisms to execute, record, and basis.
administer these transactions correctly. 3. Audit or internal review staffs periodically
Appropriate valuation and modeling method- review data integrity, model algorithms, key
ologies must be used. They must be able to underlying assumptions, and the appropriate-
determine the initial and ongoing value of ness of the valuation and modeling process
retained interests. Accounting rules provide a for the securitized assets the BO retains. The
method to recognize an immediate gain (or loss) findings of such reviews should be reported
on the sale, in part, through booking a retained directly to the board or an appropriate board
interest. The carrying value, however, of that committee.
interest must be fully documented, based on 4. Accurate and timely risk-based capital calcu-
reasonable assumptions, and regularly analyzed lations are maintained, including recognition
for any subsequent impairment in value. The and reporting of any recourse obligation
best evidence of fair value is a quoted market resulting from securitization activity.
price in an active market. When quoted market 5. Internal limits are in place to govern the
prices are not available, accounting rules allow maximum amount of retained interests as a
fair value to be estimated. This estimate must be percentage of total equity capital.
6. A realistic liquidity plan is in place for the
interests relative to its capital or is otherwise at risk from BO in case of market disruptions.
impairment of these assets.

Page 2 6. See FAS 157, Fair Value Measurements.
2128.06.2 INDEPENDENT cover the various risks inherent in securitization

RISK-MANAGEMENT FUNCTION transactions. The absence of quality MIS will
hinder managements ability to monitor specific
BOs engaged in securitizations should have an pool performance and securitization activities.
independent risk-management function com- At a minimum, MIS reports should address
mensurate with the complexity and volume of the following:
their securitizations and their overall risk expo-
sures. The risk-management function should 1. Securitization summaries for each transac-
ensure that securitization policies and operating tion. The summary should include relevant
procedures, including clearly articulated risk transaction terms such as collateral type,
limits, are in place and appropriate for the BOs facility amount, maturity, credit-
circumstances. A sound asset securitization pol- enhancement and subordination features,
icy should include or address, at a minimum financial covenants (termination events and
spread-account capture triggers), right of
1. a written and consistently applied accounting repurchase, and counterparty exposures.
methodology; Management should ensure that the summa-
2. regulatory reporting requirements; ries for each transaction are distributed to all
3. valuation methods, including FAS 157 valua- personnel associated with securitization
tion assumptions, and procedures to formally activities.
approve changes to those assumptions; 2. Performance reports by portfolio and spe-
4. a management reporting process; and cific product type. Performance factors
5. exposure limits and requirements for include gross portfolio yield, default rates
both aggregate and individual transaction and loss severity, delinquencies, prepayments
monitoring. or payments, and excess spread amounts.
The reports should reflect the performance of
It is essential that the risk-management func- assets, both on an individual-pool basis and
tion monitor origination, collection, and default- total managed assets. These reports should
management practices. This includes regular segregate specific products and different mar-
evaluations of the quality of underwriting, keting campaigns.
soundness of the appraisal process, effective- 3. Vintage analysis for each pool using monthly
ness of collections activities, ability of the data. Vintage analysis will help management
default-management staff to resolve severely understand historical performance trends and
delinquent loans in a timely and efficient man- their implications for future default rates,
ner, and the appropriateness of loss-recognition prepayments, and delinquencies, and there-
practices. Because the securitization of assets fore retained interest values. Management
can result in the current recognition of antici- can use these reports to compare historical
pated income, the risk-management function performance trends with underwriting stan-
should pay particular attention to the types, vol- dards, including the use of a validated credit-
umes, and risks of assets being originated, trans- scoring model, to ensure loan pricing is con-
ferred, and serviced. Senior management and sistent with risk levels. Vintage analysis also
the risk-management staff must be alert to any helps in the comparison of deal performance
pressures on line managers to originate abnor- at periodic intervals and validates retained-
mally large volumes or higher-risk assets to interest valuation assumptions.
sustain ongoing income needs. Such pressures 4. Static-pool cash-collection analysis. A static-
can lead to a compromise of credit-underwriting pool cash-collection analysis involves
standards. This may accelerate credit losses in reviewing monthly cash receipts relative to
future periods, impair the value of retained inter- the principal balance of the pool to determine
ests, and potentially lead to funding problems. the cash yield on the portfolio, comparing
The risk-management function should also the cash yield to the accrual yield, and track-
ensure that appropriate management informa- ing monthly changes. Management should
tion systems (MIS) exist to monitor securitiza- compare monthly the timing and amount of
tion activities. Reporting and documentation cash flows received from the trust with those
methods must support the initial valuation of projected as part of the FAS 157 retained-
retained interests and ongoing impairment interest valuation analysis. Some master-trust
analyses of these assets. Pool-performance structures allow excess cash flow to be
information will help well-managed BOs
ensure, on a qualitative basis, that a sufficient BHC Supervision Manual January 2016
amount of economic capital is being held to Page 3
shared between series or pools. For amortization, spread capture, changes to

revolving-asset trusts with this master-trust overcollateralization requirements, and
structure, management should perform a events that would result in servicer removal.
cash-collection analysis for each master-trust
structure. These analyses are essential in
assessing the actual performance of the port-
folio in terms of default and prepayment 2128.06.3 VALUATION AND
rates. If cash receipts are less than those MODELING PROCESSES
assumed in the original valuation of the
retained interest, this analysis will provide The method and key assumptions used to value
management and the board with an early the retained interests and servicing assets or
warning of possible problems with collec- liabilities must be reasonable and fully
tions or extension practices, and impairment documented. The key assumptions in all valua-
of the retained interest. tion analyses include prepayment or payment
5. Sensitivity analysis. A sensitivity analysis rates, default rates, loss-severity factors, and
measures the effect of changes in default discount rates. BOs are expected to take a logi-
rates, prepayment or payment rates, and dis- cal appropriate approach when developing
count rates to assist management in establish- securitization assumptions and capitalizing
ing and validating the carrying value of the future income flows. It is important that
retained interest. Stress tests should be per- management quantifies the assumptions at least
formed at least quarterly. Analyses should quarterly on a pool-by-pool basis and maintains
consider potential adverse trends and deter- supporting documentation for all changes to the
mine best, probable, and worst case assumptions as part of the valuation. Policies
scenarios for each event. Other factors that should define the acceptable reasons for chang-
need to be considered are the impact of ing assumptions and require appropriate
increased defaults on collections staffing, the management approval.
timing of cash flows, spread-account capture An exception to this pool-by-pool valuation
triggers, overcollateralization triggers, and analysis may be applied to revolving-asset trusts
early-amortization triggers. An increase in if the master-trust structure allows excess cash
defaults can result in higher-than-expected flows to be shared between series. In a master
costs and a delay in cash flows, thus decreas- trust, each certificate of each series represents
ing the value of the retained interests. Man- an undivided interest in all of the receivables in
agement should periodically quantify and the trust. Therefore, valuations are appropriate
document the potential impact to both earn- at the master-trust level.
ings and capital, and report the results to the To determine the value of the retained interest
board of directors. Management should at inception, and make appropriate adjustments
incorporate this analysis into their overall going forward, the BO must implement a rea-
interest-rate risk measurement system.7 sonable modeling process to comply with FAS
Examiners will review the BO-conducted 157. Management is expected to employ appro-
analysis and the volatility associated with priate valuation assumptions and projections,
retained interests when assessing the Sensi- and to maintain verifiable objective documenta-
tivity to Market Risk component rating (the tion of the fair value of the retained interest.
S in the CAMELS rating system for banks Senior management is responsible for ensuring
or the M for the BHC rating system8). that the valuation model accurately reflects the
6. Statement of covenant compliance. Ongoing cash flows according to the terms of the securiti-
compliance with deal-performance triggers zations structure. For example, the model
as defined by the pooling and servicing should account for any cash collateral or over-
agreements should be affirmed at least collateralization triggers, trust fees, and
monthly. Performance triggers include early insurance payments if appropriate. The board
and management are accountable for the model
builders possessing the necessary expertise and
7. The Joint Agency Policy Statement on Interest-Rate technical proficiency to perform the modeling
Risk (see SR-96-13 and section 2127.0) advises institutions process. Senior management should ensure that
with a high level of exposure to interest-rate risk relative to
capital that they will be directed to take corrective action.
internal controls are in place to provide for the
8. See sections 4070.0 and 4070.1. ongoing integrity of MIS associated with securi-
tization activities.
BHC Supervision Manual January 2016 As part of the modeling process, the risk-
Page 4 management function should ensure that peri-
odic validations are performed to reduce vulner- Operational and managerial standards have
ability to model risk. Validation of the model been established for internal control and infor-
includes testing the internal logic, ensuring mation systems.9 A system of internal controls
empirical support for the model assumptions, should be maintained that is appropriate to the
and back-testing the models using actual cash BOs size and the nature, scope, and risk of its
flows on a pool-by-pool basis. The validation activities.10
process should be documented to support con-
clusions. Senior management should ensure the
validation process is independent from line 2128.06.6 AUDIT FUNCTION OR
management and from the modeling process. INTERNAL REVIEW
The audit scope should include procedures to
ensure that the modeling process and validation A BOs board of directors is responsible for
mechanisms are both appropriate for the BOs ensuring that its audit staff or independent
circumstances and executed consistent with its review function is competent regarding securiti-
asset securitization policy. zation activities. The audit function should per-
form periodic reviews of securitization activi-
ties, including transaction testing and
2128.06.4 USE OF OUTSIDE PARTIES verification, and report all findings to the board
or appropriate board committee. The audit func-
Third parties are often engaged to provide pro- tion also may be useful to senior management in
fessional guidance and support regarding a BOs identifying and measuring risk related to securi-
securitization activities, transactions, and valu- tization activities. Principal audit targets should
ing of retained interests. The use of outside include compliance with securitization policies,
resources does not relieve directors of their operating and accounting procedures (FAS 140),
oversight responsibility, or relieve senior man- deal covenants, and the accuracy of MIS and
agement of its responsibilities to provide super- regulatory reports. The audit function also
vision, monitoring, and oversight of securitiza- should confirm that the BOs regulatory report-
tion activities, particularly the management of ing process is designed and managed to facili-
the risks associated with retained interests. Man- tate timely and accurate report filing. Further-
agement is expected to have the experience, more, when a third party services loans, the
knowledge, and abilities to discharge its duties auditors should perform an independent verifi-
and understand the nature and extent of the risks cation of the existence of the loans to ensure
retained interests present, and to have the poli- that balances reconcile to internal records.
cies and procedures necessary to implement an
effective risk-management system to control
such risks. Management must have a full under- 2128.06.7 REGULATORY REPORTING
standing of the valuation techniques employed, OF RETAINED INTERESTS
including the basis and reasonableness of under-
lying assumptions and projections. The securitization and subsequent removal of
assets from a BOs balance sheet requires addi-
tional reporting as part of the regulatory report-
2128.06.5 INTERNAL CONTROLS ing process. Common regulatory reporting
errors stemming from securitization activities
Effective internal controls are essential to a may include
BOs management of the risks associated with
securitization. When properly designed and con-
sistently enforced, a sound system of internal 9. See the safety-and-soundness standards for national
controls will help management safeguard the banks at 12 CFR 30 (OCC), and for savings associations at 12
BOs resources; ensure that financial informa- CFR 570 (OTS).
10. BOs that are subject to the requirements of FDIC
tion and reports are reliable; and comply with regulation 12 CFR 363 should include an assessment of the
contractual obligations, including securitization effectiveness of internal controls over their asset securitiza-
covenants. It will also reduce the possibility of tion activities as part of managements report on the overall
significant errors and irregularities, and assist in effectiveness of the system of internal controls over financial
reporting. This assessment implicitly includes the internal
their timely detection. Internal controls typically controls over financial information that is included in regula-
(1) limit authorities; (2) safeguard access to and tory reports.
use of records; (3) separate and rotate duties;
and (4) ensure both regular and unscheduled BHC Supervision Manual July 2008
reviews, including testing. Page 5
1. failure to include off-balance-sheet assets qualitative, of the underlying securitized

subject to recourse treatment when calculat- assets;
ing risk-based capital ratios; 4. the role of retained interests as credit
2. failure to recognize retained interests and enhancements to special-purpose entities and
retained subordinate security interests as a other securitization vehicles, including a dis-
form of credit enhancement; cussion of techniques used for measuring
3. failure to report loans sold with recourse in credit risk; and
the appropriate section of the regulatory 5. sensitivity analyses or stress-testing con-
report; and ducted by the BO, showing the effect of
4. overvaluing retained interests. changes in key assumptions on the fair value
of retained interests.
A BOs directors and senior management are
responsible for the accuracy of its regulatory
reports. Because of the complexities associated 2128.06.9 RISK-BASED CAPITAL FOR
with securitization accounting and risk-based RECOURSE AND LOW-LEVEL-
capital treatment, attention should be directed to RECOURSE TRANSACTIONS
ensuring that personnel who prepare these
reports maintain current knowledge of reporting For regulatory purposes, recourse is generally
rules and associated interpretations. This often defined as an arrangement in which an institu-
will require ongoing support by qualified tion retains the risk of credit loss in connection
accounting and legal personnel. with an asset transfer, if the risk of credit loss
exceeds a pro rata share of its claim on the
assets.11 In addition to broad contractual lan-
2128.06.8 MARKET DISCIPLINE AND guage that may require the seller to support a
DISCLOSURES securitization, recourse can arise from retained
interests, retained subordinated security inter-
Transparency through public disclosure is cru- ests, the funding of cash-collateral accounts, or
cial to effective market discipline and can rein- other forms of credit enhancements that place a
force supervisory efforts to promote high stan- BOs earnings and capital at risk. These
dards in risk management. Timely and adequate enhancements should generally be aggregated
information on the BOs asset securitization to determine the extent of a BOs support of
activities should be disclosed. The information securitized assets. Although an asset securitiza-
in the disclosures should be comprehensive; tion qualifies for sales treatment under GAAP,
however, the amount of disclosure that is appro- the underlying assets may still be subject to
priate will depend on the volume of securitiza- regulatory risk-based capital requirements.
tions and complexity of the BO. Well-informed Assets sold with recourse should generally be
investors, depositors, creditors, and other coun- risk-weighted as if they had not been sold.
terparties can provide a BO with strong incen- Securitization transactions involving recourse
tives for maintaining sound risk-management may be eligible for low-level-recourse treat-
systems and internal controls. Adequate disclo- ment.12 Risk-based capital standards provide
sure allows market participants to better under- that the dollar amount of risk-based capital
stand the BOs financial condition and apply required for assets transferred with recourse
market discipline, creating incentives to reduce should not exceed the maximum dollar amount
inappropriate risk taking or inadequate risk- for which a BO is contractually liable. The
management practices. Examples of sound dis- low-level-recourse treatment applies to transac-
closures include tions accounted for as sales under GAAP in
which a BO contractually limits its recourse
1. accounting policies for measuring retained exposure to less than the full risk-based capital
interests, including a discussion of the requirements for the assets transferred. Under
impact of key assumptions on the recorded the low-level-recourse principle, the BO holds
value; capital on approximately a dollar-for-dollar
2. the process and methodology used to adjust
the value of retained interests for changes in 11. See the risk-based capital treatment for sales with
key assumptions; recourse at 12 CFR 3, appendix A, section (3)(b)(1)(iii)
(OCC), and 12 CFR 567.6(a)(2)(i)(c) (OTS). For a further
3. risk characteristics, both quantitative and explanation of recourse, see the glossary of the Call Report
instructions, Sales of Assets for Risk-Based Capital
BHC Supervision Manual July 2008 Purposes.
Page 6 12. See 60 Fed. Reg. 8177, February 13, 1995 (FRB).
basis up to the amount of the aggregate credit threaten its solvency. A BOs board of directors
enhancements. and management is expected to develop and
If a BO does not contractually limit the maxi- implement policies that limit the amount of
mum amount of its recourse obligation, or if the retained interests that may be carried as a per-
amount of credit enhancement is greater than centage of total equity capital, based on the
the risk-based capital requirement that would results of their valuation and modeling pro-
exist if the assets were not sold, the low-level- cesses. Well-constructed internal limits also
recourse treatment does not apply. Instead, the lessen the incentives for a BOs personnel to
BO must hold risk-based capital against the engage in activities designed to generate near-
securitized assets as if those assets had not been term paper profits that may be at the expense
sold. Retained interests that lack objectively of its long-term financial position and
verifiable support or that fail to meet the super- reputation.
visory standards set forth in this section will be
classified as loss and disallowed as assets of the
BO for regulatory capital purposes. 2128.06.11 INSPECTION OBJECTIVES
1. To determine whether the BOs retained
2128.06.10 CONCENTRATION LIMITS interests from asset securitization are prop-
IMPOSED ON RETAINED INTERESTS erly documented, valued, and accounted for.
2. To verify that the amount of those retained
The creation of a retained interest asset (the interests not supported by adequate docu-
debit) typically also results in an offsetting mentation has been charged off for regula-
gain on sale (the credit). BOs that securitize tory reporting purposes and that the involved
high-yielding assets with long durations may assets are not used for risk-based calculation
create a retained-interest asset value that purposes.
exceeds the risk-based capital charge that would 3. To ascertain the existence of sound risk mod-
be in place if it had not sold the assets (under the eling, management information systems
existing risk-based capital guidelines, capital is (MIS), and disclosure practices for asset
not required for the amount over 8 percent of securitization.
the securitized assets). Serious problems can 4. To obtain assurances that the board of direc-
arise for those BOs that distribute contrived tors and management oversee sound policies
earnings only later to be faced with a downward and internal controls concerning the record-
valuation and charge-off of part or all of the ing and valuation of retained interests
retained interests. derived from asset securitization activities.
As an example, a BO could sell $100 in 5. To determine if liquidity problems may arise
subprime home-equity loans and book a retained as the result of an overdependence on asset
interest of $20 using innapropriate valuation securitization activities for day-to-day core
assumptions. Under the current capital rules, the funding.
BO is required to hold approximately $8 in 6. To determine that sufficient capital is held
capital. This $8 is the current capital require- commensurate with the risk exposures aris-
ment if the loans were never removed from the ing from recourse obligations generated by
balance sheet (8 percent of $100 = $8). How- asset securitizations.
ever, the institution is still exposed to substan- 7. To determine whether there is an indepen-
tially all the credit risk, plus the additional risk dent audit function that is capable of evaluat-
to earnings and capital from the volatility of the ing retained interests involving asset securiti-
retained interest. If the value of the retained zation activities.
interest decreases to $10 due to the inappropri-
ate assumptions or changes in market condi-
tions, the $8 in capital is insufficient to cover the 2128.06.12 INSPECTION
entire loss. PROCEDURES
Normally, the sponsor will eventually receive
any excess cash flow remaining from securitiza- 1. Determine the existence of independent risk-
tions after investor interests have been met. management processes and MIS, and
However, recent experience has shown that whether they are being used to monitor
retained interests are vulnerable to sudden and securitization-pool performance on an aggre-
sizeable write-downs that can hinder a BOs
access to the capital markets; damage its reputa- BHC Supervision Manual July 2008
tion in the marketplace; and, in some cases, Page 7
gate and individual transaction level. and reporting of any recourse obligation
2. Review the MIS reports and determine resulting from securitization activities.
whether the reports provide 6. Ascertain that internal limits govern the
a. securitization summaries for each transac- amount of retained interests held as a per-
tion; centage of total equity capital.
b. performance reports by portfolio and spe- 7. Establish that an adequate liquidity contin-
cific product type; gency plan is in place and that it will be used
c. vintage analysis for each pool using in the event of market disruptions. Determine
monthly data; further whether liquidity problems may arise
d. static-pool cash-collection analysis; as the result of an overdependence on asset
e. sensitivity analysis; and securitization activities for day-to-day core
f. a statement of covenant compliance. funding.
3. Review the BOs valuation assumptions and 8. Determine whether consistent, conservative
modeling methodologies, and determine if accounting practices are in place that satisfy
they are appropriate and are being used to the reporting requirements of regulatory
establish, evaluate, and adjust the carrying supervisors, GAAP reporting requirements,
value of retained interests on a regular and and valuation assumptions and methods.
timely basis. Ascertain that adequate disclosures of asset
4. Determine if audit or internal review staffs securitization activities are made commensu-
periodically review data integrity, model rate with the volume of securitizations and
algorithms, key underlying assumptions, and the complexities of the BO.
the appropriateness of the valuation and 9. Establish that risk-exposure limits and
modeling process for the securitized assets requirements exist and are adhered to on an
that the BO retains. aggregate and individual transaction basis.
5. Review the risk-based capital calculations,
and determine if they include recognition

Page 8
Subprime Lending (Risk Management and
Internal Controls) Section 2128.08
Subprime lending presents unique and signifi- management, and those with inadequate or weak
cantly greater risk to banking organizations controls. The subprime-lending policy state-
(BOs) associated with the activity,1 raising ments are directed primarily to insured deposi-
issues about how well they are prepared to tory institutions and their subsidiaries. As such,
manage and control those risks. Subprime- the guidance applies to bank holding companies
lending institutions need strong risk- with regard to their oversight and supervision of
management practices and internal controls, as insured depository institutions. Bank holding
well as board-approved policies and procedures companies should also consider the statements
that appropriately identify, measure, monitor, guidance as they supervise the lending activities
and control all associated risks. BOs consider- of their nonbanking subsidiaries. Bank holding
ing or engaging in this type of lending should company examiners should consider this guid-
recognize the additional risks inherent in this ance in conjunction with the loan-administration
activity and determine if these risks are accept- and lending-standards inspection guidance in
able and controllable, given their organizations section 2010.2 and with the guidance for asset
financial condition, asset size, level of capital securitization in section 2128.02. The inter-
support, and staff size. agency subprime-lending policy statements are
In response to concerns about subprime lend- described below.
ing, the statement Interagency Guidance on
Subprime Lending was issued on March 1,
1999.2 The statements objective is to increase 2128.08.1 INTERAGENCY GUIDANCE
awareness among examiners and financial insti- ON SUBPRIME LENDING
tutions of some of the pitfalls and hazards of
this type of lending. (See SR-99-06.) Additional Insured depository institutions traditionally
interagency examination guidance was issued avoided lending to customers with poor credit
on January 31, 2001, to further strengthen the histories because of the higher risk of default
supervision of certain institutions, primarily and resulting loan losses. However, some lend-
those institutions having subprime-lending pro- ers5 extend their risk-selection standards to
grams with an aggregate credit exposure equal- attract lower-credit-quality accounts. Moreover,
ing or exceeding 25 percent of their tier 1 capi- previous turmoil in the equity and asset-backed
tal.3 (See SR-01-04.) The aggregate credit securities markets has caused some nonbank
exposure includes principal outstanding and subprime specialists to exit the market, which
committed, accrued and unpaid interest, and any created increased opportunities for financial
retained residual interests4 relating to securi- institutions to enter, or expand their participa-
tized subprime loans. The Federal Reserve may tion in, the subprime-lending business
also apply the additional guidelines to certain The term subprime lending is defined for
smaller subprime portfolios, such as those expe- this statement as extending credit to borrowers
riencing rapid growth or adverse performance who exhibit characteristics indicating a signifi-
trends, those administered by inexperienced cantly higher risk of default than traditional
bank lending customers.6 Subprime borrowers
1. The term banking organizations refers to bank hold- represent a broad spectrum of debtors, ranging
ing companies and their banking and nonbanking subsidiaries. from those who have repayment problems
2. The statement was adopted and issued by the Board of because of an adverse event, such as job loss or
Governors of the Federal Reserve System, the Federal
Deposit Insurance Corporation, the Office of the Comptroller medical emergency, to those who persistently
of the Currency, and the Office of Thrift Supervision. mismanage their finances and debt obligations.
3. The March 1999 and January 2001 subprime-lending Subprime borrowers typically have weakened
interagency guidance is consolidated within this section. To credit histories that include payment delinquen-
focus on the supervisory guidance that applies primarily to
institutions having subprime-lending programs equaling or cies and possibly more severe problems, such as
exceeding 25 percent of tier 1 capital, see the January 2001 charge-offs, judgments, and bankruptcies. They
release specifically. The March 1999 interagency supervisory
guidance applies to all institutions that engage in subprime 5. The terms lenders, financial institutions, and insti-
lending. tutions refer to insured depository institutions and their
4. Residual interests are on-balance-sheet assets that repre- subsidiaries.
sent interests (including beneficial interests) in transferred 6. For purposes of this statement, loans to customers who
financial assets retained by a seller (or transferor) after a are not subprime borrowers are referred to as prime.
securitization or other transfer of financial assets. They are
structured to absorb more than a pro rata share of credit loss
related to the transferred assets through subordination provi- BHC Supervision Manual December 2002
sions or other credit-enhancement techniques. Page 1
Subprime Lending 2128.08
may also display reduced repayment capacity as profitable, provided the price charged by the
measured by credit scores, debt-to-income lender is sufficient to cover higher loan-loss
ratios, or other criteria that may encompass bor- rates and overhead costs related to underwriting,
rowers with incomplete credit histories. Gener- servicing, and collecting the loans. The ability
ally, subprime borrowers will display a range of to securitize and sell subprime portfolios at a
one or more credit-risk characteristics, such profit while retaining the servicing rights has
as made subprime lending attractive to a larger
number of institutions, further increasing the
1. two or more 30-day delinquencies in the last number of subprime lenders and loans. Some
12 months, or one or more 60-day delinquen- financial institutions have experienced losses
cies in the last 24 months; attributable to ill-advised or poorly structured
2. judgment, foreclosure, repossession, or subprime-lending programs. The losses have
charge-off in the prior 24 months; attracted greater supervisory attention to
3. bankruptcy in the last five years; subprime lending and the ability of an insured
4. relatively high default probability as evi- depository institution to manage the unique risks
denced by, for example, a credit bureau risk associated with this activity.
score (FICO) of 660 or below (depending on Institutions should recognize the additional
the product or collateral), or by other bureau risks inherent in subprime lending and deter-
or proprietary scores with an equivalent mine if these risks are acceptable and con-
default-probability likelihood; or trollable given the institutions staff, financial
5. debt-service-to-income ratio of 50 percent or condition, size, and level of capital support.
greater, or an otherwise limited ability to Institutions that engage in a small volume of
cover family living expenses after deducting subprime lending should have systems in place
total monthly debt-service requirements from commensurate with their level of risk.
monthly income.
Subprime loans are loans to borrowers display- 2128.08.1.1 Risk Management

ing one or more of these characteristics at the
time of origination or purchase. The following items are essential components of
a well-structured risk-management program for
This guidance applies to direct extensions of subprime lenders:
credit; the purchase of subprime loans from
other lenders, including delinquent or credit- 1. Planning and strategy. Before engaging in
impaired loans purchased at a discount; the pur- subprime lending, the board and manage-
chase of subprime automobile or other financing ment should ensure that proposed activities
paper from lenders or dealers; and the pur- are consistent with the institutions over-
chase of loan companies that originate subprime all business strategy and risk tolerances,
loans. Subprime lending does not include loans and that all involved parties have properly
to borrowers who have had minor, temporary acknowledged and addressed critical busi-
credit difficulties but are now current. Also, the ness risk issues. These issues include the
subprime-lending guidance does not generally costs associated with attracting and retaining
apply to prime loans that develop credit prob- qualified personnel, investments in the tech-
lems after acquisition; loans initially extended nology necessary to manage a more complex
in subprime programs that are later upgraded, as portfolio, a clear solicitation and origination
a result of their performance, to programs tar- strategy that allows for after-the-fact assess-
geted to prime borrowers; and community ment of underwriting performance, and the
development loans as defined in the Community establishment of appropriate feedback and
Reinvestment Act (CRA) regulations that may control systems. The risk-assessment process
have some higher risk characteristics, but are should extend beyond credit risk and appro-
otherwise mitigated by guarantees from govern- priately incorporate operating, compliance,
ment programs, private credit enhancements, or and legal risks. Finally, the planning process
other appropriate risk-mitigation techniques. should set clear objectives for performance,
Subprime loans command higher interest including the identification and segmentation
rates and loan fees than those offered to of target markets or customers, as well as set
standard-risk borrowers. Subprime loans can be performance expectations and benchmarks
for each segment and the portfolio as a
BHC Supervision Manual December 2002 whole. Institutions establishing a subprime-
Page 2 lending program should proceed slowly and
cautiously into this activity to minimize the g. procedures for separate tracking and
impact of unforeseen personnel, technology, monitoring of loans approved as excep-
or internal-control problems and to deter- tions to stated policy guidelines
mine if favorable initial profitability esti- h. credit-file documentation requirements,
mates are realistic and sustainable. such as applications, offering sheets, loan
2. Staff expertise. Subprime lending requires and collateral documents, financial state-
specialized knowledge and skills that many ments, credit reports, and credit memo-
financial institutions may not possess. Mar- randa to support the loan decision
keting, account-origination, and collections i. a correspondent/broker/dealer approval
strategies and techniques often differ from process, including measures to ensure that
those employed for prime credit; thus, it may loans originated through this process meet
not be sufficient to have the same lending the institutions lending standards
staff responsible for both subprime loans and If the institution elects to use credit scoring
other loans. Additionally, servicing and col- (including applications scoring) for approv-
lecting subprime loans can be very labor als or pricing, the scoring model should be
intensive. If necessary, the institution should based on a development population that cap-
implement programs to train staff. The board tures the behavioral and credit characteristics
should ensure that staff possess sufficient of the subprime population targeted for the
expertise to appropriately manage the risks products offered. Because of the significant
in subprime lending and that staffing levels variance in characteristics between the
are adequate for the planned volume of subprime and prime populations, institutions
subprime activity. The experience, or season- should not rely on models developed solely
ing, of staff and loans should be taken into for products offered to prime borrowers. Fur-
account as performance is assessed over ther, the model should be reviewed fre-
time. quently and updated as necessary to ensure
3. Lending policy. A subprime-lending policy that assumptions remain valid.
should be appropriate to the size and 4. Purchase evaluation. As they evaluate
complexity of the institutions operations expected profits, institutions that purchase
and should clearly state the goals of the subprime loans from other lenders or dealers
subprime-lending program. While not must give due consideration to the cost of
exhaustive, the following lending standards servicing these assets and to the loan losses
should be addressed in any subprime-lending that may be experienced. For instance, some
policy: lenders who sell subprime loans charge bor-
a. types of products offered as well as those rowers high up-front fees, which are usually
that are not authorized financed into the loan. This provides an
b. portfolio targets and limits for each credit incentive for originators to produce a high
grade or class volume of loans with little emphasis on qual-
c. lending and investment authority clearly ity, to the detriment of a potential purchaser.
stated for individual officers, supervisors, Further, subprime loans, especially those pur-
and loan committees chased from outside the institutions lending
d. a framework for pricing decisions and area, are at special risk for fraud or misrepre-
profitability analysis that considers all sentation (that is, the quality of the loan may
costs associated with the loan, including be less than the loan documents indicate).
origination costs, administrative or servic- Institutions should perform a thorough
ing costs, expected charge-offs, and due-diligence review before committing to
capital purchase subprime loans. Institutions should
e. evaluation of collateral and appraisal not accept loans from originators that do not
standards meet their underwriting criteria, and they
f. well-defined and specific underwriting should regularly review loans offered to
parameters (that is, acceptable loan term, ensure that loans purchased continue to meet
debt-to-income ratios, and loan-to-
collateral-value ratios for each credit Guidelines for Real Estate Lending Policies, which establish
grade and a minimum acceptable credit supervisory loan-to-value (LTV) limits on various types of
score) that are consistent with any appli- real estate loans and impose limits on an institutions aggre-
gate investment in loans that exceed the supervisory LTV
cable supervisory guidelines 7 limits. (See 12 C.F.R. 208, appendix C.)
7. Extensions of credit secured by real estate, whether the BHC Supervision Manual December 2002
credit is subprime or otherwise, are subject to the Interagency Page 3
those criteria. Deterioration in the quality of institutions portfolio (for example, by origi-
purchased loans or in the portfolios actual nator, loan-to-value, debt-to-income ratios,
performance versus expectations requires a or credit scores), and assigned staff should
thorough reevaluation of the lenders or deal- produce reports that management can use to
ers who originated or sold the loans, as well evaluate the performance of subprime loans.
as a reevaluation of the institutions criteria The review process should focus on whether
for underwriting loans and selecting dealers performance meets expectations. Institutions
and lenders. Any such deterioration may also then need to consider the source and charac-
highlight the need to modify or terminate the teristics of loans that do not meet expecta-
correspondent relationship or to adjust under- tions and make changes in their underwriting
writing and dealer or lender selection criteria. policies and loan-administration procedures
5. Loan-administration procedures. After to restore performance to acceptable levels.
the loan is made or purchased, loan- When evaluating actual performance
administration procedures should provide for against expectations, it is particularly impor-
the diligent monitoring of loan performance tant that management review credit scoring,
and establish sound collection efforts. To pricing, and ALLL-adequacy models. Mod-
minimize loan losses, successful subprime els driven by the volume and severity of
lenders have historically employed stronger historical losses experienced during an eco-
collection efforts, such as calling delinquent nomic expansion may have little relevance in
borrowers frequently, investing in tech- an economic slowdown, particularly in the
nology (for example, using automatic dialing subprime market. Management should ensure
for follow-up telephone calls on delinquent that models used to estimate credit losses or
accounts), assigning more experienced col- to set pricing allow for fluctuations in the
lection personnel to seriously delinquent economic cycle and are adjusted to account
accounts, moving quickly to foreclose or for other unexpected events.
repossess collateral, and allowing few loan 7. Consumer protection. Institutions that origi-
extensions. This aspect of subprime lending nate or purchase subprime loans must take
is very labor intensive but critical to the special care to avoid violating fair lending
programs success. To a large extent, the cost and consumer protection laws and regula-
of such efforts can be a tradeoff with future tions. Higher fees and interest rates com-
loss expectations, when an institution ana- bined with compensation incentives can fos-
lyzes the profitability of subprime lending ter predatory pricing or discriminatory
and assesses its appetite to expand or con- steering of borrowers to subprime prod-
tinue this line of business. Subprime-loan- ucts for reasons other than the borrowers
administration procedures should be in writ- underlying creditworthiness. An adequate
ing and at a minimum should detail compliance-management program must iden-
a. billing and statement procedures; tify, monitor, and control the consumer pro-
b. collection procedures; tection hazards associated with subprime
c. content, format, and frequency of manage- lending.
ment reports; Subprime mortgage lending may trigger
d. asset-classification criteria; the special protections of the Home Owner-
e. methodology to evaluate the adequacy of ship and Equity Protection Act of 1994, sub-
the allowance for loan and lease losses title B of title I of the Riegle Community
(ALLL); Development and Regulatory Improvement
f. criteria for allowing loan extensions, Act of 1994. This act amended the Truth in
deferrals, and re-agings; Lending Act to provide certain consumer
g. foreclosure and repossession policies and protections in transactions involving a class
procedures; and of nonpurchase, closed-end home mortgage
h. loss-recognition policies and procedures. loans. Institutions engaging in this type of
6. Loan review and monitoring. Once an institu- lending must also be thoroughly familiar
tion books the loans, designated staff must with the obligations set forth in Regulation Z
perform an ongoing analysis of subprime (12 C.F.R. 226.32), Regulation X, and the
loans, not only on an aggregate basis but also Real Estate Settlement Procedures Act
for subportfolios. Information systems (RESPA) (12 U.S.C. 2601) and should adopt
should be in place to segment and stratify the policies and implement practices that ensure
compliance.
BHC Supervision Manual December 2002 The Equal Credit Opportunity Act makes
Page 4 it unlawful for a creditor to discriminate
against an applicant on a prohibited basis alternate funding sources, and measures for
regarding any aspect of a credit transaction. raising additional capital.
Similarly, the Fair Housing Act prohibits dis- Institutions should refer to the Statement
crimination in connection with residential of Financial Accounting Standards No. 140
real estaterelated transactions. Loan officers (FAS 140), Accounting for Transfers and
and brokers must treat all similarly situated Servicing of Financial Assets and Extin-
applicants equally and without regard to any guishments of Liabilities, for guidance on
prohibited-basis characteristic (for example, accounting for these transactions. If a securi-
race, sex, or age). This is especially impor- tization transaction meets FAS 140 sale or
tant with respect to how loan officers or servicing criteria, the seller must recognize
brokers assist customers in preparing their any gain or loss on the sale of the pool
applications or otherwise help them to immediately and carry any retained interests
qualify for loan approval. in the assets sold (including servicing rights/
8. Securitization and sale. To increase their obligations and interest-only strips) at fair
loan-production and -servicing income, some value. Management should ensure that the
subprime lenders originate loans and then key assumptions used to value these retained
securitize and sell them in the asset-backed interests are reasonable and well supported,
securities market. Strong demand from both for the initial valuation and for subse-
investors and favorable accounting rules quent quarterly revaluations. In particular,
often allow securitization pools to be sold management should consider the appropriate
at a gain, providing further incentive for discount rates, credit-loss rates, and prepay-
lenders to expand their subprime-lending ment rates associated with subprime pools
program. However, the securitization of when valuing these assets. Since the relative
subprime loans carries inherent risks, includ- importance of each assumption varies with
ing interim credit risk and liquidity risk, the underlying characteristics of the product
that are potentially greater than those types, management should segment securi-
for securitizing prime loans. Accounting for tized assets by specific pool, as well as by
the sale of subprime pools requires assump- predominant risk and cash-flow characteris-
tions that can be difficult to quantify, and tics, when making the underlying valuation
erroneous assumptions could lead to the sig- assumptions. In all cases, however, institu-
nificant overstatement of an institutions tions should take a conservative approach
assets. Moreover, the practice of providing when developing securitization assumptions
support and substituting performing loans for and capitalizing expected future income from
nonperforming loans to maintain the desired subprime lending pools. Institutions should
level of performance on securitized pools has also consult with their auditors as necessary
the effect of masking credit-quality to ensure their accounting for securitizations
problems. is accurate.
Institutions should recognize the volatility 9. Reevaluation. Institutions should periodically
of the secondary market for subprime loans evaluate whether the subprime-lending pro-
and the significant liquidity risk incurred gram has met profitability, risk, and perfor-
when originating a large volume of loans mance goals. Whenever the program falls
intended for securitization and sale. Investors short of original objectives, an analysis
can quickly lose their appetite for risk in an should be performed to determine the cause,
economic downturn or when financial mar- and the program should be modified appro-
kets become volatile. As a result, institutions priately. If the program falls far short of
that have originated, but have not yet sold, the institutions expectations, management
pools of subprime loans may be forced to sell should consider terminating it. Questions that
the pools at deep discounts. If an institution management and the board need to ask may
lacks adequate personnel, risk-management include the following:
procedures, or capital support to hold a. Have cost and profit projections been
subprime loans originally intended for sale, met?
these loans may strain an institutions liquid- b. Have projected loss estimates been
ity, asset quality, earnings, and capital. Con- accurate?
sequently, institutions actively involved in c. Has the institution been called upon to
the securitization and sale of subprime loans provide support to enhance the quality
should develop a contingency plan that
addresses back-up purchasers of the securi- BHC Supervision Manual December 2002
ties or the attendant servicing functions, Page 5
and performance of loan pools it has transaction-level testing and portfolio-level

securitized? reviews should be incorporated into the conclu-
d. Were the risks inherent in subprime lend- sions about overall asset quality, the adequacy
ing properly identified, measured, moni- of the ALLL and capital, and the adequacy of
tored, and controlled? portfolio risk-management practices.
e. Has the program met the credit needs of
the community that it was designed to
address? 2128.08.1.2.1 Transaction-Level Testing
Subprime-loan portfolios contain elevated risks,
2128.08.1.2 Examination Review and and actual subprime-lending practices often can
Analysis deviate from stated policy and procedural guid-
ance. Therefore, examiners should supplement
The following supervisory guidance (up to the the portfolio-level examination procedures with
inspection objectives) applies only to the exami- transaction-level testing to determine whether
nation of a bank holding companys federally
insured subsidiary banks that have subprime- 1. individual loans adhere to existing policy,
lending programs equaling or exceeding 25 per- underwriting, risk-selection, and pricing
cent of tier 1 capital and to those insured banks standards;
that have other designated subprime programs 2. individual loans and portfolios are classified
referenced in SR-01-4. in accordance with the subprime-lending
The heightened risk levels and potential vola- guidelines described in this section, or in
tility in delinquency and loss rates posed by other Federal Reserve credit-extending
subprime-lending programs warrant examiners supervisory guidance;
increased ongoing attention. The risks inherent 3. management, board, and regulatory reporting
in subprime-lending programs call for frequent is accurate and timely;
reviews. There are generally two levels of 4. existing loans conform to specified account-
review appropriate for subprime activities: management standards (such as over-limits,
line increases, reductions, cancellations,
1. Portfolio-level reviews include assessments re-scoring, or collections);
of underwriting standards, marketing prac- 5. key risk controls and control processes are
tices, pricing, management information and adequate and functioning as intended;
control systems (quality control, audit and 6. roll rates and other loss-forecasting methods
loan review, vendor management, compli- used to determine ALLL levels are accurate
ance), portfolio performance, and the appro- and reliable; and
priate application of regulatory and internal 7. lending practices exist that may appear
allowance and capital policies. unsafe, unsound, or abusive and unfair.
2. Transaction-level testing includes the testing
of individual loans for compliance with
underwriting and loan-administration guide- 2128.08.1.3 Adequacy of the ALLL
lines; the appropriate treatment of loans
under delinquency, re-aging, and cure pro- Examiners should assess the adequacy of the
grams; and the appropriate application of ALLL to ensure that the portion allocated to the
regulatory and internal allowance and capital subprime portfolio is sufficient to absorb esti-
policies. mated credit losses for this portfolio. Consistent
with interagency policy,8 the term estimated
Examiners should perform a portfolio-level credit losses means an estimate of the amount
review and some transaction testing at each that is not likely to be collected; that is, net
institution engaged in subprime lending, during charge-offs that are likely to be realized given
each regularly scheduled examination cycle. the facts and circumstances as of the evaluation
The Federal Reserve will perform regular off- date.9 These estimated losses should meet the
site supervisory monitoring and may require
subprime lenders to supply supplementary infor- 8. The Interagency Policy Statement on the Allowance for
mation about their subprime portfolios between Loan and Lease Losses was issued December 21, 1993, and
the ALLL methodologies and documentation standards were
examinations. The examiners findings from issued July 2, 2001.
9. Estimates of credit losses should include accrued inter-
BHC Supervision Manual December 2002 est and other accrued fees (for example, uncollected credit
Page 6 card fees or uncollected late fees) that have been added to the
criteria for accrual of loss contingency, as set account-management practices, and current eco-
forth under generally accepted accounting prin- nomic or business conditions that may alter
ciples (GAAP), consistent with supervisory such experience. The allowance should repre-
ALLL policy. sent a prudent, conservative estimate of losses
that allows a reasonable margin for imprecision.
Institutions should clearly document loss esti-
mates and the allowance methodology in writ-
2128.08.1.3.1 New Entrants to the ing. This documentation should describe the
Business analytical process used, including
In some instances, an institution (for example, a
1. portfolio-segmentation methods applied;
newly chartered institution or an existing institu-
2. loss-forecasting techniques and assumptions
tion entering the subprime-lending business)
employed;
may not have sufficient previous loss experience
3. definitions of terms used in ratios and model
to estimate an allowance for subprime-lending
computations;
activities. In such cases, industry statistics or
4. relevance of the baseline loss information
another institutions loss data for similar loans
used;
may be a better starting point to determine the
5. rationale for adjustments to historical experi-
ALLL than the institutions own data for devel-
ence; and
oping loss rates. When an institution uses loss
6. a reconciliation of forecasted loss rates to
rates developed from industry statistics or from
actual loss rates, with significant variances
other institutions to determine its ALLL, it
explained.
should demonstrate and document that the
attributes of the loans in its portfolio or portfolio
segment are similar to those in the other institu-
tions (or industrys) portfolio. 2128.08.1.4 Classification Guidelines for
Subprime Lending
2128.08.1.3.2 Pools of Subprime Well-managed subprime lenders should recog-

LoansNot Classified nize the heightened loss characteristics in their
portfolios and internally classify their delin-
The ALLL required for subprime loans should quent accounts well before the time frames out-
be sufficient to absorb at least all estimated lined in the retail classification policy issued by
credit losses on outstanding balances over the the Federal Financial Institutions Examination
current operating cycle, typically 12 months. Council (FFIEC) on June 12, 2000. Examiners
The board of directors and management are should classify subprime loans and portfolios in
expected to ensure that the institutions process accordance with the guidelines in this section
for determining an adequate level for the ALLL and other applicable Federal Reserve supervi-
is based on a comprehensive and adequately sory guidelines. Classified loans are loans that
documented analysis of all significant factors. are not protected adequately by the current
The consideration factors should include histori- sound worth and paying capacity of the bor-
cal loss experience, ratio analysis, peer-group rower or the collateral pledged. As such, full
analysis, and other quantitative analysis as a liquidation of the debt may be in jeopardy. Pools
basis for the reasonableness of the ALLL. To of classified subprime loans (to include, at a
the extent that the historical net charge-off rate minimum, all loans past due 90 days or more)
is used to estimate expected credit losses, it should be reviewed for impairment, and an
should be adjusted for changes in trends, condi- adequate allowance should be established con-
tions, and other relevant factors, including busi- sistent with existing interagency policy.
ness volume, underwriting, risk selection,
loan balances and, as a result, that are reported as part of the

institutions loans on the balance sheet. An institution may 2128.08.1.4.1 Individual Loans
include these types of estimated losses in either the ALLL or a
separate valuation allowance, which would be netted against Examiners should not automatically classify or
the aggregated loan balance for regulatory reporting purposes. place loans in special mention merely because
When accrued interest and other accrued fees are not added to
the loan balances and are not reported as part of loans on the
they are subprime. Rather, classifications should
balance sheet, the collectibility of these accrued amounts
should nevertheless be evaluated to ensure that the institu- BHC Supervision Manual December 2002
tions income is not overstated. Page 7
reflect the borrowers capacity and willingness 2128.08.1.5 Required Documentation for
to repay and the adequacy of collateral pledged. Cure Programs
Loans to borrowers that do not have the capac-
ity to service their loans generally will be classi- Cure programs, including such practices as
fied substandard. When repayment capacity is re-aging, extensions, renewals, rewrites, or other
insufficient to support the orderly liquidation of types of account restructuring, are subject to the
the debt, and the collateral pledged is insuffi- standards outlined in the retail classification pol-
cient to mitigate risk of loss, then a more severe icy. In accordance with that policy, cure pro-
classification and nonaccrual is warranted. grams should be used only when the institution
Subprime loans that are past due 90 days or has substantiated the customers renewed will-
more should be classified at least substandard ingness and ability to repay. Examiners will
based on a reasonable presumption that their expect institutions to maintain documentation
past-due status indicates an inadequate capacity supporting their analysis of the customers
or unwillingness to repay. A more stringent renewed ability and willingness to repay the
classification approach may be appropriate loan at the time it is extended, renewed, or
based on the historical loss experience of a deferred. When the institution cannot demon-
particular institution. Classification of other strate both the willingness and ability of the
subprime loans as doubtful or loss will be based customer to repay, the loan should not be
on examiners analysis of the borrowers capac- renewed, extended, deferred, or rewritten, and
ity to repay, and on the quality of institution the loan should be moved back to its pre-cure
underwriting and account-management practices delinquency status. Documentation should
as evidenced in the loan file or by other include one or more of the following:
documentation.
In some cases, the repayment of principal, 1. a new verification of employment
interest, and fees on some subprime loans may 2. a recomputed debt-to-income ratio indicating
be overly dependent on collateral pledged. This sufficient improvement in the borrowers
occurs when the risk of default is so high that an financial condition to support orderly
abundance of collateral is taken to mitigate risk repayment
of loss in the event of default. From a safety- 3. a refreshed credit score or updated bureau
and-soundness perspective, institutions should report
be discouraged from lending solely on the basis 4. a file memo evidencing discussion with the
of collateral pledged. Such loans will generally customer
be classified substandard. Further, when the bor-
rower does not demonstrate the capacity to ser- When documentation of the customers renewed
vice the loan from sources other than collateral willingness and ability to repay the loan is
pledged, the loan may be placed on nonaccrual. absent or deficient, management practices
should be criticized.
2128.08.1.4.2 Portfolios
2128.08.1.6 Predatory or Abusive
When the portfolio review or loan sample indi- Lending Practices
cates serious concerns with credit-risk selection
practices, underwriting standards, or loan qual- The term subprime is often misused to refer
ity, examiners should consider classifying or to certain predatory or abusive lending prac-
criticizing the entire portfolio or segments of the tices. Lending practices can be designed to
portfolio. Such a decision may be appropriate in responsibly provide service to customers and
cases where risk is inordinately high or delin- enhance credit access for borrowers with special
quency reports reflect performance problems. credit needs. Subprime lending that is appropri-
Some subprime-lending portfolios may pose ately underwritten, priced, and administered can
very high risk. These may include portfolios of serve these goals.
unsecured loans or secured, high loan-to-value Some forms of subprime lending may be abu-
loans to borrowers who clearly exhibit inad- sive or predatory, however. Lending practices
equate capacity to repay the debt in a reasonable may be designed to transfer wealth from the
time frame. Most such portfolios should be clas- borrower to the lender or loan originator with-
sified at least substandard. out a commensurate exchange of value. This is
sometimes accomplished when the lender struc-
BHC Supervision Manual December 2002 tures a loan to a borrower who has little or no
Page 8 ability to repay the loan from sources other than
the collateral pledged. When default occurs, the An institutions overall capital adequacy will be
lender forecloses or otherwise takes possession evaluated on a case-by-case basis through
of the borrowers property (generally the bor- on-site examinations and off-site monitoring
rowers home or automobile). In other cases, the procedures, considering, among other factors,
lender may use the threat of foreclosure or the institutions own documented analysis of the
repossession to induce duress on the borrower capital needed to support subprime lending.
for payment. Typically, predatory lending Institutions that are determined to have insuffi-
involves at least one, and perhaps all three, of cient capital must correct the deficiency within a
the following elements: reasonable time frame or be subject to supervi-
sory action. In light of the higher risks associ-
1. making unaffordable loans based on the ated with this type of lending, higher minimum-
assets of the borrower rather than on the capital requirements may be imposed on
borrowers ability to repay an obligation institutions engaging in subprime lending.
2. inducing a borrower to refinance a loan The sophistication of this analysis should be
repeatedly in order to charge high points and commensurate with the size, concentration level,
fees each time the loan is refinanced (that is, and relative risk of the institutions subprime-
loan flipping) lending activities and should consider the fol-
3. engaging in fraud or deception to conceal the lowing elements:
true nature of the loan obligation or ancillary
products from an unsuspecting or unsophisti- 1. portfolio-growth rates
cated borrower 2. trends in the level and volatility of expected
losses
Loans to borrowers who do not demonstrate 3. the level of subprime-loan losses incurred
the capacity to repay the loan, as structured, over one or more economic downturns, if
from sources other than the collateral pledged such data or analyses are available
are generally considered unsafe and unsound. 4. the impact of planned underwriting or mar-
Such lending practices should be criticized in keting changes on the credit characteristics
the examination report as imprudent. Further, of the portfolio, including the relative levels
examiners should refer any loans with the afore- of risk of default, loss in the event of
mentioned characteristics to Federal Reserve default, and the level of classified assets
consumer compliance/fair lending specialists for 5. any deterioration in the average credit qual-
additional review. ity over time due to adverse selection or
retention
6. the amount, quality, and liquidity of collat-
2128.08.1.7 Capitalization eral securing the individual loans
7. any asset, income, or funding-source
The Federal Reserves minimum capital require- concentrations
ments generally apply to portfolios that exhibit 8. the degree of concentration of subprime
substantially lower risk profiles than those that credits
exist in subprime-loan programs. Therefore, 9. the extent to which current capitalization
these requirements may not be sufficient to consists of residual assets or other poten-
reflect the risks associated with subprime port- tially volatile components
folios. 10. the degree of legal or reputation risk associ-
Subprime-lending activities can present a ated with the subprime business lines
greater-than-normal risk for financial institu- pursued
tions and the deposit insurance funds; therefore, 11. the amount of capital necessary to support
the level of capital institutions need to support the institutions other risks and activities
this activity should be commensurate with the
additional risks incurred. Each subprime lender Given the higher risk inherent in subprime-
is responsible for quantifying the amount of lending programs, examiners should reasonably
capital needed to offset the additional risk in expect, as a starting point, that an institution
subprime-lending activities and for fully docu- would hold capital against such portfolios in an
menting the methodology and analysis support- amount that is one and one-half to three times
ing the amount specified. greater than what is appropriate for non-
The amount of additional capital necessary subprime assets of a similar type. Refinements
will vary according to the volume and type of
subprime activities conducted and the adequacy BHC Supervision Manual December 2002
of the institutions risk-management program. Page 9
should depend on the factors analyzed above, and easily understood by the institutions
with particular emphasis on the trends in the board and senior management;
level and volatility of loss rates, and on the 2. the inputs are reliable and relate directly to
amount, quality, and liquidity of collateral the subject portfolios (for example, baseline
securing the loans. Institutions should have capi- loss history or default probabilities should
tal ratios that are well above the averages for reflect each segment of the institutions port-
their traditional peer groups or other similarly folio and not just a blend of prime and
situated institutions that are not engaged in subprime borrowers);
subprime lending. 3. assumptions are well documented and con-
Some subprime asset pools warrant increased servative; and
supervisory scrutiny and monitoring, but not 4. any models are subject to a comprehensive
necessarily additional capital. For example, validation process.
well-secured loans to borrowers who are slightly
below what is considered prime quality may The results of the stress-test exercises should be
entail minimal additional risks compared with a documented factor in the analysis and determi-
prime loans, and they may not require additional nation of capital adequacy for the subprime
capital if adequate controls are in place to portfolios.
address the additional risks. On the other hand, Institutions that engage in subprime-lending
institutions that underwrite higher-risk subprime programs without adequate procedures to esti-
pools, such as unsecured loans or high loan-to- mate and document the level of capital neces-
value second mortgages, may need significantly sary to support their activities should be criti-
higher levels of capital, perhaps as high as cized. Where capital is deemed inadequate to
100 percent of the loans outstanding, depending support the risk in subprime-lending activities,
on the level and volatility of risk. examiners should consult with their Reserve
Bank supervisory official to determine the
appropriate course of action. Such actions may
2128.08.1.7.1 Stress Testing include requiring additional capital in accor-
dance with the Federal Reserves capital
An institutions capital adequacy analysis adequacy rules or requiring the institution to
should include stress testing as a tool for esti- submit an acceptable capital plan in accordance
mating unexpected losses in its subprime- with safety-and-soundness guidelines.
lending pools. Institutions should project the
performance of their subprime-loan pools under
conservative stress-test scenarios, including an
estimation of the portfolios susceptibility to 2128.08.1.8 Subprime-Lending Examiner
deteriorating economic, market, and business Responsibilities
conditions. Portfolio stress testing should
include shock testing of basic assumptions, Using the interagency guidance and any supple-
such as delinquency rates, loss rates, and recov- mental Federal Reserve guidelines, examiners
ery rates on collateral. Stress tests should also should assess carefully managements ability to
consider other potentially adverse scenarios, administer the higher risk in subprime port-
such as changing attrition or prepayment rates; folios. The examiner should judge manage-
changing utilization rates for revolving prod- ments ability to manage the risk involved in the
ucts; changes in credit score distribution; and subprime-lending program, in particular, the
changes in the capital-market demand for whole quality of the risk-management and control pro-
loans or asset-backed securities supported by cesses in place, and more importantly, the extent
subprime loans. These are representative to which management is adhering to those pro-
examples; actual factors will vary by product, cesses. When examiners determine that risk-
market segment, and the size and complexity of management practices are deficient, they should
the portfolio relative to the institutions overall criticize management and initiate corrective
operations. Whether stress tests are performed action. Such actions may include formal or
manually, or through automated modeling tech- informal enforcement actions or a plan to
niques, it is expected that achieve adequate capitalization. When a pri-
mary supervisor determines that an institutions
1. the process is clearly documented, rational, risk-management practices are materially defi-
cient, the primary supervisor may instruct the
BHC Supervision Manual December 2002 institution to discontinue its subprime-lending
Page 10 programs.
2128.08.1.9 AppendixQuestions and weakened credit histories. Such products often

Answers for Examiners Regarding the differ substantially in pricing and terms from
Expanded Guidance for products offered to prime borrowers, and they
Subprime-Lending Programs usually have separate and distinctly different
underwriting standards. An institution offering a
To assist examiners who review subprime- product that attracts a disproportionate number
lending activities, the following questions and of borrowers with weakened credit histories
answers were developed to provide additional likely has a subprime program whether or not
guidance on the expanded interagency guidance the activity is called a subprime program. The
that was issued on January 31, 2001. guidance will apply to these programs when the
resultant aggregate credit exposure is at least
25 percent of the institutions tier 1 capital.
2128.08.1.9.1 Applicability of the Institutions with significant programs are
Guidance expected to have the necessary risk-management
and internal-control systems in place to properly
Question 1: Does the guidance apply to all identify, measure, monitor, and control the
institutions? inherent risks in their subprime portfolios. Risk
management and controls for these programs
No. The guidance will not affect the vast major- typically involve enhanced performance moni-
ity of insured institutions engaged in traditional toring, intensive collection activities, and other
consumer lending. The guidance applies to insti- loss-mitigation strategies. If an institution sys-
tutions that systematically target the subprime tematically targets the subprime market but does
market through programs that employ tailored not segregate these loans from its prime port-
marketing, underwriting standards, and risk folio, it is doubtful that the institution has the
selection. necessary risk-management and control systems
The guidance does not address traditional in place to safely engage in the activity.
consumer lending that has historically been the
mainstay of community banking. It does not
apply to institutions extending credit to 2128.08.1.9.2 Subprime Characteristics
subprime borrowers as part of their standard
community-lending process, or making loans to Question 3: Why does the Expanded Guidance
subprime borrowers as an occasional exception for Subprime Lending Programs use a credit
to a prime-lending program, even if the aggre- bureau risk score (FICO) of 660 as a cutoff
gate of these loans totals more than 25 percent point for subprime lending?
of tier 1 capital. Such institutions continue to be
subject to the normal supervisory process. The guidance does not use credit scores, or any
Institutions engaging in subprime-lending other single risk factor, as a definitive cutoff
programs generally have knowingly and pur- point for subprime lending. The characteristics
posefully focused on the subprime-lending mar- listed are not explicit, bright-line definitions.
kets through planned business strategies, tai- The range of credit characteristics used to
lored products, and explicit borrower targeting. describe subprime borrowers is intended to help
In instances where significant exposures to examiners identify lenders that are engaged in
subprime borrowers are identified, examiners subprime-lending programs. These characteris-
should consider the institutions marketing pro- tics describe borrowers with varying, but signifi-
gram, loan products, pricing, underwriting stan- cantly higher, probabilities of default than prime
dards and practices, and portfolio performance borrowers. The guidance states that this list is
to determine if the institution has a program that illustrative rather than exhaustive and is not
warrants the supervision and safeguards out- meant to define specific parameters for all
lined in the guidance. borrowers.
A credit bureau score of 660 (FICO) is used
Question 2: Does the guidance apply when an only as an example to illustrate a credit score
institution offers a product that attracts a dis- that generally indicates a higher default prob-
proportionate number of subprime borrowers, ability. The guidance indicates the probability of
but which the institution does not explicitly iden- default, as evidenced by the credit score, will
tify as subprime? vary by product and collateral. The subprime
A subprime program commonly features prod- BHC Supervision Manual December 2002
ucts specifically tailored to borrowers with Page 11
guidance lists several characteristics that denote sional delinquencies and minor charge-offs
a higher probability of default. Examiners are on revolving debt, static pool net losses of
directed to use these characteristics as a starting 3.1 percent to 7.5 percent, and FICO credit
point to expand their review of lending pro- scores ranging from 620679.12
grams targeting subprime borrowers in accor- 4. Freddie Mac has used the FICO score of 660
dance with risk-focused examination proce- or below to designate higher-risk borrowers
dures. The severity of risk may vary requiring more comprehensive review. Fred-
significantly for the different characteristics die Mac views a score in the 620660 range
listed, as well as for the type and quality of as an indication that the borrowers willing-
collateral. Examiners should take this into con- ness to repay debt as agreed is uncertain.
sideration when reviewing the portfolio and FICO scores below 620 are placed in the
determining the adequacy of loan-loss reserves cautious-review category, and Freddie
and capital. Mac considers scores below 620 as a strong
The characteristics used in the guidance are indication that the borrowers credit reputa-
well recognized in the investment and lending tion is not acceptable...13
industries. A number of public debt rating agen-
cies and financial institutions, including the
government-sponsored enterprises (GSEs), use 2128.08.1.9.3 Capital Guidance
similar credit characteristics to differentiate risk
among borrowers. Specific examples include the Question 4: If an institution is engaged in
following: subprime lending as described by the guidance,
does the 1.5-to-3-times capital described in the
1. Fitch defines a subprime borrower as ...one guidance automatically apply?
with a credit profile worse than that of a
prime A quality borrower, whose credit No. The expanded interagency guidance on
report would typically reveal no recent mort- subprime lending is flexible examination guid-
gage delinquencies and whose credit profile ance; the capital range does not automatically
would yield a credit score in the range above apply because the guidance is not a capital rule
680. Fitchs mortgage credit grade matrix or regulation. Rather, the guidance describes an
lists the following credit-history elements for expectation that subprime lenders hold sufficient
A- the highest subprime grade: one 30-day loan-loss reserves and capital to offset the addi-
delinquency in the last 12 months on a mort- tional risks that may exist in subprime activities.
gage debt; one 30-day delinquency in the last The agencies expect institutions to have meth-
24 months on installment debt, or two 30- odologies and analyses in place to support and
day delinquencies in the last 24 months on document the level of reserves and capital
revolving debt; bankruptcy in past five years; needed for the additional risks assumed. The
chargeoff or judgments exceeding $500 in higher the risk, the more reserves and capital
the past 24 months; and/or a debt-to-income needed to support the activity. Institutions with
ratio of 45 percent.10 lower-risk subprime portfolios may not need
2. Standard & Poors subprime-mortgage additional reserves and capital. In addition,
underwriting guidelines define subprime A- examiners are reminded that subprime lending
characteristics as two or more 30-day is only one element in the evaluation of the
delinquencies on mortgage and consumer institutions overall capital adequacy. If the
credit, one 60-day delinquency on consumer analysis shows that the institution has adequate
credit, debt-to-income ratio of 45 percent, capital for all its assets and activities, including
and no bankruptcy in the past five years. subprime lending, there is no additional capital
Standard & Poors also ...considers requirement arising from the guidance.
subprime borrowers to have a FICO credit Examiners are instructed not to unilaterally
score of 659 or below.11 require additional reserves and capital based on
3. Standard & Poors has classified nonprime B the guidance. Any determination made by an
auto securitization pools as having occa- examiner that an institutions reserves or capital
are deficient will be discussed with the institu-
10. Fitch IBCA, Duff & Phelps, Rating U.S. Residential
Subprime Mortgage Securities, March 16, 2001: 2.
12. Standard & Poors, Auto Loan Criteria and Market
11. Standard & Poors, U.S. Residential Subprime Mort-
Overview 1998, Structured Finance Ratings Asset-Backed
gage Criteria, Structured Finance, 1999: 12, 169.
Securities, 6.
13. Freddie Mac, Single-Family Seller/Servicer Guide,
BHC Supervision Manual December 2002 chapter 37, section 37.6, Using FICO Scores in Underwrit-
Page 12 ing, March 7, 2001.
tions management and with each agencys ing companys overall business strategy and
appropriate supervisory office before a final risk tolerances, and that critical business
decision is made. risks have been identified and considered.
2. Assess whether the bank holding company
Question 5: Are the regulatory expectations for has the financial capacity, including capital
higher capital levels consistent with capital lev- adequacy, to conduct the high-risk activity
els supporting subprime assets outside the of subprime lending safely, without any
insured banking industry? undue concentrations of credit.
3. Ascertain if management has committed the
Yes. The regulatory expectations of higher capi- necessary resources, including, in particu-
tal maintenance are consistent with expectations lar, technology and skilled personnel, to
in the capital markets. The 1.5-to-3-times- manage and control the risks associated
capital multiple is risk based, for example, the with the volume and complexity of the bank
level of additional capital varies by relative loan holding companys subprime-lending
quality and is applied only to the subprime programs.
portfolio, not the institutions entire asset struc- 4. Determine whether the bank holding com-
ture. This is consistent with the financial market- panys contingency plans (including those
places assessment of relative risk in subprime of its banking and nonbanking subsidiaries)
assets outside the banking industry. For exam- are adequate to address alternative funding
ple, the amount of credit enhancement required sources, including back-up purchasers of
for subprime securitization structures varies any subprime loanbacked securities issued
according to the level and volatility of perceived by the bank holding company or of the
credit risk in the underlying assets. In addition, attendant servicing functions, and methods
publicly traded subprime-finance companies of raising additional capital during an eco-
(that are not currently suffering from adverse nomic downturn or when financial markets
ratings) maintain equity-capital-to-managed- become volatile.
asset ratios that are 1.5 to as much as 6 times 5. Determine if management has established
(depending on loan type and relative quality) adequate lending standards that are appro-
those of finance companies that do not special- priate for the size and complexity of the
ize in subprime loans. bank holding companys operations, includ-
ing those of its subsidiaries, and if manage-
ment is maintaining proper controls over
2128.08.2 INSPECTION OBJECTIVES the program. (See in section 2128.08.1.1 for
1. To assess and evaluate the extent of the lending standards that should be
subprime-lending activities; whether man- included in the subprime-loan program.)
agement has adequately planned for these 6. Incorporate the results of the loan-
activities; and whether management has administration portfolio-level and
developed and maintains board-approved transaction-level testing reviews into the
policies and procedures, systems, and inter- conclusions about overall asset quality, the
nal controls that identify, measure, monitor, adequacy of the ALLL and capital, and the
and control the additional risks in a manner adequacy of portfolio risk-management
that is commensurate with the risks associ- practices.
ated with the subprime-lending program. 7. Review securitization transactions for com-
2. To conduct portfolio-level reviews and pliance with FAS 140 and this guidance,
transaction-level testing of the subprime- including whether the bank holding com-
lending activities, assessing the quality and pany and its subsidiaries have provided any
performance of the subprime-loan portfolios support to maintain the credit quality of
and subprime-lending program, including its loan pools they have securitized.
profitability, delinquency, and potential and 8. Evaluate the ALLL and regulatory capital
actual loss experience. allocated to support subprime-lending pro-
3. To assess the adequacy of the ALLL for the grams, including whether the total protec-
subprime-loan portfolio. tion for subprime-asset programs and the
levels for each component are adequate.
9. Ascertain that a sound risk-management
2128.08.3 INSPECTION PROCEDURES program exists that includes the ability of
1. Determine whether the subprime-lending BHC Supervision Manual December 2002

activities are consistent with the bank hold Page 13
management to determine and quantify ers that do not have the capacity to ser-
appropriate levels for each component of vice their loans.
the program. b. Classify as at least substandard subprime
10. Evaluate the bank holding companys docu- loans that are 90 days or more past due
mented analysis of the capital needed to based on a reasonable presumption that
support its subprime-lending activities. their past-due status indicates an inad-
Ascertain whether the capital levels are risk equate capacity or unwillingness to
sensitive, that is, does allocated capital repay.
reflect the level and variability of loss esti- c. Consider classifying or criticizing the
mates within reasonably conservative entire portfolio or segments of the port-
parameters? Determine if there is a direct folio when the portfolio review or loan
link between the expected loss rates used to sample indicates serious concerns with
determine the required ALLL and the unex- credit-risk-selection practices, underwrit-
pected loss estimates used to determine ing standards, or loan quality.
capital. Document and reference the bank d. Classify as substandard high-risk unse-
holding companys overall subprime capital cured loan portfolios or secured high
evaluation in the inspection comments and loan-to-value loans to borrowers who
conclusions regarding capital adequacy. clearly exhibit inadequate capacity to
11. Analyze the performance of the subprime- repay the debt in a reasonable time
lending program, including its profitability, frame.
delinquency, and loss experience. 15. Report as unsafe and unsound imprudent
12. Consider managements response to loans to borrowers who do not demonstrate
adverse performance trends, such as higher- the capacity to repay the loan, as structured,
than-expected prepayments, delinquencies, from sources other than the pledged
charge-offs, customer complaints, and collateral.
expenses. 16. Carefully assess the ability of the parent
13. Determine if the bank holding companys bank holding companys board of directors
subprime-lending program effectively man- and management to oversee and administer
ages the credit, market, liquidity, reputa- the higher risk in subprime portfolios,
tional, operational, and legal risks associ- including those of its nonbank subsidiaries.
ated with subprime-lending operations. If risk-management practices are deficient,
14. Classify loans of the parent bank holding criticize management and reach specific
company and its nonbank subsidiaries agreements with the board of directors and
according to the following criteria: senior management to initiate corrective
a. Classify as substandard loans to borrow- action.

Page 14
Elevated-Risk Complex Structured Finance Activities
When a financial institution participates in a SR-07-05 and 72 Fed. Reg. 1,372, January 11,
complex structured finance transaction (CSFT), 2007.)
it bears the usual market, credit, and operational
risks associated with the transaction.1 In some
circumstances, a financial institution may also 2128.09.1 INTERAGENCY
face heightened legal or reputational risks due STATEMENT ON SOUND PRACTICES
to its involvement in a CSFT. For example, a CONCERNING ELEVATED-RISK
financial institution may face heightened legal COMPLEX STRUCTURED FINANCE
or reputational risks if a customers regulatory, ACTIVITIES
tax, or accounting treatment for a CSFT, or
disclosures to investors concerning the CSFT in Financial markets have grown rapidly over the
the customers public filings or financial state- past decade, and innovations in financial instru-
ments, do not comply with applicable laws, ments have facilitated the structuring of cash
regulations, or accounting principles. flows and allocation of risk among creditors,
The agencies have long expected financial borrowers, and investors in more efficient ways.
institutions to develop and maintain robust con- Financial derivatives for market and credit
trol infrastructures that enable them to identify, risk, asset-backed securities with customized
evaluate, and address the risks associated with cash-flow features, specialized financial con-
their business activities.2 Financial institutions duits that manage pools of assets, and other
must also conduct their activities in accordance types of structured finance transactions serve
with applicable statutes and regulations. There- important business purposes, such as diversify-
fore, financial institutions engaged in CSFTs are ing risks, allocating cash flows, and reducing
expected to have policies and procedures that cost of capital. As a result, structured finance
are designed to allow the institution to effec- transactions have become an essential part of
tively manage and address the full range of risks U.S. and international capital markets. Financial
associated with its CSFT activities, including institutions have played and continue to play an
the elevated legal or reputational risks that may active and important role in the development of
arise in connection with certain CSFTs. The structured finance products and markets, includ-
agencies continue to believe that this is ing the market for the more complex variations
important. of structured finance products.
This section sets forth the Interagency State- When a financial institution participates in a
ment on Sound Practices Concerning Elevated- complex structured finance transaction (CSFT),
Risk Complex Structured Finance Activities, it bears the usual market, credit, and operational
issued January 11, 2007. The supervisory guid- risks associated with the transaction. In some
ance addresses risk-management principles that circumstances, a financial institution may also
should assist institutions to identify, evaluate, face heightened legal or reputational risks due
and manage the heightened legal and reputa- to its involvement in a CSFT. For example, in
tional risks that may arise from their involve- some circumstances, a financial institution may
ment in CSFTs. The guidance is focused on face heightened legal or reputational risk if a
those CSFTs that may present heightened levels customers regulatory, tax, or accounting treat-
of legal or reputational risk to the institution and ment for a CSFT, or disclosures to investors
are defined as elevated-risk CSFTs. Such concerning the CSFT in the customers public
transactions are typically conducted by a limited filings or financial statements, do not comply
number of large financial institutions.3 (See with applicable laws, regulations, or accounting
principles. Indeed, in some instances, CSFTs
have been used to misrepresent a customers
1. The term financial institutions is not limited to federally
insured depository institutions. It refers broadly to bank hold- financial condition to investors, regulatory
ing companies (other than foreign banks), national banks, authorities, and others. In these situations, inves-
state banks, federal and state savings associations, savings and tors have been harmed and financial institutions
loan holding companies, U.S. branches and agencies of for- have incurred significant legal and reputational
eign banks, and SEC-registered broker-dealers and invest-
ment advisors. exposure. In addition to legal risk, reputational
2. The agencies are the Board of Governors of the Federal
Reserve System (FRB), the Office of the Comptroller of the ity of financial institutions, including most small institutions.
Currency (OCC), the Federal Deposit Insurance Corporation
(FDIC), the Office of Thrift Supervision (OTS), and the
Securities and Exchange Commission (SEC). BHC Supervision Manual January 2008
3. The statement will not affect or apply to the vast major- Page 1
Elevated-Risk Complex Structured Finance Activities 2128.09
risk poses a significant threat to financial institu- tutions. As in all cases, a financial institution
tions because the nature of their business should tailor its internal controls so that they are
requires them to maintain the confidence of appropriate in light of the nature, scope, com-
customers, creditors, and the general market- plexity, and risks of its activities. Thus, for
place. example, an institution that is actively involved
The agencies have long expected financial in structuring and offering CSFTs that may cre-
institutions to develop and maintain robust con- ate heightened legal or reputational risk for the
trol infrastructures that enable them to identify, institution should have a more formalized and
evaluate, and address the risks associated with detailed control framework than an institution
their business activities. Financial institutions that participates in these types of transactions
must also conduct their activities in accordance less frequently. The internal controls and proce-
with applicable statutes and regulations. dures discussed in this statement are not all
inclusive, and, in appropriate circumstances, an
institution may find that other controls, policies,
2128.09.2 SCOPE AND PURPOSE OF or procedures are appropriate in light of its
STATEMENT particular CSFT activities.
Because many of the core elements of an
This statement was issued to describe the types effective control infrastructure are the same
of risk-management principles that the agencies regardless of the business line involved, this
believe may help a financial institution to iden- statement draws heavily on controls and proce-
tify CSFTs that may pose heightened legal or dures that the agencies previously have found to
reputational risks to the institution and to evalu- be effective in assisting a financial institution to
ate, manage, and address these risks within the manage and control risks and identifies ways in
institutions internal control framework.4 which these controls and procedures can be
Structured finance transactions encompass a effectively applied to elevated-risk CSFTs.
broad array of products with varying levels of Although this statement highlights some of the
complexity. Most structured finance transac- most significant risks associated with elevated-
tions, such as standard public mortgage-backed risk CSFTs, it is not intended to present a full
securities transactions, public securitizations of exposition of all risks associated with these
retail credit cards, asset-backed commercial transactions. Financial institutions are encour-
paper conduit transactions, and hedging-type aged to refer to other supervisory guidance pre-
transactions involving plain vanilla deriva- pared by the agencies for further information
tives and collateralized loan obligations, are concerning market, credit, operational, legal,
familiar to participants in the financial markets, and reputational risks, as well as internal audit
and these vehicles have a well-established track and other appropriate internal controls.
record. These transactions typically would not This statement does not create any private
be considered CSFTs for the purpose of this rights of action and does not alter or expand the
statement. legal duties and obligations that a financial insti-
Because this statement focuses on sound tution may have to a customer, its shareholders,
practices related to CSFTs that may create or other third parties under applicable law. At
heightened legal or reputational risks the same time, adherence to the principles dis-
transactions that typically are conducted by a cussed in this statement would not necessarily
limited number of large financial institutionsit insulate a financial institution from regulatory
will not affect or apply to the vast majority of action or any liability the institution may have
financial institutions, including most small insti- to third parties under applicable law.
4. As used in this statement, the term financial institution

or institution refers to state member banks and bank holding 2128.09.3 IDENTIFICATION AND
companies (other than foreign banking organizations) in the REVIEW OF ELEVATED-RISK
case of the FRB, national banks in the case of the OCC,
federal and state savings associations and savings and loan COMPLEX STRUCTURED FINANCE
holding companies in the case of the OTS, state nonmember TRANSACTIONS
banks in the case of the FDIC, and registered broker-dealers
and investment advisors in the case of the SEC. The U.S. A financial institution that engages in CSFTs
branches and agencies of foreign banks supervised by the
FRB, the OCC, and the FDIC also are considered to be
should maintain a set of formal, written, firm-
financial institutions for purposes of this statement. wide policies and procedures that are designed
to allow the institution to identify, evaluate,
BHC Supervision Manual January 2008 assess, document, and control the full range of
Page 2 credit, market, operational, legal, and reputa-
tional risks associated with these transactions. fied as elevated-risk CSFTs should be subject to
These policies may be developed specifically heightened reviews during the institutions
for CSFTs or included in the set of broader transaction or new product approval processes.
policies governing the institution generally. A Examples of transactions that an institution may
financial institution operating in foreign jurisdic- determine warrant this additional scrutiny are
tions may tailor its policies and procedures as those that (either individually or collectively)
appropriate to account for, and comply with, the appear to the institution during the ordinary
applicable laws, regulations, and standards of course of its transaction approval or new prod-
those jurisdictions.5 uct approval process to
Financial institutions policies and procedures
should establish a clear framework for the 1. lack economic substance or business
review and approval of individual CSFTs. These purpose;
policies and procedures should set forth the 2. be designed or used primarily for question-
responsibilities of the personnel involved in the able accounting, regulatory, or tax objec-
origination, structuring, trading, review, tives, particularly when the transactions are
approval, documentation, verification, and executed at year end or at the end of a
execution of CSFTs. Financial institutions may reporting period for the customer;
find it helpful to incorporate the review of new 3. raise concerns that the client will report or
CSFTs into their existing new product policies. disclose the transaction in its public filings or
In this regard, a financial institution should financial statements in a manner that is mate-
define what constitutes a new complex struc- rially misleading or inconsistent with the
tured finance product and establish a control substance of the transaction or applicable
process for the approval of such new products. regulatory or accounting requirements;
In determining whether a CSFT is new, a finan- 4. involve circular transfers of risk (either
cial institution may consider a variety of factors, between the financial institution and the cus-
including whether it contains structural or pric- tomer or between the customer and other
ing variations from existing products; whether related parties) that lack economic substance
the product is targeted at a new class of custom- or business purpose;
ers; whether it is designed to address a new need 5. involve oral or undocumented agreements
of customers; whether it raises significant new that, when taken into account, would have a
legal, compliance, or regulatory issues; and material impact on the regulatory, tax, or
whether it or the manner in which it would be accounting treatment of the related transac-
offered would materially deviate from standard tion, or the clients disclosure obligations;6
market practices. An institutions policies 6. have material economic terms that are incon-
should require new complex structured finance sistent with market norms (for example, deep
products to receive the approval of all relevant in the money options or historic rate roll-
control areas that are independent of the profit overs); or
center before the product is offered to 7. provide the financial institution with com-
customers. pensation that appears substantially dispro-
portionate to the services provided or invest-
ment made by the financial institution or to
2128.09.3.1 Identifying Elevated-Risk the credit, market, or operational risk
CSFTs assumed by the institution.
As part of its transaction and new product The examples listed previously are provided
approval controls, a financial institution should for illustrative purposes only, and the policies
establish and maintain policies, procedures, and and procedures established by financial institu-
systems to identify elevated-risk CSFTs. tions may differ in how they seek to identify
Because of the potential risks they present to the elevated-risk CSFTs. The goal of each institu-
institution, transactions or new products identi-
6. This item is not intended to include traditional, non-
binding comfort letters or assurances provided to financial
5. In the case of U.S. branches and agencies of foreign
institutions in the loan process where, for example, the parent
banks, these policies, including management, review, and
of a loan customer states that the customer (that is, the
approval requirements, should be coordinated with the foreign
parents subsidiary) is an integral and important part of the
banks group-wide policies developed in accordance with the
parents operations.
rules of the foreign banks home country supervisor and
should be consistent with the foreign banks overall corporate
and management structure as well as its framework for risk BHC Supervision Manual July 2007
management and internal controls. Page 3
tions policies and procedures, however, should greater legal and reputational risk exposure with
remain the same: to identify those CSFTs that respect to an elevated-risk CSFT than a finan-
warrant additional scrutiny in the transaction or cial institution that acts only as a counterparty
new product approval process due to concerns for the transaction. Accordingly, a financial
regarding legal or reputational risks. institution may need to exercise a higher degree
Financial institutions that structure or market, of care in conducting its due diligence when the
act as an advisor to a customer regarding, or institution structures or markets an elevated-risk
otherwise play a substantial role in a transaction CSFT or acts as an advisor concerning such a
may have more information concerning the cus- transaction than when the institution plays a
tomers business purpose for the transaction and more limited role in the transaction.
any special accounting, tax, or financial disclo- To appropriately understand and evaluate the
sure issues raised by the transaction than institu- potential legal and reputational risks associated
tions that play a more limited role. Thus, the with an elevated-risk CSFT that a financial insti-
ability of a financial institution to identify the tution has identified, the institution may find it
risks associated with an elevated-risk CSFT may useful or necessary to obtain additional informa-
differ depending on its role. tion from the customer or to obtain specialized
advice from qualified in-house or outside
accounting, tax, legal, or other professionals. As
2128.09.3.2 Due-Diligence, Approval, with any transaction, an institution should obtain
and Documentation Process for satisfactory responses to its material questions
Elevated-Risk CSFTs and concerns prior to consummation of a
transaction.7
Having developed a process to identify In conducting its due diligence for an
elevated-risk CSFTs, a financial institution elevated-risk CSFT, a financial institution
should implement policies and procedures to should independently analyze the potential risks
conduct a heightened level of due diligence for to the institution from both the transaction and
these transactions. The financial institution the institutions overall relationship with the
should design these policies and procedures to customer. Institutions should not conclude that a
allow personnel at an appropriate level to under- transaction identified as being an elevated-risk
stand and evaluate the potential legal or reputa- CSFT involves minimal or manageable risks
tional risks presented by the transaction to the solely because another financial institution will
institution and to manage and address any participate in the transaction or because of the
heightened legal or reputational risks ultimately size or sophistication of the customer or coun-
found to exist with the transaction. terparty. Moreover, a financial institution should
carefully consider whether it would be appropri-
ate to rely on opinions or analyses prepared by
2128.09.3.2.1 Due Diligence or for the customer concerning any significant
accounting, tax, or legal issues associated with
If a CSFT is identified as an elevated-risk CSFT, an elevated-risk CSFT.
the institution should carefully evaluate and take
appropriate steps to address the risks presented
by the transaction with a particular focus on 2128.09.3.2.2 Approval Process
those issues identified as potentially creating
heightened levels of legal or reputational risk A financial institutions policies and procedures
for the institution. In general, a financial institu- should provide that CSFTs identified as having
tion should conduct the level and amount of due elevated legal or reputational risk are reviewed
diligence for an elevated-risk CSFT that is com- and approved by appropriate levels of control
mensurate with the level of risks identified. A and management personnel. The designated
financial institution that structures or markets an approval process for such CSFTs should include
elevated-risk CSFT to a customer, or that acts as representatives from the relevant business
an advisor to a customer or investors concerning line(s) and/or client management, as well as
an elevated-risk CSFT, may have additional from appropriate control areas that are indepen-
responsibilities under the federal securities laws, dent of the business line(s) involved in the trans-
the Internal Revenue Code, state fiduciary laws action. The personnel responsible for approving
or other laws or regulations and, thus, may have
7. Of course, financial institutions also should ensure that
BHC Supervision Manual July 2007 their own accounting for transactions complies with appli-
Page 4 cable accounting standards, consistently applied.
an elevated-risk CSFT on behalf of a financial conducting appropriate due diligence and taking
institution should have sufficient experience, appropriate steps to address the risks from the
training, and stature within the organization to transaction, the institution determines that the
evaluate the legal and reputational risks, as well transaction presents unacceptable risk to the
as the credit, market, and operational risks to the institution or would result in a violation of
institution. applicable laws, regulations, or accounting
The institutions control framework should principles.
have procedures to deliver the necessary or
appropriate information to the personnel respon-
sible for reviewing or approving an elevated- 2128.09.3.2.3 Documentation
risk CSFT to allow them to properly perform
their duties. Such information may include, for The documentation that financial institutions use
example, the material terms of the transaction, a to support CSFTs is often highly customized for
summary of the institutions relationship with individual transactions and negotiated with the
the customer, and a discussion of the significant customer. Careful generation, collection, and
legal, reputational, credit, market, and opera- retention of documents associated with elevated-
tional risks presented by the transaction. risk CSFTs are important control mechanisms
Some institutions have established a senior that may help an institution monitor and manage
management committee that is designed to the legal, reputational, operational, market, and
involve experienced business executives and credit risks associated with the transactions. In
senior representatives from all of the relevant addition, sound documentation practices may
control functions within the financial institution help reduce unwarranted exposure to the finan-
(including such groups as independent risk man- cial institutions reputation.
agement, tax, accounting, policy, legal, compli- A financial institution should create and col-
ance, and financial control) in the oversight and lect sufficient documentation to allow the insti-
approval of those elevated-risk CSFTs that are tution to
identified by the institutions personnel as
requiring senior management review and 1. Document the material terms of the transac-
approval due to the potential risks associated tion,
with the transactions. While this type of man- 2. Enforce the material obligations of the coun-
agement committee may not be appropriate for terparties,
all financial institutions, a financial institution 3. Confirm that the institution has provided the
should establish processes that assist the institu- customer any disclosures concerning the
tion in consistently managing the review and transaction that the institution is otherwise
approval of elevated-risk CSFTs on a firmwide required to provide, and
basis.8 4. Verify that the institutions policies and pro-
If, after evaluating an elevated-risk CSFT, the cedures are being followed and allow the
financial institution determines that its participa- internal audit function to monitor compli-
tion in the CSFT would create significant legal ance with those policies and procedures.
or reputational risks for the institution, the insti-
tution should take appropriate steps to address When an institutions policies and procedures
those risks. Such actions may include declining require an elevated-risk CSFT to be submitted
to participate in the transaction or conditioning for approval to senior management, the institu-
its participation upon the receipt of representation should maintain the transaction-related
tions or assurances from the customer that rea- documentation provided to senior management
sonably address the heightened legal or reputa- as well as other documentation, such as minutes
tional risks presented by the transaction. Any of the relevant senior management committee,
representations or assurances provided by a cus- that reflect senior managements approval (or
tomer should be obtained before a transaction is disapproval) of the transaction, any conditions
executed and be received from, or approved by, imposed by senior management, and the factors
an appropriate level of the customers manage- considered in taking such action. The institution
ment. A financial institution should decline to should retain documents created for elevated-
participate in an elevated-risk CSFT if, after risk CSFTs in accordance with its record reten-
tion policies and procedures as well as appli-
8. The control processes that a financial institution estab-
lishes for CSFTs should take account of, and be consistent
cable statutes and regulations.
with, any informational barriers established by the institution
to manage potential conflicts of interest, insider trading, or BHC Supervision Manual July 2007
other concerns. Page 5
2128.09.3.3 Other Risk-Management elevated-risk CSFTs. A financial institutions

Principles for Elevated-Risk CSFTs program should provide for periodic indepen-
dent reviews of its CSFT activities to verify and
2128.09.3.3.1 General Business Ethics monitor that its policies and controls relating to
elevated-risk CSFTs are being implemented
The board and senior management of a financial
effectively and that elevated-risk CSFTs are
institution also should establish a tone at the
accurately identified and received proper
top through both actions and formalized poli-
approvals. These independent reviews should be
cies that sends a strong message throughout the
performed by appropriately qualified audit,
financial institution about the importance of
compliance, or other personnel in a manner
compliance with the law and overall good busi-
consistent with the institutions overall frame-
ness ethics. The board and senior management
work for compliance monitoring, which should
should strive to create a firm-wide corporate
include consideration of issues such as the inde-
culture that is sensitive to ethical or legal issues
pendence of reviewing personnel from the busi-
as well as the potential risks to the financial
ness line. Such monitoring may include more
institution that may arise from unethical or ille-
frequent assessments of the risk arising from
gal behavior. This kind of culture coupled with
elevated-risk CSFTs, both individually and
appropriate procedures should reinforce
within the context of the overall customer rela-
business-line ownership of risk identification,
tionship, and the results of this monitoring
and encourage personnel to move ethical or
should be provided to an appropriate level of
legal concerns regarding elevated-risk CSFTs to
management in the financial institution.
appropriate levels of management. In appropri-
ate circumstances, financial institutions may
also need to consider implementing mechanisms
to protect personnel by permitting the confiden- 2128.09.3.3.4 Audit
tial disclosure of concerns.9 As in other areas of
The internal audit department of any financial
financial institution management, compensation
institution is integral to its defense against fraud,
and incentive plans should be structured, in the
unauthorized risk taking, and damage to the
context of elevated-risk CSFTs, so that they
financial institutions reputation. The internal
provide personnel with appropriate incentives to
audit department of a financial institution should
have due regard for the legal, ethical, and repu-
regularly audit the financial institutions adher-
tational risk interests of the institution.
ence to its own control procedures relating to
elevated-risk CSFTs, and further assess the
adequacy of its policies and procedures related
2128.09.3.3.2 Reporting to elevated-risk CSFTs. Internal audit should
periodically validate that business lines and indi-
A financial institutions policies and procedures
vidual employees are complying with the finan-
should provide for the appropriate levels of
cial institutions standards for elevated-risk
management and the board of directors to
CSFTs and appropriately identifying any excep-
receive sufficient information and reports con-
tions. This validation should include transaction
cerning the institutions elevated-risk CSFTs to
testing for elevated-risk CSFTs.
perform their oversight functions.
2128.09.3.3.3 Monitoring Compliance 2128.09.3.3.5 Training

with Internal Policies and Procedures An institution should identify relevant personnel
who may need specialized training regarding
The events of recent years evidence the need for
CSFTs to be able to effectively perform their
an effective oversight and review program for
oversight and review responsibilities. Appropri-
9. The agencies note that the Sarbanes-Oxley Act of 2002
ate training on the financial institutions policies
requires companies listed on a national securities exchange or and procedures for handling elevated-risk
inter-dealer quotation system of a national securities associa- CSFTs is critical. Financial institution personnel
tion to establish procedures that enable employees to submit involved in CSFTs should be familiar with the
concerns regarding questionable accounting or auditing mat-
ters on a confidential, anonymous basis. (See 15 U.S.C.
institutions policies and procedures concerning
78j-1(m).) elevated-risk CSFTs, including the processes
established by the institution for identification
BHC Supervision Manual July 2007 and approval of elevated-risk CSFTs and new
Page 6 complex structured finance products and for the
elevation of concerns regarding transactions or some instances, however, CSFTs have been
products to appropriate levels of management. used to misrepresent a customers financial con-
Financial institution personnel involved in dition to investors and others, and financial insti-
CSFTs should be trained to identify and prop- tutions involved in these transactions have sus-
erly handle elevated-risk CSFTs that may result tained significant legal and reputational harm. In
in a violation of law. light of the potential legal and reputational risks
associated with CSFTs, a financial institution
should have effective risk-management and
2128.09.4 CONCLUSION internal control systems that are designed to
allow the institution to identify elevated-risk
Structured finance products have become an CSFTs; to evaluate, manage, and address the
essential and important part of the U.S. and risks arising from such transactions; and to con-
international capital markets, and financial insti- duct those activities in compliance with appli-
tutions have played an important role in the cable law.
development of structured finance markets. In

Page 7
Credit Derivatives
Banking organizations must establish and main- assets. Nonbank companies may serve as coun-
tain sound risk-management policies and proce- terparties to credit-derivative transactions with
dures and effective internal controls over their banks to gain access to the commercial bank
use of credit derivatives. Credit derivatives are loan market. Such entities may not lend or may
off-balance-sheet financial instruments that are not have the facilities or staff to adequately
used to assume or lay off credit risk on loans administer a loan portfolio.
and other assets, some only to a limited extent. Under some credit-derivative arrangements, a
They allow one party (the beneficiary) to trans- beneficiary may pay a fee to the guarantor in
fer the credit risk of a reference asset, which exchange for a guarantee against any loss that
it often actually owns, to another party (the may occur, usually in excess of a prespecified
guarantor).1 This arrangement allows the guar- amount, if the reference asset defaults (a
antor party to assume the credit risk associated credit-default swap). Alternatively, the bene-
with the reference asset without directly pur- ficiary may pay the total return on a reference
chasing it. Unlike traditional guarantee arrange- asset, including any appreciation in the assets
ments, credit-derivative transactions often are price, to a guarantor in exchange for a spread
documented using master agreements developed over funding costs plus any depreciation in the
by the International Swaps and Derivatives value of the reference asset (a total-rate-of-
Association (ISDA) that are similar to those return swap).
governing swaps or options. Since credit deriva- Credit derivatives and their market are likely
tives are privately negotiated financial contracts, to take on various forms, such as the market for
they expose the user to credit risk as well as put options on specific corporate bonds or loans.
liquidity risk (thin secondary market for credit While the payoffs of these puts are expressed in
derivatives), operational risk (instruments used terms of a strike price, rather than a default
for speculation rather than hedging), counter- event, if the strike price is sufficiently high,
party risk (default), and legal risk (the contracts credit risk effectively could be transferred from
may be deemed illegal). the buyer of the put to the writer of the put. See
Banking organizations use credit-derivative SR-96-17.
instruments either as end-users, purchasing
credit protection from or providing credit pro-
tection to third parties, or as dealers intermediat- 2129.0.1 SUPERVISORY AND
ing such protection. Credit derivatives are used EXAMINER GUIDANCE
to manage overall credit-risk exposure. A bank-
ing organization may use credit derivatives to In reviewing credit derivatives, examiners
mitigate its concentration to a particular bor- should consider the credit risk associated with
rower or industry without severing the customer the reference asset as the primary risk, as they
relationship. In addition, organizations that are do for loan participations or guarantees. A bank-
approaching established in-house limits on ing organization providing credit protection
counterparty credit exposure could continue to through a credit derivative may be as exposed to
originate loans to a particular industry, using the credit risk of the reference asset as it would
credit derivatives to transfer the credit risk to a be if the asset were on its own balance sheet.
third party. Thus, for supervisory purposes, the exposure
Banking organizations may also use credit generally should be treated as if it were a letter
derivatives to diversify their portfolios by of credit or other off-balance-sheet guarantee.2
assuming the associated credit exposures and This treatment would apply, for example, in
revenue returns to different borrowers or indus- determining a banking organizations overall
tries without actually purchasing the underlying credit exposure to a borrower for purposes of
evaluating concentrations of credit. The overall
exposure should include exposure it assumes
1. For purposes of this supervisory guidance, when the
beneficiary owns the reference asset, it will be referred to as
the underlying asset. However, in some cases, the reference 2. Credit derivatives that are based on a broad-based index,
asset and the underlying asset are not the same. For example, such as the Lehman Brothers Bond Index or the S&P 500
the credit-derivative contract may reference the performance stock index, could be treated for capital and other supervisory
of an ABC Company bond, while the beneficiary banking purposes as a derivative contract. This determination should
organization may actually own an ABC Company loan. The be made on a case-by-case basis.
use of the term guarantor does not necessarily refer to a
guarantor involving a suretyship contract. The transferred risk
can be in a primary liability of the acquiring party that BHC Supervision Manual December 1999
assumes the credit risk. Page 1
Credit Derivatives 2129.0
by acting as a guarantor in a credit-derivative default using a prespecified sampling procedure

transaction where the borrower is the obligor of or may be specified in advance as a set percent-
the reference asset. age of the notional amount of the reference
Banking organizations providing credit pro- asset. Finally, the term of many credit-derivative
tection through a credit derivative should hold transactions is shorter than the maturity of the
capital and reserves against their exposure to underlying asset and, thus, provides only tempo-
the reference asset.3 This broad principle holds rary credit protection to the beneficiary.
for all credit derivatives, except for credit- Examiners must ascertain whether the amount
derivative contracts that incorporate periodic of credit protection a beneficiary receives by
payments for depreciation or appreciation, entering into a credit derivative is sufficient to
including most total-rate-of-return swaps. For warrant treatment of the derivative as a guaran-
these transactions, the guarantor can deduct the tee for regulatory capital and other supervisory
amount of depreciation paid to the beneficiary purposes. Those arrangements that provide
from the notional amount of the contract in virtually complete credit protection to the under-
determining the amount of reference exposure lying asset will be considered effective guaran-
subject to a capital charge. tees for purposes of asset classification and risk-
In some cases (for example, total-rate-of- based capital calculations. On the other hand, if
return swaps), the guarantor also is exposed to the amount of credit risk transferred by the
the credit risk of the counterparty, which for beneficiary is severely limited or uncertain, then
derivative contracts generally is measured as the the limited credit protection provided by the
replacement cost of the credit-derivative trans- derivative should not be taken into account for
action plus an add-on for the potential future these purposes.
exposure of the derivative to market price In this regard, examiners should carefully
changes. For banking organizations acting as review credit-derivative transactions in which
dealers that have matching offsetting positions, the reference asset is not identical to the asset
the counterparty risk stemming from credit- actually owned by the beneficiary banking orga-
derivative transactions could be the principal nization. For the derivative contract to be con-
risk to which the dealer banks are exposed. sidered as providing effective credit protection,
In reviewing a credit derivative entered into the examiner must review the arrangement and
by a beneficiary banking organization, the be satisfied that the reference asset is an appro-
examiner should review the organizations priate proxy for the loan or other asset, whose
credit exposure to the guarantor, as well as to credit exposure the banking organization intends
the reference assetif the asset is actually to offset. To determine this, examiners should
owned by the beneficiary. The degree to which consider, among other factors, whether the refer-
a credit derivative, unlike most other credit- ence asset and owned asset have the same obli-
guarantee arrangements, transfers the credit risk gor and seniority in bankruptcy and whether
of an underlying asset from the beneficiary to both contain mutual cross-default provisions.
the guarantor may be uncertain or limited. The A banking organizations management should
degree of risk transference depends on the terms not enter into credit-derivative transactions
of the transaction. For example, some credit unless it has the ability to understand and man-
derivatives are structured so that a payout only age the credit and other risks associated with
occurs when a predefined event of default or a these instruments in a safe and sound manner.
downgrade below a prespecified credit rating Accordingly, examiners should determine the
occurs.4 Others may require a payment only appropriateness of these instruments on an
when a defined default event occurs and a pre- entity-by-entity basis, taking into account man-
determined materiality (or loss) threshold is agements expertise in evaluating the instru-
exceeded. Default payments themselves may be ments used; the adequacy of relevant policies,
based on an average of dealer prices for the including position limits; and the quality of the
reference asset during some period of time after banking organizations relevant information sys-
tems and internal controls.5
3. For guidance on risk-based capital treatment of credit

derivatives, see section 4060.3.5.3.9.
5. For further guidance on examining the risk-management
4. It may also be necessary to review the credit documenta-
practices of banking organizations, including guidance on
tion of the primary obligor to determine the degree of trans-
derivatives, that examiners may find helpful in reviewing an
ferred risk.
organizations management of its credit-derivative activity,
see sections 2125.0, 2126.0, 2128.0, and 4070.1. See also the
BHC Supervision Manual December 1999 Commercial Bank Examination Manual and the Trading and
Page 2 Capital-Markets Activities Manual.
2129.0.2 TYPES OF CREDIT 2129.0.2.1 Credit-Default Swaps

DERIVATIVES
The purpose of a credit-default swap is to pro-
The most widely used types of credit derivatives vide protection against credit losses associated
are credit-default swaps and total-rate-of-return with a default on a specified reference asset. The
(TROR) swaps.6 While the timing and structure swap purchaser (the beneficiary) swaps the
of the cash flows associated with credit default credit risk with the provider of the swap (the
and TROR swaps differ, the economic substance guarantor). The transaction is very similar to a
of both arrangements is that they seek to trans- guarantee or financial standby letter of credit.
fer the credit risk on the asset(s) referenced in In a credit-default swap, illustrated in fig-
the transaction. ure 1, the beneficiary (Bank A) agrees to pay to
the guarantor (Bank B) a quarterly or annual
6. Another less common form of credit derivative is the fee, typically amounting to a certain number of
credit-linked note, which is an obligation that is based on a
reference asset. Credit-linked notes are similar to structured
basis points on the par value of the reference
notes with embedded credit derivatives. If there is a credit asset. In return, the guarantor agrees to pay the
event, the repayment of the bonds principal is based on the beneficiary an agreed-upon, market-based, post-
price of the reference asset. A credit-linked note may be a default amount or a predetermined fixed per-
combination of a regular bond and a credit option. The note
can promise to make periodic interest payments and a large
centage of the value of the reference asset if
lump-sum payment when the bond matures. The credit option there is a default. The guarantor makes no pay-
on the note may allow the issuer to reduce the notes payment until there is a default. A default is strictly
ments if a primary financial indicator or variable deteriorates. defined in the contract to include, for example,
When reviewing these transactions, examiners should con-
sider the purchasing banking organizations exposure to the
bankruptcy, insolvency, or payment default, and
underlying reference asset as well as the exposure to the the event of default itself must be publicly veri-
issuing entity. fiable. The guarantor may not be obliged to
Figure 1
Credit-Default Swap Cash-Flow Diagram
Credit-Default Swap
Bank A Fixed payments per quarter Bank B
Payment upon default

Five-year note If default occurs, then B pays A
for the depreciated amount of the
loan or an amount agreed upon at
C & I Loan the outset.
Principal and interest

Page 3
make any payments to the beneficiary until a 2129.0.2.2 Total-Rate-of-Return Swaps

preestablished amount of loss has been
exceeded in conjunction with a default event In a total-rate-of-return (TROR) swap, illus-
(called a materiality threshold). trated in figure 2, the beneficiary (Bank A)
The swap is terminated if the reference asset agrees to pay the guarantor (Bank B) the total
defaults before the maturity of the swap. The return on the reference asset, which consists of
amount owed by the guarantor is the difference all contractual payments, as well as any appreci-
between the reference assets initial principal ation in the market value of the reference asset.
(or notional) amount and the actual market value To complete the swap arrangement, the guaran-
of the defaulted, reference asset. The method- tor agrees to pay LIBOR plus a spread and any
ology for establishing the post-default market depreciation to the beneficiary.7 Since it bears
value of the reference asset should be set out in the risks and rewards of ownership over the
the contract. Often, the market value of the term of the swap, the guarantor in a TROR swap
defaulted reference asset may be determined by could be viewed as having synthetic ownership
sampling dealer quotes. The guarantor may have of the reference asset.
the option to purchase the defaulted, underlying At each payment-exchange date (including
asset and pursue a workout with the borrower when the swap matures) or on default, at which-
directly, an action it may take if it believes that point the swap may terminate, any depreciation
the true value of the reference asset is higher
than that determined by the swap-pricing
mechanism. Alternatively, the swap may call for
7. The reference asset is often a floating-rate instrument,
a fixed payment in the event of default, such as for example, a prime-based loan. Thus, if both sides of a
a percentage of the notional value of the refer- TROR swap are based on floating rates, interest-rate risk is
ence asset. effectively eliminated with the exception of some basis risk.
Figure 2
Total-Rate-of-Return Swap Cash-Flow Diagram
Total-Rate-of-Return Swap
Principal & Interest
Bank A plus appreciation Bank B
(beneficiary) (Total Return) (guarantor)
LIBOR plus spread

Five-year note plus depreciation
The swap has a maturity of one
year, with the C & I loan as the
C & I Loan reference asset. At each
payment date, or on default
Principal and interest of the loan, Bank B pays Bank A
for any depreciation of the loan.

Page 4
or appreciation in the amortized value of the 2129.0.3.1 Credit Exposure

reference asset is calculated as the difference
between the notional principal balance of the For internal purposes of managing credit risk,
reference asset and the dealer price.8 The banking organizations are encouraged to
dealer price is generally determined either by develop policies to determine how credit-
referring to a market quotation source or by derivative activity will be used to manage credit
polling a group of dealers, and the price reflects exposures. For example, a banking organiza-
changes in the credit profile of the reference tions internal credit policies may set forth situ-
obligor and reference asset. ations in which it is appropriate to reduce credit
If the dealer price is less than the notional exposure to an underlying obligor through
amount of the contract (the hypothetical original credit-derivative transactions. Such policies
price of the reference asset), then the guarantor need to address when credit exposure is effec-
must pay the difference to the beneficiary, tively reduced and how all credit exposures will
absorbing any loss caused by a decline in the be monitored, including those resulting from
credit quality of the reference asset.9 Thus, a credit-derivative activities.
TROR swap differs from a standard direct credit
substitute in that the guarantor is guaranteeing
not only against default of the reference obligor, 2129.0.3.2 Concentrations of Credit
but also against a deterioration in that obligors
credit quality, which can occur even if there is Concentrations of credit may be defined as
no default.
TROR swaps allow banking organizations to loans collateralized by a common security;
diversify credit risk and at the same time main- loans to one borrower or related group of
tain confidentiality of their clients financial borrowers;
records since the borrowing entitys financial loans that depend on a particular agricultural
records are held by the originating lender. When commodity;
the loans are sold, the records are transferred to aggregate loans to major employers, their
the new acquiring lender. TROR swaps gener- employees, and their major suppliers;
ally involve fewer administrative costs than loans within industry groups;
those involved in a loan-sales transaction. Risk out-of-territory loans;
diversification can thus be achieved at a reduced the aggregate amount of paper purchased from
cost. any one source; or
those loans that often have been included in
other homogeneous risk groupings.
Credit concentrations, by their nature, depend

2129.0.3 OTHER SUPERVISORY
on common key factors, and when weaknesses
ISSUES
develop, they have an adverse impact on each
individual loan making up the concentration.11
The decision to treat credit derivatives as guar- Generally, examiners should not consider a
antees could have significant supervisory impli- banking organizations asset concentration to a
cations for the way examiners treat concentra- particular borrower reduced because of the
tion risk, classified assets, the adequacy of the existence of a nongovernment guarantee on one
allowance for loan and lease losses (ALLL),10 of the borrowers loans since the underlying
and transactions involving affiliates. Examples concentration to the borrower still exists. How-
of how credit derivatives that effectively trans- ever, examiners should consider how the bank-
fer credit risk could affect supervisory proce- ing organization manages the concentration,
dures are discussed below. which could include the use of nongovernmen-
tal guarantees. Asset concentrations are to be
listed in the confidential Administrative and
8. Depending on contract terms, a TROR swap may not Other Matters page D of the inspection report
terminate on default of the reference asset. Instead, payments
would continue to be made on subsequent payment dates to highlight that the ultimate risk to the banking
based on the reference assets post-default prices until the organization stems from these concentrations,
swaps contractual maturity.
9. As in a credit-default swap, the guarantor may have the
11. See sections 2010.2, 2010.7, and 2065.2.
option of purchasing the underlying asset from the beneficiary
at the dealer price and trying to collect from the borrower
directly. BHC Supervision Manual December 1996
10. See sections 2010.7 and 2065.2. Page 5
although the associated credit risk may be miti- ness, in whole or in part, during the remaining
gated by the existence of nongovernmental term of the underlying asset.
guarantees. However, credit derivatives tend to have a
Any nongovernment guarantee will be shorter maturity than the underlying asset being
included with other exposures to the guarantor protected. Furthermore, it is uncertain whether
to determine if there is an asset concentration the credit derivative will be renewed once it
with respect to the guarantor. Thus, the use of matures. Thus, when determining whether to
credit derivatives will increase the beneficiarys classify an underlying asset protected by a credit
concentration exposure to the guarantor without derivative, examiners need to consider the term
reducing the concentration risk of the under- of the credit derivative in relation to the matu-
lying borrower. Similarly, a guarantor banking rity of the protected underlying asset, the prob-
organizations exposure to all reference assets ability that the protected underlying asset will
will be included in its overall credit exposure to default while the guarantee is in force, and
the reference obligor. whether the credit risk has actually been trans-
ferred. In general, the beneficiary banking orga-
nization continues to be exposed to the credit
2129.0.3.3 Classification of Assets risk of the classified underlying asset when the
maturity of the credit derivative is shorter than
The criteria used to classify assets are primarily the underlying asset. Thus, in these situations of
based on their degree of risk and the likelihood maturity mismatch, the examiners presumption
of repayment, as well as on the potential effect may be against a diminution of the severity of
of the assets on the banks safety and sound- the underlying assets classification.
ness.12 When evaluating the quality of a loan, For guarantor banking organizations, examin-
examiners should review the overall financial ers should review the credit quality of indi-
condition of the borrower; the borrowers credit vidual reference assets in derivative contracts in
history; any secondary sources of repayment, the same manner as other credit instruments,
such as guarantees; and other factors. The pri- such as standby letters of credit. Thus, examin-
mary focus in the review of a loans quality is ers should evaluate a credit derivative in which
the original source of payment. The assessment a banking organization provides credit protec-
of the credit quality of a troubled loan, however, tion based on the overall financial condition and
should take into account support provided by a resources of the reference obligor; the obligors
financially responsible guarantor.13 credit history; and any secondary sources of
The protection that a credit derivative from a repayment, such as collateral. As a rule, expo-
financially responsible guarantor provides on an sure from providing credit protection through a
underlying asset may be sufficient to preclude credit derivative should be classified if the refer-
classification of the underlying asset or reduce ence asset is classified.14
the severity of classification. Sufficiency
depends on the extent of credit protection that is
provided. To be considered a guarantee for pur- 2129.0.3.4 Transactions Involving
poses of determining the classification of assets, Affiliates
a credit derivative must transfer the credit risk
from the beneficiary to the financially respon- Credit-derivative transactions can involve two
sible guarantor; the financially responsible guar- or more legal entities (affiliates) within the
antor must have both the financial capacity and same banking organization. Thus, transactions
willingness to provide support for the credit; the between or involving affiliates raise important
guarantee (the credit-derivative contract) must supervisory issues, especially whether such
be legally enforceable; and the guarantee must arrangements are effective guarantees of affiliate
provide support for repayment of the indebted- obligations or transfers of assets and their
related credit exposure between affiliates. Bank-
ing organizations should carefully consider
existing supervisory guidance on interaffiliate
12. Loans that exhibit potential weaknesses are catego-
rized as substandard, while those with well-defined weak-
nesses and a distinct possibility of loss are either doubtful
14. A guarantor banking organization providing credit pro-
or loss.
tection through the use of a credit derivative on a classified
13. See section 5010.10 of this manual and section 2060.1
asset of a beneficiary bank may preclude classification of its
of the Commercial Bank Examination Manual.
derivative contract by laying off the risk exposure to another
financially responsible guarantor. This could be accomplished
BHC Supervision Manual December 1996 through the use of a second offsetting credit-derivative
Page 6 transaction.
transactions before entering into credit- whose credit exposure the banking organization
derivative arrangements involving affiliates, par- intends to offset.
ticularly when substantially the same objec- b. Consider whether the reference asset
tives could be met using traditional guarantee and owned asset have the same obligor and
instruments. seniority in bankruptcy and whether both con-
tain mutual cross-default provisions.
5. Determine whether management has the
2129.0.4 INSPECTION OBJECTIVES ability to understand and manage the credit and
other risks associated with credit derivatives in
1. To determine if the banking organization a safe and sound manner. Consider manage-
is providing credit protection through a credit ments expertise in evaluating the instruments;
derivative. the adequacy of relevant policies, including
2. To ascertain whether the banking orga- position limits; and the quality of the banking
nization has and maintains sound risk- organizations relevant management informa-
management policies and procedures and tion systems and internal controls.
effective internal controls over the use of credit 6. Evaluate the management of a banking
derivatives. organizations asset concentration to a particular
3. To review and evaluate existing risk borrower, which could include the use of non-
involving credit-derivative arrangements. governmental guarantees on one or more of the
4. To ascertain whether adequate capital and borrowers loans. List the asset concentrations
reserves are held against exposures to reference in the confidential Administrative and Other
assets, including whether risk-based capital Matters page D of the inspection report.
computations have accounted for any additional 7. Review the quality of loans and the overall
risk resulting from derivative arrangements. financial condition of the borrower; the borrow-
ers credit history; any secondary sources of
repayment, such as financially responsible guar-
2129.0.5 INSPECTION PROCEDURES antors; and other factors.
8. When determining whether to classify an
1. Consider credit risk associated with refer- underlying asset protected by a credit deriva-
ence assets as primary risks. Determine whether tive, compare the term of the credit derivative in
the credit-risk exposure is treated as if it was relation to the maturity of the protected under-
a letter of credit or other off-balance-sheet lying asset, the probability that the protected
guarantee. underlying asset will default while the guarantee
2. Review the organizations credit exposure is in force, and whether the credit risk has
to the guarantor, as well as to the reference actually been transferred.
asset. Determine if the asset is actually owned 9. For guarantor banking organizations,
by the beneficiary. review the credit quality of individual reference
3. Ascertain whether the amount of credit assets in derivative contracts in the same man-
protection a beneficiary receives when entering ner as other credit instruments, such as standby
into a credit derivative is sufficient to warrant letters of credit.
treatment of the derivative as a guarantee for a. Evaluate a credit derivative in which a
regulatory capital and other supervisory banking organization provides credit protection
purposes. based on the overall financial condition and
4. Review credit-derivative transactions in resources of the reference obligor; the obligors
which the reference asset is not identical to the credit history; and any secondary sources of
asset actually owned by the beneficiary banking repayment, such as collateral.
organization. b. If the reference asset is classified, clas-
a. Ascertain if the reference asset is an sify the exposure from providing credit protec-
appropriate proxy for loans or other assets tion through a credit derivative.

Page 7
Risk and Capital ManagementSecondary-Market Credit Activities
WHATS NEW IN THIS REVISED economic conditions. Supervisors and bank
SECTION management alike should remain alert to the
possibility that loan performance could deterio-
Effective July 2009, this section was revised to rate if certain sectors of the economy experience
delete a reference to SR-95-17 that was super- problems. The recent rise in consumer bankrupt-
seded by SR-98-12 (see section 2126.1). cies, credit card delinquencies, and credit
charge-offs illustrates this concern. These types
of developments could have significant implica-
2129.05.05 RISK IDENTIFICATION tions for the risks associated with secondary-
AND RISK MANAGEMENT OF market credit activities.
SECONDARY MARKET CREDIT This section identifies some of the important
ACTIVITIES risks involved in several of the more common
types of secondary-market credit activities.
Banking organizations have substantially Guidance is provided on sound practices, along
increased their secondary-market credit activi- with special considerations that supervisors
ties, such as loan syndications, loan sales and should take into account in assessing the risk-
participations, credit derivatives, and asset secu- management systems for these activities. A
ritizations, as well as their provision of credit banking organizations failure to adequately
enhancements and liquidity facilities to these understand the risks inherent in secondary-
types of transactions. These activities can market credit activities and the failure to incor-
enhance both credit availability and bank profit- porate such risk within its risk-management sys-
ability, but managing the risks of these activities tems and internal capital allocations may
poses increasing challenges. The risks involved, constitute an unsafe and unsound banking
while not new to banking, may be less obvious practice.
and more complex than the risks of traditional A fundamental principle is advanced in this
lending activities. Some secondary-market guidance: Banking organizations should explic-
credit activities involve credit, liquidity, opera- itly incorporate the full range of risks of their
tional, legal, and reputational risks in concentra- secondary-market credit activities into their
tions and forms that may not be fully recognized overall risk-management systems.2 In particular,
by management or adequately incorporated in a supervisors and examiners should determine
banking organizations risk-management sys- whether banking organizations are recognizing
tems. In reviewing these activities, supervisors1 the risks of secondary-market credit activities
and examiners should assess whether banking by (1) adequately identifying, quantifying, and
organizations fully understand and adequately monitoring these risks; (2) clearly communicat-
manage the full range of the risks involved in ing the extent and depth of these risks in reports
secondary-market credit activities. to senior management and the board of directors
The heightened need for management atten- and in regulatory reports; (3) conducting ongo-
tion to these risks is underscored by reports ing stress testing to identify potential losses and
from examiners, surveys of senior lending offi- liquidity needs under adverse circumstances;
cers, and discussions with trade and advisory and (4) setting adequate minimum internal stan-
groups. All of these individuals have indicated dards for allowances or liabilities for losses,
that competitive conditions over the past few
years have encouraged an easing of credit terms
2. This guidance applies to the secondary-market credit
and conditions in both commercial and con- activities conducted by state member banks, bank holding
sumer lending. In addition, indications are that companies, Edge corporations, and U.S. branches and agen-
some potential participants in loan syndications cies of foreign banks. For this guidance, secondary-market
have found it necessary to make complex credit credit activities include, but are not limited to, loan syndica-
tions, loan participations, loan sales and purchases, credit
decisions within a much shorter time frame than derivatives, asset securitizations, and both implied and direct
has been customary. Although the recent easing credit enhancements that may support these or the related
may not be imprudent, the incentives and pres- activities of the banking organization, its affiliates, or third
sures to lower credit standards have increased as parties. Asset-securitization activities refers to the issuance,
underwriting, and servicing of asset-backed securities; the
competition has intensified and borrowers have provision of credit or liquidity enhancements to securitized
experienced generally favorable business and transactions; and investment in asset-backed securities.
1. The term supervisors is intended to refer to Federal BHC Supervision Manual July 2009
Reserve System staff. Page 1
Risk and Capital Adequacy Management of the Exposures Arising from Secondary-Market Credit Activities 2129.05
capital, and contingency funding. Incorporating The transactions involving credit and liquid-
secondary-market credit activities into banking ity enhancements tend to be complex and may
organizations risk-management systems and expose the institutions extending them to hidden
internal capital adequacy allocations is particu- obligations that may not become evident until
larly important. This guidance builds on, sup- the transactions have deteriorated. In substance,
ports, and is fully consistent with existing guid- such activities move the credit risk off the
ance on risk management issued by the Federal balance sheet by shifting risks associated with
Reserve.3 traditional on-balance-sheet assets into off-
Improvements in technology, greater stan- balance-sheet contingent liabilities. Given the
dardization of lending products, and the use of potential complexity and, in some cases, the
credit enhancements have helped to increase indirect nature of these enhancements, the actual
dramatically the volume of loan syndications, credit-risk exposure can be difficult to assess,
loan sales, loan participations, asset securitiza- especially in the context of traditional credit-
tions, and credit guarantees undertaken by com- risk limit, measurement, and reporting systems.
mercial banks, affiliates of bank holding compa- Moreover, many secondary-market credit
nies, and some U.S. branches and agencies of activities involve new and compounded dimen-
foreign banks. In addition, the advent of credit sions of reputational, liquidity, operational, and
derivatives permits banking organizations to legal risks that are not readily identifiable and
trade credit risk, manage it in isolation from may be difficult to control. For example,
other types of risk, and maintain credit relation- recourse provisions and certain asset-backed
ships while transferring the associated credit security structures can give rise to significant
risk. Such developments have improved the reputational- and liquidity-risk exposures, and
availability of credit to businesses and consum- ongoing management of underlying collateral in
ers, allowed management to better tailor the mix securitization transactions can expose a banking
of credit risk within loan and securities port- organization to unique operating and legal risks.
folios, and helped to improve overall bank For those banking organizations involved in
profitability. providing credit enhancements in connection
Certain credit and liquidity enhancements that with loan sales and securitizations, and those
banking organizations provide to facilitate vari- banking organizations involved in credit deriva-
ous secondary-market credit activities can make tives and loan syndications, supervisors and
the evaluation of their risks less straightforward examiners should assess whether the banking
than evaluating the risks involved in traditional organizations systems and processes adequately
on-balance-sheet banking activities. These identify, measure, monitor, and control all of the
enhancements, or guarantees, generally mani- risks involved in the secondary-market credit
fest themselves as recourse provisions; securiti- activities. In particular, the risk-management
zation structures that entail credit-linked early- systems employed should include the identifica-
amortization and collateral-replacement events; tion, measurement, and monitoring of these
and direct-credit substitutes, such as letters of risks, as well as an appropriate methodology for
credit and subordinated interests that, in effect, the internal allocation of capital and reserves.
provide credit support to secondary-market The stress testing conducted within the risk-
instruments and transactions.4 measurement element of the management sys-
tem should fully incorporate the risk exposures
3. For a more detailed discussion of risk management, see of these activities under various scenarios in
SR-04-18, Bank Holding Company Rating System; order to identify their potential effect on a bank-
SR-03-4, Risk Management and Valuation of Mortgage Ser- ing organizations liquidity, earnings, and capi-
vicing Assets Arising from Mortgage Banking Activities; tal adequacy. Moreover, management reports
and SR-99-37, Risk Management and Valuation of Retained
Interests Arising from Securitization Activities; SR-95-51 should adequately communicate to senior man-
(as amended by SR-04-18), Rating the Adequacy of Risk agement and the board of directors the risks
Management Processes and Internal Controls at State Mem- associated with these activities and the contin
ber Banks and Bank Holding Companies; SR-98-12,
Investment Securities and End-User Derivatives Activities;
Enhancement for Securitized Receivables. In addition, bank-
SR-93-69, Examining Risk Management and Internal Con-
ing organizations have retained the risk of loss, that is,
trols for Trading Activities of Banking Organizations; and
recourse, on sales and securitizations of assets when, in accor-
SR-90-16, Implementation of Examination Guidelines for
dance with generally accepted accounting principles, they
the Review of Asset Securitization Activities.
record on their balance sheets interest-only strips receivables
4. Examiners should also review SR-96-30, Risk-Based
or other assets that serve as credit enhancements. For more
Capital Treatment for Spread Accounts that Provide Credit
information, see Statement of Financial Accounting Standards
No. 140, Accounting for Transfers and Servicing of Finan-
BHC Supervision Manual July 2009 cial Assets and Extinguishment of Liabilities, and the instruc-
Page 2 tions to the Reports of Condition and Income.
gency plans that are in place to deal with

adverse conditions. (See SR-97-21.)
2129.05.1 CREDIT RISKS IN

SECONDARY-MARKET CREDIT
ACTIVITIES
Banking organizations should be aware that the
credit risk involved in many secondary-market
credit activities may not always be obvious. For
certain types of loan sales and securitization
transactions, a banking organization may actu-

Page 2.1
ally be exposed to essentially the same credit organizations are increasingly employing these
risk as it is in traditional lending activities, even instruments, either as end-users, purchasing
though a particular transaction may, superfi- credit protection fromor providing credit pro-
cially, appear to have isolated the banking orga- tection tothird parties, or as dealers intermedi-
nization from any risk exposure. In such cases, ating such protection. In reviewing credit
removing an asset from the balance sheet may derivatives, supervisors should consider the
not result in a commensurate reduction in credit credit risk associated with the reference asset, as
risk. Transactions that can give rise to this risk well as general market risk and the risk of the
include loan sales with recourse; credit deriva- counterparty to the contract.
tives; direct-credit substitutes, such as letters of With respect to credit-derivative transactions
credit; liquidity facilities extended to securitiza- in which banking organizations are mitigating
tion programs; and certain asset-securitization the credit risk of their assets, supervisors and
structures, such as the structure typically used to examiners should carefully review those situa-
securitize credit card receivables. tions in which the reference assets are not iden-
tical to the assets actually owned by the institu-
tions. Supervisors should consider whether the
2129.05.1.1 Loan Syndications reference asset is an appropriate proxy for the
loan or the other asset whose credit exposure the
Recently, the underwriting standards of some banking organization intends to offset.
syndications have been relaxed through the eas-
ing or elimination of certain covenants or the
use of interest-only arrangements. Bank man- 2129.05.1.3 Recourse Obligations, Direct-
agement should continually review syndication Credit Substitutes, and Liquidity Facilities
underwriting standards and pricing practices to
ensure that they remain consistent over time 2129.05.1.3.1 Recourse Obligations
with (1) the degree of risk associated with the
activity and (2) the potential for unexpected Partial, first-loss recourse obligations retained
economic developments to adversely affect bor- when selling assets, as well as the extension of
rower creditworthiness. partial credit enhancements (for example,
In some cases, potential participants in loan 10 percent letters of credit), can be a source of
syndications have felt it necessary to make deci- concentrated credit risk by exposing institutions
sions to commit to the syndication within a to the full amount of expected losses on the
shorter period of time than is customary. Super- protected assets. For instance, the credit risk
visors and examiners should determine whether associated with whole loans or pools of assets
syndicate participants are performing their own that are sold to secondary-market investors can
independent credit analysis of the syndicated often be concentrated within the partial, first-
credit and should make sure participants are not loss recourse obligations retained by the bank-
placing undue reliance on the analysis of the ing organizations selling and securitizing the
lead underwriter or on commercial-loan credit assets. In these situations, even though institu-
ratings. Banking organizations should not feel tions may have reduced their exposure to cata-
pressured to make an irrevocable commitment strophic loss on the assets sold, they generally
to participate in a syndication until such an retain the same credit-risk exposure they would
analysis is complete. if they continued to hold the assets on their
balance sheets.
2129.05.1.2 Credit Derivatives

2129.05.1.3.2 Direct-Credit Substitutes
Credit derivatives are generally off-balance-
sheet financial instruments5 that are used by Institutions also assume concentrated credit risk
banking organizations to assume or mitigate the through the extension of partial direct-credit
credit risk of loans and other assets.6 Banking substitutes, such as the purchase of subordinated
interests and the extension of letters of credit.
5. Credit-linked notes are on-balance-sheet instruments. For example, banking organizations that spon-
6. See SR-96-17, Supervisory Guidance for Credit sor certain asset-backed commercial paper pro-
Derivatives, for a discussion of supervisory issues regarding grams, or so-called remote-origination conduits,
credit derivatives, including the risk-based capital treatment
of credit derivatives held in the banking book. SR-97-18,
can be exposed to high degrees of credit risk
Application of Market Risk Capital Requirements to Credit
Derivatives, provides guidance on the risk-based capital BHC Supervision Manual July 2005
treatment of credit derivatives held in the trading book. Page 3
even though it may seem that their notional 2129.05.1.4 Asset-Securitization

exposure is minimal. Such a remote origination Structures
conduit lends directly to corporate customers
referred to it by the sponsoring banking organi- The structure of various securitization transac-
zation that used to lend directly to these same tions can result in an institutions retaining the
borrowers. The conduit funds this lending activ- underlying credit risk in a sold pool of assets.
ity by issuing commercial paper that, in turn, is An example of this contingent credit-risk reten-
guaranteed by the sponsoring banking organization is credit card securitizations in which the
tion. The net result is that the sponsoring institu- securitizing organization explicitly sells the
tion has much the same credit-risk exposure credit card receivables to a master trust but, in
through this guarantee as it would if it had made substance, retains the majority of the economic
the loans directly and held them on its books. risk of loss associated with the assetsbecause
However, this credit extension is an off-balance- of the credit protection provided to investors by
sheet transaction, and the associated risks may the excess yield, spread accounts, and structural
not be fully reflected in the institutions risk- provisions of the securitization. Excess yield
management system. provides the first level of credit protection that
can be drawn upon to cover cash shortfalls
between the principal and coupon owed to
2129.05.1.3.3 Liquidity Facilities investors and the investors pro rata share of the
master trusts net cash flows. The excess yield is
Banking organizations that extend liquidity equal to the difference between the overall yield
facilities to securitized transactions, particularly on the underlying credit card portfolio and the
asset-backed commercial paper programs, may master trusts operating expenses.8 The second
be exposed to high degrees of credit risk that level of credit protection is provided by the
may be subtly embedded within the facilities spread account, which is essentially a reserve
provisions. Liquidity facilities are commitments funded initially from the excess yield.
to extend short-term credit to cover temporary The structural provisions of credit card secu-
shortfalls in cash flow. While all commitments ritizations generally provide credit protection to
embody some degree of credit risk, certain com- investors through the triggering of early-
mitments extended to asset-backed commercial amortization events. Such an event usually is
paper programs to provide liquidity may subject triggered when the underlying pool of credit
the extending institution to the credit risk of the card receivables deteriorates beyond a certain
underlying asset pool, often trade receivables, or point and requires that the outstanding credit
to the credit risk of a specific company using the card securities begin amortizing early to pay off
program for funding. Often the stated purpose investors before the prior credit enhancements
of such liquidity facilities is to provide funds to are exhausted. As the early amortization acceler-
the program to retire maturing commercial ates the redemption of principal (paydown) on
paper when a mismatch occurs in the maturities the security, the credit card accounts that were
of the underlying receivables and the commer- assigned to the master credit card trust return to
cial paper, or when a disruption occurs in the the securitizing institution more quickly than
commercial paper market. However, depending had originally been anticipated, thus exposing
on the provisions of the facilitysuch as the institution to liquidity pressures and any
whether the facility covers dilution of the under- further credit losses on the returned accounts.
lying receivable poolcredit risk can be shifted
from the programs explicit credit enhance-
ments to the liquidity facility.7 Such provisions 2129.05.2 REPUTATIONAL RISKS
may enable certain programs to fund riskier
assets and yet maintain the credit rating on the The secondary-market credit activities of many
programs commercial paper without increasing institutions may expose them to significant repu-
the programs credit-enhancement levels. tational risks. Loan-syndication underwriting
7. Dilution essentially occurs when the receivables in the

underlying asset poolbefore collectionare no longer
8. The monthly excess yield is the difference between the
viable financial obligations of the customer. For example,
overall yield on the underlying credit card portfolio and the
dilution can arise from returns of consumer goods or unsold
master trusts operating expenses. It is calculated by subtract-
merchandise by retailers to manufacturers or distributors.
ing from the gross portfolio yield the (1) coupon paid to
investors; (2) charge-offs for that month; and (3) servicing
BHC Supervision Manual July 2005 fee, usually 200 basis points paid to the banking organization
Page 4 sponsoring the securitization.
may present significant reputational-risk expo- 2129.05.3 LIQUIDITY RISKS

sure to lead underwriters because syndicate par-
ticipants may seek to hold the lead underwriter The existence of recourse provisions in asset
responsible for actual or perceived inadequacies sales, the extension of liquidity facilities to secu-
in the loans underwriting, even though partici- ritization programs, and the early-amortization
pants are responsible for conducting an indepen- triggers of certain asset-securitization transac-
dent due-diligence evaluation of each credit. tions can involve significant liquidity risk to
Such risk may be compounded by the rapid institutions engaged in these secondary-market
growth of new investors in this market, usually credit activities. Institutions should ensure that
nonbanks that may not have previously endured their liquidity contingency plans fully incorpo-
a downturn in the loan market. rate the potential risk posed by their secondary-
There is the possibility that pressure may be market credit activities. With the issuance of
brought to bear on the lead participant to repur- new asset-backed securities, the issuing banking
chase portions of the syndication if the credit organization should determine the potential
deteriorates in order to protect its reputation in effect on its liquidity at the inception of each
the market, even though the syndication was transaction and throughout the life of the securi-
sold without recourse. In addition, the deteriora- ties to better ascertain its future funding needs.
tion of the syndicated credit exposes the lead An institutions contingency plans should
organization to possible litigation, as well as consider the need to obtain replacement funding
increased operational and credit risk. One way and specify the possible alternative funding
to mitigate reputational risk in syndications is sources, in the event of the amortization of
for banking organizations to know their custom- outstanding asset-backed securities. This is par-
ers and to determine whether syndication cus- ticularly important for securitizations with
tomers are in a position to conduct their own revolving receivables, such as credit cards, when
evaluation of the credit risks involved in the an early amortization of the asset-backed securi-
transaction. ties could unexpectedly return the outstanding
Asset-securitization programs can also be a balances of the securitized accounts to the issu-
source of increasing reputational risk. Often, ing institutions balance sheet. An early amorti-
banking organizations sponsoring the issuance zation of a banking organizations asset-backed
of asset-backed securities act as servicer, admin- securities could impede its ability to fund
istrator, or liquidity provider in the securitiza- itselfeither through reissuance or other
tion transaction. It is imperative that these insti- borrowingssince the institutions reputation
tutions are aware of the potential losses and risk with investors and lenders may be adversely
exposure associated with reputational risk. The affected.
securitization of assets whose performance has
deteriorated may result in a negative market
reaction that could increase the spreads on an 2129.05.4 INCORPORATING THE
institutions subsequent issuances. In order to RISKS OF SECONDARY-MARKET
avoid a possible increase in their funding costs, CREDIT ACTIVITIES INTO RISK
institutions have supported their securitization MANAGEMENT
transactions by improving the performance of
the securitized asset pool. This has been accom- Supervisors should verify that an institution
plished, for example, by selling discounted incorporates the risks involved in its secondary-
receivables or adding higher-quality assets to market credit activities in its overall risk-
the securitized asset pool. Thus, an institutions management system. The system should entail
voluntary support of its securitization in order to (1) inclusion of risk exposures in reports to the
protect its reputation can adversely affect the institutions senior management and board to
sponsoring or issuing organizations earnings ensure proper management oversight; (2) adop-
and capital. tion of appropriate policies, procedures, and
Such methods of improving the credit quality guidelines to manage the risks involved;
of securitized asset pools have been used by (3) appropriate measurement and monitoring of
banking organizations in providing voluntary risks; and (4) assurance of appropriate internal
support to their securitizations, especially for controls to verify the integrity of the manage-
credit card master trusts. These actions gener- ment process with respect to these activities.
ally are taken to avoid either a rating downgrade The formality and sophistication with which the
or an early amortization of the outstanding
asset-backed securities.
Page 5
risks of these activities are incorporated into an not place undue reliance on the credit analysis
institutions risk-management system should be performed by the lead organization. Rather, the
commensurate with the nature and volume of its participant should have clearly defined policies
secondary-market credit activities. Institutions and procedures to ensure that it performs its
with significant activities in this area are own due diligence in analyzing the risks inher-
expected to have more elaborate and formal ent in the transaction.
approaches to manage the risk of their
secondary-market credit activities.
2129.05.4.2 Management Information and
Risk-Measurement Systems
2129.05.4.1 Board of Directors and
Senior Management Responsibilities An institutions management information and
risk-measurement systems should fully incorpo-
Both the board of directors and senior manage- rate the risks involved in its secondary-market
ment are responsible for ensuring that they fully credit activities. Banking organizations must be
understand the degree to which the organization able to identify credit exposures from all
is exposed to the credit, market, liquidity, opera- secondary-market credit activities and be able to
tional, legal, and reputational risks involved in measure, quantify, and control those exposures
the institutions secondary-market credit activi- on a fully consolidated basis. The economic
ties. They are also responsible for ensuring that substance of the credit exposures of secondary-
the formality and sophistication of the tech- market credit activities should be fully incorpo-
niques used to manage these risks are commen- rated into the institutions efforts to quantify its
surate with the level of the organizations activi- credit risk, including efforts to establish more-
ties. The board should approve all significant formal grading of credits to allow for statistical
policies relating to the management of risk aris- estimation of loss-probability distributions.
ing from secondary-market credit activities and Secondary-market credit activities should also
should ensure that the risk exposures are fully be included in any aggregations of credit risk by
incorporated in board reports and risk- borrower, industry, or economic sector.
management reviews. It is particularly important that an institu-
Senior management is responsible for ensur- tions information systems can identify and seg-
ing that the risks arising from secondary-market regate those credit exposures arising from the
credit activities are adequately managed on both institutions loan-sale and securitization activi-
a short-term and long-run basis. Management ties. Such exposures include the sold portions of
should ensure that there are adequate policies participations and syndications, exposures aris-
and procedures in place for incorporating the ing from the extension of credit-enhancement
risk of these activities into the overall risk- and liquidity facilities, the effects of an early-
management process of the institution. Such amortization event, and the investment in asset-
policies should ensure that the economic sub- backed securities. The management reports
stance of the risk exposures generated by these should provide the board and senior manage-
activities is fully recognized and appropriately ment with timely and sufficient information to
managed. In addition, banking organizations monitor the institutions exposure limits and
involved in securitization activities should have overall risk profile.
appropriate policies, procedures, and controls
with respect to underwriting asset-backed secu-
rities; funding the possible return of revolving 2129.05.4.3 System of Internal Controls
receivables (for example, credit card receivables
and home equity lines); and establishing limits One of managements most important responsi-
on exposures to individual institutions, types of bilities is establishing and maintaining an effec-
collateral, and geographic and industrial concen- tive system of internal controls that, among
trations. Lead banking organizations in loan other things, enforces the official lines of author-
syndications should have policies and proce- ity and the appropriate separation of duties in
dures in place that address whether or in what managing the risks of the institution. These
situations portions of syndications may be internal controls must be suitable for the type
repurchased. Furthermore, banking organiza- and level of risks given the nature and scope of
tions participating in a loan syndication should the institutions activities. Moreover, these inter-
nal controls should provide reasonable assur-
BHC Supervision Manual July 2005 ance of reliable financial reporting (in published
Page 6 financial reports and regulatory reports), includ-
ing adequate allowances or liabilities for Supervisors and examiners should review the
expected losses. substance of secondary-market transactions
when assessing underlying risk exposures. For
example, partial, first-loss direct-credit substi-
2129.05.5 STRESS TESTING tutes providing credit protection to a securitiza-
tion transaction can, in substance, involve much
The use of stress testing, including consider- the same credit risk as that involved in holding
ation of multiple market events that could affect the entire asset pool on the institutions balance
a banking organizations credit exposures and sheet. Supervisors and examiners should ensure
securitization activities, is another important that banking organizations have implemented
element of risk management. Stress testing reasonable methods for allocating capital against
involves identifying possible events or changes the economic substance of credit exposures aris-
in market behavior that could have unfavorable ing from early-amortization events and liquidity
effects on the institution and assessing the orga- facilities associated with securitized transac-
nizations ability to withstand them. Stress test- tions. Such facilities are usually structured as
ing should not only consider the probability of short-term commitments to avoid a risk-based
adverse events, but also likely worst-case sce- capital requirement, even though the inherent
narios. Such an analysis should be done on a credit risk may be approaching that of a
consolidated basis and consider, for instance, guarantee.9
the effect of higher-than-expected levels of If, in the supervisors judgment, an institu-
delinquencies and defaults, as well as the conse- tions capital level is not sufficient to provide
quences of early-amortization events with protection against potential losses from such
respect to credit card securities that could raise credit exposures, this deficiency should be
concerns regarding the institutions capital reflected in the banking organizations
adequacy and its liquidity and funding capabili- CAMELS or RFI/C(D) ratings. Furthermore,
ties. Stress-test analyses should also include supervisors and examiners should discuss the
contingency plans regarding the actions man- capital deficiency with the institutions manage-
agement might take, given certain situations. ment and, if necessary, its board of directors.
Such an institution will be expected to develop
and implement a plan for strengthening the
2129.05.6 CAPITAL ADEQUACY organizations overall capital adequacy to levels
deemed appropriate given all the risks to which
As they do with all risk-bearing activities, insti- it is exposed.
tutions should fully support the risk exposures
of their secondary-market credit activities with
adequate capital. Banking organizations should 2129.05.7 INSPECTION OBJECTIVES
ensure that their capital positions are sufficiently
strong to support all of the risks associated with 1. To determine whether there are risk-
these activities on a fully consolidated basis and management systems and whether they accu-
should maintain adequate capital in all affiliated rately identify all the risk exposures stem-
entities engaged in these activities. The Federal ming from secondary-market activities.
Reserves risk-based capital guidelines establish 2. To evaluate secondary-market credit activi-
minimum capital ratios, and those banking orga- ties and to determine if there has been a
nizations exposed to high or above-average
degrees of risk are therefore expected to operate 9. For further guidance on distinguishing, for risk-based
capital purposes, whether a facility is a short-term commit-
significantly above the minimum capital ment or a direct-credit substitute, see SR-92-11, Asset-
standards. Backed Commercial Paper Programs. Essentially, facilities
When evaluating capital adequacy, supervi- that provide liquidity, but which also provide credit protection
sors should ensure that banking organizations to secondary-market investors, are to be treated as direct-
credit substitutes for purposes of risk-based capital. See sec-
that sell assets with recourse, assume or mitigate tion 2128.03 for a discussion of the limited risk-based capital
credit risk through the use of credit derivatives, risk-weighted assets exclusion of an asset-backed commercial
and provide direct-credit substitutes and liquid- paper (ABCP) program when the banking organization is the
ity facilities to securitization programs are sponsor and must consolidate under GAAP its ABCP pro-
gram that is defined as a variable interest entity. The amend-
(1) accurately identifying and measuring these ment was approved by the Board on July 17, 2004 (effective
exposures and (2) maintaining capital at aggre- September 30, 2004).
gate levels sufficient to support the associated
credit, market, liquidity, reputational, opera- BHC Supervision Manual July 2005
tional, and legal risks. Page 7
lowering of credit standards that could cause market activities and the conditions under
the institutions financial condition to dete- which a loan syndication can be
riorate during less-favorable business and purchased;
economic conditions. d. determining whether management is con-
3. To establish whether the institutions man- ducting ongoing stress testing to identify
agement system performs stress testing to potential losses and liquidity needs under
evaluate the risk exposures of secondary- adverse and worst-case scenarios; and
market credit activities under various sce- e. making certain that senior management is
narios and to evaluate the potential effect of setting adequate minimum internal stan-
the activities on the institutions liquidity, dards for allowances or liabilities for
earnings, and capital adequacy. losses, capital, and contingency funding.
4. To review the substance of the institutions 2. Assess whether the institutions systems and
secondary-market transactions, when assess- processes adequately identify, measure,
ing underlying risk exposures. monitor, and control all of the risks involved
5. To ascertain whether liquidity contingency in the institutions secondary-market credit
plans exist and to determine whether they activities.
fully incorporate the potential risk posed by 3. Determine whether the various risks associ-
secondary-market credit activities, including ated with secondary-market activities are
the need to obtain replacement funding. incorporated into contingency plans, includ-
6. To determine whether the board of directors ing replacement funding plans and identified
is fully informed of the risks involved in alternative funding sources, to lessen the
secondary-market activities and whether it impact of those risks.
approves policies, controls, and procedures 4. Establish whether there is an adequate and
to control exposures arising from credit, effective system of internal controls that
liquidity, operational, legal, reputational, and enforces official lines of authority and the
other risks. appropriate separation of duties in managing
7. To determine whether the institution has a the risks associated with secondary-market
sufficiently strong capital position to support activities.
all the risk associated with secondary-market 5. Review loan-syndication contract agree-
credit activities and that it has a capital plan ments, underwriting documentation, and rel-
for strenghtening its overall capital adequacy evant correspondence with loan-syndication
position. contractual parties to establish whether
8. To ascertain whether there is an effective a. the bank holding companys management
system of internal controlsfocused on lines has performed adequate credit investiga-
of authority and the separation of dutiesto tions and evaluations of the syndicate
monitor and contain the risks associated with loans, the syndicate participants, and the
secondary-market activities. extent of the BHCs credit-risk exposures;
b. the syndication customers are in a posi-
tion to conduct their own investigations
and evaluation of the credit risks involved
2129.05.8 INSPECTION PROCEDURES in the transaction; and
c. undue reliance is placed on the lead
1. Determine whether the institutions senior underwriter, the participants, or on their
management is recognizing the risk involved commercial-loan credit ratings.
in secondary-market credit activities by 6. For credit derivatives
a. determining if there is adequate identify- a. analyze the credit risk associated with the
ing, quantifying, and monitoring of risk; reference asset, the general market risk,
b. clearly communicating the extent and and the counterparty risk; and
depth of those risks in discussions, presen- b. determine, for those reference assets that
tations, and inspection reports that are are not identical assets actually owned,
delivered to the board of directors and whether the reference asset is an appropri-
senior officials of the institution; ate proxy for the loan or other assets
c. presenting to the board of directors, for its whose credit exposure is to be offset.
approval, all significant policies relating 7. Review the substance of secondary-market
to the risk management of secondary- transactions, when evaluating and analyzing
underlying risk exposures.
BHC Supervision Manual July 2005 8. Evaluate and determine that there are reason-
Page 8 able methods for internally allocating capital
against the economic substance of credit 9. Incorporate the evaluation of potential risks
exposures that arise from amortization events and losses from credit exposures, including
and liquidity facilities associated with securi- management deficiencies, into the institu-
tized transactions. tions supervisory ratings.

Page 9
Futures, Forward, and Option Contracts
Section 2130.0
2130.0.1 INTRODUCTION (call), a specified quantity of an underlying
security, money market instrument or commod-
Effective March 1, 1983, the Board issued an ity at or before the stated expiration of the
amended bank holding company policy state- contract. At expiration, if the value of the option
ment entitled Futures, Forward and Options on increases, the holder will exercise the option or
U.S. Government and Agency Securities and close it at a profit. If the value of the option does
Money Market Instruments. Bank holding not increase, the holder would probably let the
companies are now required to furnish written option expire (or close it out at a profit) and,
notification to their District Federal Reserve consequently, will lose the cost (premium paid)
Banks within 10 days after financial contract of (for) the option. Alternatively, the option may
activities are begun by the parent or a nonbank be sold prior to expiration.
subsidiary. The policy is consistent with the Clearing CorporationA corporation orga-
joint policy statement previously issued by the nized to function as the clearing house for an
three federal bank regulators with regard to exchange. The clearing house registers, moni-
banks participating in financial contracts, and tors, matches and guarantees trades on a futures
reflects the Boards judgment that bank holding market, and carries out financial settlement of
companies, as sources of strength for their sub- futures transactions. The clearing house acts as
sidiary banks, should not take speculative posi- the central counterparty to all trades executed
tions in such activities. on the exchange. It substitutes as a seller to all
If a bank holding company or nonbank sub- buyers and as a buyer to all sellers. In addition,
sidiary is taking or intends to take positions in the clearing corporation serves to insure that all
financial contracts, that companys board of contracts will be honored in the event of a
directors should approve written policies and counterparty default.
establish appropriate limitations to ensure that Clearing MemberA member firm of the
the activity is conducted in a safe and sound clearing house or corporation. Membership in
manner. Also, appropriate internal control and clearing associations or corporations is restricted
audit procedures should be in place to monitor to members of the respective commodity ex-
the activity. The following discussion and changes, but not all exchange members are
inspection procedures apply to futures contract clearing house members. All trades of a non-
activity generally, but are intended to focus spe- clearing member must be registered with, and
cifically on financial futures contracts. For a eventually settled through, a clearing member.
discussion of currency futures and options and Commodities Futures Trading Commission
the examination procedures for those instru- The CFTC is a federal regulatory agency
ments, see sections F and G in the Merchant and charged with regulation of futures trading in all
Investment Bank Examination Manual. commodities. It has broad regulatory authority
Information, instructions, and inspection pro- over futures trading. It must approve all future
cedures have been provided for verifying com- contracts traded on U.S. commodity exchanges,
pliance with the Boards policy statement. It is ensure that the exchanges enforce their own
intended that the policy statement will ensure rules (which it must review and approve), and
that contract activities are conducted in accor- direct an exchange to take any action needed to
dance with safe and sound banking practices. maintain orderly markets whenever it believes
The task of evaluating BHC contract activities that an emergency exists.
is the responsibility of System examiners. The Contract ActivitiesThis term is used in this
following information and inspection proce- manual to refer to banking organization partici-
dures are intended to serve as a guide for Fed- pation in the futures, forward, standby contract,
eral Reserve Bank staff in that effort. or options markets to purchase and sell U.S.
government and agency securities or money
market instruments, foreign currencies and other
2130.0.2 DEFINITIONS financial instruments.
ConvergenceThe process by which the fu-
BasisBasis is defined as the difference tures market price and the cash market price of a
between the futures contract price and the cash financial instrument or commodity converge as
market price of the same underlying security, the futures contract approaches expiration.
money market instrument, or commodity.
Call OptionA contract that gives the buyer BHC Supervision Manual December 1992
(holder) the right, but not the obligation to buy Page 1
Futures, Forward, and Option Contracts 2130.0
Covered Call OptionsThis term refers to or commodity on a future date at a specified

the issuance or sale of a call option where the price. While futures contracts traditionally spec-
option seller owns the underlying deliverable ified a deliverable instrument, newer contracts
security or financial instrument. have been developed that are based on various
Cross HedgingThe process of hedging a indexes. Futures contracts based on indexes set-
cash or derivative instrument position with tle in cash and never result in delivery of an
another cash or derivative instrument that has underlying instrument; some traditional con-
significantly different characteristics. For exam- tracts that formerly specified delivery of an
ple, an investor who wants to hedge the sales underlying instrument have been redesigned to
price of long-term corporate bonds might hedge specify cash settlement. New financial futures
by establishing a short position in a treasury contracts are continually being proposed and
bond or treasury bond futures contract, but since adopted for trading on various exchanges.
the corporate bonds cannot be delivered to sat- Futures Commission Merchant (FCM)An
isfy the contract, the hedge would be a cross FCM functions like a broker in securities. An
hedge. To be successful, the price movements of FCM must register with the Commodities
the hedged instrument must be highly correlated Futures Trading Commission (CFTC) in order
to that of the position being hedged. to be eligible to solicit or accept orders to buy or
Difference CheckA difference check is sent sell futures contracts. The services provided by
by the party which recognizes a loss when a an FCM include a communications system for
forward contract is closed out by the execution transmittal of orders, and may include research
of an offsetting forward contract pursuant to a services, trading strategy suggestions, trade exe-
pair-off clause. In essence, the difference check cution, and recordkeeping services.
represents a net cash settlement on offsetting Financial Futures ContractsStandardized
transactions between the same two parties and contracts traded on organized exchanges to pur-
replaces a physical delivery and redelivery of chase or sell a specified security, money market
the underlying securities pursuant to offsetting instrument, or foreign currency on a future date
contracts. at a specified price on a specified date. Futures
Financial ContractThis term is used in the contracts on GNMA mortgage-backed securities
manual to refer to financial futures, forward, and Treasury bills were the first interest rate
standby contracts, and options to purchase and futures contracts. Other financial futures con-
sell U.S. government and agency securities, tracts have been developed, including contracts
money market instruments, foreign currency on Eurodollars, currencies, and Euro-Rate dif-
futures and other financial instruments. ferentials. It is anticipated that new and similar
Firm Forward ContractThis term is used financial futures contracts will continue to be
to describe a forward contract under which de- proposed and adopted for trading on various
livery of a security is mandatory. See Standby exchanges.
Contract for a discussion of optional delivery Futures ExchangeUnder the Commodities
forward contracts. Exchange Act (CEA), a board of trade desig-
Forward ContractsOver-the-counter con- nated by the Commodity Futures Trading Com-
tracts for forward placement or delayed delivery mission as a contract market. Trading occurs on
of securities in which one party agrees to pur- the floor of the exchange and is conducted by
chase and another to sell a specified security at a open auction in designated trading areas.
specified price for future delivery. Contracts GNMA or GINNIE MAEEither term is used
specifying settlement in excess of 30 days fol- to refer to the Government National Mortgage
lowing trade date shall be deemed to be forward Association. Ginnie Mae is a government corpo-
contracts. Forward contracts are usually non- ration within the U.S. Department of Housing
standardized and are not traded on organized and Urban Development. In creating GNMA,
exchanges, generally have no required margin Congress authorized it to grant a full faith and
payments, and can only be terminated by agree- credit guaranty of the U.S. government to
ment of both parties to the transaction. The term mortgage-backed securities issued by private
also applies to derivative contracts such as sector organizations.
swaps, caps, and collars. HedgeThe process of entering transactions
Futures ContractsStandardized contracts that will protect against loss through compensa-
traded on organized commodity exchanges to tory price movement. A hedge transaction is one
purchase or sell a specified financial instrument which reduces the organizations overall level
of risk.
BHC Supervision Manual December 1992 Initial Futures MarginIn the futures mar-
Page 2 ket, a deposit held by an FCM on behalf of a
client against which daily gains and losses on rities positions in proprietary trading and invest-
futures positions are added or subtracted. A ment accounts. Futures positions are typically
futures margin represents a good-faith deposit marked-to-market at the end of each trading
or performance bond to guarantee a partici- session.
pants performance of contractual obligations. Naked Call OptionRefers to the issuance or
Interest Rate CapA multi-period interest sale of a call option where the option seller does
rate option for which the buyer pays the seller a not own the underlying deliverable security or
fee to receive, at predetermined future times, the instrument.
excess, if any, of a specified floating interest rate Open InterestRefers to the number of
index above a specified fixed per annum rate futures contracts outstanding for a given deliv-
(cap or strike rate). Caps can be sold separately ery month in an individual futures contracts.
or may be packaged with an interest rate swap. The mechanics of futures trading require that
Interest Rate Collarthe combination, in sin- for every open long futures contract there is an
gle contract, of a simultaneous sale of a cap and open short futures contract. For example, an
the purchase of a floor, or, a purchase of a cap open interest of 10,000 futures contracts means
and sale of a floor. The buyer of the collar is a that there are 10,000 long contract holders and
buyer of a cap and the seller of a floor. By 10,000 short contract holders.
selling the floor, the collar buyer gives up the Options ContractsOption contracts require
possibility of benefiting from a decline in inter- that the buyer of the option pay the seller (or
est rates below the strike rate in the floor compo- writer) of the option a premium for the right, but
nent. On the other hand, the fee earned in selling not the obligation, to exercise an option to buy
the floor lowers the cost of protection against (call option) or sell (put option) the instrument
interest rate reversal. underlying the option at a stated price (strike or
Interest Rate Flooris the reverse of an exercise price) on a stated date (European style
interest rate cap. The buyer pays a premium to option) or at any time before or on the stated
obtain protection against a decline in interest expiration date (American style option). There
rates below a specified level. are also exchange traded options contracts:
Long ContractA financial contract to buy (1) put and call options on futures contracts that
securities or money market instruments at a are traded on commodities exchanges; and
specified price on a specific future date. (2) put and call options that specify delivery of
Long HedgeThe long hedge, also called the securities or money market instruments (or that
anticipatory hedge is the process by which a are cash settled) that are traded on securities
market participant protects a cash or risk posi- exchanges. The key economic distinction
tion by buying a futures or forward contract, i.e. between options on futures and options on secu-
taking a long financial contract position. rities, is that the party who exercises an option
Maintenance MarginMaintenance margin on a futures contract receives a long or short
is the minimum level to which an equity posi- futures position rather than accepting or making
tion can decline as a result of a price decline delivery of the underlying security or financial
before additional margin is required. In other instrument.
words, it is the minimum margin which a cus- Pair-Off ClauseA pair-off clause specifies
tomer must keep on deposit with a member at that if the same two parties to a forward contract
all times. Each futures contract has specified trade should subsequently execute an offsetting
maintenance margin levels. A margin call is trade (e.g. a long contract against an outstanding
issued when a customers initial margin balance short contract), settlement can be effected by
falls below the maintenance margin level speci- one party sending the other party a difference
fied by the exchange. Maintenance margin must check rather than having physical delivery and
be satisfied by the deposit of cash or agreed redelivery of securities.
upon cash equivalents. The amount of cash re- Par CapThis term refers to a provision in
quired is that amount which is sufficient to the contract of sale for Ginnie Mae mortgage-
restore the account balance to the initial margin backed securities which restricts delivery only
level. to pools which bear an interest rate sufficiently
Mandatory DeliverySee Firm Forward high so that the securities would trade at or
Contract. below par when computed based on the agreed
Mark-to-marketThe process by which the to yield.
carrying value (market value or fair value) of a Put OptionAn option contract which gives
financial instrument is revalued, and which is
recognized as the generally accepted accounting BHC Supervision Manual December 1992
principle for determining profit or loss on secu- Page 3
the holder the right, but not the obligation, to value of a cash bond as compared to a price
sell (put) a specified quantity of a financial decline of an accessible T-bond futures contract.
instrument (money market) or commodity at a Yield Maintenance ContractThis is a for-
specified price on or before the stated expiration ward contract written with terms which main-
date of the contract. If price of the underlying tain the yield at a fixed rate until the delivery
instrument occurs, the purchaser will exercise or date. Such a contract permits the holder of a
sell the option. If a decline in price of the short forward contract to deliver a different cou-
underlying instrument does not occur, the option pon security at a comparable yield.
purchaser will let it expire and will lose only the
cost (premium paid) of (for) the option.
Round TurnCommissions for executing 2130.0.3 FINANCIAL CONTRACT
futures transactions are charged on a round turn TRANSACTIONS
basis. A round turn constitutes opening a futures
position and closing it out with an offsetting Futures, forward and options contracts are
contract, i.e. executing a short contract and clos- merely other tools for use in assetliability man-
ing out the position with a long contract or agement. These contracts are neither inherently
vice-versa. a panacea nor a speculative vehicle for use by
Short ContractA financial contract to sell banks and bank holding companies. Rather, the
securities or money market instruments at a benefit or harm resulting from engaging in
specified price on a specified future date. financial contract activities results from the
Short HedgeThe process by which a cus- manner in which contracts are used. Proper utili-
tomer protects a cash or risk position by selling zation of financial contracts can reduce the risks
a futures or forward contract, i.e. taking a short of interest or exchange rate fluctuations. On the
financial contract position. The purpose of the other hand, financial contracts can serve as
short hedge is to lock in a selling price. leverage vehicles for speculation on rate
Standby ContractOptional delivery forward movements.
contracts on U.S. government and agency secu-
rities arranged between securities dealers and
customers that do not involve trading on orga- 2130.0.3.1 Markets and Contract Trading
nized exchanges. The buyer of a standby con-
tract (put option) acquires, upon paying a fee, Forward contract (OTC) trading of Government
the right to sell securities to the other party at a National Mortgage Association (GNMA) or
stated price at a future time. The seller of a Ginnie Mae Mortgage-Backed Securities pre-
standby (the issuer) receives the fee, and must ceded exchange trading of GNMA futures con-
stand ready to buy the securities at the other tracts in 1975.
partys option. See the fuller discussion of
Standby Contracts under 2130.0.3.1.2)
TBA (To Be Announced) TradingTBA is 2130.0.3.1.1 Forward Contracts
the abbreviation used in trading Ginnie Mae
securities for forward delivery when the pool Forward contracts are executed solely in an
number of securities bought or sold is to be over-the-counter market. The party executing a
announced at a later date. contract to acquire securities on a specified
Variation Marginis when, in very volatile future date is deemed to have a long forward
markets, additional funds are required to be contract; and the party agreeing to deliver secu-
deposited to bring the account back to its initial rities on a future date is described as a party
margin level, while trading is in progress. Varia- holding a short forward contract. Each con-
tion margin requires that the needed funds be tract is unique in that its terms are arrived at
deposited within the hour, or when reasonably after negotiation between the parties.
possible. If the customer does not satisfy the For purposes of illustrating a forward con-
variation or maintenance margin call(s), the tract, assume that SMC Corporation is an origi-
futures position is closed. Unlike initial margin, nator of government guaranteed mortgages and
variation margin must be in cash. Also refer to issuer of GNMA securities. SMC Corporation
Maintenance Margin. has a proven ability to manage and predict the
Weighted Hedgea hedge that is used to volume of its loan originations over a time
compensate for a greater decline in the dollar horizon of three to four months. To assure a
profit or prevent a loss on current loan origina-
BHC Supervision Manual December 1992 tions, SMC Corporation may enter binding over-
Page 4 the-counter commitments to deliver 75% of its
mortgage production which will be converted GNMA mortgage-backed securities identified

into GNMA securities three months in the by a pool number) will be delivered. Instead,
future. If SMC agrees to sell $3 million of such contracts generally identify the deliverable
GNMA securities (11% coupon) to the WP securities as having been traded on a TBA
Securities Firm at par in three months, SMC basis (to be announced). Prior to settlement,
Corporation is considered to have entered a the dealer holding the short contract will send a
short (commitment to sell) forward contract. final confirmation to the other party specifying
Conversely, WP has entered a long (commit- the actual securities to be delivered, accrued
ment to buy) forward contract. The two parties interest, dollar price, settlement date, coupon
to the transaction are both now obligated to rate, and the method of payment.
honor the terms of the contract in three months, Forward contracts are not typically marked-
unless the contract is terminated by mutual to-market. Both parties in a forward contract are
agreement. exposed to credit risk, since either party can
It should be noted that executing a short default on its obligation.
forward contract is not the same as executing
the short sale of a security. Generally, a short
sale of a security is understood to represent the 2130.0.3.1.2 Standby Contracts
speculative sale of a security which is not owned
by the seller. The short seller either purchases Standby contracts are put options that trade
the security prior to settlement date or borrows over-the-counter, with initial and final confirma-
the security to make delivery; however, a tion procedures that are quite similar to those on
short forward contract merely connotes the forward transactions. Standby contracts were
side of the contract required to make delivery on developed to allow GNMA issuers to hedge
a future date. Short forward contracts should not their production of securities, especially in
be considered inherently speculative, but must instances where mortgage bankers have
be considered in light of the facts surrounding extended loan commitments in connection with
the contract. the construction of new subdivisions. When a
Forward trading can be done on a mandatory mortgage banker agrees to finance a subdivision
delivery (sometimes referred to as firm for- with conventional and government guaranteed
ward contracts) basis or on an optional deliv- mortgages it is difficult to predict the actual
ery basis (standby contract). With respect to number of FHA and VA guaranteed loans which
a mandatory trade, the contract can also be will be originated. Hence, it is risky for a
written with a pair-off clause. A pair-off GNMA issuer to enter mandatory forward con-
clause specifies that if the same two parties to a tracts to deliver the entire estimated amount of
trade should subsequently execute an off-setting loans eligible to be pooled as GNMA securities.
trade (e.g., the banking organization executes a By entering an option contract and paying a fee
long contract against an outstanding short confor the option to put securities to another
tract), settlement can be effected by one party party, a GNMA issuer or securities dealer ob-
sending the other party a difference check tains downside market protection, but remains
rather than having a physical delivery and rede- free to obtain the benefits of market apprecia-
livery of securities. tion since it can walk away from the option
When a forward contract is executed by a contract. In addition to the flexibility of walking
dealer, a confirmation letter or contract is sent to away and selling securities at the prevailing
the other party to the transaction. The contract market price when GNMA prices are rising, a
will disclose pertinent data about the trade, such GNMA issuer avoids the potential risk of pur-
as the size of the trade, coupon rate, the date chasing mortgages or GNMA securities to cover
upon which final delivery instructions will be short forward contracts in the event that produc-
issued, and the yield at which the trade was tion of GNMA securities falls below anticipated
effected. In addition, the contract letter will levels.
specify whether it is permissible for the short When a securities dealer sells a standby con-
side of the trade to deliver a different coupon tract granting a GNMA issuer the right to put
security at a comparable yield (yield mainte- securities to it, the dealer, in turn, will attempt to
nance contract) if the coupon specified in the purchase a matching standby contract from an
contract is not available for delivery. Contracts investor because the dealer does not want to
which prohibit the delivery of securities requir- shoulder all of the downside market risk. There
ing a premium over par are considered to have a
par cap. The initial contract letter generally BHC Supervision Manual December 1992
does not specify which specific securities (e.g., Page 5
is also potential for securities firms to deal in Assumptions

standby contracts having no relationship to the
issuance of GNMA securities. 1. Fee paid to banking organization = 1% of
Some illustrations of standby contracts fol- contract value
low. They are intended to illustrate the mechan- 2. Contract delivery price = 98
ics of a standby contract when a banking organi- 3. Coupon = 12%
zation has sold or issued a standby contract
granting the contra party the option to put
Situation 1
GNMA securities to the banking organization.
On contract exercise date: Market Price = 100.
Therefore, the dealer would sell securities at
market rather than put them to the bank.
Dealer Banking organization
Sale price 100 Purchase price N/A

Fee paid (1) Fee Received 1
99 1
Result: Dealer sacrificed 1% to insure Result: Banking organization earned

sale price. 1% fee for standing by.
Situation 2 Therefore, dealer would deliver securities pursu-

ant to the standby contract.
On contract exercise date: Market price = 95.
Dealer Banking organization
Sale price 98 Purchase price 98

Market price 95 Market price 95
Contract gain 3 Contract loss (3)
Fee paid (1) Fee received 1
Actual gain 2 Actual loss (2)
Result: Dealer paid 1% fee to avoid Result: Banking organization received

3 point market loss. 1% fee to compensate for purchasing
securities 3 points above market.
2130.0.3.1.3 Futures Contracts rities) has a short contract. If a customer

desires to purchase (sell) a futures contract, the
Futures Contract transactions involve three brokerpossibly a member of a clearing house
types of participants: customersthe buyers or of an exchangewill take the order to the ex-
sellers of contracts, brokers, and a futures exchange floor and purchase (sell) a contract sold
change. As in the forward markets, a buyer (bought) by another customer (through another
(party committed to take delivery of securities broker).1 All futures transactions are made
specified in the futures contract) of a futures
contract has a long contract and the seller
(party committed to deliver the underlying secu- 1. Brokers in commodities are required to register as
futures commission merchants (FCMs) with the Commod-
ities Futures Trading Commission (CFTC) in order to be
BHC Supervision Manual December 1992 eligible to solicit or accept orders to buy or sell futures
Page 6 contracts.
through and carried on the books of clearing FCMs require customers to reimburse them for
house member brokers, who are treated by the posting additional margin.
exchange as their own customers. Hence, there Once a customer has executed a futures con-
are always an equal number of long and short tract to make or accept delivery of securities in
contracts outstanding, referred to as the open the future it is obligated to fulfill the terms of
interest, since the auction process requires a the contract. A futures contract cannot be resold
buyer and seller for every contract. over-the-counter because futures contracts are
All futures contracts are obligations of an not transferable. However, a customer may ter-
exchanges clearing association or corporation, minate its obligation under a futures contract
i.e. the clearing association is on the opposite either by making or accepting delivery of the
side of each long and short contract; and all securities as specified by the contract, or by
transactions are guaranteed within the resources executing an offsetting futures contract (long
of the exchanges clearing association (on most contract to cancel a short contract or vice-versa)
futures exchanges a small fee is collected on with the same broker to cancel the original
each transaction and placed into an insurance contract on the same exchange. The overwhelm-
fund). Should an FCM default on a futures ing majority of futures contracts are closed out
contract, the association pays the costs of com- by the execution of an offsetting contract prior
pleting the contract. to expiration.
The key to understanding futures transactions
is the fact that futures contract prices on U.S.
government and agency securities move in the
2130.0.4 MARGIN REQUIREMENTS same manner as bond prices; e.g. rising interest
rates result in falling futures prices and falling
In order to insure the integrity of futures mar- interest rates result in rising futures prices.
kets, the clearing house requires that member Hence, the purchase of a futures contract
brokers (clearing house members) deposit initial (long futures contract) at a price of 98 will
margin in connection with new futures positions result in a loss if future market participants
carried for the firm, other brokers or FCMs for perceive rising interest rates in the month of
whom the clearing house member clears trans- contract expiration and act accordingly; then the
actions, and public customers. The clearing offsetting of a futures contract (executing a
house members in turn require their customers short futures contract) would have to be at a
whether they are other FCMs or public custom- lower price; e.g. 96. As in the case of any
ersto deposit margin.2 The FCMs generally commercial transaction, the participant has a
require that public customers meet initial mar- loss if the sale price is lower than the purchase
gin requirements by depositing cash, pledging price, or a gain if the sale price is higher than the
government securities, or obtaining irrevocable purchase price.
standby letters of credit from substantial com-
mercial banking organizations. Daily mainte-
nance margin or variation margin calls (deposits 2130.0.4.1 Variation Margin Calls
of cash required to keep a certain minimum
balance in the margin account) based upon each Variation margin calls for each contract and
days closing futures prices are calculated pursu- expiration month are based upon the closing
ant to rules of the various futures exchanges, futures exchange price. If there is a change from
and clearing house members are required to the previous days closing prices, the long con-
meet daily variation margin calls on positions tract holders will be required to post additional
carried for customers and the firm. In turn, the margin which will be passed through via the
clearing house process to short contract holders
or vice-versa. Subsequent to the computation of
variation margin calls, the clearing house mem-
2. In general, the futures exchanges set different initial ber brokers are required to post variation margin
margin requirements based upon the types of activity engaged on behalf of the clearing firm and its customer
in by the customer. Margin requirements are higher for cus- accounts prior to commencement of the next
tomer contracts characterized as speculative than for those
contracts deemed to be hedge positions. The commodities days trading. Then, the clearing brokers call
industry traditionally defines someone with a business need their FCM and public customers requesting
for using the futures market as a hedger; others are defined as more margin to bring the accounts up to the
speculators. Therefore, in instances where there are different
initial hedge and speculative margin requirements, it is as-
sumed that banking organizations will only be required to BHC Supervision Manual December 1992
meet margin required for hedgers. Page 7
required maintenance margin level.3 Of course, the initial margin level. If there is a drop in the
if a futures position has a gain at the end of the value of the contract which places the margin
day, the clearing firm receives a deposit in its account balance below the initial margin level
margin account. The firm, in turn, increases the but above the variation margin level, the cus-
margin account balances of customers holding tomer is not required to deposit additional mar-
contracts with gains. gin monies. Alternatively, if there is a positive
For illustrative purposes, we will again as- flow of margin monies the customer is free to
sume that a customer purchased a futures con- withdraw any amount which exceeds the initial
tract (long contract, face value $100,000) at a margin requirement.
price of 98. If the next closing futures price is The entire marking-to-the-market process is
97, the customer will have suffered a one point repeated at the close of the next business day
margin loss (if the customer chose to offset the using a comparison of the previous days clos-
long contract with a short contract, the transac- ing price (97) to the current closing price. (The
tion would be closed out at a one point loss). preceding example is simplified because it
Conversely, the party with a short contract exe- implies that the customer deposits promptly the
cuted at 98 would receive a one point margin required margin. In reality, margin is not always
payment to his account. deposited so quickly.)
Assuming that the initial margin requirement In summary, futures trading is a zero sum
is $1,500 and the variation margin requirement game because of the equal number of long and
is $1,000, the following summarizes the steps short contracts outstanding, and the variation
followed in administering a customers (long margin payments reflect this fact, i.e. for every
position) margin account in connection with the long contract holder posting variation margin,
previously described transaction. there is a short contract holder receiving margin.
Margin
Account 2130.0.5 THE DELIVERY PROCESS
Transaction Balance
Futures contracts are defined as standardized
contracts traded on organized exchanges to pur-
1. Deposit initial margin $1,500
chase or sell a specified financial instrument or
2. Purchase $100,000
physical commodity on a future date at a speci-
contract @ 98 500
fied price. Even when a participant keeps a
3. Day 1Closing futures price 97
contract open for delivery, the specified price
(Reduction of $1,000 in
(which corresponds to a specified yield) is actu-
margin account to reimburse
ally obtained through a combination of past
broker for posting margin with
futures market gains or losses (incurred through
clearing corporation).
the daily mark to market process) and the cur-
4. FCM calls customer to request
rent futures market price. For invoicing pur-
$1,000 to bring account up to
poses, the actual delivery price is based upon a
required initial margin level.
closing futures market settlement price on a
5. Reimbursement to FCM
date designated by the exchange. In addition,
of $1,000 1,500
the final calculation of a delivery price on a
bond contract will typically involve an adjust-
ment reflecting the fact that the coupon issue to
It is important to note that once the margin
be delivered against the contract grade (8 per-
account balance falls below the variation margin
cent) futures contract is not an 8 percent bond.
level, the customer is required to deposit addi-
For example, when current U.S. treasury bond
tional funds to replenish the account balance to
coupons are 12 percent it is highly unlikely that
a party with a short futures position would
deliver a bond with an 8 percent coupon.
3. It should be noted that public customers generally have
more time to meet maintenance margin calls than do FCMs.
However, if a customer fails to meet a variation margin call
within three days, the FCM must take a charge against its net
capital if it fails to close out the customers contract (17
2130.0.6 MECHANICS AND
C.F.R. 1.17(c)5(viii)). OPERATION OF FUTURES
EXCHANGES
Page 8 Certain technical factors should be noted with
respect to futures markets. First, futures markets 2130.0.7 COMPARISON OF FUTURES,

are not totally free markets. Rules of the FORWARD, AND STANDBY
exchanges put artificial constraintsdaily price CONTRACTS
movement limitsupon the amount of daily
market movement allowed in given types of Excluding the fact that futures contracts are
futures contracts. For example, government traded on organized exchanges, there are many
securities prices in the cash market will move as similarities between contracts. Conceptually, the
far as the market participants deem necessary to contracts are interchangeable; each type of con-
reflect the market for those securities, while tract can be utilized for hedging, speculating, or
the futures market specifying delivery of the arbitrage strategies, but none of the contracts are
underlying security will be constrained from transferable to third parties. While engaging in
having the same potential unlimited market contract activities allows the participants to
movement. There have been instances where either assume or shift the risks of interest rate
persons desiring to close out a futures contract changes associated with the security deliverable
by executing an offsetting contract have been under the contract, such contracts fail to provide
unable to do so for one or more days until the the other benefits of owning the underlying
exchanges daily trading limits allowed futures security. Specifically, financial contracts do not
prices to ratchet up or down to the level that pay interest, do not have a U.S. government
reflected the true market price as perceived guaranty of payment of principal at maturity,
by hedgers, speculators, and arbitragers. and cannot be pledged to secure public deposits
Although the preceding illustrates the basic or be used as collateral for repurchase agree-
nature of futures price movements, do not ments. The forward markets are perceived to be
assume that futures and cash market prices delivery markets wherein there is a high per-
always move in the same direction at the same centage of delivery of the underlying security.
velocity. Futures prices by definition predict As in the case of other futures markets, the
future events, e.g., a market participant can buy financial futures markets were not designed to
a futures contract to take delivery of a three be delivery markets. Nevertheless, there have
month Treasury bill two years in the future.4 been a number of instances when a relatively
In such an instance, the holder of a long T-bill high percentage of financial futures contracts
futures contract agrees to the future purchase of have resulted in delivery. Some persons suggest
a government security which has not yet been tax reasons and the deliverable supply of securi-
issued. There is no reason to assume that a ties as two factors that have contributed to the
contract with a distant maturity will move in the much higher delivery of securities than delivery
same manner as the cash market for a three of physical commodities. It is, of course, also
month Treasury bill. In addition, there is a rela- easier and cheaper to make delivery of securi-
tionship between the cash market price of an ties rather than railroad carloads of grain.
existing security and the price of that security in Trading units on futures exchanges are stan-
the futures market which is called the basis. The dardized. The standardized trading unit in a
basis can vary significantly over the life of a physical commodity which may be a railroad
given futures contract. In the contract delivery car of grain; the typical trading unit in a govern-
month, the futures market price will converge ment or agency security futures contract may be
towards the cash market price (the basis ap- $100,000 or $1 million par principal at a coupon
proaches zero), adjusted for technical factors rate (on coupon issues) fixed by the exchange.
that reflect the costs of processing and deliver- On the other hand, forward and standby con-
ing securities. If the futures market price did not tracts are not traded in standardized units
converge towards the cash market price in the with given contract maturity months. Instead,
delivery month, the arbitragers would take off- forward and standby contracts are custom made
setting futures and cash market positions to arbi- to suit the needs of the two parties to the
trage away any profitable discrepancies between transaction.
the two markets. While all contract holders are involved with
market risks, the holders of forward and standby
contracts are especially prone to credit risk.
Unlike futures contracts where the mechanics of
exchange trading provide for the futures ex-
4. All financial futures contracts have a number of contract
change clearing association to guaranty perfor-
expiration months extending into the future. As the near term
contract expires, a contract with a more distant expiration date BHC Supervision Manual December 1992
is added. Page 9
mance of each contract, forward and standby There are two basic types of options: calls
contracts are only as good as the entity on the and puts. The call option is any option which
other side of the contract. Anyone who reads the obligates the writer to deliver to the buyer at a
financial press should be aware that prior to the set price (exercise or strike price) within a spec-
passage of the Government Securities Act of ified time limit the underlying financial instru-
1986, there were a number of defaults involving ment. When the market price of the underlying
forward and standby contracts. In an effort to instrument is above the exercise (strike) price of
bring increased integrity into the unregulated the call, the call option is in-the-money. Con-
forward contract markets, there has been a trend versely, when the market price of the underlying
by some of the major securities dealers to financial instrument is below the exercise
require the posting of margin in connection with (strike) price of the call option, the call is out-
forward contract trading. There are no uniform of-the-money. When the market price of the
margin requirements governing all aspects of underlying instrument is equal to the strike
forward contract trading, nor is there a uniform price, the option is at-the-money. At expira-
application of margin requirements by dealers tion, the buyer will exercise the option if it is
requiring house margin (or internal margin in-the-money or let it expire unexercised if it
requirements established and enforced by indi- is out-of-the-money. An out-of-the-money call
vidual securities dealers). GNMA has estab- option has no value at expiration, since buyers
lished limited margin requirements (24 C.F.R. will not purchase the underlying instrument at a
390.52), as described below. price above the current market price. Prior to
expiration, the value of an in-the-money call
option is at least equal to the market value of the
2130.0.8 OPTION CONTRACTS underlying instrument minus the strike price.
The ownership of a call provides significant
Subsequent to the Boards initial adoption of a leverage, but raises the breakeven price relative
policy statement governing futures, forward, and to ownership of the underlying instrument.
standby contracts, trading of interest rate options Holding the call limits the amount of potential
began on organized futures and securities ex- loss and offers unlimited potential for gains.
changes. Proponents of exchange traded options A put option gives the buyer the right, but not
argue that such instruments are attractive to the obligation, to sell the underlying instrument
users because they permit the user to obtain at a specified price (exercise or strike price),
down side price risk protection, yet benefit before or at expiration. When the market price
from favorable price movement. In contrast, of the underlying instrument is below the strike
futures and forward contracts allow the user to price of the put option, the put is in-the-
lock in a specific price, but the user must forgo money, and a put option is out-of-the-money
future participation if the market should experi- when the market price of the underlying finan-
ence an upward price movement. Furthermore, cial instrument is above the strike price of the
the purchaser of an option pays a one time put option. Ownership of a put option offers
premium for this protection and is spared the leveraged profitability if the market value of the
contingent liabilities associated with futures underlying instrument declines.
margin calls. Some portfolio managers commonly employ
An option is a contract that gives the buyer, covered call writing strategies to gain fee
or holder, the right, but not the obligation, to income from options written on securities held
buy or sell a specified financial instrument at a in the portfolio. If an option position is covered,
fixed price, called the exercise or strike price, the seller owns the underlying financial instru-
before or at a certain future date. Some options, ment or commodity or has a futures position.
however do not provide for the delivery of the For example, an option position would be cov-
underlying financial instrument and, instead, are ered if a seller owns cash market U.S. Treasury
cash settled. Moreover, in some cases, the bonds or holds a long position on a Treasury
underlying financial instrument is an index. bond futures contract. Writing covered calls
Options that can be exercised before or at the has only limited potential for gain. Writing
expiration date are referred to as American covered calls is not a proper strategy for a
options; if an option can be exercised only on market that could rise or fall by substantial
the expiration date, it is termed a European amounts. It is generally used in a flat market
option. environment.
Referring to the above example, if a seller
BHC Supervision Manual December 1992 holds neither the cash market U.S. Treasury
Page 10 Bonds or was not long on the Treasury bond
futures contract, the writer would have an subtracting intrinsic value from the option pre-
uncovered or naked position. In such mium. For example,
instances, margin would be required (by the
exchange, if an exchange traded optionnot the
Time value = Option premium Intrinsic values
case for an OTC option) since the seller would
be obligated to satisfy the terms of the option Time value = 510/64 4.00
contract if the option buyer exercises the con-
Time value = 1.15384
tract. The risk potential for loss in writing
naked calls (calls against which there are no
securities held in portfolio) is great since the The option premium is affected by several
party required to deliver must purchase the re- other factors. One factor involves the compari-
quired securities at current market prices. Naked son of the underlying futures price versus the
covered call writing is generally viewed to be strike price of the option. An options price is
speculative since the risks are theoretically increased the more that it is in-the-money. A
unlimited, particularly if it is done solely to second factor is volatility. Volatile prices of the
generate fee income. underlying financial instrument can help stimu-
Options are purchased and traded either on late demand for the options, thus increasing the
organized exchanges or in the over-the-counter premium. A third factor that affects the pre-
(OTC) market. Option contracts follow three- mium of an option is the time until expiration.
month expiration cycles (example: March/June/ Option premiums are subject to greater price
September/December). The option contracts fluctuations because the underlying value of the
expire on the Saturday following the third Fri- futures contract changes more with a longer
day in the expiration month. Thus, options are time period. Other factors that affect the option
considered as wasting assets because they premium are the strike rate(s) and the domestic
have a limited life since they expire on a certain and foreign (if applicable) interest rates.
day, even though it may be weeks, months, or An exchange-traded option is often referred
years from now. The expiration date is the last to as a standardized option, reflecting the fact
day the option can be exercised. After that date that the terms of the contract are uniform with
the option is worthless. respect to the underlying instrument, amounts,
Option premium valuation. The price (value) exercise prices, and expiration dates. OTC
of an option premium is determined competi- options are characterized by terms and condi-
tively by open outcry auction on the trading tions which are unique to each transaction.
floor of the exchange. The premium value is Large financial institutions are often dealers in
affected by the inflow of buy and sell orders customized interest rate or foreign exchange
reaching the exchange floor. The buyer of the options. For example, a banking organization
option pays the premium in cash to the seller of might write a cap, or series of put option on
the option which is credited to the sellers pounds sterling to protect the dollar value of a
account. Several factors affect the value of an sterling denominated receivable due in one year.
option premium, as discussed below. The option In this case, an option can be tailored to fit the
premium consists of two parts, intrinsic value exact needs of the buyer.
and time value. The intrinsic value is the Like futures contracts, contract performance
gross profit that would be realized upon immedi- on exchange-traded options is guaranteed by the
ate exercise of the option. Stated another way, it clearing corporation which interposes itself as a
is the amount by which the option is in-the- central counterparty to all transactions. It substi-
money. It is the higher of: the value of an option tutes itself as a seller to all buyers and as a buyer
if it is exercised today; or zero. For in-the- to all sellers. Standardization combined with the
money call options, it is the difference between clearing corporations guarantee facilitates trad-
the price of the underlying financial instrument, ing and helps to insure liquidity in the market.
and the exercise (strike) price of the option. For The buyer or seller of an exchange-traded option
in-the-money put options, it is the difference may always close out an open position by enter-
of the exercise (strike) price of the put option ing into an offsetting transaction, with the same
and the price of the underlying financial instru- strike price and expiration date, and for the
ment. The intrinsic value is zero for at-the- same amount. Indeed, most exchange-traded
money or out-of-the-money options. The options are liquidated prior to maturity with an
time value derives from the chance that an offsetting transaction, rather than by exercising
option will gain intrinsic value in the future or
that its intrinsic value will increase before matu- BHC Supervision Manual December 1992
rity of the contract. Time value is determined by Page 11
the option in order to buy or sell the underlying 500. As opposed to a regular call or put option
instrument. on equity securities where there must be a sale
Buyers of exchange-traded options are not and delivery of shares of stock, there is no
required to post funds to a margin account delivery of the underlying instrument when an
because their risk is limited to the premium paid index option is exercised. Rather, settlement is
for the option. However, writers (sellers) of in cash.
options are required to maintain margin
accounts because they face substantial amounts
of risk. The amount of the margin varies
depending upon the volatility in the price of the 2130.0.8.1.2 Foreign Currency Options
option. As the option moves closer and closer to
The right to buy (call) or sell (put) a quantity of
being in-the-money, the writer is required to
a foreign currency for a specified amount of the
deposit more and more into his margin account,
domestic currency is a foreign currency option.
in order to guarantee his performance should the
The size of the contract is standard for each
option eventually be exercised.
currency. The contracts are quoted in cents per
Options on futures contracts provide the
unit of foreign currency. As an example, one
holder with the right to purchase (call) or sell
call option for the British pound is 12,500
(put) a specified futures contract at the options
pounds.
strike price. The difference between the strike
price on the option and the quote on the futures
contract represents the intrinsic value of the
option. Options on futures contracts differ from 2130.0.8.2 Caps, Floors, and Collars
traditional options in one key way: the party
who exercises an option on a futures contract Caps, floors, and collars provide risk protection
receives a long or short futures position (de- against floating interest rates. The market for
pending on whether he is exercising a call or put these products is an outgrowth of the OTC mar-
option) rather than accepting or making delivery ket in fixed income (bond) options.
of the underlying security or financial instru- An interest rate cap contract pays the buyer
ment. When the holder of a call option on a cash if the short term interest index rises
futures contract exercises the option and the above the strike rate in the contract in exchange
futures contract is delivered, the option writer for a fee. In combination with a floating rate
must pay the option holder the difference obligation, it effectively sets a maximum level
between the futures contracts current value and on interest rate payments. If market rates are
the strike price of the exercised call. The buyer below the cap rate, no payments are made
takes on a long position, and the writer a short under the cap agreement. Thus, the buyer of a
position in the futures contract. When a futures cap is able to place a ceiling on his floating
put option is exercised, the holder takes on a rate borrowing costs without having to forego
short futures position, and the writer a long potential gains from any decline in market
position. The writer of the put pays the holder rates.
the difference between the current price of the Cap agreements typically range in maturity
futures contract and the strike price of the put from 6 months to as long as 12 years, with reset
option. The resultant futures position, like any dates or frequencies that are usually monthly,
other futures position, is subject to a daily quarterly, or semiannual. The London Interbank
marked-to-market valuation. In order to liqui- Offered Rate (LIBOR) is the most widely used
date the futures position, both the buyer and reference rate for caps, floors, and collars. Other
the seller must undertake offsetting futures indexes used as reference rates are commercial
transactions. paper rates, the prime interest rate, Treasury bill
rates, and certain tax-exempt rates. Cap fees
depend upon the cap level, the maturity of the
2130.0.8.1 Other Option Contracts agreement, the volatility of the index used as the
reference rate, and market conditions. The
2130.0.8.1.1 Stock Index Options higher the cap rate, the lower the premium.
The fee is usually paid up front, but can be
A stock index option is a call or a put that is amortized.
based on a stock market index such as the S & P An interest rate floor agreement is used to
protect the overall desired rate of return associ-
BHC Supervision Manual December 1992 ated with a floating-rate asset. In accordance
Page 12 with the agreement, the seller receives a fee for
the floor agreement from the holder of the margin.5 However, the GNMA margin require-
underlying asset. When interest rates fall, the ments exclude the majority of GNMA forward
holder of the floor contract is protected by the contracts and only pertain to contracts involving
agreement, which specifies the fixed per annum GNMA issuers with other parties.6
rate (floor rate) that will be retained on those The Commodities Futures Trading Commis-
assets, at specified times during the life of the sion (CFTC) is the agency authorized by
agreement, even though floating interest rates Congress to supervise the trading of commodi-
may decline further. ties, including financial futures. Exchanges
An interest rate collar is a variation of a which trade commodities must register with
cap-only agreement. Under this arrangement the the CFTC. In addition, the various futures
seller of the collar, for a fee, agrees to limit the exchanges must receive CFTC approval before
buyers floating rate of interest within one they can begin trading a new futures instrument.
agreement by a simultaneous sale of a cap Brokers and dealers who execute futures con-
and purchase of a floor, or purchase of a cap tracts for customers must register as Futures
and sale of a floor. When the reference rate is Commission Merchants (FCM) with the
above the cap rate the seller makes payments to CFTC. There are also CFTC registration
the buyer sufficient to return the buyers floating requirements pertaining to firms engaging in
rate interest cost to the cap rate. Conversely, the commodities activities similar to an investment
buyer makes payments to the collar provider to advisor or mutual fund in the securities markets.
bring its rate back to the floor whenever the Finally, the surveillance activities of the various
reference rate falls below the floor rate. In effect, futures exchange examiners are subject to over-
under a collar agreement the buyer is selling a sight by the CFTC.
string of call options (the floor) back to the With the exception of reporting requirements
provider of the cap. The premium received from concerning persons or entities with large futures
selling the floor reduces the overall cost of the positions, the CFTCs jurisdiction generally
cap to the buyer of the collar. Thus, the pre- does not extend to financial institutions. Rather,
mium for a floor/ceiling, or collar, agreement, is the federal and state banking agencies, state
lower than for a cap-only agreement with the insurance commissions, and the Office of Thrift
cap at the same level. This is because the floor Supervision are responsible for supervising
sold to the provider of the collar has a certain regulated entities future activities, if permitted,
value, which is passed along to the buyer in the under statute or regulation.
form of a lower premium.
The disadvantage to collars, of course, is that
they limit the buyers ability to profit from
2130.0.10 EXAMPLES OF CONTRACT
declines in market rates below the specified
STRATEGIES
floor. Clearly, ones interest rate expectations
play an important role in determining whether
For purposes of reporting large positions to the
or not to use a collar agreement. It should also
CFTC a market participant defines its future
be noted that collar agreements involve credit
activities as speculative or as hedging.
risk on both sides of the agreement, similar to
Basically, CFTC rules consider a participant to
the credit risk considerations found in interest
be a hedger if certain facets of such persons
rate swap agreements. The buyer of the collar is
business can be hedged in the futures markets;
exposed to the risk that the provider may default
persons who do not have a business need for
on payments due under the cap agreement; and
participating are deemed to be speculators. It is
the provider of the collar is exposed to the risk
anticipated that bank holding companies charac-
that the buyer may default on payments due
terize their contract activities as hedging, or
under the floor agreement.
possibly as arbitrage between various markets.
5. Initial margin requirements necessitate the pledging of

2130.0.9 REGULATORY something of value prior to initiation of a transaction. Depos-
FRAMEWORK iting maintenance margin refers to pledging something of
value in reaction to market movements; e.g. depositing cash
representing the difference between a forward contract price
GNMA has adopted limited margin require- and its current market value.
ments. Specifically, the GNMA margin require- 6. See SR-625 dated July 23, 1980.
ments (12 C.F.R. 390.52) require marking-
to-market and the posting of maintenance BHC Supervision Manual December 1992
Page 13
Examiners must scrutinize contract positions for (losses) will approximately offset any losses
purposes of evaluating risk. (gains) on the hedged position.
The Board policy statement concerning bank 3. The contract position taken should have a
holding companies7 states: life which is equal to or greater than the end of
. . . the Board believes that any positions the period during which the hedge will be out-
that bank holding companies or their nonbank standing. For example, if interest rate protection
subsidiaries take in financial contracts should was deemed necessary for a six-month time
reduce risk exposure, that is, not be specula- span, it would not ordinarily be wise to enter a
tive. It should be noted, however, that a more contract expiring in three months.
liberal interpretation of the policy statement has
been permitted for dealer subsidiaries. For ex-
ample, in a government securities dealer subsid- 2130.0.10.1 The Mortgage Banking Price
iary, it is permissible to use related financial Hedge
contracts as a substitute trading instrument for
Assume that a mortgage banking subsidiary
cash market instruments. Thus, the use of finan-
agrees in June to originate mortgages at a fixed
cial contracts is not limited solely to reducing
yield in the following October. Unless the loan
the risk of dealing activities.
originator has a forward commitment to sell the
Some examples of contract strategies are pro-
loans to a permanent investor(s), it is exposed to
vided which reduce risk when viewed in isola-
a decline in the principal value of mortgages
tion. A definition of a financial hedge is:
due to a rise in interest rates between the com-
to enter transactions that will protect
mitment date and ultimate sale of the loans. An
against loss through a compensatory price
example of a traditional short hedge would
movement.
be the sale of futures contracts in an attempt to
In looking at a hedge transaction in isolation,
reduce the risk of price fluctuation and insure a
there should be certain elements present to make
profitable sale of the loans. However, in follow-
a hedge workable:
ing this strategy the mortgage originator also
1. The interest rate futures or forward con-
chooses to forfeit its ability to reap a profit if
tract utilized should have a high positive corre-
interest rates should fall.
lation (prices that tend to move in the same
If interest rates increased, the loss on the sale
direction with similar magnitude) with the cash
of mortgages or a pool of mortgage-backed se-
position being hedged. In other words, the
curities will probably be largely offset by a gain
futures or forward position taken should be
on the futures transaction; see example below. If
structured so that an upward price movement in
interest rates fall, the mortgage originator would
the contract offsets a downward price move-
gain on the resale of mortgages but lose on the
ment in the cash or risk position being hedged,
futures market transaction. Hence, in a true
and vice versa.
hedge, the hedgers earnings are relatively unaf-
2. The type (e.g. T-bill, T-bond, etc.) and size
fected by a change in market interest rates in
of the contract position8 taken should have a
either direction.
proportionate relationship to the cash or risk
Generally accepted accounting principles
position being hedged, so that futures gains
applicable to mortgage activity require that
mortgages held for resale be periodically reval-
7. The Boards policy statement on engaging in futures, ued to the lower of cost or market (Financial
forwards, and option contracts. Accounting Standards Board Statement No. 65,
8. Futures market participants engage in a practice, some-
times known as factorweighting or overhedging, to de-
Accounting for Certain Mortgage Banking
termine the appropriate number of futures contracts necessary Activities). Unrealized gains and losses on out-
to have the proper amount of compensatory price movement standing futures contracts are matched against
against a hedged cash or risk position. For example, it would related mortgages or mortgage commitments
require 10 mortgaged-backed futures contracts (8% coupon,
$100,000 face value) to hedge an inventory of $1,000,000
when the inventory is revalued to the lower of
mortgage-backed (8% coupon) securities. Alternatively, 14 cost or market; i.e. the lower of cost or market
mortgage-backed futures contracts would be required to hedge valuation is based upon a net figure including
a $1 million inventory of mortgage-backed securities with a unrealized related futures gains and losses.
1312% coupon. Overhedging or factor weighting is necessary
in hedging securities with higher coupons than those specified
in futures contracts (currently 8% on bond futures) because
higher coupon securities move more in price for a given 2130.0.10.2 Basis
change in yield than lower coupons.
Basis is the difference between the cash (spot)
BHC Supervision Manual December 1992 price of a security (or commodity) and its
Page 14 futures price. In other words:
Basis = Spot price Future price The rate basis is useful in analyzing hedges of
short-term instruments since it nets out all
For short-term and intermediate futures con- effects resulting from aging. For example, if a
tracts, the futures price is the quoted futures one year T-bill has a rate of 9 percent with a
price times an appropriate conversion factor. price of 85, and a 3-month T-bill has a rate of
For short-term futures contracts the quoted 9 percent and a price of 94, the price basis
futures price is 100 less the annualized futures would be 9. If a cash security ages, it does not
interest rate. The invoice price must be deter- necessarily mean that a change in the rate basis
mined using yield-to-price conventions for the has taken place.
financial instrument involved.
Basis may be expressed in terms of prices.
Due to the complexities involved in determining
the futures price, it is thus better to redefine 2130.0.10.3 Trading Account Short
price basis using actual futures delivery prices Hedge
rather than quoted futures prices. Thus, the price
basis for fixed income securities should be rede- Another example of a short hedge pertains to
fined as: securities dealers that maintain bond trading
accounts. While bonds are held long (actual-
Price Basis = Spot price ly owned by the dealer) in trading accounts,
Futures delivery price. dealers are subject to two risks. First, there is
the risk that the cost can change regardless of
Basis may also be expressed in terms of inter- whether the funds are generated through repur-
est rates. The rate basis is defined as: chase agreement financing or the dealers other
funding sources. When there is an inverted yield
Rate basis = Spot rate Futures rate curve (short-term interest rates are higher than
long-term rates), trading portfolio bonds in
The spot rate refers to the current rate on the inventory yield less than the cost of funds
instrument that can be held and delivered on the required to carry them. Second, there is the risk
contract. The futures rate represents the interest that bond market interest rates will rise, thus
rate that corresponds to the futures delivery forcing the dollar price of bonds down.
price of the deliverable instrument.
2130.0.10.3.1 Example 1: A Perfect Short Hedge 1
Month Cash Market Futures Market
June Mortgage department makes commitment to a Sells 10 December mortgage-

builder to originate $1 million of mortgages backed futures at 96-832
(based on current GNMA 8s cash price) at for $962,500 to yield
98-2832 for $988,750 8.59 percent
October Mortgage department originates then sells $1 Buys 10 December mortgage-

million of pooled mortgages to investors at a backed futures at 93,
price of 95-2032, for $956,250 for $930,000 to yield
8.95 percent
Loss: $32,500 Gain: $32,500
1. The effects of margin and brokerage costs on the trans-

action are not considered. It should be noted that perfect
hedges generally do not occur.
The following example pertains to a bond trad- mission charges and uses futures contracts
ing account. Assume that the dealer purchases maturing in March 19x9 because the dealers
Treasury bonds on October 4 and simulta-
neously sells a similar amount of Treasury bond BHC Supervision Manual December 1992
futures contracts. The illustration ignores com- Page 15
technical analysis discovered an advantage in previous December contract was the next avail-
using the March 19x9, rather than the previous able contract still trading.)
December contract as a hedge. (At that time the
Cash Market Futures Market
10/04/1998 Purchase $5MM T-bonds maturing Aug. Sell $5MM T-bonds futures contracts
2005, 8% coupon at 87-1032: expiring Mar. 1999 at 86-2132:
Principal = $4,365,625 Contract value = $4,332,813
10/23/1998 Sell $5MM T-bonds at 79.0: Buy $5MM T-bond futures

Mar. 1999 at 79-132
Principal = 3,950,000 Contract value = 3,951,563
Cash loss = ($415,625) Futures gain = $381,250
Although the hedge did not prevent the dealers There are a number of approaches available
trading account from losing money, it limited to attempt to ensure that future time deposits
the loss to $34,375 instead of $415,625. can be obtained without paying higher than mar-
It is worth noting that the preceding example ket interest rates. One method is forecasting the
also illustrates some of the dangers of using appropriate interest rate to be paid on a given
interest rate futures contracts. Although the time deposit three months in the future. How-
futures market proved useful to the trading de- ever, forecasting has become increasingly diffi-
partment, a futures contract could have serious cult to do with accuracy in the recent periods of
consequences for a dealer using an alleged fluctuating interest rates. An alternative ap-
long hedge to lock-in an attractive yield. proach would be to quote the current C.D. rate
(adjusted slightly for competitive factors) with
an intent to hedge in the futures market if the
banking organizations interest rate bid is
2130.0.10.4 Long Hedge accepted. Upon receiving notification that its
In certain areas of the country, financial institu- deposit bid has been accepted, the institution
tions desiring to hold public deposits are re- can then purchase an appropriate number of
quired to bid competitively for deposits. The futures contracts to insure a profitable invest-
case discussed below pertains to a situation ment spread three months hence when it actu-
where the competitive bids must be tendered ally receives the deposit.
one calendar quarter in advance of receiving the The following example on June 1, 19x0; the
deposit. In this example, the asset side of the facts are as follows:
balance sheet is not discussed since it is as-
sumed that a banking organization paying the Size of public deposits
prevailing one-year C.D. interest rate can utilize offered $10 million
the funds at a profitable spread. Date of deposit September 2, 19x0
In this type of situation the bidding institu- Term 1 year
tions are generally vulnerable to falling interest Current C.D. rate 814%
rates; one can safely assume that an institution
selected to hold public deposits would not be
dismayed to learn subsequently that interest For purposes of this illustration, assume that a
rates had risen and it had locked-in a funding bid was submitted to pay 814% for one year on
source at or below market rates. However, the $10 million. The bids were due June 1 and
funds will not be received for another 3 months. notification was given June 2 of the intention to
Thus, there is the possibility that interest rates provide the funds on September 2; and the bank-
could drop in the interim, leaving a reduced or ing organization decided to purchase futures
possibly negative net interest margin when the contracts on June 2.
funds are deployed. A Treasury bill futures contract, expiring in
3 months, is selected as the hedging vehicle
BHC Supervision Manual December 1992 because it reflects price movement of an instru-
Page 16 ment with a comparable maturity to one-year
C.D., and there was no C.D. futures contract but not identical, instrument. This type of hedg-
trading. For purposes of this illustration, it is ing is a measured risk since the outcome of such
assumed that the contract offers sufficient liquid- a transaction is a function of the price correla-
ity to enable the banking organization to readily tion of the instruments being hedged. At any
offset its open futures position when necessary. given moment it is conceivable that a negative
Using the bill contract is an example of cross correlation could exist between two unlike
hedging which is defined as the buying or instruments despite the presence of a strong
selling of an interest rate futures contract to correlation over an extended time period.
protect the value of a cash position of a similar,
Date C.D. Rate Transactions T-bill Futures 1
June 2, 19x0 8.25% Purchase 40 Contracts 91.84 8.16%

Sept. 2, 19x0 11.00% Sell 40 Contracts 90.05 9.95%
1. The size of the trading unit is based upon U.S. T-bills the difference between the actual T-bill yield and 100.00.
having a face value at maturity of $250,000 (40 2 250M = Every one basis point movement on a contract is equal to
10MM). Prices are quoted in terms of an index representing $25.00 per contract.
2130.0.10.4.1 Evaluation of the Hedge 2130.0.10.5 Using Options to Create an

Interest Rate Floor
Total interest (not compounded)
to be paid (814%) $ 825,000 Assume that on September 28th it is decided to
Alternative C.D. interest rollover a $1,000,000 investment in 13-week
(not compounded) Treasury bills on November 28, which also hap-
at current rate (11%) 1,100,000 pens to be the expiration date for call options on
the December Treasury bill futures contract.
Difference 275,000 The banking organization, concerned that inter-
Futures trading loss* (179,000) est rates will fall between September 28 and the
Net difference $ 96,000 rollover date, wishes to hedge the rollover of its
investment. The portfolio manager can set a
*ComputationPurchase price 91.84 minimum yield on the rollover investment by
Sale price 90.05
either buying a Treasury bill future call option,
1.79 or 179 basis points
(179 2 $25.00 2 40 contracts = $179,000) or by buying a Treasury bill futures contract.
Further assume that the December Treasury bill
In retrospect, it would have been better if the futures contract can be bought for a price of
banking organization would not have hedged. 93.70 which implies a discount yield of
By agreeing to an interest rate on June 2, it 6.30 percent. Treasury bill futures call options
obtained deposits on September 2 and will pay with a strike price of 93.75, implying a discount
approximately $275,000 less in interest pay- yield of 6.25 percent, sell for a premium of
ments to the municipality than is required on an 20 basis points, or $600 (20 basis points 2
ordinary C.D.(s) issued on September 2. The $25/basis point = $500).
$179,000 futures trading loss, of course, re- If the banking organization could actually
duced the windfall interest income due the bank- buy a Treasury bill futures contract that expired
ing organization. A net interest income spread on exactly November 28, then there would be a
of approximately $96,000, instead of a perfect hedge since the rate of return on the bills
$275,000, demonstrates two principles: 1) cross would be explicitly fixed by the futures hedging
hedging can cause unexpected results; and 2) it strategy. However, the closest maturing Trea-
is quite difficult to find perfect hedges in the real sury bill futures contract expires in December,
world. The hedge was structured so that a cash several weeks after the rollover date for the
gain was offset by a futures lossincorporating banking organizations investment. Uncertainty
the offsetting principles of a hedge transaction. over the actual discount yield of the Treasury
If the general level of interest rates had fallen, a bills on the rollover date and the yield produced
futures gain should have occurred to offset the
higher (relative to prevailing market rates) cost BHC Supervision Manual December 1992
of funds obtained on September 2. Page 17
by the hedge is known as basis risk, the risk 2130.0.10.6 Hedging a Borrowing with
that the yield on the hedge may differ from the an Interest Rate Cap
expected yield on the hedged item. For purposes
of this example, assume that the yield on the In order to limit a borrowers interest rate risk,
futures contract equals the actual discount yield sophisticated banking institutions may offer cap
on the 13-week Treasury bills at the rollover agreements as part of a loan package to their
date. Thus, the futures hedge in this example clients. While such an arrangement provides
will provide an effective discount yield of some comfort that the borrowers ability to re-
6.30 percent on the rollover of the 13-week pay will not be jeopardized by a sharp increase
Treasury bill investment. in interest rates, it obviously transfers that inter-
Assume that rates fall after September 28 and est rate risk back to the lender. Nevertheless,
that the discount yield on Treasury bill futures many banking institutions feel they are better
contracts declines from 6.30 percent to 6.00 per- able to manage that risk than are some of their
cent at the November 28 expiration date of the clients. Cap agreements have also been utilized
December Treasury bill futures options con- to cap the rate on issued liabilities. For example,
tract. The option to buy the Treasury bill futures an institution might be able to issue medium-
will be exercised since the strike price of 93.75 term floating rate notes at 3-month LIBOR plus
is below the market price of 94.00 for the an eighth of a percent. Alternatively, that institu-
underlying futures contract, yielding a profit of tion could issue a capped floating rate note at
25 basis points or $625 (25 basis points 2 3-month LIBOR plus three-eights of a percent.
$25/basis point). The profit must be offset by the By subsequently selling the cap separately back
20 basis point cost of the option, which reduces into the market the institution could, achieve
the net profit to 5 basis points. The effective sub-LIBOR funding, depending on the proceeds
hedged discount yield is 6.05 percent (6.00 per- from the sale of the cap.
cent on the 13-week Treasury billsassuming A cap agreement is typically specified by
no basis riskplus the 5 basis point profit from following terms: notional principal amount;
the hedge). The option hedge produces a yield maturity; underlying index, frequency of reset,
that is 5 basis points higher than the unhedged strike level. As an illustration, a cap agreement
yield, but 25 basis points lower than the might have the following terms:
6.30 percent yield that would have resulted from
hedging with futures.
Although the option hedge resulted in a lower Notional Principal
effective yield than the futures hedge, it set an Amount $10,000,000
absolute floor on the investment. This is because
any decline in the discount yield of the Treasury Maturity 2 Years
bills below 6.05 percent would be offset dollar Underlying Index 3-month LIBOR
for dollar by the additional profits from the
hedge. The real advantage of the option hedge is Rate Fixing quarterly
that, although it establishes a floor that is lower Payment quarterly, in arrears, on
than the rate fixed by the futures hedge, it allows an actual/360-day basis
the hedger to participate in any increase in inter-
est rates above the cost of the call premium. For Cap Level 9%
example, if interest rates increased such that the Up Front Fee 1.11% of par
price on the December Treasury bill futures ($111,000)
contract on November 28 falls to 93.00, imply-
ing a discount yield of 7.00 percent, the option
would expire unexercised since the strike price Under the terms of this agreement, if at any
is above the price of the underlying futures of the quarterly rate fixing dates 3-month
contract. Again, assuming that the spot price for LIBOR exceeds the cap level then the seller of
the 13-week Treasury bills is equal to the futures the cap would pay the buyer an amount equal to
price, the effective discount yield is 6.80 percent the difference between the two rates. For exam-
(7.00 percent minus the 20 basis point call ple, if at a reset date LIBOR was set at 10 per-
option premium), 50 basis points higher than the cent, the payment would be:
yield that would have been provided by the
futures hedge.

Page 18
10%(90/360 2 $10,000,000) One final point should be made with respect

to hedging based upon pairing a futures con-
tract against a portfolio security. Since this type

9%(90/360 2 $10,000,000) of hedging can be done while considering
only the asset side of the balance sheet, it is
=
possible that such a strategy could increase
$25,000 interest-rate risk rather than reduce it. For exam-
ple, assume (unrealistically) that there is a per-
Thus, the writer of the cap would pay the buyer fect balance between variable-rate assets and
$25,000. If 3-month LIBOR for the quarter were liabilities, and the firm is evaluating fixed-rate
set at or below the cap level of 9 percent, no assets and liabilities. Management determines
payment would be made. that there is a perfect balance between fixed-rate
assets and liabilities and then isolates the last
fixed-rate asset and liability. Make the further
assumption that the organization holds a six-
2130.0.11 ASSET-LIABILITY month note yielding 12 percent which is
MANAGEMENT financed by funds maturing in six months which
costs the organization 10.5 percent. By execut-
Financial contracts can be used as a tool in an ing a short futures contract paired against the
overall asset-liability management strategy. In six-month note, the organization would move
order to use financial contracts in this context, a from an overall hedged position to an
BHC or nonbank subsidiary must first identify unhedged position. In other words, the
where interest-rate exposure lies as indicated by futures contract would move the organization
mismatches between asset and liability struc- from an overall neutral position and expose the
tures. In those instances where the BHC or organization to interest-rate risk.
nonbank subsidiary has variable-rate assets and It should be evident why it is more productive
variable-rate liabilities with comparable maturi- to consider the big picture in inspections
ties, there is, in theory, no need to hedge with rather than focusing upon individual or
financial contracts since that portion of the paired (futures against each position) transac-
asset-liability structure is already hedged. The tions. The most meaningful approach is to
same holds true for fixed-rate assets and liabili- evaluate hedging strategies and open financial
ties (yielding a positive interest-rate margin) of contract positions in light of its business needs,
comparable maturities. Once a BHC or nonbank operations, and asset-liability mix.
subsidiary has identified the undesired mis-
matches in assets and liabilities, financial con-
tracts can be used to hedge against the identifi- 2130.0.12 INSPECTION OBJECTIVES
able mismatchfor example, long positions in
contracts can be used as a hedge against funding 1. To determine the purpose of financial-
interest-sensitive assets with fixed-rate sources contract positions. Any positions that bank
of funds, and short positions in contracts can be holding companies or their nonbank subsidi-
used as a hedge against funding fixed-rate assets aries (except certain authorized dealer
with interest-sensitive liabilities. subsidiaries) take in financial contracts
BHCs or nonbank subsidiaries that choose to should reduce risk exposure, that is, not be
employ financial contracts as a tool in their speculative.
general asset-liability management program and 2. To determine whether prudent written poli-
properly use financial contracts are striving cies, appropriate limitations, and internal
towards worthwhile goals. The discipline of controls and audit programs have been estab-
identifying mismatches between assets and lished and whether management information
liabilities tends to focus the practitioners atten- systems are sufficiently adequate to monitor
tion on the entire balance sheet. Examiners risks associated with contracts involving
should be aware that marketing efforts on behalf futures, forwards, and options (including
of the futures exchanges have attempted to focus caps, floors, and collars).
upon just one side of the balance sheet by pair- 3. To determine whether policy objectives con-
ing a futures contract with an asset or a liabil- cerning the relationship of subsidiary bank-
ity. In considering financial-contract activities, ing organizations and the parent bank hold-
examiners need to remember that financial-
contract activities must be evaluated in light of BHC Supervision Manual December 1998
both sides of a balance sheet. Page 19
ing company specify that each banking sions, and personnel to execute, monitor, and
organization in a holding company system audit contract activities). A well-constructed
must be treated as a separate entity. policy should be designed to preclude vari-
4. To determine reporting compliance in ous operating areas of a banking orga-
accordance with the Boards bank holding nization from taking offsetting financial con-
company policy statements. See section tract positions. Finally, there should be
2130.0.17 for the appropriate cites. established benchmarks for determining
whether financial contracts are meeting
desired objectives.
3. Determine if policy objectives concerning
2130.0.13 INSPECTION PROCEDURES the relationship of subsidiary banking organi-
zations and the parent bank holding company
The term banking organization is used gener- comply with the Boards directives.
ally to refer to a bank holding company, the Each banking organization in a holding
parent company, or nonbank subsidiary. company system must be treated as a sepa-
rate entity. The policy statement accommo-
1. Determine if the banking organizations dates centralized holding companies in that
financial-contract activities are related to the the holding companies are free to provide
basic business of banking. guidance to subsidiary banking organizations
Consider whether the financial-contract and execute contracts as agent on behalf of
activities are closely related to the basic busi- the banking organization, provided that each
ness of banking; that is, taking deposits, mak- banking organization maintains responsibil-
ing and funding loans, providing services to ity for financial contract transactions
customers, and operating at a profit for share- executed on its behalf. Accordingly, a hold-
holders without taking undue risks. Taking ing company that has centralized manage-
financial-contract positions solely to profit ment could, and perhaps should, consider the
upon interest-rate forecasts is considered to interest-rate exposure of its subsidiary banks
be an unsafe and unsound practice. Profit- on a consolidated basis in determining
ability of contract activities is not the crite- whether future contracts can usefully be
rion for evaluating such activities. It is quite employed to reduce that exposure, but any
probable that a bona fide hedge strategy future contracts that are executed must be
could result in a contract loss which would recorded on the books and records of a sub-
be offset by increased interest earnings or a sidiary bank that will directly benefit from
higher price for an asset sold, for example, a such contracts.
pool of mortgages. Criticize contracts placed The question concerning the relationship
solely to profit upon interest-rate movements. of a subsidiary bank to its holding company
Verify that contract activities are conducted may also lead one to consider the relation-
in accordance with the Boards policy state- ship of a subsidiary bank with its correspon-
ment. Where contract positions are of exces- dent bank or broker. One might also query to
sive size and could jeopardize the financial what extent may less sophisticated institu-
health of the entity under examination, the tions rely upon brokers and/or correspondent
gains or losses realized because of financial- banking organizations for advice in this area?
contract activities should be criticized. Less sophisticated institutions can place
2. Ascertain whether policy objectives high- only limited reliance on others for advice in
light the circumstances under which financial this area. The bank holding company policy
contracts should be used. statement9 emphasizes that responsibility for
Determine whether management and oper- financial-contract activities rests solely with
ating personnel have received sufficient guid- management. Additional information on
ance. Carefully constructed policy objectives securities transactions and the selections of
should be formulated with the knowledge securities dealers can be found in sec-
that although proper utilization of financial tion 2126.1.
contracts limits loss potential, such utiliza- 4. Ascertain whether policy objectives and/or
tion also limits potentials for gains. Policy position limits require prudence on the part
objectives should be formulated to limit of authorized personnel entering into these
required resources (margin monies, commis- new activities. If discretion is left to senior
BHC Supervision Manual December 1998 9. The Boards policy statement on engaging in futures,
Page 20 forwards, and option contracts.
managers, determine whether management 7. Ascertain whether the banking organizations

has issued instructions to ensure that the board of directors has established written
level of financial-contract activity is prudent limitations with respect to financial-contract
relative to the capabilities of persons autho- positions.
rized to execute and monitor contracts. NOTE: The bank holding company pol-
A new activity such as financial contracts icy statement requires that the board of
should, as a general rule, be entered slowly. directors establish written policies and posi-
In developing expertise, management should tion limitations in connection with
mandate a low level of activity until persons financial-contract activities. If a committee
authorized to execute contracts gain suffi- has been delegated similar responsibilities
cient expertise or until new personnel are within the organization, and a committee
employed that have sufficient training and makes the decision, its recommendation
experience to engage in financial-contract should be ratified by the board of directors.
activities on a larger scale. Senior manage- 8. If there is the potential to exceed the above
ment must develop the expertise to under- limitations in certain instances, determine
stand and evaluate techniques and strategies whether there are firm, written procedures
employed to ensure that an experienced pro- in place concerning the authorizations nec-
fessional does not engage in improper or essary to exceed limits.
imprudent activities. 9. Determine whether the board of directors, a
5. If a banking organization uses financial con- duly authorized committee thereof, or inter-
tracts as part of its overall asset-liability man- nal auditors review at least monthly
agement strategy, determine whether the financial-contract positions to ascertain con-
organization developed an adequate system formance with limitations. (See item (b) of
for evaluating its interest-rate risk. the bank holding company policy
Without a system for identifying and mea- statement.)
suring interest-rate risk, it is impossible to 10. Determine if the banking organization
engage in hedging activity in an informed maintains general-ledger memorandum
and meaningful manner. Failure to identify accounts or commitment registers to
the mismatches in the organizations asset- adequately identify and control all
liability mix would make it difficult to select financial-contract commitments to make or
the proper number and types of financial take delivery of securities or money market
contractsfor example, bond or bill finan- instruments.
cial contractsto provide an appropriate 11. Determine if the banking organization
amount of interest-rate-risk protection. issues or writes option contracts expiring in
Evaluate whether the organizations interest- excess of 150 days which give the other
rate-risk measurement techniques appear rea- party to the contract the option to deliver
sonable to determine whether the financial securities to it.
contracts employed were successful in pro- Examiners should review the facts sur-
viding the proper amount of futures gains rounding standby contracts issued by hold-
(losses) to cover the hedged risk position. ing companies. Examiners should also
6. Determine if the recordkeeping system is review accounting entries connected with
sufficiently detailed to permit personnel to bank holding company standby contracts to
document and describe in detail how determine whether standbys were issued to
financial-contract positions taken have con- earn fee income up front and exploit the
tributed to the attainment of the banking lack of generally accepted accounting
organizations stated objectives. principles.
There is no universal, adequate record- 12. Determine whether financial-contract posi-
keeping system for this purpose. Examiners tions are properly disclosed in notes to the
must evaluate each individual system rela- statements of financial condition and
tive to the organizations stated objectives income and that the contract positions have
and activities. If the recordkeeping system been properly reported on FR Y-9C, Sched-
cannot be used to illustrate how financial ule HC-F, Off-Balance-Sheet Items.
contracts contributed to the attainment of the 13. Determine whether the banking organiza-
banking organizations stated objectives, the tion has implemented a system for monitor-
recordkeeping system is inadequate. BHCs ing credit-risk exposure associated with
with inadequate recordkeeping systems
should be instructed to make appropriate BHC Supervision Manual December 1998
modifications. Page 21
various customers and dealers with whom requires market participants to assume the mar-
operating personnel are authorized to trans- ket risks of either owning securities or short-
act business. ing securities. Issuing (or selling) standby con-
All financial-contract trading involves tracts granting the other party to the contract the
market risks. However, forward and OTC option to deliver securities is a practice which
options trading, as well as swap activities, results in the issuer functioning as an insurer
also involve credit risk. The key concern is against downside market risk for the other party;
whether the contra party to a transaction in essence, the party receiving the standby fee
will be ready, willing, and able to perform assumes all of the interest-rate risks of security
on contract settlement and payment dates. ownership, but receives none of the benefits.
While maintaining control over credit-risk
exposure should ensure that a financial 2130.0.13.2 Reviewing
organization will not enter excessive (rela- Financial-Contract Positions
tive to the financial condition of the contra
party) forward or standby contracts, moni- The preceding questions were designed to focus
toring such exposure may not prevent the examiners attention on a bank holding com-
default in all instances. panys stated objectives for engaging in finan-
14. Ascertain whether the banking organization cial contract activities and the manner in which
has implemented internal controls and inter- such activities are conducted. It is also vital to
nal audit programs to ensure adherence to review position records with respect to financial
written policies and prevent unauthorized contracts or, if necessary, prepare a schedule
trading and other abuses. grouping similar contracts by maturity. Once
15. Determine if the Reserve Bank was notified the various positions have been scheduled it
at the inception of bank holding company will be possible to evaluate the risk of contract
futures, forward, and option activities as positions relative to the organization under
required by paragraph (f) of the holding inspection.
company policy statement (Federal Reserve
Regulatory Service 4830). 2130.0.13.3 Factors to Consider in
16. Determine if the personnel engaged in Evaluating Overall Risk
financial-contract activities have sufficient
knowledge and understanding of the mar- To determine whether contract positions are rea-
kets to perform those functions. sonable, an examiner must evaluate positions in
light of certain key factors: the size of the orga-
nization, its capital structure, its business needs,
2130.0.13.1 Evaluating the Risks of
and its capacity to fulfill its obligations. For
Contract Activities
example, open contracts to purchase $7 million
Evaluating the organizations stated objectives of GNMA securities would be viewed differ-
and their effects on overall risk is a difficult task ently in a BHC with $24 million of assets than
involving legitimate cause for concern because in a BHC with $1 billion of assets.
of the high degree of leverage involved in con- There is no guaranty that financial contract
tract activities. Although there is an emerging prices and cash market prices will move in the
trend towards dealers requiring margin on for- same direction at the same velocity; however,
ward trades, forward contract transactions gen- contract prices and cash market prices ulti-
erally have not required margin deposits, and mately move towards price convergence in the
thus, grant users unlimited leverage. Although delivery month. Keeping this fact in mind, the
the amount of margin required for futures trades risk evaluating process can be simplified by
is extremely small (for example, $1,500 initial thinking of the securities underlying the various
margin to take a $1 million futures position), the contracts as a frame of reference. For example,
rules of the exchanges do require a daily mark if a BHC holds long futures contracts on
to market and a requirement that members of $10 million (par value) of Treasury bonds the
the futures exchanges meet maintenance margin examiner should first evaluate the effect
calls on behalf of their customers. Customers, of (excluding tangible benefits of ownership, e.g.,
course, are generally required to promptly reim- interest income, pledging, etc.) on the organiza-
burse brokers for margin posted on their behalf. tion of holding $10 million of bonds in its
Nevertheless, engaging in contract activities portfolio and the resultant appreciation or depre-
ciation if interest rates rise or fall by a given
BHC Supervision Manual December 1998 amount. A short contract of $10 million Trea-
Page 22 sury bonds would be evaluated as if the banking
organization had executed a short sale for With respect to forward contracts, there is an
$10 million. In addition, the examiner would active forward market for GNMA securities
have to consider the positive or negative flow of specifying delivery of the underlying securities
funds received or disbursed as margin to reflect up to four or five months in the future. If a
daily contract gains and losses. While commis- banking organization is executing contracts for
sions on futures contracts are not a major factor more distant maturities, management should be
in hedging transactions, they also should be queried as to why it is necessary to trade outside
considered in this evaluation. Typically, com- the normal trading cycle.
missions are charged on a round turn basis
meaning that commissions are charged based
upon an assumption that each futures contract 2130.0.13.5 Relationship to Banking
will be offset prior to maturity. Since each con- Activities
tract will have to be offset, or securities bought
or delivered, it should be determined whether In evaluating contract activities, examiners
funds will be available to offset contracts or should verify that contract strategies are carried
fund delivery. In the case of certain short to fruition in connection with their relationship
contracts, a determination must be made as to overall objectives. Examiners may find it
to whether deliverable securities are held useful to recommend additional recordkeeping
or committed for purchase by the banking in borderline cases when they encounter situa-
organization. tions where financial-contract positions are
closed out frequently during the hedge period,
but not frequently enough to be considered trad-
2130.0.13.4 Contract Liquidity ing rather than hedging activities. Examiners
should suggest proper documentation with
In addition to looking at the big picture, regard to financial contracts executed and any
examiners should consider a position in a given additional recordkeeping as needed. Specifi-
contract maturity month relative to the volume cally, users could be requested to establish writ-
of contracts outstanding. For example, in futures ten criteria specifying what circumstances will
trading there is generally a greater open interest trigger the closing of such contracts. Then users
in the next contract maturity month and perhaps would be judged by how well they adhered to
the following one or two contract maturity the criteria as well as whether the plan reduced
months. As one moves away from the near term risk. Hopefully, such recordkeeping would give
contracts, there is generally less trading and less users the latitude to close out a financial-
open interest in the more distant contracts. contract position working against them (as
Open interest or the amount of contracts out- determined by some prearranged benchmark),
standing is reported in financial newspapers and yet still require sufficient discipline to prevent
other publications. Generally, the contracts with users from selectively executing financial con-
the largest open interest and daily trading vol- tracts merely to profit upon interest-rate
ume are considered to be the most liquid. forecasts.
To illustrate the concept discussed above, one The preceding discussion should reinforce the
should consider the following example. A red fact that the actual utilization of financial con-
flag should be apparent if a contract review tracts is not a clear-cut issue in terms of hedging
discloses that the organization has taken a size- verses speculation. However, certain key con-
able position in a contract expiring in two years. cepts should be kept in mind. First, a decision to
When the examiner checks financial newspapers hedge with futures or forward contracts involves
and other publications, he or she may discover making a decision that one is content to lock in
that the BHCs position represents 20 percent of an effective cost of funds, a sale price of a
the open interest in that contract. Such a situa- specific asset, etc. However, the decision to
tion would clearly be unsafe and unsound hedge which gives downside protection also
because the relatively huge position coupled means forfeiting the benefits which would result
with the typically less liquid conditions in dis- from a favorable market movement. Thus, in
tant contracts makes it highly unlikely that the evaluating hedge strategies, the organization
BHC could quickly close out its position if should be judged as to whether it maintained
necessary. In addition, one should also question hedge positions long enough to accomplish its
why the distant maturity was chosen since there objectives.
is no immediate reason to expect a close correla-
tion to the cash market for the underlying BHC Supervision Manual December 1998
security. Page 23
Caution should be employed in performing the Consolidated Financial Statements for Bank
the analysis of financial contracts used to obtain Holding Companies in accordance with Finan-
targeted effective interest rates. Examiners cial Accounting Standards Board (FASB) State-
should not evaluate transactions solely on a ment No. 80, Accounting for Futures Con-
paired basis, that is, looking at paired cash tracts. Foreign-currency futures contracts shall
market and financial-contract positions and for- be reported in accordance with the guidance in
getting about financial-contract positions rela- FASB Statement No. 52, Foreign Currency
tive to the organizations entire balance sheet, Translation.
nor should examiners fail to review the overall
nature of financial-contract activities. For exam-
ple, individual opening and closing of financial
contracts could appear reasonable, but the 2130.0.14.1 Performance Bonds under
aggregate activities may be indicative of an Futures Contracts
organization that is in reality operating a futures
When the reporting banking organization, as
trading account solely to profit on interest-rate
either buyer or seller of futures contracts, has
expectations.
posted a performance bond in the form of a
margin account deposited with a broker or
2130.0.13.6 Parties Executing or Taking exchange, the current balance (as of the report
the Contra Side of a Financial Contract date) of that margin account shall be reported in
Other Assets. The balance in the margin account
In addition to monitoring contra-party credit includes the following:
risk, serious efforts should be made to ensure
that the banking organization carefully scruti- 1. the original margin deposit, plus (less)
nizes the selection of brokers and dealers. In the 2. any additions (deductions) as a result of daily
case of futures contracts, the Commodity fluctuations in the market value of the related
Exchange Act requires that an entity functioning contracts (i.e., variation margin), plus
as a futures commission merchant be registered 3. any additional deposits made to the account
with the CFTC. However, not every FCM may to meet margin calls or otherwise (i.e.,
be a member of a commodities exchange. Mem- maintenance margin), less
bers of an exchange are given additional super- 4. any withdrawals of excess balances from the
vision by the exchange, while nonmembers are account
subject to audit by the National Futures Associa-
tion. In selecting any broker or dealer, an organi- When the performance bond takes the form
zation should give careful consideration to its of a pledge of assets with a broker rather than a
reputation, financial viability, and length of time margin account, the pledged assets shall be
in business. If an organization intends to deal maintained on the books of the pledging bank-
with a newly established FCM or broker-dealer, ing organization and no other balance-sheet
special efforts should be made to verify the entry is made for the performance bond. In this
reputation and integrity of its principals. (For case, gains and losses resulting from daily fluc-
additional discussion, see Federal Reserve tuations in the market value of the related con-
Regulatory Service 31562). Although such tracts are generally settled with the broker in
measures cannot ensure that problems will not cash. However, if the pledging banking organi-
subsequently develop with an FCM or broker- zation also maintains a working balance with
dealer, some careful forethought can tend to the broker against which recognized daily mar-
ensure that relationships will not be developed ket gains and losses are posted, the working
with persons or firms who had serious problems balance should be reported in Other Assets, and
in the past. treated in the same manner as a margin account.
2130.0.14 ACCOUNTING FOR 2130.0.14.2 Valuation of Open Positions

FUTURES CONTRACTS
All open positions in futures contracts must be
All futures contracts, except for foreign- reviewed at least monthly (or more often, if
currency futures contracts, shall be reported in material) and their current market values deter-
mined. The market value of a futures contract is
BHC Supervision Manual December 1998 to be based on published price quotations. These
Page 24 futures positions must be revalued at their cur-
rent market values on these valuation dates and the futures contract shall be related to the
any changes in these values reported in accor- accounting for the hedged item so that changes
dance with the guidance presented below for in the market value of the futures contract are
hedge or nonhedge contracts, as appropriate. recognized in income when the effects of related
changes in the price or interest rate of the
hedged item are recognized. If a banking organi-
2130.0.14.3 Criteria for zation must include unrealized changes in the
Hedge-Accounting Treatment fair value of a hedged item in income, a change
in the market value of the related futures con-
A futures contract shall be accounted for as a tract shall be recognized in income when the
hedge when the following conditions are met: change occurs. Otherwise, a change in the mar-
ket value of a futures contract that qualifies as a
1. The banking organization must have deter- hedge of an existing asset or liability shall be
mined that the item or group of items to be recognized as an adjustment of the carrying
hedged (that is, the identifiable assets, liabili- amount of the hedged item. A change in the
ties, firm commitments, or anticipated trans- market value of a futures contract that is a hedge
actions) will expose it to price or interest-rate of a firm commitment shall be included in the
risk. measurement of the transaction that satisfies the
2. The futures contract must reduce the expo- commitment. A change in the market value of a
sure to risk. This will be demonstrated if, at futures contract that is a hedge of an anticipated
the inception of the hedge and throughout transaction shall be included in the measure-
the hedge period, high correlation is ment of the subsequent transaction.
expected to exist between the changes in the
Once the carrying amount of an asset or lia-
prices of both the contract and the hedged
bility has been adjusted for the change in the
item or group of items.10 In other words, the
market value of a futures contract, the adjust-
banking organization must monitor the price
ment must be recognized in income in the same
movements of both the hedge contract and
manner as other components of the carrying
the hedged items to determine that it is prob-
amount of that asset or liability (for example,
able that changes in the market value of the
using the interest method). If the item being
futures contract will offset the effects of price
hedged is an interest-bearing financial instru-
changes on the hedged items.
ment otherwise reported at amortized historical
3. The futures contract must be designated in
cost, then the changes in the market value of the
writing as a hedge by management at the
hedge contract that have been reflected as
inception of the hedge.
adjustments in the carrying amount of the finan-
In order for a futures contract to qualify as
cial instrument shall be amortized as an adjust-
a hedge of an anticipated transaction, the
ment of interest income or expense over the
following two additional criteria must be
expected remaining life of the hedged item.
met:
a. The significant characteristics and If a futures contract that has been accounted
expected terms of the anticipated transac- for as a hedge of an anticipated transaction is
tion must be identified. closed before the date of the related transaction,
b. The occurrence of the anticipated transac- the accumulated change in value of the contract
tion must be probable.11 shall be carried forward (assuming high correla-
tion continues to exist) and included in the
measurement of the related transaction. When it
2130.0.14.4 Gains and Losses from becomes probable that the quantity of the antici-
Monthly Contract Valuations of Futures pated transaction will be less than that originally
Contracts That Qualify as Hedges hedged, a pro rata portion of the futures results
that would have been included in the measure-
If the hedge criteria are met, the accounting for ment of the transaction shall be recognized as a
gain or loss.
When futures contracts that are hedges are
10. Generally, banking practice maintains that correlation terminated, the gain or loss on the terminated
in the changes in the market values of the futures contract and contracts must be deferred and amortized over
the hedged item must be at least 80 percent for the high
correlation criteria in FASB Statement No. 80 to be met.
the remaining life of the hedged item.
11. It will be particularly difficult to meet this criteria when
an anticipated transaction is not expected to take place in the BHC Supervision Manual December 1998
near future. Page 25
2130.0.14.5 Gains and Losses from 2130.0.16 INTERNAL CONTROLS

Monthly Contract Valuations of Futures AND INTERNAL AUDIT
Contracts That Do Not Qualify as Hedges
The following is designed to illustrate desirable
For futures contracts that are not accounted for internal controls and internal audit procedures
as hedges, the change that has occurred in the applicable to the organizations activities in
market value of open positions since the last call financial contracts. This illustration is not
report date shall be reflected in current income, intended to serve as an absolute standard relat-
either as other noninterest income for net ing to contract activities, but is designed to
gains or other noninterest expense for net supplement examiners knowledge relating to
losses. internal controls and internal audits in this con-
If high correlation ceases to exist, the banking text. In evaluating internal controls and audits,
organization should discontinue accounting for the examiner will need to evaluate the scope of
a futures contract as a hedge. When this occurs, futures, forward, and options activities to deter-
the portion of the change in the market value of mine whether internal controls and audit proce-
the contract that has not offset the market value dures are adequate in relation to the volume and
changes of the hedged item, since the inception nature of the activities.
of the hedge, must be reflected in the Report of
Income as other noninterest income or other
noninterest expense, as appropriate. The con- 2130.0.16.1 Internal Controls
tract should thereafter be accounted for as a
nonhedge contract with subsequent changes in It is a managements responsibility to minimize
the contracts market value reflected in current the risks inherent in financial-contract activities
period income. through the establishment of policies and proce-
When futures contracts that are not hedges dures covering organizational structure, segre-
are terminated, the gain or loss on the termi- gation of duties, operating and accounting sys-
nated contract must be recognized currently in tem controls, and comprehensive management
the Report of Income as other noninterest reporting. Formal written procedures should be
income or other noninterest expense, as in place in connection with purchases and sales,
appropriate. processing, accounting, clearance and safekeep-
There is the potential for holding companies ing activities relating to these transactions. In
and nonbank subsidiaries to follow the refer- general, these procedures should be designed to
enced accounting applications and break ensure that all financial contracts are properly
hedges with unrealized futures gains to rec- recorded and that senior management is aware
ognize income, and maintain hedges with of the exposure and gains or losses resulting
futures losses and adjust the carrying basis of from these activities. Some examples of desir-
the paired, that is, hedged asset. Examiners able controls follow:
should look for patterns of taking gains and
losses with a view to determining whether the 1. Written documentation indicating what types
opening and closing of contracts is consistent of contracts are eligible for purchase by the
with the organizations risk-reducing strategies. organization, which individual persons are
eligible to purchase and sell contracts, which
individual persons are eligible to sign con-
tracts or confirmations, and the names of
2130.0.15 PREPARING INSPECTION firms or institutions with whom employees
REPORTS are authorized to conduct business.
2. Written position limitations for each type of
Unsatisfactory comments pertaining to a bank contract established by the banking organiza-
holding companys financial-contract activities tions board of directors and written proce-
should be noted on the Examiners Com- dures for authorizing trades, if any, in excess
ments, Policies and Supervision, and of those limits.
Analysis of Financial Factors or other appro- 3. A system to monitor the organizations expo-
priate page depending on the severity of the sure with customers and those broker-
comments within the bank holding company dealers and institutions eligible to do busi-
inspection report. ness with it. To implement this, management
must determine the amount of credit risk
BHC Supervision Manual December 1998 permissible with various parties and then
Page 26 institute surveillance procedures to ensure
that such limits are not exceeded with- 8. Procedures for resolving customer com-
out written authorization from senior plaints by someone other than the person
management. who executed the contract.
4. Separation of duties and supervision to 9. Procedures for verifying brokers reports of
ensure that persons executing transactions margin deposits and contract positions (use
are not involved in approving the accounting an outside pricing source), and reconciling
media and/or making accounting entries. such reports to the records.
Further, persons executing transactions 10. Procedures for daily review of outstanding
should not have authority to sign incoming contracts and supervision of traders. In
or outgoing confirmations or contracts, rec- addition, there should be periodic reports to
oncile records, clear transactions, or control management reflecting the margin deposits
the disbursement of margin payments. and contract positions.
5. A clearly defined flow of order tickets and 11. Selecting and training competent person-
confirmations. Confirmations generated nel to follow the written policies and
should, preferably, be prenumbered. In addi- guidelines.
tion to promptly recording all commitments
in a daily written commitment ledger, the 2130.0.16.2 Internal Audit
related documentation should be filed sepa-
rately for purposes of audit and examination. The scope and frequency of the internal audit
The flow of confirmations and order tickets program should be designed to review the inter-
should be designed to verify accuracy and nal control procedures and verify that the inter-
enable reconciliations throughout the system, nal controls purported to be in effect are being
for example, to ensure that a person could followed. Further, the internal auditor should
not execute unauthorized transactions and verify that there are no material inadequacies in
bypass part of the accounting system, and to the internal control procedures that would per-
enable the reconcilement of traders position mit a person acting individually to perpetrate
reports to those positions maintained by an errors or irregularities involving the records of
operating unit. the organization or assets that would not be
6. Procedures to route incoming confirmations detected by the internal control procedures in
to an operations unit separate from the trad- time to prevent material loss or misstatement of
ing unit. Confirmations received from bro- the banking organizations financial statements
kers, dealers, or others should be compared or serious violation of applicable banking, bank
to confirmations (or other control records) holding company, or securities rules or regula-
prepared by the banking organization to tions. Any weaknesses in internal control proce-
ensure that it will not accept or make deliv- dures should be reported to management, along
ery of securities, or remit margin payments, with recommendations for corrective action. If
pursuant to contracts unless there is proper internal auditors do not report to an audit com-
authorization and documentation. mittee, the person to whom they report should
7. Procedures for promptly resolving fails to not be in a position to misappropriate assets.
receive or fails to deliver securities on the In addition, auditors should occasionally spot-
date securities are due to be received or sent check contract prices and mark-to-market
pursuant to contracts. adjustments.

Page 27
Statement of policy concerning bank 225.142 4830

holding companies engaging in
futures, forward, and options
contracts on U.S. government and
agency securities and money market
instruments
Policy Statement on Financial 31535

Contracts
Supervisory Policy Statement on 31562

Investment Securities and
End-User Derivatives Activities

Page 28
Securities Lending
Section 2140.0
Financial institutions, including bank holding securities loans are divided between the lender
company subsidiaries, are lending securities and the customer account that owns the securi-
with increasing frequency, and, in some ties. In situations involving cash collateral, part
instances, a financial institution may lend its of the interest earned on the temporary invest-
own investment or trading-account securities. ment of cash is returned to the borrower, and the
Financial institutions lend customers securities remainder is divided between the lender and the
held in custody, safekeeping, trust, or pension customer account that owns the securities.
accounts. Because the securities available for
lending often greatly exceed the demand for
them, inexperienced lenders may be tempted to 2140.0.2 DEFINITIONS OF CAPACITY
ignore commonly recognized safeguards. Bank-
ruptcies of broker-dealers have heightened regu- Securities lending may be done in various
latory sensitivity to the potential for problems in capacities and with differing associated liabili-
this area. ties. It is important that all parties involved
understand in what capacity the lender is acting.
For the purposes of these guidelines, the rel-
2140.0.1 SECURITIES-LENDING evant capacities are as follows:
MARKET
1. Principal. A lender offering securities from
Securities brokers and commercial banks are the its own account is acting as principal. A
primary borrowers of securities. They borrow lender institution offering customers securi-
securities to cover securities fails (securities sold ties on an undisclosed basis is also consid-
but not available for delivery), short sales, and ered to be acting as principal.
option and arbitrage positions. Securities lend- 2. Agent. A lender offering securities on behalf
ing, which used to involve principally corporate of a customer-owner is acting as an agent.
equities and debt obligations, increasingly For the lender to be considered a bona fide or
involves loans of large blocks of U.S. govern- fully disclosed agent, it must disclose the
ment and federal-agency securities. names of the borrowers to the customer-own-
Securities lending is conducted through open- ers (or give notice that names are available
ended loan agreements, which may be termi- upon request), and must disclose the names
nated on short notice by the lender or borrower. of the customer-owner to borrowers (or give
Repurchase agreements are generally used by notice that names are available upon
owners of securities as financing vehicles and, request). In all cases, the agents compensa-
in certain respects, are closely analogous to tion for handling the transaction should be
securities lending. The objective of securities disclosed to the customer-owner. Undis-
lending, however, is to receive a safe return in closed agency transactions, that is, blind
addition to the normal interest or dividends. brokerage transactions in which partici-
Securities loans in industry practice are gener- pants cannot determine the identity of the
ally collateralized by U.S. government or contra party, are treated as if the lender was
federal-agency securities, cash, or letters of the principal.
credit.1 At the outset, each loan is collateralized 3. Directed agent. A lender which lends securi-
at a predetermined margin. If the market value ties at the direction of the customer-owner is
of the collateral falls below an acceptable level acting as a directed agent. The customer
during the time a loan is outstanding, a margin directs the lender in all aspects of the transac-
call is made by the lender institution. If a loan tion, including to whom the securities are
becomes over-collateralized because of appreci- loaned, the terms of the transaction (rebate
ation of collateral or market depreciation of a rate and maturity/call provisions on the loan),
loaned security, the borrower usually has the acceptable collateral, investment of any cash
opportunity to request the return of any exces- collateral, and collateral delivery.
sive margin. 4. Fiduciary. A lender which exercises discre-
When a securities loan is terminated, the tion in offering securities on behalf of and for
securities are returned to the lender and the the benefit of customer-owners is acting as a
collateral to the borrower. Fees received on fiduciary. For purposes of these guidelines,
1. Broker-dealers borrowing securities are subject to the
restrictions of the Federal Reserves Regulation T (12 C.F.R. BHC Supervision Manual December 1998
220.10), which specifies acceptable borrowing purposes. Page 1
Securities Lending 2140.0
the underlying relationship may be as agent, in more than one account. Possible methods
trustee, or custodian. include loan volume analysis, automated queue,
5. Finder. A finder brings together a borrower a lottery, or some combination of these. Securi-
and a lender of securities for a fee. Finders ties loans should be fairly allocated among all
do not take possession of the securities or accounts participating in a securities-lending
collateral. Delivery of securities and collat- program.
eral is direct between the borrower and the Internal controls should include operating
lender, and the finder does not become procedures designed to segregate duties and
involved. The finder is simply a fully dis- timely management reporting systems. Periodic
closed intermediary. internal audits should assess the accuracy of
accounting records, the timeliness of manage-
ment reports, and the lenders overall compli-
2140.0.3 GUIDELINES ance with established policies and the firms
procedures.
All bank holding companies or their subsidi-
aries that participate in securities lending should
establish written policies and procedures gov- 2140.0.3.3 Credit Analysis and Approval
erning these activities. Other than commercial of Borrowers
banks with trust departments, the bank holding
company subsidiaries most likely to be engaged In spite of strict standards of collateralization,
in securities lending are non-deposit-taking trust securities-lending activities involve risk of loss.
companies and certain discount brokers which Such risks may arise from malfeasance or fail-
provide custody services and make margin ure of the borrowing firm or institution. There-
loans. At a minimum, policies and proce- fore, a duly established management or super-
dures should cover each of the topics in these visory committee of the lender should formally
guidelines. approve, in advance, transactions with any
borrower.
Credit and limit approvals should be based
2140.0.3.1 Recordkeeping upon a credit analysis of the borrower. A review
should be performed before establishing such a
Before establishing a securities-lending pro- relationship and reviews should be conducted at
gram, a financial firm or institution must estab- regular intervals thereafter. Credit reviews
lish an adequate recordkeeping system. At a should include an analysis of the borrowers
minimum, the system should produce daily financial statement, and should consider capi-
reports showing which securities are available talization, management, earnings, business repu-
for lending, and which are currently lent, out- tation, and any other factors that appear rel-
standing loans by borrower, outstanding loans evant. Analyses should be performed in an
by account, new loans, returns of loaned securi- independent department of the lender, by per-
ties, and transactions by account. These records sons who routinely perform credit analyses.
should be updated as often as necessary to Analyses performed solely by the person(s)
ensure that the lender institution fully accounts managing the securities-lending program are not
for all outstanding loans, that adequate collat- sufficient.
eral is required and maintained, and that policies
and concentration limits are being followed.
2140.0.3.4 Credit and Concentration
Limits
2140.0.3.2 Administrative Procedures
After the initial credit analysis, management of
All securities lent and all securities standing as the lender should establish an individual credit
collateral must be marked to market daily. Pro- limit for the borrower. That limit should be
cedures must ensure that any necessary calls for based on the market value of the securities to be
additional margin are made on a timely basis. borrowed, and should take into account possible
In addition, written procedures should outline temporary (overnight) exposures resulting from
how to choose the customer account that will be a decline in collateral values or from occasional
the source of lent securities when they are held inadvertent delays in transferring collateral.
Credit and concentration limits should take into
BHC Supervision Manual December 1998 account other extensions of credit by the lender
Page 2 to the same borrower or related interests.
Procedures should be established to ensure lending relationship should specify how cash
that credit and concentration limits are not collateral is to be invested.
exceeded without proper authorization from Using cash collateral to pay for liabilities of
management. the lender or its holding company would be an
improper conflict of interest unless that strategy
was specifically authorized in writing by the
2140.0.3.5 Collateral Management owner of the lent securities.
Securities borrowers generally pledge and main-

tain collateral at a level equal to at least 100 per-
cent of the value of the securities borrowed.2
2140.0.3.7 Letters of Credit as Collateral
The minimum amount of excess collateral, or
margin, acceptable to the lender should relate If a lender plans to accept letters of credit as
to price volatility of the loaned securities and collateral, it should establish guidelines for their
the collateral (if other than cash).3 Generally, use. Those guidelines should require a credit
the minimum initial collateral on securities loans analysis of the banks issuing the letter of credit
is at least 102 percent of the market value of the before securities are lent against that collateral.
lent securities plus, for debt securities, any Analyses must be periodically updated and
accrued interest. reevaluated. The lender should also establish
Collateral must be maintained at the agreed concentration limits for the banks issuing letters
margin. A daily mark-to-market or valuation of credit, and procedures should ensure they are
procedure must be in place to ensure that calls not exceeded. In establishing concentration lim-
for additional collateral are made on a timely its on letters of credit accepted as collateral, the
basis. The valuation procedures should take into lenders total outstanding credit exposures from
account the value of accrued interest on debt the issuing bank should be considered.
securities.
Securities should not be lent unless collateral
has been received or will be received simulta- 2140.0.3.8 Written Agreements
neously with the loan. As a minimum step
toward perfecting the lenders interest, collat- Securities should be lent only pursuant to a
eral should be delivered directly to the lender or written agreement between the lender and the
an independent third-party trustee. owner of the securities, specifically authorizing
the institution to offer the securities for loan.
The agreement should outline the lenders
2140.0.3.6 Cash as Collateral authority to reinvest cash collateral (if any) and
responsibilities with regard to custody and valu-
When cash is used as collateral, the lender is ation of collateral. In addition, the agreement
responsible for making it income productive. should detail the fee or compensation that will
Lenders should establish written guidelines for go to the owner of the securities in the form of a
selecting investments for cash collateral. Gener- fee schedule or other specific provision. Other
ally, a lender will invest cash collateral in repur- items which should be covered in the agreement
chase agreements, master notes, a short-term have been discussed earlier in these guidelines.
investment fund (STIF), U.S. or Eurodollar cer- A lender must also have written agreements
tificates of deposit, commercial paper, or some with the parties who wish to borrow securities.
other type of money market instrument. If the These agreements should specify the duties and
lender is acting in any capacity other than as responsibilities of each party. A written agree-
principal, the written agreement authorizing the ment may detail acceptable types of collateral
(including letters of credit); standards for collat-
2. Employee benefit plans subject to the Employee Retire- eral custody and control, collateral valuation
ment Income Security Act are specifically required to collater- and initial margin, accrued interest, marking to
alize securities loans at a minimum of 100 percent of the
market value of loaned securities (see section 2140.0.3.10
market, and margin calls; methods for transmit-
below). ting coupon or dividend payments received if a
3. The level of margin should be dictated by level of risk security is on loan on a payment date; condi-
being underwritten by the securities lender. Factors to be tions which will trigger the termination of a loan
considered in determining whether to require margin above
the recommended minimum include the type of collateral, the
(including events of default); and acceptable
maturity of collateral and lent securities, the term of the
securities loan, and the costs which may be incurred when BHC Supervision Manual December 1998
liquidating collateral and replacing loaned securities. Page 3
methods of delivery for loaned securities and securities for an employee benefit plan subject
collateral. to ERISA should take all steps necessary to
design and maintain its program to conform
with these exemptions.
Prohibited Transaction Exemption 81-6 per-
2140.0.3.9 Use of Finders mits the lending of securities owned by
employee benefit plans to persons who could be
Some lenders may use a finder to place securi- parties in interest with respect to such plans,
ties, and some financial institutions may act as provided certain conditions specified in the
finders. A finder brings together a borrower and exemption are met. Under those conditions,
a lender for a fee. Finders should not take pos- neither the borrower nor an affiliate of the bor-
session of securities or collateral. The delivery rower can have discretionary control over the
of securities loaned and collateral should be investment of plan assets, or offer investment
direct between the borrower and the lender. A advice concerning the assets, and the loan must
finder should not be involved in the delivery be made pursuant to a written agreement. The
process. exemption also establishes a minimum accept-
The finder should act only as a fully disclosed able level for collateral based on the market
intermediary. The lender must always know the value of the loaned securities.
name and financial condition of the borrower of Prohibited Transaction Exemption 82-63 per-
any securities it lends. If the lender does not mits compensation of a fiduciary for services
have that information, it and its customers are rendered in connection with loans of plan assets
exposed to unnecessary risks. that are securities. The exemption details certain
Written policies should be in place concern- conditions which must be met.
ing the use of finders in a securities-lending
program. These policies should cover circum-
stances in which a finder will be used, which 2140.0.3.11 Indemnification
party pays the fee (borrower or lender), and
which finders the lender institution will use. Certain lenders offer participating accounts
indemnification against losses in connection
with securities-lending programs. Such indem-
nifications may cover a variety of occurences
2140.0.3.10 Employee Benefit Plans including all financial loss, losses from a bor-
rower default, or losses from collateral default.
The Department of Labor has issued two class Lenders that offer such indemnification should
exemptions which deal with securities-lending obtain a legal opinion from counsel concerning
programs for employee benefit plans covered by the legality of their specific form of indemnifi-
the Employee Retirement Income Security Act cation under federal and/or state law.
(ERISA): Prohibited Transaction Exemption A lender which offers an indemnity to its
81-6 (46 FR 7527 (January 23, 1981) and cor- customers may, in light of other related factors,
rection (46 FR 10570 (February 3, 1981))), and be assuming the benefits and, more importantly,
Prohibited Transaction Exemption 82-63 (47 FR the liabilities of a principal. Therefore, lenders
14804 (April 6, 1982)). The exemptions autho- offering indemnification should also obtain writ-
rize transactions which might otherwise consti- ten opinions from their accountants concerning
tute unintended prohibited transactions under the proper financial statement disclosure of their
ERISA. Any firm engaged in the lending of actual or contingent liabilities.

Page 4
Securities Lending policy 31579.5

statement of the Federal
Financial Institutions
Examination Council,
adopted by the Federal
Reserve Board on May 6,
1985

Page 5
Repurchase Transactions 1
Section 2150.0
Depository institutions and others involved with assure control of the securities covered by the
the purchase of United States Government and agreement.
Agency obligations under agreements to resell All firms that engage in securities repurchase
(reverse repurchase agreements),2 have some- agreement transactions should establish written
times incurred significant losses. The most im- credit policies and procedures governing these
portant factors causing these heavy losses have activities. At a minimum, those policies and
been inadequate credit risk management and the procedures should cover the following:
failure to exercise effective control over securi- Written policies should establish know your
ties collateralizing the transactions. 3 counterparty principles. Engaging in repur-
The following minimum guidelines address chase agreement transactions in volume and in
the need for managing credit risk exposure to large dollar amounts frequently requires the ser-
counterparties under securities repurchase vices of a counterparty who is a dealer in the
agreements and for controlling the securities in underlying securities. Some firms which deal in
those transactions, and should be followed when the markets for U.S. Government and Federal
entering into repurchase agreements with securi- agency securities are subsidiaries of, or related
ties dealers and others. to, financially stronger and better known firms.
Depository institutions and nonbank subsidi- However, these stronger firms may be indepen-
aries that actively engage in repurchase agree- dent of their U.S. Government securities subsid-
ments are encouraged to have more comprehen- iaries and affiliates and may not be legally obli-
sive policies and controls to suit their particular gated to stand behind the transactions of related
circumstances. The examining staffs of the Fed- companies. Without an express guarantee, the
eral Reserve should review written policies and stronger firms financial position cannot be
procedures of dealers to determine their ade- relied upon in assessing the creditworthiness of
quacy in light of these minimum guidelines and a counterparty.
the scope of each subsidiarys operations. It is important to know the legal entity that is
the actual counterparty to each repurchase
agreement transaction. Know about the actual
2150.0.1 CREDIT POLICY counterpartys character, integrity of manage-
GUIDELINES ment, activities, and the financial markets in
which it deals. Be particularly careful in con-
The apparent safety of short-term repurchase ducting repurchase agreements with any firm
agreements which are collateralized by highly that offers terms that are significantly more
liquid, U.S. Government and Federal agency favorable than those currently prevailing in the
obligations has contributed to an attitude of market.
complacency. Some portfolio managers have In certain situations firms may use, or serve
underestimated the credit risk associated with as, brokers or finders in order to locate repur-
the performance of the counterparty to the trans- chase agreement counterparties or particular
actions, and have not taken adequate steps to securities. When using or acting as this type of
agent the names of each counterparty should be
fully disclosed. Do not enter into undisclosed
1. A repurchase agreement is a transaction involving the agency or blind brokerage repurchase trans-
sale of assets by one party to another, subject to an agreement
by the seller to repurchase the assets at a specified date or in
actions in which the counterpartys name is not
specified circumstances. disclosed.
2. In order to avoid confusion among market participants
who sometimes use the same term to describe different sides
of the same transaction, the term repurchase agreement
will be used in the balance of this statement to refer to both
2150.0.1.1 Dealings with Unregulated
repurchase and reverse repurchase agreements. A repurchase Securities Dealers
agreement is one in which a party that owns securities ac-
quires funds by transferring the securities to another party A dealer in U.S. Government and Federal
under an agreement to repurchase the securities at an agreed
upon future date. A reverse repurchase (resale) agreement is
agency obligations is not necessarily a Federally
one in which a party provides funds by acquiring securities insured bank or thrift, or a broker/dealer regis-
pursuant to an agreement to resell them at an agreed upon tered with the Securities and Exchange Com-
future date. mission. Therefore, the dealer firm may not
3. Throughout this document repurchase agreements are
generally discussed in terms of secured credit transactions.
This usage should not be deemed to be based upon a legal BHC Supervision Manual December 1992
determination. Page 1
Repurchase Transactions 2150.0
be subject to any Federal regulatory oversight. related companies that could have an impact on
A firm doing business with an unregulated the financial condition of the counterparty.
securities dealer should be certain that the dealer When transacting business with a subsidiary,
voluntarily complies with the Federal Reserve consolidated financial statements of a parent are
Bank of New Yorks minimum capital guide- not adequate. Repurchase agreements should not
line, which currently calls for liquid capital to be entered into with any counterparty that is
exceed measured risk by 20 percent (that is, the unwilling to provide complete and timely dis-
ratio of a dealers liquid capital to risk of 1.2:1). closure of its financial condition. As part of this
This ratio can be calculated by a dealer using analysis, the firm should make inquiry about the
either the Securities and Exchange Commis- counterpartys general reputation and whether
sions Net Capital Rule for Brokers and Dealers there have been any formal enforcement actions
(Rule 15c31) or the Federal Reserve Bank of against the counterparty or its affiliates by State
New Yorks Capital Adequacy Guidelines for or Federal securities regulators.
United States Government Securities Deal- Maximum position and temporary exposure
ers. To ensure that an unregulated dealer com- limits for each approved counterparty should be
plies with either of those capital standards, it established based upon credit analysis per-
should certify its compliance with the capital formed. Periodic reviews and updates of those
standard and provide the following three forms limits are necessary.
of certification: Individual repurchase agreement counterparty
1. A letter of certification from the dealer limits should consider overall exposure to the
that the dealer will adhere on a continuous basis same or related counterparty. Repurchase agree-
to the capital adequacy standard; ment counterparty limitations should include the
2. Audited financial statements which dem- overall permissible dollar positions in repur-
onstrate that as of the audit date the dealer was chase agreements, maximum repurchase agree-
in compliance with the standard and the amount ment maturities and limits on temporary expo-
of liquid capital; and sure that may result from decreases in collateral
3. A copy of a letter from the firms certified values or delays in receiving collateral.
public accountant stating that it found no mate-
rial weaknesses in the dealers internal sys-
tems and controls incident to adherence to the
standard.4 2150.0.2 GUIDELINES FOR
Periodic evaluations of counterparty credit- CONTROLLING REPURCHASE
worthiness should be conducted by individuals AGREEMENT COLLATERAL
who routinely make credit decisions and who
are not involved in the execution of repurchase Repurchase agreements can be a useful asset
agreement transactions. and liability management tool, but repurchase
Prior to engaging in initial transactions with a agreements can expose a firm to serious risks if
new counterparty, obtain audited financial state- they are not managed appropriately. It is possi-
ments and regulatory filings (if any) from coun- ble to reduce repurchase agreement risk by
terparties, and insist that similar information be negotiating written agreements with all repur-
provided on a periodic and timely basis in the chase agreement counterparties and custodian
future. Recent failures of government securities banks. Compliance with the terms of these writ-
dealers have typically been foreshadowed by ten agreements should be monitored on a daily
delays in producing these statements. Many basis. If prudent management control require-
firms are registered with the Securities and Ex- ments of repurchase agreements are too burden-
change Commission as broker/dealers and have some, other asset/liability management tools
to file financial statements and should be willing should be used.
to provide a copy of these filings. The marketplace perceives repurchase agree-
The counterparty credit analysis should con- ment transactions as similar to lending transac-
sider the financial statements of the entity that is tions collateralized by highly liquid Govern-
to be the counterparty as well as those of any ment securities. However, experience has shown
that the collateral securities will probably not
serve as protection if the counterparty becomes
4. This letter should be similar to that which must be given
insolvent or fails, and the purchasing firm does
to the SEC by registered broker/dealers. not have control over the securities. Ultimate
responsibility for establishing adequate control
BHC Supervision Manual December 1992 procedures rests with management of the firm.
Page 2 Management should obtain a written legal opin-
ion as to the adequacy of the procedures utilized firms interest in the securities as superior to
to establish and protect the firms interest in the that of any other person; or
underlying collateral. appropriate entries on the books of a third
A written agreement specific to a repurchase party custodian acting pursuant to a tripartite
agreement transaction or master agreement gov- agreement with the firm and the counterparty,
erning all repurchase agreement transactions ensuring adequate segregation and identi-
should be entered into with each counterparty. fication of either physical or book-entry
The written agreement should specify all the securities.
terms of the transaction and the duties of both
the buyer and seller. Senior managers should Where control of the underlying securities is
consult legal counsel regarding the content of not established, the firm may be regarded only
the repurchase and custodial agreements. The as an unsecured general creditor of the insolvent
repurchase and custodial agreements should counterparty. In such instance, substantial losses
specify, but should not be limited to, the are likely to be incurred. Accordingly, a firm
following: should not enter into a repurchase agreement
without obtaining control of the securities un-
Acceptable types and maturities of collateral less all of the following minimum procedures
securities;
are observed: (1) it is completely satisfied as to
Initial acceptable margin for collateral securi-
the creditworthiness of the counterparty; (2) the
ties of various types and maturities
transaction is within credit limitations that have
Margin maintenance, call, default and sellout
been pre-approved by the board of directors, or
provisions;
a committee of the board, for unsecured transac-
Rights to interest and principal payments;
Rights to substitute collateral; and tions with the counterparty; (3) periodic credit
The persons authorized to transact business evaluations of the counterparty are conducted;
on behalf of the firm and its counterparty. and (4) the firm has ascertained that collateral
segregation procedures of the counterparty are
adequate. Unless prudential internal procedures
of these types are instituted and observed, the
2150.0.2.1 Confirmations firm may be cited for engaging in unsafe or
unsound practices.
Some repurchase agreement confirmations may All receipts and deliveries of either physical
contain terms that attempt to change the firms or book-entry securities should be made accord-
rights in the transaction. The firm should obtain ing to written procedures, and third party deliv-
and compare written confirmations for each re- eries should be confirmed in writing directly by
purchase agreement transaction to be certain the custodian. It is not acceptable to receive
that the information on the confirmation is con- confirmation from the counterparty that the
sistent with the terms of the agreement. The securities are segregated in a firms name with a
confirmation should identify specific collateral custodian; the firm should, however, obtain a
securities. copy of the advice of the counterparty to the
custodian requesting transfer of the securities to
the firm. Where securities are to be delivered,
2150.0.2.2 Control of Securities payment for securities should not be made until
the securities are actually delivered to the firm
As a general rule, a firm should obtain posses- or its agent. The custodial contract should pro-
sion or control of the underlying securities and vide that the custodian takes delivery of the
take necessary steps to protect its interest in the securities subject to the exclusive direction of
securities. The legal steps necessary to protect the firm.
its interest may vary with applicable facts and Substitution of securities should not be
law and accordingly should be undertaken with allowed without the prior consent of the firm.
the advice of counsel. Additional prudential The firm should give its consent before the
management controls may include: delivery of the substitute securities to it or a
third party custodian. Any substitution of securi-
delivery of either physical securities to, or in ties should take into consideration the following
the case of book entry securities, making ap- discussion of margin requirements.
propriate entries in the books of a third party
custodian designated under a written custodial BHC Supervision Manual December 1992
agreement which explicitly recognizes the Page 3
2150.0.2.3 Margin Requirements required, the firms rights to sell securities or

otherwise liquidate the repurchase agreement
The amount paid under the repurchase agree- should be exercised without hesitation.
ment should be less than the market value of the
securities, including the amount of any accrued
interest, with the difference representing a pre- 2150.0.2.4 Overcollateralization
determined margin. Factors to be considered in
establishing an appropriate margin include the A firm should use current market values, includ-
size and maturity of the repurchase transaction, ing the amount of any accrued interest, to deter-
the type and maturity of the underlying securi- mine the price of securities that are sold under
ties, and the creditworthiness of the counter- repurchase agreements. Counterparties should
party. Margin requirements on U.S. Government not be provided with excessive margin. Thus,
and Federal agency obligations underlying re- the written repurchase agreement contract
purchase agreements should allow for the antic- should provide that the counterparty must make
ipated price volatility of the security until the additional payment or return securities if the
maturity of the repurchase agreement. Less mar- margin exceeds agreed upon levels. When ac-
ketable securities may require additional margin quiring funds under repurchase agreements it is
to compensate for less liquid market conditions. prudent business practice to keep at a reason-
Written repurchase agreement policies and pro- able margin the difference between the market
cedures should require daily mark-to-market of value of the securities delivered to the counter-
repurchase agreement securities to the bid side party and the amount borrowed. The excess
of the market. Repurchase agreements should market value of securities sold may be viewed
provide for additional securities or cash to be as an unsecured loan to the counterparty subject
placed with the firm or its custodian bank to to the unsecured lending limitations for the firm
maintain the margin within the predetermined and should be treated accordingly for credit
level. policy and control purposes.
Margin calculations should also consider
accrued interest on underlying securities and the
anticipated amount of accrued interest over the 2150.0.3 OPERATIONS
term of the repurchase agreement, the date of
interest payment and which party is entitled to A firms operational functions should be de-
receive the payment. In the case of pass-through signed to regulate the custody and movement of
securities, anticipated principal reductions securities and to adequately account for trading
should also be considered when determining transactions. Because of the dollar volume and
margin adequacy. speed of trading activities, operational ineffi-
Prudent management procedures should be ciencies can quickly result in major problems.
followed in the administration of any repurchase In some cases, a firm may not receive or
agreement. Longer term repurchase agreements deliver a security by settlement date. When a
require managements daily attention to the firm fails to receive a security by the settlement
effects of securities substitutions, margin main- date, a liability exists until the transaction is
tenance requirements (including consideration consummated or cancelled. When the security is
of any coupon interest or principal payments) not delivered to the contra-party by settlement
and possible changes in the financial condition date, a receivable exists until that fail is re-
of the counterparty. Engaging in open repur- solved. Fails to deliver for an extended time,
chase agreement transactions without maturity or a substantial number of cancellations, are
dates may be regarded as an unsafe and unsound sometimes characteristic of poor operational
practice unless the firm has retained rights to control or questionable trading activities.
terminate the transaction quickly to protect itself Fails should be controlled by prompt report-
against changed circumstances. Similarly, auto- ing and follow-up procedures. The use of multi-
matic renewal of short-term repurchase agree- copy confirmation forms enables operational
ment transactions without reviewing collateral personnel to retain and file a copy by settlement
values and adjusting collateral margin may date and should allow for prompt fail reporting
be regarded as an unsafe and unsound practice. and resolution.
If additional margin is not deposited when

Page 4
Federal Financial 31579

Institutions Examination
Council policy statement,
adopted by the Federal
Reserve Board on
November 12, 1985, on
repurchase agreements

Page 5
Recognition and Control of Exposure to Risk
Section 2160.0
Risk management is an important responsibility The list of exposures that banks commonly
of any bank holding company. The objective of identify has increased dramatically in the past
this responsibility is to determine and limit the decade. Historically, the primary focus has been
extent of the holding company organizations on the exposure of the loan portfolio centering
vulnerability to uncontrollable variables. While on the financial security of each individual loan;
all companies perform risk evaluation in some recently industry and geographical exposure of
form and exercise some degree of control over loans has increased in importance. The exposure
its magnitude, the precise processes used differ of fixed assets, such as buildings, to fires, floods
considerably across organizations in terms of and other problems also has been recognized. In
formality, extensiveness, and effectiveness. It more recent years, exposure of mismatched
should be recognized that many organizations maturities of assets and liabilities to interest rate
have only an implicit risk evaluation process, movements has increased in importance as
and that it may be appropriate to recommend interest-rate movements have sharply fluctu-
that this process be formalized. Ultimately, the ated. While this exposure had always existed, it
board of directors of the parent company should had not been recognized as particularly danger-
be held accountable for the consolidated risk ous until recently. Another example of an expo-
evaluation and control. sure that historically was considered safe is
Risk management at any level involves two repurchase agreements backed by government
basic elements: evaluation and control. Risk securities. When Drysdale Government Securi-
evaluation involves three steps: determination ties, Inc. failed, several risks were brought to
of exposures; specification of uncontrollable lightwhether the instrument is a loan (that
variables that have an impact on each exposure; would be tied up in case of bankruptcy) or a sale
and quantification of the expected effect of each and potential liability when serving as an agent
variable on exposure. After the extent of exist- of a government securities firm that fails. A
ing or potential risk is determined, decisions to particularly difficult area to evaluate is exposure
limit or control risk are made. This procedure is to legal action. For example, a suit against a
ever present, since most transactions create ex- bank over lending terms and representations is
posure, and every exposure has some element of difficult to anticipate and the exposure could be
risk. The following two sections discuss the risk significant.
evaluation and the risk control processes in very Numerous exposures exist that many holding
broad terms in an attempt to provide a frame- company organizations may not recognize. For
work that can be applied to most organizations. example, the Federal Reserve System encour-
ages evaluation of wire transfer exposure. This
exposure is very large and theoretically a break-
down on the framework or compromise of inter-
2160.0.1 RISK EVALUATION nal systems could result in major failures. Expo-
sure from foreign exchange contracts also can
The risk identification process begins with a be large, and may not always be recognized.
determination of exposures that an institution Fraud and exposure of management to kidnap-
has to the environment. ping continue to increase in importance. And
Exposure conceptually occurs in every trans- finally, some major holding company organiza-
action undertaken by a banking organization. tions have found that dependence on short-term
Because of the magnitude of the list of potential market funds creates a risky exposure. When
exposures, institutions generally limit their access to a funding market may be suddenly
efforts to extremely large exposures, to areas withdrawn, the exposure of the entire funding
where losses appear likely, and to activities process is an issue.
where the market is changing and new expo- The second step of the risk identification pro-
sures are created. The size of an exposure gener- cess is specification of the variables that could
ally is dependent on the size of a transaction. affect an exposure and determination of what
This is true both for transactions recorded on the impact would be.
accounting balance sheets and for those which This process is difficult, since any number of
occur off balance sheet. Exposure is not neces- variables may influence an exposure. Further-
sarily determined by the likelihood of loss. For more, as the environment changes new variables
example, many holding company organizations
have a large exposure in Treasury bills, but BHC Supervision Manual December 1992
do not consider these transactions to be risky. Page 1
Recognition and Control of Exposure to Risk 2160.0
may appear relevant and the effects of variables the environment changes, the effect of a variable
may change. For example, the recent problems on an exposure changes as does the cost and
of public sector lending to foreign countries probability of the occurrence. For example, in
with loans denominated in dollars having float- the 1970s the impact of inflation on the bank-
ing interest rates during inflationary periods may ing system would have been very different with-
not have been fully evaluated at the time of the out the concurrent economic downturn and the
lending process. technological advances.
Determining influential variables is particu-
larly difficult with new products. A historical
examination cannot be made of these new prod- 2160.0.2 RISK CONTROL
ucts and questions may go unanswered regard-
ing the stability of the new markets. For exam- After management has identified and evaluated
ple, problems have occurred in hedging risk, they may decide the risk or cost of an
operations as underlying instruments did not action is sufficiently low (and management is
move as expected, thus negating the hedging confident all possible variables have been identi-
contract. Consequently, the hedge created an fied) that the holding company can take on the
exposure rather than reducing an exposure. risk as it is; if not there are a number of options
The final step of the risk identification pro- that can be used to control the risk. Attempts to
cess is risk quantification. control risk can be accomplished through a com-
Conceptually, this involves calculation of an bination of three general techniques: purchase
expected loss of value related to variance of a of insurance, limitation of exposure size, and
particular environmental factor. This has two reduction of the expected cost associated with a
parts: (1) estimation of the probability that a variance. The use of insurance to decrease the
given variance will occur; and (2) determination effect of a loss on the corporation is common for
of the cost impact of each potential variance. exposure to fire, theft, kidnapping, and internal
Probabilities are often drawn up in general fraud. Various types of loans are underwritten
terms. In some cases historical records facilitate by third parties. The innovative use of insurance
estimation of probabilities. Measurement of may prove to have various applications to risk
credit risk in an organization that specializes by control in the banking industry. As with other
industry or geography may be an example of contracts, the financial strength and reputation
this. In the most recent recession, however, of the counterparty (the insurer) are important,
many past records have proven not to be accu- and the organizations method of selecting and
rate predictors. In other situations, the holding monitoring underwriters should be evaluated.
company organization may evaluate the effect Management generally limits the level of
of a change but be unwilling to estimate proba- exposure in relationship to the size of assets,
bilities of the change occurring. An example capital or earnings. In most situations, relating
of this is managing asset and liability maturi- the level of exposure to capital would appear
ties. The effect of a change in interest rates on appropriate. Reduction of exposure will auto-
profits may be determined; but, in many cases, matically reduce risk, assuming other variables
institutions will not derive probabilities on the remain constant. Constraints should be deter-
direction and/or magnitude of interest rate mined by line management at a seniority level
movements. commensurate with the degree of perceived risk.
The difficulty of quantifying costs and proba- Depending on the degree of risk, there may be a
bilities is exacerbated by emergence of new need for the board of directors to approve the
products and by environmental changes. With a constraints.
new product, it is particularly difficult to deter- The third method of reducing the potential
mine the cost of a variance. For example, atten- loss to the corporation involves decreasing the
tion to interest rate risk has induced organiza- probability of a variance occurring or decreas-
tions to resort to hedging to reduce exposure. ing the probable effect when a variance occurs.
Innovative instruments are difficult to hedge, This is exemplified by the exposure to fire.
however, since the issuer may inaccurately Installation of fire alarms and other precautions
gauge price movements. In this case, the expo- could reduce the expected loss substantially.
sure results not from price movements, but from Similarly, hedging with financial futures is a
inability to predict the relationship between method used to reduce the effect of interest rate
market and price fluctuations. Furthermore, as movement on the profits of the holding com-
pany organization when the maturities of assets
BHC Supervision Manual December 1992 and liabilities are not equal.
Page 2 The final option management has, after risk
Recognition and Control of Exposure to Risk 2160.0
has been evaluated, is simply not to participate 6. To determine what actions are necessary
in the activity if the risk is determined to be too to rebalance transactions of a holding company
high for the expected return. organization to a prudent level.
The inspection procedures should include a
broad-based evaluation of parent level risk man-
agement. Managements effectiveness in identi- 2160.0.4 INSPECTION PROCEDURES
fying risk, its willingness to accept risk, and its
ability to control risk should be regularly evalu- 1. Review the financial condition and the
ated. In an environment of rapid change and operations of the holding company organization
emerging financial instruments, there needs to to detect substantive exposure-risk situations.
be sufficient expertise to recognize the existence 2. Review managements policies, proce-
of new sources of risk concentration to eval- dures, and practices in recognizing exposure-
uate the companys command of those sources. risk factors.
3. Determine awareness that all management
levels need to be cognizant of exposures related
2160.0.3 INSPECTION OBJECTIVES to transactions of their respective operations.
4. Review the holding companys exposure-
1. To review the risk evaluation and control risk figures, or constraints placed on types of
process. transactions.
2. To determine if managements system of 5. Discuss with management the significance
identifying risks is effective, and if the parent of exposure-risks facing the holding company
company is adequately informed of risks and whether or not those risks are set at seem-
throughout the organization. ingly prudent levels.
3. To determine managements recognition 6. Recommend that the organization address
of new risks that may arise from the changing any areas where the holding company is per-
environment. ceived to have assumed an imprudent level of
4. To determine the reasonableness of the risk.
holding companys exposure-risk figures.
5. To assess the effect on the holding compa-
nys financial condition if the risk figures are
realized.

Page 3
Purchase and Sale of Loans Guaranteed by the
U.S. Government Section 2170.0
2170.0.1 INTRODUCTION 2170.0.3 RECOMMENDATIONS FOR
PURCHASING INSTITUTIONS
On April 10, 1985, the Board approved a super-
visory policy, via the Federal Financial Institu- Purchasers of U.S. government guaranteed loans
tions Examination Council, for supervising should be aware that the purchase premiums are
banking organizations that participate in the pur- not guaranteed and are not paid by the guaran-
chase and sale of loans guaranteed by the U.S. teeing Federal agency when the loans are pre-
government. The policy reminds those organiza- paid. Because payment of premiums which do
tions that premiums received in lieu of servicing not reasonably relate to the yield on the loan can
fees, with respect to the selling and servicing distort published financial reports by overstating
entity, are to be amortized over the life of the the value of a banking organizations assets, it
loan; and that, with respect to the purchaser, the will generally be viewed as an unsafe and un-
premiums paid over the face value of the note sound practice to pay purchase premiums which
are not guaranteed and are not paid by the result in a significant overstatement in the value
guaranteeing federal agency when the loans are of bank assets.
prepaid or in default. The statement thus cau- Many government guaranteed loans currently
tions against paying inappropriate or excessive being originated and sold are variable rate.
premiums. These variable rate loans normally should not
trade at anything more than a modest premium
or discount from par. Examiners will carefully
2170.0.2 RECOMMENDATIONS FOR review any loans being sold or purchased at
ORIGINATING AND SELLING significant premiums and will criticize any
INSTITUTIONS involvement with excessive premiums as an
unsafe and unsound business practice. Exces-
Examiners should review the extent and nature
sive purchase premiums will be classified loss.
of activities in connection with the sale of gov-
The loans will be required to be revalued to the
ernment guaranteed loans. Lax or improper
market value at the time of the acquisition and
management of the selling institutions servic-
the excessive premiums will be charged against
ing responsibilities should be criticized. Out-of-
current earnings.
trade area lending for the purpose of resale of
In addition, any unamortized loan premium
any portion of U.S. government guaranteed
on a government guaranteed loan must be im-
loans should be carefully reviewed to ensure
mediately charged against income if the loan is
that the practice is conducted in a safe and
prepaid, regardless of whether payment is
sound manner.
received from the borrower or the guaranteeing
All income, including servicing fees and pre-
agency.
miums charged in lieu of servicing fees, associ-
ated with the sale of U.S. government guaran-
teed loans, should be recognized only as earned
and amortized to appropriate income accounts
over the life of the loan.

Page 1
Sale of Uninsured Annuities
Section 2175.0
2175.0.1 INTRODUCTION have been challenged by insurance associations
on the basis that annuities are insurance prod-
Banking organizations have become increas- ucts and, therefore, may be sold by national
ingly involved in marketing third-party unin- banks only in a town of less than 5,000.2
sured annuities to their retail customers either State member banks generally have been per-
directly or through third-party companies. As mitted to engage in the brokerage of both
annuity sales have grown, so have concerns that variable- and fixed-rate annuities consistent with
some methods used to sell these instruments their general corporate powers. In order to
could give purchasers the impression that the engage in this activity without filing a formal
annuities are federally insured deposits or that application, staff has advised interested banks
they are obligations of a bank. In the event of that the brokerage of annuities must be
default by an annuities underwriter, this impres- expressly authorized under state law (or by the
sion could cause a loss of public confidence in a state banking regulatory agency on a case-by-
depository institution, leading to unexpected case basis) and constitute an activity incidental
withdrawals and liquidity pressures. Moreover, to the banks banking activities.
a bank or bank holding company that advertises The authority of state member banks to con-
or markets annuities in a way viewed as mis- tinue to engage in this activity, in the same
leading could potentially be held liable for manner and subject to the conditions discussed
losses sustained by annuity holders. above, does not appear to depend on a resolu-
This manual section provides guidelines to tion of the issues.3 State member banks have
examiners for reviewing the sale of uninsured been permitted to engage in general insurance
annuities by bank holding companies and banks agency activities since 1937,4 and to engage in
that have legal authority to act as agent in the brokerage activities under the same limitations
sale of annuities. State member banks and bank applicable to bank holding companies. In addi-
holding companies should not market, sell, or tion, the Board has determined that the nonbank-
issue uninsured annuities or allow third parties ing restrictions in the Bank Holding Company
to market, sell, or issue uninsured annuities on Act do not apply to the direct activities of banks
depository-institution premises in a manner that owned by a bank holding company.5
conveys the impression or suggestion that such The authority of bank holding companies to
instruments are either (1) federally insured engage directly or through a nonbanking subsid-
deposits or (2) obligations of or guaranteed by iary in the sale of annuities has not yet been
an insured depository institution. Consequently, determined. In Norwest Corporation,6 the Board
state member banks should not sell these instru- considered a proposal by a nonbanking affiliate
ments at teller windows or other areas where to engage in the sale of variable- and fixed-rate
retail deposits are routinely accepted. annuities. The Board concluded that, under the
specific facts of that case, it was unnecessary to
reach the question of whether the sale of annu-
2175.0.2 PERMISSIBILITY OF ities is an insurance agency activity because
UNINSURED ANNUITY SALES Norwest is one of a small number of bank
holding companies entitled to act as agent in the
The legal status of annuities under the Bank
Holding Company Act is somewhat uncertain at
the present time. The Office of the Comptroller 2. The Variable Annuity Life Insurance Company v. Clarke,
No. H-91-1016 (S.D. Tex. filed Apr. 16, 1991) (NCNB
of the Currency has authorized national banks to litigation).
act as agent in the sale of annuities on the basis 3. NCNB litigation.
that variable-rate annuities are securities and 4. Prior to 1937, the Board imposed as a condition of
fixed-rate annuities are financial investment membership in the Federal Reserve System that a bank dis-
continue all insurance activities other than insurance activities
instruments.1 These determinations, however, in a town of less than 5,000. The purpose of this restriction
was to conform insurance activities allowed for state member
banks to those allowed for national banks.
5. Merchants National Corp., 75 Federal Reserve Bulletin
1. Interpretive Letter No. 331, April 4, 1985, reprinted in 388 (1989), affd, 890 F.2d 1275 (2d Cir. 1989), cert. denied,
[19851987 Transfer Binder] Fed. Banking L. Rep. (CCH) 111 S. Ct. 44 (1990).
85,501; OCC Interpretive Letter No. 499 (February 12, 6. 76 Federal Reserve Bulletin 873 (1990).
1990), reprinted in [19891990] Fed. Banking L. Rep. (CCH)
83,090. National banks are authorized to buy and sell securi-
ties for the account of customers and broker financial invest- BHC Supervision Manual June 1996
ment instruments. Page 1
Sale of Uninsured Annuities 2175.0
sale of any type of insurance pursuant to Ex- itys age. Normally, funds may not be with-
emption G of the Garn Act.7 drawn prior to the first anniversary date of the
annuity.8
Annuities sold at depository institutions often
2175.0.3 CHARACTERISTICS OF include rate guarantees over the life of the
ANNUITY INSTRUMENTS instrument. They also frequently mature in one,
three, or five years, similar to maturity ranges
An annuity is an investment from which a per- on certificates of deposit.
son receives periodic payments based on earlier Insurance companies arrange for the sale of
payments made to the obligor. Annuities are annuities on the premises of depository institu-
commonly underwritten by insurance compa- tions in different ways. Some insurance compa-
nies, then marketed and sold either directly or nies approach banks directly. At other times,
through third parties, such as banks. Insurance wholesalers (who market the products of a
companies retain the actuarial and underwriting number of different insurance companies) may
risks on these annuities. approach a bank. Depending on state restric-
Annuities may be either variable or fixed- tions on insurance activities, sales might be
rate. An investor in a variable annuity contract conducted by bank employees, employees of
purchases a share in an investment portfolio and bank subsidiary insurance agencies, or by third-
then receives payments that vary according to party insurance agents leasing space on the
the performance of the portfolio. A purchaser banks premises.
of a fixed-rate annuity contract, in contrast, Sales commissions on annuities vary by the
receives a fixed-rate payment or minimum level type of annuity. Commissions earned on single-
of payments. Annuity payments can usually be premium products generally vary from 4 percent
received monthly, quarterly, semi-annually, or to 6 percent, but they decline sharply when the
annually. product sold includes a bail-out provision.
Variable- and fixed-rate annuities may be pur- Wholesalers may also give retailers a commis-
chased in a single lump sum (single pre- sion when the annuity is renewed, based on the
mium) or in periodic contributions (flexible accumulated value of the annuity. Commissions
premium). Minimum and maximum contribu- in some instances are paid on a variable basis,
tions to annuities vary among vendors. Some rising as the volume of sales increases.
single-premium annuities have bail-out fea-
tures which allow holders to withdraw all funds
if the rate of return on the annuity contract falls 2175.0.4 IMPROPER MARKETING
below a specified rate. PRACTICES
The ability to take money out of an annuity
prior to maturity varies by product, as does the Banks have become involved in the sale of
imposition of a surrender penalty by the insurer uninsured annuities through marketing programs
when withdrawal occurs prior to maturity. When designed to appeal specifically to their retail
a penalty is imposed, the insurer generally cal- customers. It is important that these programs
culates the penalty as a percentage of the annu- not employ marketing practices that could mis-
ity products accumulated value. The penalty lead the banks customers. For example, the use
for withdrawal generally declines with the annu- in annuities advertisements of terms such as
CD, deposit, and interest plan to imply
7. The Garn Act amended section 4(c)(8) of the Bank that the instruments are insured deposits would
Holding Company Act to prohibit generally bank holding be inappropriate. Also, advertisements that
companies from engaging in insurance activities as a princi- prominently display the banks name and logo
pal, agent, or broker with certain exceptions. Under the ex-
press language of the Garn Act, the sale of insurance is not in a way that suggests the product is an obliga-
closely related to banking and is not permissible for a bank tion of the bank are similarly inappropriate.
holding company unless it qualifies under one of the seven Disclosure that the annuities are not federally
specified exceptions (Exemptions AG) in the Garn Act. insured and are not obligations of the bank
Exemption G applies to a limited number of bank holding
companies that received approval from the Board prior to should be displayed prominently in annuity con-
January 1, 1971, to conduct insurance agency activities. In tracts and related documentation, on printed
order to utilize Exemption G or any other Garn Act exemp-
tions that may be applicable, the bank holding company must
8. If an investor withdraws tax-deferred income from an
file an application and would be subject to the proposed
annuity before the investor is 5912 years old, the IRS levies a
restrictions through the application process.
tax penalty on the person equal to 10 percent of the amount of
tax-deferred income withdrawn. This penalty may be avoided
BHC Supervision Manual June 1996 only if the person reinvests annuity proceeds in another tax-
Page 2 deferred investment within 60 days of the withdrawal.
advices, and verbally emphasized in telemarket- all related documents disclose prominently in
ing contacts. Finally, personnel selling unin- bold print that the annuities:
sured annuities should be distinguishable from (a) are not deposits or obligations of
bank employees conducting normal retail an insured depository institution; and
deposit-taking operations. (b) are not insured by the Federal
Deposit Insurance Corporation.
(2) State member banks should not sell
2175.0.5 INSPECTION OBJECTIVES annuity instruments at teller windows or other
areas where retail deposits are routinely ac-
1. To review the marketing and sale of unin- cepted. In assessing the adequacy of disclosures
sured annuities sold by the bank holding com- and the separation of the marketing and sale of
pany and its member banks, or those sold uninsured annuities from the retail deposit-
through a third party. taking function, examiners should take into
2. To determine whether the bank holding account whether:
company and its banks have adequate policies (a) advertisements do not contain
and procedures in place and if they are moni- words, such as deposit, CD, etc., or a logo
tored by the parent company. that could lead an investor to believe an annuity
3. To determine if, prior to agreeing to sell is an insured deposit instrument;
annuities, a comprehensive financial analysis is (b) the obligor of the annuity contract
made of the financial condition of the annuities is prominently disclosed, and names or logos of
underwriter and whether products of only finan- the insured depository institution are not used in
cially secure underwriters are sold. a way that might suggest the insured depository
4. To determine whether the contract and institution is the obligor;
advertising and related documents disclose
(c) adequate verbal disclosures are
prominently that the annuities do not represent
made during telemarketing contacts and at the
deposits or obligations of an insured depository
time of sale;
institution and that they are not insured by the
Federal Deposit Insurance Corporation. (d) retail deposit-taking employees of
5. To ascertain that annuities are not sold at the insured depository institution are not en-
teller windows or other areas where deposits are gaged in the promotion or sale of uninsured
routinely accepted. annuities;
(e) information on uninsured annu-
ities is not contained in retail deposit statements
2175.0.6 INSPECTION PROCEDURES of customers or in the immediate retail deposit-
taking area;
1. Determine whether the bank holding com- (f) account information on annuities
pany and its banks have adequate policies and owned by customers is not included on insured
procedures in place: deposit statements; and
a. to assess the financial condition of the (g) officer or employee remuneration
annuities underwriter; associated with selling annuities is limited to
Banking organizations engaged in the reasonable levels in relation to the individuals
sale of annuities are expected to sell only prod- salary.
ucts of financially secure underwriters. Prior (3) If a bank allows a third-party entity
to agreeing to sell annuities, a comprehensive to market annuities on depository institution
financial analysis of the obligor should be per- premises, examiners should take into account
formed and reviewed with the banking organiza- whether:
tions directors. The policies should also include (a) the depository institution has
a program to evaluate the underwriters finan- assured itself that the third-party company is
cial condition at least annually and to review the properly registered or licensed to conduct this
credit ratings assigned to the underwriter by activity;
the independent agencies evaluating annuity (b) depository institution personnel
underwriters. are not involved in sales activities conducted by
b. to ensure that the marketing and sale of the third party;
uninsured annuities is not misleading and is (c) desks or offices are not used to
separated and distinguished from routine retail market or sell annuities, are separate and dis-
deposit-taking activities.
(1) With regard to the sale of annuities, BHC Supervision Manual December 1992
determine whether the contract, advertising, and Page 3
tinctly identified as being used by an outside 3. Determine whether the banks obtain a
party; and signed statement from the customer indicating
(d) depository institution personnel that the customer understands that the annuity is
do not normally use desks or offices used by a not a deposit or any other obligation of the
third party for annuities sales. depository institution, that the depository insti-
2. Determine that advertisements do not tution is only acting as an agent for the insur-
prominently display the banks name and logo ance company (underwriter), and that the annu-
that suggests the product is an obligation of a ity is not FDIC insured.
BHC bank.

Page 4
Support of Bank-Affiliated Investment Funds Section 2178.0
On January 5, 2004, the federal banking and 2178.0.1 POLICY ON BANKS
thrift agencies1 (the agencies) issued an inter- PROVIDING FINANCIAL SUPPORT
agency policy to alert banking organizations, TO ADVISED FUNDS
including their boards of directors and senior
management, of the safety-and-soundness To avoid engaging in unsafe and unsound bank-
implications of and the legal impediments to a ing practices, banks should adopt appropriate
bank providing financial support to investment policies and procedures governing routine or
funds2 advised by the bank, its subsidiaries, or emergency transactions with bank-advised
affiliates (that is, affiliated investment funds). A investment funds. Such policies and procedures
banking organizations investment advisory ser- should be designed to ensure that the bank will
vices can pose material risks to the banks not (1) inappropriately place its resources and
liquidity, earnings, capital, and reputation and reputation at risk for the benefit of the funds
can harm investors, if the associated risks are investors and creditors; (2) violate the limits and
not effectively controlled. In addition, bank- requirements contained in sections 23A and 23B
affiliated investment advisers are encouraged to of the Federal Reserve Act and Regulation W,
establish alternative sources of financial support other applicable legal requirements, or any spe-
to avoid seeking support from affiliated banks. cial supervisory condition imposed by the agen-
(See SR-04-1 and SR-94-53.) cies; or (3) create an expectation that the bank
Banks are under no statutory requirement to will prop up the advised fund. Further, the agen-
provide financial support to the funds they cies expect banking organizations to maintain
advise; however, circumstances may motivate appropriate controls over investment advisory
banks to do so for reasons of reputation risk and activities that include:
liability mitigation. This type of support by
banking organizations to funds they advise Establishing alternative sources of emergency
includes credit extensions, cash infusions, asset support from the parent holding company,
purchases, and the acquisition of fund shares. In nonbank affiliates, or external third parties
very limited circumstances, certain arrange- prior to seeking support from the bank.
ments between banks and the funds they advise Instituting effective policies and procedures
have been expressly determined to be legally for identifying potential circumstances trig-
permissible and safe and sound when properly gering the need for financial support and the
conducted and managed. However, the agencies process for obtaining such support. In the
are concerned about other occasions when emer- limited instances that the bank provides finan-
gency liquidity needs may prompt banks to sup- cial support, the banks procedures should
port their advised funds in ways that raise pru- include an oversight process that requires for-
dential and legal concerns. Federal laws and mal approval from the banks board of direc-
regulations place significant restrictions on tors, or an appropriate board-designated com-
transactions between banks and their advised mittee, independent of the investment
funds. In particular, sections 23A and 23B of the advisory function. The banks audit commit-
Federal Reserve Act and the Boards Regulation tee also should review the transaction to
W (12 C.F.R. 223) place quantitative limits and ensure that appropriate policies and proce-
collateral and market-terms requirements on dures were followed.
many transactions between a bank and certain Implementing an effective risk-management
of its advised funds. system for controlling and monitoring risks
posed to the bank by the organizations invest-
ment advisory activities. Risk controls should
include establishing appropriate risk limits,
liquidity planning, performance measurement
systems, stress testing, compliance reviews,
and management reporting to mitigate the
1. The Board of Governors of the Federal Reserve System
(Board), the Office of the Comptroller of the Currency (OCC),
need for significant bank support.
the Federal Deposit Insurance Corporation (FDIC), and the Implementing policies and procedures that
Office of Thrift Supervision (OTS). ensure that the bank is in compliance with
2. Bank-advised investment funds include mutual funds, existing disclosure and advertising require-
alternative strategy funds, collective investment funds, and
other funds where the bank, its subsidiaries, or affiliates is the
investment adviser and receives a fee for its investment BHC Supervision Manual June 2004
advice. Page 1
Support of Bank-Affiliated Investment Funds 2178.0
ments to clearly differentiate the investments 2178.0.4 INSPECTION PROCEDURES

in advised funds from obligations of the bank
or insured deposits. 1. Determine if the BHC has adequate over-
Ensuring proper regulatory reporting of con- sight policies, procedures, and practices to
tingent liabilities arising out of its investment ensure that its banking and nonbank subsidi-
advisory activities in the banking organiza- aries that advise investment funds do not
tions published financial statements in accor- a. inappropriately place the resources and
dance with FAS 5, and fiduciary settlements, reputation of the bank at risk for the bene-
surcharges, and other losses arising out of its fit of affiliated investment funds investors
investment advisory activities in accordance and creditors;
with the instructions for completing call report b. violate the limits and requirements in Fed-
Schedule RC-T (Fiduciary and Related eral Reserve Act sections 23A and 23B
Services). and Regulation W, other applicable legal
requirements, or any special supervisory
2178.0.2 NOTIFICATION AND condition imposed by the agencies; or
CONSULTATION WITH THE c. create an expectation that a bank will sup-
PRIMARY FEDERAL REGULATOR port the advised fund (or funds).
2. Find out how the BHC ensures through its
Because of the potential risks posed by the communications with subsidiaries that bank-
provision of financial support to advised funds, affiliated investment advisers are encouraged
bank management should notify and consult to establish alternative sources of financial
with its appropriate federal banking agency prior support from an unaffiliated bank or other
to (or immediately after, in the event of an affiliate.
emergency) the bank providing material finan- 3. Ascertain whether the BHCs internal or
cial support to its advised funds. The appropri- external auditors verified that its oversight
ate federal banking agency will closely scruti- policies and procedures for bank-advised
nize the circumstances surrounding the funds were adequately communicated to its
transaction and will address situations that raise banking subsidiaries to ensure compliance
supervisory concerns. with the January 5, 2004, Interagency Policy
on Banks and Thrifts Providing Financial
Support to Funds Advised by the Banking
2178.0.3 INSPECTION OBJECTIVES Organization or Its Affiliates. Compliance
1. To determine if the BHC has adequate over- includes the BHCs or subsidiarys notifica-
sight and control of its functionally regulated tion of and consultation with its appropriate
investment adviser subsidiaries. federal banking agency before (or, in an
2. To review and assess the existence, emergency, immediately after) providing
adequacy, maintenance, and monitoring of material financial support to an affiliated
the BHCs policies, procedures, and prac- investment fund.
tices (includes those involving the parent 4. Find out if the BHCs internal audit function
companys oversight and investment adviser monitors any financial support given to bank
subsidiaries). The BHCs policies, proce- or nonbank subsidiaries advised funds and if
dures, and practices should be designed to the internal auditors follow up on compli-
limit the exposures to financial, litigation, or ance with any policies, limits, or internal
reputational risk arising from its bank and controls that are intended to restrict the
nonbank subsidiaries. activities.
3. To ensure that the BHCs banking subsidi- 5. Determine if the BHC is able to assess at all
aries that advise investment funds are in times the extent of its subsidiary banks risk
compliance with the Interagency Policy on exposures that may arise from providing sup-
Banks and Thrifts Providing Financial Sup- port to affiliated investment funds.
port to Funds Advised by the Banking Orga-
nization or Its Affiliates.

Page 2
Securities Activities in Overseas Markets
Section 2180.0
Existing regulations permit banks and bank prudence. The affiliation of a securities com-
holding companies to engage in a wide range of pany, especially one engaged in corporate debt
securities activities in overseas markets. For a and equities transactions, with a banking organi-
number of years these activities were not con- zation raises a potential for conflict of interest
sidered to be significant in the context of total and in some cases could pose substantial addi-
bank and bank holding company assets. Indige- tional risk to the institution.
nous rules and market practice served to con- In those U.S. banking organizations where
strain to a degree securities activities of U.S. overseas securities trading and brokering are
banking organizations overseas. significant in scope or are prominent in the scale
Changes in local rules now make it possible of the local market, examination procedures
for members of the London stock exchange to must incorporate an assessment of the controls,
be wholly-owned by non-member companies limits, and safeguards implemented by the orga-
and by year-end 1986 will allow stockbrokers to nization to monitor and contain risk. Securities
act as principals or market makers in securities. activities should be subject to the same degree
These new rules are expected to change signifi- of scrutiny and rigorous assessment of risk as
cantly the complexion of the London securities bank lending activities. In addition, examiners
market. In this context, U.S. banking organiza- should monitor the substance and nature of all
tions are making substantial investments in U.K. transactions.
securities firms, and are also significantly ex- In particular, the following kinds of activities
panding their securities business in other foreign should be reviewed to determine whether they
and international markets. raise considerations of safety and soundness or
The Board has expressed its concerns, in con- otherwise do not conform to standards of pru-
nection with an application by a banking organi- dence required of U.S. banking organizations:
zation to expand its securities activities over-
seas, that proper safeguards, limits, and controls The degree of lending by a bank holding
will be exercised to protect the organization company to its securities affiliate, especially
from undue risk. Applications generally state when loans are extended to support or en-
the methods through which the banking organi- hance the obligations underwritten by the
zation plans to control risk and establish over- securities affiliate;
sight over securities operations. While these The extent to which securities underwritten
safeguards are initially evaluated at the time the by an affiliate are purchased by the bank hold-
application is made, nevertheless, examinations ing company as principal or trustee; and,
of bank holding companies and Edge corpora- The extent to which the parent is liable to an
tions should incorporate an assessment of all exchange for any losses incurred by the affil-
overseas securities activities in order to deter- iate due to failure to deliver securities or settle
mine the degree to which these activities con- contracts.
form to high standards of banking and financial

Page 1
Violations of Federal Reserve Margin Regulations Resulting
from Free-Riding Schemes Section 2187.0
Targeted examinations and investigations by the from financing these new issues. If the money to
Federal Reserve and the Enforcement Division pay for the securities is not in the account when
of the Securities Exchange Commission (SEC), the securities are delivered in a delivery-versus-
as well as court actions, have found banks in payment (DVP) transaction, a bank that permits
violation of Regulation U, Credit by Banks for completion of the transaction creates a tempo-
the Purpose of Purchasing or Carrying Margin rary overdraft in the customers account. This
Stock, (12 C.F.R. 221) when their trust depart- overdraft is an extension of credit that subjects
ments, using bank or other fiduciary funds, have the banks to Regulation U.
extended credit to individuals involved in illegal The typical free-riding scheme involves a
day trading or free-riding schemes. These activi- new customers opening a custodial agency
ties also involved the aiding and abetting of account into which a number of broker-dealers
violations of two other securities credit regula- will deliver securities or funds in DVP transac-
tions: Regulation T, Credit by Brokers and Deal- tions. Although a deposit may be made into the
ers (12 C.F.R. 220), and Regulation X, Borrow- custodial agency account, the amount of trading
ers of Securities Credit, (12 C.F.R. 224). is greatly in excess of the original deposit, caus-
Day trading and free-riding schemes involve ing the financial institution to extend its own
the purchase and sale of stock on the same day credit to meet the payment and delivery obliga-
(or within a very short period of time) and the tions of the account. Therefore, although the
funding of the purchases with the proceeds of financial institution may be earning fees as a
the sale. Banking organizations1 engaging in result of the activity in these accounts, it is
such illegal activities may subject themselves to subjecting itself to substantial losses if the mar-
disciplinary proceedings, as well as to substan- ket prices for the purchased securities fall or the
tial credit risk. transactions otherwise fail. In addition, other
Federal Reserve examiners should ensure that liabilities under federal banking and securities
banks and bank holding companies (including laws may be involved.
the broker-dealer and trust activities of banking
and nonbanking subsidiaries of state member
banks and bank holding companies) are not 2187.0.2 SECURITIES CREDIT
engaged in such illegal activities. Examiners REGULATIONS
must make certain that these entities have taken
all steps necessary to prevent their customers 2187.0.2.1 Regulation U, Credit by
from involving them in free-riding. Prompt Banks or Persons Other Than Brokers or
enforcement action may be needed to eliminate Dealers for the Purpose of Purchasing or
free-riding activities. (See SR-93-13.) Carrying Margin Stocks
Any extension of credit in the course of settling
2187.0.1 TYPICAL DAY TRADING OR customer securities transactions, including those
FREE-RIDING ACTIVITIES occuring in a trust department or trust subsidi-
ary of a bank holding company, must comply
The free-riding conduct in question typically with all of the provisions of Regulation U.2
involves trading large amounts of securities Regulation U requires all extensions of credit
without depositing the necessary money or for the purpose of buying or carrying margin
appropriate collateral in their customer
accounts. The customer seeks to free-ride, that
is, purchase and sell the same securities and pay
for the purchase with the proceeds of the sale. 2. For purposes of the regulation, the definition of bank
Often, free-riding schemes involve initial public specifically includes institutions exercising fiduciary pow-
ers. (See 12 C.F.R. 221.2, 15 U.S.C. 78(c)(a)(6), and Federal
offerings because broker-dealers are prohibited Reserve Regulatory Service at 5795 (1946).) When used in
discussing a banks trust department or any other type of
financial institution exercising fiduciary powers, the term
1. The use of the term banking organization in this extension of credit includes overdrafts in settling custom-
section, with regard to Regulation U, means a bank, trust ers accounts that may be covered by advances from the
department of a bank, or trust company of a bank holding banking organization, from other fiduciary customers, or from
company that is subject to Regulation U. Regulation U a combination of both.
includes any nondealer nonbank subsidiary of a bank holding
company that extends purpose credit by margin stock. With
regard to Regulation T, it refers to any nonbank company that BHC Supervision Manual December 1998
conducts broker-dealer activities. Page 1
Violations of Federal Reserve Margin Regulations Resulting from Free-Riding Schemes 2187.0
stock that are secured by margin stock to be tions, broker-dealers may not discover that they
within the 50 percent limit. To avoid violations are selling securities to the customer in violation
of the Boards securities credit regulations, on of Regulation T. A similar aiding and abetting
settlement date, the customers account must violation of Regulation X could occur if a cus-
hold sufficient funds, excluding the proceeds of tomer used the financial institution to induce a
the sale of the security, to pay for each security broker-dealer to violate Regulation T.
purchased. Although Regulation U applies only
to transactions in margin stock, free-riding in
nonmargin stocks in custodial agency accounts 2187.0.3 NEW-CUSTOMER INQUIRIES
could result in a banking organizations aiding AND WARNING SIGNALS
and abetting violations of Regulations T and X
and other securities laws, and could raise finan- Examiners should make certain that all banks
cial safety-and-soundness issues. and other financial-institution subsidiaries of a
bank holding company are administering and
following appropriate written policies and pro-
2187.0.2.2 Regulation T, Credit by cedures concerning the establishment of custo-
Brokers and Dealers, and Regulation X, dial agency accounts or any new account involv-
Borrowers of Securities Credit ing customer securities transactions. Such
policies and procedures should address, among
Because the custodial agency accounts are used other things, ways an institution can protect
to settle transactions effected by the customer at itself against free-riding schemes. One way is to
broker-dealers, a banking organization that obtain adequate background and credit informa-
opens this type of account should have some tion from new clients, including whether the
general understanding of how Regulation T customer intends to obtain credit to use with the
restricts the customers use of the account at the account. This type of activity requires more
institution. Regulation T requires the use of a extensive monitoring than the typical DVP
cash account for customer purchases or sales on account in which no credit is extended. It would
a DVP basis. Section 220.8(a) of Regulation T be prudent to inquire why a new customer is not
specifies that cash-account transactions are using the margin-account services of its broker-
predicated on the customers agreement that the dealers. If the account is to be used as a margin
customer will make full cash payment for secu- account, a financial institution must obtain Form
rities before selling them and does not intend to FR U-1 from the customer and must sign and
sell them before making such payment. There- constantly update the form.
fore, free-riding is prohibited in a cash account. The financial institution should obtain from
A customer who instructs his or her agent finan- the customer a list of broker-dealers that will be
cial institution to pay for a security by relying sending securities to or receiving funds from the
on the proceeds of the sale of that security in a account in DVP transactions. If a number of
DVP transaction is causing, or aiding or abet- broker-dealers may be used, the institution
ting, the broker-dealer to violate the credit should obtain from the customer a written state-
restrictions of Regulation T. Regulation X, ment that all transactions with the broker-dealer
which generally prohibits borrowers from will- will conform with Regulations T and X and that
fully causing credit to be extended in violation the customer is aware that a security purchased
of Regulations T or U, also applies to the cus- in a cash account is not to be sold until it is paid
tomer in such cases. for. Similarly, when obtaining instructions for
As described above, banking organizations3 settling DVP transactions for a customer, the
involved in customer free-riding schemes may financial institution should clarify that it will not
be aiding and abetting violations of Regulation rely upon the proceeds from the sale of those
T by the broker-dealers who deliver securities securities to pay for the purchase of the same
or funds to the banking organizations custom- securities.
ers accounts. As long as a financial institution
uses its funds to complete a customers transac-
2187.0.4 SCOPE OF THE INSPECTION
FOR FREE-RIDING ACTIVITIES
3. For a discussion of Regulation T as it applies to a bank
holding companys broker-dealer nonbank subsidiary, see sec-
tion 3230.0. Examiners, bank holding companies, state mem-
ber banks, and financial-institution and trust
BHC Supervision Manual December 1998 subsidiaries owned by bank holding companies
Page 2 (also U.S. branches and agencies of foreign
banks exercising trust powers) should ensure also institute enforcement proceedings against
that their banking organizations monitor the banking organizations it supervises and
accounts closely for an initial period to detect against any institution-affiliated parties involved
patterns typical of free-riding, including intra- in these activities, including cease-and-desist
day overdrafts, and to ensure that sufficient orders, civil money penalty assessments, and
funds or margin collateral are on deposit at all removal and permanent-prohibition actions.
times. Frequent transactions in securities being
offered in an initial public offering may suggest
an avoidance of Regulations T and X. If it 2187.0.6 INSPECTION OBJECTIVES
appears that a customer is attempting to free-
ride, the financial institution should immedi- 1. To make certain that policies of the bank
ately alert the broker-dealers involved in trans- holding companys board, and the supervi-
ferring securities and take steps to minimize its sory operating procedures, internal controls,
own credit risk and legal liability. and audit procedures will ensure, in the
At a minimum, examiners should also evalu- course of settling customers securities
ate a trust institutions ability to ensure that it transactions
does not extend to a customer more credit on a. that bank extensions of credit within the
behalf of a bank or other financial institution holding company comply with the provi-
than is permitted under Regulation U. If there sions of Regulation U (including the
are any questions in this regard, examiners requirement that initial extensions of
should consult with their Reserve Banks trust credit that are secured by margin stock are
examiners. Any overdraft that is related to a within the initial 50 percent margin limit)
purchase or sale of margin stock, and that is and
secured by margin stock, is an extension of b. that customer accounts hold sufficient
credit subject to the regulation, including over- funds on the settlement date for each secu-
drafts that are outstanding for less than a day. rity purchased.
Board staff have published a number of opin- 2. To determine
ions discussing the application of Regulation U a. whether the banking organizations of the
to various transactions relating to free-riding. bank holding company can adequately
Free-riding violations that could endanger the monitor compliance with Regulation U
banking organization (for example, fraudulent through systems of internal controls, train-
activities that could subject the organization to ing, and compliance procedures (i.e., use
losses or lawsuits), as well as significant viola- of credit compliance committees) that
tions that were previously noted but have not address free-riding activities within the
yet been corrected, should be noted in the back-office function 4 and
inspection report. Violations of the Boards b. whether noncompliance is properly
Regulation T, U, or X, as applicable to the reported.
inspection, should be reported on the Examin- 3. To initiate corrective action when policies,
ers Comments and Violations report pages. The practices, procedures, or internal controls are
report should discuss what action has or will be not sufficient to prevent free-riding schemes,
taken to correct those violations. and when violations of the Boards regula-
tions have been noted by bank examiners or
self-regulatory organizations.
2187.0.5 SEC AND FEDERAL
RESERVE SANCTIONS AND 2187.0.7 INSPECTION PROCEDURES
ENFORCEMENT ACTIONS
1. Review the bank holding companys board
The SEC, in exercising its broad authority to of directors policies for its banking institu-
enforce the Boards securities credit regulations, tion subsidiaries regarding supervisory
requires banks to (1) establish credit compliance operational policies, procedures, and internal
committees to formulate written policies and controls for loans extended for the purpose
procedures concerning the extension of purpose
credit in their securities-clearance business,
4. Refers to the movement of cash and securities relating to
(2) establish training programs for bank person- trades and to the processing and recording of trades. This
nel responsible for the conduct of their process is also called the securities-clearance cycle.
securities-clearance business, and (3) submit to
outside audits to verify their compliance with BHC Supervision Manual December 1998
the conditions of injunctions. The Board may Page 3
of buying or carrying margin stock and controlling securities positions and

secured directly or indirectly by margin financial-instrument contracts that serve
stock. as collateral for loans;
a. Determine whether the policies require, monitoring established restrictions and
for each extension of credit not specifi- limits placed on the amounts and types
cally exempted under Regulation U, that a of transactions to be executed with each
Form FR U-1 be executed and signed by customer and the dollar amounts placed
the customer and accepted and signed by on unsettled trades;
a duly authorized officer of the banking obtaining appropriate documentation
organization acting in good faith. consisting of essential facts pertaining
b. Determine whether the policies limit to each customer, and in particular,
extensions of credit to no more than the financial information evidencing the
maximum allowed loan value of the col- customers ability to pay for ordered
lateral, as set by section 221.7 of Regula- securities, repay extensions of credit,
tion U, and whether those policies require and meet other financial commitments;
adherence to margin requirements. monitoring the location of all collateral;
2. Review the bank holding companys board ensuring that there are no overdrawn
of directors credit policies and operating margin accounts; and
policies, internal controls, and internal audit monitoring the status of failed transac-
procedures to determine if they provide tions for the purpose of detecting free-
adequate safeguards against customers free- riding schemes.
riding practices. In so doing 3. Determine if the bank holding companys
a. determine if new-customer accounts are audit committee or its internal or external
required to be approved by appropriate auditors are required to review a selected
personnel; and random sample of individual or custodial
b. establish whether the bank holding com- agency accounts for customer free-riding
panys credit-system policies require activities.
Credit by brokers 220

and dealers (Reg. T)
Regulation U, Credit by Banks 221

or Persons Other Than (Reg. U)
Brokers or Dealers for
the Purpose of Purchasing
or Carrying Margin Stocks
Purpose credit 5942.15,

delivery-versus- 5942.18,
payment transactions 5942.2,
5942.21,
5942.22
Borrowers of 224
securities credit (Reg. X)

Page 4
Note Issuance and Revolving Underwriting
Credit Facilities Section 2220.3
2220.3.1 NOTE ISSUANCE FACILITY prearranged share of any notes issued. Any
(NIF) notes not taken up at the issuer-set margin are
distributed to underwriters at the pre- estab-
One type of off-balance-sheet activity is the lished maximum (cap) rate.
note issuance facility (NIF). The first public
facility was arranged in 1981. A NIF is a
medium-term arrangement under which a bor-
2220.3.2 REVOLVING
rower can issue short-term paper. The paper is
UNDERWRITING FACILITY (RUF)
issued on a revolving basis, with maturities
ranging from as low as 7 days to up to one year. Another type of facility, a revolving underwrit-
Underwriters are committed either to purchasing facility (RUF), was introduced in 1982. A
ing any unsold notes or to providing standby revolving underwriting facility is a medium-
credit. Bank borrowing usually involves com- term revolving commitment to guarantee the
mercial paper consisting of short-term certifi- overseas sale of short-term negotiable promis-
cates of deposit and for nonbank borrowers it sory notes (usually a fixed-spread over LIBOR)
would generally be promissory notes (Euro- issued by the borrower at or below a predeter-
notes). NIF is the most common term used for mined interest rate. RUFs separate the roles of
this type of arrangement. Other terms include the medium-term risk-taker and the providers of
the revolving underwriting facility (RUF), and the funding (the short-term investors). RUFs
the standby note issuance facility (SNIF). NIFs, and NIFs allow access to capital sources at
RUFs, and SNIFs are essentially the same credit interest rates considerably below conventional
product. The NIF is usually structured for 5 to financing rates. The savings in interest cost are
7 years. derived because the borrower obtains the lower
Euronotes are denominated in US dollars and interest costs prevailing in the short-term mar-
are issued with high face values (often $500,000 kets, while still retaining the security of longer
or more), being intended for the more sophisti- term financing commitments. The notes issued
cated investor (professional or institutional in- under RUFs are attractive for institutional inves-
vestors). Holders of the notes show them as an tors since they permit greater diversification of
asset on their balance sheets. The underwriting risk than the certificates of deposit of only one
commitment represents an off-balance sheet bank. Underwriters favor them because their
item. The NIF allows the various functions per- commitments do not appear on the statement of
formed by a single institution in a syndicated financial condition. RUFs are usually structured
credit to be separated and performed by differ- for periods of four to seven years.
ent institutions. A revolving underwriting facility (RUF) dif-
Instead of lending money, as in a syndicated fers from a (NIF) in that it separates the func-
credit, the NIF arranger provides a mechanism tions of underwriting and distribution. With a
for placing notes with other investors when RUF, the lead bank (manager or arranger) acts
funds are needed. The underwriting commit- as the only placing agent. The arranger retains
ment transforms the maturity, assuring the bor- total control over the placing of the notes. The
rower access to short-term funds over the lead bank provides assistance to a borrower who
medium term, which remains off-balance sheet, forms a lending group of banks. The borrower,
unless drawn upon. The underwriters take the assisted by a lead bank (arranger), obtains a
short-term credit risk since they face the risk of medium term revolving commitment that guar-
lending to a borrower that has difficulty in antees the sale of short-term negotiable promis-
obtaining full confidence from investors. sory notes at or below a pre-determined interest
NIFs can be arranged with an issuer-set mar- rate. The participating group of banks arrange
gin whereby the issuer determines the margin the funding, subject to certain lending condi-
over LIBOR (the London Interbank Offered tions and rates, for the duration of the facility. In
Rate), or some other index at which notes will return, the borrower pays a facility fee to the
be offered. The issuer thus benefits from any revolving credit banks.
improvement in market conditions. The notes
are placed by the placing agent, but senior BHC Supervision Manual December 1992
underwriters have the option of purchasing a Page 1
Note Issuance and Revolving Underwriting Credit Facilities 2220.3
When the borrower desires funds, a place- transaction. The major source of risk is thus the
ment agent or tender panel1 places short-term liquidity risk that is derived from the uncer-
notes with other banks and institutional inves- tainty of the timing or amount of required fund-
tors (usually having maturities of 90 days, 180 ing. If the underlying notes cannot be marketed
days or 12 months). The short term notes can be at or below the interest rate specified in the
issued to these investors at significantly lower agreement, the bank would need to discount the
interest rates than would be available from a notes to whatever rate would be necessary to
revolving credit facility that the same banks make the notes attractive to investors, perhaps
would have been willing to provide. The note taking an up-front loss to avoid funding a low
purchasers generally have a rollover option at margin loan.
maturity and new note purchasers are added as NIFs and RUFs involve less credit risk than
needed. The note purchasers bear the risk of loss extensions of credit because of the additional
in the event of default by the borrower. New step that is required before funding takes place,
note purchasers are added as needed. In the a step that is not present with a revolving credit
event the full line of credit is not placed with the agreement. In other words, no funding is
note purchasers on any rollover date, the revolv- required until: (1) a decision is made by the
ing credit banks must make funding available borrower to issue notes; and (2) the placing
for the difference at the previously committed agent becomes unable to place the short-term
revolving credit interest rates, subject to the notes with short-term investors. Further, the risk
terms and conditions within the agreement. of loss rests with the note investors. The under-
With the RUF, and the use of a sole placing writers risk of nonpayment is not present until
agent, the underwriters are not assured of secur- the rollover date. If there has been a significant
ing any notes that they could place themselves deterioration in the issuer/borrowers financial
nor can they benefit from any improvement in condition on that date, the issuer/borrower may
terms available in the market. The hindrance is be prevented from drawing under the facility.
removed by the use of NIFs with an issuer-set This would be dependent on the funding condi-
margin whereby the issuer determines the mar- tions or the cancellation provisions stipulated in
gin over an index at which notes will be offered. the agreement.
Another form of a RUF is a transferable
revolving underwriting facility (TRUF). With
this arrangement the underwriter is able, with 2220.3.4 PRICING AND FEES
the borrowers approval, to transfer all rights
and obligations under the underwriting commit- The forms of compensation involving a NIF and
ment to another institution at any time during RUF are: the underwriting and commitment fee;
the life of the facility. the one-time arrangement fee, and the periodic
placement fees. An annual fixed underwriting
fee is paid by the borrower on the amount of
2220.3.3 RISK underlying commitment. This fee must be paid
regardless of the frequency of usage of the
The loan commitments involved in NIF and facility or whether or not the underwriters are
RUF transactions contain substantially the same required to make any purchases of the short-
terms as other loan commitments extended to term paper. This compensation is for the com-
similar borrowers. The failure of the borrower mitment to underwrite the issuance of the notes.
to satisfy the revolving standby agreement re- The arranger receives a one-time arrangement
lieves the banks of any obligation to fund the fee based on a percentage of the amount of the
facility. The issuer pays the borrowing costs on
1. The tender panel was introduced in 1983. It is usually the notes issued, usually at a spread above or
made up of several commercial investment banks and other below an index. A portion of this borrowing fee
institutional investors. The panel members bid for any notes is retained by the placement agent or the tender
issued, up to a predetermined maximum spread. The revolv-
ing credit banks can bid as part of the tender panel, but they
panel members as compensation for placing the
are not required to do so. Any notes not bid for are purchased paper.
by the revolving credit banks or they extend credit of an equal Competitive pricing on NIFs and RUFS
amount. The tender panel may be a continuous tender panel causes them to be very thinly margined. Com-
whereby the underwriters are entitled to purchase notes from
the lead manager up to their pro rata share at any time during
mitment fees may be as low as 5 basis points for
the offer period, if available, at the market price. blue chip customers, while BBB credit-rated
or equivalent borrowers might be charged as
BHC Supervision Manual December 1992 much as 20 basis points. Because of the thin
Page 2 spread some banks may only be serving as an
Note Issuance and Revolving Underwriting Credit Facilities 2220.3
arranger, preferring to not participate in the mar- the notes is set to approximate the normal mar-
ket. Typical fees for this service may consist of: ket level for the issuers short term borrowing-
an up-front arrangement fee of 20 basis points s.This facility would have a higher underwriting
on the total principal amount of the facility, and fee than a standby facility, because the regular
an annual placement fee such as 12.5 basis issuances of notes increase the likelihood that
points on the short-term notes sold. Revolving the underwriting bank will have to purchase
credit banks usually receive facility fees and notes that cannot be placed.
annual maintenance fees.
If the underwriters have to purchase the notes,
the backup rate of interest may be the index plus 2220.3.6 RUF DOCUMENTS
10 to 15 basis points for blue chip companies to
plus 37.5 basis points over the index for BBB The revolving credit agreement is the primary
rated borrowers. The interest rates charged (if document in a RUF. It includes the principal
funded) are usually lower because of market- agreement of the transaction, executed by the
pricing conventions (lower spreads) and the revolving credit banks and the borrower. It con-
intense competition within the market. tains the terms and conditions under which the
borrower can draw on the facility. The docu-
ment includes the financial covenants and events
2220.3.5 STANDBY RUFS of default.
An agency agreement between the borrower
Some RUFS may provide for a utilization fee or and the placement agent designates the place-
may provide for a higher yield on the notes in ment agent for the notes and sets forth the
the event that more than a nominal amount of conditions of the agents obligations for arrang-
paper is allocated to the underwriters. Such a ing the sale of the notes. Included are represen-
provision would more likely be found in a tations and warranties of the borrower regarding
standby facility. Standby facilities are backup the authority to enter into the agreement and to
commitments under which notes are not issue the notes.
expected to be issued. This provision essentially A description of the terms and conditions of
protects the underwriter from having to book the facility is contained within an information
loans that are earning an insufficient yield. The memorandum. Detail is provided with regard to
structure of the facility generally determines its the use of the proceeds, current and historical
pricing depending upon the requirements of the financial information, a description of the
issuer/borrower. company, its finances and operations. It is dis-
Standby RUFs substitute for committed bank tributed to prospective credit banks and note
lines which may be used, for example, as purchasers.
backup commitments for issuance of U.S. com- The note is the last document involving a
mercial paper. Commitment fees will be low RUF. Usually the notes will be unsecured obli-
because of the low probability that funds will gations of the borrower and will include rep-
need to be advanced. A standby facility will resentations and warranties of the company
make borrowing from the underwriter very regarding authorization and the absence of
expensive in relation to what the issuer might material litigation and bankruptcy proceedings.
have to pay. Otherwise, the underlying notes are It will also contain a statement that a revolving
issued on a regular basis, the maximum yield on credit facility is available to the borrower.

Page 3
Real Estate Appraisals and Evaluations
Section 2231.0
WHATS NEW IN THIS REVISED at a minimum, that real estate appraisals be
SECTION performed in accordance with generally
accepted uniform appraisal standards as evi-
Effective July 2011, this section was revised to denced by the appraisal standards promulgated
include the December 2010 Interagency by the Appraisal Standards Board (ASB), and
Appraisal and Evaluation Guidelines (Inter- that such appraisals be in writing.2 The regula-
agency Guidelines). The Interagency Guidelines tion also sets forth additional appraisal stan-
pertain to all real estaterelated financial trans- dards including that the appraisal and analysis
actions originated or purchased by a regulated contain sufficient information to support the
instutution (including a bank holding company) banking organizations decision to engage in the
or its subsidiaries for its own portfolio or as transaction and provide the real propertys mar-
assets held for sale, including activities of com- ket value.
mercial and residential real estate mortgage The intent of title XI and the Boards regula-
operations, capital markets groups, and asset tion is to protect federal financial and public
securitization and sales units. The Interagency policy interests in real estaterelated financial
Guidelines provide a comprehensive discussion transactions that require the services of an
of the Boards expectations for a banking orga- appraiser in connection with federally related
nizations appraisal and evaluation program as transactions.3 Federally related transactions are
well as background information on the technical defined as those real estaterelated financial
aspects of appraisals. (See SR-10-16 and its transactions that an agency engages in, contracts
attachment.) for, or regulates and that require the services of
an appraiser.4 Each state has established a pro-
The Boards long-standing policy on real estate gram for certifying and licensing real estate
appraisals emphasizes the importance of sound appraisers who are qualified to perform apprais-
appraisal policies and procedures in a banking als in connection with federally related transac-
organizations real estate lending activity. With tions. Additionally, title XI designated the
the passage of title XI of the Federal Financial Appraisal Qualifications Board and the ASB of
Institutions Reform, Recovery, and Enforce- the Appraisal Foundation, a nonprofit appraisal
ment Act of 1989 (FIRREA), the Board and the industry group, as the authority for establishing
other federal financial institutions regulatory qualifications criteria for appraiser certification
agencies adopted regulations in August 1990 and standards for the performance of an
relating to the performance and use of apprais- appraisal. The statute established the Appraisal
als by federally regulated financial institutions, Subcommittee of the Federal Financial Institu-
which were amended in June 1994. The Boards tions Examination Council (FFIEC). It was des-
appraisal standards regulation may be found in ignated the entity to monitor the requirements
Regulation Y, subpart G, 12 C.F.R. 225.1 established to meet the intent of title XI. If the
The Boards appraisal regulation requires,1a Appraisal Subcommittee issues a finding that
the policies, practices, or procedures of a state
are inconsistent with title XI, the services of
1. The appraisal standards for federally related transactions licensed or certified appraisers from that state
are found in sections 225.61 to 225.67 of subpart G of
Regulation Y. Section 225.63 was amended, effective Decem- may not be used in connection with federally
ber 28, 1998, to exclude from the Boards appraisal require- related transactions. Further, several provisions
ments transactions that involve underwriting or dealing in in title XI of FIRREA were amended by the
mortgage-backed securities. The amendment permits bank Dodd-Frank Wall Street Reform and Consumer
holding company subsidiaries engaged in underwriting and
dealing in securities to underwrite and deal in mortgage- Protection Act of 2010 (Dodd-Frank Act), pro-
backed securities without demonstrating that the loans under- viding additional authority to the Appraisal Sub-
lying the securities are supported by appraisals that meet the committee in its oversight of states appraiser
Boards appraisal requirements. (See 1999 FRB 50.)
1a. A banking organization is required to use a certified
appraiser for complex one- to four-family residential property appraisal
means that the properties to be appraised, the form of owner-
all federally related transactions $1 million or more,
ship, or market conditions are atypical (12 C.F.R. 225.63(d)).
nonresidential federally related transactions $250,000 or
2. See 12 USC 3339.
more, and
3. See 12 USC 3339.
complex residential federally related transactions $250,000
4. See 12 USC 3350(4).
or more.
A banking organization is requested to use either a state-
certified or a state-licensed appraiser for noncomplex residen- BHC Supervision Manual July 2011
tial federally related transactions that are under $1 million. A Page 1
Real Estate Appraisals and Evaluations 2231.0
regulatory programs. (See sections 1471-1473 lines also promote consistency in the application
of Pub. L. 111-203, 124 Stat. 1376 (2010).) and enforcement of the agencies appraisal regu-
Over the years, the Board and the other fed- lations. (See SR-10-16.)
eral banking regulatory agencies (the Office of
the Comptroller of the Currency and the Federal
Deposit Insurance Corporation (the agencies))
have issued several appraisal-related guidance 2231.0.1 INTERAGENCY APPRAISAL
documents to assist institutions in implementing AND EVALUATION GUIDELINES
and complying with the appraisal regulation.5 In (INTERAGENCY GUIDELINES)
December 2010, the agencies issued the Inter-
agency Appraisal and Evaluation Guidelines
FIRREA requires each agency to prescribe ap-
(Interagency Guidelines) to clarify their
propriate standards for the performance of real
appraisal regulations and to promote best prac-
estate appraisals in connection with federally
tices in institutions appraisal and evaluation
related transactions,6 which are defined as
programs. (See SR-10-16.) The Interagency
those real estaterelated financial transactions
Guidelines pertain to all real estaterelated
that an agency engages in, contracts for, or
financial transactions originated or purchased by
regulates and that require the services of an ap-
a regulated institution or its operating subsidiary
praiser.7 The agencies appraisal regulations
for its own portfolio or as assets held for sale,
must require, at a minimum, that real estate ap-
including activities of commercial and residen-
praisals be performed in accordance with gener-
tial real estate mortgage operations, capital mar-
ally accepted uniform appraisal standards as
kets groups, and asset securitization and sales
evidenced by the appraisal standards
units. The Interagency Guidelines provide a
promulgated by the ASB, and that such apprais-
comprehensive discussion of the Boards expec-
als be in writing.8 An agency may require
tations for a banking organizations appraisal
compliance with additional appraisal standards
and evaluation program as well as background
if it makes a determination that such addi-
information on the technical aspects of
tional standards are required to properly carry
appraisals.
out its statutory responsibilities.9 Each of the
A banking organizations collateral-valuation
agencies has adopted additional appraisal
program needs to consider when an appraisal or
standards.10
evaluation should be obtained to monitor collat-
eral risk and to support credit analysis, includ- The agencies real estate lending regulations
ing for purposes of rating or classifying the and guidelines,11 issued pursuant to section 304
credit. When a credit becomes troubled, the of the Federal Deposit Insurance Corporation
primary source of repayment often shifts from Improvement Act of 1991 (FDICIA),12 require
the borrowers cash flow and income to the each institution to adopt and maintain written
expected proceeds from the sale of the real real estate lending policies that are consistent
estate collateral. Therefore, it is important that with principles of safety and soundness and that
banking organizations have a sound and inde- reflect consideration of the real estate lending
pendent basis for determining the value of the guidelines issued as an appendix to the regula-
real estate collateral. (See SR-09-07.) tions. The real estate lending guidelines state
The expectations that an institution conduct that an institutions real estate lending program
its appraisal and evaluation program for real should include an appropriate real estate
estate lending in a safe and sound manner appraisal and evaluation program.
remains unchanged with the issuance of the
Interagency Guidelines. They reflect develop-
ments concerning appraisals and evaluations, as 6. See 12 USC 3339.
well as changes in appraisal standards and 7. See 12 USC 3350(4).
8. See 12 USC 3339.
advancements in regulated institutions collat- 9. See 12 USC 3339.
eral valuation methods. The Interagency Guide- 10. See, e.g., 12 CFR 225, subpart G, and 12 CFR 208,
subpart E.
11. The Federal Reserve did not adopt the real estate
5. The Board has issued several other guidance documents
lending standards for bank holding companies and their non-
related to appraisals and real estate lending that provide
bank subsidiaries. However, bank holding companies and
additional information on the establishment of an effective
their nonbank subsidiaries are expected to conduct their real
real estate appraisal and evaluation program. (See SR-95-16,
estate lending activities in a prudent manner consistent with
SR-95-27, SR-05-05, SR-05-11, and SR-05-14.)
safe and sound lending standards. A bank subsidiary of a
BHC should refer to 12 C.F.R. 208, subpart G.
BHC Supervision Manual July 2011 12. See Pub. L. 102-242, section 304, 105 Stat. 2354
Page 2 (1991); 12 USC 1828(o).
2231.0.2 SUPERVISORY POLICY sufficient information to support the credit

decision;
An institutions real estate appraisal and evalua- maintain criteria for the content and appropri-
tion policies and procedures will be reviewed as ate use of evaluations consistent with safe and
part of the inspection of the institutions overall sound banking practices;
real estaterelated activities. Examiners will provide for the receipt and review of the
consider the size and the nature of an institu- appraisal or evaluation report in a timely man-
tions real estaterelated activities when assess- ner to facilitate the credit decision;
ing the appropriateness of its program. develop criteria to assess whether an existing
While borrowers ability to repay their real appraisal or evaluation may be used to sup-
estate loans according to reasonable terms port a subsequent transaction;
remains the primary consideration in the lending implement internal controls that promote
decision, an institution also must consider the compliance with these program standards,
value of the underlying real estate collateral in including those related to monitoring third-
accordance with the Boards appraisal regula- party arrangements;
tions. Institutions that fail to comply with the establish criteria for monitoring collateral val-
Boards appraisal regulations or to maintain a ues; and
sound appraisal and evaluation program consis- establish criteria for obtaining appraisals or
tent with supervisory guidance will be cited in evaluations for transactions that are not other-
supervisory letters or inspection reports and may wise covered by the appraisal requirements of
be criticized for unsafe and unsound banking the Boards appraisal regulations.
practices. Deficiencies will require appropriate
corrective action.
When analyzing individual transactions, 2231.0.4 INDEPENDENCE OF THE
examiners will review an appraisal or evaluation APPRAISAL AND EVALUATION
to determine whether the methods, assumptions, PROGRAM
and value conclusions are reasonable. Examin-
ers also will determine whether the appraisal or For both appraisal and evaluation functions, an
evaluation complies with the Boards appraisal institution should maintain standards of
regulations and is consistent with supervisory independence as part of an effective collateral-
guidance as well as the institutions policies. valuation program for all of its real estate lend-
Examiners will review the steps taken by an ing activity. The collateral-valuation program is
institution to ensure that the persons who per- an integral component of the credit under-
form the institutions appraisals and evaluations writing process and, therefore, should be
are qualified, competent, and are not subject to isolated from influence by the institutions loan-
conflicts of interest. production staff. An institution should establish
reporting lines independent of loan production
for staff who administer the institutions
2231.0.3 APPRAISAL AND collateral-valuation program, including the
EVALUATION PROGRAM ordering, reviewing, and acceptance of apprais-
als and evaluations. Appraisers must be
An institutions board of directors or its desig- independent of the loan production and collec-
nated committee is responsible for adopting and tion processes and have no direct, indirect, or
reviewing policies and procedures that establish prospective interest, financial or otherwise, in
an effective real estate appraisal and evaluation the property or transaction.13 These standards of
program. The program should independence also should apply to persons who
perform evaluations.
provide for the independence of the persons For a small or rural institution or branch, it
ordering, performing, and reviewing apprais- may not always be possible or practical to sepa-
als or evaluations;
establish selection criteria and procedures to 13. The Boards appraisal regulations set forth specific
evaluate and monitor the ongoing perfor- appraiser independence requirements that exceed those set
mance of appraisers and persons who perform forth in the Uniform Standards of Professional Appraisal
Practice. Institutions also should be aware of separate require-
evaluations; ments on conflicts of interest under Regulation Z (Truth in
ensure that appraisals comply with the Lending), 12 CFR 226.42(d).
Boards appraisal regulations and are consis-
tent with supervisory guidance; BHC Supervision Manual July 2011
ensure that appraisals and evaluations contain Page 3
rate the collateral-valuation program from the An institutions policies and procedures
loan-production process. If absolute lines of should ensure that it avoids inappropriate
independence cannot be achieved, an institution actions that would compromise the
should be able to demonstrate clearly that it has independence of the collateral-valuation func-
prudent safeguards to isolate its collateral- tion,16 including
valuation program from influence or interfer-
ence from the loan-production process. In such communicating a predetermined, expected, or
cases, another loan officer, official, or director of qualifying estimate of value, or a loan amount
the institution may be the only person qualified or target loan-to-value ratio to an appraiser or
to analyze the real estate collateral. To ensure person performing an evaluation;
their independence, such lending officials, offi- specifying a minimum value requirement for
cers, or directors must abstain from any vote or the property that is needed to approve the loan
approval involving loans on which they ordered, or as a condition of ordering the valuation;
performed, or reviewed the appraisal or evalua-
tion. conditioning a persons compensation on loan
Communication between the institutions consummation;
collateral-valuation staff and an appraiser or per- failing to compensate a person because a
son performing an evaluation is essential for the property is not valued at a certain amount;17
exchange of appropriate information relative to implying that current or future retention of a
the valuation assignment. An institutions poli- persons services depends on the amount at
cies and procedures should specify methods for which the appraiser or person performing an
communication that ensure independence in the evaluation values a property; or
collateral-valuation function. These policies and excluding a person from consideration for
procedures should foster timely and appropriate future engagement because a propertys
communications regarding the assignment and reported market value does not meet a speci-
establish a process for responding to questions fied threshold.
from the appraiser or person performing an
evaluation. After obtaining an appraisal or evaluation, or
An institution may exchange information as part of its business practice, an institution
with appraisers and persons who perform evalu- may find it necessary to obtain another appraisal
ations, which may include providing a copy of or evaluation of a property and it would be
the sales contract14 for a purchase transaction. expected to adhere to a policy of selecting the
However, an institution should not directly or most credible appraisal or evaluation, rather
indirectly coerce, influence, or otherwise than the appraisal or evaluation that states the
encourage an appraiser or a person who per- highest value. (Refer to the Reviewing
forms an evaluation to misstate or misrepresent Appraisals and Evaluations subsection below
the value of the property.15 Consistent with its for additional information on determining and
policies and procedures, an institution also may documenting the credibility of an appraisal or
request the appraiser or person who performs an evaluation.) Further, an institutions reporting of
evaluation to a person suspected of noncompliance with the
Uniform Standards of Professional Appraisal
consider additional information about the sub- Practice (USPAP), and applicable federal or
ject property or about comparable properties; state laws or regulations, or otherwise engaged
provide additional supporting information in other unethical or unprofessional conduct to
about the basis for a valuation; or the appropriate authorities would not be viewed
correct factual errors in an appraisal. by the Federal Reserve as coercion or undue
influence. However, an institution should not
use the threat of reporting a false allegation in
14. Refer to USPAP Standards Rule 1-5(a) and the Ethics
Rule. order to influence or coerce an appraiser or a
15. For mortgage transactions secured by a consumers person who performs an evaluation.
principal dwelling, refer to 12 CFR 226.42 under Regulation
Z (Truth in Lending). Regulation Z also prohibits a creditor
from extending credit when it knows that the appraiser inde-
pendence standards have been violated, unless the creditor
16. See 12 CFR 226.42(c).
determines that the value of the property is not materially
17. This provision does not preclude an institution from
misstated.
withholding compensation from an appraiser or person who
provided an evaluation based on a breach of contract or
BHC Supervision Manual July 2011 substandard performance of services under a contractual pro-
Page 4 vision.
2231.0.5 SELECTION OF APPRAISERS dent person is selected to perform a valuation

OR PERSONS WHO PERFORM assignment. An institution should maintain
EVALUATIONS documentation to demonstrate that the appraiser
or person performing an evaluation is compe-
An institutions collateral-valuation program tent, independent, and has the relevant experi-
should establish criteria to select, evaluate, and ence and knowledge for the market, location,
monitor the performance of appraisers and per- and type of real property being valued. Further,
sons who perform evaluations. The criteria the person who selects or oversees the selection
should ensure that of appraisers or persons providing evaluation
services should be independent from the loan
The person selected possesses the requisite production area. An institutions use of a
education, expertise, and experience to com- borrower-ordered or borrower-provided
petently complete the assignment. appraisal violates the agencies appraisal regula-
The work performed by appraisers and per- tions. However, a borrower can inform an insti-
sons providing evaluation services is periodi- tution that a current appraisal exists, and the
cally reviewed by the institution. institution may request it directly from the other
The person selected is capable of rendering an financial services institution.
unbiased opinion.
The person selected is independent and has no
direct, indirect, or prospective interest, finan- 2231.0.5.1 Approved Appraiser List
cial or otherwise, in the property or
transaction. If an institution establishes an approved
The appraiser selected to perform an appraisal appraiser list for selecting an appraiser for a
holds the appropriate state certification or particular assignment, the institution should
license at the time of the assignment. Persons have appropriate procedures for the develop-
who perform evaluations should possess the ment and administration of the list. These proce-
appropriate appraisal or collateral-valuation dures should include a process for qualifying an
education, expertise, and experience relevant appraiser for initial placement on the list, as
to the type of property being valued. Such well as periodic monitoring of the appraisers
persons may include appraisers, real estate performance and credentials to assess whether
lending professionals, agricultural extension to retain the appraiser on the list. Further, there
agents, or foresters.18 should be periodic internal review of the use of
the approved appraiser list to confirm that
An institution or its agent must directly select appropriate procedures and controls exist to
and engage appraisers. The only exception to ensure independence in the development,
this requirement is that the agencies appraisal administration, and maintenance of the list. For
regulations allow an institution to use an residential transactions, loan-production staff
appraisal prepared for another financial services can use a revolving, preapproved appraiser list,
institution provided certain conditions are met. provided the development and maintenance of
An institution or its agents also should directly the list is not under their control.
select and engage persons who perform evalua-
tions. Independence is compromised when a 2231.0.5.2 Engagement Letters
borrower recommends an appraiser or a person
to perform an evaluation. Independence is also An institution should use written engagement
compromised when loan-production staff selects letters when ordering appraisals, particularly for
a person to perform an appraisal or evaluation large, complex, or out-of-area commercial real
for a specific transaction. For certain transac- estate properties. An engagement letter facili-
tions, an institution also must comply with the tates communication with the appraiser and
provisions addressing valuation independence documents the expectations of each party to the
in Regulation Z (Truth in Lending).19 appraisal assignment. In addition to the other
An institutions selection process should information, the engagement letter will identify
ensure that a qualified, competent, and indepen- the intended use and user(s), as defined in
USPAP. An engagement letter also may specify
18. Although not required, an institution may use state- whether there are any legal or contractual
certified or state-licensed appraisers to perform evaluations.
Institutions should refer to USPAP Advisory Opinion 13 for
restrictions on the sharing of the appraisal with
guidance on appraisers performing evaluations of real prop-
erty collateral. BHC Supervision Manual July 2011
19. See 12 CFR 226.42. Page 5
other parties. An institution should include the certification that the appraiser has complied
engagement letter in its credit file. To avoid the with USPAP. An institution may refer to the
appearance of any conflict of interest, appraisal appraisers USPAP certification in its assess-
or evaluation development work should not ment of the appraisers independence con-
commence until the institution has selected and cerning the transaction and the property.
engaged a person for the assignment. Under the agencies appraisal regulations, the
result of an Automated Valuation Model
(AVM), by itself or signed by an appraiser, is
2231.0.6 TRANSACTIONS THAT not an appraisal, because a state-certified or
REQUIRE APPRAISALS state-licensed appraiser must perform an
appraisal in conformance with USPAP and the
Although the agencies appraisal regulations agencies minimum appraisal standards. Fur-
exempt certain real estaterelated financial ther, the Dodd-Frank Act21 provides [i]n
transactions from the appraisal requirement, conjunction with the purchase of a consum-
most real estaterelated financial transactions ers principal dwelling, broker price opinions
over the appraisal threshold are considered fed- may not be used as the primary basis to deter-
erally related transactions and, thus, require mine the value of a piece of property for the
appraisals.20 The agencies also reserve the right purpose of loan origination of a residential
to require an appraisal under their appraisal mortgage loan secured by such piece of prop-
regulations to address safety and soundness con- erty.22
cerns in a transaction. (See Appendix Be written and contain sufficient information
AAppraisal Exemptions.) and analysis to support the institutions deci-
sion to engage in the transaction. An institu-
tion should obtain an appraisal that is appro-
2231.0.7 MINIMUM APPRAISAL priate for the particular federally related
STANDARDS transaction, considering the risk and complex-
ity of the transaction. The level of detail
The Boards appraisal regulations include mini- should be sufficient for the institution to
mum standards for the preparation of an understand the appraisers analysis and opin-
appraisal. (See Appendix DGlossary for ion of the propertys market value. As pro-
terminology used in these guidelines.) The vided by the USPAP Scope of Work Rule,
appraisal must appraisers are responsible for establishing the
scope of work to be performed in rendering an
Conform to generally accepted appraisal opinion of the propertys market value. An
standards as evidenced by the USPAP promul- institution should ensure that the scope of
gated by the ASB of the Appraisal Foundation work is appropriate for the assignment. The
unless principles of safe and sound banking appraisers scope of work should be consis-
require compliance with stricter standards. tent with the extent of the research and analy-
Although allowed by USPAP, the agencies ses employed for similar property types, mar-
appraisal regulations do not permit an ket conditions, and transactions. Therefore, an
appraiser to appraise any property in which institution should be cautious in limiting the
the appraiser has an interest, direct or indirect, scope of the appraisers inspection, research,
financial or otherwise in the property or trans- or other information used to determine the
action. Further, the appraisal must contain an propertys condition and relevant market fac-
opinion of market value as defined in the tors, which could affect the credibility of the
agencies appraisal regulations. (See discus- appraisal.
sion on the definition of market value below.) According to USPAP, appraisal reports
Under USPAP, the appraisal must contain a must contain sufficient information to enable
the intended user of the appraisal to under-
stand the report properly. An institution
20. In order to facilitate recovery in designated major
disaster areas, subject to safety and soundness considerations, should specify the use of an appraisal report
the Depository Institutions Disaster Relief Act of 1992 pro- option that is commensurate with the risk and
vides the Board with the authority to waive certain appraisal complexity of the transaction. The appraisal
requirements for up to three years after a presidential declara- report should contain sufficient disclosure of
tion of a natural disaster. Pub. L. 102-485, section 2, 106 Stat.
2771 (October 23, 1992); 12 USC 3352. the nature and extent of inspection and
BHC Supervision Manual July 2011 21. Pub. L. 111-203, 124 Stat. 1376 (2010).
Page 6 22. Dodd-Frank Act, section 1473(r).
research performed by the appraiser to verify and, as applicable, its prospective market
the propertys condition and support the value upon completion and/or prospective
appraisers opinion of market value. (See market value upon stabilization. Prospective
Appendix DGlossary for the definition market value opinions should be based upon
of appraisal report options.) current and reasonably expected market con-
Institutions should be aware that provisions ditions. When an appraisal includes prospec-
in the Dodd-Frank Act address appraisal tive market value opinions, there should be a
requirements for a higher-risk mortgage to a point of reference to the market conditions
consumer.23 To implement these provisions, and time frame on which the appraiser based
the agencies recognize that future regulations the analysis.25 An institution should under-
will address the requirement that the appraiser stand the real propertys as is market value
conduct a physical property visit of the inte- and should consider the prospective market
rior of the mortgaged property.24 value that corresponds to the credit decision
Analyze and report appropriate deductions and the phase of the project being funded, if
and discounts for proposed construction or applicable.
renovation, partially leased buildings, non- Be performed by state-certified or state-
market lease terms, and tract developments licensed appraisers in accordance with
with unsold units. Appraisers must analyze, requirements set forth in the appraisal regula-
apply, and report appropriate deductions and tion. In determining competency for a given
discounts when providing an estimate of mar- appraisal assignment, an institution must con-
ket value based on demand for real estate in sider an appraisers education and experience.
the future. This standard is designed to avoid While an institution must confirm that the
having appraisals prepared using unrealistic appraiser holds a valid credential from the
assumptions and inappropriate methods in appropriate state appraiser regulatory author-
arriving at the propertys market value. (See ity, a state certification or license is a mini-
Appendix CDeductions and Discounts mum credentialing requirement. Appraisers
for further explanation on deductions and dis- are expected to be selected for individual
counts.) assignments based on their competency to
Be based upon the definition of market value perform the appraisal, including knowledge of
set forth in the appraisal regulation. Each the property type and specific property
appraisal must contain an estimate of market market.
value, as defined by the agencies appraisal As stated in the agencies appraisal regula-
regulations. The definition of market value tions, a state-certified or state-licensed
assumes that the price is not affected by undue appraiser may not be considered competent
stimulus, which would allow the value of the solely by virtue of being certified or licensed.
real property to be increased by favorable In communicating an appraisal assignment, an
financing or seller concessions. Value opin- institution should convey to the appraiser that
ions such as going concern value, value in the agencies minimum appraisal standards
use, or a special value to a specific property must be followed.
user may not be used as market value for
federally related transactions. An appraisal
may contain separate opinions of such values 2231.0.8 APPRAISAL DEVELOPMENT
so long as they are clearly identified and dis-
closed. The Boards appraisal regulations require
The estimate of market value should con- appraisals for federally related transactions to
sider the real propertys actual physical condi- comply with the requirements in USPAP, some
tion, use, and zoning as of the effective date of of which are addressed below. Consistent with
the appraisers opinion of value. For a transac- the USPAP Scope of Work Rule,26 the appraisal
tion financing construction or renovation of a must reflect an appropriate scope of work that
building, an institution would generally provides for credible assignment results. The
request an appraiser to provide the propertys appraisers scope of work should reflect the
current market value in its as is condition,
25. See USPAP, Statement 4 on Prospective Value Opin-
ions, for further explanation.
23. Under the law, the provisions are effective 12 months
26. See USPAP, Scope of Work Rule, Advisory Opinions
after final regulations to implement the provisions are pub-
28 and 29.
lished. See Dodd-Frank Act, section 1400(c)(1) or 12 USC
1601.
24. Section 1471 of the Dodd-Frank Act added new sec- BHC Supervision Manual July 2011
tion 129H to the Truth in Lending Act (15 USC 1631 et seq.). Page 7
extent to which the property is identified and 2231.0.9 APPRAISAL REPORTS

inspected, the type and extent of data
researched, and the analyses applied to arrive at An institution is responsible for identifying the
opinions or conclusions. Further, USPAP appropriate appraisal report option to support its
requires the appraiser to disclose whether he or credit decisions. The institution should consider
she previously appraised the property. the risk, size, and complexity of the transac-
While an appraiser must comply with USPAP tion and the real estate collateral when
and establish the scope of work in an appraisal determining the appraisal report format to be
assignment, an institution is responsible for specified in its appraisal engagement instruc-
obtaining an appraisal that contains sufficient tions to an appraiser.
information and analysis to support its deci- USPAP provides various appraisal report
sion to engage in the transaction. Therefore, to options that an appraiser may use to present the
ensure that an appraisal is appropriate for the results of appraisal assignments. The major dif-
intended use, an institution should discuss its ference among these report options is the level
needs and expectations for the appraisal with of detail presented in the report. A report option
the appraiser. Such discussions should assist the that merely states, rather than summarizes or
appraiser in establishing the scope of work and describes the content and information required
form the basis of the institutions engagement in an appraisal report, may lack sufficient sup-
letter, as appropriate. These communications porting information and analysis to explain the
should adhere to the institutions policies and appraisers opinions and conclusions.
procedures on independence of the appraiser Generally, a report option that is restricted to
and not unduly influence the appraiser. An a single client and intended user will not be
institution should not allow lower cost or the appropriate to support most federally related
speed of delivery time to inappropriately influ- transactions. These reports lack sufficient sup-
ence its appraisal ordering procedures or the ap- porting information and analysis for underwrit-
praisers determination of the scope of work for ing purposes. These less detailed reports may be
an appraisal supporting a federally related appropriate for real estate portfolio monitoring
transaction. purposes. (See Appendix DGlossary for
As required by USPAP, the appraisal must the definition of appraisal report options.)
include any approach to value (that is, the cost, Regardless of the report option, the appraisal
income, and sales comparison approaches) that report should contain sufficient detail to allow
is applicable and necessary to the assignment. the institution to understand the scope of work
Further, the appraiser should disclose the performed. Sufficient information should
rationale for the omission of a valuation include the disclosure of research and analysis
approach. The appraiser must analyze and performed, as well as disclosure of the research
reconcile the information from the approaches and analysis typically warranted for the type of
to arrive at the estimated market value. The appraisal, but omitted, along with the rationale
appraisal also should include a discussion on for its omission.
market conditions, including relevant informa-
tion on property value trends, demand and sup-
ply factors, and exposure time. Other informa- 2231.0.10 TRANSACTIONS THAT
tion might include the prevalence and effect of REQUIRE EVALUATIONS
sales and financing concessions, the list-to-sale
price ratio, and availability of financing. In The Boards appraisal regulations permit an
addition, an appraisal should reflect an analysis institution to obtain an appropriate evaluation of
of the propertys sales history and an opinion as real property collateral in lieu of an appraisal for
to the highest and best use of the property. transactions that qualify for certain exemptions.
USPAP requires the appraiser to disclose These exemptions include transactions that
whether or not the subject property was
inspected and whether anyone provided Have a transaction value equal to or less than
significant assistance to the appraiser signing the appraisal threshold of $250,000.
the appraisal report. Constitute a business loan with a transaction
value equal to or less than the business loan
threshold of $1 million, and is not dependent
on the sale of, or rental income derived from,
real estate as the primary source of repay-
BHC Supervision Manual July 2011 ment.
Page 8 Involve an existing extension of credit at the
lending institution, provided that tion and analysis to support the value conclu-
There has been no obvious and material sion is not acceptable as an evaluation. For
change in market conditions or physical example, a valuation method that provides a
aspects of the property that threaten the sales or list price, such as a broker price opin-
adequacy of the institutions real estate ion, cannot be used as an evaluation because,
collateral protection after the transaction, among other things, it does not provide a prop-
even with the advancement of new mon- ertys market value. Further, the Dodd-Frank
ies; or Act provides [i]n conjunction with the pur-
There is no advancement of new monies chase of a consumers principal dwelling, bro-
other than funds necessary to cover rea- ker price opinions may not be used as the pri-
sonable closing costs. mary basis to determine the value of a piece of
property for the purpose of loan origination of a
For more information on real estaterelated residential mortgage loan secured by such piece
financial transactions that are exempt from the of property.27 Likewise, information on local
appraisal requirement, see Appendix housing conditions and trends, such as a com-
AAppraisal Exemptions. For a discussion on petitive market analysis, does not contain suffi-
changes in market conditions, see the Validity cient information on a specific property that is
of Appraisals and Evaluations subsection needed, and therefore, would not be acceptable
below. as an evaluation. The information obtained from
Although the Boards appraisal regulations such sources, while insufficient as an evalua-
allow an institution to use an evaluation for tion, may be useful to develop an evaluation or
certain transactions, an institution should estab- appraisal.
lish policies and procedures for determining An institution should establish policies and
when to obtain an appraisal for such transac- procedures for determining an appropriate
tions. For example, an institution should con- collateral-valuation method for a given transac-
sider obtaining an appraisal as an institutions tion considering associated risks. These policies
portfolio risk increases or for higher risk real and procedures should address the process for
estaterelated financial transactions, such as selecting the appropriate valuation method for a
those involving transaction rather than using the method that
renders the highest value, lowest cost, or fastest
loans with combined loan-to-value ratios in turnaround time.
excess of the supervisory loan-to-value limits, A valuation method should address the prop-
atypical properties, ertys actual physical condition and characteris-
properties outside the institutions traditional tics as well as the economic and market condi-
lending market, tions that affect the estimate of the collaterals
transactions involving existing extensions of market value. It would not be acceptable for an
credit with significant risk to the institution, institution to base an evaluation on unsupported
or assumptions, such as a property is in average
borrowers with high-risk characteristics. condition, the zoning will change, or the prop-
erty is not affected by adverse market condi-
tions. Therefore, an institution should establish
2231.0.11 EVALUATION criteria for determining the level and extent of
DEVELOPMENT research or inspection necessary to ascertain the
propertys actual physical condition, and the
An evaluation must be consistent with safe and economic and market factors that should be
sound banking practices and should support the considered in developing an evaluation. An
institutions decision to engage in the transac- institution should consider performing an
tion. An institution should be able to demon- inspection to ascertain the actual physical condi-
strate that an evaluation, whether prepared by an tion of the property and market factors that
individual or supported by an analytical method affect its market value. When an inspection is
or a technological tool, provides a reliable esti- not performed, an institution should be able to
mate of the collaterals market value as of a demonstrate how these property and market fac-
stated effective date prior to the decision to tors were determined.
enter into a transaction. (Refer to Appendix
BEvaluations Based on Analytical Methods 27. Dodd-Frank Act, section 1473(r).
or Technological Tools.)
A valuation method that does not provide a BHC Supervision Manual July 2011
propertys market value or sufficient informa- Page 9
2231.0.12 EVALUATION CONTENT 2231.0.13 VALIDITY OF APPRAISALS

AND EVALUATIONS
An evaluation should contain sufficient informa-
tion detailing the analysis, assumptions, and The Board allows an institution to use an exist-
conclusions to support the credit decision. An ing appraisal or evaluation to support a subse-
evaluations content should be documented in quent transaction in certain circumstances.
the credit file or reproducible. The evaluation Therefore, an institution should establish crite-
should, at a minimum, ria for assessing whether an existing appraisal
or evaluation continues to reflect the market
value of the property (that is, remains valid).
Identify the location of the property.
Such criteria will vary depending upon the con-
Provide a description of the property and its dition of the property and the marketplace, and
current and projected use. the nature of the transaction. The documentation
Provide an estimate of the propertys market in the credit file should provide the facts and
value in its actual physical condition, use and analysis to support the institutions conclusion
zoning designation as of the effective date of that the existing appraisal or evaluation may be
the evaluation (that is, the date that the analy- used in the subsequent transaction. A new
sis was completed), with any limiting appraisal or evaluation is necessary if the origi-
conditions. nally reported market value has changed due to
Describe the method(s) the institution used to factors such as
confirm the propertys actual physical condi-
tion and the extent to which an inspection was passage of time;
performed. volatility of the local market;
Describe the analysis that was performed and changes in terms and availability of financing;
the supporting information that was used in natural disasters;
valuing the property. limited or over supply of competing
properties;
Describe the supplemental information that
improvements to the subject property or com-
was considered when using an analytical
peting properties;
method or technological tool.
lack of maintenance of the subject or compet-
Indicate all source(s) of information used in ing properties;
the analysis, as applicable, to value the prop- changes in underlying economic and market
erty, including: assumptions, such as capitalization rates and
External data sources (such as market lease terms;
sales databases and public tax and land changes in zoning, building materials, or tech-
records); nology; and
Property-specific data (such as previous environmental contamination.
sales data for the subject property, tax as-
sessment data, and comparable sales
information); 2231.0.14 REVIEWING APPRAISALS
Evidence of a property inspection; AND EVALUATIONS
Photos of the property;
Description of the neighborhood; or The Boards appraisal regulations specify that
Local market conditions. appraisals for federally related transactions must
Include information on the preparer when an contain sufficient information and analysis to
evaluation is performed by a person, such as support an institutions decision to engage in the
the name and contact information, and signa- credit transaction. For certain transactions that do
ture (electronic or other legally permissible not require an appraisal, the Boards regulations
signature) of the preparer. require an institution to obtain an appropriate
evaluation of real property collateral that is
(See Appendix BEvaluations Based on consistent with safe and sound banking practices.
Analytical Methods or Technological Tools for As part of the credit approval process and
guidance on the appropriate use of analytical prior to a final credit decision, an institution
methods and technological tools for developing should review appraisals and evaluations to
an evaluation.) ensure that they comply with the Boards
appraisal regulations and are consistent with
BHC Supervision Manual July 2011 supervisory guidance and its own internal poli-
Page 10 cies. This review also should ensure that an
appraisal or evaluation contains sufficient infor- tence to perform the review commensurate with
mation and analysis to support the decision to the complexity of the transaction, type of real
engage in the transaction. property, and market. Further, reviewers should
Through the review process, the institution be capable of assessing whether the appraisal or
should be able to assess the reasonableness of evaluation contains sufficient information and
the appraisal or evaluation, including whether analysis to support the institutions decision to
the valuation methods, assumptions, and data engage in the transaction.
sources are appropriate and well supported. An A small or rural institution or branch with
institution may use the review findings to moni- limited staff should implement prudent safe-
tor and evaluate the competency and ongoing guards for reviewing appraisals and evaluations
performance of appraisers and persons who per- when absolute lines of independence cannot be
form evaluations. (See the discussion in the achieved. Under these circumstances, the review
Selection of Appraisers or Persons Who Per- may be part of the originating loan officers
form Evaluations subsection above.) overall credit analysis, as long as the originating
When an institution identifies an appraisal or loan officer abstains from directly or indirectly
evaluation that is inconsistent with the Boards approving or voting to approve the loan.
appraisal regulations and the deficiencies cannot An institution should assess the level of
be resolved with the appraiser or person who in-house expertise available to review appraisals
performed the evaluation, the institution must for complex projects, high-risk transactions, and
obtain an appraisal or evaluation that meets the out-of-market properties. An institution may
regulatory requirements prior to making a credit find it appropriate to employ additional person-
decision. Though a reviewer cannot change the nel or engage a third party to perform the
value conclusion in the original appraisal, an reviews. When using a third party, an institution
appraisal review performed by an appropriately remains responsible for the quality and
qualified and competent state-certified or state- adequacy of the review process, including the
licensed appraiser in accordance with USPAP qualification standards for reviewers. (See the
may result in a second opinion of market value. discussion in the Third-Party Arrangements
An institution may rely on the second opinion of subsection below.)
market value obtained through an acceptable
USPAP-compliant appraisal review to support
its credit decision. 2231.0.14.2 Depth of Review
An institutions policies and procedures for
reviewing appraisals and evaluations, at a mini- An institution should implement a risk-focused
mum, should approach for determining the depth of the
review needed to ensure that appraisals and
address the independence, educational and evaluations contain sufficient information and
training qualifications, and role of the analysis to support the institutions decision to
reviewer; engage in the transaction. This process should
reflect a risk-focused approach for determin- differentiate between high- and low-risk transac-
ing the depth of the review; tions so that the review is commensurate with
establish a process for resolving any deficien- the risk. The depth of the review should be
cies in appraisals or evaluations; and sufficient to ensure that the methods, assump-
set forth documentation standards for the tions, data sources, and conclusions are reason-
review and resolution of noted deficiencies. able, well supported, and appropriate for the
transaction, property, and market. The review
also should consider the process through which
2231.0.14.1 Reviewer Qualifications the appraisal or evaluation is obtained, either
directly by the institution or from another finan-
An institution should establish qualification cri- cial services institution. The review process
teria for persons who are eligible to review should be commensurate with the type of trans-
appraisals and evaluations. Persons who review action as discussed below:
appraisals and evaluations should be indepen-
dent of the transaction and have no direct or Commercial Real Estate. An institution
indirect interest, financial or otherwise, in the should ensure that appraisals or evaluations
property or transaction, and be independent of for commercial real estate transactions are
and insulated from any influence by loan-
production staff. Reviewers also should possess BHC Supervision Manual July 2011
the requisite education, expertise, and compe- Page 11
subject to an appropriate level of review. meets the Boards appraisal requirements,

Transactions involving complex properties or then the institution must obtain an appraisal
high-risk commercial loans should be prior to engaging in the transaction.
reviewed more comprehensively to assess the Appraisals from Other Financial Services
technical quality of the appraisers analysis. Institutions.28 The Boards appraisal regula-
For example, an institution should perform a tions specify that an institution may use an
more comprehensive review of transactions appraisal that was prepared by an appraiser
involving large-dollar credits, loans secured engaged directly by another financial services
by complex or specialized properties, and institution, provided the institution determines
properties outside the institutions traditional that the appraisal conforms to the Boards
lending market. Persons performing such appraisal regulations and is otherwise accept-
reviews should have the appropriate expertise able. An institution should assess whether to
and knowledge relative to the type of property use the appraisal prior to making a credit
and its market. decision. An institution should subject such
The depth of the review of appraisals and appraisals to at least the same level of review
evaluations completed for commercial proper- that the institution performs on appraisals it
ties securing lower-risk transactions may be obtains directly for similar properties and
less technical in nature, but still should pro- document its review in the credit file. The
vide meaningful results that are commensu- documentation of the review should support
rate with the size, type, and complexity of the the institutions reliance on the appraisal.
underlying credit transaction. In addition, an Among other considerations, an institution
institution should establish criteria for when should confirm that
to expand the depth of the review. the appraiser was engaged directly by the
One- to Four-Family Residential Real Estate. other financial services institution;
The reviews for residential real estate transac- the appraiser had no direct, indirect, or
tions should reflect a risk-focused approach prospective interest, financial or other-
that is commensurate with the size, type, and wise, in the property or transaction; and
complexity of the underlying credit transac- the financial services institution (not the
tion, as well as loan and portfolio risk charac- borrower) ordered the appraisal. For
teristics. These risk factors could include debt- example, an engagement letter should
to-income ratios, loan-to-value ratios, level of show that the financial services institution,
documentation, transaction dollar amount, or not the borrower, engaged the appraiser.
other relevant factors. With prior approval
from its primary federal regulator, an institu- An institution must not accept an appraisal
tion may employ various techniques, such as that has been readdressed or altered by the
automated tools or sampling methods, for per- appraiser with the intent to conceal the original
forming pre-funding reviews of appraisals or client. Altering an appraisal report in a manner
evaluations supporting lower risk residential that conceals the original client or intended
mortgages. When using such techniques, an users of the appraisal is misleading, does not
institution should maintain sufficient data and conform to USPAP, and violates the Boards
employ appropriate screening parameters to appraisal regulations.
provide adequate quality assurance and should
ensure that the work of all appraisers and
persons performing evaluations is periodically 2231.0.14.3 Resolution of Deficiencies
reviewed. In addition, an institution should
establish criteria for when to expand the depth An institution should establish policies and pro-
of the review. cedures for resolving any inaccuracies or weak-
An institution may use sampling and audit nesses in an appraisal or evaluation identified
procedures to verify the sellers representa- through the review process, including proce-
tions and warranties that the appraisals for the dures for:
underlying loans in a pool of residential loans
satisfy the Boards appraisal regulations and Communicating the noted deficiencies to and
are consistent with supervisory guidance and requesting correction of such deficiencies by
an institutions internal policies. If an institu-
tion is unable to confirm that the appraisal 28. An institution generally should not rely on an evalua-
tion prepared by or for another financial services institution
because it will not have sufficient information relative to the
BHC Supervision Manual July 2011 other institutions risk-management practices for developing
Page 12 evaluations.
the appraiser or person who prepared the tent with supervisory guidance.29 Therefore, an
evaluation. An institution should implement institution should have the resources and exper-
adequate internal controls to ensure that such tise necessary for performing ongoing oversight
communications do not result in any coercion of third-party arrangements.
or undue influence on the appraiser or person An institution should have internal controls
who performed the evaluation. for identifying, monitoring, and managing the
Addressing significant deficiencies in the risks associated with using a third-party arrange-
appraisal that could not be resolved with the ment for valuation services, including compli-
original appraiser by obtaining a second ance, legal, reputational, and operational risks.
appraisal or relying on a review that complies While the arrangement may allow an institution
with Standards Rule 3 of USPAP and is per- to achieve specific business objectives, such as
formed by an appropriately qualified and com- gaining access to expertise not available inter-
petent state-certified or state-licensed nally, the reduced operational control over out-
appraiser prior to the final credit decision. sourced activities poses additional risk. Consis-
Replacing evaluations prior to the credit deci- tent with safe and sound practices, an institution
sion that do not provide credible results or should have a written contract that clearly
lack sufficient information to support the final defines the expectations and obligations of both
credit decision. the financial institution and the third party,
including that the third party will perform its
services in compliance with the Boards
appraisal regulations and consistent with super-
2231.0.14.4 Documentation of the visory guidance.
Review Prior to entering into any arrangement with a
third party for valuation services, an institution
An institution should establish policies for docu- should compare the risks, costs, and benefits of
menting the review of appraisals and evalua- the proposed relationship to those associated
tions in the credit file. Such policies should with using another vendor or conducting the
address the level of documentation needed for activity in-house. The decision to outsource any
the review, given the type, risk, and complexity part of the collateral-valuation function should
of the transaction. The documentation should not be unduly influenced by any short-term cost
describe the resolution of any appraisal or evalu- savings. An institution should take into account
ation deficiencies, including reasons for obtain- all aspects of the long-term effect of the relation-
ing and relying on a second appraisal or evalua- ship, including the managerial expertise and
tion. The documentation also should provide an associated costs for effectively monitoring the
audit trail that documents the resolution of noted arrangement on an ongoing basis.
deficiencies or details the reasons for relying on If an institution outsources any part of the
a second opinion of market value. collateral-valuation function, it should exercise
appropriate due diligence in the selection of a
third party. This process should include suffi-
cient analysis by the institution to assess
2231.0.15 THIRD-PARTY whether the third-party provider can perform the
ARRANGEMENTS services consistent with the institutions perfor-
mance standards and regulatory requirements.
An institution that engages a third party to per- An institution should be able to demonstrate
form certain collateral-valuation functions on its that its policies and procedures establish effec-
behalf is responsible for understanding and tive internal controls to monitor and periodi-
managing the risks associated with the arrange- cally assess the collateral-valuation functions
ment. An institution should use caution if it performed by a third party.
engages a third party to administer any part of An institution also is responsible for ensuring
its appraisal and evaluation function, including
ordering or reviewing appraisals and evalua- 29. See, for example, FFIEC statement, Risk Management
tions, selecting an appraiser or person to per- of Outsourced Technology Service (November 28, 2000) for
form evaluations, or providing access to analyti- guidance on the assessment, selection, contract review, and
monitoring of a third party that provides services to a regu-
cal methods or technological tools. lated institution. Refer to the institutions primary federal
An institution is accountable for ensuring that regulator for additional guidance on third-party arrangements.
any services performed by a third party, both
affiliated and unaffiliated entities, comply with BHC Supervision Manual July 2011
applicable laws and regulations and are consis- Page 13
that a third party selects an appraiser or a person cations and demonstrated competency for the
to perform an evaluation who is competent and assignment;
independent, has the requisite experience and establish procedures to test the quality of the
training for the assignment, and thorough appraisal and evaluation review process;
knowledge of the subject propertys market. use, as appropriate, the results of the institu-
Appraisers must be appropriately certified or tions review process and other relevant infor-
licensed, but this minimum credentialing mation as a basis for considering a person for
requirement, although necessary, is not suffi- a future appraisal or evaluation assignment;
cient to determine that an appraiser is competent and
to perform an assignment for a particular prop- report appraisal and evaluation deficiencies to
erty or geographic market. appropriate internal parties and, if applicable,
An institution should ensure that when a third to external authorities in a timely manner.
party engages an appraiser or a person who
performs an evaluation, the third party conveys
to that person the intended use of the appraisal 2231.0.16.1 Monitoring Collateral Values
or evaluation and that the regulated institution is
the client. For example, an engagement letter Consistent with the Boards real estate lending
facilitates the communication of this regulations and guidelines,30 an institution
information. should monitor collateral risk on a portfolio and
An institutions risk-management system on an individual credit basis. Therefore, an
should reflect the complexity of the outsourced institution should have policies and procedures
activities and associated risk. An institution that address the need for obtaining current
should document the results of ongoing moni- collateral-valuation information to understand
toring efforts and periodic assessments of the its collateral position over the life of a credit
arrangement(s) with a third party for compli- and effectively manage the risk in its real estate
ance with applicable regulations and consis- credit portfolios. The policies and procedures
tency with supervisory guidance and its perfor- also should address the need to obtain current
mance standards. If deficiencies are discovered, valuation information for collateral supporting
an institution should take remedial action in a an existing credit that may be modified or
timely manner. considered for a loan workout.
Under their appraisal regulations, the Board
reserves the right to require an institution to
2231.0.16 PROGRAM COMPLIANCE obtain an appraisal or evaluation when there are
safety and soundness concerns on an existing
Deficiencies in an institutions appraisal and real estate secured credit. Therefore, an institu-
evaluation program that result in violations of tion should be able to demonstrate that sufficient
the Boards appraisal regulations or contraven- information is available to support the current
tions of the Boards supervisory guidance reflect market value of the collateral and the classifica-
negatively on management. An institutions tion of a problem real estate credit. When such
appraisal and evaluation policies should estab- information is not available, an examiner may
lish internal controls to promote an effective direct an institution to obtain a new appraisal or
appraisal and evaluation program. The compli- evaluation in order to have sufficient informa-
ance process should tion to understand the current market value of
the collateral. Examiners would be expected to
maintain a system of adequate controls, verifi- provide an institution with a reasonable amount
cation, and testing to ensure that appraisals of time to obtain a new appraisal or evaluation.
and evaluations provide credible market
values;
insulate the persons responsible for ascertain- 2231.0.16.2 Portfolio Collateral Risk
ing the compliance of the institutions
appraisal and evaluation function from any Prudent portfolio-monitoring practices include
influence by loan-production staff;
ensure the institutions practices result in the 30. The Federal Reserve did not adopt the real estate
selection of appraisers and persons who per- lending standards for bank holding companies and their non-
bank subsidiaries. However, bank holding companies and
form evaluations with the appropriate qualifi- their nonbank subsidiaries are expected to conduct their real
estate lending activities in a prudent manner consistent with
BHC Supervision Manual July 2011 safe and sound lending standards. A bank subsidiary of a
Page 14 BHC should refer to 12 C.F.R. 208, subpart G.
criteria for determining when to obtain a new Loan Modifications. A loan modification to an
appraisal or evaluation. Among other consider- existing credit that involves a limited
ations, the criteria should address deterioration change31 in the terms of the note or loan
in the credit since origination or changes in agreement and that does not adversely affect
market conditions. Changes in market condi- the institutions real estate collateral protec-
tions could include material changes in current tion after the modification does not rise to the
and projected vacancy, absorption rates, lease level of a new real estaterelated financial
terms, rental rates, and sale prices, including transaction for purposes of the Boards
concessions and overruns and delays in con- appraisal regulations. As a result, an institu-
struction costs. Fluctuations in discount or direct tion would not be required to obtain either a
capitalization rates also are indicators of chang- new appraisal or evaluation to comply with
ing market conditions. the Boards appraisal regulations, but should
In assessing whether changes in market con- have an understanding of its collateral risk.
ditions are material, an institution should con- For example, institutions can use automated
sider the individual and aggregate effect of these valuation models or other valuation
changes on its collateral protection and the risk techniques when considering a modification
in its real estate lending programs or credit to a residential mortgage loan. An institution
portfolios. Moreover, as an institutions reliance should have procedures for ensuring an
on collateral becomes more important, its poli- alternative collateral-valuation method
cies and procedures should provides reliable information. In addition, an
institution should be able to demonstrate that
ensure that timely information is available to a modification reflects prudent underwriting
management for assessing collateral and asso- standards and is consistent with safe and
ciated risk; sound lending practices. Examiners will
specify when new or updated collateral valua- assess the adequacy of valuation information
tions are appropriate or desirable to under- an institution uses for loan modifications.
stand collateral risk in the transaction(s); and Loan Workouts. As noted above under Moni-
delineate the valuation method to be toring Collateral Values, an institutions poli-
employed after considering the property type, cies and procedures should address the need
current market conditions, current use of the for current information on the value of real
property, and the relevance of the most recent estate collateral supporting a loan workout. A
appraisal or evaluation in the credit file. loan workout can take many forms, including
a modification that adversely affects the insti-
Consistent with sound collateral-valuation tutions real estate collateral protection after
monitoring practices, an institution can use a the modification, a renewal or extension of
variety of techniques for monitoring the effect loan terms, the advancement of new monies,
of collateral-valuation trends on portfolio risk. or a restructuring with or without concessions.
Sources of relevant information may include These types of loan workouts are new real
external market data, internal data, or reviews of estaterelated financial transactions.
recently obtained appraisals and evaluations. An If the loan workout does not include the
institution should be able to demonstrate that it advancement of new monies other than rea-
has sufficient, reliable, and timely information sonable closing costs, the institution may
on market trends to understand the risk associ- obtain an evaluation in lieu of an appraisal.
ated with its lending activity. For loan workouts that involve the advance-
ment of new monies, an institution may obtain
an evaluation in lieu of an appraisal provided
2231.0.16.3 Modifications and Workouts there has been no obvious and material change
of Existing Credits
31. A loan modification that entails a decrease in the
interest rate or a single extension of a limited or short-term
An institution may find it appropriate to modify nature would not be viewed as a subsequent transaction. For
a loan or to engage in a workout with an exist- example, an extension arising from a short-term delay in the
ing borrower. The Board expects an institution full repayment of the loan when there is documented evidence
to consider current collateral valuation informa- that payment from the borrower is forthcoming, or a brief
delay in the scheduled closing on the sale of a property when
tion to assess its collateral risk and facilitate an there is evidence that the closing will be completed in the near
informed decision on whether to engage in a term.
modification or workout of an existing real
estate credit. (See the discussion above under BHC Supervision Manual July 2011
Portfolio Collateral Risk.) Page 15
in market conditions and no change in the complaint with the appropriate state appraiser
physical aspects of the property that threatens certifying and licensing agency under certain
the adequacy of the institutions real estate circumstances.33
collateral protection after the workout. An institution also must file a suspicious
In these cases, an institution should sup- activity report (SAR) with the Financial Crimes
port and document its rationale for using this Enforcement Network of the Department of the
exemption. An institution must obtain an Treasury (FinCEN) when suspecting fraud or
appraisal when a loan workout involves the identifying other transactions meeting the SAR
advancement of new monies and there is an filing criteria.34 Examiners finding evidence of
obvious and material change in either market unethical or unprofessional conduct by apprais-
conditions or physical aspects of the property, ers should instruct the institution to file a com-
or both, that threatens the adequacy of the plaint with state appraiser regulatory officials
institutions real estate collateral protection and, when required, to file a SAR with FinCEN.
after the workout (unless another exemption If there is a concern regarding the institutions
applies). 32 (See also Appendix A ability or willingness to file a complaint or make
Appraisal Exemptions for transactions a referral, examiners should forward their find-
where an evaluation would be allowed in lieu ings and recommendations to their supervisory
of an appraisal.) office for appropriate disposition and referral to
Collateral-Valuation Policies for Modifica- state appraiser regulatory officials and FinCEN,
tions and Workouts. An institutions policies as necessary.
should address the need for obtaining current
collateral-valuation information for a loan
modification or workout. The policies should 2231.0.18 APPENDIXES IN
specify the valuation method to be used and INTERAGENCY APPRAISAL AND
address the need to monitor collateral risk on EVALUATION GUIDELINES
an ongoing basis taking into consideration
changing market conditions and the bor- There are four appendixes included with the
rowers repayment performance. An institu- guidelines. They are summarized below and can
tion also should be able to demonstrate that be found in section A. 4140.1 of the Commer-
the collateral-valuation method used is reli- cial Bank Examination Manual.
able for a given credit or loan type.
Further, for loan workouts, an institutions Appendix AAppraisal Exemptions: A com-
policies should specify conditions under mentary on the 12 exemptions from the agen-
which an appraisal or evaluation will be cies appraisal regulations. The appendix pro-
obtained. As loan repayment becomes more vides an explanation of the agencies statutory
dependent on the sale of collateral, an institu- authority to provide for appraisal regulatory
tions policies should address the need to exemptions and the application of these exemp-
obtain an appraisal or evaluation for safety tions.
and soundness reasons even though one is not
otherwise required by the Boards appraisal Appendix BEvaluations Based on Analytical
regulations. Methods and Technological Tools: A discussion
of the agencies expectations for evaluations
that are based on analytical methods and techno-
2231.0.17 REFERRALS logical tools, including the use of automated
valuation models and tax assessment valuations.
An institution should file a complaint with the
appropriate state appraiser regulatory officials Appendix CDeductions and Discounts Mini-
when it suspects that a state-certified or state- mum: A discussion on appraisal standards for
licensed appraiser failed to comply with USPAP, determining the market value of a residential
applicable state laws, or engaged in other
unethical or unprofessional conduct. In addition, 33. See 12 CFR 226.42(g).
effective April 1, 2011, an institution must file a 34. Refer to 12 CFR 208.62, 211.5(k), 211.24(f), and
225.4(f). Refer also to the Federal Financial Institutions
Examination Council Bank Secrecy Act/Anti-Money Launder-
ing Examination Manual (revised April 29, 2010) to review
32. For example, if the transaction value is below the
the general criteria, but note that instructions on filing a SAR
appraisal threshold of $250,000.
through the Financial Crime Enforcement Network (FinCEN)
of the Department of the Treasury are attached to the SAR
BHC Supervision Manual July 2011 form. The SAR form is available on FinCENs website:
Page 16 www.fincen.gov/forms/bsa_forms/#SAR.
tract development, including an explanation of cies) of the existing building in relation to a new
the requirement to analyze and report appropri- structure.
ate deductions and discounts for proposed con- The cost approach consists of four basic
struction or renovation, partially leased build- steps: (1) estimate the value of the land as
ings, nonmarket lease terms, and tract though vacant, (2) estimate the current cost of
developments with unsold units. reproducing the existing improvements, (3) esti-
mate depreciation and deduct from the repro-
Appendix DGlossary: Definitions of terms duction cost estimate, and (4) add the estimate
related to real estate lending, appraisals, and of land value and the depreciated reproduction
regulations to aid in the reading of the cost of improvements to determine the value
guidelines. estimate.
2231.0.19 BACKGROUND 2231.0.19.2 Sales Comparison Approach

INFORMATION ON APPRAISAL
VALUATION APPROACHES The essence of the sales comparison approach is
to determine the price at which similar proper-
An appraiser typically utilizes three market- ties have recently sold on the local market.
value approaches to analyze the value of Through an appropriate adjustment for differ-
property: ences in the subject property and the selected
comparable properties, the appraiser estimates
cost approach the market value of the subject property based
sales comparison approach on the sales price of the comparable properties.
income approach The process used in determining the degree of
comparability of two or more properties
All three approaches have particular merits involves judgment about their similarity with
depending upon the type of real estate being respect to age, location, condition, construction,
appraised. For single-family residential prop- layout, and equipment. The sales price or list
erty, the cost and comparable sales approaches price of those properties deemed most compa-
are most frequently used since the common use rable tend to set the range for the value of the
of the property is the personal residence of the subject property.
owner. However, if a single-family residential
property is intended to be used as a rental prop-
erty, the appraiser would have to consider the 2231.0.19.3 Income Approach
income approach as well. For special-use com-
mercial properties, the appraiser may have diffi- The income approach estimates the projects
culty obtaining sales data on comparable proper- expected income over time converted to an esti-
ties and may have to base the value estimate on mate of its present value. The income approach
the cost and income approaches. is typically used to determine the market value
If an approach is not used in the appraisal, the of income-producing properties such as office
appraiser should disclose the reason the buildings, apartment complexes, hotels, and
approach was not used and whether this affects shopping centers. In the income approach, the
the value estimate. appraiser can use several different capitalization
or discounted cash-flow techniques to arrive at a
market value. These techniques include the
2231.0.19.1 Cost Approach band-of-investments method, mortgage-equity
method, annuity method, and land-residual tech-
In the cost approach to value estimation, the nique. Which technique is used depends on
appraiser obtains a preliminary indication of whether there is project financing, whether there
value by adding the estimated depreciated repro- are long-term leases with fixed-level payments,
duction cost of the improvements to the esti- and whether the value is being rendered for a
mated land value. This approach is based on the component of the project such as land or build-
assumption that the reproduction cost is the ings.
upper limit of value and that a newly con- The accuracy of the income-approach method
structed building would have functional and depends on the appraisers skill in estimating
mechanical advantages over an existing build-
ing. The appraiser would evaluate any func- BHC Supervision Manual July 2011
tional depreciation (disadvantages or deficien- Page 17
the anticipated future net income of the property or normal, occupancy and rent level is pro-
and in selecting the appropriate capitalization jected. Each years net operating income during
rate and discounted cash flow. The following that period is discounted to arrive at the present
data are assembled and analyzed to determine value of expected future cash flows. The proper-
potential net income and value: tys anticipated sales value at the end of the
period until stabilization (its terminal or rever-
Rent schedules and the percentage of occu- sion value) is then estimated. The reversion
pancy for the subject property and for compa- value represents the capitalization of all future
rable properties for the current year and sev- income streams of the property after the pro-
eral preceding years. This provides gross jected occupancy level is achieved. The termi-
rental data and shows the trend of rentals and nal or reversion value is then discounted to its
occupancy, which are then analyzed by the present value and added to the discounted
appraiser to estimate the gross income the income stream to arrive at the total present
property should produce. market value of the property.
Expense data such as taxes, insurance, and Most importantly, the analysis should be
operating costs paid from revenues derived based on the ability of the project to generate
from the subject property and by comparable income over time based upon reasonable and
properties. Historical trends in these expense supportable assumptions. Additionally, the dis-
items are also determined. count rate should reflect reasonable expectations
A time frame for achieving stabilized, or nor- about the rate of return that investors require
mal, occupancy and rent levels (also referred under normal, orderly, and sustainable market
to as a holding period). conditions.
Basically, the income approach converts all

expected future net operating income into 2231.0.19.4 Value Correlation
present-value terms. When market conditions
are stable and no unusual patterns of future rents The three value estimatescost, sales compari-
and occupancy rates are expected, the direct son, and incomemust be evaluated by the
capitalization method is used to value income appraiser and correlated into a final value esti-
properties. This method calculates the value of a mate based on the appraisers judgment. Corre-
property by dividing an estimate of its stabilized lation does not imply averaging the value esti-
annual income by a factor called a cap rate. mates obtained by using the three different
Stabilized income is generally defined as the approaches. Where these value estimates are
yearly net operating income produced by the relatively close together, correlating them and
property at normal occupancy and rental rates; it setting the final market value estimate presents
may be adjusted upward or downward from no special problem. It is in situations where
todays actual market conditions. The cap rate widely divergent values are obtained by using
usually defined for each property type in a mar- the three appraisal approaches that the examiner
ket areais viewed by some analysts as the must exercise judgment in analyzing the results
required rate of return stated as a percent of and determining the estimate of market value.
current income.
The use of this technique assumes that the use
of either the stabilized income or the cap rate
accurately captures all relevant characteristics 2231.0.19.5 Other Definitions of Value
of the property relating to its risk and income
potential. If the same risk factors, required rate While the Boards appraisal regulation requires
of return, financing arrangements, and income that the appraisal contain the market value of
projections are used, explicit discounting and the real estate collateral, there are other defini-
direct capitalization should yield the same tions of value that are encountered in appraising
results. and evaluating real estate transactions. These
For special-use properties, new projects, or include the following:
troubled properties, the discounted cash flow
(net present value) method is the more typical Fair Value. This is an accounting term that is
approach to analyzing a propertys value. In this generally defined as the amount in cash or
method, a time frame for achieving a stabilized, cash-equivalent value of other consideration
that a real estate parcel would yield in a current
BHC Supervision Manual July 2011 sale between a willing buyer and a willing
Page 18 seller (the selling price), that is, other than in a
forced or liquidation sale.35 According to as the estimated selling price in the ordinary
accounting literature, fair value is generally course of business less estimated costs of
used in valuing assets in nonmonetary transac- completion (to the stage of completion assumed
tions, troubled debt restructuring, quasi- in determining the selling price), holding, and
reorganizations, and business combinations disposal. The NRV is generally used to evaluate
accounted for by the purchase method. An the carrying amount of assets being held for
accountant generally defines fair value as mar- disposition and properties representing collat-
ket value; however, depending on the circum- eral. While the market value or future selling
stances, these values may not be the same for a price are generally used as the basis for the
particular property. NRV calculation, the NRV also reflects the cur-
rent owners costs to complete the project and to
Investment Value. This is based on the data and hold and dispose of the property. For this rea-
assumptions that meet the criteria and objectives son, the NRV will generally be less than the
of a particular investor for a specific property or market value.
project. The investors criteria and objectives
are often substantially different from partici-
pants criteria and objectives in a broader mar- 2231.0.20 SUPERVISORY
ket. Thus, investment value can be significantly EXPECTATIONS AND FINDINGS
higher than market value in certain circum-
stances and should not be used in credit analysis In conjunction with assessing overall adequacy
decisions. of a banking organizations appraisal and evalu-
ation function to support safe and sound real
Liquidation Value. This assumes that there is estate lending, examiners should review the
little or no current demand for the property but banking organization for compliance with the
the property needs to be disposed of quickly, Boards appraisal regulation and related guide-
resulting in the owner sacrificing potential prop- lines. The following summarizes possible
erty appreciation for an immediate sale. inspection findings and references to the appli-
cable provisions in the Boards regulations or
Going-Concern Value. This is based on the relevant section in the Interagency Guidelines.
value of a business entity rather than the value
of just the real estate. The valuation is based on Banking organizations appraisal function is
the existing operations of the business that has a weak:
proven operating record, with the assumption The banking organization has failed to
that the business will continue to operate. satisfy supervisory expectations as indi-
cated in the Interagency Appraisal and
Assessed Value. This represents the value on Evaluation Guidelines. See the Appraisal
which a taxing authority bases its assessment. and Evaluation Program subsection
The assessed value and market value may differ above.
considerably due to tax assessment laws, timing Banking organization does not have adequate
of reassessments, and tax exemptions allowed procedures for monitoring market conditions
on properties or portions of a property. for its CRE lending:
A bank subsidiary of a bank holding com-
Net Realizable Value (NRV). This is recognized pany must monitor real estate market con-
under generally accepted accounting principles ditions in its lending area and have credit
administration policies that address the
35. See Accounting Standards Codification (ASC) Topic type and frequency of collateral valua-
820, Fair Value Measurements and Disclosures (formerly
FASB Statement No. 157, Fair Value Measurements). It
tions. Violation of 12 CFR 225, subpart G
defines fair value and establishes a framework for measuring (real estate lending standards regulation
fair value. ASC Topic 820 should be applied when other and guidelines).
accounting topics require or permit fair value measurements. The banking organization has failed to
Fair value is defined as the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction
comply with the Interagency Guidelines.
between market participants in the assets or liabilitys princi- See the Monitoring Collateral Values
pal (or most advantageous) market at the measurement date. subsection above.
This value is often referred to as an exit price. An orderly Appraisal fails to comply with regulation:
transaction is a transaction that assumes exposure to the
market for a period prior to the measurement date to allow for
Violation of 12 CFR 225.64 (minimum
marketing activities that are usual and customary for transac-
tions involving such assets or liabilities; it is not a forced BHC Supervision Manual July 2011
liquidation or distressed sale. Page 19
appraisal standards) or 12 CFR 225.65 independence between the appraisal and

(appraiser independence). evaluation process and the loan production
Examiners may require the banking orga- function (i.e., the credit decision).
nization to obtain a new appraisal for 3. To determine whether the banking organiza-
safety-and-soundness reasons (12 CFR tions policies and procedures address the
225.63(c)). requirement to monitor real estate collateral
The banking organization fails to obtain an values and market conditions on a portfolio
appraisal as required by the regulation: basis and over the life of the credit.
Violation of 12 CFR 225.63(a). 4. To determine that appraisals performed in
The banking organization must obtain an connection with federally related transac-
appraisal. tions comply with the minimum standards
For further background, refer to the Inter- of the Boards regulation and the Uniform
agency Guidelines, the Transactions That Standards of Professional Appraisal Prac-
Require Appraisals subsection, and tice.
Appendix AAppraisal Exemptions. 5. To determine that the banking organiza-
The banking organization fails to obtain an tions policies and practices for performing
evaluation for certain exempted transactions: evaluations comply with supervisory guid-
Violation of 12 CFR 225.63(b) (see the ance and ensure that qualified individuals
provision on evaluations required). perform evaluations.
For further background, refer to the Inter- 6. To determine whether the banking organiza-
agency Guidelines and the section on tion has effective policies and procedures
Transactions That Require Evaluations for the review of appraisals and evaluations,
as well as Appendix AAppraisal including procedures for addressing
Exemptions. deficiencies.
The banking organization must obtain an 7. To determine that appraisers used in con-
evaluation. nection with federally related transactions
The evaluation is inadequate: hold a valid state license or certification as
The banking organization has failed to applicable for the property being appraised.
satisfy supervisory expectations as indi- 8. To determine that appraisers are competent
cated in the Interagency Appraisal and to render appraisals in federally related
Evaluation Guidelines. transactions, and are independent of the
For further background, refer to the transaction, or other lending, investment, or
Interagency Guidelines, the Evaluation collection functions as appropriate.
Development and Evaluation Content 9. To determine that the banking organization
subsections, and Appendix BEvaluations has appropriate oversight over any third
Based on Analytical Methods or Techno- party providing appraisal management
logical Tools. services.
Depending upon the noted deficiencies, 10. To determine that the banking organization
examiners should require the banking has appropriate policies and procedures
organization to perform a new evaluation. governing the use of analytical methods and
technological tools in the preparation of
evaluations.
2231.0.21 INSPECTION OBJECTIVES 11. To initiate corrective action when policies,
practices, procedures, or internal controls
1. To determine whether policies, practices, are deficient, or when violations of laws or
procedures, and internal controls regarding regulations or noncompliance with provi-
real estate appraisals and evaluations for sions of supervisory guidelines have been
real estaterelated financial transactions are noted.
adequate.
2. To determine whether the banking organiza-
tions officers and employees are operating 2231.0.22 INSPECTION PROCEDURES
in conformance with the board of directors
appraisal policies and that such policies pro- 1. On the basis of the evaluation of internal
mote compliance with the appraisal regula- controls and the work performed by internal
tions and related-supervisory guidance and or external auditors, or inspection findings
from the institutions real estate lending
BHC Supervision Manual July 2011 activity, determine the scope of the
Page 20 inspection.
2. Test for compliance with policies, practices, appraisers qualifications, experience, and
procedures, and internal controls in conjunc- educational background; confirms the
tion with performing the remaining inspec- appraisers independence; ensures that
tion procedures. Obtain a listing of any appraisals are not used if they were pre-
deficiencies noted in the latest review pared by an individual recommended or
performed by internal or external auditors or selected by the borrower (including those
a previous inspection report and determine if individuals listed by the banking organi-
appropriate corrections have been made. zation as approved appraisers); and
a. Provide copies of the banking organiza- ensures that appraisals conform to the
tions appraisal and evaluation policies Boards appraisal regulation and are con-
and procedures to examiners assigned to sistent with supervisory guidance.
functional areas in which real estate d. The program ensures that evaluations
related transactions may require the ser- conform to the Boards guidance on
vices of an appraiser or evaluator. evaluations.
b. When individual real estaterelated trans- e. The program is adequate for the banking
actions such as loan D.P.C. assets or other organizations size and location and for
real estate owned (OREO) transactions the nature and complexity of its real estate
are examined, appraisals and evaluations lending and other real estaterelated
should be reviewed for compliance with activities.
the Boards appraisal regulation, supervi- f. The policies and procedures require that
sory guidance, and the banking organiza- appraisals and evaluations be written and
tions appraisal and evaluation programs. contain sufficient information on the real
c. When real estaterelated transactions are estate collaterals market value to support
examined on a portfolio basis, the the banking organizations decision to
appraisal and evaluation processes for the enter into the transaction.
activity should be examined. Examiners g. The program includes policies and proce-
should determine whether these processes dures concerning the need for current col-
ensure that appraisals and evaluations lateral valuation information to under-
comply with the Boards appraisal regula- stand the banking organizations collateral
tion, supervisory guidance, and the bank- position over the life of the credit and to
ing organizations appraisal and evalua- manage risk in its real estate credit port-
tion programs. folio.
3. Review the appraisal and evaluation program h. The policies and procedures address the
and determine the following: need for current collateral valuation infor-
a. The board of directors has adopted poli- mation for loans that the banking organi-
cies and procedures that zation is considering for modification or a
establish and maintain an effective, workout.
independent appraisal and evaluation i. If the program utilizes an approved
program for all of the institutions lend- appraiser list, the banking organization
ing functions; has appropriate procedures for the devel-
are sufficiently comprehensive; opment and administration of the list.
require an appropriate level of review j. The program addresses appraisal and
of appraisals and evaluations to pro- evaluation review procedures, including
mote compliance with the Boards the communications with the appraiser or
appraisal regulation and supervisory the individual who performed the evalua-
guidance as well as safe and sound tion, resolution of deficiencies, and the
lending; and decision to obtain a second appraisal or
are applied uniformly to all units evaluation.
engaged in real estaterelated activity. k. The board or senior management reviews
b. The appraisal and evaluation program annually its appraisal and evaluation
establishes criteria which the banking related policies and procedures and
organization uses to select, evaluate, records such review in its minutes.
monitor, and ensure the independence of 4. Evaluate the banking organizations
appraisers and the individuals who per- appraisal and evaluation program with
form evaluations as well as those indi- respect to the following:
viduals who perform and oversee the
review of appraisals and evaluations. BHC Supervision Manual July 2011
c. The program considers the independent Page 21
a. the adequacy of written appraisals and is, failure to use the cost, comparable-
evaluations sales, or income approach in an
b. the manner in which officers are operating appraisal when the approach is appro-
in conformance with established priate for the type of property
policy use of dissimilar comparables in the
c. internal control deficiencies or exceptions, comparable-sales approach to valuation,
including lack of independence of the for example, the age, size, quality, or
appraisal and evaluation process from the location of the comparable is signifi-
loan-production function cantly different from the subject prop-
d. the integrity of the appraisal and evalua- erty, making reconciliation of value
tion process, including appraisal and difficult
evaluation compliance procedures underestimation of factors such as
e. the integrity of individual appraisals and construction cost, construction period,
evaluations, including the adequacy, rea- lease-up period, and rent concessions
sonableness, and appropriateness of the
use of best-case assumptions for the
methods, assumptions, and techniques
income approach to valuation without
used and whether the appraisals and
performing a sensitivity analysis on the
evaluations comply with the Boards
factors that would identify the lenders
appraisal regulation and supervisory
downside risk
guidance
f. the adequacy of the appraisal and evalua- overly optimistic assumptions such as a
tion review practices, including the depth high absorption rate in an overbuilt mar-
and content of the review, documentation ket or assumptions on discount and
support for the review, and the resolution capitalization rates that do not reflect
of deficiencies market conditions and investors
g. the adequacy of policies and internal con- expected rate of return
trols for managing and monitoring third failure to analyze and report appropriate
parties that provide appraisal management deductions and discounts when the
services to the banking organization appraisal provides a market value esti-
h. the integrity of policies and procedures mate based on the future demand of the
governing the use of automated valuation real estate (such as proposed construc-
models in the development of evaluations tion, partially leased buildings, non-
i. the eligibility of the banking organization market lease terms, and unsold units in
to assign a 50 percent risk weight to cer- a residential tract development)
tain one- to four-family residential mort- the nonreconcilement of demographic
gage loans for risk-based capital purposes factors (such as existing housing inven-
(See section 4060.3, Assessment of tory, projected completions, and
Capital Adequacy.) expected market share to the value ren-
j. recommended corrective action when dered) and the discussion of demo-
policies, practices, or procedures are graphic factors as background
found to be deficient information
k. the degree of violations, if any, of the the opinion of market value includes the
Boards appraisal regulation and the value of both real property and non-real
extent of noncompliance with supervisory property (e.g., furnishings or an intan-
guidance, if noted gible asset)
l. other matters of significance: lack of documentation on the reasons
misrepresentation of data, such as the that an alternative market value was
omission of information on favorable used in the credit decision from the
financing, seller concessions, sales his- opinion of market value provided in the
tory, market conditions, propertys cur- appraisal or evaluation
rent performance (i.e., occupancy and
rental rate), project feasibility (i.e., lease 5. Report any instances of questionable conduct
or sale absorption rate), zoning, ease- by appraisers, along with the supporting
ments, or deed restrictions documentation, to the Reserve Bank for pos-
sible referral to the appropriate state
inadequate techniques of analysis, that
appraisal authorities.
BHC Supervision Manual July 2011 6. Update workpapers with any information that
Page 22 will facilitate future inspections.
2231.0.23 INTERNAL CONTROL Uniform Standards of Professional

QUESTIONNAIRE Appraisal Practice (USPAP) and the
Boards regulation and guidelines?
Review the banking organizations internal h. appraisal and evaluation review proce-
controls, policies, practices, and procedures for dures that require the performance of
real estate appraisals and evaluations. The bank- the review prior to the credit decision,
ing organizations system should be accurately resolution of noted deficiencies, and
and fully documented and should include, documentation of the review in the
where appropriate, narrative descriptions, flow credit file, and, if necessary, obtaining a
charts, copies of forms used, and other pertinent second appraisal or relying on USPAPs
information. Items marked with an asterisk standard rule 3 in performing a review
require substantiation by observation or testing. or performing another evaluation?
i. an appropriate level of review for
appraisals and evaluations ordered by
2231.0.23.1 Policies the banking organizations agents or
obtained from another financial ser-
1. Has the board of directors, consistent with vices institution?
its duties and responsibilities, adopted j. adequate level of oversight when the
written appraisal and evaluation policies banking organization uses a third party
that define the following: for appraisal management services?
a. managements responsibility for select- k. use of analytical methods and techno-
ing, evaluating, monitoring, and ensur- logical tools (such as automated valua-
ing the independence of the individual tion models or tax assessment valua-
who is performing the appraisal or tions) in the development of
evaluation? evaluations that is appropriate for the
b. the basis for selecting staff appraisers risk and type of transaction and
and engaging fee appraisers for a property?
particular appraisal assignment and for l. internal controls to prevent officers,
ensuring that the individual is loan officers, or directors who order or
independent of the transaction; pos- review appraisals and evaluations from
sesses the requisite qualifications, having the sole authority for approving
expertise, and educational background; the requested loans?
demonstrates competency for the m. procedures for promoting compliance
market and property type; and has the with the appraisal independence provi-
required state certification or license if sions of Regulation Z (Truth in Lend-
applicable? ing) for open- and closed-end consumer
c. procedures for when to obtain apprais- credit transactions secured by a con-
als and evaluations? sumers principal dwelling?
d. procedures for prohibiting the use of a 2. Does the board of directors annually
borrower-ordered or borrower-provided review these policies and procedures to
appraisal? ensure that the appraisal and evaluation
e. procedures for monitoring collateral policies and procedures meet the needs of
risk on a loan and portfolio basis as to the banking organizations real estate lend-
when to obtain a new appraisal or new ing activity and remains compliant with
evaluation, including the frequency, the Boards regulation and supervisory
triggering events, scope of appraisal guidance?
work, valuation methods, and report
option?
f. appraisal and evaluation compliance
procedures to determine that appraisals 2231.0.23.2 Appraisals
and evaluations are reviewed by quali-
fied and adequately trained individuals *1. Are appraisals in writing, dated, and
who are not involved in the loan- signed by the appraiser?
production process? *2. Does the appraisal meet the minimum
g. appraisal and evaluation review proce- standards of the Boards regulation and
dures to ensure that the banking organi-
zations appraisals and evaluations are BHC Supervision Manual July 2011
consistent with the standards of the Page 23
USPAP, and supervisory guidance, con- erty or the value of non-real property),
taining sufficient information and analysis if the banking organization requests
to support the banking organizations deci- such information?
sion to engage in the transaction? Does the *3. Are appraisals received before the banking
appraisal organization makes its final credit or other
a. reflect an appropriate scope of work credit decision (for example, is the date
that will provide for credible results, the loan committee approved the credit
including the extent to which the prop- later than the date of the appraisal)?
erty is identified and inspected, the type *4. If the banking organization is depending
and extent of data research performed, on an appraisal obtained for another finan-
and the analyses applied to arrive at an cial services institution as support for its
opinion of market value? transaction, does the banking organization
b. disclose the purpose and use of the have appraisal review procedures to ensure
appraisal? that the appraisal meets the standards of
c. provide an opinion of the collateral the appraisal regulation, including inde-
market value as defined in the Boards pendence? (These types of transactions
appraisal regulation and further clari- would include loan participations, loan
fied in supervisory guidance? purchases, and mortgage-backed
d. provide an effective date for the opin- securities.)
ion of market value? *5. If an appraisal for one transaction is used
e. provide the sales history of the subject for a subsequent transaction, does the
property for the prior three years? banking organization sufficiently docu-
f. reflect valuation approaches (that is, ment its determination that the appraiser is
cost, income, and sales comparison independent, the appraisal complies with
approaches) that are applicable for the the appraisal regulations, and the appraisal
property type and market? is still valid?
g. include an analysis and reporting of
appropriate deductions and discounts
when the appraisal provides a market 2231.0.23.3 Appraisers
value estimate based on the future
demand of the real estate (such as pro- 1. Are appraisers fairly considered for
posed construction, partially leased assignments regardless of their member-
buildings, non-market lease terms, and ship or lack of membership in a particular
unsold units in a residential tract appraisal organization?
development)? 2. Before the banking organization selects an
h. evaluate and reconcile the three appraiser for an assignment, does the
approaches into an opinion of market banking organization confirm that the
value estimate based on the appraisers appraiser has the requisite qualifications,
judgment? education, experience, and competency for
i. explain why an approach is inappropri- both the property type and market to com-
ate and not used in the appraisal? plete the appraisal?
j. fully support the assumptions and the 3. If a banking organization pre-screens
value rendered through adequate appraisers and uses an approved appraiser
documentation and information on mar- list, does it have procedures for assessing
ket conditions and trends? an appraisers qualifications, selecting an
k. evaluate key assumptions and potential appraiser for a particular assignment, and
ramifications to the opinion of market evaluating the appraisers work for reten-
value if these assumptions are not tion on the list?
realized? 4. The following items apply for large, com-
l. present an opinion of the collaterals plex, or out-of-area commercial real estate
market value in an appraisal report properties:
option that addresses the property type, a. Are written engagement letters used
market, risk, and type of transaction? when ordering appraisals, and are cop-
m. disclose and define other value opin- ies of the letters retained or included in
ions (such as disposal value of the prop- the appraisal report?
b. Does the banking organization have
BHC Supervision Manual July 2011 procedures for determining when such
Page 24 appraisals should be reviewed by
another appraiser (that is, a USPAP 2231.0.23.4 Evaluations

standard rule 3 appraisal review)?
5. Are appraisers independent of the 1. Are the individuals performing evalua-
transaction? tions independent of the transaction?
a. Are staff appraisers independent of the *2. Are the evaluations required to be in writ-
lending, investment, and collection ing, dated, and signed?
functions and not involved, except as *3. Does the banking organization require suf-
an appraiser, in the federally related ficient information and documentation to
transaction? Has a determination been support the estimate of value and the indi-
made that they have no direct or individuals analysis?
rect interest, financial or otherwise, in *4. Are the development and content of the
the property? evaluation reflective of transaction risk
b. Are fee appraisers engaged directly by and appropriate for the property type?
the banking organization or its agent? *5. Are the valuation methods used, and does
Has a determination been made that the supporting information in the evalua-
they have no direct or indirect interest, tion provide a reliable estimate of the
financial or otherwise, in the property propertys market value as of a stated
or transaction? effective date prior to the credit decision?
*6. If analytical methods or technological
c. Are any appraisers recommended or
tools are used in the development of an
selected by the borrower (applicant)?
evaluation, is the use of the method or tool
6. If the banking organization has staff consistent with safe and sound banking
appraisers to perform appraisals or practices and supervisory guidance?
appraisal reviews, does the banking orga- *7. If an evaluation obtained for one transac-
nization periodically have independent tion is used for a subsequent transaction,
appraisers evaluate their work for quality does the banking organization sufficiently
and confirm that they have the knowledge document its determination that the evalu-
and competency to perform their work and ation is still valid?
continue to hold the appropriate state *8. Are evaluations received before the bank-
license or certification? ing organization enters into a loan commit-
7. If fee appraisers are used by the banking ment?
organization, does the banking organiza- *9. Does the banking organization have evalu-
tion investigate their qualifications, ation review procedures to ensure that the
experience, education, background, and evaluation meets the Boards regulation
reputations? and guidance?
8. Is the status of an appraisers state certi- *10. If a tax assessment valuation is used in the
fication or license verified with the state development of an evaluation, has the
appraiser regulatory authority to ensure banking organization demonstrated that
that the appraiser is in good standing? there is a valid correlation between the tax
9. Does the banking organization have proce- assessment data and the propertys market
dures for filing complaints with the appro- value?
priate state appraiser regulatory officials
when it suspects the fee appraiser failed to
comply with USPAP, applicable state laws, 2231.0.23.5 Evaluators
or engaged in other unethical or unprofes-
sional conduct?
1. Are individuals who perform evaluations
10. Are fee appraisers paid the same fee competent to complete the assignment?
whether or not the loan is granted? 2. Do the individuals who perform evalua-
11. Does the banking organization pay a cus- tions possess the appropriate collateral
tomary and reasonable fee for appraisal valuation training, expertise, and experi-
services in the market where the property ence relevant to the type of property being
is located when the appraisal is for an valued?
open- and closed-end consumer credit 3. Are evaluations prepared by individuals
transaction secured by a consumers prin- who are independent of the transaction?
cipal dwelling as required under Regula-
tion Z? BHC Supervision Manual July 2011
Page 25
2231.0.23.6 Monitoring Collateral Values 2231.0.23.8 Analytical Methods And

Technological Tools
1. Does the banking organization have poli-
cies to monitor collateral risk on a port- 1. Does the banking organization have staff,
folio and on an individual credit basis? or if necessary engage a third party, with
2. Does the policy address the need to obtain the requisite expertise and training to man-
current valuation information for collat- age the selection, use, and validation of an
eral supporting an existing credit that may analytical method or technological tool?
be modified or considered for a loan 2. Does the banking organization have
workout? adequate policies, procedures, and internal
3. Does the criteria for determining when to controls governing the selection, use, and
obtain a new appraisal or new evaluation validation of the valuation method or tool
address deterioration in the credit; mate- for the development of an evaluation?
rial changes in market conditions; and 3. Does the banking organization have appro-
revisions to, or delays in, the projects priate policies and procedures governing
development and construction? the selection of automated valuation model
4. Does the banking organization sufficiently (AVM)? For instance, did the banking
document and follow its criteria for obtain- organization:
ing reappraisals or reevaluations? Perform the necessary level of due dili-
gence in selecting an AVM vendor and
its models, considering how model
2231.0.23.7 Third Party Arrangements developers conducted performance test-
ing as well as the sample size used and
1. Did the banking organization exercise the geographic level tested (such as
appropriate due diligence in the selection county level or zip code).
of a third party to perform appraisal man- Establish acceptable minimum perfor-
agement services for the banking organiza- mance criteria for a model prior to, and
tion? independent of, the validation process.
2. Does the banking organization have the Perform validation of the model(s) dur-
resources and expertise necessary for per- ing the selection process and document
forming ongoing oversight of such third the validation process.
party arrangements? Evaluate underlying data used in the
3. Does the banking organization have the model(s), including the data sources and
internal controls for identifying, monitor- types, frequency of updates, quality con-
ing, and managing the risks associated trol performed on the data, and the
with the use of the third party? sources of the data in states where pub-
4. Does the banking organization adequately lic real estate sales data are not dis-
document the results of its ongoing moni- closed.
toring and periodic assessments of the Assess modeling techniques and the
third partys compliance with applicable inherent strengths and weaknesses of
regulations and consistency with supervi- different model types as well as how a
sory guidance? model(s) performs for different property
5. Does the banking organization take timely types.
remedial actions when deficiencies are dis- Evaluate the AVM vendors scoring sys-
covered? tem and methodology for the model(s).
6. Does the banking organization ensure that Determine whether the scoring system
the third party selects an appraiser or a provides an appropriate indicator of
person to perform an evaluation who is model reliability by property types and
competent, qualified, independent, and geographic locations.
appropriately licensed or certified for a 4. Does the banking organization have proce-
given assignment? dures for monitoring the use of an
7. Does the banking organization ensure that AVM(s), including an ongoing validation
the third party conveys to the appraiser or process?
the person who performs the evaluation 5. Does the banking organization maintain
that the banking organization is the client? AVM performance criteria for accuracy
and reliability in a given transaction, lend-
BHC Supervision Manual July 2011 ing activity, and geographic location?
Page 26 6. Has the banking organization established a
criteria for determining whether a particu- 10. Does the banking organization have appro-
lar valuation method or tool is appropriate priate controls to ensure that the selected
for a given transaction or lending activity, method or tool produces a reliable esti-
considering associated risks, including mate of market value that supports the
transaction size and purpose, credit qual- banking organizations decision to engage
ity, and leverage tolerance (loan-to-value)? in a transaction?
7. Does the criteria consider when market 11. Do the banking organizations policies and
events or risk factors would preclude the procedures adequately address the extent
use of a particular method or tool? to which
8. Does the banking organization have inter- An inspection or research should be per-
nal controls to preclude value shopping formed to ascertain the propertys actual
when more than one AVM is used for the physical condition, and
same property?
9. Do the banking organizations policies Supplemental information should be
include standards governing the use of obtained to assess the effect of market
multiple methods or tools, if applicable, conditions or other factors on the esti-
for valuing the same property or to support mate of market value.
a particular lending activity?
Appraisal standards for 3310, Subpart G, 4-053

federally related 3331, 225.6167 4-054.4
transactions 3351
Interagency Appraisal and 3-1577

Evalutation Guidelines,
December 2010
The Uniform Standards of

Professional Appraisal
Practice


Page 27
Guidelines for the Review and Classification
of Troubled Real Estate Loans Section 2240.0
These guidelines are designed to in ensure that actual or potential problems in the individual
troubled real estate loans receive consistent commercial real estate projects or transactions
treatment nationwide. The guidelines are not financed by the institution.
intended to be a substitute for the examiners There are several warning signs that real
judgment or for careful analysis of applicable estate markets or projects are experiencing prob-
credit and collateral factors. Use of the word lems that may result in real estate values
institution in these guidelines refers to any decreasing from original appraisals or projec-
lending source within the bank holding com- tions. Adverse economic developments and/or
pany organization, whether the lender is the an overbuilt market can affect a projects eco-
parent company, a bank, thrift, or nonbanking nomic feasibility and may cause a real estate
subsidiary. project and the loan to become troubled. Avail-
able indicators, such as permits forand the
value ofnew construction, absorption rates,
2240.0.1 EXAMINER REVIEW OF employment trends, and vacancy rates, are use-
COMMERCIAL REAL ESTATE ful in evaluating the condition of commercial
LOANS real estate markets. Weaknesses disclosed by
these types of statistics may indicate that a real
2240.0.1.1 Loan Policy and estate market is experiencing difficulties that
Administration Review may result in cash flow problems for individual
real estate projects, declining real estate values,
As part of the analysis of an institutions com-
and ultimately, in troubled commercial real
mercial real estate loan portfolio, examiners
estate loans.
review lending policies, loan administration pro-
Indicators of potential or actual difficulties in
cedures, and credit risk control procedures. The
commercial real estate projects may include:
maintenance of prudent written lending policies,
effective internal systems and controls, and
An excess of similar projects under
thorough loan documentation are essential to
construction.
the institutions management of the lending
Construction delays or other unplanned
function.
adverse events resulting in cost overruns that
The policies governing an institutions real
may require renegotiation of loan terms.
estate lending activities must include prudent
Lack of a sound feasibility study or analysis
underwriting standards that are periodically
that reflects current and reasonably antici-
reviewed by the board of directors and clearly
pated market conditions.
communicated to the institutions management
Changes in concept or plan (for example, a
and lending staff. The institution must also have
condominium project converted to an apart-
credit risk control procedures that include, for
ment project because of unfavorable market
example, prudent internal limits on exposure, an
conditions).
effective credit review and classification pro-
Rent concessions or sales discounts resulting
cess, and a methodology for ensuring that the
in cash flow below the level projected in the
allowance for loan and lease losses is main-
original feasibility study or appraisal.
tained at an adequate level. The complexity and
Concessions on finishing tenant space, mov-
scope of these policies and procedures should
ing expenses, and lease buyouts.
be appropriate to the size of the institution and
Slow leasing or lack of sustained sales activ-
the nature of the institutions activities, and
ity and increasing sales cancellations that may
should be consistent with prudent banking prac-
reduce the projects income potential, result-
tices and relevant regulatory requirements.
ing in protracted repayment or default on the
loan.
2240.0.1.2 Indicators of Troubled Real Delinquent lease payments from major
Estate Markets and Projects, and Related tenants.
Indebtedness Land values that assume future rezoning.
Tax arrearages.
In order to evaluate the collectibility of an insti-
tutions commercial real estate portfolio, exam- As the problems associated with a commer-
iners should be alert for indicators of weakness
in the real estate markets served by the institu- BHC Supervision Manual December 1992
tion. They should also be alert for indicators of Page 1
Guidelines for the Review and Classification of Troubled Real Estate Loans 2240.0
cial real estate project become more pro- resources, and payment record of the borrower;
nounced, problems with the related indebted- the prospects for support from any financially
ness may also arise. Such problems include responsible guarantors; and the nature and
diminished cash flow to service the debt and degree of protection provided by the cash flow
delinquent interest and principal payments. and value of the underlying collateral.2 How-
While some commercial real estate loans ever, as other sources of repayment for a
become troubled because of a general downturn troubled commercial real estate loan become
in the market, others become troubled because inadequate over time, the importance of the
they were originated on an unsound or a liberal collaterals value in the analysis of the loan
basis. Common examples of these types of prob- necessarily increases.
lems include: The appraisal regulations of the federal bank
and thrift regulatory agencies require institu-
Loans with no or minimal borrower equity. tions to obtain appraisals when certain criteria
Loans on speculative undeveloped property are met.3 Management is responsible for review-
where the borrowers only source of repaying each appraisals assumptions and conclu-
ment is the sale of the property. sions for reasonableness. Appraisal assumptions
Loans based on land values that have been should not be based solely on current conditions
driven up by rapid turnover of ownership, but that ignore the stabilized income-producing
without any corresponding improvements to capacity of the property.4 Management should
the property or supportable income projec- adjust any assumptions used by an appraiser in
tions to justify an increase in value. determining value that are overly optimistic or
Additional advances to service an existing pessimistic.
loan that lacks credible support for full repay- An examiner analyzes the collaterals value
ment from reliable sources. as determined by the institutions most recent
Loans to borrowers with no development appraisal (or internal evaluation, as applicable).
plans or noncurrent development plans. An examiner reviews the major facts, assump-
tions, and approaches used by the appraiser
Renewals, extensions and refinancings that
(including any comments made by management
lack credible support for full repayment from
on the value rendered by the appraiser). Under
reliable sources and that do not have a reason-
the circumstances described below, the exam-
able repayment schedule.1 iner may make adjustments to this assessment
of value. This review and any resulting adjust-
ments to value are solely for purposes of an
2240.0.1.3 Examiner Review of examiners analysis and classification of a credit
Individual Loans, Including the Analysis and do not involve actual adjustments to an
of Collateral Value appraisal.
A discounted cash flow analysis is an appro-
The focus of an examiners review of a commer- priate method for estimating the value of
cial real estate loan, including binding commit- income-producing real estate collateral.5 This
ments, is the ability of the loan to be repaid. The analysis should not be based solely on the cur-
principal factors that bear on this analysis are rent performance of the collateral or similar
the income-producing potential of the under-
lying collateral and the borrowers willingness
2. The treatment of guarantees in the classification process
and capacity to repay under the existing loan is discussed in subsection 2240.0.3.
terms from the borrowers other resources if 3. Department of the Treasury, Office of the Comptroller
necessary. In evaluating the overall risk associ- of the Currency, 12 CFR Part 34 (Docket No. 9016); Board
ated with a commercial real estate loan, examin- of Governors of the Federal Reserve System, 12 CFR Parts
208 and 225 (Regulation H and Y; Docket No. R0685);
ers consider a number of factors, including the Federal Deposit Insurance Corporation, 12 CFR 323 (RIN
character, overall financial condition and 3064AB05); Department of the Treasury; Office of Thrift
Supervision, 12 CFR Part 564 (Docket No. 901495).
4. Stabilized income generally is defined as the yearly net
1. As discussed more fully in Manual section 2240.0.2, the
operating income produced by the property at normal occu-
refinancing or renewing of loans to sound borrowers would
pancy and rental rates; it may be adjusted upward or down-
not result in a supervisory classification or criticism unless
ward from todays actual market conditions.
well-defined weaknesses exist that jeopardize repayment of
5. The real estate appraisal regulations of the federal bank
the loans. Consistent with sound banking practices, institu-
and thrift regulatory agencies include a requirement that an
tions should work in an appropriate and constructive manner
appraisal (a) follow a reasonable valuation method that
with borrowers who may be experiencing temporary
addresses the direct sales comparison, income, and cost
difficulties.
approaches to market value; (b) reconcile these approaches;
and (c) explain the elimination of each approach not used. A
BHC Supervision Manual December 1992 discounted cash flow analysis is recognized as a valuation
Page 2 method for the income approach.
properties; rather, it should take into account, on and income projections should not be used.
a discounted basis, the ability of the real estate Direct capitalization of nonstabilized income
to generate income over time based upon rea- flows should also not be used.
sonable and supportable assumptions. Assumptions, when recently made by quali-
When reviewing the reasonableness of the fied appraisers (and, as appropriate, by institu-
facts and assumptions associated with the value tion management) and when consistent with the
of the collateral, examiners may evaluate: discussion above, should be given a reasonable
amount of deference. Examiners should not
Current and projected vacancy and absorption challenge the underlying assumptions, including
rates; discount rates and cap rates used in apprais-
Lease renewal trends and anticipated rents; als, that differ only in a limited way from norms
Volume and trends in past due leases; that would generally be associated with the
Effective rental rates or sale prices (taking property under review. The estimated value of
into account all concessions); the underlying collateral may be adjusted for
Net operating income of the property as com- credit analysis purposes when the examiner can
pared with budget projections; and establish that any underlying facts or assump-
Discount rates and direct capitalization tions are inappropriate and can support alterna-
(cap) rates. tive assumptions.
The capacity of a property to generate cash

flow to service a loan is evaluated based upon 2240.0.2 CLASSIFICATION
rents (or sales), expenses, and rates of occu- GUIDELINES
pancy that are reasonably estimated to be
achieved over time. The determination of the As with other types of loans, commercial real
level of stabilized occupancy and rental rates estate loans that are adequately protected by the
should be based upon an analysis of current and current sound worth and debt service capacity
reasonably expected market conditions, taking of the borrower, guarantor, or the underlying
into consideration historical levels when appro- collateral generally are not classified. Similarly,
priate. The analysis of collateral values should loans to sound borrowers that are refinanced or
not be based upon a simple projection of current renewed in accordance with prudent underwrit-
levels of net operating income if markets are ing standards, including loans to creditworthy
depressed or reflect speculative pressures but commercial or residential real estate developers,
can be expected over a reasonable period of should not be classified or criticized unless well-
time to return to normal (stabilized) conditions. defined weaknesses exist that jeopardize repay-
Judgment is involved in determining the time ment. An institution will not be criticized for
that it will take for a property to achieve stabi- continuing to carry loans having weaknesses
lized occupancy and rental rates. that result in classification or criticism as long
Examiners do not make adjustments to ap- as the institution has a well-conceived and effec-
praisal assumptions for credit analysis purposes tive workout plan for such borrowers, and effec-
based on worst case scenarios that are unlikely tive internal controls to manage the level of
to occur. For example, an examiner would not these loans.
necessarily assume that a building will become In evaluating commercial real estate credits
vacant just because an existing tenant who is for possible classification, examiners apply stan-
renting at a rate above todays market rate may dard classification definitions. In determining
vacate the property when the current lease the appropriate classification, consideration
expires. On the other hand, an adjustment to should be given to all important information on
value may be appropriate for credit analysis repayment prospects, including information on
purposes when the valuation assumes renewal at the borrowers creditworthiness, the value of,
the above-market rate, unless that rate is a rea- and cash flow provided by, all collateral support-
sonable estimate of the expected market rate at ing the loan, and any support provided by finan-
the time of renewal. cially responsible guarantors.
When estimating the value of income- The loans record of performance to date is
producing real estate, discount rates and cap important and must be taken into consideration.
rates should reflect reasonable expectations As a general principle, a performing commer-
about the rate of return that investors require cial real estate loan should not automatically be
under normal, orderly and sustainable market
conditions. Exaggerated, imprudent, or unsus- BHC Supervision Manual December 1992
tainably high or low discount rates, cap rates, Page 3
classified or charged-off solely because the should be classified doubtful when the poten-
value of the underlying collateral has declined tial for full loss may be mitigated by the out-
to an amount that is less than the loan balance. comes of certain pending events, or when loss is
However, it would be appropriate to classify a expected but the amount of the loss cannot be
performing loan when well-defined weaknesses reasonably determined.
exist that jeopardize repayment, such as the lack If warranted by the underlying circumstances,
of credible support for full repayment from reli- an examiner may use a doubtful classifica-
able sources. tion on the entire loan balance. However, this
These principles hold for individual credits, would occur infrequently.
even if portions or segments of the industry to
which the borrower belongs are experiencing
financial difficulties. The evaluation of each 2240.0.2.2 Guidelines for Classifying
credit should be based upon the fundamental Partially Charged-off Loans
characteristics affecting the collectibility of the
particular credit. The problems broadly associ- Based upon consideration of all relevant factors,
ated with some sectors or segments of an indus- an evaluation may indicate that a credit has
try, such as certain commercial real estate mar- well-defined weaknesses that jeopardize collec-
kets, should not lead to overly pessimistic tion in full, but that a portion of the loan may be
assessments of particular credits that are not reasonably assured of collection. When an insti-
affected by the problems of the troubled sectors. tution has taken a charge-off in an amount suffi-
cient that the remaining recorded balance of the
loan (a) is being serviced (based upon reliable
2240.0.2.1 Classification of Troubled sources) and (b) is reasonably assured of collec-
Project-Dependent Commercial Real tion, classification of the remaining recorded
Estate Loans6 balance may not be appropriate. Classification
would be appropriate when well-defined weak-
The following guidelines for classifying a trou- nesses continue to be present in the remaining
bled commercial real estate loan apply when the recorded balance. In such cases, the remaining
repayment of the debt will be provided solely by recorded balance would generally be classified
the underlying real estate collateral, and there no more severely than substandard.
are no other available and reliable sources of A more severe classification than substan-
repayment. The guidelines are not intended to dard for the remaining recorded balance would
address loans that must be treated as Other be appropriate if the loss exposure cannot be
Real Estate Owned for bank and BHC report- reasonably determined, e.g., where significant
ing purposes. risk exposures are perceived, such as might be
As a general principle, for a troubled project- the case for bankruptcy situations or for loans
dependent commercial real estate loan, any por- collateralized by properties subject to environ-
tion of the loan balance that exceeds the amount mental hazards. In addition, classification of the
that is adequately secured by the value of the remaining recorded balance would be appropri-
collateral, and that can clearly be identified as ate when sources of repayment are considered
uncollectible, should be classified loss.7 The unreliable.
portion of the loan balance that is adequately
secured by the value of the collateral should
generally be classified no worse than substan- 2240.0.2.3 Guidelines for Classifying
dard. The amount of the loan balance in excess Formally Restructured Loans
of the value of the collateral, or portions thereof,
The classification treatment previously dis-
6. The discussion in this section is not intended to address cussed for a partially charged off loan would
loans that must be treated as other real estate owned for also generally be appropriate for a formally
bank regulatory reporting purposes or real estate owned for
thrift regulatory reporting purposes. Guidance on these assets
restructured loan when partial charge-offs have
is presented in supervisory and reporting guidance of the been taken. For a formally restructured loan, the
agencies. focus of the examiners analysis is on the ability
7. For purposes of this discussion, the value of the collat- of the borrower to repay the loan in accordance
eral is the value used by the examiner for credit analysis
purposes, as discussed in a previous section of this policy
with its modified terms. Classification of a for-
statement. mally restructured loan would be appropriate, if,
after the restructuring, well-defined weaknesses
BHC Supervision Manual December 1992 exist that jeopardize the orderly repayment of
Page 4 the loan in accordance with reasonable modified
terms.8 Troubled commercial real estate loans information on the guarantors financial condi-
whose terms have been restructured should tion, income, liquidity, cash flow, contingent
be identified in the institutions internal credit liabilities, and other relevant factors (including
review system, and closely monitored by credit ratings, when available) to demonstrate
management. the guarantors financial capacity to fulfill the
obligation. Also, it is important to consider the
number and amount of guarantees currently
2240.0.3 TREATMENT OF extended by a guarantor, in order to determine
GUARANTEES IN THE that the guarantor has the financial capacity to
CLASSIFICATION PROCESS fulfill the contingent claims that exist.
Initially, the original source of repayment and
the borrowers intent and ability to fulfill the
2240.0.3.2 Considerations Relating to a
obligation without reliance on third party guar-
Guarantors Willingness to Repay
antors will be the primary basis for the review
and classification of assets.9 The federal bank Examiners normally rely on their analysis of the
and thrift regulatory agencies will, however, guarantors financial strength and assume a will-
consider the support provided by guarantees in ingness to perform unless there is evidence to
the determination of the appropriate classifica- the contrary. This assumption may be modified
tion treatment for troubled loans. The presence based on the track record of the guarantor,
of a guarantee from a financially responsible including payments made to date on the asset
guarantor, as described below, may be suffi- under review or other obligations.
cient to preclude classification or reduce the Examiners give due consideration to those
severity of classification. guarantors that have demonstrated their ability
For purposes of this discussion, a guarantee and willingness to fulfill previous obligations in
from a financially responsible guarantor has their evaluation of current guarantees on similar
the following attributes: assets. An important consideration will be
whether previously required performance under
The guarantor must have both the financial guarantees was voluntary or the result of legal
capacity and willingness to provide support or other actions by the lender to enforce the
for the credit; guarantee. However, examiners give limited cre-
The nature of the guarantee is such that it can dence, if any, to guarantees from obligors who
provide support for repayment of the indebt- have reneged on obligations in the past, unless
edness, in whole or in part, during the remain- there is clear evidence that the guarantor has the
ing loan term; and10 ability and intent to honor the specific guarantee
The guarantee should be legally enforceable. obligation under review.
Examiners also consider the economic incen-
The above characteristics generally indicate tives for performance from guarantors:
that a guarantee may improve the prospects for
repayment of the debt obligation. Who have already partially performed under
the guarantee or who have other significant
2240.0.3.1 Considerations Relating to a investments in the project;
Guarantors Financial Capacity Whose other sound projects are cross-
collateralized or otherwise intertwined with
The lending institution must have sufficient the credit; or
Where the guarantees are collateralized by
readily marketable assets that are under the
8. An example of a restructured commercial real estate
loan that does not have reasonable modified terms would be a
control of a third party.
cash flow mortgage which requires interest payments only
when the underlying collateral generates cash flow but pro-
vides no substantive benefits to the lending institution.
9. Some loans are originated based primarily upon the
2240.0.3.3 Other Considerations as to the
financial strength of the guarantor, who is, in substance, the Treatment of Guarantees in the
primary source of repayment. In such circumstances, examin- Classification Process
ers generally assess the collectibility of the loan based upon
the guarantors ability to repay the loan.
10. Some guarantees may only provide for support for
In general, only guarantees that are legally
certain phases of a real estate project. It would not be appro-
priate to rely upon these guarantees to support a troubled loan BHC Supervision Manual December 1992
after the completion of these phases. Page 5
enforceable will be relied upon. However, all such, these limited guarantees would not be
legally enforceable guarantees may not be relied upon to support a troubled loan after the
acceptable. In addition to the guarantors finan- completion of those phases.
cial capacity and willingness to perform, it is Examiners also consider the institutions
expected that the guarantee will not be subject intent to enforce the guarantee and whether
to significant delays in collection, or undue com- there are valid reasons to preclude an institution
plexities or uncertainties about the guarantee. from pursuing the guarantee. A history of timely
The nature of the guarantee is also considered enforcement and successful collection of the full
by examiners. For example, some guarantees for amount of guarantees will be a positive consid-
real estate projects only pertain to the develop- eration in the classification process.
ment and construction phases of the project. As

Page 6
Retail-Credit Classification
Section 2241.0
During the early 1980s, open-end credit prima- call report instructions, banks and their con-
rily consisted of credit card accounts with small sumer finance subsidiaries are required to use
lines of credit to the most creditworthy borrow- the contractual method, which ages loans based
ers. Currently, open-end credit consists of much on the status of contractual payments. BHCs, in
larger lines of credit that have been extended to preparing their financial statements, are permit-
diverse borrowers with a variety of risk profiles. ted to use the range of options available under
In 1980, the Federal Financial Institutions GAAP. This, in effect, allows uninsured, non-
Examination Council (FFIEC) (the Federal bank consumer finance subsidiaries of BHCs to
Reserve Board, Federal Deposit Insurance Cor- employ the recency method, which ages loans
poration, Office of the Comptroller of the Cur- according to the date of the most recent pay-
rency, and, in 1987, the Federal Home Loan ment, regardless of the contractual terms of the
Bank Board (now the Office of Thrift Supervi- loan.
sion)) adopted a uniform policy for the classifi- In general, the contractual method provides a
cation of installment credit based on delin- more accurate reflection of loan performance
quency status. The 1980 policy also provided and, therefore, is the preferred methodology,
for different charge-off time frames for open- especially from the standpoint of financial-
end and closed-end credit. statement transparency and public disclosure.
Because open-ended borrowing practices had Examiners should encourage BHCs and their
changed and institutional practices for charging consumer finance subsidiaries to use the con-
off open-end accounts based on their past-due tractual method. However, BHCs should not
status were inconsistent, the agencies (the FRB, change their aging methodology from contrac-
FDIC, OTS, and OCC) undertook a review of tual to recency without the prior concurrence of
the 1980 FFIEC classification policy in concert the Federal Reserve. A BHC subsidiary may not
with a review of all written policies, as man- change its methodology if the intent or effect of
dated by section 303(a) of the Riegle Commu- such a change is to mask asset quality or finan-
nity Development and Regulatory Improvement cial weaknesses. Moreover, in the event that
Act of 1994 (RCDRIA). In February 1999, an consumer receivables are transferred from a
updated policy was issued, effective for use on bank to its BHC or the BHCs nonbanking
FFIEC bank call reports beginning December subsidiaries, the BHC or the nonbanking subsid-
31, 2000. This new policy was revised again iaries should continue to age the receivables
and reissued in June 2000, with the same effec- according to the contractual method.
tive date. (The June 2000 policy supersedes When a BHC uses the recency method, it
both the 1980 policy and the updated February should have adequate controls in place to accu-
1999 policy.) The June policy provides supervi- rately track the performance of loans within the
sory guidance for residential and home equity retail portfolio and to demonstrate sound and
loans; fraudulent loans; loans to deceased per- compelling business reasons for the use of the
sons; loans to borrowers in bankruptcy; treat- recency method. Examiners should see section
ment of partial payments involving past-due 3100.0 for further guidance on the review of
loans; and re-aging, deferrals, renewals, or consumer finance operations.
rewrites of open-end and closed-end credit. The
agencies are to use this expanded supervisory
guidance when applying the uniform classifica- 2241.0.1 UNIFORM RETAIL-CREDIT
tions to retail-credit loans extended by deposi- CLASSIFICATION AND
tory institutions. See SR-00-8. ACCOUNT-MANAGEMENT POLICY
While the terms of the revised policy apply
only to federally insured depository institutions, The uniform retail-credit classification and
the Federal Reserve believes the guidance is account-management policy issued by the
broadly applicable to bank holding companies FFIEC (and approved by the Federal Reserve
(BHCs) and their nonbank lending subsidiaries. Board) is reproduced below. The Board has
Accordingly, examiners should apply the clarified certain provisions of this policy. In this
revised policy, as appropriate, in the inspection text, the Boards revisions are in brackets. Sec-
of consumer finance subsidiaries of BHCs. tion numbers have also been added to the sub-
When reviewing consumer finance subsidi- titles of the text.
aries of banking organizations, examiners
should consider the methodology used for aging BHC Supervision Manual December 2000
retail loans. In accordance with the FFIEC bank Page 1
Retail-Credit Classification 2241.0
The Uniform Retail-Credit Classification and charging off the entire loan balance, loans
Account-Management Policy1 establishes stan- with nonreal estate collateral may be writ-
dards for the classification and treatment of ten down to the value of the collateral, less
retail credit in financial institutions. Retail credit cost to sell, if repossession of collateral is
consists of open- and closed-end credit extended assured and in process.
to individuals for household, family, and other 3. One- to four-family residential real estate
personal expenditures, and includes consumer loans and home equity loans that are past due
loans and credit cards. For purposes of this 90 days or more with loan-to-value ratios
policy, retail credit also includes loans to indi- greater than 60 percent should be classified
viduals secured by their personal residence, substandard. Properly secured residential real
including first mortgage, home equity, and estate loans with loan-to-value ratios equal to
home-improvement loans. Because a retail- or less than 60 percent are generally not
credit portfolio generally consists of a large classified based solely on delinquency status.
number of relatively small-balance loans, evalu- Home equity loans to the same borrower at
ating the quality of the retail-credit portfolio on the same institution as the senior mortgage
a loan-by-loan basis is inefficient and burden- loan with a combined loan-to-value ratio
some for the institution being examined and for equal to or less than 60 percent need not be
examiners. classified. However, home equity loans
Actual credit losses on individual retail cred- where the institution does not hold the senior
its should be recorded when the institution mortgage, that are past due 90 days or more
becomes aware of the loss, but in no case should should be classified substandard, even if the
the charge-off exceed the time frames stated in loan-to-value ratio is equal to, or less than,
this policy. This policy does not preclude an 60 percent.
institution from adopting a more conservative For open- and closed-end loans secured by
internal policy. Based on collection experience, residential real estate, a current assessment
when a portfolios history reflects high losses of value should be made no later than 180
and low recoveries, more conservative stan- days past due. Any outstanding loan balance
dards are appropriate and necessary. in excess of the value of the property, less
The quality of retail credit is best indicated by cost to sell, should be classified loss and
the repayment performance of individual bor- charged off.
rowers. Therefore, in general, retail credit
should be classified based on the following 4. Loans in bankruptcy should be classified loss
criteria: and charged off within 60 days of receipt of
notification of filing from the bankruptcy
1. Open- and closed-end retail loans past due court or within the time frames specified in
90 cumulative days from the contractual due this classification policy, whichever is
date should be classified substandard. shorter, unless the institution can clearly
2. Closed-end retail loans that become past due demonstrate and document that repayment is
120 cumulative days and open-end retail likely to occur. Loans with collateral may be
loans that become past due 180 cumulative written down to the value of the collateral,
days from the contractual due date should be less cost to sell. Any loan balance not
classified loss and charged off.2 In lieu of charged off should be classified substandard
until the borrower re-establishes the ability
1. [For the Federal Reserves depository institution classi- and willingness to repay for a period of at
fication guidelines, see section 2060.1, Classification of
Credits, in the Commercial Bank Examination Manual.] least six months.
2. For operational purposes, whenever a charge-off is nec- 5. Fraudulent loans should be classified loss
essary under this policy, it should be taken no later than the and charged off no later than 90 days of
end of the month in which the applicable time period elapses.
Any full payment received after the 120- or 180-day charge- discovery or within the time frames adopted
off threshold, but before month-end charge-off, may be con- in this classification policy, whichever is
sidered in determining whether the charge-off remains shorter.
appropriate.
OTS regulation 12 CFR 560.160(b) allows savings institu- 6. Loans of deceased persons should be classi-
tions to establish adequate (specific) valuation allowances for fied loss and charged off when the loss is
assets classified loss in lieu of charge-offs. determined or within the time frames adopted
Open-end retail accounts that are placed on a fixed repay- in this classification policy, whichever is
ment schedule should follow the charge-off time frame for
closed-end loans. shorter.

Page 2
2241.0.1.1 Other Considerations for temporary financial difficulties, such as loss of

Classification job, medical emergency, or change in family
circumstances like loss of a family member. A
If an institution can clearly document that a permissive policy on re-agings, extensions,
past-due loan is well secured and in the process deferrals, renewals, or rewrites can cloud the
of collection, such that collection will occur true performance and delinquency status of the
regardless of delinquency status, then the loan portfolio. However, prudent use is acceptable
need not be classified. A well-secured loan is when it is based on a renewed willingness and
collateralized by a perfected security interest in, ability to repay the loan, and when it is struc-
or pledges of, real or personal property, includ- tured and controlled in accordance with sound
ing securities with an estimable value, less cost internal policies.
to sell, sufficient to recover the recorded invest- Management should ensure that comprehen-
ment in the loan, as well as a reasonable return sive and effective risk management and internal
on that amount. In the process of collection controls are established and maintained so that
means that either a collection effort or legal re-ages, extensions, deferrals, renewals, and
action is proceeding and is reasonably expected rewrites can be adequately controlled and moni-
to result in recovery of the loan balance or its tored by management and verified by examin-
restoration to a current status, generally within ers. The decision to re-age, extend, defer, renew,
the next 90 days. or rewrite a loan, like any other modification of
contractual terms, should be supported in the
institutions management information systems.
2241.0.1.2 Partial Payments on Open- Adequate management information systems
and Closed-End Credit usually identify and document any loan that is
re-aged, extended, deferred, renewed, or rewrit-
Institutions should use one of two methods to ten, including the number of times such action
recognize partial payments. A payment equiva- has been taken. Documentation normally shows
lent to 90 percent or more of the contractual that the institutions personnel communicated
payment may be considered a full payment in with the borrower, the borrower agreed to pay
computing past-due status. Alternatively, the the loan in full, and the borrower has the ability
institution may aggregate payments and give to repay the loan. To be effective, management
credit for any partial payment received. For information systems should also monitor and
example, if a regular installment payment is track the volume and performance of loans that
$300 and the borrower makes payments of only have been re-aged, extended, deferred, renewed,
$150 per month for a six-month period, [the or rewritten and/or placed in a workout program.
institution could aggregate the payments
received ($150 six payments, or $900). It
could then give credit for three full months 2241.0.1.4 Open-End Accounts
($300 x three payments) and thus treat the loan
as] three full months past due. An institution Institutions that re-age open-end accounts
may use either or both methods in its portfolio, should establish a reasonable written policy and
but may not use both methods simultaneously adhere to it. To be considered for re-aging, an
with a single loan. account should exhibit the following:
1. The borrower has demonstrated a renewed

2241.0.1.3 Re-aging, Extensions, willingness and ability to repay the loan.
Deferrals, Renewals, and Rewrites
Re-aging of open-end accounts, and extensions, time of the extension and not added to the balance of the loan.
deferrals, renewals, and rewrites of closed-end Deferral: Deferring a contractually due payment on a closed-
loans3 can be used to help borrowers overcome end loan without affecting the other terms, including maturity,
(or the due date for subsequently scheduled payments,) of the
loan. The account is shown current upon granting the deferral.
Renewal: Underwriting a matured, closed-end loan generally
3. These terms are defined as follows. Re-age: Returning a
at its outstanding principal amount and on similar terms.
delinquent, open-end account to current status without collect-
Rewrite: Underwriting an existing loan by significantly chang-
ing (at the time of aging) the total amount of principal,
ing its terms, including payment amounts, interest rates, amor-
interest, and fees that are contractually due. Extension:
tization schedules, or its final maturity.
Extending monthly payments on a closed-end loan and rolling
back the maturity by the number of months extended. The
account is shown current upon granting the extension. If BHC Supervision Manual December 2000
extension fees are assessed, they should be collected at the Page 3
2. The account has existed for at least nine Management should ensure that comprehen-
months. sive and effective risk management, reporting,
3. The borrower has made at least three con- and internal controls are established and main-
secutive minimum monthly payments or the tained to support the collection process and to
equivalent cumulative amount. Funds may ensure timely recognition of losses. To be effec-
not be advanced by the institution for this tive, management information systems should
purpose. track the subsequent principal reductions and
charge-off history of loans that have been
Open-end accounts should not be re-aged granted an extension, deferral, renewal, or
more than once within any twelve-month period rewrite.
and no more than twice within any five-year
period. Institutions may adopt a more conserva-
tive re-aging standard; for example, some insti- 2241.0.1.6 Examination Considerations
tutions allow only one re-aging in the lifetime of
an open-end account. Additionally, an over- Examiners should ensure that institutions adhere
limit account may be re-aged at its outstanding to this policy. Nevertheless, there may be
balance (including the over-limit balance, inter- instances that warrant exceptions to the general
est, and fees), provided that no new credit is classification policy. Loans need not be classi-
extended to the borrower until the balance falls fied if the institution can document clearly that
below the predelinquency credit limit. repayment will occur irrespective of delin-
Institutions may re-age an account after it quency status. Examples might include loans
enters a workout program, including internal well secured by marketable collateral and in the
and third-party debt-counseling services, but process of collection, loans for which claims are
only after receipt of at least three consecutive filed against solvent estates, and loans supported
minimum monthly payments or the equivalent by valid insurance claims.
cumulative amount, as agreed upon under the The Uniform Retail-Credit Classification and
workout or debt-management program. Account-Management Policy does not preclude
Re-aging for workout purposes is limited to examiners from classifying individual retail-
once in a five-year period and is in addition to credit loans that exhibit signs of credit weakness
the once-in-twelve-months/twice-in-five-years regardless of delinquency status. Similarly, an
limitation described above. To be effective, examiner may also classify retail portfolios, or
management information systems should track segments thereof, where underwriting standards
the principal reductions and charge-off history are weak and present unreasonable credit risk,
of loans in workout programs by type of and may criticize account-management prac-
program. tices that are deficient.
In addition to reviewing loan classifications,
the examiner should ensure that the institutions
2241.0.1.5 Closed-End Loans allowance for loan and lease losses provides
adequate coverage for probable losses inherent
Institutions should adopt and adhere to explicit in the portfolio. Sound risk- and account-
standards that control the use of extensions, management systems, including a prudent retail-
deferrals, renewals, and rewrites of closed-end credit lending policy, measures to ensure and
loans. The standards should exhibit the monitor adherence to stated policy, and detailed
following: operating procedures, should also be imple-
mented. Internal controls should be in place to
1. The borrower should show a renewed will- ensure that the policy is followed. Institutions
ingness and ability to repay the loan. that lack sound policies or fail to implement or
2. The standards should limit the number and effectively adhere to established policies will be
frequency of extensions, deferrals, renewals, subject to criticism.
and rewrites.
3. Additional advances to finance unpaid inter- Issued by the Federal Financial Institutions
est and fees should be prohibited. Examination Council on June 6, 2000.

Page 4
Domestic and Other Reports to Be Submitted
to the Federal Reserve Section 2250.0
In carrying out its regulatory and supervisory tory report, or who cause the failure to file or a
responsibilities, the Board requires the submis- late filing of a required regulatory report, may
sion of various reports from bank holding com- be assessed a civil money penalty of up to
panies. These reports are an integral part of the $25,000 per day.
Boards supervision, monitoring, and surveil-
lance functions. Information from these reports
is used to evaluate the performance of bank 2250.0.2 APPROVAL OF DIRECTORS
holding companies, appraise their financial con- AND SENIOR OFFICERS OF
dition, and determine their compliance with DEPOSITORY INSTITUTIONS
applicable laws and regulations. The examiner
must review the reports (submitted to the Fed- The Federal Deposit Insurance Act (12 U.S.C.
eral Reserve System) for accuracy and timeli- 1811) was amended to require each insured
ness and insist on their being amended if mate- depository institution and depository institution
rial errors are found. If inaccurate data are holding company to give 30 days prior notifica-
submitted, the resulting ratios could conceal tion to the federal banking authority of (1) the
deteriorating trends in the companys financial proposed addition of any individual to its board
condition and performance. Bank holding com- of directors or (2) the employment of any indi-
panies should maintain sufficient internal sys- vidual as a senior executive officer. This require-
tems and procedures to ensure that reporting is ment applies to the following institutions:
accomplished according to appropriate regula-
tory requirements. Clear, concise, and orderly 1. institutions that have been chartered less than
workpapers should support the data presented two years
and provide a logical tie between report data 2. institutions that have undergone a change in
and the financial records. For detailed current control within the preceding two years
information on who must submit reports and 3. institutions that are in a troubled condition or
what the reporting requirements are, see whose capital is below minimum standards
the Boards public site on the Internet at the
following address: www.federalreserve.gov/ The agencies have the authority to issue a notice
boarddocs/reportforms. of disapproval to stop the appointment or
employment of an individual if they feel that
appointing or employing the person would not
2250.0.1 PENALTIES FOR ERRORS IN be in the interests of the public, taking into
REPORTS account that individuals competence, experi-
ence, character, and integrity.
Section 8 of the Bank Holding Company Act
(the act) was amended to provide for the assess-
ment of civil money penalties for the submis- 2250.0.3 INSPECTION OBJECTIVES
sion of late, false, or misleading reports filed by
bank holding companies that are required by the 1. To determine that required reports are being
act and Regulation Y and for the failure to file filed on time.
the required regulatory reports. Financial institu- 2. To determine that the contents of reports are
tions that have adequate procedures to avoid accurate and complete.
any inadvertent errors but that unintentionally 3. To recommend corrective and, if needed, for-
submit incorrect information or are minimally mal enforcement action when official report-
late in publishing or transmitting the reports can ing practices, policies, or procedures are
be fined up to $2,000 per day. The financial deficient.
institution has the burden of proving that the
error was inadvertent. If the error was not inad-
vertent, a penalty of up to $20,000 per day can 2250.0.4 INSPECTION PROCEDURES
be assessed. If the submission was done in a
knowing manner or with reckless disregard for 1. A bank holding companys historical record
the law, a fine of up to $1 million or 1 percent of concerning the timely submission of reports
the institutions assets can be assessed for each should be ascertained by reviewing relevant
day of the violation. Institution-affiliated parties
who participate in any manner in the filing of an BHC Supervision Manual June 1999
institutions false or misleading required regula- Page 1
Domestic and Other Reports to Be Submitted to the Federal Reserve 2250.0
Reserve Bank files. The examiner should 3. At the conclusion of the review process, the
determine, from documentation in the files, examiner should discuss the following with
which reports should have been filed because management, when applicable:
of the passage of time or the occurrence of an a. inaccuracies found in reports and the need
event. If a report is delinquent, the bank for submission of amended pages or
holding company should be instructed to pre- reports
pare and submit the report expeditiously. b. violations of law, rulings, or regulations
2. Copies of regulatory reports filed since the c. recommended corrective action when
prior inspection should be reviewed and policies or procedures have contributed to
compared with company records on a ran- deficiencies noted in the reports or the
dom, line-by-line basis, using a significance untimely submission of report(s)
test. In some cases, the review will necessar- 4. Details concerning the late or inaccurate
ily extend to supporting schedules and work- preparation of reports should be listed in the
papers that substantiate the data reflected in inspection report on the Other Supervisory
the reports. If the initial reports reviewed are Issues report page. If the matter is considered
found to be substantially correct, then the significant, it should be noted on the Examin-
scope of subsequent reviews may be cur- ers Comments and Matters Requiring Spe-
tailed. If the reports are found to be incorrect, cial Board Attention report page, as well.
the overall review procedures should be When the exceptions are considered minor
intensified. When an error or misstatement is and have been discussed with management
considered significant, the matter should be and corrected, it will suffice to state this on
brought to managements attention and the the Other Supervisory Issues workpaper sup-
bank holding company should be required to porting page.
submit adjusted data. Improper methods used 5. When it is determined that false, misleading,
in preparing reports should be called to man- or inaccurate information is contained in
agements attention. The examiner should financial statements or reports, consider
explain all changes carefully and assist bank whether formal enforcement action is needed
holding company personnel in whatever way to ensure that the offending bank holding
possible to ensure proper reporting in future company, financial institution, or other entity
reports. under the holding company structure will
correct the statements and reports.

Page 2
Domestic and Other Reports to Be Submitted to the Federal Reserve 2250.0
Submission of reports concerning 1844(c)

compliance with the act, or
regulations or orders under it
Annual reports 1844(c) 225.5(b)
Report on intercompany 1844(c) 225.5(b)

transactions
Reports emanating from 1844(c) 225.5(b)

inspection report
recommendations
Reports emanating from cease- 1818(b), (c)

and-desist orders
Civil money penalties for errors 324

on bank call and BHC Reports 1847

Page 3
Venture Capital
Section 2260.0
2260.0.1 INTRODUCTION those next in generation to existing ones, that
have a wide market appeal and the potential for
Venture capital activities are usually conducted strong growth. Such products are preferred
through one or more of the following types of because of their shorter development time and
entities: Small Business Investment Companies possible faster realization of profits. One of the
(SBIC); Minority Enterprise Small Business ways a venture capital company makes money
Investment Companies (MESBIC); Non- is by purchasing the common stock of an emerg-
licensed Venture Capital Companies; and Part- ing company and selling it when the company
nerships or Venture Capital Funds. SBICs and has grown and the stock has appreciated in
MESBICs are licensed and regulated by the value. It also generates earnings by making con-
Small Business Administration (SBA); the other vertible preferred stock investments and by
types are not. Both SBICs and MESBICs are lending money in the form of subordinated de-
limited by regulation to investing in and lending bentures and term loans. Usually lending agree-
to small businesses; whereas, non-licensed ven- ments contain provisions which enable a ven-
ture capital companies and partnerships have ture capital company to acquire shares or
greater latitude. The activities of MESBICs increase existing holdings through the exercise
(section 103d companies) are specifically lim- of warrants or stock options at a later date.
ited to small firms owned by socially or eco- Although in most cases some equity interest is
nomically disadvantaged persons. Most banks taken, venture capital companies, generally, do
and bank holding companies engage in venture not acquire a controlling interest in a business
capital activities through an SBIC because of its they finance.
broad ability to take equity positions in other Once financing commences, venture capital
companies. SBICs are permitted to own up to companies typically take an active role in the
49.9 percent of the voting shares of a company. management of the companies. They usually
By contrast, a non-licensed venture capital com- receive representation on the companys board
pany that is a subsidiary of a bank holding of directors, which enables them to review bud-
company may not own more than 4.9 percent of gets and assist in structuring the companys
the voting shares of a business. To escape from long-range strategic plan. Guiding a company
this limitation some bank holding companies through its developing stages is considered
have formed partnerships or venture capital essential for the achievement of equity apprecia-
funds. However, a bank holding company can tion and realization of the high returns sought
only participate as a limited partner with an by venture capital companies.
ownership interest not to exceed 24.9 percent.
Limited partnerships are preferred by those bank
holding companies who do not possess the 2260.0.2 LOANS AND INVESTMENTS
expertise for this type of activity but seek the
potential opportunity for high returns. Investments and lending philosophy may differ
Through the use of private capital and, in among venture capital companies. Some choose
some cases, borrowed money, venture capital to be equity-oriented; that is, they look for
companies invest in and lend to new and grow- higher returns on investments through capital
ing business enterprises. They prefer to invest in appreciation, while others favor lending in the
and lend to companies that exhibit strong man- form of loans or convertible debt securities
agement talent and clearly defined strategies. which provide cash flow to fund operations and
Many of the companies are yet unknown to the service debt. However, most companies will
public. Their products either have been intro- strive for a diversified portfolio in terms of the
duced to the market or are due to arrive in the type of investment and industry mix. The range
next few years. Venture capital companies do of financing possibilities associated with lend-
not favor pioneering research. Instead, they are ing and/or investing is as follows:
interested in financing innovative products, i.e.,

Page 1
Venture Capital 2260.0
First Step Financing Funds needed for seed capital to help develop an idea.
Start-up Financing Funds needed to cover the cost of preparing a business plan,
conducting market studies and opening a business.
First Stage Financing Funds needed to start manufacturing and selling the product(s).
Second Stage Financing Funds needed for working capital to expand production and build
inventories. Company is operating but not yet profitable.
Third Stage Financing Funds needed to improve the product, build working capital and
expand marketing and production facilities. At this point, the com-
pany should be generating a profit.
Fourth Stage Financing Additional working capital funds needed prior to initial public
offering which may be as much as a year later.
In addition to the above, venture capital com- 2260.0.3 FUNDING

panies will consider financing leveraged buy-
outs and turnaround situations. A venture capital company may use private
The degree of risk assumed varies according capital, leverage, or a combination of both to
to the stage of financing, i.e., lower stages con- fund its portfolio of loans and investments. Ven-
tain greater risk because of the requirement for ture capital companies obtain private capital
longer-term investment discipline than higher from their parent organization, either banks or
stages. Investments in start-up companies typi- bank holding companies. Generally, private cap-
cally take five to seven years or more to mature. ital is used to fund high-risk, lower-stage invest-
Because of the high risk involved, most bank- ments, although some companies may diversify
affiliated venture capital companies will avoid their portfolio and deploy a portion of capital in
the earlier or lower stages of financing. Newly loans, debentures and preferred stock. Leverage
established venture capital companies and espe- may be derived from internal and external bor-
cially those that use leverage tend to focus on rowings. SBICs that are banking subsidiaries
the intermediate and latter stages of financing. may receive funding in the form of loans from
These stages are represented primarily by their parent bank. For those companies that are a
debenture financing, preferred stock invest- subsidiary of a bank holding company, internal
ments, and straight term loans. In structuring a funding may be provided by the bank holding
portfolio, a venture capitalist should consider company from internal cash flow or its external
both liquidity and capital protection. The ideal borrowing sources. A bank holding company
financing mix might entail a limited amount of might borrow from its available bank lines or
money invested in common stock with the other borrowing sources to fund venture capital
remainder distributed between debentures, operations. There is, however, one exception;
loans, and preferred stock. These instruments that is, the use of commercial paper proceeds to
will provide income to cover operating expenses fund venture capital investments and loans does
and service debt as well as give some protection not appear to qualify under the exemptive provi-
should the business start to decline. Limited sions of section 3(a)(3) of the Securities Act of
holdings of common stock give the company 1933. SBICs and MESBICs can obtain exter-
the opportunity to enhance earnings through nal financing from the U.S. government and the
capital gains without adversely effecting cash private sector, while, non-licensed venture capi-
flow. Regardless of the type of financing tal companies are limited to only private sources
offered, the ability to exist from an investment for their external financing. Under current SBA
or loan through either the issuance of public regulations, an SBIC can borrow up to $35 mil-
stock or a cash buyout by a larger company is lion from the federal financing bank with no
the goal of a venture capital company. limit as to the aggregate amount of private debt.
Because of the investment restrictions on
BHC Supervision Manual December 1992 MESBICs, the SBA allows them to incur
Page 2 higher leverage. MESBICs are permitted to
borrow up to four times their capital base and includes a separate category for net unrealized
issue preferred stock to the SBA up to two times appreciation (depreciation) on equity interests.
their capital base. MESBICs also have no limit Net unrealized appreciation (depreciation) on
on the aggregate amount of private debt. All equity interests represents the gross amount
government borrowings ings are through the reported under loans and investments less an
federal financing bank and carry the guarantee appropriate provision for taxes. Since unreal-
of the SBA. Such borrowings are classified as ized appreciation (depreciation) on equity inter-
senior debt. ests represents future profits (losses) they are
measured separately in the equity account rather
than in earnings.
2260.0.4 PROFITABILITY There are no industry norms with which to
measure capital adequacy. What is known, how-
Earnings of venture capital companies can fluc- ever, is that the SBA requires a minimum capital
tuate widely depending on the nature of their investment of $1,000,000 to establish an SBIC.
activities. Those companies that blend their Moreover, regulations governing SBICs limit
portfolios with loans, debentures and preferred the dollar amount of investments and/or loans to
stock investments tend to be more predictable a single customer to 20 percent of an SBICs
and less erratic in earnings performance than capital base. Although banks are limited by
companies that are strictly equity-oriented. The statute to a maximum capital investment in an
difference being that loans, debentures and pre- SBIC of 4.9 percent of their primary capital,
ferred stock provide income to cover operating statistics show that SBICs have substantially
expenses and debt service requirements, while less than this limit. By contrast, there are no
common stock investments may not yield posi- restrictions as to the amount of capital that a
tive returns for several years. Portfolio diversifi- bank holding company may invest in a nonbank
cation tends to smooth out earnings, although affiliated venture capital company. Dependence
the potential for major fluctuations in earnings on capital to fund portfolio loans and invest-
exists in the future should capital gains be real- ments seems to be preferred as the cost of
ized on equity investments. In measuring earn- leverage, at present, cannot provide meaningful
ings performance, one should consider the com- spreads. It can be assumed that the larger the
bination of net realized earnings (net investment capital position the higher the dollar amount
income plus net realized gains (losses) on sale available for investing and/or lending to a single
of investments) and net unrealized appreciation customer.
or depreciation on investment holdings found in Sustained profitability and satisfactory asset
the capital structure of the balance sheet. It is quality are required to maintain financial sound-
not uncommon to see aggregate returns on capi- ness and capital adequacy. The SBA will con-
tal reach 50 sider an SBICs capital as impaired if net unreal-
or more. Typically, returns of this magnitude ized depreciation and/or operating losses equal
are influenced by either large gains realized on 50 percent or more of its capital base. It would
the sale of investments or a substantial amount seem appropriate to use this guideline for mea-
of unrealized appreciation on investments held suring the adequacy of capital of non-licensed
or a combination of both. Appreciation or depre- venture capital companies that are affiliated with
ciation in portfolio investments represents a bank holding company.
potential realized gains or losses and, therefore,
should be considered in evaluating the compa-
nys earnings performance. Specifically, the 2260.0.6 INSPECTION OBJECTIVES
change in year-to-year net unrealized apprecia-
tion or depreciation is a factor that should be 1. To determine whether the company is
considered in analyzing results. When measur- operating within the scope of its approved activ-
ing the companys contribution to consolidated ities and within the provisions of the Act and
earnings, net unrealized appreciation or depreci- Regulation Y.
ation should be ignored. 2. To determine whether transactions with
affiliates, especially banks, are in accordance
with applicable statutes and regulations.
2260.0.5 CAPITALIZATION 3. To determine the quality of the asset port-
folios and whether the allowance for losses is
In addition to the usual equity components of
capital stock, surplus and retained earnings, the BHC Supervision Manual December 1992
capital structure of a venture capital company Page 3
adequate in relation to portfolio risk and 4. Latest directors valuation of loans and
whether the nonaccrual policy is appropriate. investments and results of latest internal loan or
4. To determine the viability of the company credit review;
as a going concern, and whether its affiliate 5. Copies of the most recent internal and
status represents a potential or actual adverse external audit reports;
influence upon the parent holding company and 6. Trial balance of all loans and investments,
its affiliated bank and nonbank subsidiaries and indicating the percent ownership of a company
the condition of the consolidated corporation. involving an equity interest;
5. To determine whether the company has 7. Listing of loans, debentures and preferred
formal written policies and procedures relating stock on which scheduled payments are in ar-
to lending and investing. rears 30 days or more or on which payments are
6. To determine if such policies and proce- otherwise not being made according to original
dures are adequate and that management is terms;
operating in conformance with the established 8. Details of internal and external borrowing
policies. arrangements; and
7. To assess managements ability to operate 9. Any agreements, guarantees or pledges be-
the company in a safe and sound manner. tween the subsidiary and its parent holding com-
8. To suggest corrective action when poli- pany or affiliates.
cies, practices or procedures are deficient, or After reviewing the above information, a
when asset quality is weak, or when violations decision whether or not to conduct an on-site
of laws or regulations have been noted. inspection must be made. Some of the determi-
nants of this decision would include: relative
size; current level and trend of earnings; asset
quality as indicated in the directors valuation of
2260.0.7 INSPECTION PROCEDURES loans and investments; and the condition of the
2260.0.7.1 Pre-Inspection company when last inspected. From the infor-
mation provided, it might be determined that the
All SBICs and MESBICs are subject to com- company is operating properly and is in sound
prehensive regulations and annual examinations condition. In such a case, an on-site inspection
administered by the SBA. Therefore, it is not may not be warranted. Conversely, a deteriorat-
necessary to conduct a full scope inspection of ing condition might be detected which would
these subsidiaries. The bank holding company warrant a visit even though a satisfactory condi-
inspection should focus on the quality of assets, tion had been determined during the previous
as disclosed in the annual directors valuation inspection. All non-licensed venture capital
and financial statements submitted to the SBA companies should be inspected on-site at least
on an annual basis, transactions with affiliates once every three years.
and an overall financial evaluation.
The decision whether the operations of a
non-licensed venture capital company will be 2260.0.7.2 On-Site Inspection
inspected on-site is based on the availability
and adequacy of data from either the parent If the decision was made to conduct an on-
holding company or that which is obtained upon site inspection of the subsidiary, the examiner
request from the subsidiary. The following should expand the scope of the review to include
information should be obtained and thoroughly these additional procedures:
reviewed prior to making a decision to go on- 1. Hold a brief meeting with the chief execu-
site: tive officer of the company to establish contact
1. Minutes of the board and executive com- and present a brief indication of the scope of the
mittee meetings since inception of company or inspection;
the date of the previous inspection; 2. Review the companys policy statements
2. Comparative interim and fiscal financial for loans, investments, nonaccruals, and charge-
statements containing value accounting adjust- offs;
ments, including the year-end filing with the 3. Review the latest internal review by the
SBA; companys directors or the loan review depart-
3. Listing of contingent liabilities, including ment of the bank affiliate or bank holding
any pending material litigation; company;
4. Conduct an independent review of the
BHC Supervision Manual December 1992 portfolio;
Page 4 a. Establish the minimum dollar of loans
and investments to be reviewed to achieve at 7. Compare companys general ledger with

least 70 percent coverage of the portfolio; statements prepared for the latest FR Y6;
b. Review loans and investments in sam- 8. Review the quality and liquidity of other
ple, giving consideration to the following: investment holdings;
9. Review and classify, if necessary, assets
Latest balance sheet and income data;
acquired in liquidation of a customers business
Profitability projections;
due to default. Determine compliance of divesti-
Product(s) being produced by customer
ture period with section 4(c)(2) of The Bank
and their market acceptance;
Holding Company Act;
Business plan;
10. Review the manner and frequency in
Extent of relationship with customer;
which subsidiary management reports to the
Funding sources; and
parent holding company;
Ultimate source of repayment.
11. Follow-up on matters criticized in the
c. Discuss the more serious problem loans most recent audit reports and the previous
and investments with management; inspection report on the subsidiary; and
d. Classify, if necessary, those loans and 12. Assess the expertise of subsidiary man-
investments that exhibit serious weaknesses agement and awareness of subsidiary directors.
where collectibility is problematical or worse.
Lower classification criteria must accompany
these assets, which possess a higher degree of 2260.0.7.3 Matters Warranting
credit risk than found in other types of nonbank Recommendation in Inspection Report
lending;
e. Determine the diversification of risk Deficiencies or concerns that warrant citation in
within the portfolio, i.e., the mix of loans and the inspection report for the attention of man-
investments and the type of industries financed; agement are:
f. Review the adequacy of the allowance 1. Lack of policies and/or controls in the
for loan losses and determine the reasonableness lending and investing functions;
of the amount of unrealized appreciation or de- 2. Improper diversification of risk in the loan
preciation reported on the balance sheet in con- and investment portfolio;
junction with the asset evaluation; and 3. Adverse tie-in arrangements with the affil-
g. Determine whether the board of direc- iate bank(s):
tors or parent holding company has established 4. Lack of management expertise;
credit limits for the maximum amount of loans 5. Impairment of capital as a result of operat-
and investments to be extended to a single cus- ing losses or high unrealized depreciation on
tomer. Verify adherence to the limits. equity interests or a combination of both; and
5. Review equity investments for compliance 6. Lack of adequate reporting procedures to
with the 4.9 percent maximum limitation to any parent holding company management.
one customer;
6. Verify office locations and activities with
system approvals;

Page 5
2260.0.8 LAWS, REGULATIONS, INTERPRETATIONS AND ORDERS
Acquisition of SBIC by a 1843(c)(8) 225.111 4173

bank holding company 1843(c)(5) 4175
4174
Limitations of an SBICs 13 C.F.R. 107.901(a)

control over business
enterprises
Criteria for various types of 13 C.F.R. 121.310

business investments of an 13 C.F.R. 121.311
SBIC
Acquisition of a non-licensed 1843(c)(8) 225.112

venture capital company by a
bank holding company
Formation of joint ventures 1843(c)(6)

(limited partnerships) for
purpose of conducting
venture capital activities
Limitation on equity interests 1843(c)(6)

of a non-licensed venture
capital company affiliated
with a bank holding company
Loans to affiliates 371c

Section 23A of FR Act
Restrictions on 371c
transactions with affiliates
Acquisition of shares 1843(c)(2)

acquired DPC
Acquisition of assets 1843(c)(2) 225.132 4175.1

acquired DPC

Page 6
2260.0.9 APPENDIX 1VENTURE CAPITAL COMPANY SAMPLE BALANCE

SHEET
December 31, 19XX
ASSETS
Cash XXXX
Money Market investments XXXX
Loans and investments XXXX
Loans XXXX
Debt securities XXXX
Equity interests XXXX
Total loans and investments XXXX
Less: Allowance for losses on loans and investments XXXX
Plus: Unrealized appreciation (depreciation) on equity interests XXXX
Net loans and investments XXXX
Interest and dividends receivable XXXX
Assets acquired in liquidation of loans and investments XXXX
Other assets XXXX
Total assets XXXX
LIABILITIES
Notes payableaffiliates XXXX

Notes payableothers XXXX
Accrued taxes payable XXXX
Deferred tax credits XXXX
Other liabilities XXXX
Total liabilities XXXX
STOCKHOLDERS EQUITY
Common stock (par value XXX) XXXX

Surplus XXXX
Retained earnings XXXX
Net unrealized appreciation (depreciation) of equity interests XXXX
Total stockholders equity XXXX
Total liabilities and stockholders equity XXXX

Page 7
2260.0.10 APPENDIX 2VENTURE CAPITAL COMPANYSAMPLE INCOME

STATEMENT
For Fiscal Year Ended

December 31, 19XX
INTEREST INCOME
Interest on loans and debt securities XXX

Dividends on equity interests XXX
Interest on money market investments XXX
Total interest income XXX
INTEREST EXPENSE
Interest on notes payable to affiliates XXX

Interest on notes payable to others XXX
Total interest expense XXX
NET INTEREST INCOME XXX
PROVISION FOR LOAN LOSSES XXX

Net interest after provision for loan losses XXX
OTHER REVENUE
Income from assets acquired in liquidation of loans and investments XXX
Management Fees XXX
Total other revenue XXX
Net interest and other revenue XXX
NONINTEREST EXPENSE
Salaries and benefits XXX

Management and service fees XXX
Other expenses XXX
Total noninterest expense XXX
Income before taxes XXX

Applicable taxes XXX
Net investment income XXX
Realized gain (loss) on sale of securities, net of tax XXX
Net income XXX

Page 8
Supervision of Savings and Loan Holding Companies
Section 2500.0
WHATS NEW IN THIS REVISED this transition, examiners will be using the first
SECTION supervisory cycle2 to inform SLHCs how their
operations compare to the Boards supervisory
Effective January 2016, this section is revised to expectations and assign indicative ratings. For
delete a reference to SR letter 02-1, Revisions specific information about the supervisory
to Bank Holding Company Supervision Proce- approach during the first supervisory cycle for
dures for Organizations with Total Consolidated holding companies of varying size and complex-
Assets of $5 Billion or Less. The letter is no ity, see attachments A and B to SR-11-11,
longer active. Effective July 2015, this section Supervision of Savings and Loan Holding
was also revised to include a reference to SR Companies (SLHCs). Once the indicative rat-
letter 14-9, Incorporation of Federal Reserve ing has been assigned, the SLHCs will be super-
Policies into the Savings and Loan Holding vised and assigned ratings consistent with the
Company Supervision Program, which pro- BHC supervisory program and cycle.
vides a listing of supervisory guidance docu- Federal Reserve supervisory staff should
ments (SR letters) that were issued prior to July assess whether an SLHC conducts its operations
21, 2011. The Federal Reserve has determined in a safe and sound manner and in compliance
that these SR letters are applicable to savings with applicable laws and regulations. Staff
and loan holding companies. should also determine whether an SLHC, its
subsidiary depository institution(s), and nonde-
Title III of the Dodd-Frank Wall Street Reform pository subsidiaries are in compliance with any
and Consumer Protection Act1 (Dodd-Frank Act) enforcement actions, applications commitments,
transferred to the Board of Governors of the or other supervisory directives (including cita-
Federal Reserve System (Board) the supervisory tions in previous examinations or inspections).
functions of the Office of Thrift Supervision If Federal Reserve supervisory staff concludes
(OTS) related to savings and loan holding that an SLHC is not conducting its operations in
companies (SLHCs) and their nondepository a safe and sound manner; is in violation of
subsidiaries beginning on July 21, 2011. The applicable law or regulations; or is not comply-
Dodd-Frank Act also provides that all regula- ing with any outstanding enforcement action,
tions, guidelines, and other advisory materials commitment, or supervisory directive, or if the
issued by the OTS on or before the transfer date primary regulator of a subsidiary savings asso-
with respect to SLHCs and their nondepository ciation has determined that it is not in satisfac-
subsidiaries will be enforceable until modified, tory condition, appropriate action should be
terminated, set aside, or superseded by the Board. taken against the SLHC, including possible for-
The Board intends, to the greatest extent mal or informal enforcement actions.
possible, taking into account any unique When communicating inspection findings,
characteristics of SLHCs and the requirements of examiners should use standard Federal Reserve
the Home Owners Loan Act (HOLA), to assess terminology to differentiate among matters
the condition, performance, and activities of requiring immediate attention (MRIAs) and
SLHCs on a consolidated basis in a manner that matters requiring attention (MRAs).3 Examiners
is consistent with the Boards established should discuss with management those practices
risk-based approach regarding bank holding that are not consistent with the safety-and-
company (BHC) supervision. As with BHCs, the soundness principles. When MRIAs and/or
Boards supervisory objective will be to ensure MRAs have been identified and communicated
that an SLHC and its nondepository subsidiaries to the SLHC in a report of inspection, examiners
are effectively supervised and can serve as a should work with the SLHC to establish a plan
source of strength for, and do not threaten the and appropriate timetable for SLHC manage-
soundness of, its subsidiary depository institu- ment to address these matters within a reason-
tion(s). The frequency and scope of supervisory
activities for holding companies is discussed in 2. The first supervisory cycle for an SLHC is the period of
detail in section 5000 of this manual. time between July 21, 2011, and the close of the first required
The Board understands that it will take time inspections.
3. See SR-13-13/CA-13-10, Supervisory Considerations
to acquaint SLHCs with the Boards supervi- for the Communication of Supervisory Findings and its
sory policies and approach. To help facilitate attachment, and section 5000.0.9.3 of this manual.
1. Pub. L. 111-203, July 21, 2010; 124 Stat. 1376. See BHC Supervision Manual January 2016
Section 312, Powers and Duties Transferred. Page 1
Supervision of Savings and Loan Holding Companies 2500.0
able period. In determining the appropriate time- currently found in the Boards Regulation Y,
table for addressing deficiencies, examiners Regulation Y will not apply to SLHCs. Although
should consider the nature, scope, complexity, SLHCs are similar to BHCs, SLHCs are not
and risk of the deficiency. Supervision staff at subject to the Bank Holding Company Act. In
the Board will review MRIAs and MRAs peri- particular, SLHCs may engage in a wider array
odically to ensure appropriate prioritization and of activities than those permissible for BHCs and
consistent treatment across SLHCs. may have concentrations in real estate lending
that are not typical for BHCs.
The Federal Reserve has identified supervi-
2500.0.1 APPLICABLE LAW, sory guidance documents (SR letters) that it
REGULATIONS, AND GUIDANCE determined to be applicable to SLHCs. The
letters were issued prior to July 21, 2011 (the
The main governing statute for SLHCs is date of transfer of supervision and regulation of
HOLA. Other statutes apply to both SLHCs and SLHCs from the former Office of Thrift Super-
BHCs, such as the Change in Bank Control Act vision (OTS) to the Federal Reserve Board).
and the Management Interlocks Act. On August Refer to SR-14-9, Incorporation of Federal
12, 2011, the Board issued an interim final rule Reserve Policies into the Savings and Loan
codifying all the rules that apply to SLHCs.4 Holding Company Supervision Program, and
Although the Board anticipates conforming its attached listing of the SR letters.
certain portions of the OTS rules to those
4. See 76 Fed. Reg. 56508, September 13, 2011. (See also

the Boards press release issued on August 12, 2011.)

Page 2
Table of Contents
3000 Nonbanking Activities
3000.0 Introduction to BHC Nonbanking and FHC Activities
3000.0.1 Categories of Nonbanking Activities

3000.0.2 Appendix 1Activities Approved by the Board as
Being Considered Closely Related to Banking
Under Section 4(c)(8) of the Bank Holding Company
Act (Section 225.28(b) of Regulation Y)
3000.0.3 Appendix 2Activities Considered Closely Related
to Banking Under Section 4(c)(8) of the Bank
Holding Company Act
3000.0.4 Appendix 3Activities Considered Not to Be
Closely Related to Banking Under Section 4(c)(8)
of the Bank Holding Company Act
3001.0 Section 2(c) of the BHC ActSavings Bank

Subsidiaries of BHCs Engaging in Nonbanking
Activities
3005.0 Section 2(c)(2)(F) of the BHC ActCredit Card Bank

Exemption from the Definition of a Bank
3005.0.1 Section 2(c)(2

3005.0.2 Section 2(c)(2)(F) )
3010.0 Section 4(c)(i) and (ii) of the BHC ActExemptions

from Prohibitions on Acquiring Nonbank Interests
3010.0.2 Labor, Agricultural, or Horticultural Organizations
3010.0.3 Family-Owned Companies
3020.0 Section 4(c)(1) of the BHC ActInvestment in

Companies Whose Activities Are Incidental to
Banking
3020.0.2 Providing Banking Quarters
3020.0.3 Safe Deposit Business
3020.0.4 Furnishing Services to Banking Subsidiaries
3020.0.5 Furnishing Services to Nonbank Subsidiaries
3020.0.6 Liquidating Assets
3020.0.8.1 Section 4(c)(1)(A)Bank Premises
3020.0.8.2 Section 4(c)(1)(B)Safe Deposit Business
3020.0.8.3 Section 4(c)(1)(C)Services
3020.0.8.4 Section 4(c)(1)(D)Liquidation Subsidiary

Page 1
Table of Contents 3000 Nonbanking Activities
3030.0 Section 4(c)(2) and (3) of the BHC ActAcquisition

of DPC Shares or Assets, Including Real Estate
3030.0.1 Exemption to Section 4(c)(2) Disposition

Requirements of DPC Shares
3032.0 Rental of Other Real Estate Owned Residential Property
3032.0.1 Policy Statement on Rental of Residential Other Real Estate

Owned Properties
3032.0.1.1 Risk-Management Considerations for Residential OREO
Property Rentals
3032.0.1.1.1 Compliance with Maximum OREO Holding-Period
Requirements
3032.0.1.1.2 Compliance with Landlord-Tenant and Other Associated
Requirements
3032.0.1.1.3 Other Considerations
3032.0.1.2 Specific Expectations for Large-Scale Residential OREO
Rentals
3032.0.1.3 Additional Materials for Reference
3040.0 Section 4(c)(4) of the BHC ActInterests in

Nonbanking Organizations
3040.0.1 Transfer of Shares to a Trustee

3040.0.2 Trust Company Subsidiaries
3040.0.3 Qualifying Foreign Banking Organization Owning or
Controlling Shares of a Company in a Fiduciary Capacity
3040.0.4 Other Reporting Requirements
3050.0 Section 4(c)(5) of the BHC ActInvestments Under

Section 5136 of the Revised Statutes
3050.0.1 Companies in Which BHCs May Invest

3050.0.2 Limitations
3060.0 Section 4(c)(6) and (7) of the BHC ActOwnership

of Shares in Any Nonbank Company of
5 Percent or Less
3060.0.1 Section 4(c)(6)

3060.0.1.1 D.P.C. Shares

Page 2
3060.0.1.2 Acquisition of Nonbank InterestsRoyalties

as Compensation
3060.0.2 Section 4(c)(7)
3060.0.3.1 Section 4(c)(6)
3060.0.3.2 Section 4(c)(7)
3060.0.4.1 Section 4(c)(6)
3060.0.4.2 Section 4(c)(7)
3070.0.1 Board Oversight and Management
3070.0.1.1 Board Oversight
3070.0.1.2 Management
3070.0.1.3 Organizational Structure
3070.0.1.4 Control Environment
3070.0.1.5 Control Programs
3070.0.1.5.1 Internal Audit
3070.0.1.5.2 External Audit
3070.0.1.5.3 Loan Review
3070.0.1.5.4 Quality Control
3070.0.1.5.5 Insurance Program
3070.0.1.5.6 Litigation
3070.0.1.5.7 Supervisory Approach for Qualified and Non-Qualified
Mortgage Loans
3070.0.1.6 Inspection Objectives
3070.0.1.7 Inspection Procedures
3070.0.2 Production Activities
3070.0.2.1 Types of Loans
3070.0.2.2 Production Channels
3070.0.2.3 Production Strategies
3070.0.2.4 Production Process
3070.0.2.5 Production Risks
3070.0.2.6 Overages
3070.0.3 Marketing Activities
3070.0.3.1 Oversight
3070.0.3.2 Securitization
3070.0.3.3 Pooling Practices
3070.0.3.4 Marketing Risks and Risk Management
3070.0.3.4.1 Techniques
3070.0.3.4.2 Unsalability
3070.0.3.4.3 Pricing Risk
3070.0.3.4.4 Fallout
3070.0.3.4.5 Hedging Strategies
3070.0.3.4.6 Position Reports
3070.0.3.4.7 Counterparty Performance
3070.0.4 Servicing/Loan Administration
3070.0.4.1 Revenue Generation
Page 3
3070.0.4.2 Cost Containment

3070.0.4.3 Growth Strategies
3070.0.4.4 Servicing Agreements
3070.0.4.5 Recourse Obligations
3070.0.4.6 Guaranty Fees
3070.0.4.8 Data Security/Contingency Planning
3070.0.5 Financial Analysis
3070.0.5.1 Balance Sheet
3070.0.5.1.1 Assets
3070.0.5.1.2 Liabilities
3070.0.5.1.3 Equity Capital
3070.0.5.2 Income Statement
3070.0.5.3 Unique Characteristics
3070.0.5.4 Asset Quality
3070.0.5.4.1 Classification Procedures
3070.0.5.4.2 Presentation of Classifications
3070.0.5.4.3 Reserves
3070.0.5.5 Earnings Performance
3070.0.5.6 Liquidity and Funding
3070.0.5.6.1 Financial Flexibility
3070.0.5.6.2 Cash-Flow Analysis
3070.0.5.6.3 Asset/Liability Management
3070.0.5.7 Capital Adequacy
3070.0.5.8 Overall Assessment
3070.0.6 Mortgage-Servicing Assets and Liabilities
3070.0.6.1 Measurement
3070.0.6.2 Impairment Testing
3070.0.6.3 Disclosures
3070.0.6.4 Intercompany MSAs
3070.0.6.5 Table Funding
3070.0.6.6 Regulatory Reporting
3070.0.6.7 Risk-Based Capital
3070.0.6.8 Previously Recognized Excess Servicing-Fee Receivables
3070.0.6.9 MSA Hedging Practices and Instruments
3070.0.6.9.1 Hedging Practices
3070.0.6.9.2 Hedge Accounting
3070.0.6.9.3 Relevant MSA Characteristics
3070.0.6.9.4 Hedge Instruments
3070.0.7 Intercompany Transactions
3070.0.7.1 Section 23A of the FRA
3070.0.7.1.1 Quantitative Restrictions
3070.0.7.1.2 Collateral Requirements
3070.0.7.1.3 Prohibited Transactions
3070.0.7.1.4 Exemptions from Section 23A of the FRA
3070.0.7.2 Section 23B of the FRA
3070.0.7.3 Management and Service Fees
3070.0.7.4 Tie-In Considerations of the BHC Act
Page 4
3070.0.7.4.1 Section 225.7(d) of Regulation Y

3070.0.7.4.2 Interaffiliate Tying Arrangements Treated the Same as
Intrabank Arrangements
3070.0.7.4.3 Foreign Transaction under Section 106
3070.0.7.4.4 Technical Change
3070.0.7.5 Inspection Objective
3070.0.8 Regulation Y Compliance
3070.0.9 On-Site Inspection of Mortgage Banking Subsidiaries
3070.0.10 Laws, Regulations, Interpretations, Orders
3070.0.11 Appendix AFirst Day Letter
3070.0.12 Appendix BAccounting Literature
3070.0.13 Appendix CRegulatory Guidance
3070.3 Nontraditional MortgagesAssociated Risks
3070.3.1 Nontraditional Loan Terms and Underwriting Standards

3070.3.1.1 Qualifying Borrowers for Nontraditional Loans
3070.3.1.2 Collateral-Dependent Loans
3070.3.1.3 Risk Layering
3070.3.1.4 Reduced Documentation
3070.3.1.5 Simultaneous Second-Lien Loans
3070.3.1.6 Introductory Interest Rates
3070.3.1.7 Lending to Subprime Borrowers
3070.3.1.8 Non-Owner-Occupied Investor Loans
3070.3.2 Portfolio and Risk-Management Practices
3070.3.2.1 Policies
3070.3.2.2 Concentrations
3070.3.2.3 Controls
3070.3.2.4 Third-Party Originations
3070.3.2.5 Secondary-Market Activity
3070.3.2.6 Management Information and Reporting
3070.3.2.7 Stress Testing
3070.3.2.8 Capital and Allowance for Loan and Lease Losses
3070.3.3 Consumer Protection Issues
3070.3.3.1 Concerns and Objectives
3070.3.3.2 Legal Risks
3070.3.3.3 Recommended Practices
3070.3.3.4 Communications with Consumers
3070.3.3.4.1 Promotional Materials and Product Descriptions
3070.3.3.4.2 Monthly Statements on Payment-Option ARMs
3070.3.3.4.3 Practices to Avoid
30703.3.3.5 Control Systems
3070.3.4 Appendix (Terms Used in This Document)

Derivative Commitments to Originate and Sell
Mortgage Loans
3071.0.1 Interagency Advisory on Accounting and Reporting
for Commitments to Originate and Sell Mortgage Loans
3071.0.1.1 Accounting and Reporting

Page 5
3071.0.1.1.1 Accounting Policies

3071.0.1.1.2 Derivative Loan Commitments
3071.0.1.1.3 Forward Loan-Sales Commitments
3071.0.1.1.4 Netting of Contracts
3071.0.1.1.5 Hedge Accounting
3071.0.1.1.6 Income-Statement Effect
3071.0.1.2 Valuation
3071.0.1.2.1 Fair Value
3071.0.1.2.2 SAB 105
3071.0.1.3 Standard-Setter Activities
3071.0.1.4 Changes in Accounting for Derivative Loan Commitments
and Loan-Sales Agreements
3071.0.1.5 Definitions of Terms Used in the Advisory
3071.0.1.5.1 Derivative Loan Commitment
3071.0.1.5.2 Forward Loan-Sales Commitment
3071.0.1.5.3 Mandatory-Delivery Contract
3071.0.1.5.4 Best-Efforts Contract
3071.0.1.5.5 Master Agreement
3071.0.1.6 Example of the Accounting for Commitments to Originate
and Sell Mortgage Loans
3071.0.1.6.1 ABC Mortgage Financial Institution (Best-Efforts Contracts
and No Application of Fair-Value Hedge Accounting)
3071.0.1.6.1.1 Background
3071.0.1.6.1.2 Discussion of ABCs Approach to Valuing Derivative Loan
Commitments and Forward Loan-Sales Commitments
3071.0.1.6.1.3 Regulatory Reporting
3072.0 Activities Related to Extending Credit
3072.8 Real Estate Settlement Services
3073.0 Education-Financing Activities

3073.0.1 Expanded Student-Loan Servicing Activities
3080.0 Section 4(c)(8) of the BHC ActServicing Loans

3084.0 Asset-Management, Asset-Servicing, and Collection

Activities
3084.0.1 Asset-Management Services to Certain
Governmental Agencies and to Unaffiliated
Financial Institutions with Troubled Assets
3084.0.2 Asset-Management Services for Assets Originated
by Nonfinancial Institutions
3090.0 Section 4(c)(8) of the BHC ActReceivables
3090.1 Factoring

Page 6
3090.1.2 Funding
3090.1.4.2 Credit Department
3090.1.4.3 Asset Evaluation
3090.2 Accounts Receivable Financing
3090.2.2 Funding
3090.2.4.2 Accounting and Controls
3090.2.4.3 Definitions
3090.2.4.4 Over-Advances and Other Loans
3090.2.4.5 Asset Evaluation
3090.2.4.6 D.P.C. Assets
3090.2.4.7 Financial Condition
3100.0 Section 4(c)(8) of the BHC ActConsumer Finance
3100.0.2 Funding
3100.0.4.1 On-Site Phase
3100.0.4.2 Policy Evaluation
3100.0.4.3 Evaluation of the Supervisory Structure
3100.0.4.4 Detailed Procedures for an Office Visit
3100.0.4.5 Additional Procedures
3100.0.4.7 Asset Classification Policy
3100.0.4.8 Ratio Analysis
3100.0.4.9 Delinquency
3100.0.4.10 Liquidation
3100.0.4.11 Loss Reserves
3100.0.4.12 Volume
3100.0.4.13 Evaluation of the Companys Condition
3104.0 Acquiring Debt in Default
3104.0.1 Acquisition of Defaulted DebtBoard Order
3105.0 Credit Card Authorization and Lost/Stolen Credit Card

Reporting Services
3107.0 Stand-Alone Inventory-Inspection Services

Page 6.1
3110.0 Section 4(c)(8) of the BHC ActIndustrial Banking
3110.0.1 Nonbanking Acquisitions Not Requiring Prior Board

Approval
3111.0 Section 4(c)(8) of the BHC ActAcquisition of

Savings Associations
3111.0.1 Acquisition of a Savings Association
3111.0.2 Approval to Become a BHC by Acquiring Another BHC
3111.0.2.1 Financial, Managerial, and Other Supervisory

Considerations
3111.0.2.2 Nonbanking Activities
3111.0.2.3 Noncontrolling Investment
3111.0.2.4 Appendix ASLHC Passivity Commitments
3120.0 Section 4(c)(8) of the BHC ActTrust Services
3120.0.1 On-Site Inspections
3130.0 Section 4(c)(8) of the BHC ActGeneral Financial

and Investment Advisory Activities
3130.1 Investment or Financial Advisers
3130.1.1 Real Estate Development Advisers for State

and Local Government
3130.1.3.1 Scope of Inspection
3130.1.3.2 Inspection Checklist
3130.1.3.2.1 Review of Fundamental Policies and Procedures
3130.1.3.2.2 Supervision and Organization
3130.1.3.2.2.1 Supervision and Organization Checklist
3130.1.3.2.3 Portfolio Management
3130.1.3.2.4 Conflicts of Interest
3130.1.3.2.5 Recordkeeping
3130.1.3.2.6 Security Storage and Processing
3130.1.3.2.7 Other Matters
3130.1.4 Inspection Findings
3130.1.5 On-Site Inspection by Trust Examiner(s)

Page 6.2
3130.2 Reserved for Future Use
3130.3 Advice on Mergers and Similar Corporate Structurings,

Capital Structurings, and Financing Transactions
3130.3.1 Adviser to a Mortgage or Real Estate Investment Trust

3130.3.1.1 Evaluating Advisory Activities for a REIT
3130.3.4 Financial Advice on Issuing Securities of Foreign
Governments in the United States
3130.3.4.1 Financial Advice to the Canadian Federal, Provincial,
and Municipal Governments
3130.3.4.2 Providing Financial Advice to the Japanese National
and Municipal Governments and Their Agencies
3130.3.5 Providing Financial-Feasibility Studies and Valuation
Services
3130.3.5.1 Valuation Services
3130.3.5.2 Utility-Rate Testimony in Support of Utility-Company
Valuations
3130.3.6 Education-Financing Advisory Services
3130.4 Informational, Statistical Forecasting, and Advisory

Services for Transactions in Foreign Exchange and
Swaps, Commodities, and Derivative Instruments
3130.4.1 Informational, Statistical Forecasting, and Advice

On Such Transactions or Instruments as Foreign-
Exchange Swaps, Commodities, and Derivatives
3130.4.2 Financial Advice as to the Structuring of and Arranging
for Loan Syndications, Interest-Rate Swaps, Caps,
and Similar Transactions
3130.4.3 Advice Relating to the Structuring of and Arranging
for Currency Swaps
3130.4.4 Advice with Respect to Futures Contracts
3130.4.4.1 Limited Advisory Services with Respect to Futures
Contracts on Stock Indexes and Options on Such
Futures Contracts
3130.4.4.2 Advice on Certain Futures and Options on Futures
3130.4.5 Providing Discretionary Portfolio Management
Services on Futures and Options on Futures on
Nonfinancial Commodities
3130.4.6 Combination of Providing Advice with Other
Nonbanking Activities
3130.4.6.1 Providing Nonfinancial Futures Advice and the
Combining of Foreign-Exchange, Government
Securities Advisory, and Execution Services
3130.5 Section 4(c)(8)Providing Educational Courses and

Instructional Materials for Consumers on Individual
Financial Management

Page 7
3130.6 4(c)(8)Tax-Planning and Tax-Preparation Services

3140.0 Section 4(c)(8) of the BHC ActLeasing Personal

or Real Property
3140.0.1 Leasing Authorizations within Regulation Y
3140.0.2 Permissible Leasing Activities
3140.0.2.1 Automobile Fleet Leasing and Fleet-Management Services
3140.0.2.2 Railcar Leasing and Railcar Fleet Management Services
3140.0.3 Accounting for Leases
3140.0.3.1 Accounting for Leases by a Lessee
3140.0.3.1.1 Operating Method of Accounting for Leases
3140.0.3.1.2 Capitalized-Lease Method of Accounting for Leases
3140.0.3.2 Accounting for Leases by a Lessor
3140.0.3.2.1 Operating Lease (Lessor)
3140.0.3.2.2 Direct Financing Capitalized Lease
3140.0.3.2.3 Balance-Sheet Presentation
3140.0.3.2.4 Classification
3140.0.3.2.5 Delinquency
3140.0.4 Leveraged Leases
3150.0 Section 4(c)(8) of the BHC ActCommunity Welfare

Projects
3150.0.1 Investments in Corporations or Projects to Promote

Community WelfareBoard Interpretation
3150.0.2 Examples of Board-Approved Activities Designed to
Promote Community Welfare
3150.0.3 Examples of Investments Viewed as Not Promoting
Community Welfare
3160.0 Section 4(c)(8) of the BHC ActEDP Servicing

Company
3160.0.1 IntroductionProvision of Data Processing and

Transmission Services
3160.0.2 Incidental Activities
3160.0.3 Section 4(c)(8) vs. Section 4(c)(1)
3160.0.4 Mini-Computer Activities

Page 8
3160.0.5 Hardware and Software as an Integrated Package

3160.0.6 Packaged Financial Systems
3160.0.7 Excess Capacity
3160.0.8 Byproducts
3160.0.9 Requirement of Separate Recordkeeping
3160.0.10 Summary
3160.0.12.1 Pre-Inspection
3160.0.12.2 On-Site
3160.1 Section 4(c)(8) of the BHC ActEDP Servicing:

Network for the Processing and Transmission
of Medical Payment Data
3160.2 Electronic Benefit Transfer, Stored-Value-

Card, and Electronic Data Interchange
Services
3160.2.1 Electronic Benefit Transfer Services

3160.2.2 Stored-Value-Card Services
3160.2.2.1 Stored-Value-Card Closed Systems
3160.2.2.2 Stored-Value-Card Open Systems
3160.2.3 Electronic Data Interchange Services
3160.2.4 Board Approval
3160.3 Data Processing Activities: Obtaining Travelers

Checks and Postage Stamps Using an ATM
Card and Terminal
3160.4 Providing Data Processing in Connection with the

Distribution, through ATMs, of Tickets, Gift
Certificates, Prepaid Telephone Cards, and Certain
Other Documents
3160.5 Engage in Transmitting Money
3160.5.1 Engage in Transmitting Money in the United States
3165.1 Support ServicesPrinting and Selling MICR-

Encoded Items
3170.0 Section 4(c)(8) of the BHC ActInsurance Agency

3170.0.1 Insurance Agency Activities Permissible for Bank

Holding Companies
3170.0.2 Insurance Agency Activities
3170.0.3 Permissible Types of Coverage Including Grandfather
Privileges

Page 9
3170.0.3.1 Insurance Activities Permissible for Bank Holding

Companies per Section 225.28(b)(11)(i) of the Boards
Regulation Y
3170.0.3.2 Section 225.28(b)(11)(ii) of Regulation YSale of
Credit-Related Property Insurance by Finance
Company Subsidiaries of a BHC
3170.0.3.2.1 Definition of a Finance Company
3170.0.3.2.2 Property Insurance a Finance Company May Sell
3170.0.3.3 Section 225.28(b)(11)(iii) of Regulation YInsurance
in Small Towns
3170.0.3.4 Section 225.28(b)(11)(iv) of Regulation YInsurance
Agency Activities Conducted on May 1, 1982
3170.0.3.4.1 Limitations on Expansion of Grandfather Rights
3170.0.3.4.2 Transfer of Grandfather Rights among Subsidiaries
3170.0.3.5 Section 225.28(b)(11)(v) of Regulation YBank
Holding Companys Insurance Coverage for
Internal Operations
3170.0.3.6 Section 225.28(b)(11)(vi) of Regulation YSmall Bank
Holding Companies
3170.0.3.7 Section 225.28(b)(11)(vii) of Regulation YInsurance
Agency Activities Conducted before 1971
3170.0.3.7.1 Agency Activities
3170.0.4 Income from the Sale of Credit Life Insurance
3170.0.4.1 Policy Statement on Income from Sale of Credit Life
Insurance
3170.0.4.2 Disposition of Credit Life Insurance Income
3180.0 Section 4(c)(8) of the BHC ActInsurance

Underwriters
3180.0.1 Insurance Underwriting Activities

3180.0.1.1 Insurance Underwriting Activities Permissible for Bank
Holding Companies per Section 225.28(b)(11)(i) of
the Boards Regulation YCredit Insurance
3180.0.2 Limited Property Insurance Related to an Extension of
Credit (Finance Company Subsidiary of a Bank
Holding Company)
3180.0.3 Insurance Activities before 1971
3180.0.4 Underwriting as Reinsurer
3190.0 Section 4(c)(8) of the BHC ActCourier Services


Page 10
3200.0 Section 4(c)(8) of the BHC ActManagement

Consulting and Counseling Services
3200.0.1 Management Consulting Limitations

3202.0 Employee Benefits Consulting Services

3202.0.1 Board Orders Involving Employee Benefits Consulting
3204.0 Career Counseling
3204.0.1 Career CounselingInitial Board Order
3210.0 Section 4(c)(8) of the BHC ActMoney Orders,

Savings Bonds, and Travelers Checks

3210.1 Payment Instruments

3210.1.1 Issuing Consumer-Type Payment Instruments Having
a Face Value of Not More than $10,000
3210.1.2 Issuing and Selling Official Checks with No Maximum
Face Value
3210.1.3 Issuing and Selling Drafts and Wire Transfers Payable
in Foreign Currencies
3210.1.4 Issuing and Selling Variably Denominated Payment
Instruments without Limitation as to Face Value
3220.0 Section 4(c)(8) of the BHC ActArranging

Commercial Real Estate Equity Financing
3230.0 Section 4(c)(8) of the BHC ActAgency

Transaction Services for Customer Investments
(Securities Brokerage)
3230.0.1 Overview on Securities Brokerage as a Nonbanking

Activity
3230.0.2 Initial Board Order Approval for Securities Brokerage
3230.0.2.1 Margin Lending
3230.0.2.2 Maintenance of Customer Securities Accounts
3230.0.2.3 Custodial Services
3230.0.3 Margin Credit Activities and Securities Brokerage
3230.0.4 Activity Added to Regulation Y
3230.0.5 Market Entry into Securities Brokerage

Page 11
3230.0.6 Purpose of Inspection of Securities Brokerage

Activities
3230.0.8 Scope of Inspection
3230.0.9 Materials Required for Inspection
3230.0.10.1 Organization and Management
3230.0.10.2 Operations
3230.0.10.2.1 Execution
3230.0.10.2.2 Settlement
3230.0.10.2.3 Delivery
3230.0.10.2.4 Recordkeeping
3230.0.10.2.5 Audits and Controls
3230.0.10.3 Conflicts of Interest
3230.0.10.3.1 Relationship with Affiliated Trust Departments
3230.0.10.4 Earnings, Volume Trends, and Prospects
3230.0.10.6 Presentation of Findings
3230.0.11 Examination Checklists
3230.0.11.1 Securities Brokerage Inspection Checklist
3230.0.11.2 Securities Brokerage/Internal Control Checklist
3230.05 Section 4(c)(8) of the BHC ActSecurities

Brokerage (Board Decisions)
3230.1 Securities Brokerage in Combination with
Investment Advisory Services
3230.2 Securities Brokerage with Discretionary Investment

Management and Investment Advisory Services
3230.3 Offering Full-Service Brokerage Services for

Bank-Ineligible Securities
3230.4 Private-Placement and Riskless-Principal Activities
3230.4.1 Engaging in Commercial-Paper Placement Activities

to a Limited Extent
3230.4.2 Acting as Agent in the Private Placement of All
Types of Securities and Acting as Riskless Principal
3230.4.3 Incorporation of Private-Placement Nonbanking
Activities into the Boards Regulation Y
3230.4.4 Riskless Principal
3230.4.4.1 Description of Riskless-Principal Transactions
3230.4.4.2 Underwriting and Riskless Principal
3230.4.4.3 Summary of Board Action on Acting as Agent in
Private Placement and as Riskless Principal in
Buying and Selling Securities
3230.4.4.4 Changes to the Underwriting Conditions for Riskless-
Principal Activities
3230.4.4.5 Incorporation of Riskless-Principal Transactions into
Regulation Y

Page 12
3230.5 Acting as a Municipal Securities Brokers Broker
3230.6 Acting as a Conduit in Securities Borrowing and Lending
3240.0 Section 4(c)(8) of the BHC ActUnderwriting and

Dealing in U.S. Government Obligations, Municipal
Securities, and Money Market Instruments
3240.0.1 History of Board Approvals of Underwriting and

Dealing in Government Obligations and Money
Market Instruments
3240.0.2 Adding the Activity to Section 225.28(b) of
Regulation Y
3240.0.3 Regulation of Dealer Activities
3240.0.4 Dealer Activities
3240.0.5 Government and Municipal Securities
3240.0.6 U.S. Government Securities Trading
3240.0.6.1 When-Issued Trading
3240.0.6.2 Due Bills
3240.0.6.3 Clearance
3240.0.6.4 Short Sales
3240.0.6.5 Arbitrage
3240.0.7 Money Market Trading
3240.0.7.1 Bankers Acceptances
3240.0.7.2 Certificates of Deposit
3240.0.8 Repurchase Agreements and Securities Lending
3240.0.9 Policy Summary
3240.0.10 Scope of the Inspection
3240.0.13 Review of Internal Controls
3240.0.13.1 Securities Underwriting Trading Policies
3240.0.13.2 Offsetting Resale and Repurchase Transactions
3240.0.13.3 Custody and Movement of Securities
3240.0.13.4 Purchase and Sales Transaction
3240.0.13.5 Customer and Dealer Accounts
3240.0.13.6 Other
3250.0 Section 4(c)(8) of the BHC ActAgency Transactional

Services (Futures Commission Merchants and
Futures Brokerage)
3250.0.1 Scope of Guidance

3250.0.2 Evaluation of FCM Risk Management
3250.0.2.1 Board and Senior Management Oversight
3250.0.2.2 Policies, Procedures, and Limits
3250.0.2.3 Risk Measurement, Monitoring, and Reporting
3250.0.3 Futures Exchanges, Clearinghouses, and FCMs
3250.0.4 Commodity Exchange Act, Commodity Futures Trading
Commission, and Self-Regulatory Organizations
3250.0.5 Federal Reserve Regulation of FCMs and CTAs

Page 13
3250.0.6 Participation in Foreign Markets

3250.0.7 Specific Risks and Their Risk-Management
Considerations
3250.0.7.1 Credit Risk
3250.0.7.1.1 Customer-Credit Risk
3250.0.7.1.2 Customer-Financing Risk
3250.0.7.1.3 Clearing-Only Risk
3250.0.7.1.4 Carrying-Broker Risk
3250.0.7.1.5 Executing-FCM Risk
3250.0.7.1.6 Pit-Broker Risk
3250.0.7.1.7 Clearinghouse Risk
3250.0.7.1.8 Guarantees
3250.0.7.2 Market Risk
3250.0.7.3 Liquidity Risk
3250.0.7.4 Reputation Risk
3250.0.7.4.1 Commodity Trading Adviser
3250.0.7.5 Operations Risk, Internal Controls, Internal Audits,
and Compliance
3250.0.7.5.1 Operations Risk
3250.0.7.5.2 Internal Controls
3250.0.7.6 Internal Audits and Their Review
3250.0.8 Inspection Guidance
3250.0.10 FCM Inspection Procedures
3250.0.11 FCM Supplemental Checklist Questionnaire
3251.0 Futures Commission Merchants Board Orders
3251.0.1 FCM Brokerage of Futures Contracts on a Municipal
Bond Index
3251.0.2 FCM Brokerage of Certain Futures Contracts on
Stock Indexes Including Options
3251.0.3 Limited FCM Clearing-Only and Executing-Only Trades
3251.0.4 FCM Clearing Transactions by Preapproved Execution
Groups
3251.0.5 FCMExecuting and Clearing, and Clearing Without
Executing, Futures and Options on Futures on
Nonfinancial Commodities
3251.0.5.1 BHCs Execution and Clearance of Futures and Options
on Futures on Nonfinancial Commodities
3251.0.5.2 FCMs Execution and Clearance of Futures and Options
on Futures on Nonfinancial Commodities
3251.0.6 FCM and Related Advisory Services for Options on
Eurotop 100 Index Futures and the One-Month Canadian
Bankers Acceptance Futures
3251.0.7 FCM Trading for Its Own Account in Futures, Options,
and Options on Futures Contracts Based on Certificates
of Deposit or Other Money Market Instruments
3251.0.8 FCM Engaging in Commodity and Index Swap
Transactions as an Originator, Principal, Agent,
Broker, or Advisor

Page 14
3251.0.9 FCM Trading in Futures, Options, and Options on Futures

Contracts Based on Commodities or on Stock, Bond,
or Commodity Indices for Its Own Account
3251.0.10 Appendix APrevious Prior-Approval Requirements for
Bank Holding Companies Proposing to Engage in
FCM Activities
3251.0.11 Providing Discretionary Portfolio Management Services
on Futures and Options on Futures on Financial
Commodities
3251.0.12 FCM Execution, Clearance, and Advisory Services for
Contracts on Financial and Nonfinancial Commodities
for Noninstitutional Customers
3251.0.12.1 Providing FCM Services to Certain Sophisticated
Noninstitutional Customers
3251.0.12.2 Foreign-Exchange Activities
3251.0.12.3 Boards Decision on the Proposed FCM Activities
3251.0.13 FCM Serving as a Primary Clearing Firm for a Limited
Number of Floor Traders and Brokerage Services for
Forward Contracts on Financial and Nonfinancial
Commodities
3251.0.13.1 Primary Clearing Firm for a Limited Number of
Professional Floor Traders
3251.0.13.2 Brokerage Services with Respect to Forward Contracts
Based on Certain Financial and Nonfinancial
Commodities
3251.0.13.3 Conclusion
3255.0 Agency Transactional ServicesOther Transactional
Services
3255.0.1 Brokering Options on Securities Issued or

Guaranteed by the U.S. Government and Its
Agencies and Options on U.S. and Foreign
Money-Market Instruments
3255.0.2 Brokering Options in Foreign Currency on Exchanges
Regulated by the SEC
3255.0.3 Executing and Clearing CFTC-Regulated Options on
Bullion and Foreign Exchange on Authorized
Commodity Exchanges
3260.0 Section 4(c)(8) of the BHC ActInvestment Transactions

as Principal
3260.0.1 Underwriting and Dealing in Government Obligations

and Money Market Instruments
3260.0.2 Foreign Exchange
3260.0.3 Dealing in Gold, Silver, Platinum, and Palladium
Bullion and Coins
3260.0.4 Engaging as Principal in Derivatives Involving Financial
Assets and Nonfinancial Assets or Groups of Assets
3260.0.4.1 Trading for a Companys Own Account in Futures, Options,
and Options on Futures Based on U.S. Government
Securities and Certain Money Market Instruments

Page 15
3260.0.4.2 Dealing as a Registered Options Trader on Foreign-

Exchange Options
3260.0.4.3 Acting as a Specialist in Options on Foreign Exchange
3260.0.4.4 Acting as a Dealer, Broker with Respect to Interest-
Rate and Currency Swaps and Related Transactions
3260.0.4.5 Currency Swaps for Hedging a BHCs Own Position
in Foreign Currency
3260.0.4.6 Derivative Transactions as Principal
3270.0 Section 4(c)(8) of the BHC ActReal Estate and

Personal Property Appraising
3270.0.1 Scope of Inspection

3270.0.2 Appraisal Standards for Federally Related
Transactions
3270.0.3 Appraisers Qualifications
3270.0.4 Key Components of a Personal Property Appraisal
Report
3270.0.5 Appraisal of Construction and Construction Analysis
Services
3320.0 Section 4(c)(8) of the BHC ActCheck-Guaranty

and Check-Verification Services

3330.0 Section 4(c)(8) of the BHC ActOperating a

Collection Agency

3340.0 Section 4(c)(8) of the BHC ActOperating a Credit

Bureau

3500.0 Tie-In Considerations of the BHC Act
3500.0.1 Anti-Tying Restrictions and Other Provisions

3500.0.1.1 Section 106 Statutory Exception
3500.0.2 Regulatory Exceptions
3500.0.2.1 Traditional-Bank-Product Exception
3500.0.2.2 Safe Harbor for Combined-Balance Discounts

Page 16
3500.0.2.2.1 Combined-Balance DiscountMembers of a Household

or Family, Taken Together, May Constitute a
Customer
3500.0.2.3 Safe Harbor for Foreign Transactions
3500.0.2.4 Bank Holding Company Subsidiary Banks Issuing Securities-
Based Credit
3500.0.2.4.1 A BHCs Subsidiary Banks Issuing Securities-Based
Credit Can Require Borrowers to Keep the Securities
Collateral in an Account at the BHCs Broker-
Dealer Affiliate
3500.0.2.4.2 Bank Customers Receiving Securities-Based Credit
Can Be Required to Hold Securities Collateral
at a Broker-Dealer Affiliate Account
3500.0.3 Applicability of Anti-Tying Exceptions to Entities
Other Than Banks
3500.0.4 Tying Arrangements Relating to Nonbank Banks
3500.0.5 Voluntary Versus Involuntary Tying Arrangements
3500.0.8 Inspection Checklist for Compliance with the Tying
Prohibitions
3510.0 Sections 4(c)(9) and 2(h) of the BHC Act

Nonbanking Activities of Foreign Banking
Organizations
3510.0.1 Regulation K
3510.0.2 Nonbanking Exemptions from the BHC Act
for QFBOs Under Sections 4(c)(9) and 2(h)
3510.0.2.1 Section 4(c)(9) of the BHC Act
3510.0.2.2 Section 2(h) of the BHC Act
3510.0.2.3 Foreign Banks Underwriting of Securities
3510.0.3 Grandfather Rights
3520.0 Section 4(c)(10) of the BHC ActGrandfather

Exemption from Section 4 for BHCs Which
Are Banks
3530.0 Section 4(c)(11) of the BHC ActAuthorization for

BHCs to Reorganize Share Ownership Held on the
Basis of Any Section 4 Exemption
3540.0 Section 4(c)(12) of the BHC ActTen-Year

Exemption from Section 4 of the BHC Act
3550.0 Section 4(c)(13) of the BHC ActInternational

Activities of Domestic Bank Holding Companies
3550.0.1 Investments and Activities Abroad

3550.0.2 Investment Procedures

Page 17
3550.0.3 General Consent for Well-Capitalized and Well-Managed

Investors
3550.0.3.1 Individual Limit for Investment in a Subsidiary
3550.0.3.2 Individual Limit for Investments in a Joint Venture
3550.0.3.3 Individual Limit for Portfolio Investment
3550.0.3.4 Aggregate Investment Limits
3550.0.4 Limited General Consent for an Investor That Is Not Well
Capitalized or Well Managed
3550.0.4.1 Individual Limit
3550.0.4.2 Aggregate Limit
3550.0.5 Calculating Compliance with the Individual and Aggregate
General-Consent Limits
3550.0.6 Other Eligible Investments Under General Consent
3550.0.7 Investment Ineligible for General Consent
3550.0.8 Investments Made with Prior Notice to or the Specific
Consent of the Board
3550.0.9 Examination of Foreign Subsidiaries of BHCs
3550.0.10 Investments by Bank Holding Companies, Edge
Corporations, and Member Banks in Foreign
Companies
3560.0 Section 4(c)(14) of the BHC ActExport Trading

Companies

3560.0.1.1 Export Trading Company Questionnaire
3600.0 Permissible Activities by Board Order

3600.1 Operating a Pool Reserve Plan
3600.2 Reserved
3600.4
3600.5 Engaging in Nonbank Activities via Foreign Branches
3600.5.1 New York Investment Company

3600.5.2 Engaging in Banking Activities through Foreign
Branches of a Nonbank Company
3600.6 Operating a Securities Exchange
3600.7 Acting as a Certification Authority for Digital Signatures
3600.7.1 Acting as Certification Authority in Connection with

Financial and Nonfinancial Transactions
3600.8 Private Limited Investment Partnership

Page 18
3600.9 Reserved
3600.12
3600.13 FCM Activities
3600.13.1 Serving as, and Controlling a Private Limited Partnership

as, a Commodity Pool Operator
3600.14 Reserved
3600.16

Page 18.1
3600.17.1 Engaging in Title Insurance Agency Activities

Pursuant to Regulation Y
3600.18 Reserved
3600.20
3600.21 Underwriting and Dealing
3600.21.1 Underwriting and Dealing in Commercial Paper to a

Limited Extent
3600.21.2 Engage in Underwriting and Dealing, to a Limited
Extent, in Municipal Revenue Bonds, Mortgage-
Related Securities, and Commercial Paper
3600.21.3 Engage in Limited Underwriting and Dealing in
Consumer-Receivable-Related Securities
3600.21.4 Limited Underwriting and Dealing in Debt and Equity
Securities
3600.21.5 Acting as a Dealer-Manager in Connection with
Cash-Tender and Exchange-Offer Transactions
3600.21.6 Underwriting Private Ownership Industrial
Development Bonds
3600.22 Reserved
3600.23 Issuance and Sale of Mortgage-Backed Securities

Guaranteed by GNMA
3600.24 Sales Tax Refund Agent and Cashing U.S. Dollar

Payroll Checks
3600.24.1 Acting as a Sales Tax Refund Agent for the

State of Louisiana
3600.24.2 Cashing U.S. Dollar Payroll Checks Drawn on
Unaffiliated Banks
3600.25 Providing Government Services

3600.26 Real Estate Settlement Through a Permissible Title
Insurance Agency
3600.27 Providing Administrative and Certain Other Services

to Mutual Funds
3600.27.1 Glass-Steagall Act Issues in Providing Administrative

Services
3600.27.2 Permissibility of Proposed Administrative Services
Activities
3600.27.3 Boards Conclusion on Providing Administrative Services
3600.28 Developing Broader Marketing Plans and Advertising

and Sales Literature for Mutual Funds
3600.28.1 Control Considerations Involving Promotional

and Marketing Activities

Page 19
3600.28.2 Management Interlock Control Considerations

3600.29 Providing Employment Histories to Third Parties
3600.29.1 Credit-Related Employment Histories

3600.29.2 Non-Credit-Related Employment Histories
3600.30 Title Abstracting
3600.30.1 Real Estate Title Abstracting Activities

3600.30.2 Aircraft Title Abstracting Activities
3610.1 Financing Customers Commodity Purchase and Forward

Sales
3610.2 Certain Volumetric-Production-Payment Transactions

Involving Physical Commodities
3700.0 Impermissible Activities
3700.1 Land Investment and Development
3700.2.1 Premium Funding

3700.2.2 Life Insurance Underwriting
3700.2.3 Sale of Level-Term Life Insurance
3700.2.4 Underwriting Real Estate Mortgage Guarantee
Insurance
3700.2.5 Underwriting Property and Casualty Insurance
3700.2.6 Title Insurance
3700.3 Real Estate Brokerage and Syndication
3700.3.1 Brokerage
3700.3.2 Syndication
3700.4 General Management Consulting
3700.5 Property Management
3700.6 Travel Agencies
3700.7 Providing Credit Ratings on Bonds, Preferred Stock,

and Commercial Paper
3700.8 Acting as a Specialist in Foreign-Currency Options on

a Securities Exchange
3700.9 Design and Assembly of Hardware for the Processing

or Transmission of Banking and Economic Data
3700.10 Armored Car Services

Page 20
3700.11 Computer Output Microfilm Service
3700.12 Clearing Securities Options and Other Financial

Instruments for the Accounts of Professional
Floor Traders
3900.0 Section 4(k) of the BHC ActFinancial Holding
Companies
3900.0.1 FHC Supervisory Oversight Authority
3900.0.2 Roles of Supervisors
3900.0.3 FHC Supervision Objectives
3900.0.4 FHC Supervision in Practice
3900.0.4.1 Information Gathering, Assessments, and Supervisory
Cooperation
3900.0.4.2 Ongoing Supervision
3900.0.4.2.1 FHC Structure, Management, and the Applications Process
3900.0.4.2.2 Reporting and Examination
3900.0.4.2.3 Capital Adequacy
3900.0.4.2.4 Intra-Group Exposures and Concentrations
3900.0.4.2.5 Enforcement Powers
3900.0.4.3 Promotion of Sound Practices and Improved Disclosure
3900.0.4.4 Supervisory Response to Challenges Posed by FHCs
3901.0 U.S. Bank Holding Companies Operating as Financial

Holding Companies
3901.0.1 Supervisory Concerns
3901.0.2 Holding Company Fails to Continue Meeting Financial
Holding Company Capital and Management
Requirements
3901.0.3 Depository Institution Subsidiary Fails to Maintain a
Satisfactory or Better CRA Rating
3902.0 Reserved
3903.0 Foreign Banks Operating as Financial Holding Companies
3903.0.1 Financial Holding Company Qualification Requirements

for Foreign Banks
3903.0.2 Foreign Bank Fails to Continue Meeting FHC
Capital and Management Requirements
3903.0.3 Insured Branch Fails to Maintain a Satisfactory
or Better CRA Rating
3904.0 Reserved
3905.0 Permissible Activities for FHCs
3905.0.1 Nonbank Activity Authorizations for FHCs

3905.0.2 Activities That Are Permissible for FHCs Under
Section 225.86(a) of Regulation Y

Page 21
3905.0.3 Securities Underwriting, Dealing, and Market-Making

Activities
3906.0 Disease Management and Mail-Order Pharmacy Activities
3907.0 Merchant Banking
3907.0.1 Merchant Banking Investment Authority

3907.0.2 Permitted Investments
3907.0.2.1 Securities Affiliate
3907.0.2.2 Investments in Companies Engaged in Nonfinancial
Activities
3907.0.2.3 Bona Fide Underwriting or Merchant Banking
or Investment Activity
3907.0.2.3.1 Investments Made Directly or Through Funds
3907.0.2.3.2 Definition of Portfolio Company and Financial Holding
Company
3907.0.3 Limits on Managing or Operating a Portfolio Company
Held as a Merchant Banking Investment
3907.0.3.1 Relationships That Involve Routine Management
or Operation
3907.0.3.2 Relationships That Do Not Constitute Routine Management
or Operation
3907.0.3.2.1 Other Permissible Covenants Not Involving the FHC in
Routinely Managing and Operating a Portfolio Company
3907.0.3.2.2 FHC May Routinely Manage or Operate a Portfolio
Company in Special Circumstances
3907.0.3.3 Depository Institutions Prohibited from Managing
or Operating Portfolio Companies
3907.0.4 Holding Periods for Merchant Banking Investments
3907.0.4.1 Holding-Period Tacking Provisions
3907.0.5 Private Equity Funds
3907.0.5.1 Definition of Private Equity Fund
3907.0.5.2 Permissible Holding Period for Private Equity Fund
Investments
3907.0.5.3 Routine Management and Operation Restrictions for Private
Equity Funds
3907.0.5.4 Other Matters Related to Private Equity Funds
3907.0.5.4.1 Funds That Are Not Qualifying Private Equity Funds
3907.0.6 Temporary Aggregate Investment Thresholds for MBIs
3907.0.7 Risk-Management, Reporting, and Recordkeeping Policies
3907.0.7.1 Policies, Procedures, Systems, and Reports
3907.0.7.2 Notice of Commencement of Merchant Banking Activities
3907.0.7.3 Quarterly and Annual Reporting Requirements
3907.0.7.4 Notice of Large Merchant Banking Acquisitions
3907.0.8 Cross-Marketing Restrictions
3907.0.8.1 Marketing Products or Services Involving a Portfolio
Company
3907.0.9 Presumption of Control Under Sections 23A and 23B
of the FRA

Page 22
3908.0 Reserved
3909.0 Supervisory Guidance on Equity Investment and Merchant

Banking Activities
3909.0.1 Legal and Regulatory Authority for Equity Investments
3909.0.2 Sound Practices for Equity Investments
3909.0.2.1 Oversight by the Board of Directors and Senior
Management
3902.0.2.2 Management of the Investment Process
3909.0.2.2.1 Equity Investment Policies and Limits
3909.0.2.2.2 Equity Investment Procedures
3909.0.2.3.1 Documentation of the Investment Process
3909.0.2.3.2 Legal Compliance
3909.0.2.3.3 Compensation
3009.0.3 Disclosure of Equity Investment Activities
3009.0.4 Institutions Lending to or Engaging in Other Transactions
with Portfolio Companies
3909.0.5 Supervisory Objectives
3909.0.6 Supervisory Procedures
3910.0 Acting as a Finder
3910.0.1 Limitations on an FHC That Acts as a Finder

3910.0.2 Required Disclosures
3912.0 To Acquire, Manage, and Operate Defined Benefit Pension

Plans in the United Kingdom
3920.0 Limited Physical-Commodity-Trading Activities
3920.0.1 Engaging in Limited FHC Commodity-Trading Activities

Involving a Particular Commodity as a Complement to
the BHC-Permissible Financial Activity of Engaging
Regularly in Commodity Derivatives Based on That
Commodity
3920.0.2 Trading in Certain Physical Commodities not Approved by
the CFTC for Trading on a Futures Exchange
3920.0.2.1 Commodities Approved for Trading on Non-U.S. Exchanges
3920.0.2.1.1 Take and Make Delivery of Nickel
3920.0.2.2 Commodities That Are Not Approved for Trading in the
U.S. or on Certain Non-U.S. Exchanges
3920.0.2.2.1 Market in Financially Settled Contracts
3920.0.2.2.2 Fungibility
3920.0.2.2.3 Liquidity
3920.0.2.2.4 Trading Limits
3920.0.2.2.5 Altering Commodities
3920.0.2.2.6 Risks of Proposed Physical Commodity Trading Activities
3920.0.3 Energy Management Services as a Complement to a
Financial Activity
3920.0.3.1 Provision of Energy Management Services
3920.0.3.2 Energy Management Services as a Complementary Activity
3920.0.3.3 Limitations on Energy Management Services

Page 23
3920.0.4 Energy Tolling Services as A Complement to a Financial

Activity
3920.0.4.1 FHCs Proposal
3920.0.4.2 Physical Commodity Trading
3920.0.4.3 Long-Term Electricity Supply Contracts
3920.0.4.4 Energy Tolling Agreements
3920.0.4.5 Risks of Energy Tolling
3920.0.4.6 Energy Tolling is Complementary
3950.0 Insurance Sales Activities and Consumer Protection in Sales

of Insurance
3950.0.1 Overview and Scope
3950.0.2 Supervisory Approach for the Review of Insurance
and Annuity Sales Activities
3950.0.2.1 Supervisory Objective
3950.0.2.2 State Regulation of Insurance Activities
3950.0.2.3 Functional Regulation
3950.0.2.4 Information Sharing with the Functional Regulator
3950.0.3 Statutory and Regulatory Requirements and Policy
Guidance
3950.0.3.1 Privacy Rule and the Fair Credit Reporting Act
3950.0.3.2 Anti-Tying Prohibitions
3950.0.3.3 Policy Statement on Income from Sale of Credit Life
Insurance
3950.0.4 Risk-Management Program
3950.0.4.1 Elements of a Sound Insurance or Annuity Sales Program
3950.0.4.1.1 Sales Practices and Handling of Customer Complaints
3950.0.4.1.2 Third-Party Arrangements
3950.0.4.1.3 Designation, Training, and Supervision of Personnel
3950.0.5 Risk Assessment of Insurance and Annuity Sales Activities
3950.0.6 Consumer Protection in Sales of Insurance Rules
3950.0.6.1 Overview of the CPSI Regulation
3950.0.6.2 Misrepresentations Prohibited
3950.0.6.3 Insurance Disclosures
3950.0.6.4 Credit Disclosures
3950.0.6.5 Consumer Acknowledgment
3950.0.6.6 Location
3950.0.6.7 Referrals
3950.0.6.8 Qualifications
3950.0.6.9 Relationship of the CPSI Regulation to State Regulation
3950.0.6.10 Relationship to Federal Reserve Guidance on the Sale
3950.0.6.11 Examining a State Member Bank for Compliance with
the CPSI Regulation
3950.7 Appendix AJoint Interpretations of the Consumer
Protection in Sales of Insurance Regulation
3950.0.7.1 Disclosures
3950.0.7.1.1 Credit Disclosures
3950.0.7.1.2 Disclosures for Sales by Mail and Telephone
3950.0.7.1.3 Use of Short-Form Insurance Disclosures

Page 24
3950.0.7.2 Acknowledgment of Disclosures

3950.0.7.2.1 Reasonable Efforts to Obtain Written Acknowledgment
3950.0.7.2.2 Appropriate Form or Format for Acknowledgment Provided
Electronically
3950.0.7.2.3 Retention of Acknowledgments by an Insurance Company
3950.0.7.2.4 Form of Written Acknowledgment
3950.0.7.2.5 Timing of Acknowledgment Receipt
3950.0.7.3 Scope of the CPSI Regulation
3950.0.7.3.1 Applicability to Private Mortgage Insurance
3950.0.7.3.2 Applicability to Federal Crop Insurance
3950.0.7.3.3 Solicitations and Applications Distributed Before,
but Returned After, the Effective Date of the CPSI
Regulation
3950.0.7.4 Renewals of Insurance
3950.0.7.4.1 Disclosures Required with Renewals of Insurance Coverage
3950.0.7.4.2 On-Behalf-of Test and Use of Corporate Name or Logo
3950.0.7.5.1 Appropriate Documentation of an Oral Disclosure or Oral
Acknowledgment
3950.0.7.5.2 Setting for Insurance Sales
3950.0.8 Appendix BGlossary
3950.0.10.1 Risk Assessment of Insurance and Annuity Sales Activities
3950.0.10.2 Consumer Protection in Sales of Insurance Regulation
3950.0.11.1 Risk Assessment of Insurance and Annuity Sales Activities
3950.0.11.1.1 Program Management
3950.0.11.1.2 Management Information Systems
3950.0.11.1.3 Compliance Programs and Internal Audits
3950.0.11.2 Consumer Protection in Sales of Insurance Regulation
3950.0.11.2.1 Advertising and Promotional Materials
3950.0.11.2.2 Disclosures
3950.0.11.2.3 Consumer Acknowledgment
3950.0.11.2.4 Physical Separation from Deposit Activities
3950.0.11.2.5 Qualifications and Licensing
3950.0.11.2.6 Hiring, Training, and Supervision
3950.0.11.2.7 Referrals
3950.0.11.2.8 Third-Party Agreements
3950.0.11.2.9 Consumer Complaints
3980.0 Establishment of an Intermediate Holding Company
3980.0.1 Additional Board Authority for Certain Nonbank Financial

Companies and Bank Holding Companies
3980.0.1.1 Establishment of an Intermediate Holding Company
3980.0.1.1.1 Action the Board May Require
3980.0.1.1.2 Required Board Actions
3980.0.2 Internal Financial Activities
3980.0.3 Source of Strength
3980.0.4 Parent Company Reports
3980.0.5 Limited Parent Company Enforcement
3980.0.5.1 Application of Other Act

Page 25
Introduction to BHC Nonbanking and FHC Activities
Section 3000.0
WHATS NEW IN THIS REVISED company the activities of which the Board
SECTION after due notice and opportunity for hearing
has determinedpursuant to section 225.28 of
Section 604(e) of the Dodd-Frank Wall Street Regulation Y or Board order issued prior to
Reform and Consumer Protection Act of 2010, November 12, 1999to be so closely related to
Pub. L. No. 111203, 124 Stat. 1601 (2010), banking or managing or controlling banks as to
(Dodd-Frank Act), added the ...risk to the sta- be a proper incident thereto. The act also pro-
bility of the United States banking or financial vided that any bank holding company might
system... to the example listing of possible apply to the Board for permission to engage in
adverse effects. The amendment is included an activity that had not yet been determined to
below. See 12 U.S.C. 1843(j)(2)(A). be permissible if the applicant was of the opin-
ion that the activity in its particular circum-
The Bank Holding Company Act of 1956 (BHC stances was closely related to banking or man-
Act) was enacted to limit the expansion of bank- aging or controlling banks. Section 225.28(b) of
ing institutions into nonbanking activities. A the Boards Regulation Y lists permissible non-
bank holding company was defined in the BHC banking activities that the Board has deemed to
Act as an entity that owned or controlled 25 per- meet these criteria. (See appendix 1.) The list of
cent or more of the voting shares of two or permissible nonbanking activities has been
more banks; companies owning only one bank expanded at various times.
were exempted from regulation under the BHC The Board also has permitted by order, on an
Act. individual basis, certain activities that it has
During the 1960s, the number of commercial considered to be closely related to banking
enterprises that purchased one bank, engaged in under section 4(c)(8) of the BHC Act. In doing
nonbanking activities, and remained exempt from so, the Board did not expand the list of permis-
regulation grew dramatically. As a result of this sible activities under section 225.28(b) of Regu-
change in the structure of bank ownership, Con- lation Y. (For a list of such activities, see appen-
gress enacted the Bank Holding Company Act dix 2.)
Amendments of 1970. Of these amendments, In determining whether the performance of a
the most significant is the extension of the act to nonbank activity by a bank holding company or
grant to the Federal Reserve Board the authority the acquisition of a nonbank firm by a bank
to regulate the activities of one-bank holding holding company was a proper incident to bank-
companies. ing, the Board applies a public interest test.
In 1978, Congress passed the International The Board must consider whether performance
Banking Act (IBA). Section 8 of the IBA expanded of a nonbank activity by a bank holding com-
the nonbanking prohibitions of the BHC Act to pany or a subsidiary of such company can rea-
foreign banks that engage in the business of sonably be expected to produce benefits to the
banking in the United States directly through a public, such as greater convenience, increased
branch or agency or indirectly through a subsid- competition, or gains in efficiency, that out-
iary commercial lending company. This expanded weigh possible adverse effects, such as undue
the nonbanking restrictions beyond simply cov- concentration of resources, decreased or unfair
ering foreign banks that own or control U.S. competition, conflicts of interest, unsound bank-
banks or bank holding companies. However, ing practices, or risk to the stability of the
section 2(h) of the BHC Act provides foreign United States banking or financial system. (See
organizations that are principally engaged in the 12 U.S.C. 1843(j)(2)(A).)
business of banking outside the United States An interpretation of Regulation Y (12 C.F.R.
with exemptions from the nonbanking prohibi- 225.126) dated April 28, 1972, and amended
tions of the BHC Act. Further exemptions have September 20, 1972, listed activities that the
been granted by the Boards discretionary author- Board determined do not satisfy the so closely
ity under section 4(c)(9) when such exemptions related test under section 4(c)(8). The Board
were in the public interest and were consistent subsequently determined that a number of other
with the purposes of the BHC Act. activities do not satisfy the closely related test.
Under section 4(c) of the BHC Act, Congress (For a complete list of these impermissible
exempted a limited number of investments from activities, see appendix 3, and, for a brief
the general prohibition against owning or con-
trolling shares of nonbank concerns. Section BHC Supervision Manual July 2012
4(c)(8) permitted investment in shares of any Page 1
Introduction to BHC Nonbanking and FHC Activities 3000.0
description of a selected number of the activities BHCs Engaging in Nonbanking Activities

denied by the Board, see section 3700.0 et seq.) in Foreign Countries
As the primary regulator for bank holding
companies and their directly held nonbank sub- A bank holding company has greater leeway to
sidiaries, the Federal Reserve System conducts perform nonbanking activities abroad than in
inspections of their operations, financial condi- the United States in that it may engage in non-
tion, and compliance with appropriate banking banking activities abroad that would not be per-
and other related statutes and regulations. Inspec- missible in the United States. However, activi-
tion personnel are called upon to evaluate the ties abroad are subject to limitations. Section
current condition of the organizations, as well as 211.8 of Regulation K requires a bank holding
their future prospects. company to limit its direct and indirect activities
On August 10, 1987, the Competitive Equal- abroad to those usual in connection with bank-
ity Banking Act of 1987 was signed into law. ing and financial activities and to necessary
This act redefined the definition of bank in related activities. Section 211.10 also lists par-
section 2 of the BHC Act so that an FDIC- ticular activities that are permissible abroad and
insured institution is deemed a bank. An in- provides rules regarding when a bank holding
sured bank is defined in section 3(h) of the company must submit an application to engage
Federal Deposit Insurance Act (12 U.S.C. in such activities directly or through investments.
1813(h)).
Edge Act or Agreement Corporations

State-Authorized Activities of Savings
Banks A bank holding company may own an Edge Act
or agreement corporation. The Federal Reserve
A special rule was established for qualified Act and Regulation K govern the permissible
savings banks (state-chartered, FDIC-insured activities of Edge Act or agreement corpora-
institutions organized before March 5, 1987) tions. An Edge Act or agreement corporation is
that are subject to the BHC Act. (See section an international banking vehicle that may only
2090.7.) In accordance with section 3 of the engage in listed or approved activities that are
BHC Act, a qualified savings bank may engage incidental to international or foreign business.
in any nonbanking activity, except insurance (See 12 C.F.R. 211.6) The restriction generally
activities, either directly or through a subsidiary, permits an Edge Act or agreement corporation
that it is permitted to conduct directly as a to engage only in international banking or finan-
state-chartered savings bank, even if those cial activities. (See 12 C.F.R. 211.8.)
activities are not otherwise permissible for bank
holding companies. To engage in those activi-
ties, however, a qualified savings bank must Companies that own only an Edge Act or agree-
remain a savings bank and a subsidiary of a ment corporation. Any company, other than a
savings bank holding company (a company that bank, that acquired an Edge Act or agreement
controls one or more qualified savings corporation after March 5, 1987, must conform
banks whose total aggregate assets, upon forma- its activities to section 4 of the BHC Act.
tion and at all times thereafter, constitute at
least 70 percent of the assets of the holding
company). With respect to insurance activities,
qualified savings banks may engage in under-
writing and selling savings bank life insurance
if the savings bank is located in Connecticut,
Massachusetts, or New York, and if certain other
conditions are met.

Page 2
Underwriting and Dealing in Debt and

Equity Securities
Beginning in January 1989, certain nonbanking

subsidiaries of bank holding companies were
approved to underwrite and deal in debt or
equity securities (excluding open-end invest-
ment companies), subject to the prohibition on
affiliation with an organization dealing in securi-
ties under section 20 of the Glass-Steagall Act.
(See 1989 FRB 192.) The Board delayed com-
mencement of the activity by each applicant
until it determined that the applicant had estab-
lished the necessary managerial and operational
infrastructure to commence the expanded under-
writing and dealing activity and to comply with
the Board order. The applicants capital plan
had to be determined to be adequate along with
the necessary policies and procedures needed to
comply with the Boards order. The Boards
order requires that loans to and capital invest-
ments in the underwriting subsidiary be deducted
from the bank holding companys capital, as
provided for in the Boards capital adequacy
guidelines. The Board further confirmed that the
activities could not be conducted in any other
subsidiary other than the Board-approved sec-
tion 20 subsidiary. (See section 3600.21.4.)
As for underwriting and dealing in equity
securities, the Board stated in the order that it
would review within a year whether applicants
could commence the activity. The first Board

Page 2.1
authorization to commence underwriting and Act. The revenues derived therefrom should not
dealing in equity securities was given on Sep- be subject to the 25 percent revenue limitation
tember 20, 1990, subject to the commitments placed on bank-ineligible securities activities.
given by the bank holding company in connec- (See section 3230.4.)
tion with its respective Board order, including
its commitment to maintain the capital of its
section 20 subsidiary at levels necessary to sup- Foreign Banks Authorized to Operate
port its activities and commensurate with indus- Section 20 Subsidiaries to Underwrite
try standards, and to increase the capital of the and Deal in Corporate Debt, Commercial
section 20 subsidiary accordingly as it grew. Paper, and Other Securities
In a Board order (1990 FRB 158), the Board
Modifications to the Boards Orders authorized a foreign bank to operate a section
Authorizing BHC Subsidiaries to 20 subsidiary under the bank to underwrite and
Underwrite and Deal in Bank-Ineligible deal in corporate debt, commercial paper, and
Securities Consistent with Section 20 of other securities. (Securities issued by open-end
the Glass-Steagall Act investment companies are not included.) The
foreign bank operated outside the United States
The Board announced its approval of modifica- but owned a subsidiary bank in the United
tions to its previous section 20 authorizations by States. To achieve equality between the domes-
order on September 21, 1989 (1989 FRB 751). tic and foreign banking operations in the United
The modifications (1) raised from 5 percent to States and in an effort to negate any advantages
10 percent (currently 25 percent) the revenue that a foreign bank might have over a domestic
limit on the amount of total revenues a section bank, the Board considered the foreign bank as
20 subsidiary might derive from bank-ineligible a bank holding company even though the bank
securities underwriting and dealing activities, was not part of a bank holding company struc-
and (2) permitted underwriting and dealing in ture. In so doing, the Board imposed restrictions
the securities of affiliates, consistent with sec- on the section 20 subsidiary. The foreign bank
tion 20 of the Glass-Steagall Act, if the securi- might fund the section 20 subsidiary, but that
ties were rated by an unaffiliated, nationally action required prior Board approval. In addi-
recognized statistical rating organization or were tion, the section 20 subsidiary might not borrow
issued or guaranteed by the Federal National from its parent bank. Any loans to, transfers of
Mortgage Association (Fannie Mae), the Fed- assets to, or investments in the section 20 sub-
eral Home Loan Mortgage Corporation sidiary also required Board approval. (See 1990
(FHLMC), or the Government National Mort- FRB 158, 455, 554, 568, 573, 652, and 683.)
gage Association (GNMA), or if they repre-
sented interests in such obligations.
Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 (FIRREA)
Acting as Agent in the Private Placement
of All Types of Securities and Acting as FIRREA became law on August 9, 1989. The
Riskless Principal in Buying and Selling law revised section 4(c)(8) of the BHC Act and
Securities authorized the Board to approve applications
from bank holding companies for the acquisi-
In another Board order, the Board authorized a tions of savings associations. The Board thus
bank holding company to transfer its private- revised section 225.28(b)(4)(i) of Regulation Y
placement activities from its commercial bank to include as a permissible nonbanking activity
subsidiary to its section 20 subsidiary. The sec- the owning, controlling, or operating of a sav-
tion 20 subsidiary would act as agent in the ings association, if the savings association
private placement of all types of securities, engaged only in deposit-taking, lending, and
including the provision of related advisory ser- other activities permissible for bank holding
vices, and would buy all types of securities on companies. The legislation required the Board
the order of investors as a riskless principal. to remove tandem restrictions found in previous
The Board concluded that the section 20 subsid- Board orders that were not prohibited by FIRREA
iarys private placement of debt and equity secu- and, in approving applications, to confine
rities within the limits proposed did not involve
the underwriting or public sale of securities for BHC Supervision Manual June 2003
the purposes of section 20 of the Glass-Steagall Page 3
limitations on transactions between the savings Effective September 10, 1992, the Board added
association and its bank holding company affili- two nonbanking activities to Regulation Y that
ates to those required by sections 23A and 23B were previously approved by Board order. The
of the Federal Reserve Act. FIRREA made sec- two activities dealt with full brokerage services
tions 23A and 23B applicable to savings asso- and financial advisory services. (See 12 C.F.R.
ciations as though they were member banks. 225.28(b)(6) and (7).)
Two exceptions apply: (1) no extensions of
credit may be granted by a savings association
to an affiliate unless the affiliate is engaged only Comprehensive Revision of Regulation Y
in activities permissible for bank holding com-
panies under the BHC Act, and (2) savings In August 1996, the Board proposed compre-
associations may not purchase or invest in secu- hensive revisions to Regulation Y that were
rities of an affiliate other than shares of a subsid- designed to significantly reduce regulatory bur-
iary. The legislation also provided for a sister- den, improve efficiency, and eliminate unwar-
bank exemption from the provisions of sec- ranted constraints on credit availability. The pro-
tions 23A and 23B of the Federal Reserve Act. posal followed a Board review of its regulations
(See sections 2020.1.1.6 and 2090.8.1.) that was required by the Riegle Community
Development and Regulatory Improvement Act
of 1994. The changes (1) removed a number of
restrictions on the permissible nonbanking
1992 Revisions to the Regulation Y List activities of BHCs, (2) expanded and reorga-
of Nonbanking Activitiesthe Laundry nized the regulatory list of permissible nonbank-
List ing activities to include numerous nonbanking
activities that had been previously approved
During 1992, the Board initiated several actions only by Board order,1 (3) streamlined the
that affected certain nonbanking activities. The application/notice process for BHCs and the
first action, effective May 18, 1992, amended procedures governing change in bank control
section 225.28(b) of Regulation Y with regard notices, and (4) revised the tying rules to enhance
to tangible personal property leases. Subject to banking organizations ability to provide cus-
the stated limitations, a bank holding company tomer discounts on services. Included were
can rely on estimated residual values of up to changes that streamlined the procedures for
100 percent of the acquisition costs of the leased well-run BHCs to seek Federal Reserve System
property in order to recover the bank holding approval to acquire additional banks within cer-
companys leasing costs. Previously, the non- tain limits. The Board approved these revisions
banking activity had only been approved by to Regulation Y, effective April 21, 1997.
Board order. (See the initial Board order at 1990
FRB 462 and the subsequent Board orders at
1990 FRB 960 and 1991 FRB 187 and 490.) Limitation on Board-Approved
The Board issued a revised interpretive rule, Nonbanking Activities
effective August 10, 1992, regarding investment
advisory activities of bank holding companies The Gramm-Leach-Bliley Act (the GLB Act)
to expressly provide that a bank holding com- amended the BHC Act to limit bank holding
pany or its nonbank subsidiary may act as agent companies that are not financial holding compa-
for customers in the brokerage of shares of an nies to engaging only in activities which had
investment company advised by the holding been determined by the Board by regulation or
company or any of its subsidiaries. In addition, order under section 4(c)(8) of the BHC Act and
the revision provided that a bank holding com- section 225.28 of Regulation Y before Novem-
pany or its nonbank subsidiary may provide ber 12, 1999 (the approval date of the GLB
investment advice to customers regarding the Act), to be so closely related to banking as to be
purchase or sale of shares of an investment a proper incident thereto (subject to such terms
company advised by an affiliate. In both instances, and conditions contained in such regulation or
the Board requires certain disclosures to be order, unless modified by the Board) (12 U.S.C.
made to address potential conflicts of interest or 1843(c)(8)). Prior to November 12, 1999, the
adverse effects. (See 12 C.F.R. 225.125(h) of
Regulation Y.)
1. See subsection 3000.0.2, appendix 1. See also section
225.28(b) of Regulation Y. In addition to these activities,
BHC Supervision Manual June 2003 other activities have been approved by Board order. For a list
Page 4 of those activities, see subsection 3000.0.3, appendix 2.
Board had determined that [a]ny activity usual An FHC may engage in any other activities
in connection with making, acquiring, broker- that the Board and the Secretary of the Treasury
ing, or servicing loans or other extensions of jointly determine to be financial in nature or
credit, as determined by the Board is closely incidental to financial activities. An FHC may
related to banking. Accordingly, the Board also engage in any nonfinancial activity that the
retains authority after the GLB Act to define the Board determines (1) is complementary to a
scope of this section 4(c)(8) activity and to financial activity and (2) does not pose a sub-
modify the terms and conditions that apply to stantial risk to the safety and soundness of
the activity. depository institutions or the financial system
generally. The activities of BHCs and foreign
banks that are not FHCs continue to be limited
Financial Holding Companies to activities currently authorized under section
4(c) of the BHC Act to be closely related to
The GLB Act, approved in November 1999, banking and permissible for BHCs. No addi-
amended section 4 of the BHC Act and expanded tional activities may be found to be so closely
the powers of qualifying BHCs and foreign related to banking as to be a proper incident
banks that elect to become financial holding thereto after November 11, 1999, thus limiting
companies (FHCs). An FHC is defined in the the ability of BHCs and foreign banks that are
GLB Act as a BHC that meets certain eligibility not FHCs to expand their activities.
requirements. The law repealed those provisions In this manual, the sections in the 3900 series
of the Glass-Steagall Act and the BHC Act that have been designated for FHCs. Those sections
restricted the ability of BHCs to affiliate with discuss FHC qualification requirements (domes-
securities firms and insurance companies. For a tic and foreign); permissible nonbanking FHC
bank holding company to become an FHC and activities designated by statute (for example,
be eligible to engage in new activities autho- merchant banking activities) or regulation, includ-
rized under the GLB Act, the GLB Act requires ing activities jointly approved by the Board and
that all depository institutions controlled by the the Secretary of the Treasury; and the supervi-
BHC be well capitalized and well managed. sory approach and guidance for FHCs.
With regard to a foreign bank that operates a To implement the provisions of the GLB Act
branch or agency or that owns or controls a that govern FHCs, the Board amended Regula-
commercial lending company in the United States, tion Y by adding subpart I for FHCs. The provi-
the GLB Act requires the Board to apply compa- sions of an interim rule became effective March
rable capital and management standards that 11, 2000, and the Board approved a final rule
give due regard to the principle of national treat- effective December 21, 2000. Key provisions of
ment and equality of competitive opportunity. the final rule are discussed within the 3900
Qualifying BHCs that elect to become FHCs sections of this manual. With respect to permis-
can engage in a broad array of financially related sible activities of FHCs, the rule includes activi-
activities, including (1) securities underwriting ties that previously were determined to be closely
and dealing, (2) insurance agency and insurance related to banking under section 225.28 of Regu-
underwriting activities, and (3) merchant bank- lation Y, activities that are usual in connection
ing activities. With respect to merchant banking, with transactions of banking abroad (including
the GLB Act (1) permits an FHC to retain a those in section 211.10 of Regulation K), and
merchant banking investment only as long as other activities defined as financial in nature by
necessary to dispose of the investment on a the GLB Act.
reasonable basis consistent with the financial
viability of its merchant banking activities, and
(2) provides that an FHC may not routinely
manage or operate a company held as a mer- 3000.0.1 CATEGORIES OF
chant banking investment except as necessary to NONBANKING ACTIVITIES
obtain a reasonable return on the investment.
The statute also sets forth parameters for the Section 4(c)(8) of the BHC Act authorizes bank
relationships between the Federal Reserve and holding companies to engage directly or through
other regulators. The statute differentiates between a subsidiary in activities that the Board deter-
the Federal Reserves relations with regulators mined before November 12, 1999, to be so
of depository institutions and functional regula- closely related to banking or managing or con-
tors, such as those for nonbanking or nonfinan-
cial activities such as insurance, securities, and BHC Supervision Manual June 2003
commodities activities. Page 5
trolling banks as to be a proper incident thereto. banking or to managing or controlling banks,

The Board and the courts established the follow- the Board also must find that the proposed activ-
ing guidelines for determining whether a non- ity is a proper incident to banking and that
banking activity is closely related to banking:2 performance of an activity by a bank holding
company could reasonably be expected to pro-
1. whether banks have generally provided the duce benefits to the public (such as greater
service convenience, increased competition, or gains in
2. whether banks generally provide services efficiency) that outweigh possible adverse
that are operationally or functionally so simi- effects (such as undue concentration of resources,
lar to the proposed service as to equip them decreased or unfair competition, conflicts of
particularly well to provide the proposed ser- interest, or unsound banking practices). The fol-
vice lowing describes three categories of bank hold-
3. whether banks generally provide services ing company nonbanking activities:
that are so integrally related to the proposed
service as to require their provision in spe- 1. those that have been found to be permissible
cialized form and are listed in Regulation Y, the so-called
laundry list activities (see appendix 1)
In addition, before November 12, 1999, the 2. those that are permissible by Board order
Board considered other factors in deciding what only (see appendix 2)
activities were closely related to banking.3 For 3. those that have been denied by the Board
those activities found to be closely related to (see appendix 3)
2. National Courier Association v. Board of Governors,

516 F. 2d 1229 (D.C. Cir. 1975).
3. Alabama Association of Insurance Agents v. Board of
Governors, 533 F.2d 224 (5th Cir. 1976), cert. denied, 435
U.S. 904 (1978).

Page 6
3000.0.2 APPENDIX 1Activities Approved by the Board as Being Considered

Closely Related to Banking Under Section 4(c)(8) of the Bank Holding Company
Act (Section 225.28(b) of Regulation Y)
Year Added
Permitted by Regulation 1 to Regulation Y
Note: The bulleted items in this appendix are provided for historical reference
only. The narrative before the bulleted items reflects the current Regulation Y
authorization.
1. Extending credit and servicing loans 1971
Making, acquiring, brokering, or servicing loans or other extensions

of credit (including factoring, issuing letters of credit, and accepting
drafts) for the companys account or the account of others.
2. Activities related to extending credit 2
a. Appraising
(1) Real estate appraising 1980
(2) Personal property appraising 1986
b. Arranging commercial real estate equity financing 1983
c. Check-guaranty services 1986
d. Collection agency services 1986
e. Credit bureau services 1986
f. Asset management, servicing, and collection activities 1997
g. Acquiring debt in default 1995
h. Real estate settlement servicing 1997
3. Leasing personal or real property or acting as agent, broker,

or adviser in leasing such property
Personal property leasing 3 1971

Real property leasing 1974
4. Operating nonbank depository institutions
a. Owning, controlling, or operating an industrial bank, Morris Plan 1971

bank, or industrial loan company so long as the institution is not
a bank
b. Owning, controlling, or operating a savings association, if the savings 1989
association engages in deposit-taking activities, lending, and other
activities that are permissible for bank holding companies
5. Trust company functions or activities 1971
6. Financial and investment advisory activities: acting as an investment adviser 1971

or financial adviser to any person, including (without limiting these activities
in any way)

Page 7
Year Added
a. Serving as an investment adviser to an investment company registered 1972

under the Investment Company Act of 1940, including sponsoring,
organizing, and managing a closed-end investment company
Investment or financial advising 1971
Advisory services to open-end (mutual fund) investment companies 1972
b. Furnishing general economic information and advice, general economic 1984
statistical forecasting services, and industry studies
c. Providing advice in connection with mergers, acquisitions, divestitures, 1992
investments, joint ventures, leveraged buyouts, reorganizations,
recapitalizations, capital structurings, financing transactions, and similar
transactions, 4 and conducting financial feasibility studies 5
Financial futures and options on futures 1986
d. Providing information, statistical forecasting, and advice with respect to 1992
any transaction in foreign exchange, swaps and similar transactions,
commodities, and any forward contract, option, future, option on a
future, and similar instruments
Financial futures and options on futures 1986
Providing financial advice to
state and local governments and 1973
foreign governments, including foreign municipalities and agencies 1992
of foreign governments, such as with respect to the issuance of their
securities
Inclusion of any investment or financial advisory activity without restriction 1997
Discretionary investment advice to be provided to any person (includes 1997
investment advice regarding derivative transactions to institutional or
retail customers as an investment, commodity trading, or other adviser)
regarding contracts related to financial or nonfinancial assets (such
advice is no longer restricted to institutional customers)
Financial and investment advice (or any permissible nonbanking activity) 1997
can be provided in any combination of permissible nonbanking activities
listed in Regulation Y
e. Providing educational courses and instructional materials to consumers on 1986
individual financial-management matters
f. Providing tax-planning and tax-preparation services 1986
7. Agency transactional services for customer investments (principal positions)
a. Securities brokerage services (including securities clearing and/or

securities execution services on an exchange) for the account of cus-
tomers and does not include securities underwriting or dealing
(1) Securities brokerage services (including securities clearing and/or 1982
securities execution services on an exchange), whether alone or
(2) In combination with advisory services and incidental activities 1992
(including related securities credit activities and custodial services)
b. Riskless-principal transactions 1997
c. Private-placement services 1997
d. Futures commission merchant activities 1984
A nonbanking subsidiary may act as an FCM with respect to any 1997
exchange-traded futures contract and options on a futures
contract based on a financial or nonfinancial commodity

Page 8
Year Added
e. Other transactional services such as providing to customers as 1997

agent transactional services with respect to the following:
(1) Swaps and similar transactions
(2) Investment transactions as principal 6
(3) Transactions permissible for a state member bank
(4) Any other transaction involving a forward contract, an option, futures,
an option on a futures or similar contract (whether traded on an exchange
or not) relating to a commodity that is traded on an exchange
8. Investment transactions as principal
a. Underwriting and dealing in government obligations and money market 1984

instruments
b. Investing and trading activities. Engaging as principal in the following:
(1) Foreign exchange 1984
(2) Forward contracts, options, futures, options on futures, swaps, 1997
and similar contracts, whether traded on exchanges or not,
based on any rate, price, financial asset (including gold, silver,
platinum, palladium, copper, or any other metal approved by
the Board), nonfinancial asset, or group of assets, other than
a bank-ineligible security, if the transaction meets certain require-
ments (A bank-ineligible security is any security that a state member
bank is not permitted to underwrite or deal in under 12 U.S.C. 24 and 335.)
(3) Forward contracts, options, futures, options on futures, swaps, and 1997
similar contracts, whether traded on exchanges or not, based on an
index of a rate, a price, or the value of any financial asset, nonfinancial
asset, or group of assets, if the contract requires cash settlement
9. Management consulting and counseling activities
a. Providing management consulting advice on any matter (financial,

economic, accounting, or audit) to any other company 7
Unaffiliated banks (depository institutions) 1974
Nonbank depository institutions 1982
Other unaffiliated depository institutions 1997
Any financial, economic, account, or audit matter to any other company 1997
b. Employee benefits consulting services 1997
c. Career counseling services 1997
10. Support services
a. Courier services 1973

b. Printing and selling MICR-encoded checks and related documents 1997
11. Insurance agency and underwriting
a. Credit insurance: acting as principal, agent, or broker for insurance

(including home mortgage redemption insurance)
Acting as insurance agent or broker primarily in connection with credit 1971
extensions 8
Underwriting credit life and credit accident and health insurance 1972
related to an extension of credit

Page 9
Year Added
b. Finance company subsidiary: insurance agent or broker for extension 1982

of credit by finance company subsidiary
c. Insurance agency activities in small towns 1984
d. Insurance agency activities conducted on May 1, 1982 1984
e. Supervision of retail insurance agents 1984
f. Insurance agency activities by small bank holding companies 1984
g. Insurance agency activities conducted before 1971 1984
12. Community development
a. Financing and investment in community development activities 1971

b. Advisory and related services designed to promote community welfare 1997
13. Issuance and sale of payment instruments
a. Issuance and sale of retail money orders 1984

b. Sale of savings bonds 1979
c. Issuance and sale of travelers checks 1981
14. Data processing
a. Providing data processing and data transmission services; facilities

(including data processing and data transmission hardware, 9 software,
documentation, or operating personnel); databases; advice; and access
to services, facilities, or databases by any technological means
Providing bookkeeping and data processing 1971
Data processing and transmission services 1982
Providing data processing and transmission advice to anyone on 1997
processing and transmitting banking, financial, and economic data
b. Conducting data processing and data transmission activities not described 1997
in a. that are not financial, banking, or economic 10
1. See section 225.28(b) of Regulation Y for the details of 6. Transactions described in section 225.28(b)(8) of Regu-
the regulatory authorizations. lation Y.
2. A Board staff opinion, issued July 9, 2002, concluded 7. Management consulting services may be provided to
that a BHCs certain proposed flood zonedetermination ser- other customers not described in section 225.28(b)(9) of the
vices are usual in connection with making mortgage loans and rule, but the revenues derived therefrom are subject to a
that these activities are within the scope of permissible activi- 30 percent annual revenue limitation.
ties related to extending credit under section 225.28(b)(2) of 8. Scope narrowed to conform to court decisions in 1979
Regulation Y. and 1981; in 1982, it was further narrowed by title VI of the
3. The provision of higher residual value leasing for tan- GarnSt Germain Depository Institutions Act.
gible personal property was added to Regulation Y in 1992, 9. Beginning in April 1997, the general-purpose hardware
including acting as agent, broker, or adviser in leasing such may not constitute more than 30 percent (previously 10 per-
property. cent) of the cost of any package offering.
4. The words and similar transactions were added in 10. The total revenue may not exceed 30 percent (increased
1997. to 49 percent, effective January 8, 2004) of the companys
5. Feasibility studies do not include assisting management total annual revenues derived from data processing, data
with the planning or marketing for a given project or provid- storage, and data transmission activities.
ing general operational or management advice.

Page 10
3000.0.3 APPENDIX 2Activities Considered Closely Related to Banking Under

Section 4(c)(8) of the Bank Holding Company Act
Manual
Section
Permitted by Order on an Individual Basis Year Approved 3600.
1. Operating a pool-reserve plan for the pooling of loss reserves 1971 1

of banks with respect to loans to small businesses
2. Operating an article XII New York investment company 1977 5.1
3. Underwriting and dealing in commercial paper to a limited extent 1987 21.1
4. Underwriting and dealing in, to a limited extent, municipal revenue 1987 21.2
bonds, mortgage-related securities, and commercial paper
5. Underwriting and dealing in, to a limited extent, municipal revenue 1987 21.3
bonds, mortgage-related securities, consumer receivablerelated
securities, and commercial paper
6. Issuing and selling mortgage-related securities backed by the 1988 23

guarantees of the Government National Mortgage Association
7. Engaging in title insurance agency activities (approved under 1988 17.1

exemption G of the GarnSt Germain Depository Institutions
Act of 1982)
8. Underwriting and dealing in, to a limited extent, corporate 1989 21.4

debt and equity securities
9. Acting as a sales-tax refund agent 1990 24.1
10. Providing real estate settlement activities through a permissible 1990 26

title insurance agency (exemption G companies only)
11. Providing administrative and certain other services to mutual funds 1993 27
12. Acting as a dealer-manager in connection with cash-tender 1993 21.5

and exchange-offer transactions
13. Privately placing limited partnership interests 1994 8
14. Engaging in real estate title abstracting 1995 30
15. Providing employment histories to third parties 1995 29
16. Underwriting private ownership industrial development 1995 21.6

bonds by a section 20 company
17. Serving as a commodity pool operator of investment funds 1996 13.1

engaged in purchasing and selling futures and options on futures
on certain financial and nonfinancial commodities

Page 11
Manual
Section
Permitted by Order on an Individual Basis Year Approved 3600.
18. Development of broader marketing plans and advertising, 1997 28

sales literature, and marketing materials for mutual funds
(see 1997 FRB 678)
19. Sale of government services involving (see 1998 FRB 481) 1998 25
a. postage stamps and postage-paid envelopes

b. public transportation tickets and tokens
c. vehicle registration services (including the sale and distribution
of license plates and license tags for motor vehicles)
d. notary public services
20. Operating a securities exchange 1999 6
21. Acting as a certification authority for digital signatures 1999 7

Page 12
3000.0.4 APPENDIX 3Activities Considered Not to Be Closely Related to

Banking Under Section 4(c)(8) of the Bank Holding Company Act
Activities Denied by the Board Year Denied
1. Insurance premium funding (equity funding) (combined sales of mutual 1971

funds and insurance)
2. Underwriting general life insurance not related to credit extension 1971
3. Real estate brokerage 1972
4. Land investment and development 1972
5. Real estate syndication 1972
6. General management consulting 1972
7. Property management 1972
8. Trading in platinum and palladium coin and bullion 1 1973
9. Armored car service 2 1973
10. Sale of level term credit life insurance 1974
11. Underwriting mortgage guarantee insurance 1974
12. Computer output microfilm services 3 1975
13. Operating a travel agency 1976
14. Underwriting property and casualty insurance 1978
15. Real estate advisory activities 1980
16. Certain contract key entry services 1980
17. Offering investment notes with transactional features 1982
18. Engaging in pit arbitrage spread transactions on commodities 1982

exchanges to generate trading profits
19. Engaging in the publication and sale of personnel tests 1984

and related materials
20. Providing credit ratings on bonds, preferred stock, and commercial paper 1984
21. Providing independent expert actuarial opinions of a general nature 1984

for purposes such as divorce action and personal injury litigation
22. Acting as a specialist in foreign-currency options on a securities exchange 1985

Page 13
Activities Denied by the Board Year Denied
23. Title insurance activities (See the Board letter dated March 17, 1986,
re: Independence Bancorp, Inc. and the Board order
at 1989 FRB 31)
24. Acting as a broker for customers in the purchase and sale of forward contracts 1991
based on certain financial and nonfinancial commodities, and acting as the
primary clearing firm for professional floor traders 4
1. Authorized by the Board in 1995 FRB 190 (platinum) posed transactions posed potential violations of section 23B
and 1996 FRB 571 (palladium). of the Federal Reserve Act and that the applicant had failed to
2. On June 18, 1990, the Board determined that the activity prove that the activity is a proper incident to banking.
of providing armored car services to the general public is 3. The Boards interpretation of Regulation Y at 12 C.F.R.
closely related to banking (see 1990 FRB 676). In order for 225.123 was amended on November 25, 1987, by deleting
the Board to approve a nonbank activity for a bank holding item (e)(4) relating to the impermissibility of the activity (see
company, the Board must also find that the activity is a 52 Federal Register 4516045161 and 1987 FRB 933).
proper incident thereto. On February 10, 1993, the Board 4. The Board subsequently approved this activity by Board
denied the application (1993 FRB 352), finding that the pro- order. (See 1997 FRB 138.)

Page 14
Section 2(c) of the BHC Act (Savings Bank Subsidiaries
of BHCs Engaging in Nonbanking Activities) Section 3001.0
As an FDIC insured institution, a savings bank holding company parent of the qualified savings
qualifies as a bank under section 2(c) of the bank cease to be a savings bank holding com-
BHC Act, as amended by section 101(a) of the pany, the savings bank must cease engaging in
Competitive Equality Banking Act of 1987 these activities within two years.
(CEBA). CEBA amended the BHC Act, in In a separate application a nonoperating com-
section 3(f), stating that any qualified savings pany, which was formed for the purpose of
bank, which is a subsidiary of a bank holding acquiring a savings bank, insured by the Federal
company, could engage directly, or through a Deposit Insurance Corporation, applied for the
subsidiary, in any nonbanking activity, except Boards approval to become a bank holding
for certain insurance activities, that it is permit- company pursuant to section 3(a)(1) of the Bank
ted to engage in by State lawincluding activi- Holding Company Act, acquiring all of the vot-
ties which are not otherwise permitted for bank ing shares of the savings bank. The savings
holding companies under section 4(c)(8) of the bank engages through subsidiaries in real estate
BHC Act. In order for a qualified savings bank, investment and development activities autho-
that is a subsidiary of a bank holding company, rized pursuant to State law.
to engage in such activities, however, the bank As part of the Boards analysis in this case,
holding company must be a savings bank hold- including its evaluation of the capital and finan-
ing company as defined in section 2( l ) of the cial resources of the bank holding company and
BHC Act, in other words, 70 percent of the the bank involved, the Board considered the risk
assets of the bank holding company must con- to the Applicant and to the savings bank of the
sist of one or more savings banks at the time of real estate development activities to be con-
formation. ducted by the savings bank through its nonbank
Insurance activities of any qualified savings subsidiaries. The Board expressed serious reser-
bank which is a subsidiary of a bank holding vations with regard to this application and simi-
company are limited to the insurance activities lar applications by bank holding companies to
allowed under section 4(c)(8) of the BHC Act. acquire savings banks engaged directly or through
A qualified savings bank that was authorized to subsidiaries in real estate development activi-
engage in the sale or underwriting of savings ties. In the Boards view the conduct of real
bank life insurance, as of March 5, 1987, can estate development activities through a holding
sell or underwrite such insurance directly, pro- company subsidiary rather than a bank sub-
vided that it is permitted to underwrite and sidiary would provide more effective corporate
engage in the sale of savings bank life insurance separateness.
as that activity is authorized for savings banks The Board approved the application by Order
by state law, and is located in Massachusetts, on October 30, 1987 (1987 FRB 925), relying
Connecticut, or New York. Should the bank on the Applicants commitments.

Page 1
Section 2(c)(2)(F) of the BHC Act (Credit Card Bank
Exemption from the Definition of a Bank) Section 3005.0
WHATS NEW IN THIS SECTION Financial Group proposed to acquire substan-
tially all of the outstanding stock of MB BHC
Effective January 2006, this section has been and, indirectly, MB Bank. Prior to the acquisi-
revised to incorporate a table of Laws, Regula- tion, MB Bank planned to convert itself to a
tions, Interpretations, and Orders concerning a depository institution that would qualify for the
credit card bank exemption found in section credit card bank exemption under the BHC Act.
2(c)(2)(F) of the Bank Holding Company Act. Before the acquisition, but after MB Banks
(See the discussion below of the Board staff conversion to a credit card bank, MB BHC also
legal interpretation dated February 18, 2005.) proposed to redeem approximately 50 percent of
its common stock.
To comply with the provisions of the credit
3005.0.1 SECTION 2(c)(2) card bank exemption under the BHC Act, other
representations and commitments were made by
Section 2(c)(2) of the Bank Holding Company and on behalf of MB Bank and MB BHC.
Act (the BHC Act) provides 10 exemptions Under these commitments, MB Bank would
from the definition of a bank for purposes of the
BHC Act. Section 2(c)(2)(F) sets forth the crite- 1. engage only in credit card operations2 as of
ria that an institution must meet in order to and after the acquisition, including selling
qualify for the so-called credit card bank exemp- advertising space in monthly statements mailed
tion. The credit card bank exemption applies to to account holders (statement stuffers);
any institution, including an institution that 2. provide, as agent, limited debt-protection ser-
accepts collateral for extensions of credit by vices to its credit card customersservices
holding deposits under $100,000, and by other in which, for a fee, customers can receive
means which debt relief from MB Bank during certain
unexpected hardships (the limited debt-
1. engages only in credit card operations; protection coverage provides for the pay-
2. does not accept demand deposits or deposits ment of MB Banks outstanding credit card
that the depositor may withdraw by check or balance in the event of the borrowers death,
similar means for payment to third parties or disability, or involuntary unemployment); and
others; 3. not engage in the business of making com-
3. does not accept any savings or time deposit mercial loans as of and after the acquisition.
of less than $100,000;
4. maintains only one office that accepts depos- MB Bank also agreed to cease providing cer-
its; and tain ancillary services within three months of
5. does not engage in the business of making the acquisition by (1) selling a credit report
commercial loans.1 monitoring service offered by an unaffiliated
third party and (2) selling a membership-based
3005.0.2 SECTION 2(c)(2)(F) roadside-assistance product offered by an unaf-
filiated third party. In addition, MB Bank com-
On February 18, 2005, Board staff issued an mitted to restricting the scope of its deposit
interpretation in response to a banks (MB Banks) operations as of, and after, the acquisition to
legal counsel, who had requested a determina- comply with the credit card bank exemption
tion that (1) MB Bank would qualify for the provisions of the BHC Act. MB Bank agreed to
credit card bank exemption from the defini- not accept demand deposits or deposits that the
tion of bank in section 2(c)(2)(F) of the BHC depositor may withdraw by check or similar
Act and that (2) no application to the Board means for payment to third parties or others.
would be required under the BHC Act either for
the proposed acquisition of control of MB Bank
(the acquisition) by Financial Group (a joint 2. The Senate report accompanying S. 790 states that the
venture), or for the proposed redemption of engage only in credit card operations language was in-
tended to limit a qualifying institution to engage only in the
shares of common stock of MB Banks parent, business of issuing and processing credit cards for individuals
MB BHCa bank holding company for the and in transactions that are necessary and incident to that
purposes of the BHC Actin connection with business.
the acquisition.
1. 12 U.S.C. 1841(c)(2)(F). Page 1
Section 2(c)(2)(F) of the BHC Act (Credit Card Bank Exemption) 3005.0
Moreover, except for deposits that serve as col- vicing, and marketing services provided to the
lateral for MB Banks credit card loans (collat- issuing bank, within three months of the acquisi-
eral deposits), MB Bank will not accept savings tion. MB Bank would also cease engaging in
or time deposits of less than $100,000. MB any account-servicing activities for debit card or
Bank also represented that each collateral deposit credit card accounts of affiliated or unaffiliated
held by MB Bank will be no greater than the banks within three months of the acquisition
amount of the relevant customers line of credit (except on a temporary basis in connection with
with the bank. Any deposit not conforming to acquisitions of credit card accounts by MB Bank
the credit card bank exemption requirements or from other credit card lenders).
the representations and commitments within the Various other specific representations and
letter of interpretation and not transferred to an commitments regarding MB Banks investment
unaffiliated third party prior to the acquisition activity were also made, including a commit-
would be liquidated by MB Bank prior to the ment to divest within two years of the acquisi-
acquisition through a wire transfer to the rel- tion certain reverse-mortgage-loan participations.
evant depositor. MB Bank would maintain only Based on all the facts of record and subject to
one office that accepts deposits. the commitments and representations stated in
At the time of the determination request, MB the Board staffs February 18, 2005, interpreta-
Bank was issuing debit cards and holding related tion and in letters to the Boards Legal Division,
deposits that were not permissible for a deposi- the Boards Legal Division informed MB Banks
tory institution that qualifies for the credit card legal counsel that it would not recommend that
bank exemption under the BHC Act. Therefore, the Board find MB Bank to be a bank for
to qualify for the credit card bank exemption, purposes of the BHC Act as of and after the
MB Bank committed to transferring, before the acquisition, or that the Board require Financial
acquisition, its current debit card accounts and Group or its parent companies to file an applica-
related deposits to another bank (the issuing tion with the Board under section 3 of the BHC
bank), which would issue new debit cards under Act for the acquisition. Because MB Bank would
the issuing banks name to the current holders cease to be a bank, the Board also determined
of MB Banks debit card accounts. MB Bank that it would not require MB BHC to provide
also committed that it would cease all debit notice to the Board to redeem MB Bank shares
cardrelated activity, including origination, ser- pursuant to 12 C.F.R. 225(4)(b).
Credit card bank exemption 1841(c)(2)(F) 225.104 Staff interpretation

under section 2(c)(2)(F) dated February 18
of the BHC Act 2005

Page 2
Section 4(c)(i) and (ii) of the BHC Act (Exemptions From
Prohibitions on Acquiring Nonbank Interests) Section 3010.0
3010.0.1 INTRODUCTION to assure that exemption was allowed and to
verify the date the company became exempt
The prohibitions against a bank holding com- under section 501. The date of exemption is
pany having or acquiring nonbank interests do determined as follows. A company which files
not apply to bank holding companies meeting for exemption within 18 months after its organi-
the requirements of section 4(c)(i) and (ii) of the zation is considered exempt as of the date of its
Act. organization. The date of IRS approval is the
date of exemption if application for exemption
is filed more than 18 months after organization.
3010.0.2 LABOR, AGRICULTURAL The date of exemption must be no later than
OR HORTICULTURAL January 4, 1977, for the company to be entitled
ORGANIZATIONS to exemption from section 4 of the Act. The fact
that an organization pays income taxes annually
Section 4(c)(i)Any company that was on does not disallow its exemption under section
January 4, 1977, both a bank holding company 501 of the tax code. Despite its tax exemption,
and a labor, agricultural or horticultural organi- an organization is subject to tax on its unrelated
zation exempt from taxation under section 501 business income.
of the Internal Revenue Code of 1954, or
. . . any labor, agricultural or horticultural orga-
nization to which all or substantially all of the 3010.0.3 FAMILY-OWNED
assets of such company are hereafter transferred. COMPANIES
Exemption under this section was amended
when the Financial Institutions Regulatory and Section 4(c)(ii)A company covered in 1970
Interest Rate Control Act of 1978 became effec- more than 85 percentum of the voting stock of
tive early in 1979. The effect of the amendment which was collectively owned on June 30, 1968,
was to repeal exemption under this section for and continuously thereafter, directly or indi-
labor, agricultural or horticultural organizations rectly, by or for members of the same family, or
becoming BHCs after January 4, 1977, except their spouses, who are lineal descendants of
for those organizations becoming BHCs by means common ancestors.
of acquiring all or substantially all of the assets The phrase voting stock does not limit the
of a company that was both a BHC and a labor, form of an organization to an incorporated entity.
agricultural or horticultural oganization exempt Exemption under this section extends to other
from taxation on January 4, 1977. In order for a forms of business associations which meet the
holding company to be entitled to this exemp- definition of a company. For example, for a
tion, net income derived from the organization partnership, the 85 percent rule applies to gen-
cannot inure to the benefit of any individual. eral partnership interest and for a trust which
Organizations must be formed primarily for the meets the definition of a company, the 85 per-
betterment of the working conditions of the cent rule applies to beneficial ownership. A
labor organizations members, or improvement company must continue to control the same
in the grade of agricultural or horticultural prod- subsidiary bank that it controlled on June 30,
ucts for an agricultural or horticultural organiza- 1968, to retain its exemption under this section.
tion. The growing of products for profit by Lineal descendants of common ancestors in-
agricultural or horticultural organizations would clude descendants by half as well as full blood
disqualify them for exemption. Thus the phrase and legally adopted children.
any labor, agricultural or horticultural In January 1980, the Board approved an ap-
organization is intended to include only such plication of a one-bank holding company cov-
organizations that are also exempt from taxation ered by the exemption in 4(c)(ii) to acquire an
under section 501 of the Internal Revenue Code additional bank, but stated that the holding com-
of 1954. pany could no longer rely on that section for
In order for a labor, agricultural or horticul- conducting its nonbanking activities. Based upon
tural organization to receive exemption from its review of the legislative intent of Congress in
taxation under section 501(c)(5) of the Internal providing this exemption, it was the Boards
Revenue Code of 1954, it must file an applica- judgment that the exceptionally broad exemp-
tion (form 1024) with the IRS. In response to
the application, the organization receives a BHC Supervision Manual December 1992
determination letter which should be reviewed Page 1
4(c)(i) and (ii) (Exemptions for Acquiring Nonbank Interests) 3010.0
tion afforded by section 4(c)(ii) must be limited ing for a section 4(c)(i) or 4(c)(ii) exemption are
to family-owned one-bank holding companies not routinely inspected on a periodic basis, when
that are not engaged in the management of inspected their exempt status should be verified.
banks. Moreover, in the Boards view, upon the All nonbank activities of exempt organizations
acquisition of an additional bank, a one-bank should be examined in the inspection. The nature
holding company that is exempt under section of all such activities and the dates they were
4(c)(ii) of the Act, would become engaged in commenced should be documented in the work
the management of banks, and would thereby papers to establish their current permissibility
terminate its eligibility for the exemption. In in the event the organization should lose its
addition, the Board believed that to permit unsu- exemption from section 4.
pervised nonbank expansion by a multibank 2. For BHCs exempt under section 4(c)(i),
holding company would constitute an evasion the examiner should ascertain the date the com-
of the Act, which the Board is authorized to pany became exempt under section 501 of the
prevent pursuant to section 5(b) of the Act. tax code. Also, the stock books of the subsidiary
bank or other pertinent documents should be
reviewed to assure that the company was a BHC
3010.0.4 INSPECTION OBJECTIVES on January 4, 1977.
3. When verifying a companys exemption
1. To verify that a holding company qualifies under section 4(c)(ii), the stock records of the
for exemption from the prohibitions of section 4 subsidiary bank and the stock records, partner-
by virtue of either section 4(c)(i) or 4(c)(ii). ship agreements, trust agreements and other
2. Review the activities conducted by a com- records of the bank holding company should be
pany qualifying for an exemption under section reviewed to assure that the following conditions
4(c)(ii) of the BHC Act, which may be faced have been satisfied:
with revocation of the exemption, and deter- a. 25 percent or more of the voting stock
mine if there may be eligibility for permanent of the subsidiary bank has been continuously
grandfathering under section 4(a)(2) of the BHC owned by the BHC since June 30, 1968;
Act. b. Members of the same family have con-
tinuously held an 85 percent or more interest in
the holding company since June 30, 1968.
1. Although bank holding companies qualify-

Acquisition of an additional 1980 FRB 165
bank by a company exempt
under 4(c)(ii)
Successor to a Company 1980 FRB 349

Exempt under 4(c)(ii)

Page 2
Section 4(c)(1) of the BHC Act (Investment in Companies
Whose Activities are Incidental to Banking) Section 3020.0
3020.0.1 INTRODUCTION 3020.0.4 FURNISHING SERVICES TO
BANKING SUBSIDIARIES
By virtue of section 4(c)(1) of the Act, a bank
holding company may invest, without supervi- Section 4(c)(1)(C) of the BHC Act provides that
sory approval, in the shares of companies engaged a BHC may invest in a company which fur-
in activities that Congress felt were incidental to nishes services to or performs services for the
the business of banking. The following activi- bank holding company or its banking subsidi-
ties are permissible investments for bank hold- aries. Section 225.22(a) of Regulation Y pro-
ing companies under this section. vides that a bank holding company may, without
the Boards prior approval, furnish services to
or perform services for its banking and non-
banking subsidiaries either directly or indirectly
3020.0.2 PROVIDING BANKING through a subsidiary. Generally, a BHC may
QUARTERS only provide services related to the internal op-
erations of the BHC or its subsidiaries. A bank
Section 4(c)(1)(A) provides that a BHC may holding company or its subsidiaries may not
invest in a company engaged in holding or rely on the servicing exemption to deal with the
operating properties used wholly or substan- public as principal, but may deal with outside
tially by any banking subsidiary of such bank parties provided they are acting only as agent
holding company in the operations of such bank- for the holding company or its subsidiaries.
ing subsidiary or acquired for such future use. The term services implies servicing opera-
Normally, bank utilization of 50 percent or tions a bank may carry on itself, but which the
more of the property would meet the require- BHC chooses to have done through a nonbank
ments of this section. Investments in property subsidiary. Section 225.22(a)(2) states that
where usage of such property by subsidiary services for the internal operations of the bank
banks is less than 50 percent will be reviewed holding company or its subsidiaries include:
on an ad hoc basis to determine its permissibil- accounting, auditing, appraising, advertising,
ity under this section. Future needs of the bank public relations, data processing, data transmis-
holding company and its bank subsidiaries will sion services, data bases or facilities, personnel
be considered when reviewing these cases. services, courier services, holding or operating
In acquiring property, a bank holding com- property used wholly or substantially by a sub-
pany must have definite plans for use of the sidiary in its operations or for its future use, and
property as a subsidiary banks premises within selling, purchasing or underwriting insurance
a reasonable period of time. Property may not such as blanket bond insurance, group insurance
be acquired and indefinitely warehoused until a for employees, and property and casualty insur-
need develops for the property. ance. For the later insurance activities, bank
This section of the BHC Act does not provide holding companies are permitted under the
the authority for a BHC to invest in the shares servicing exemption to act as agent or to
of a company engaged in holding or operating underwrite insurance on their own risks (e.g.
properties used by nonbank subsidiaries. Di- blanket bond insurance or employee group
rectly holding or operating properties used by a insurance plans). Refer to section 225.22(a)(2)
nonbank subsidiary is considered an incidental of Regulation Y for other services permissible
activity necessary to carry on the main business for the internal operations of the BHC or its
activity of the subsidiary and thus is exempt subsidiaries.
under section 4(a)(2)(A) of the Act and section The servicing exemption extends to services
225.22(a)(2)(vi) of Regulation Y. that are normally performed by a bank for its
customers or correspondent banks. These activi-
ties generally include computerized billing, pay-
roll, accounting, financial records maintenance
3020.0.3 SAFE DEPOSIT BUSINESS and other similar data processing services as
long as the subsidiary bank is permitted under
Section 4(c)(1)(B) of the Act provides that a applicable State or federal law to provide the
holding company may invest in the shares of a service. These services may be provided only
company whose activities are limited to con-
ducting a safe deposit business. Refer to Section BHC Supervision Manual December 1992
225.22(b) of Regulation Y. Page 1
4(c)(1) (Investment in Companies Whose Activities are Incidental to Banking) 3020.0
upon request by the customers to the subsidiary company may form a wholly-owned subsidiary
bank. Furthermore, the contractual arrangements to engage in activities that such company could
must be made between the customer and the itself engage in.
bank. The company can service existing service
contracts the bank has originated but is prohib-
ited from purchasing the contracts or entering 3020.0.6 LIQUIDATING ASSETS
into contracts to provide services directly to the
public. Section 4(c)(1)(D) provides that a BHC may
The purchasing of participations by the parent own shares of a company which engages in
in loans from subsidiary banks generally is not liquidating assets acquired from such BHC (not
considered an exempt activity under the author- including its nonbank subsidiaries) or its bank-
ity of sections 4(a)(2) or 4(c)(1). Holding coming subsidiaries or which were acquired from
panies that engage in the purchase of participa- any other source prior to May 9, 1956, or the
tions from their subsidiary banks should file an date on which such company became a BHC,
application pursuant to Section 4(c)(8) of the whichever is later.
BHC Act. Purchasing participations in loans for Assets acquired for liquidation by a section
the purpose of providing liquidity or acquiring a 4(c)(1)(D) subsidiary are subject to the same
portion of a line of credit to facilitate the needs time limitations as shares acquired D.P.C. pursu-
of the banks customers (overlines) provides a ant to section 4(c)(2) of the Act.
service or benefit to the bank and is considered BHCs seeking to hold the shares of a liquidat-
an acceptable purchase under the services ing or nominee subsidiary organized to dispose
exemption. In all cases where a participation in of assets acquired D.P.C. by a BHC nonbank
a loan is purchased, the loan must be made in subsidiary, can rely on the Boards August 1980
the name of the bank and serviced by the respec- interpretation permitting, without prior regula-
tive bank. The purchasing of a loan for reasons tory approval, a BHC to form a subsidiary to
other than those set forth above may be viewed perform activities which itself could perform
as a direct lending activity. under exemption A of section 4(a)(2).

3020.0.5 FURNISHING SERVICES TO
NONBANK SUBSIDIARIES 1. To determine whether the activities con-
ducted by companies in which the BHC has a
The Bank Holding Company Act of 1956 pro- greater than 5 percent investment in the com-
hibited a BHC itself from engaging in any busi- pany and for which the BHC claims exemption
ness except (1) banking, (2) managing or con- under section 4(c)(1) of the BHC Act, are the
trolling banks, and (3) furnishing services to its types of permissible activities contemplated by
bank subsidiaries. In 1970, Congress amended that sectionactivities claimed under the prem-
section 4 of the BHC Act to expressly authorize ises exemption under 4(c)(1)(A), the safe de-
a BHC to furnish services to or perform services posit business exemption under 4(c)(1)(B), the
for its nonbank subsidiaries as well as its bank services exemption under (4)(c)(1)(C), or the
subsidiaries under exemption A of section 4(a)(2). liquidating subsidiary exemption (4)(c)(1)(D).
While section 4(c)(1) authorizes a BHC to in-
vest in shares of a company engaged in certain
activities, exemption A provides the authority 3020.0.8 INSPECTION PROCEDURES
for a BHC to engage in those activities directly.
The Board issued an interpretation (12 C.F.R. The inspection of a nonbank subsidiary exempt
225.141), effective August 1980, which stated under section 4(c)(1) of the Act should center
that it will permit, without any regulatory ap- on a review of the activities to assure that those
proval, a bank holding company to form a activities are the types permissible under section
wholly-owned subsidiary to perform servicing 4(c)(1) subsections A, B, C and D.
activities for both banking and nonbanking sub-
sidiaries that the holding company itself could
perform directly or through a department or a 3020.0.8.1 Section 4(c)(1)(A)Bank
division under section 4(a)(2)(A) of the BHC Premises
Act. In addition, an approved section 4(c)(8)
The following procedural steps should be per-
BHC Supervision Manual December 1992 formed in connection with an inspection of a
Page 2 bank premises company.
1. Obtain a list of all real estate held by the 6. When reviewing services provided to bank-
company including the following information: ing subsidiaries for their customers:
a. Property description and location; a. List and describe all services provided;
b. Date acquired; b. Determine that the company is operat-
c. Current utilization; ing as an adjunct to its affiliated banks for the
d. Extent of utilization by banking subsid- purpose of facilitating the banks operations,
iaries and others indicating percentage of square and not as a separate, self-contained organization;
feet leased to subsidiaries. c. Review contractual arrangements to as-
2. When use of the property by a subsidiary sure that the company has not purchased any
bank(s) is less than 50 percent, discuss future service contracts from a subsidiary bank and has
plans for the use of the property with manage- not entered directly into agreements to provide
ment. Note any related discussion contained in services to any party other than the bank;
the minutes of directors and committee meet- d. Review and evaluate all services to
ings, and action taken to date to implement determine whether they are services that the
these plans. Lease agreements with other ten- subsidiary bank is permitted to provide under
ants should be reviewed to determine the term applicable State or federal law.
of a lease including options to renew.
3. Evaluate the permissibility of holding each
property under the premises exemption. 3020.0.8.4 Section 4(c)(1)(D)
4. Review and evaluate other activities Liquidating Subsidiary
engaged in and assets held by the company to
establish their permissibility under the premises The following procedural steps should be fol-
exemption. Such activities could include leasing lowed in connection with an inspection of a
property and providing a general maintenance liquidation company in which the BHC holds an
service to other tenants. investment.
1. Obtain a list of all assets acquired by the
company for the purpose of liquidation includ-
3020.0.8.2 Section 4(c)(1)(B)Safe ing the following information:
Deposit Business a. Asset description and location;
b. Date acquired;
Activities exempt under this section are re- c. Source of acquisition;
stricted to conducting a safe deposit business. d. Liquidation plans, including timetable
All activities engaged in and assets held by and selling price;
companies for which the BHC is claiming ex- e. Cost of assets and book value, including
emption under this section should be reviewed detail on any improvements.
and evaluated to determine their permissibility 2. Verify that assets acquired from sources
under this exception. other than the parent or its subsidiary banks
were acquired prior to May 9, 1956, or the date
on which the holding company became a BHC,
3020.0.8.3 Section 4(c)(1)(C)Services whichever is later.
3. Verify that assets acquired for liquidation
The following procedural steps should be per- did not originate in a nonbank subsidiary. If a
formed when inspecting service companies. section 4(c)(1)(D) liquidating subsidiary is hold-
1. List and describe all services provided to ing a material amount of assets acquired from a
subsidiaries in the inspection report. nonbank subsidiary, discuss the propriety of
2. Review and evaluate the types of services these holdings with the Reserve Bank office
provided to the banking and nonbanking subsid- staff and, if necessary, Board staff in the Divi-
iaries to determine their permissibility. sion of Banking Supervision and Regulation or
3. Obtain from management any written bank the Legal Division.
holding company policies concerning the provi- 4. Review the bank holding companys poli-
sion of services and the assessment of fees or cies, practices and procedures concerning the
discuss with management the basis on which liquidation of assets and determine if the subsid-
service fees are established. iary is in compliance with the time limits indi-
4. Comment on the reasonableness of fees cated above.
relative to the fair market value, cost, volume, 5. Discuss with management and note the
or quality of such services rendered.
5. Indicate if all service contracts have been BHC Supervision Manual December 1992
approved by each subsidiarys board of directors. Page 3
liquidation plans and progress to date in liqui- 7. Check improvements made to property by
dating assets that have been held in excess the company to assure that the nature and use of
of 12 months. Note any related discussion found the asset has not substantially changed. The
in the minutes of directors and committee investment of funds to change substantially the
meetings. nature of the asset (such as undeveloped real
6. Comment on whether management is mak- estate) to increase its value would generally be
ing a bona fide effort to dispose of all assets for viewed as engaging in real estate development,
fair value. an activity which is not permissible.
Purchase of instalment paper for 225.104 4192

subsidiary banks as furnishing of
services
Furnishing insurance not services 225.109 4193
Services for banks that are not 225.113 4194

subsidiaries
Computer services for customers of 225.118 4195

subsidiary banks
Applicability of Bank Service Corp. 225.115 4174.1

Act in certain BHC situations
Mortgage company services 225.122 4196
Insurance and sale of short-term debt 250.221, 4867

obligations by BHCs 225.130
Operations subsidiaries of a BHC 225.141
Shares held by a subsidiary bank in a 225.101(g) 4185

bank premises company and the 225.141
applicability of section 4(c)(1)(A)
Investment in an asset liquidation 1843(c)(1)(D)

subsidiary
Providing services to bank and 1843(a)(2)(A) 225.22(a)

nonbank subsidiaries
BHC dealing for a BHCs own account 1987 FRB 61

in futures, and options on futures,
on gold and silver bullion to limit price
risks in trading
BHC subsidiaries performing services 1980 FRB 774

that BHC could itself perform

Page 4
Approved 4(c)(8) subsidiary forming an 1979 FRB 566

operations subsidiary to perform footnote 1
activities it could itself perform

Page 5
Section 4(c)(2) and (3) of the BHC Act (Acquisition
of DPC Shares, Assets, or Real Estate) Section 3030.0
Section 4(c)(2) of the Bank Holding Company for extensions beyond the two-year divestiture
Act permits a bank holding company or any of period.1 In accordance with a Board interpreta-
its subsidiaries to acquire shares in satisfaction tion (12 C.F.R. 225.138), extensions should not
of debts previously contracted (DPC) in good be granted except under compelling circum-
faith. The shares must be disposed of within two stances, and periodic progress reports on dives-
years from the date they were acquired, except titure plans are generally required. When these
that the Board is authorized upon application of permissible extension periods expire, the Board
a company to grant additional exemptions if, in no longer has discretion to grant further exten-
its judgment, the extension would not be detri- sions. A BHC would be in violation of the act if
mental to the public interest and either the bank shares, other assets, or real estate acquired DPC
holding company has made a good faith attempt is not disposed of within the prescribed time
to dispose of those shares during the five-year frame.
period, or the disposal of the shares would have In July 1980, the Board issued an interpreta-
been detrimental to the company. The aggregate tion of Regulation Y (12 C.F.R. 225.140) that
duration of the extensions cannot extend beyond provided for a possible approval for an addi-
10 years. tional five-year period for the divestiture of real
Even though the statute refers specifically to estate acquired DPC. With respect to DPC real
shares, the Board has taken the position, in estate, this interpretation requires that (1) the
section 225.22(d) of its Regulation Y and in an value of the real estate on the books of the
interpretation (12 C.F.R. 225.140), that the con- company be written down to fair market value,
gressional policy evidenced by section 4(c)(2) (2) the carrying costs cannot be significant in
should apply to DPC acquisitions of other assets, relation to the overall financial position of the
other than shares (assets), and real estate by company, and (3) the company must make good
bank holding companies and their nonbanking faith efforts to effect divestiture. Fair market
subsidiaries. Section 225.22(d)(1) provides the value should be derived from appraisals, compa-
same holding periods (including provision for rable sales, or some other reasonable method.
extensions) for other DPC assets or real estate Companies holding real estate for this extended
as are provided by statute for DPC shares. period are expected to make active efforts to
Regulation Y, section 225.22(d), addresses dispose of it, and they should advise the Reserve
nonbanking acquisitions that do not require prior Bank regularly concerning their ongoing efforts.
Board approval. With respect to DPC acquisi- In accordance with the Boards interpretation
tions, voting securities, or other assets or real (12 C.F.R. 225.140), after two years from the
estate acquired by foreclosure or otherwise, in date of acquisition of DPC assets, the holding
the ordinary course of collection of a debt previ- company is to report annually to the Federal
ously contracted (DPC property) in good faith, Reserve on its efforts to accomplish divestiture
Regulation Y does not require the Boards prior of the assets. The Reserve Bank will monitor the
approval if the DPC property is divested within efforts of the company to effect an orderly dives-
two years of acquisition. Regulation Y further titure. Divestiture may be ordered before the
states that the Board may, upon request, extend end of the authorized holding period (beyond
the two-year period for up to three additional the initial two-year period that requires no Board
years. Further, the Board may permit additional authorization) if supervisory concerns warrant
extensions for up to five years (for a total of such action.
10 years). This provision applies to shares, real Section 4(c)(1)(D) allows a bank holding
estate, or other assets in which the holding com- company to establish a subsidiary to hold real
pany demonstrates that each extension would estate acquired by itself or by any of its banking
not be detrimental to the public interest and subsidiaries for debts previously contracted, for
either the bank holding company has made good the purpose of disposing of the real estate in an
faith attempts to dispose of such shares, real orderly manner. Permissible activities of this
estate, or other assets, or the disposal of the
shares, real estate, or others assets during the 1. Each Federal Reserve Bank has been delegated the
authority (12 C.F.R. 265.2(f)(12)) to extend the time within
initial period would have been detrimental to which a bank holding company or any of its subsidiaries must
the company. Transfers within the bank holding divest itself of interests acquired in satisfaction of a debt
company system do not extend any period for previously contracted.
divestiture of the property.
Under the Boards delegated authority, the BHC Supervision Manual June 1997
Reserve Banks may approve a BHCs requests Page 1
Section 4(c)(2) and (3) (Acquisition of DPC Shares or Assets, Including Real Estate) 3030.0
liquidating subsidiary include completion of a 3030.0.1 EXEMPTION TO

real estate development project and other activi- SECTION 4(c)(2) DISPOSITION
ties necessary to make the real estate saleable. REQUIREMENTS OF DPC SHARES
The date of acquisition is the date the bank
holding company (or subsidiary of the bank Section 4(c)(5) of the Bank Holding Company
holding company) acquired the DPC asset. Sec- Act allows a bank to own shares in certain
tion 4(c)(1)(D) may not be used to extend the nonbanking companies, specifically, the kinds
time under which a bank holding company and amounts eligible for investment by national
may indirectly hold DPC property under sec- banking associations under the provisions of
tion 4(c)(2). In most cases where a subsidiary section 5136 of the Revised Statutes (see
bank has held property for the statutory holding section 3050.0 for a detailed explanation of
period, a BHC may not shift the property to section 4(c)(5)). The exemption provided by
another subsidiary or to the parent to avoid section 4(c)(5) covers any shares, including
disposing of the property. However, due to the shares acquired DPC, that meet the conditions
complexity and potential impact on the organi- set forth in that exemption. Therefore, DPC
zation of a forced divestment at the end of the shares held by a banking subsidiary of a bank
holding period, inspection personnel and Reserve holding company which meet section 4(c)(5)
Bank staff are encouraged to discuss the situa- conditions are not subject to the disposition
tion with Board staff to tailor the supervisory requirement prescribed in section 4(c)(2); how-
response to the particular situation. ever, such shares would continue to be subject
With respect to the transfer by a subsidiary of to requirements for disposition as may be pre-
other DPC shares, other assets, or real estate to scribed by provisions of any other applicable
another company in the holding company sys- banking laws or by the appropriate bank super-
tem, including a section 4(c)(1)(D) liquidating visory authorities.
subsidiary, or to the holding company itself, Section 4(c)(6) of the act allows a bank hold-
such transfers would not alter the original dives- ing company to own shares, including those
titure period applicable to such shares or assets acquired DPC, of any nonbank company that
at the time of their acquisition. Moreover, to does not exceed 5 percent of the outstanding
ensure that assets are not carried at inflated voting shares of such company. The Board has
values for extended periods of time, the Board expressed an opinion (12 C.F.R. 225.101(f)) that
expects, in the case of all such intercompany any shares acquired DPC under this section,
transfers, that the shares or assets will be trans- whether by a holding company or a bank subsid-
ferred at a value no greater than the fair market iary, are not subject to the disposition require-
value at the time of transfer and that the transfer ments of section 4(c)(2) of the act.
will be made in a normal arms-length trans- Real property is often shown on an entitys
action. With regard to DPC assets (except for books as other real estate (ORE). Possession of
DPC shares as described above) acquired by a ORE usually results from a distressed loan col-
banking subsidiary of a holding company, as lateralized by a lien on real estate. In addition,
long as the assets continue to be held by the in attempting to salvage other types of credit, an
bank itself, the Board will regard them as being entity may have obtained title to real property
solely within the authority of the primary super- through process of law or by voluntary deed.
visor of the bank. Acquisition costs for other real estate acquired
Section 4(c)(3) of the Bank Holding Com- for debts previously contracted usually consist
pany Act permits a bank holding company to of the principal amount that was due on the
acquire shares or real estate from any of its defaulted loan at the time the entity took posses-
subsidiaries if a subsidiary had been requested sion, unpaid interest, legal fees and other fore-
to dispose of the shares by any federal or state closure costs, accrued and unpaid taxes, and
authority having power to examine the respec- mechanics liens. Property acquired DPC may
tive subsidiary. The Board does not have author- be recorded on the companys books by capital-
ity to extend the two-year disposition period izing the loan amount and acquisition costs.
under section 4(c)(3) of the act. Section 4(c)(3) Advances to complete the project can be included
may not be used to extend the statutory period in the capitalized investment if the ORE is an
in which a bank must dispose of DPC assets unfinished project. The fact that the additional
(10 years in the case of DPC real estate assets, investment is being used to improve the prop-
five years for all other). erty and make the property more saleable should
be evident.
BHC Supervision Manual June 1997 A company owning a DPC asset should main-
Page 2 tain records documenting its efforts to dispose
of the asset. Because an ORE asset is normally a acquired, and plans for disposal of the shares or
nonliquid, nonproductive asset of uncertain value, asset. In addition, a list of DPC shares, other
a company should attempt to dispose of the assets, or real estate which has been disposed of
asset at the earliest date possible. Unless special since the previous inspection or within the past
circumstances are present, a company should year should be obtained. Compare these lists
sell the ORE asset when a price offer sufficient with the list compiled during the preinspection
to cover the acquisition, investment, and carry- review.
ing costs is obtained. 4. Review other real estate owned accounts
to evaluate
a. the fair market value of the property (A
qualified appraiser should appraise the property
3030.0.2 INSPECTION OBJECTIVES at the time of acquisition, and subsequent timely
appraisals should be conducted to determine the
1. To determine compliance with applicable current fair market value of the property.);
laws, rulings, and regulations, and to initiate b. the carrying costs of the property; and
corrective action when violations appear in these c. the companys efforts to dispose of the
areas. property (Information on file should include
2. To determine whether policies, practices, documentation showing a record of offers made
and internal controls regarding DPC shares, by potential buyers and other information
other assets, or real estate are adequate and to reflecting efforts to sell the property (i.e., adver-
recommend correction when deficiencies are tisement brochures)).
noted. 5. Determine whether additional advances
3. To evaluate the quality of DPC shares, have been made on an unfinished project and
other assets, or real estate and the progress whether evidence supports that the advances are
toward their disposition. making the property more saleable.
4. To determine whether the DPC shares, 6. Determine whether a first-lien status exists
other assets, or real estate acquired are recorded and whether there are any tax liens or other
at fair market value. encumbrances against the property.
7. Discuss DPC shares, other assets, or real
estate and their values with management who is
familiar with the history and current status of
3030.0.3 INSPECTION PROCEDURES the shares or asset and assign classification, if
warranted. A substandard classification may be
1. During the preinspection review, compile applied when a company is sustaining losses in
a list of shares, other assets, and real estate maintaining the property, and prospects for sale
known to have been acquired DPC by the bank are not evident or encouraging. A companys
holding company and its nonbank subsidiaries, acquisition of property through foreclosure often
as well as a list of shares known to have been indicates a lack of demand and, as time elapses,
acquired DPC by the BHCs bank subsidiaries. the value of the real estate may become more
Information on this list should include questionable if the lack of demand persists. If
a. a description of the shares or asset(s); the carrying amount of the investment exceeds
b. the fair market value of the shares and the estimated value of the property, an adequate
asset(s), and the method of valuation, if available; allowance reserve for any difference should be
c. the name of the company owning the established and maintained. Property that is in
shares and asset(s); and the process of being sold for an amount in
d. the date the shares and asset(s) were excess of the carrying value should not be clas-
acquired. sified if it appears that ultimate payment will be
2. If the shares or asset has been held longer forthcoming.
than the initial holding period, determine whether 8. List shares, other assets, and real estate
the BHC has requested an extension of time. acquired DPC under other assets in the
3. In the Officers Questionnaire, request a inspection report. For significant shares and
list of DPC shares, other assets, or real estate assets, the examiner may choose to present in
owned by the holding company and its nonbank- the inspection report or in the workpapers, which-
ing subsidiaries, and a list of DPC shares owned ever is deemed appropriate, the following
by the holding companys bank subsidiaries, information:
including a detailed description of the shares or
asset, the value of the shares or asset on the BHC Supervision Manual June 1997
entitys books, the date the shares or asset was Page 3
a. a brief description sufficient to identify d. a summary of the carrying costs subse-

the property, the manner in which the property quent to assumption and income generated from
was acquired, and the reasons for its acquisition the property
b. the value of the shares or assets on the e. the date when the holding company or
books of the company, the method used to deter- its subsidiary must dispose of the property or
mine the booked value, and whether it is the fair request an extension to continue to hold the
market value DPC shares or asset
c. a brief statement as to managements f. the amount classified, if appropriate
efforts to sell the property, its opinion of the g. any apparent discrepancies with rules or
likelihood of sale, and the anticipated sales price regulations
Transactions not requiring

Board approval:
1. Acquisition of securities by 1843(c)(2) 225.12(b)

a BHC with majority control
2. Acquisition of securities by a 225.12(c) 4020 1980 FRB 654

BHC with majority control
Required disposal by 1843(c)(3)

Regulatory Agency
Section 4(c)(5) and 4(c)(6) 225.101 4187

shares with respect to
Section 4(c)(2)
Delegation of Authority to extend 265.2(f)(12)

time to dispose of DPC shares
and assets
Policy statement concerning 225.138

divestitures by BHCs
Disposition of property acquired 225.22,

in satisfaction of debts 225.140
previously contracted

Page 4
Section 4(c)(2) and (3) of the BHC Act (Rental of Other
Real Estate Owned Residential Property) Section 3032.0
The Federal Reserve issued a policy statement properties to third-party tenants as part of an
on April 5, 2012, indicating that banking organi- orderly disposition strategy within statutory and
zations1 may rent one- to four-family residential regulatory limits.3
Other Real Estate Owned (OREO) properties The general policy of the Federal Reserve is
without having to demonstrate continuous active that banking organizations should make good-
marketing of the properties, provided that suit- faith efforts to dispose of OREO properties at
able policies and procedures are followed.2 Key the earliest practicable date. Consistent with this
risk-management considerations are described policy, in light of the extraordinary market con-
for banking organizations that engage in the ditions that currently prevail, banking organiza-
rental of residential OREO, including compli- tions may rent residential OREO properties
ance with holding-period requirements for OREO, (within statutory and regulatory holding-period
compliance with landlord-tenant and associated limits) without having to demonstrate continu-
requirements, and accounting according to gen- ous active marketing of the property, provided
erally accepted accounting principles (GAAP). that suitable policies and procedures are fol-
Rental OREO properties with leases in place lowed. Under these conditions and circum-
and demonstrated cash flow from rental opera- stances, banking organizations would not con-
tions sufficient to generate a reasonable rate of travene supervisory expectations that they show
return should generally not be classified. good-faith efforts to dispose of OREO by
The statement establishes specific supervi- renting the property within the applicable hold-
sory expectations for banking organizations that ing period. Moreover, to the extent that OREO
undertake large-scale residential OREO rentals rental properties meet the definition of commu-
(generally, 50 properties or more available for nity development under the Community Rein-
rent). Such organizations should have formal vestment Act (CRA) regulations, they would
policies and procedures governing the operation receive favorable CRA consideration.4 In all
and administration of OREO rental activities, respects, banking organizations that rent OREO
including property-specific rental plans, policies properties are expected to comply with all appli-
and procedures for compliance with applicable cable federal, state, and local statutes and
laws and regulations, a risk-management frame- regulations.
work, and oversight of third-party property man- Home prices have been under considerable
agers. (See SR-12-5/CA-12-3 and their downward pressure since the financial crisis
attachments.) began, in part due to the large volume of houses
for sale by creditors, whether acquired through
foreclosure or voluntary surrender of the prop-
3032.0.1 POLICY STATEMENT ON erty by a seriously delinquent borrower (dis-
RENTAL OF RESIDENTIAL OTHER tressed sales). Creditors, in turn, often seek to
REAL ESTATE OWNED PROPERTIES liquidate their inventories of such properties
quickly. Since 2008, it is estimated that millions
In light of the large volume of distressed resi- of residential properties have passed through
dential properties and the indications of higher lender inventories. These distressed sales repre-
demand for rental housing in many markets, sent a significant proportion of all home sales
some banking organizations may choose to make transactions, despite some ebb and flow, and
greater use of rental activities in their disposi- thus are a contributing element to the downward
tion strategies than in the past. This policy state- pressure on home prices. With mortgage delin-
ment reminds banking organizations and exam- quency rates remaining stubbornly high, the
iners that the Federal Reserves regulations and continued inflow of new real estate owned prop-
policies permit the rental of residential OREO
3. The term residential properties in this policy state-
1. The policy statement applies to state member banks, ment encompasses all one-to-four family properties and does
BHCs, nonbank subsidiaries of BHCs, savings and loan hold- not include multi-family residential or commercial properties.
ing companies, non-thrift subsidiaries of savings and loan 4. The Federal Reserves CRA regulations define commu-
holding companies, and U.S. branches and agencies of foreign nity development to include activities that provide affordable
banking organizations (collectively, banking organizations). housing to low- and moderate-income individuals as well as
2. This policy statement supplements other relevant Fed- those activities that revitalize or stabilize low- and moderate-
eral Reserve guidance, including the Boards policy statement income areas (see 12 CFR 228.12(g)(1) and (4)).
on the disposition of property acquired in satisfaction of debts
previously contracted. See 12 CFR 225.140. Also see sections
3020.0.6, 3030.0, and 3090.2.4.6 of this manual and section BHC Supervision Manual July 2012
2200.0 of the Commercial Bank Examination Manual. Page 1
Section 4(c)(2) and (3) (Rental of Other Real Estate Owned Residential Property) 3032.0
erties to the marketexpected to be millions key documents, and is otherwise sufficient to

more over the coming yearswill continue to safeguard and manage the individual OREO
weigh on house prices for some time.5 assets.8 In contrast, banking organizations with
Banking organizations include their holdings large inventories of residential OREO
of such properties in OREO on regulatory reports properties950 or more individual properties
and other financial statements.6 Existing federal available for rent or rentedshould utilize a
and state laws and regulations limit the amount framework that systematically documents how
of time banking organizations may hold OREO they meet the supervisory expectations described
property.7 In addition, there are established in the next section. All banking organizations
supervisory expectations for management of that rent OREO properties, irrespective of the
OREO properties and the nature of the efforts size of their holdings, should adhere to the guid-
banking organizations should make to dispose ance set forth in this section.
of these properties during that period.
3032.0.1.1.1 Compliance with Maximum

3032.0.1.1 Risk-Management OREO Holding-Period Requirements
Considerations for Residential OREO
Property Rentals Banking organizations should pursue a clear and
credible approach for ultimate sale of the rental
In all circumstances, the Federal Reserve expects OREO property within the applicable holding-
a banking organization considering such rentals period limitations. Exit strategies in some cases
to evaluate the overall costs, benefits, and risks may include special transaction features to
of renting. The banking organizations decision facilitate the sale of OREO, potentially includ-
to rent OREO might depend significantly on the ing prudent use of seller-assisted financing or
condition of individual properties, local market rent-to-own arrangements with tenants.
conditions for rental and owner-occupied hous-
ing, and its capacity to engage in rental activity
in a safe and sound manner and consistent with 3032.0.1.1.2 Compliance with
applicable laws and regulations. Landlord-Tenant and Other Associated
Banking organizations should have an opera- Requirements
tional framework for their residential OREO
rental activities that is appropriate to the extent Banking organizations residential property
to which they rent OREO properties. In general, rental activities are expected to comply with all
banking organizations with relatively small hold- applicable federal, state, and local laws and
ings of residential OREO propertiesfewer than regulations, including landlord-tenant laws;
50 individual properties rented or available for landlord licensing or registration requirements;
rentshould use a framework that appropri- property maintenance standards; eviction
ately records the organizations rental decisions protections (such as under the Protecting Ten-
and transactions as they take place, preserves ants at Foreclosure Act); protections under the
Servicemembers Civil Relief Act;10 and anti-
5. For further discussion of housing market conditions and discrimination laws, including the applicable
the obstacles to conversions of OREO properties to rental, see
The U.S. Housing Market: Current Conditions and Policy
provisions of the Fair Housing Act and the
Considerations, Federal Reserve staff white paper, January 4, Americans with Disabilities Act. Prior to
2012 (housing white paper). undertaking the rental of OREO properties,
6. Other real estate owned is comprised of all real estate
other than (1) bank premises owned or controlled by the bank
8. A preliminary analysis of the Consolidated Reports of
and its consolidated subsidiaries and (2) direct and indirect
Condition and Income (Call Report) data suggests that roughly
investments in real estate ventures.
98 percent of community banks held 50 or fewer residential
7. Generally, the Federal Reserve allows BHCs to hold
OREO properties.
OREO property for up to five years, with an additional
9. For purposes of this guidance, the supervisory expecta-
five-year extension subject to certain circumstances (see 12
tions for OREO rentals and the number of properties available
CFR 225.140). National banks are subject to similar restric-
for rent should include those properties for which tenants
tions. State member banks and licensed branches of foreign
were already in place at the time of foreclosure or transfer of
banks are subject to the holding periods and other limitations
ownership, and for which tenants are afforded certain protec-
on OREO activity established by their respective licensing
tions under the Protecting Tenants at Foreclosure Act of 2009.
authorities, which vary. Savings and loan holding companies
See the Federal Reserves Consumer Compliance Handbook,
generally may acquire real estate for rental (see 12 USC
section IV, for further information.
1467a(c)(2) and 12 CFR 238.53(b)).
10. See CA-09-5, Information and Examination Proce-
dures for the Protecting Tenants at Foreclosure Act of 2009,
BHC Supervision Manual July 2012 July 30, 2009, and CA-05-3, Servicemembers Civil Relief
Page 2 Act of 2003, May 6, 2005.
banking organizations should determine 3032.0.1.2 Specific Expectations for

whether such activities are legally permissible Large-Scale Residential OREO Rentals
under applicable laws, including state laws.
When applicable, banking organizations should Banking organizations with large inventories of
review homeowner and condominium associa- residential OREO properties that decide to engage
tion bylaws and local zoning laws for prohibi- in rental activities should have in place a docu-
tions on renting a property. Banking organiza- mented rental strategy, including formal policies
tions may use third-party vendors to manage and procedures for OREO rental activities, and
properties but should provide necessary a documented operational framework. Policies
oversight to ensure that property managers fully and procedures should clearly describe how the
understand and comply with these federal, state, banking organization will comply with all appli-
and local requirements. cable laws and regulations. Policies and proce-
dures should include processes for determining
whether the properties meet local building code
3032.0.1.1.3 Other Considerations requirements and are otherwise habitable, and
whether improvements to the properties are
Banking organizations should account for needed in order to market them for rent. In
OREO assets in accordance with GAAP and addition, policies and procedures should estab-
applicable regulatory reporting instructions.11 lish operational standards for the banking orga-
Banking organizations should also provide the nizations rental activities, including that adequate
appropriate classification treatment for their insurance policies are in place, that property and
residential OREO holdings. Residential OREO other tax obligations are met on a timely basis,
is typically treated as a substandard asset, as and that expenditures on improvements are
defined by the interagency classification appropriate to the value of the property and to
guidelines. (See section 5010.10.1 which prevailing norms in the local market.
discusses the Uniform Agreement on the Clas- Policies and procedures should also require
sification of Assets and Appraisal of Securities plans for rental of residential OREO properties,
Held by Banks and Thrifts, as revised June 15, down to the individual property level, that cover
2004.) It sets forth the definitions of the clas- the full holding period from the time the bank
sification categories and the specific examina- received title to ultimate sale by the bank. Plans
tion procedures and information that are to be should identify which properties would be eli-
used for classifying bank assets, including gible for rental. Plans also should establish crite-
securities. (See SR-04-9.) See also section ria by which properties are chosen for market-
2060.1 of the Commercial Bank Examination ing as rental properties, and the process by
Manual. Residential properties, however, with which rental decisions should be made and
leases in place and demonstrated cash flow from implemented. Plans should describe the general
rental operations sufficient to generate a reason- conditions under which the organization believes
able rate of return12 should generally not be a rental approach is likely to be successful,
classified. including appropriate consideration of rental
market and economic conditions in respective
local markets.
11. See the instructions for the Call Report as to the Finally, policies and procedures should address
reporting of OREO transactions and to the Consolidated all risk-management issues that arise in renting
Financial Statements for Bank Holding Companies (FR Y-9C).
See more generally this manuals section 2200.1, Other Real
residential OREO properties. Some risk ele-
Estate Owned. ments parallel those found in other banking
12. Whether a rate of return is reasonable depends on a activities, for example, the credit risk associated
number of considerations including local market conditions, with tenants potential failure to make timely
the time horizon of the rental, and the nature of the property.
Commonly used measures include a capitalization rate (known
kets a cap rate above 8 percent would likely represent a
as a cap rate, which generally is the expected annual cash
reasonable rate of return. Large one-time expenditures that are
flows from renting the property relative to the price at which
idiosyncratic to a given year but are normal to residential
the property holder could expect to sell it in the owner-
properties over their lifetime, such as replacement cost for
occupied market), as discussed in the housing white paper, or
worn-out appliances, should generally not be the reason that a
other measures of internal rate of return. Depending on the
property would be classified. Costs of improvement should be
circumstances and risks associated with the property, valid
treated as capital expenditures with a corresponding effect on
indications that a level of return is reasonable could include
properties carrying value to the extent the improvements
(but would not be limited to) comparisons with normal returns
improve the properties values.
for single-family rentals in the relevant local market; rates of
return on other similar local real estate investments; or cap
rates or other measures of internal rate of return on invest- BHC Supervision Manual July 2012
ments with similar risk profiles. For example, in many mar- Page 3
rent payments, or potential conflict of interest nance logs, and security deposits and charges to
issues such as the use of a firm by a banking these deposits. Banking organizations should
organization to both provide information on a provide for adequate oversight of vendors.14
propertys value and list that property for sale
on behalf of the banking organization. Other
risks unique to such rental include 3032.0.1.3 Additional Materials for
Reference
dealing with vacancy, marketing, and re-rental
of previously occupied properties;13 Accounting Standards Codification (ASC) 310-
liability risk arising from rental activities, 40, Receivables-Troubled Debt Restructur-
along with the use and management of liabil- ings by Creditors (formerly known as FAS 15,
ity insurance or other approaches to mitigate Accounting by Debtors and Creditors for
that liability and risk; and Troubled Debt Restructurings).
ASC 360-10-30, Property, Plant and
legal requirements arising from the potential Equipment-Initial Measurement (formerly
need to take action against tenants for rent included in FAS 144, Accounting for the
delinquency, potentially including eviction. Impairment or Disposal of Long-Lived
Such requirements may include notice periods. Assets).
ASC 360-10-35, Property, Plant and
Banking organizations may need to develop new Equipment-Subsequent Measurement.
policies and risk-management processes to The disposition of other real estate is ad-
address properly these categories of risk. dressed in ASC 360-20-40, Property, Plant
In many cases, banking organizations will use and Equipment-Real Estate Sales-
third-party vendors (for example, real estate Derecognition (formerly within FAS 66,
agents or professional property managers) to Accounting for Sales of Real Estate), which
manage their OREO properties. Policies and includes specific criteria for the recognition of
procedures should provide that such individuals profit.
or organizations have appropriate expertise in SR-10-16, Interagency Appraisal and Evalu-
property management, be in sound financial ation Guidelines, December 2, 2010 and this
condition, and have a good track record in man- manuals section 4140.1. For the sale of OREO
aging similar properties. Policies and proce- property with a value of $250,000 or less, a
dures should also call for contracts with such BHC or state member bank may obtain an
vendors to carry appropriate terms and provide, evaluation in lieu of an appraisal.
among other key elements, for adequate man- SR-95-16, Real Estate Appraisal Require-
agement information systems and reporting to ments for Other Real Estate Owned (OREO),
the banking organization, including rent rolls March 28, 1995.
(along with actual lease agreements), mainte-
14. See Federal Financial Institutions Examination Council

13. Various jurisdictions may apply specific requirements
statement on Risk Management of Outsourced Technology
to landlords in their marketing and re-rental activities (for
Services (November 28, 2000, SR-00-17 and the appendix of
example, an obligation to offer potential tenants an initial
section 4060.1 of the Commercial Bank Examination
lease term of two years).
Manual), which provides illustrative guidance on constructing
outsourcing risk assessments, due diligence in selecting a
BHC Supervision Manual July 2012 service provider, contract review, and monitoring of a third
Page 4 party that provides services to a regulated institution.
Section 4(c)(4) of the BHC Act
(Interests in Nonbanking Organizations) Section 3040.0
Section 4(c)(4) of the Bank Holding Company 3040.0.2 TRUST COMPANY
Act (the act) provides that nonbank shares held SUBSIDIARIES
or acquired by a bank in good faith in a fidu-
ciary capacity are exempt from the general pro- Even though section 4(c)(4) refers to shares
hibitions of section 4 of the act. This exemption held or acquired by a bank in good faith in a
is provided to allow banks to continue their fiduciary capacity, the exemption also applies to
normal fiduciary operations without significant shares held or acquired in a fiduciary capacity
interference and without being subject to the by a trust company subsidiary of a bank holding
limitations of the Bank Holding Company Act. company.
Without this exemption, a subsidiary bank could
act as trustee for up to only 5 percent of a
nonbank companys shares, as provided by sec- 3040.0.3 QUALIFYING FOREIGN
tion 4(c)(6) of the act. BANKING ORGANIZATION OWNING
Certain exceptions were included within the OR CONTROLLING SHARES OF A
body of the section 4(c)(4) exemption to prevent COMPANY IN A FIDUCIARY
use of the trust vehicle to circumvent the intent CAPACITY
of the act. The section 4(c)(4) exemption is not
applicable when shares acquired are held by a A foreign bank that maintains branches in the
trust that is considered a company under sec- United States is subject to the provisions of the
tion 2(b) of the act. Under section 2(b), a trust is BHC Act in the same manner and to the same
defined as a company if it does not terminate extent as a U.S. bank holding company.1 Section
within 25 years or within 21 years and 10 4 of the BHC Act prohibits a bank holding
months after the death of individuals living on company and its subsidiaries from owning or
the effective date of the trust. Such trusts are controlling nonbanking assets or shares or
generally referred to as perpetual trusts and engaging in any nonbanking activity unless it
include employee benefits and charitable trusts qualifies for an exemption.2 Accordingly, such a
that can operate in perpetuity. foreign bank may not own nonbanking assets or
Another exception to the exemption implies shares (such as real estate), directly or through
that no more than 5 percent of the shares of a any company it controls, unless it qualifies for
nonbank company may be held by a subsidiary an exemption from the nonbanking prohibitions
bank as trustee under a trust established for the of section 4 of the BHC Act.
benefit of the bank itself; the banks parent Under section 211.23(f)(4) of Regulation K,
company or any of its subsidiaries; or the share- a qualifying foreign banking organization may
holders or employees of the bank, the parent [o]wn or control voting shares of any company
company, or its subsidiaries, as indicated in in a fiduciary capacity under circumstances that
section 2(g)(2) of the act. Employee benefit would entitle such shareholding to an exemp-
trusts have become a principal source of banks tion under section 4(c)(4) of the [BHC
trust assets. As strictly applied, section 4(c)(4) Act] . . .3 Section 225.22(d)(3) of the Boards
would limit acquisition of stock of a nonbank Regulation Y (which implements section 4(c)(4)
company to 5 percent of its shares for employee of the BHC Act) provides that the BHC Acts
trust accounts of banks that are subsidiaries of nonbanking prohibitions shall not apply to vot-
bank holding companies. ing securities or assets acquired by a bank or
other company (other than a trust that is a com-
pany) in good faith in a fiduciary capacity, if the
voting securities or assets are . . . held in the
ordinary course of business and not acquired for
3040.0.1 TRANSFER OF SHARES TO the benefit of the company or its shareholders,
A TRUSTEE employees, or subsidiaries.4
Under section 4(c)(4), if a bank holding com-

pany transfers nonbank shares to a trustee and 1. 12 U.S.C. 3106(a).
2. 12 U.S.C. 1843.
the trustee has one or more directors in common 3. 12 C.F.R. 211.23(f)(4).
with the bank holding company, the nonbank 4. 12 C.F.R. 225.22(d)(3).
shares are deemed to be controlled by the bank
holding company until the Board determines BHC Supervision Manual July 2005
otherwise. Page 1
4(c)(4) (Interests in Nonbanking Organizations) 3040.0
Two subsidiaries of the foreign bank CMB obtained from parties that are unaffiliated with
AG (the foreign bank) that are located in Ger- the foreign bank or any of its subsidiaries. For
many currently invest in non-U.S. real estate for their services to the trusts, IGC and CGS would
the benefit of third-party investors. One of the receive an annual management fee based prima-
subsidiaries, IGC, manages only retail invest- rily on the net asset value of the trusts. The
ment trusts (beneficial interests in which are foreign banks legal counsel contended that the
typically sold widely to retail investors); the proposed ownership of U.S. real estate by IGC
other subsidiary, SGC, manages only institu- and SGC for the account of the trusts would
tional investment trusts (beneficial interests in qualify for the fiduciary exemptions available in
which are sold to 30 or fewer institutional inves- Regulation K and Regulation Y.
tors). Through its legal counsel, the foreign bank Under the arrangement, the two subsidiaries
requested an interpretation of section 4 of the are subject to fiduciary duties that closely resemble
BHC Act (12 U.S.C. 1843) and section those of a trustee in the United States. Under the
211.23(f)(4) of the Boards Regulation K (12 German Investment Law, the investment trusts
C.F.R. 211.23(f)(4)) that would permit its two would not be legal entities separate from the
asset-management subsidiaries, IGC and SGC, two subsidiaries, IGC and SGC. The foreign
to sponsor and manage German-based invest- bank made several representations and commit-
ment trusts that invest in U.S. real estate. ments in support of its inquirers interpretation
The powers and duties of the asset- that the proposed ownership of U.S. real estate
management services provided by IGC and SGC by IGC and SGC for the account of the trusts
to their investment trusts are governed by the would qualify for the fiduciary exemptions under
German Investment Law and a trust agreement section 211.23(f)(4) of Regulation K and sec-
entered into between IGC or SGC, on the one tion 225.22(d)(3) of Regulation Y. In particular,
hand, and the investor, on the other hand (the the foreign bank committed that neither it nor its
trust agreement). IGC and SGC are subject to subsidiaries or employee benefit plans would
the supervision and regulation of the German own any beneficial interests in the investment
bank supervisory authority (BaFin). Compli- trusts.
ance by IGC and SGC with the German Invest- Based on all the facts, including all the repre-
ment Law and the trust agreement would be sentations and commitments made by or on
monitored and enforced by BaFin. Amendments behalf of the foreign bank, IGC, and SGC,
in 2002 to the German Investment Law liberal- Board legal staff stated that it would not recom-
ized the ability of companies to sponsor, man- mend that the Board disagree with the inquirers
age, and serve as distributor for one or more interpretation of the availability of the fiduciary
retail or institutional investment trusts, allowing exemptions in section 211.23(f)(4) of Regula-
investment in real estate outside the European tion K and section 225.22(d)(3) of Regulation Y
Economic Area, including in the United States. to the foreign bank. The fiduciary exemptions in
In light of the 2002 changes in German law, the Boards Regulations K and Y (12 CFR
IGC established a retail investment trust (the 211.23(f)(4) and 225.22(d)(3)) would, therefore,
retail trust) to invest in real estate located in the permit the two subsidiaries of the foreign bank
United States, Europe, and Asia. In addition, to take title to U.S. real estate on behalf of the
SGC is established as an investment trust for investment trusts and for the benefit of the
institutional investors (the institutional trust, investors in the trusts. (See the Board staffs
and, together with the retail trust, the trusts) to legal interpretation dated November 24, 2004.
invest in U.S. real estate. The trusts proposed to See also the summary of the interpretation in the
invest in existing commercial real estate proper- Federal Reserve Regulatory Service at 3-744.13
ties in major U.S. cities (the properties), but not and 4-305.2.)
in undeveloped U.S. real estate. As required by
the German Investment Law, title to each of the
properties would be held either directly by IGC
or SGC or by a special-purpose entity estab-
lished and controlled by IGC or SGC.
3040.0.4 OTHER REPORTING
REQUIREMENTS
Interests in the trusts would be sold only to
non-U.S. persons. All property management,
leasing, real estate brokerage, and refurbishment In certain circumstances, holdings in fiduciary
services obtained by the properties would be capacities of nonbank stock over 5 percent may
also trigger reporting requirements under the
BHC Supervision Manual July 2005 federal securities laws.
Page 2
4(c)(4) (Interests in Nonbanking Organizations) 3040.0
3040.0.5 INSPECTION OBJECTIVES ing procedures to establish that bank trust de-
partments report 5 percent holdings in nonbank
To determine that nonbank shares held by a companies. In multibank companies, determine
bank in a fiduciary capacity are in compliance that controls are in place to aggregate nonbank
with section 4(c)(4). shares held by each bank so that if an aggregate
of 5 percent is held, it is reported in the Y-6.

Review the holding companys internal report-
Interests in nonbanking organiza- 1843 225.12(a) 3744.13

tions 1843(c)(4) 225.22(d)(3)
A qualifying foreign banking 211.23(f)(4) 4305.2

organization may own or control
voting shares of any company in
a fiduciary capacity

Page 3
Section 4(c)(5) of the BHC Act (Investments Under Section
5136 of the Revised Statutes) Section 3050.0
Section 4(c)(5) of the Bank Holding Company 1. Small business investment companies
Act permits (without prior approval) invest- (SBICs).
ments by a bank holding company in shares of 2. Agriculture credit companies.
the kinds and amounts eligible for investment 3. Edge and agreement corporations.
by national banks under the provisions of sec- 4. Bank premises companies (usually exempt
tion 5136 of the Revised Statutes (12 U.S.C. under section 4(c)(1)(A)).
24(7)). 5. Bank service corporations (usually exempt
National banks are prohibited by section 5136 under section 4(c)(1)(C)).
of the Revised Statutes from purchasing and 6. Safe deposit companies.
holding shares of any corporation except those 7. Obligations of student loan marketing
corporations whose shares are specifically made associations.
eligible by federal statute. This prohibition is 8. State housing corporations.
made applicable to State member banks by sec-
tion 9, paragraph 20 of the Federal Reserve Act
(12 U.S.C. 335). 3050.0.2 LIMITATIONS
In 1968, the Board interpreted section 5136
as permitting a member bank to purchase shares On most 5136 authorizations, share investments
of a corporation engaging in business (at loca- are limited in some form, usually based on a
tions the bank is authorized to engage in busi- percentage of the banks capital and surplus.
ness) and carrying out functions the bank is Under section 4(c)(5), a holding companys
empowered to perform directly. Section 5136 is investment in such shares is also limited by
a broad statute with types of permissible activi- amount and type to those permitted for a na-
ties both explicitly defined and implied indi- tional bank to prevent avoidance of these limita-
rectly without express definition. Therefore, to tions by a bank holding company.
limit the need for constant Board interpretation
regarding the implied areas of section 5136, the
Board curtailed the authority of a bank holding 3050.0.3 INSPECTION OBJECTIVES
company to acquire shares on the basis of sec-
tion 4(c)(5) through section 225.22(d) of Regu- 1. To determine the permissibility of each
lation Y. As a result, effective June 30, 1971, activity encountered during the inspection which
permissible shares for bank holding company claims a section 4(c)(5) exemption.
acquisition under section 4(c)(5) are limited to 2. To determine if the operations and financ-
those explicitly authorized by any federal stating of the section 4(c)(5) activity is not to the
ute. Additional reasons for limiting the scope of detriment of the bank(s).
activities to those explicitly defined by statute,
are that section 4(c)(5) acquisitions require neither
prior Board approval, nor the opportunity for 3050.0.4 INSPECTION PROCEDURES
interested parties to express their views, nor any
prior regulatory consideration of anti-trust and 1. Review compliance with section 5136 of
related matters. the Revised Statutes to determine if the activity
is expressly permitted by any federal statute.
2. Determine the financial condition of the
3050.0.1 COMPANIES IN WHICH activity and its impact on the bank affiliate.
BHCS MAY INVEST
The following is a list of permissible compa-
nies expressly authorized by federal statute. The
list includes the companies most frequently
encountered.

Page 1
4(c)(5) (Investments Under Section 5136 of the Revised Statutes) 3050.0
Permissible investments (Section 5136 of

for a national bank the Revised
Statutes)
Investment in bank 371d 250.200 4185

premise corporation
Investment in bank service 186165 250.301 1329

corporation
Investment in small 15 USC 682b 225.107 4173

business investment 225.111 4175
corporation (SBIC) 225.112 4174
Operating subsidiaries/ 250.141 3415.4

loan production offices
Section 23A 371c 250.240 31133

Section 23B 371c 1206.1
Mortgage company 225.122 4196

Page 2
Section 4(c)(6) and (7) of the BHC Act (Ownership of Shares in
Any Nonbank Company of 5 Percent or Less) Section 3060.0
3060.0.1 SECTION 4(c)(6) ship does not constitute control as otherwise
defined in section 2 of the Act.
This section provides an exemption for owner- Note that section 4 prohibits engaging in non-
ship of shares of any nonbank company that do bank activities other than those permitted by
not exceed 5 percent of the outstanding voting section 4(c)(8). Thus, if a BHC may be deemed
shares of such company. The exemption is de- to be engaging in an activity through the
signed to permit diversification of investments medium of a company in which it owns less
by a bank holding company and its subsidiaries than 5 percent of the voting stock it may never-
which do not result in control of a nonbanking theless require Board approval, despite the sec-
organization. The Board has indicated through tion 4(c)(6) exemption.
an interpretation of 12 U.S.C. 225.101, that in
its opinion, the 5 percent limitation applies to
the aggregate amount of voting stock in a partic- 3060.0.1.2 Acquisition of Nonbank
ular nonbank company held by the entire bank InterestsRoyalties as Compensation
holding company organization including the
parent company and all of its direct and indirect A bank holding company requested an opinion
bank and nonbank subsidiaries. This is to pre- on the permissibility of its subsidiarys receiv-
vent a holding company from acquiring a con- ing limited overriding royalty interests in oil,
trolling interest in a nonbank company through gas, and other hydrocarbon leasehold interests
ownership of small blocks of stock by numerous as partial compensation for investment advisory
subsidiaries in circumvention of the provisions services in connection with those properties.
of section 4 of the BHC Act. The bank holding company was not acquiring
more than 5 percent interest in any project. The
subsidiary was to place the assigned royalties in
3060.0.1.1 D.P.C. Shares a compensation plan for assignment to certain
professional employees. Neither the subsidiary
The same interpretation (12 C.F.R. 225.101) nor any affiliate were to acquire, hold, locate,
also addresses the question of the applicability sponsor, develop, organize, or manage any other
of section 4(c)(6) to nonbank shares acquired energy property investment or in any other man-
in satisfaction of debts previously contracted ner control the investment. The subsidiary was
(D.P.C.) by a subsidiary bank, any nonbank to hold interest in energy properties only if the
subsidiaries, or the parent company. In this interest had not yet been reassigned to an
instance, the Board expressed the opinion that employee, or if an employee terminates service
the 5 percent exemption provided by section with the subsidiary and is required to reassign
4(c)(6) covers any nonbank shares, including his or her energy properties to the subsidiary.
those acquired D.P.C. Consequently, shares which The bank holding companys proposal was con-
meet such conditions are not subject to the sistent with section 4(c)(6) of the Bank Holding
disposition requirements of section 4(c)(2) of Company Act, which exempts passive invest-
the Act. It is important to remember that the ments of 5 percent or less from the prohibitions
exemption provided by section 4(c)(6) applies of section 4 of the Bank Holding Company Act.
only to shares of any nonbank company. Acqui-
sitions of any bank shares are subject to the
provisions contained in section 3(a) of the Act. 3060.0.2 SECTION 4(c)(7)
Although the 5 percent limitation of this sec-
tion applies, by its language, to voting shares This section provides bank holding companies
rather than any class of voting shares as used the opportunity to own, directly or indirectly,
elsewhere in the Act, the Board has indicated in shares of an investment company (any amount
12 C.F.R. 225.137 that it applies to any class up to 100 percent of outstanding shares) pro-
of voting shares rather than to the aggregate of vided that each of the following conditions is
all classes of voting shares held. Thus section met:
4(c)(6) is not available to a group of BHCs each 1. The investment company is not itself a
owning a class of voting securities even if bank holding company;
each BHC owns less than 5 percent of all shares 2. The investment company is not engaged in
outstanding. Further, section 4(c)(6) must be
viewed as permitting ownership of 5 percent of BHC Supervision Manual December 1992
a companys voting stock only when that owner- Page 1
4(c)(6) and (7) (Ownership of Shares in Any Nonbank Company of 5 Percent or Less) 3060.0
any business other than investing in securities; of the voting shares of any nonbank company
and (other than those owned pursuant to other provi-
3. Securities in which the investment com- sions of the Act) is held by the bank holding
pany invests do not include more than 5 percent company and its subsidiaries.
of the outstanding voting securities of any
company.
4. As in section 4(c)(6), the 5 percent limita- 3060.0.3.2 Section 4(c)(7)
tion applies, by its language, to voting shares
rather than any class of voting shares, as used 1. To determine the overall quality of the
elsewhere in the Act. However, the criterion investments held.
applies to any class of voting shares for pur- 2. To determine the financial impact of the
poses of this section. ownership of such shares upon the bank holding
The 5 percent restriction does not prevent an company and its subsidiaries.
investment company from having direct or indi- 3. To determine if policies, practices and pro-
rect subsidiaries of its own, provided that own- cedures regarding investments are adequate.
ership of such subsidiaries is permitted under 4. To suggest corrective action where neces-
another provision of the Act. Rather, the limita- sary in the areas of policies, procedures, or laws
tion is intended to apply only to securities pur- and regulations.
chased in the ordinary course of investing by the
investment company.
The legislative history of this provision of the
Act does not provide a clear indication as to the 3060.0.4 INSPECTION PROCEDURES
type of institutions encompassed under the term
investment company as used in this section. 3060.0.4.1 Section 4(c)(6)
It appears, however, that any company primarily
engaged in the purchasing and ownership of 1. Review investments held to determine that
securities may be regarded as an investment the BHC has a total interest of no more than
company for purposes of this section. Section 5 percent.
4(c)(7) can be viewed, more or less, as an exten- 2. Determine that 5 percent does not consti-
sion of section 4(c)(6) which permits a bank tute control.
holding company to directly or indirectly through 3. Determine that the BHC is not engaged
subsidiaries own up to 5 percent of the voting in any nonbank activity through its 5 percent
stock of any nonbank company. In fact, until the ownership.
Amendments of 1966, the Bank Holding Com-
pany Act incorporated both section 4(c)(6) and
section 4(c)(7) under one section. From a practi- 3060.0.4.2 Section 4(c)(7)
cal standpoint, the parent company is allowed,
under section 4(c)(6), to directly engage in the 1. Where section 4(c)(7) applies, compare
same activities as an investment company. Ac- the investment companys general ledgers with
cordingly, most holding companies conduct these statements prepared for the latest FR Y6.
activities through the parent company, rather 2. Obtain schedules of investments in voting
than through an investment company subsidiary. shares of any companies. Review quality of
Such an arrangement prevents duplicate pay- such shares (utilizing rating service publica-
ment of certain taxes and provides more flexi- tions, etc.) and check for ownership interests
bility for utilizing funds in other areas of the exceeding 5 percent.
organization. 3. Review policies (written or oral) regarding
purchase and sale of stocks.
4. Obtain and evaluate documentation relat-
3060.0.3 INSPECTION OBJECTIVES ing to credit review for securities held. Deter-
3060.0.3.1 Section 4(c)(6) mine adequacy of procedures to maintain credit
updates.
1. To determine that the investments held 5. Compare carrying value of stocks to cur-
pursuant to section 4(c)(6) comply with the Act rent market value to determine market deprecia-
and 12 C.F.R. 225.101 and 225.137. tion, if any and determine adequacy of any
2. To determine that no more than 5 percent established reserves.
6. Perform verification procedures, including
BHC Supervision Manual December 1992 physical review of stock held in safekeeping,
Page 2 where practical.
4(c)(6) and (7) (Ownership of Shares in Any Nonbank Company of 5 Percent or Less) 3060.0
7. Determine that purchases and sales of stocks 8. Review minutes of the board of directors
are appropriately approved by directors or des- meetings (where an investment company sub-
ignated officers. sidiary is involved).
4(c)(6)
Applicability to shares 225.101 4187
acquired D.P.C.
Aggregating shares owned 225.101 4187

by subsidiaries
Five percent limit on any 225.137 4189

class of voting securities
Control with less than 225.137 4189

5 percent
4(c)(7)
Indirect ownership of 225.102 4188
shares of investment
company

Page 3
Section 4(c)(8) of the BHC Act (Mortgage Banking)
Section 3070.0
WHATS NEW IN THIS REVISED collateralized by the underlying mortgages

SECTION (mortgage-backed securities). The pools of col-
lateralized mortgage loans backing mortgage-
Effective July 2014, this section was revised to backed securities provide a form of risk diversi-
include a brief discussion of the December 13, fication for the investor.
2013, Interagency Statement on Supervisory Originations, secondary market sales, and
Approach for Qualified and Non-Qualified Mort- servicing constitute the primary functional busi-
gage Loans that was issued to clarify the safety ness lines within a typical mortgage company.
and soundness expectations and Community Re- As an originator of mortgages, the company is
investment Act (CRA) considerations for regu- responsible for the initial phase of the mortgage,
lated institutions engaged in residential mort- from original contacts with the borrowers to the
gage lending. The section references the closing of the loans. At closing, the company
Consumer Financial Protection Bureaus (CFPB) disburses its funds and becomes the lender of
Ability-to-Repay and Qualified Mortgage Stan- record. Mortgage loans can also be acquired
dards Rule that was issued on January 10, 2013 through a network of correspondent companies.
(effective on January 10, 2014). Institutions may Most mortgage banking companies use a com-
issue qualified mortgages or non-qualified mort- bination of origination and acquisition strate-
gages, based on their business strategies and gies. The decision about whether to originate
risk appetites. Refer to SR-13-20 and its attach- or purchase loans also varies over time due
ment. to fluctuations in demand and pricing
discrepancies.
A mortgage banker specializes in the origina- The secondary marketing department is
tion, acquisition, and sale of residential real responsible for selling loans in the secondary
estate loans to permanent investors (the second- market and managing the interest-rate risk asso-
ary mortgage market). Most mortgage banking ciated with loans during the interim period. In
firms that are affiliated with banks and bank most cases, the mortgage company retains the
holding companies primarily originate residen- loans until it can find a permanent investor to
tial real estate loans, although some firms may purchase the loans. The mortgage banker obtains
engage in interim and other lending secured by purchase commitments from permanent inves-
real estate. Unlike their nonbank competitors, tors and submits completed loan documentation
the vast majority of the loans mortgage banks packages to the investors for their approvals in
originate are sold to permanent investors in the satisfaction of the commitments.
secondary mortgage market. As part of the overall process, the mortgage
Mortgage banks can retain or sell their loans banker maintains a relationship with a variety of
and sell or retain the servicing of their mort- other permanent investors to whom the origi-
gages. The mortgage banking industry currently nated mortgages are sold. These investors are
offers a wide variety of products, market mech- generally institutional investors such as securi-
anisms, financing vehicles, and financial strate- ties dealers, commercial banks, life insurance
gies due to competitive pressures within the companies, pension funds, and other financial
mortgage banking industry and rapid growth in and nonfinancial institutions. Some of these
the demand for loans and related securities investors are restricted by state law, charter, or
within the secondary mortgage market. Mort- bylaws as to the type of mortgages and the
gage bankers use these marketing and financing locations of the property in which they can
strategies to differentiate themselves from the invest. Accordingly, their purchase commit-
competition in terms of interest rates, maturities, ments should incorporate these limits as well as
down-payment requirements, and product the price and/or required yield of the mortgage
offerings. loans or mortgage-backed securities. When these
The earnings stream, cash flow, and capital commitments are filled and the mortgages sold
needs of a mortgage banking company are all to the investors, the mortgage banker may retain
highly influenced by managements decision the servicing rights to the mortgages it sells to
whether to retain or sell the mortgage loans as permanent investors or sell the servicing rights
well as the related mortgage-servicing rights. in the secondary market.
The majority of loans that are sold in the sec- The servicing department manages the loans
ondary market are originated under government-
sponsored programs. Such loans are either sold BHC Supervision Manual July 2014
directly or are converted into securities that are Page 1
Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0
that were retained in permanent loan portfolio ing subsidiaries located elsewhere within the
or those that were sold to another permanent bank holding companys organizational structure.
investor. Fees paid for services rendered in The mortgage banker, as a lender, has the
administering the mortgage portfolios of inves- flexibility to fund any and all phases of a project
tors are a principal source of revenue for most including land acquisition, development, and
mortgage bankers. In general, the company re- construction. Land acquisition credit may be
ceives a fee that is usually based on a percent of extended for the acquisition of more than one
the unpaid balance of the administered mort- parcel of land, which may not necessarily be
gages. In return for the fee, the servicer is identified with a specific project. More fre-
responsible for collecting and remitting pay- quently, acquisition credit is tied into a specific
ments, managing the tax and insurance escrow project for which the lender expects to fund
accounts, inspecting the properties when required, more than one phase. In development-phase
pursuing delinquent borrowers, foreclosing on lending, funds are advanced to improve the
the mortgages when necessary, and providing property, bring utilities on-site, cut roadways,
accounting support. Considering the services and prepare the site for its intended use. Many
rendered and the generally low fees involved, residential and industrial park projects are
the servicing portfolio must be sizable for the funded through this phase, with the sale of indi-
company to be profitable. The servicing port- vidual parcels providing the repayment of the
folio may represent very little credit risk to the loan. Construction lending funds the project
servicer and can be a valuable source of residual from the foundation to completion. For those
income to the company. loans that fund two or more phases, there may
The mortgage banking industry is experienc- be no clear distinction between the phases as
ing significant consolidation. To be competitive, certain elements of each may be underway
participants must maximize economies of scale concurrently.
and efficiencies. Emphasis has been placed on On large projects funded through completion,
using more efficient systems and technologies such as apartment and office buildings where
that enhance loan processing, underwriting, ser- the construction is to be repaid from a perma-
vicing, and the management of pipeline risk (the nent mortgage, the lender will usually require
interest-rate risk associated with the holding the borrower to obtain a permanent mortgage
period for the mortgages). Existing mortgage commitment from a third party. While this take-
banking firms are larger and operate more effi- out commitment may or may not be arranged
ciently (faster, cheaper, and with higher quality) through the lenders network of investors, this
than they did in the past. Operating efficiencies commitment provides the lender with some
are achieved through the use of sophisticated assurance of repayment. In some cases, particu-
information systems, such as electronic data larly in unsettled market environments, these
interchange, imaging, optical character recogni- takeouts are not available, and the lender may
tion, expert systems, and other forms of artifi- issue a standby commitment. On occasion,
cial intelligence. no permanent financing will be available upon
Within a bank holding company, mortgage completion and the lender will extend a bridge
banking subsidiaries generally focus on residen- loan for the interim period between project
tial mortgage lending. As discussed initially, completion and the placement of a permanent
these mortgage bankers may also engage in mortgage. Making construction loans without
other forms of lending. On an industry basis, takeout commitments from responsible term
they extend loans to real estate brokers who buy lenders could expose the construction lender to
properties for resale, engage in second mortgage adverse interest-rate movements as well as the
and home improvement lending (usually through market acceptability of the project. The absence
dealer agreements), and extend interim loans. of a takeout can represent a weakness in a loan.
Interim loans represent a means of funding a The general lack of takeouts in a portfolio
project through one or more phases, with the should be a criticizable management practice
property and improvements as collateral for the (unless mitigating circumstances prevail) and
loan. The size of interim loans may range from should be discussed with management.
a single residence under construction to large This section provides inspection guidance and
industrial, commercial, or residential projects. procedures for mortgage banking nonbank sub-
Construction lending and other forms of lending sidiaries of bank holding companies. Except for
may be provided by other such real estate lend- the limited guidance that pertains only to bank
holding companies, they may also serve as exam-
BHC Supervision Manual July 2014 ination guidance and procedures for mortgage
Page 2 banking subsidiaries of state member banks.
The way in which these procedures are used

should be determined on a case-by-case basis
depending on the size of a particular company
and its business activities. The information in
Board Oversight and Management, Finan-
cial Analysis, and Intercompany Transac-
tions presented in this section is applicable to
all mortgage banking reviews. The subsection
Mortgage-Servicing Rights is recommended
for use in companies that have significant risk
exposure. The examiner should also target func-
tional areas such as production, marketing, and
servicing/loan administration.
3070.0.1 BOARD OVERSIGHT AND

MANAGEMENT
The examiner should assess the quality and

effectiveness of a mortgage banking companys
board of directors (board) and executive man-

Page 2.1
agement team, the appropriateness of its organi- whether directors are fulfilling their fiduciary
zational structure, the nature of its internal con- responsibilities. At a minimum, directors
trol environment, and the effectiveness of internal should
control programs.1 Such internal control pro-
grams may include internal and external audits, select and retain a competent executive man-
loan review, quality control over mortgage loans agement team;
originated and/or serviced for investors, compli- establish, with management, the companys
ance, fraud detection, and related employee short- and long-term business objectives and
training programs. adopt operating policies to achieve those
The board and executive management team objectives in a safe and sound manner;
must be evaluated within the context of the monitor operations to ensure they are con-
particular circumstances surrounding each mort- trolled adequately and are in compliance with
gage banking company. Since business com- laws and policies;
plexities and operating problems vary according oversee the mortgage banking companys busi-
to the institutions size, organizational structure, ness performance; and
and business orientation, directors and manag- ensure that the mortgage banking company
ers who are competent to effectively discharge meets the communitys residential mortgage
their responsibilities under one set of conditions credit needs.
may be less competent as these conditions change.
Board oversight and management should The examiner should assess whether directors
be rated satisfactory, fair, or unsatisfactory based exercise independent judgment in evaluating
on both objective operating results and more managements actions and competence, attend
subjective criteria. Performance must be eval- board and committee meetings regularly, remain
uated against virtually all the factors necessary well informed regarding the companys activi-
to operate the mortgage banking companys ties and the mortgage banking industry overall,
activities in a safe, sound, and prudent manner, and are knowledgeable regarding all applicable
including the ability to anticipate and plan for state and federal laws and regulations. The
future events that may have a material impact examiner should also review the quality of board
on the companys financial condition. Such a reporting. Board reports must provide accurate
rating should also be considered when assigning and timely information to directors with respect
a consolidated rating of risk management (see to operating results, asset-quality trends, liquid-
sections 4070.1 (SR-95-51) and 4071.0 ity and capital needs, and relevant industry and
(SR-16-11)). peer-group performance statistics for each
operational area. Directors should also receive
information regarding exceptions to established
3070.0.1.1 Board Oversight policies and operating procedures, volume-
related processing backlogs, and the effective-
The mortgage banking companys board pro- ness of the internal control programs. Informa-
vides oversight, governance, and guidance to tion on hedging products and strategies should
the executive management team. The board may be routinely provided to the board and to hold-
include executives of the mortgage banking ing company management. In connection with
company, executives of the bank holding com- this portion of the review, examiners should
pany and other affiliated companies, and outside also request and review information regarding
directors. all loans to insiders and their related interests to
The examiner should determine whether a ensure that no preferential transactions have
separate board exists, as well as the identity and been extended to these parties.
qualifications of the members. Minutes of board
meetings should be reviewed to determine
3070.0.1.2 Management
1. See section 1010.1 of the Commercial Bank Examina-
tion Manual and a report, Internal ControlIntegrated
Framework, which was issued in September 1992 by the
The executive management team generally con-
Committee of Sponsoring Organizations of the Treadway sists of a president and chief executive officer
Commission, for a more detailed discussion of internal con- (CEO), chief operating officer (COO), chief
trols. The Treadway Commission report broadly defines inter- financial officer (CFO), and senior executives in
nal control as a process, effected by an entitys board of
directors, management, and other personnel, designed to pro-
charge of production, marketing, and servicing/
vide reasonable assurance regarding the effectiveness and
efficiency of operations, reliability of financial reporting, and BHC Supervision Manual July 2016
compliance with applicable laws and regulations. Page 3
loan administration. Management formulates managements philosophy toward the business,

operating policies and procedures and oversees the extent of financial risk-taking, commitments
the day-to-day administration of mortgage bank- to maintaining procedures and controls in man-
ing activities. Management should be evaluated aging the business, and managements commit-
in terms of its technical competence, leadership ment to staff development) over a one- to three-
skills, administrative capabilities, and knowl- year time horizon. Planning efforts should also
edge of relevant state and federal laws and address system deficiencies and technological
regulations. The management assessment should advancements within the industry. Without
evaluate managements attitude toward risk, as appropriate planning, the company can only
evidenced by the type of products that are react to external events and market forces.
offered; the existence of effective hedging pro- Management should be results-oriented, but
grams; and/or the degree of reliance that is not at the expense of sound risk-management
placed on the resources of affiliate banks, non- practices. Goals and objectives should be
banks, and other entities to support mortgage specific and measurable. Management should
banking company activities. develop a performance measurement system that
Prudent operating policies and procedures tracks progress toward achieving both financial
that are consistent with the business needs and and nonfinancial goals.
risk-management practices of the parent bank
holding company should be in place for each
functional area. An effective risk-management 3070.0.1.3 Organizational Structure
program should also be in place. Without ade-
quate management oversight, excessive errors The organizational structure should be reviewed
can occur, fraud or other violations of law may to determine, on a legal-entity basis, the rela-
go undetected, and financial information may be tionship between the mortgage banking com-
reported incorrectly. Any of these events can pany, the bank holding company, and any other
damage the companys image, impair its access bank or nonbank subsidiaries. The structure
to external funding sources, and jeopardize its should also be reviewed to determine whether
ability to originate and sell mortgage loans in the lines of authority are clearly defined, the
the secondary market. responsibilities are allocated logically, and man-
It is managements responsibility to develop agement depth is sufficient within each division,
and maintain management information systems department, or functional area.
(MIS), which should be dedicated to obtaining, The president and CEO usually reports
formatting, manipulating, and presenting data to directly to the mortgage banking companys
managers when needed. Such systems should board of directors, as well as to an executive
generate accurate financial statements; identify management committee at the affiliate bank or
the need for financial, human, technological, the bank holding company level. Other report-
and physical resources; and produce timely and ing lines may exist between functional area
useful management exception reports. executives and their counterparts at either a
Management should also be evaluated on its bank affiliate or the holding company level.
ability to plan effectively. Effective planning
entails the annual approval of an operating bud-
get and the development of a long-term strategic 3070.0.1.4 Control Environment
plan that helps management anticipate changes
in the internal and external environment and Managements attitude toward risk is communi-
respond to changing circumstances. Because cated to employees through the companys cor-
losses on the origination of mortgage loans are porate culture. In general, the CEO should
common in the mortgage banking industry, man- establish and communicate a corporate culture
agement should assess the servicing time neces- that promotes safe, sound, and prudent business
sary to recapture costs and achieve required practices. The corporate culture should provide
returns. This information is critical to decisions a positive control environment, set high stan-
to purchase mortgage-servicing assets, and it dards, and reward ethical, desirable behavior.
should be incorporated into hedging strategies. Managements failure to communicate
The strategic plan should identify the com- acceptable standards of behavior may encourage
panys strengths and weaknesses, growth tar- impermissible or high-risk business practices.
gets, and other strategic initiatives (including For instance, compensation programs that are
incentive-based may generate poor-quality loans.
BHC Supervision Manual July 2016 Below-market pricing strategies or overly
Page 4 aggressive growth targets may further exacer-
bate asset-quality problems or generate loans in ing training and be encouraged to hold profes-
excess of processing and servicing capabilities. sional industry certifications. Internal audit reports
should be issued and responded to by line man-
agement in a timely fashion. Follow-up proce-
3070.0.1.5 Control Programs dures should be in place to ensure that correc-
tive measures are taken.
Management controls in a mortgage banking
company consist of an internal audit, an exter-
nal audit, loan review, compliance, quality con- 3070.0.1.5.2 External Audit
trol over loans originated and/or serviced for
investors, fraud detection procedures and related External auditors generally review and assess
employee training programs, insurance cover- the mortgage companys financial condition and
age, and legal review. The examiner should the adequacy of internal controls. The engage-
review recent reports conducted by internal loan ment letter sets forth the external auditors
review, state and federal agencies, and private responsibilities, scope, and extent of reliance
investors to determine the scope of the review, that is placed on the internal audit department
the nature of any problems noted, and the with respect to the type of engagement. When
adequacy of managements response. an external audit is to be performed, the audit is
an examination that is conducted to determine
that the present financial condition of the com-
3070.0.1.5.1 Internal Audit pany and the results of operations are fairly
stated and are in conformity with generally
The internal audit function in a mortgage bank- accepted accounting principles.
ing company is responsible for detecting irregu- Examiners should review the most recent
larities; determining compliance with applicable external audit report to determine whether the
laws and regulations; and appraising the sound- opinion regarding the companys financial state-
ness and adequacy of accounting, operating, and ments and their disclosures was qualified in any
administrative control systems. Accounting, manner. If applicable, examiners should note
operating, and administrative control systems any significant concerns or weaknesses in the
are designed to ensure the prompt and accurate companys internal control structure. Examiners
recording of transactions and a proper safe- should also review managements written
guarding of assets. response to the audit to determine whether cor-
Internal audit activities may be conducted rective measures were appropriate, complete,
through a separate department located on-site or and timely and whether the response reveals any
through the internal audit department of the internal control weaknesses.
bank holding company. Very small financial The reason behind any changes in external
institutions that do not maintain a separate audit audit firms used should be investigated. Unusual
function may rely solely on their external audi- items and areas of potential concern should be
tor to perform these functions. discussed with management and/or the external
Regardless of the organizational structure, auditor. If questions arise during the safety-and-
internal auditors must be independent of the line soundness review, the examiner should deter-
areas being reviewed, have access to all com- mine whether the area of concern was consid-
pany records, and maintain sufficient status and ered to be a material item by external auditors,
authority within the company. The internal audi- the nature of audit work performed, and the
tors findings should be reported directly to the outcome of that review. If questions persist, the
board or a designated committee thereof. examiner may want to request access to specific
The scope, frequency, and coverage provided external audit workpapers.
through the internal audit program should reflect
the size and complexity of the institution. The
audit schedule should cover underwriting prac- 3070.0.1.5.3 Loan Review
tices and other high-risk areas of mortgage
banking, including the most significant balance- Loan review activities may be conducted at the
sheet accounts, income statement accounts, and mortgage banking company or in conjunction
internal control systems. with the loan review activities of either an affili-
To yield meaningful results, the department ate or the parent bank holding company. In any
must be adequately staffed with individuals who
are experienced and knowledgeable about mort- BHC Supervision Manual July 2014
gage banking. Audit staff should receive ongo- Page 5
event, loan review should determine whether ment should operate independently from the
mortgage loans that are originated and/or pur- production and servicing/loan administration
chased meet underwriting standards as defined departments. Quality control should comple-
in the internal loan policy. Loan review may ment, not substitute, work performed by the
also sample loans to determine whether they internal audit and loan review functions.
meet underwriting criteria established by inves-
tors. The scope of the loan review program
should be evaluated. The examiner should also 3070.0.1.5.5 Insurance Program
review a copy of the most recent loan review to
determine whether problems are identified and The insurance program should be reviewed to
addressed in a timely manner. determine whether coverage adequately protects
the mortgage banking company and its affiliates
against exposure to undue financial risk. Insur-
3070.0.1.5.4 Quality Control ance policies should be reviewed and approved
by the board at least annually.
Mortgage banking companies that service loans
for investors must also maintain a separate qual-
ity control department to test the quality of 3070.0.1.5.6 Litigation
loans produced and serviced for investors.
Investors such as the Government National Mort- The legal department should be contacted to
gage Association (GNMA or Ginnie Mae), Fed- determine whether existing or pending litigation
eral Home Loan Mortgage Corporation (FHLMC exposes the mortgage banking company or its
or Freddie Mac), and FannieMae issue very affiliates to undue financial risk. Particular atten-
specific guidelines that must be met with respect tion should be paid to the status of any actual or
to the scope and frequency of such reviews. pending class action lawsuits of a material nature.
At a minimum, these investors require that Examiners should also determine whether
the mortgage banking company sample at least procedures exist to detect and investigate sus-
10 percent of all closed loans each month and pected fraud, either internal or external. In many
conduct a quality control review to determine instances, the legal department coordinates fraud
the extent of accuracy, completeness, and adher- training and investigations, as well as the sub-
ence to agency underwriting standards. Random mission of criminal referral or suspicious activi-
samples should include loans originated through ties reports and the initiation of legal action. If a
the companys own production network, pur- separate fraud division or unit does not exist,
chased loans, loans for which work was per- examiners should determine whether procedures
formed by a third party (outsourced), and loans governing the detection, investigation, and refer-
with various product characteristics, such as a ral of potentially fraudulent situations exist
high loan-to-value or a convertible feature. and function effectively. Examiners should also
Quality control personnel reverify loan docu- determine whether management reports ade-
mentation, including the appraisal, down pay- quately detail and track potential exposure.
ment, employment, and income information.
After each review, the department should issue
a comprehensive report detailing specific qual- 3070.0.1.5.7 Supervisory Approach for
ity control findings and recommendations. Qual- Qualified and Non-Qualified Mortgage
ity control reviews must be completed within Loans
90 days of closing. Exceptions to company pol-
icy or investor underwriting standards should be An Interagency Statement on Supervisory Ap-
documented and communicated to executive proach for Qualified and Non-Qualified Mort-
management. Corrective measures should be gage Loans, dated December 13, 2013, was
initiated promptly. issued to clarify the safety-and-soundness ex-
The quality control function should serve as pectations and Community Reinvestment Act
an early warning system that alerts management (CRA) considerations for regulated institutions
to situations that may jeopardize the financial engaged in residential mortgage lending. The
strength, image, or origination and sale capacity Consumer Financial Protection Bureaus (CFPB)
of the company. To function as an effective Ability-to-Repay and Qualified Mortgage Stan-
management control, the quality control depart- dards Rule1a was issued on January 10, 2013
BHC Supervision Manual July 2014 1a. See the Ability-to-Repay and Qualified Mortgage Stan-
Page 6 dards Rule (the Ability-to-Repay Rule)_ under the Truth in
(effective on January 10, 2014). Institutions may

issue qualified mortgages or non-qualified mort-
gages, based on their business strategies and
risk appetites. Residential mortgage loans will
not be subject to safety-and-soundness criticism
based on their status as either qualified mort-
gages or non-qualified mortgages. As for safety-
and-soundness expectations, the agencies1b con-
tinue to expect institutions to underwrite
residential mortgage loans in a prudent fashion
and to address key risk areas in their residential
mortgage lending, including loan terms, bor-
rower qualification standards, loan-to-value lim-
its, documentation requirements, and appropri-
ate portfolio and risk-management practices.
Refer to SR-13-20 and its attachment.
3070.0.1.6 Inspection ObjectivesBoard

Management and Oversight
1. To assess the composition, qualifications,
and degree of oversight provided by the mort-
gage companys board and executive manage-
ment team.
2. To determine whether the organizational
structure is appropriate given the nature and
scope of the mortgage banking companys
operations.
3. To evaluate the reasonableness of the oper-
ating budget, long-term business planning, per-
formance measurement systems, and MIS and
related management and board reports.
Lending Act (Regulation Z), 78 Fed. Reg. 6408 (January 30,

2013), as amended. The Ability-to-Repay Rule requires insti-
tutions to make reasonable, good faith determinations that
consumers have the ability to repay mortgage loans before
extending such loans. In accordance with the rule, a qualified
mortgage may not have certain features, such as negative
amortization, interest-only payments, or certain balloon struc-
tures, and must meet limits on points and fees and other
underwriting requirements.
1b. The federal banking financial institutions regulatory
agencies (the Federal Reserve, the Federal Deposit Insurance
Corporation, and the Office of the Comptroller of the Cur- BHC Supervision Manual July 2014
rency). Page 6.1
4. To determine the nature of the companys Internal Control Environment

internal control environment and the effective-
ness of its system of internal controls, including 1. Evaluate the nature of the internal control
internal and external audits, loan review, quality environment and how risk parameters are com-
control, suspicious activities and fraud detec- municated to employees.
tion (including criminal referral and suspicious
activities reporting) and related employee train-
ing programs, insurance coverage, and pending Internal Control Programs
litigation.
1. Assess the effectiveness of internal con-
trols in identifying and controlling risks. Inter-
3070.0.1.7 Inspection ProceduresBoard nal controls include internal and external audits,
Management and Oversight quality control for mortgage loans, insurance
coverage, and fraud detection procedures and
Board Oversight related employee training programs.
1. Review biographies of the board of direc-

tors and minutes from board and committee Internal Audit
meetings to determine whether directors are
qualified and fulfilling their fiduciary 1. Determine whether a separate internal
responsibilities. audit function exists and, if so, its degree of
2. Review the most recent package of infor- independence.
mation that was provided to directors. Do they 2. Review the qualifications of the internal
receive sufficient detail regarding the financial audit manager and his or her staff for mortgage
condition, internal controls, and risk- banking and accounting and auditing expertise.
management techniques employed within the Consider the size of the department and its
company? ongoing training programs, as well as the expe-
rience levels, educational backgrounds, and pro-
fessional certifications of the departments staff.
Management 3. Determine the scope and frequency of the
internal audit program to ensure that all high-
1. Review biographies of members of the risk areas are reviewed regularly.
executive management team to determine their 4. Review all internal audit reports, manage-
level of experience, technical knowledge, lead- ment responses to them, and follow-up audit
ership skills, and administrative capabilities. reports for work conducted since the previous
Discuss whether salaries are commensurate with inspection.
managements experience level and expertise. 5. Select a significant sample of internal audit
2. Evaluate the quality of operating policies reports and respective workpapers and conduct
and procedures within each division or func- an intensive review of the internal audit pro-
tional area and the extent to which compliance gram. Determine that all issues and exceptions
with such policies and procedures is monitored were brought forward to the final audit report,
and reported. the report was presented to the board or a com-
3. Evaluate the output from the planning pro- mittee thereof, and that any detected and dis-
cess, including the most recent operating bud- closed problems or control weaknesses received
get, business plan, and related performance mea- appropriate management attention.
surement system reports. Determine whether
6. Evaluate the internal audit departments
objectives, goals, and growth targets are
system for following up on issues and excep-
reasonable.
tions. Determine whether prompt, satisfactory
resolution of issues was effected.
Organizational Structure
External Audit
1. Review the organization chart to deter-
mine whether the organizational structure is 1. Review the engagement letter for the most
appropriate, as well as the appropriateness of recent external audit to determine the external
the division of functional responsibilities and
the degree of management depth within each BHC Supervision Manual June 1996
division or functional area. Page 7
auditors scope, responsibilities, and extent of sourcing meets the companys own quality
reliance on the internal audit department. standards?
2. Review the most recent external audit
report to determine whether the opinion regard-
ing the companys financial condition was quali- Insurance
fied in any way and whether any internal control
weaknesses were noted. Review the notes to the 1. Review insurance policies maintained for
financial statements for appropriate disclosures. the mortgage banking company to determine
3. Discuss any unusual items and areas of whether coverage is adequate and whether the
potential concern with management and/or the majority of insurable risks is included, giving
external auditor. Determine whether any areas consideration to a cost versus benefits analysis.
of concern were considered to be material items 2. Review board minutes to ascertain the date
by the external auditors, based on the nature of the board last reviewed and approved the insur-
audit work performed, managements represen- ance program.
tations in the management letter, and the out-
come of that review. If questions persist, con-
sider the need to request and review specific Litigation
external audit workpapers.
4. Discuss the reasons for any recent changes 1. Review all current and pending litigation
in external auditors with management. of a material nature and determine whether ade-
quate reserves are maintained to cover antici-
pated financial exposure.
Compliance and Disaster Recovery
1. Review the methods used to ensure com- Fraud Detection and Training
pliance with state and federal laws and regula-
tions by 1. Determine whether a separate fraud unit
a. interviewing the person who is respon- exists and whether procedures are in place
sible for compliance to determine the nature of regarding the detection and investigation of sus-
outstanding problems and the adequacy of cor- pected fraudulent activity and the issuance of
rective measures that have been taken, and related management reports.
b. reviewing the system for logging, 2. Evaluate the companys early warning sys-
tracking, and responding to customer complaints. tem for detecting potential fraud. Is the level of
2. Determine whether the disaster recovery training adequate?
plan is adequate. 3. Review any criminal referral or suspicious
activities forms filed since the prior inspection
and discuss their status with management.
Quality Control
1. Review the quality control departments 3070.0.2 PRODUCTION ACTIVITIES
policies and procedures to determine whether
the quality control program meets minimum Loan production covers the process of originat-
investor requirements. ing or acquiring loans. Production begins with
2. Review a sample of reports issued by the the initial loan application and ends when a loan
quality control unit to determine whether they has been underwritten and processed, closed,
were issued in a timely manner and conclusions and reviewed by post-closing.
were adequately documented.
3. Determine whether quality control results
are relayed to executive management and whether 3070.0.2.1 Types of Loans
follow-up procedures are adequate.
4. Determine whether the quality control unit Loans are categorized as either government or
is sufficiently staffed and independent. conventional loans. Government loans generally
5. Determine whether quality control out- carry a below-market interest rate and are either
sources work to outside parties. If so, are ade- insured by the Federal Housing Administration
quate controls in place to ensure that such out- (FHA) or guaranteed by the Veterans Adminis-
tration (VA). Both agencies protect investors
BHC Supervision Manual June 1996 holding such securities against losses in the
Page 8 event of a borrower default, thereby slightly
reducing investors required yields. To be insured their securities will be repaid. FHLMC and
or guaranteed, a loan must meet agency stan- FannieMae securitization involves the purchase
dards regarding the size, interest rate, and terms. of conventional loans from lenders and the sell-
The lender can obtain a certificate of insurance ing of mortgage-participation certificates, which
or guaranty to give support to a loan for securi- are similar to GNMA pass-through securities.
tization. A certificate of insurance or guaranty Participation certificates represent an ownership
may not be needed for a loan to be securitized.2 interest in pools of conventional loans. FHLMC
Loans that are not FHA-insured or VA- and FannieMae guarantee the monthly pass-
guaranteed are referred to as conventional loans. through of interest, the scheduled amortization
Conventional loans are generally originated for of principal, and the ultimate repayment of prin-
larger loan amounts and made to stronger bor- cipal. Unlike GNMA pass-throughs, however,
rowers. Conventional loans typically require participation certificates are not backed by the
higher down payments and bear market interest full faith and credit of the U.S. government.
rates. Most lenders that offer programs with Conventional loans are classified as either
smaller down-payment terms require that the conforming or nonconforming. Conforming
borrower purchase private mortgage insurance loans must comply with FannieMaes and/or
for the top 5 to 20 percent of the loan principal FHLMCs underwriting and documentation
balance so that a proportionate share of the guidelines in order to be sold in the secondary
credit risk is borne by a private mortgage insur- market. Conforming mortgages may be sold to
ance (PMI) company. FannieMae or FHLMC on either a recourse or
The extent of credit risk associated with a nonrecourse basis.
loan often depends on the marketing program Private pools of nonconforming loans that do
under which the loan is originated. Marketing not meet FannieMae or FHLMC guidelines may
programs and participants are described briefly be sold in the secondary market under a private
here; for a more detailed description, see Mar- label structure. Nonconforming loans are often
keting Activities later in this section. nontraditional products such as loans with
The market for residential real estate loans is teaser rates, limited documentation, and gradu-
dominated by three government-sponsored enti- ated payment schedules, as well as jumbo
ties: the Government National Mortgage Asso- loans that exceed maximum agency size require-
ciation (GNMA), the Federal Home Loan Mort- ments. To improve salability, pools of noncon-
gage Corporation (FHLMC), and the Federal forming loans may be insured through third-
National Mortgage Association (FannieMae). party credit enhancements (for example, letters
GNMA is a government agency that guarantees of credit) or various senior/subordinate struc-
the timely payment of principal and interest on tures. Since the underlying mortgages generally
pass-through securities that are backed by pools already carry private mortgage insurance, such
of FHA-insured or VA-guaranteed mortgages. pools are, in effect, doubly insured.
These guaranties are backed by the full faith and
credit of the U.S. government. Although inves-
tors will get paid in full, servicers may retain 3070.0.2.2 Production Channels
some risk of loss, particularly with respect to
VA loans (see subsection 3070.0.4.5 for addi- Mortgage loan applications are generated through
tional information on VA no-bids). either retail (internal) or wholesale (external)
Pass-through securities provide for monthly production channels. Retail loans are originated
installments of interest at the stated certificate through the companys own branch network. A
rate plus scheduled principal amortization on branch network is relatively costly, since origi-
specific dates, despite the delinquency status of nation costs often exceed the origination fees
the underlying loans, as well as any prepay- received from the borrowers.
ments and additional principal reduction. The Wholesale production channels (where con-
issuer collects the mortgage payments and, after tact with the borrower is made by another party)
retaining servicing and any other specified fees, take several forms. Whole loans can be pur-
remits monthly payments to the certificate holders. chased either individually or by using bulk com-
Although FHLMC and FannieMae are not mitments. Bulk commitments either require the
extensions of the U.S. government, the market correspondent to deliver a set amount of loans
believes that there is an implicit guaranty that (mandatory) or deliver all registered loans that
close (best effort or optional).
2. See the appropriate agency seller/servicer guide for stan-
dards and requirements regarding certificates of insurance or BHC Supervision Manual June 1997
guaranty. Page 9
Loans may be closed in the buyers own ments, an executive officers compensation based
name using its own funds, closed in the sellers on volume, an emphasis on high-risk product
name using the buyers own funds, or closed types or geographic areas, and/or dependence
and funded by the seller with delivery to the on a limited number of production channels.
buyer within a certain number of days. If the Examiners are responsible for recognizing and
seller closes in its own name, the mortgage and reaching agreement with management to better
note are generally assigned to the buyer simulta- control such high-risk production strategies where
neously upon closing. appropriate.
Three hybrid production channels are worth
mentioning here. Examiners should note that
terminology within the industry varies greatly. 3070.0.2.4 Production Process
Under the first method, table funding, a mort-
gage banking company funds loans at closing There are five principal steps in the retail pro-
that have been originated by a correspondent or duction process: (1) pipeline entry, (2) process-
broker according to the companys own specifi- ing, (3) underwriting, (4) closing and funding,
cations. Historically, the companys ability to and (5) post-closing. Each of these functions
record mortgage-servicing rights depended on should be independent from one another and
the degree of independence that was maintained separately supervised to ensure the quality of
and the extent of risk borne by the originator. the loans produced. Each step is briefly dis-
See subsection 3070.0.6, on Mortgage- cussed below.
Servicing Assets and Liabilities.
The second hybrid method, assignment of 1. Pipeline entry. A loan has entered the
trade, involves the bulk purchase of loans and pipeline when a prospective borrower completes
investor commitments to sell the loans in the a loan application. The applicant authorizes the
secondary market. The purchaser bears virtually lender to verify his or her employment, credit
no market risk under this production method. history, bank deposits, and other information
The third hybrid method, co-issue, entails the that evidences repayment capacity.
acquisition of servicing rights only, at the time a 2. Processing. The application is then pro-
security is issued. cessed to qualify the applicant and the property
Most mortgage originators operate on a non- for the loan. Processing personnel verify the
recourse basis. For purchasers of correspondent applicants employment history and credit infor-
production, credit risk increases to the extent mation and order an appraisal on the prop-
that the lender relies on other parties to correctly erty. Processing activities should be controlled
process and underwrite the loan. Contracts with through standardized procedures, checklists, and
correspondents should include representations systems.
and warranties from the correspondent that loans 3. Underwriting. The underwriting unit
delivered meet the underwriting requirements of approves or disapproves applications based on
the agency or investor program for which the underwriting criteria that are established by the
loan was originated. Approved correspondent FHA, VA, FannieMae, and FHLMC and by
lenders should be continually monitored for the private mortgage insurers and institutional
quality of the product delivered and the finan- investors. To ensure objectivity, the underwrit-
cial ability to repurchase mortgages that do not ing unit should not report to management of the
meet the standard representations and warran- production function.
ties under which the mortgages are sold. 4. Closing and funding. After an application
has been approved, the lender generally issues a
commitment letter to the borrower, which states
3070.0.2.3 Production Strategies the interest rate and terms of the loan. At clos-
ing, the lender or its agent obtains all the legal
A successful production strategy combines high and related documents executed by the parties
credit-quality standards with cost containment to the sale, disburses the proceeds of the loan,
and effective marketing. In contrast, an overly and collects certain funds from the borrower.
aggressive or inappropriate strategy leads to 5. Post-closing. After closing, a post-closing
heightened production risk. High-risk produc- review is performed to ensure that documents
tion strategies can be evidenced by relaxed were properly executed and underwriting in-
credit standards, low documentation require- structions were followed. The post-closing review
also identifies any trailing or missing documents
BHC Supervision Manual June 1997 that must be tracked and obtained to meet inves-
Page 10 tors pool certification requirements. Specific
agency requirements are detailed in the agency gage loan prices that are established by the
seller/servicer guides. Before the loan is trans- marketing department. An overage exists when
ferred to the delivery or shipping department, a lender permits an originator or broker to
processing begins for the final mortgage insur- impose a higher number of points (or a higher
ance (from the private mortgage insurer or from interest rate) on a loan to certain borrowers
the FHA/VA guaranty certificate). Receipt of than is imposed for the same product offered to
the actual certificate may take 45 to 60 days or other borrowers at a given point in time. (See
longer. Pool custodians and investors will allow CA-94-6.)
the lender to complete the sale if final documen- Overages are often used as an incentive to
tation, including the insurance certificate, is compensate originators or brokers. The amount
expected to be received within a reasonable that is received over the expected price is often
timeframe. shared by the mortgage banking company and
the originator or broker. The practice of permit-
ting overages may contribute to or result in
3070.0.2.5 Production Risks lending discrimination under the Equal Credit
Opportunity Act (ECOA) and the Fair Housing
The production process can present risks of both Act (FHAct).
a short- and potentially long-term impact. Examiners should review the mortgage bank-
Operational inefficiencies can result in high ing companys lending policy and determine
management and staff turnover, an inability to whether overages are permitted and whether the
meet investor documentation requirements, an practice has resulted in lending discrimination.
increasing number of pools that have not received If a more detailed review of overages is deemed
final certification, or an unusually high produc- necessary, such review should be performed in
tion cost structure. Operations risk often increases conjunction with the appropriate Federal Reserve
during peak volume periods. If additional Systems legal and consumer compliance staff.
resources (which can include independent ser-
vice providers) are not allocated to the process- 3070.0.2.7 Inspection Objectives
ing, underwriting, closing, and post-closing areas, Production Activities
delinquency levels may increase and workloads
may exceed existing capacity. 1. To determine the types of loans offered to
Management should be prepared to quickly borrowers and any significant changes in prod-
respond to interest-rate cycles and related vol- uct mix.
ume increases or declines, since failure to act 2. To determine whether mortgage loans are
promptly can affect earnings and capital. During securitized; if so, to determine whether mortgage-
the pooling and securitization process, for exam- backed securities are insured or otherwise guar-
ple, if the number of pools that lack final certifi- anteed by government-sponsored agencies or
cation exceed a certain limit, the company may private entities.
be required to seek financial support in the form 3. To determine what channels are used to
of a letter of credit from an affiliate bank or originate loans.
bank holding company to ensure that all required 4. To determine if production processes are
loan documentation is secured in a timely man- consistent with operational risk controls and
ner. Credit risk and operational inefficiencies efforts to minimize risk.
may also create liquidity problems and addi- 5. To determine whether production pro-
tional interest-rate risk if the company is unable cesses can handle cyclical changes in volume.
to sell its loans in the secondary market. 6. To determine whether overages are permit-
To the extent a company retains servicing on ted and to assess whether the practice has resulted
either its retail or correspondent production, in lending discrimination.
long-term credit risk issues may develop. These
include exposure to the pools being serviced
through recourse arrangements, potential non-
reimbursable foreclosure costs, or costs associ-
3070.0.2.8 Inspection Procedures-
ated with VA no-bid options.
Production Activities
General
3070.0.2.6 Overages 1. Review organization charts to determine
In certain instances, originators and loan bro- BHC Supervision Manual June 1996
kers may have the ability to deviate from mort- Page 11
the structure of the production function and its table funding, assignment of trade, or co-
status within the company. Verify that func- issuances (bulk purchases of servicing rights
tional units such as underwriting and quality only). For each production channel, review how
control are independently managed. brokers and correspondents are compensated.
2. Determine the types of mortgage products 5. Review the method for reviewing and
offered and the companys target markets. Evalu- approving brokers and correspondents and spe-
ate portfolio trends for overreliance on one cific programs under which wholesale loans are
product type and undue concentrations in one purchased. Is there an approved list of corre-
geographic area. spondents? How is it updated and how fre-
3. Discuss the companys credit culture, com- quently? Determine whether exceptions to this
pensation methods, and growth targets to deter- list are made and by whom, and whether controls
mine whether income and loan volume are are in place to prevent unauthorized purchases.
emphasized over credit quality. 6. Evaluate the process for conducting finan-
4. Determine whether the level of noncon- cial reviews on correspondents. How often are
forming or unsalable loans being originated financial statements obtained, and who analyzes
present undue risk and whether the quality and them?
delinquency trends for such loans are adequately 7. Determine whether adequate controls are
monitored. in place to detect changes in the financial condi-
tion of a correspondent, test and monitor the
quality of loans purchased, and evaluate the
Originations correspondents financial capacity to perform
under contractual repurchase obligations.
1. Review policies and procedures for retail 8. Select a sample of contracts for the largest
branch originations. How are originators com- correspondents for additional review. Do con-
pensated? Determine whether originators have tracts clearly state pricing structures, maximum
the authority to alter loan pricing parameters set dollar volumes, recourse arrangements, and
by the marketing unit. whether loans are purchased on a mandatory
2. Determine the size of the branch network delivery or a standby basis? Have any legal
and its cost structure. Is the network growing or issues arisen as a result of the contract lan-
shrinking? How does management plan for guage? How frequently does management put
anticipated changes in loan volume? back loans to its largest correspondents?
3. Determine if the mortgage banking com- 9. Determine whether management informa-
pany is involved in overage activities. If so tion systems adequately track approvals and
a. determine whether management has denials by loan type and production channel.
developed comprehensive policies and pro- Are exceptions to policy adequately tracked and
cedures, detailed documentation and tracking monitored?
reports, accurate financial reporting systems and
controls, and comprehensive customer com-
plaint tracking systems to adequately monitor
and supervise overage activities;
Processing
b. review whether overages are an essen-
1. Determine whether processing is per-
tial component of the mortgage banking com-
formed in-house or by another party (a third-
panys earnings and origination activities, and
party contractor or the originator). Review check-
review the percentage of mortgages originated
lists and procedures for the processing unit and
since the previous inspection that resulted in
determine whether loan tracking systems are
overages and the average overage per loan;
adequate.
c. determine if management reviews over-
age activity for disparate treatment and dispar- 2. Review steps that have been taken to
ate impact; and address any audit or quality control findings.
d. determine if overages are a major com- Determine whether additional corrective actions
ponent of loan officer and/or broker compensation. are necessary.
4. Review policies and procedures for whole-
sale purchases. Which production channels are
used and how do they work? Channels may Underwriting
include whole loan purchases (production flow),
1. Determine whether underwriting is per-
BHC Supervision Manual June 1996 formed in-house, by third-party underwriters, or
Page 12 by the originator. Is management planning for
peak volume periods and are controls over the posted? Does the situation pose undue financial
underwriting process adequate? risk for the company or any of its affiliates?
2. Review policies and procedures to gain a
reasonable assurance that underwriting stan-
dards are prudent and comply with investor
guidelines. If individual underwriters perform
3070.0.3 MARKETING ACTIVITIES
this function, determine whether management
The marketing department is typically respon-
has established approval limits, developed
sible for the development of mortgage products,
exception procedures for loans that are rejected
determination of products to be offered, and the
or suspended, and receives reports that track
establishment of daily mortgage prices. The
loan quality for each underwriter. If a committee
marketing department, which is also referred to
performs the underwriting function, review its
as secondary marketing, is also responsible for
charter, composition, and minutes. If a scoring
the sale of mortgage loans to investors. Given
system is used, review credit scoring methodol-
these roles, the marketing department acts as an
ogy. Can the system be overridden? If so, by
intermediary between the borrower and the
whom?
investor. All of these activities require close
3. Review a representative sample (prefer-
coordination to be effective and are appropri-
ably a statistical sample) of current loans to test
ately placed within one department.
the underwriting policies and procedures and
also determine the validity and adequacy of
documentation supporting loans held for sale or
investment. 3070.0.3.1 Oversight
4. If an unusual increase in unmarketable
loan inventory has been noted, select a small Marketing activities are generally supervised by
sample of loans in current production for addi- a marketing committee, which may consist of
tional review. Does underwriting comply with the chief executive officer, chief operating offi-
established guidelines? If a credit scoring sys- cer, chief financial officer, and the executive
tem is used, focus on loans that are of the lowest officers responsible for marketing, production,
acceptable grade. If deficiencies are noted, con- and servicing/loan administration. The market-
sider expanding the review sample. ing committee is responsible for the formulation
5. Review loans that were rejected and then of marketing policies, departmental operating
approved. Did the proper authority approve such procedures, pricing strategies, and parameters
loans, and was managements rationale ade- governing the use of various mortgage-related
quately documented? products and strategies used to hedge the interest-
rate risk associated with certain mortgage loans.
Closing/Post-Closing
3070.0.3.2 Securitization
1. Evaluate procedures, checklists, and sys-
tems for closing loans. Are all required docu- The marketing departments primary tool in per-
ments obtained from the borrower before funds forming its activities involves securitization out-
are disbursed? If not, evaluate the appropriate- lets. Securitization activities are discussed in
ness of suspense items. SR-90-16, which transmitted the following docu-
2. Determine if a post-closing documentation ments: (1) the Examination Guidelines, (2) An
review process exists to differentiate, track, and Introduction to Asset Securitization, and
obtain both trailing and missing documents. (3) Accounting Issues Relating to Asset Securi-
Assess its effectiveness. tization. There is also a discussion of these
3. Determine if wholesale loans are activities in the Commercial Bank Examination
re-underwritten at delivery. If not, how does Manual, section 4030.1. A review of the securi-
management ensure that loans are re-underwritten tization process can provide a clearer under-
in accordance with secondary marketing pro- standing as to the value the marketplace assigns
gram requirements? to a mortgage bankers production. Mortgage
4. Determine the number of pools that lack securities, however, are usually issued by an
final pool certification. Has this number exceeded entity other than the mortgage banking com-
the maximum allowable limit since the previous pany under inspection (such as government-
review? Why has this problem occurred, and
what steps are being taken to secure the neces- BHC Supervision Manual June 1997
sary documentation? Has a letter of credit been Page 13
sponsored agencies, securities affiliates, or bro- adequate to ensure that processing backlogs are
kerage firms). managed and workloads remain reasonable. Tem-
Many approaches are used for securitization, porary help and/or outsourcing may be used
but the great majority of activity occurs with during peak volume periods.
conduits such as GNMA, FHLMC, and Fannie- Operating procedures governing the selection
Mae. Conduits provide many programs that a of mortgage loans for pooling, packaging, and
mortgage originator can use to deliver a mort- sale should be evaluated to ensure that the ship-
gage or pools of mortgages in return for cash ping and pooling processes are efficient and that
or securities. To investigate current program loan files ultimately contain complete documen-
requirements and available options, the exam- tation. Management reports should identify and
iner should consult the seller guidelines issued track the number of pools that lack final agency
by the agencies. certification and the status of missing (unavail-
The securitization process presents the mar- able) and trailing (delayed) documentation.
keting department with a complex set of options If third-party guaranties are used during the
to consider when deciding how to sell the com- securitization process, procedures should also
panys loan production for maximum profit. If establish methods for evaluating and monitoring
the companys own servicing valuation differs the financial condition of all third-party entities
from pricing offered by the agencies, for instance, that provide credit enhancement. If loans or
the marketing department can use some flexibil- securities are sold with recourse, management
ity in pool formation guidelines to retain or reports should identify and track potential recourse
divest servicing cash flows. Recourse to the obligations. Management should also analyze
originator or servicer can be negotiated to reduce historical recourse losses by investor and prod-
agency guaranty fees. Agencies also alter guar- uct type and determine the appropriate level of
anty fees based on different methods of remit- reserves to cover estimated recourse exposure.
ting principal and interest payments. Sales to the
agencies can be on a best-efforts or mandatory
basis. A best-efforts basis is when loan delivery 3070.0.3.4 Marketing Risks and Risk
is not required if the loan does not close. Better Management
prices are received for the lenders acceptance 3070.0.3.4.1 Techniques
of the more rigid performance requirements of
mandatory commitments. Master commitment The marketing department manages several risks,
contracts can be reviewed by the examiner to which can be categorized as follows:
determine negotiated terms.
Although most securitization activity occurs unsalability
within the programs already mentioned, private pricing
security issues are also used. The private issues fallout
are used primarily for loans that do not meet the counterparty performance
underwriting criteria of the agencies, commonly
due to larger than accepted loan amounts (jumbo
loans). Nonconforming loan production is usu- 3070.0.3.4.2 Unsalability
ally sold to brokers or security affiliates who Under most circumstances, a mortgage banking
have marketed the product to investors, some- company will originate mortgage products that
times using complex real estate mortgage invest- are acceptable to GNMA, FannieMae, FHLMC,
ment conduits (REMICs). or other major investors. This minimizes the
risk that mortgage products originated will
not be marketable to investors and have to be
3070.0.3.3 Pooling Practices retained as a portfolio investment. However, the
marketing department may also initiate certain
As an intermediary between the borrower and products that are intended for the loan portfolio
the investor, marketing personnel coordinate the of the mortgage company or portfolios of bank
flow of loan documents from the shipping or nonbank affiliates. In the case of production
department to the pool custodian and the ulti- for bank affiliates, underwriting and pricing
mate holder. If servicing is retained, the loan arrangements must be structured to ensure com-
will be input into the companys servicing sys- pliance with the restrictions imposed by sec-
tem soon after closing. Staffing levels should be tions 23A and 23B of the Federal Reserve Act.
See the subsections on production activities
BHC Supervision Manual June 1997 (3070.0.2) and intercompany transactions
Page 14 (3070.0.7).
3070.0.3.4.3 Pricing Risk applicants will opt to make new applications at

the lower rates. As interest rates rise, the propor-
The mortgage banking business is volume driven. tion of pipeline loans that will close increases as
Because profit margins are thin and fixed costs more applicants choose to lock in rates. Mis-
associated with loan production can be large matches that occur in the long and short posi-
(especially in the case of a retail origination tions can result in financial losses when the
network), it takes a significant volume of mort- institution needs to settle its trades.
gages to generate profits. Mortgage pricing deci-
sions are critical because the price is a major
determinant in the volume of mortgages 3070.0.3.4.5 Hedging Strategies
originated.
Pricing strategies can be affected by divi- The most common hedging strategy used to
sional profit and loss allocations or external protect the inventory of closed loans and the
industry practices. A neutral price structure sets rate-committed pipeline against adverse interest-
mortgage prices that are equivalent to the expected rate movements involves the use of mandatory
price for which the mortgages will be sold to and optional forward sales of MBS. Under this
investors, plus a normal servicing spread of hedging strategy, the inventory and rate-
25 to 50 basis points depending on the type of committed pipeline (the long position) are gen-
loan. Daily adjustments are usually made to erally covered through short sales (mandatory
prices to reflect market changes for future settle- delivery contracts with settlements correspond-
ment of mortgage-backed securities (MBS). ing to expected delivery volumes). Put and call
Due to regional or local competition, mort- options on MBS are sometimes purchased to
gage banking companies often find it necessary manage heightened fallout risks during periods
to deviate from a purely neutral pricing strategy of volatile interest-rate fluctuations.
to maintain volume in certain markets. How- The typical practice is to hedge 100 percent
ever, large deviations from market price in either of the closed loan inventory that is marketable.
a lower or even upward direction can have In addition, pipeline loans very near to closing
adverse consequences. In addition to causing are generally also hedged at or close to 100 per-
marketing losses, price cutting could place cent. However, a significant degree of uncer-
operational strains on the production and servic- tainty exists as to the amount and timing of
ing areas. Premium pricing can position the 30- and 60-day rate-committed pipeline closings
company as a lender of last resort with adverse due to interest-rate fluctuations, underwriting
credit quality implications. delays, and cancellations. To control exposure
The marketing department attempts to mini- to rate movements, management must estimate
mize price risk by matching origination pricing the percentage of the rate-committed pipeline
with the price it expects to receive from inves- that is expected to close in the current economic
tors. However, estimating the price at which the environment.
mortgages can be sold can be difficult because it Although estimation techniques vary, data are
is determined in large part by external factors generally collected on a number of pipeline
such as interest rates. The longer the elapsed characteristics such as product type, whether the
time between when the mortgage applicant loan is a purchase or refinance, and whether it is
decides to lock in a loan rate and the time the retail- or wholesale-originated. Fallout behavior
loan closes, the greater the risk that the prices can vary depending on these and other factors.
for which the mortgages can be sold will change. Based on this information, management then
Some companies encourage customers to float derives an estimated closing percentage that
their interest rate until closing approaches to becomes managements operating target for cov-
reduce the volume and costs of hedging. erage of the rate-protected pipeline.
Marketing personnel often use simulation mod-
eling to assess fallout percentages, assist in
3070.0.3.4.4 Fallout balance-sheet valuations, and develop appropri-
ate hedging strategies. Such models may be
A third type of risk that the marketing depart- either purchased from outside vendors or devel-
ment manages relates to pipeline fallout. This oped in-house, and they vary greatly in their
is the risk that the proportion of loans in the degree of sophistication. In any event, the pri-
rate-committed pipeline that are expected to mary assumptions and inputs to the model should
close will change with a given change in interest
rates. As market interest rates decline, fewer BHC Supervision Manual June 1996
mortgages in the pipeline will close because Page 15
be reasonable, well documented, and reviewed 3070.0.3.4.7 Counterparty Performance

periodically by both the marketing committee
and by an independent source such as an inter- The marketing committee is also generally
nal or external audit. Results from the market- responsible for managing investor/counterparty
ing simulation model should be provided to performance risk. The marketing committee (or
management through summary reports. Infor- the treasury department of the parent bank hold-
mation may also be provided to bank holding ing company) should approve all brokers and
company personnel for asset/liability manage- dealers to which securities are sold before trad-
ment purposes. ing commences. Dealer limits should be estab-
Other products may also be used to hedge lished to limit the maximum amount of trades
inventory loans and the rate-committed pipe- outstanding with each firm. Frequent position
line, particularly loans with an adjustable rate reports should be prepared to monitor compli-
feature or other specialized characteristics. The ance with established limits. The accounting
marketing committee should review and approve department may be responsible for the ongoing
all specialized hedge products used, the degree monitoring of the financial capacity of the bro-
of correlation between the hedge product and kers and dealers.
the underlying position being hedged, and the
degree of risk that each strategy or position
entails. The accounting department should also 3070.0.3.5 Inspection Objectives
determine whether such products qualify for Marketing Activities
hedge accounting treatment, establish appropri-
ate management reports, and establish account- To review the types of products developed.
ing policies. See subsection 3070.0.6, Mortgage- To determine the pricing strategies offered to
Servicing Rights. borrowers and investors.
To review pipeline fallout estimation
techniques.
To review hedging methods as they relate to
3070.0.3.4.6 Position Reports loan production.
To determine whether information systems
To limit risk, the marketing committee should are adequate for senior management to moni-
place prudent limits on the amount of exposure tor fallout behavior and hedge performance.
that can be incurred through hedging operations.
Limits, which may be contained in the market-
ing policy, might establish a constraint on the 3070.0.3.6 Inspection Procedures
size of uncovered long positions, require that Marketing Activities
coverage be maintained at the marketing com-
mittees current closure estimates, or establish Management Oversight
a constraint based on an earnings-at-risk
measurement. 1. Review the composition of the marketing
Compliance with limits should be monitored committee and minutes from recent committee
through regular position reports, which should meetings to determine the nature and scope of
be provided to senior management (the market- its responsibilities, the frequency of meetings,
ing committee and perhaps the treasury function and the degree to which oversight over market-
of the parent company, if they participate in ing activities is provided.
decisions or policy enforcement) at least weekly. 2. Review the marketing policy as it relates
Position reports should detail the companys to product offerings, pricing strategies, loan
long and short positions in relation to limits, as sales, and hedging operations. Are all relevant
well as unrealized and realized gains and losses marketing risks identified? Note the date the
on loans and securities. Department managers marketing policy was last reviewed and approved
generally require daily position reports in order by the board of directors.
to effectively monitor the position. Marketing 3. Determine how management measures and
position reports may not reconcile directly with controls interest-rate risk associated with closed
reports prepared by the accounting department loans in inventory and rate-locked loan applica-
for financial reporting purposes. Significant dif- tions in the pipeline. How are limits established
ferences should be investigated. and quantified (i.e., earnings at risk, economic
value of equity at risk, percentage of capital,
BHC Supervision Manual June 1996 etc.)? Are such limits reasonable? Evaluate
Page 16 managements oversight of asset securitization
activities in accordance with SR-90-16, as whether all mortgage products originated by the
applicable. mortgage company are intended to be salable in
4. Assess the adequacy of management infor- the secondary market (for example, do they
mation systems and related management reports conform to guidelines issued by GNMA, Fannie-
that are designed to track compliance with Mae, FHLMC, or other major investors?). How
established policy. Determine the extent to which is actual salability monitored?
operational practices adhere to policy. How are 2. Determine if mortgage loans that are not
exceptions handled? salable are generated specifically for the perma-
nent investment portfolio of either the mort-
gage banking company or its bank or nonbank
Securitization and Pooling Practices affiliates.
3. Determine who is responsible for the review
1. Determine the secondary marketing proof temporarily unsalable loans, the frequency of
grams used to sell mortgages to investors and such reviews, the actions taken to correct docu-
the volume of sales under each program. mentation and/or credit deficiencies, and if
2. Discuss the strategies and procedures used internal controls are adequate. This information
for the selection of mortgage loans for pooling, is needed to ensure that hedge volumes are
packaging, and sale. Are there quality control accurate.
procedures in place to ensure that the files of
pooled loans contain complete documentation?
What impact does strategy have on departmen- Pricing Strategies
tal profitability?
3. Evaluate the companys securitization 1. Review the current list of mortgage prod-
practices: uct offerings and the daily price sheet. Are
prices determined centrally and are they uni-
Determine how much risk the company form? Discuss pricing strategies with manage-
retains and in what form. ment to determine whether the company uses a
Determine the source, conditions, and costs neutral, above-market, or below-market pricing
of third-party guaranties. Verify that the strategy.
financial condition of all third-party credit 2. Ascertain what procedures are in place to
enhancers is substantiated. ensure that deviations from the approved pricing
Determine the procedures used to obtain policies receive the proper degree of scrutiny
final pool certifications from investors (coor- and approval by senior management. If such
dinate with the examiner(s) assigned to the discrepancies are common, why is this occur-
production function). Determine the num- ring (competition, compensation schemes, or
ber and volume of securities that lack final departmental profitability considerations)?
certification. Is management doing every- What impact have such deviations had on pro-
thing possible to obtain missing docu- duction volumes and the companys overall
ments? Are problems volume-driven or due profitability?
to a lack of internal controls? 3. Determine what policies are in effect
regarding customer rate-locks. If a rate-lock
4. Determine whether loans or securities are expires, is it automatically renewed or is it rene-
sold with recourse. If so, are management infor- gotiated at current interest rates? Are the num-
mation systems in place to track recourse obli- ber and dollar volume of loans with expired
gations? Are analyses of recourse losses con- rate-locks adequately monitored and tracked?
ducted by investor and product type? Are reserves
held for recourse loans? What is the methodol-
ogy for determining the adequacy of reserves? Fallout
Review actual and potential losses. Are reserve
levels adequate to cover identified exposure? Is
1. Discuss the methodology used to predict
compensation tied to trading profit?
the volume of applications that are expected to
fall out of the mortgage pipeline. Is fallout
methodology well documented?
Unsalability
1. Review the marketing policy to determine Page 17
ALCO/Simulation Modeling ing products, whether such risks are significant,

and the impact on correlation. How is basis risk
1. Determine whether the expected fallout identified, monitored, and controlled?
ratio is based on intuition, historical data, or an 5. Determine whether call options are written
empirical model. Are assumptions reasonable? to enhance inventory yields. If so, verify that
Are volatility assumptions based on historical they are written against covered positions. Deter-
performance or on implied volatility levels in mine whether management is speculating in any
the market? Who is responsible for reviewing way and whether this activity subjects the com-
model assumptions, and are these individuals pany to undue risk.
sufficiently independent from the process itself? 6. Obtain profit/loss reports on hedging
Does management also engage in sensitivity activities. How frequently are they prepared,
analyses to determine the impact interest-rate how are they used, and to whom are they distrib-
fluctuations will have on expected fallout uted? Evaluate the financial results of the hedg-
levels? ing program over the past three years. Is man-
2. Determine to what extent management agement taking on excessive risk to record profits
uses output from these models in business plan- in this area?
ning, financial management, and budgeting. 7. Review management reports relating to
3. Assess the degree to which mortgage bank- pipeline and closed-loan hedging operations.
ing activities are incorporated into the parent Determine whether such reports are complete,
companys asset/liability management reports accurate, and timely. Do such reports adequately
and program. limit excesses, record exception approvals, and
detail risk exposures?
8. Review information provided to executive
Hedging Practices management and the board to determine whether
hedging practices are adequately supervised.
1. Discuss managements philosophy and
strategy to determine the amount of interest-rate
risk they are willing to accept. How successful Counterparty Risk
has the companys marketing strategy been over
the past few years and how is it changing? What
are managements primary sources of market 1. Review the marketing committees list of
information? Are sources sophisticated enough approved brokers and dealers. Have appropriate
given the size of the company and the scope of dealer limits been established and are such lim-
its activities? its adhered to? How are exceptions monitored,
reported, and controlled?
2. Review the marketing policy to determine
products and strategies used to hedge the interest-
rate risk associated with inventory loans and
rate-locked loan applications in the pipeline.
Review actual hedging practices to determine 3070.0.4 SERVICING/LOAN
whether they conform with established policy ADMINISTRATION
limitations and guidelines. What percentage of
closed loans held in inventory and loan applica- Mortgage banking companies that originate and
tions in the pipeline are matched against specific sell residential real estate loans in the secondary
investor commitments? How are coverage lev- market often retain the right to service those
els determined and how have they changed over loans for the investor for a fee. In return, the
time? Is the basis for this coverage ratio ade- servicer collects monthly payments from mort-
quately documented? Determine whether the gagors, collects and maintains escrow accounts,
current coverage ratio exposes the company to pays the mortgagors real estate taxes and insur-
undue risk associated with potential marketing ance premiums, and remits principal and inter-
losses. est payments to the ultimate investors. The ser-
3. Determine the adequacy of managements vicer also maintains records for the mortgagor,
strategies for hedging loans that have special collects late payments on delinquent accounts,
risks (ARMs with interest-rate caps and floors). inspects property, initiates and conducts foreclo-
4. Ascertain if basis risk exists for any hedg- sures, and submits regular reports to investors.
Such functions and responsibilities should be
BHC Supervision Manual June 1997 documented within a formal written servicing
Page 18 agreement.
3070.0.4.1 Revenue Generation Servicing data are available through the Mort-
gage Bankers Associations publication, Mort-
The right to service mortgage loans provides a gage Banking Performance Report. Based on
stable source of earnings and the potential for detailed financial-statement information from a
one-time gains. For this reason, servicing port- sample of companies, the report presents a com-
folio growth has become a primary objective for pilation of performance data on all aspects of
many mortgage banking companies. the mortgage banking industry.
Mortgage-servicing revenues are derived from
six sources. The primary source is the contrac-
tual servicing fee. Because this fee is usually 3070.0.4.3 Growth Strategies
expressed as a fixed percentage of each out-
standing mortgage loans principal balance,
servicing-fee revenues decline over time as the Many companies have established aggressive
loan balance declines. growth targets for their servicing portfolios. The
The second source of servicing income arises size of the portfolio may be increased through
from the interest that can be earned by the originations, purchases of loans (individual or
servicer from the escrow balance that the bor- bulk), or purchased servicing rights. Portfolio
rower often maintains with the servicer for the size is reduced through normal runoff, prepay-
payment of taxes and insurance on the under- ments, and sales of either loans or servicing
lying property. This income may vary, however, rights only. Managements growth strategy should
as some states require that interest payments on be examined in light of its expertise and systems
escrow balances be paid to the borrower. capabilities.
The third source of revenue is the float earned
on the monthly loan payment. This opportunity
for float arises because of the delay permitted 3070.0.4.4 Servicing Agreements
between the time the servicer receives the pay-
ment and the time that the payment must be
The servicer generally operates under a written
remitted to the investor.
contract with each investor. This contract, also
The fourth source of revenue consists of
known as a servicing agreement, establishes
income late fees charged to the borrower if the
minimum conditions for the servicer such as its
monthly payment is not made on time. A fifth
fiduciary responsibilities, audit requirements,
source is income in the form of commissions
and fees. Contracts may be standardized or tai-
that many servicers receive from cross-selling
lored to the individual investor.
credit life and other insurance products to the
borrowers. The sixth and last source is when the Under most servicing agreements, the ser-
servicer might generate fee income by selling vicer warrants that full principal has been
mailing lists to third parties. advanced, the mortgage is in fact a first mort-
gage on the property, and that the first mortgage
position will be maintained by the servicer.
Additional warranties that are either unwritten
3070.0.4.2 Cost Containment or implied may create significant exposure for
the servicer.
Long-term profitability is achieved through cost A servicer may also enter into an agreement
containment, technological improvements, and with another company to subservice certain
economies of scale, which reduce the per-unit loans or portfolios of loans. The companys
cost of servicing. Servicing costs vary widely method of evaluating and monitoring the finan-
across institutions depending on portfolio char- cial condition of its subservicers should also be
acteristics such as product type, loan size and reviewed. Servicing and subservicing agree-
age, delinquency status, and foreclosure statis- ments should be evaluated in terms of the sub-
tics. Nevertheless, two efficiency measures fre- servicers responsibilities, reporting require-
quently used within the industry to measure cost ments, performance, and fees. They should also
containment are unit-servicing costs and the be reviewed to determine that no additional
number of loans serviced per employee. The liabilities, real or contingent, are imposed upon
minimum size of a loan-servicing portfolio needed the company beyond its responsibilities as a
to achieve economies of scale varies across servicing agent.
institutions and depends on portfolio character-
istics and the servicers expertise and techno- BHC Supervision Manual June 1997
logical capabilities. Page 19
3070.0.4.5 Recourse Obligations this reason, the accuracy of reported recourse

obligations should be verified.
A servicing agreement may contain specific
recourse obligations that go beyond the servic-
ers customary fiduciary obligations. A mort- 3070.0.4.6 Guaranty Fees
gage banking company can choose to service
loans for investors either with or without recourse The amount of guaranty fee the mortgage bank-
back to the mortgage banking company. Servic- ing company pays the government-sponsored
ing agreements should be reviewed to determine agencies (or private issuer) is negotiated. Guar-
the extent of any recourse obligations. The risk anty fees vary based on the amount of recourse
of recourse should also be discussed with man- assumed by the mortgage banking company (the
agement to assess whether the risk is being servicer) and the timing of the cash flows. A
identified and effectively managed. smaller guaranty fee is negotiated when the
The degree of recourse varies by investor. guarantor assumes less risk or receives pay-
FannieMae offers either regular or special ments sooner in the remittance cycle. Remit-
servicing options. With FannieMaes regular tance cycles vary by investor.
option, the servicer retains all risk of loss from The examiner should discuss with servicing
mortgage default. With FannieMaes special ser- personnel the amount of risk that has been taken
vicing option, the mortgage banking company on by the marketing department in exchange for
only retains exposure for normal representations reduced guaranty fees. Excessive risk accepted
and warranties. FHLMC offers similar servicing by the mortgage banking company should be
options. FannieMae and FHLMC generally limit incorporated into the assessment of management.
eligibility for the regular servicing option to
participants with the knowledge and financial
wherewithal to make good on their recourse 3070.0.4.7 Internal Controls
obligations.
GNMA servicing carries no contractual The servicing process begins after the post-
recourse. However, in the event of mortgage closing review has been completed and the loan
default, the servicer may have exposure to has been set up on the mortgage banking com-
principal loss and other nonreimbursable panys servicing computer system. Servicers are
expenses, particularly with respect to VA- responsible for adequately safekeeping loan
guaranteed loans. If a borrower defaults on a documents. Documents must be stored in a
VA-guaranteed loan, the VA can exercise a no- secured and protected area such as a fireproof
bid put option, which allows the VA to pay out vault. Servicers must also maintain a tracking
its guaranty and leave the property with the system for following up on missing documents.
servicer for disposition. The control environment that sets the tone of
When a borrower defaults on a VA- a servicing departments operation should be
guaranteed loan, the VA makes a calculation assessed. A servicing departments management
that will guide its decision to accept or reject faces a variety of risks that it should identify
conveyance of the property. The VAs decision and control. In addition to identifying and con-
to exercise its no-bid option is based on the net trolling risks, management also needs to insti-
value of loan collateral and the VAs guaranteed
tute adequate and effective internal controls to
percentage of the indebtedness. The mortgage
match a servicing portfolios growth and the
servicer, at its option, could pay down the out-
departments technological changes. When
standing principal balance on the loan to a point
assessing the control environment, the examiner
where the VA would not be expected to exercise
its no-bid option. Such buydowns result in needs to consider the extent to which manage-
additional foreclosure losses for the servicer. ment uses internal and external audits, quality
The risk-based capital guidelines require a control reports, and investor audits to ensure
charge to capital when any risk of loss is retained that its policies and procedures are followed.
on such recourse obligations. The charge would The servicers performance should be evalu-
be at the bank holding company, the bank, or ated, with any loss of servicing due to operating
both,3 depending on ownership of the risk. For inefficiencies or excessive risk-taking discussed
and noted. A discussion of the risks within each
3. If at the bank, then it is also consolidated at the bank
operational area, as well as the management
holding company level. reports and internal controls, follows.
BHC Supervision Manual June 1997 Loan accounting. Incoming payments may be
Page 20 processed in-house, through a lockbox, or
through some combination of both. Payments advance to investors funds that have not yet
are deposited into a clearing account and then been received from the mortgagor (for exam-
transferred to the respective investor custodial ple, cash advances to ensure timely payment
bank accounts the next day. Investor remit- of principal and interest). In such cases, a
tances may be required daily, weekly, monthly, receivable is created on the balance sheet.
or as funds are received. In certain cases, Receivables relating to investor remittances
servicing agreements may specify that pay- should be aged in the same manner as escrow
ments be sent directly to security holders. receivables and periodically reviewed by a
Numerous accounts through which incoming supervisor. Stale or otherwise deemed uncol-
and outgoing payments pass should be recon- lectible receivables should be periodically
ciled daily to avoid costly processing errors. charged off in a timely manner.
The reconcilement process should be reviewed Investor reports should include detailed
with management to ensure that reconcile- account reconciliations and information on
ments are performed on a timely basis and the mortgagors name, principal balance out-
without chronic discrepancies. standing, escrow balance, delinquency status
Escrow administration. In addition to receiv- of the account, and any foreclosure activity or
ing and remitting payments, servicers are also transfer to the servicers other real estate
responsible for paying taxes and insurance on owned account. The quality and accuracy of
the underlying property. Accurate information investor reporting should be periodically
must be maintained for each loan regarding a reviewed by internal or external auditors.
legal description of the property; the appropri- Collections, foreclosures, and other real estate
ate taxing authority, due dates, and amounts (ORE). Investor requirements also vary con-
for taxes owed; and the insurance provider cerning contact with delinquent borrowers,
and due dates and amounts for insurance forbearance policies, and reimbursement for
owed. Failure to maintain such information foreclosure expenses, ORE write-downs, and
may result in missed tax and insurance pay- related losses. Detailed policies concerning
ments on the property, which may lead to collection efforts and foreclosures should be
penalties and/or lapsed insurance coverage. in place and followed. The property should be
The servicers record of tax penalties paid inspected regularly to ensure that its condition
over the past several years should be reviewed is adequately monitored. Delinquency and
to determine whether a problem exists in this foreclosure statistics should be tracked by
area. product type and originator.
Escrow account balances should be ade- Foreclosures are generally initiated after
quate to meet expected tax and insurance three full installments are due and unpaid.
obligations. If the servicer advances its own The servicer notifies the mortgagor of its
funds to cover an escrow overdraft, such pay- intent in writing and refers the case to an
ments may be capitalized and recorded as a attorney. Detailed records should be main-
receivable only if the servicer is to be reim- tained for all expenses that are incurred. If the
bursed by either the mortgagor or the inves- loan is insured, claims may ultimately be filed
tor. Escrow receivables should be aged, with against the FHA, VA, or private mortgage
stale or otherwise uncollectible receivables insurance (PMI) company. However, it should
charged off. be noted that certain interest expenses and
Escrow accounts should be analyzed at collection or foreclosure costs are not reim-
least annually, with a copy of the analysis bursable.4 These expenses are a cost of doing
sent to the mortgagor. Shortages (overdrafts) business that must be factored into the ser-
may be billed or spread out over 12 months. vicing fee charged for providing these
Overages should be returned to the borrower services.
or handled in a manner consistent with fed- The timeframe for taking title on fore-
eral and state laws and regulations. For loans closed property varies widely and is deter-
that were set up without an escrow account, mined by state law. Once title is taken, the
the examiner should verify that adequate property should be classified as ORE. Although
information has been obtained from the mort-
gagor to ensure that taxes and insurance are
current. 4. For a detailed list of both reimbursable and nonreim-
Investor reporting. Investor remittance and bursable expenses, see the agency seller/servicer guides.
reporting requirements vary greatly. Remit-
tances are contractually arranged. In some BHC Supervision Manual June 1997
instances, the servicer may be required to Page 21
all ORE is generally managed through a cen- and size necessary to accommodate both the
tralized unit, for accounting purposes, ORE current and the projected volume of transac-
may fall into one of two distinct categories: tions. Examiners should obtain information on
ORE that is owned by the mortgage banking the servicing system in use and any limitations
company, and ORE that is serviced on behalf it might pose in terms of future growth plans.
of the investor. ORE that is owned should Procedures for maintaining physical security
reconcile to the balance sheet, whereas ORE in the workplace, data security, and file backup
that is serviced for others is an off-balance- also should be discussed with management. A
sheet item. ORE appraisal, valuation, and contingency plan should describe the use of
financing policies should be consistent with alternative backup sites, as well as procedures
regulatory policy. In-substance foreclosures that would be followed to reconstruct altered or
and any troubled debt restructurings should destroyed files. Contingency plans should be
be properly identified and accounted for. reviewed and approved at least annually and
Payoffs. Loans are considered paid off when tested regularly.
the loan matures, the loan is refinanced, or the
property is sold. Prior to payoff, the servicer is
responsible for sending payoff instructions to 3070.0.4.9 Inspection Objectives
the mortgagor. After a loan has been paid off, Servicing/Loan Administration
the servicer makes a satisfaction remittance to
the investor or the pool; obtains documenta- 1. To assess the adequacy of management
tion; cancels the note; and forwards the satis- oversight of risk through policies and proce-
fied mortgage documentation plus an escrow dures, management information systems and
refund check, if applicable, to the mortgagor. reports, and other internal and external audits,
A high level of refinance activity may strain with respect to the following:
payoff personnels ability to perform this obli-
gation accurately and promptly. Management collecting monthly payments from
reports should monitor the level of payoff mortgagors
activity and alert supervisors to operational reporting loan activity and remitting funds
backlogs, the need to hire temporary person- to investors
nel, or the need to outsource work to third monitoring escrow account balances
parties. disbursing property insurance and real estate
Customer service. Poor service may damage tax payments
the mortgage banking companys business monitoring delinquencies, initiating collec-
reputation (reputation risk) and ability to tion activities, and initiating foreclosure
originate, sell, and service loans within the proceedings in a timely manner
community. Because of name recognition,
problems in this area may also adversely 2. To evaluate the level of risk assumed by
affect affiliate banks or the bank holding com- the mortgage banking company through servic-
pany and its nonbank companies. ing recourse arrangements.
For this reason, servicers should maintain
an adequate system for logging, tracking, and
responding to customer inquiries and com- 3070.0.4.10 Inspection Procedures
plaints. Management reports should track the Servicing/Loan Administration
volume and disposition of such inquiries and
complaints. Inordinate volumes of complaints Management Assessment
may be an indication of operational backlogs,
inefficiencies, or mishandling of accounts. If 1. Obtain an organization chart for the servic-
this occurs, corrective measures should be ing department and resumes for senior manage-
initiated immediately. ment and key staff members. Evaluate manage-
ments qualifications and expertise.
2. Review servicing policies and procedures
3070.0.4.8 Data Security/Contingency manuals to determine whether reasonable
Planning operating standards have been established for
each functional area. Also assess whether man-
The servicing system should be of a complexity agement reports adequately monitor compli-
ance with established policies and procedures.
BHC Supervision Manual June 1997 Determine how exceptions are identified and
Page 22 addressed.
3. Review internal and external audits, qual- interest rates (particularly those above
ity control reports, and investor audits to deter- market)
mine whether internal controls are functioning remaining contractual life
effectively. projected life
4. Evaluate safeguards in place for loan docu- geographic distribution of mortgagors
ments and determine if an adequate document delinquency statistics
tracking system exists. foreclosure statistics
5. Verify that a disaster recovery plan is in number of subserviced loans and servicers
place that covers all in-house servicing func-
tions. Verify that backup systems exist should
primary systems fail. Determine if backup sys-
Loan Accounting
tems would provide information to substantiate
servicing portfolio asset values.
1. Review with management the procedures
6. Obtain a list of subservicers and vendors, for receiving payments from mortgagors and
if any, employed to perform servicing functions. depositing funds into segregated accounts. Deter-
mine that the segregation of duties and other
Determine if a periodic review of services controls over custodian accounts are adequate.
provided by each subservicer is conducted. 2. Review any outstanding advances to
In addition, the financial condition of each investors. Evaluate the collectibility of advances,
subservicer should be evaluated at least the timeliness of charge-offs, and the adequacy
annually. of reserves.
Determine whether a contingent operating 3. Determine whether outstanding items
plan has been established should subservic- related to investor account reconciliations are
ers and vendors be unable to perform their being resolved in a timely manner. Are recon-
contractual obligations. ciliations routinely reviewed and approved by a
supervisor?
Profitability Analysis
Escrow Administration
1. Review business line profitability for the
servicing department to identify significant trends 1. Review with management the system in
and/or areas of potential weakness. Discuss and place for ensuring the timely payment of taxes,
review key efficiency measures such as unit cost insurance, and other obligations.
and cost per employee.
2. Review the servicers method for analyz-
2. Analyze servicing income and expenses to
ing the amount and adequacy of escrow account
determine whether operations are profitable and
balances, and evaluate its effectiveness. Assess
economies of scale are being achieved in line
procedures relating to shortages and overages in
with industry norms:
escrow accounts:
Determine whether all direct and indirect
Determine whether procedures comply with
costs are included.
12 U.S.C. 2609 (RESPA) and to the extent
Compare servicing revenues with costs. possible with state laws.
Assess the impact of any bulk servicing Determine whether the borrower is sent an
purchases or sales on departmental analysis statement showing the amount of
profitability. discrepancy, how it occurred, and an expla-
Analyze efficiency in light of manage- nation of how it is to be corrected.
ments growth projections.
3. Determine the volume of loans with no
3. Review servicing portfolio trends and char- escrow requirement and procedures for ensuring
acteristics, including the following: that insurance payments and taxes are current.
4. Determine how escrow funds are invested,
investors (GNMA, FannieMae, FHLMC, assess the appropriateness of the investment
private) vehicles, and review managements analysis of
recourse provisions yield on escrow funds.
loan types (30-year fixed, 15-year fixed,
ARM, balloon) BHC Supervision Manual June 1997
average loan size Page 23
5. Evaluate whether controls are in place to Verify that contacts with borrowers are
prevent the use of escrow custodial accounts to documented.
meet other obligations. Determine whether property inspections are
6. Review outstanding escrow advances, and conducted in accordance with policy.
determine if claims for reimbursement are pro- Verify that foreclosure practices comply
cessed in a timely manner. Evaluate the collect- with FHA/VA/PMI requirements and
ibility of outstanding advances and verify that guidelines.
uncollectible advances are charged off in a
timely manner. 4. Determine the average foreclosure costs
for each product type. Foreclosure costs include
Investor Reporting inspections, legal and administrative costs in
excess of those defined as normal and custom-
1. Review the list of investors for which ser- ary, VA no-bid, and VA write-downs.
vicing is performed. 5. Obtain a list of loans in foreclosure in
2. Review servicing contracts to verify that which action has been delayed, and determine if
signed, current contracts exist. Discuss with the justifications for delay are reasonable.
management the nature of any recourse provi- 6. Determine the number and dollar volume
sions, forbearance requirements, and nonreim- of delinquent loans that were purchased from
bursable collection and/or foreclosure expenses. the servicing portfolio (buyouts or buybacks).
3. Review the most recent investor audit
reports on the servicing function. Discuss findings
Assess the impact of repurchases on profit-
with management and evaluate the adequacy of
ability, the appropriateness of this practice,
any actions taken to correct deficiencies.
and the accounting procedures for these
4. Determine whether any servicing contracts
loans.
have been terminated for cause or are likely to
be lost in the near future. Determine the reason
for any termination and the extent of any correc- 7. Discuss with management the effect that
tive actions taken. negotiated guaranty fees may have on the level
of losses associated with foreclosures.
Collections and Foreclosures

Payoffs
1. Review and assess, on a statistical-sample
basis, the accuracy and adequacy of loan delin- 1. Review procedures for payoffs to deter-
quency reports by product type and originator. mine whether
Ascertain the reasons for poor or declining asset
quality within the servicing portfolio. payoff instructions are sent to the mort-
2. Review policies and procedures for col- gagor before payoff;
lecting late payments. satisfaction remittances are made to the
investor or to the pool, necessary documen-
Determine when collection efforts start once tation is obtained, notes are canceled prop-
an account becomes delinquent. erly, and documentation plus any escrow
Verify that all attempts at collecting past- refund checks are sent to the mortgagor in a
due payments are documented, including timely manner; and
each date of communication with borrow-
internal controls are in place to ensure that
ers, the nature of the communications, and
funds are not misappropriated and employee
the customers replies.
fraud is detected and reported according to
policy.
3. Select a sample of files for borrowers who
are 120 days or more delinquent and determine
whether foreclosure proceedings are instituted Other Real Estate
in a timely manner.
1. Determine the number and dollar volume
Determine if borrowers and investors are of ORE by geographic location.
appropriately notified of the initiation of
foreclosure action. Compare the volume of ORE with histori-
BHC Supervision Manual June 1997 cal levels and the industry average for
Page 24 similar-sized servicers.
Evaluate the impact of ORE on profitability. cial risk. The examiner should also investigate
Review the policies and practices for ORE any trends that appear inconsistent with the
accounting, property supervision, and mortgage banking companys industry peer group,
marketing. Verify that policies are consis- business orientation (such as wholesale versus
tent with investor guidelines and regulatory retail, originations versus servicing, etc.), and
policies. future growth plans or with the current eco-
nomic and interest-rate environment.
2. Determine whether ORE parcels are pur- Financial-statement presentation may vary
chased from the servicing unit by the bank across mortgage banking companies. If ques-
holding company or its affiliates. tions arise, financial-statement presentation and
accounting should be reviewed with the compa-
Evaluate the controls in place to limit or nys internal and/or external accountants for
prevent this practice and the accounting propriety. During the review of the financial
treatment for such loans. statements, the examiner should establish whether
Verify that information regarding ORE is regulatory reports are prepared accurately. Banks
properly reported to the parent bank or must conform to the reporting requirements of
holding company for consolidation into the Commercial Bank Reports of Condition and
regulatory reports. Income (call report). Bank holding companies
and their direct subsidiaries must conform to
generally accepted accounting principles
(GAAP). Relevant GAAP statements of the
Customer Service
Financial Accounting Standards Board include
SFAS No. 65, Accounting for Certain Mort-
1. Review the system for logging, tracking,
gage Banking Activities, as amended; SFAS
and responding to customer complaints. Has the
No. 91, Accounting for Nonrefundable Fees
volume of complaints grown? Are complaints
and Costs Associated with Originating or Ac-
addressed promptly with any problems resolved
quiring Loans and Initial Direct Costs of Leases;
in a timely manner?
SFAS No. 115, Accounting for Certain Invest-
2. Review the servicers customer-complaint
ments in Debt and Equity Securities; SFAS
file to gain more insight into the nature of the
No. 125, Accounting for Transfers and Servic-
complaints. Do complaints suggest that internal
ing of Financial Assets and Extinguishments of
policies and procedures are not being followed
Liabilities; and SFAS No. 80, Accounting for
or that staffing levels are inadequate?
Futures Contracts. Other relevant accounting
pronouncements are identified in appendix B,
Accounting Literature.
The financial analysis should also include an
3070.0.5 FINANCIAL ANALYSIS assessment of asset quality, earnings, liquidity
and funding, and capital. Any problems or con-
This section provides the examiner a framework ditions that expose the mortgage banking com-
with which to analyze the financial condition of pany, affiliate banks and nonbanks, and/or the
a mortgage banking company. The analysis be- parent bank holding company to undue financial
gins with a review of the mortgage companys risk should be brought to managements atten-
balance sheet and income statement. The finan- tion and discussed in the Examiners Com-
cial analysis should incorporate a review of ments and Matters Requiring Special Board
primary balance-sheet and income-statement Attention.
levels and trends, off-balance-sheet assets and
liabilities, asset quality, market share and earn-
ings performance, funding sources, liquidity 3070.0.5.1 Balance Sheet
needs, and capital adequacy. Any problems or
conditions that expose the mortgage banking 3070.0.5.1.1 Assets
company, affiliate banks and nonbanks, and/or
its parent bank holding company to undue finan- The asset side of the balance sheet may consist
cial risk should be brought to managements of cash, reverse repurchase agreements, market-
attention and documented in page one, Examin- able securities, receivables and advances, mort-
ers Comments and Matters Requiring Special gage loans held for sale, mortgage loans held for
Board Attention. The examiner should focus on
items that are either large relative to the compa- BHC Supervision Manual December 1998
nys operations or that may pose undue finan- Page 25
investment, mortgage-servicing assets (MSAs) banking company must demonstrate the positive
(including mortgage-servicing rights), reserves intent and ability to hold it until maturity.
for loan and other credit-related losses (contra
accounts), other real estate owned (OREO), and
other assets.
3070.0.5.1.1.2 High-Risk Securities
The examiner should also review any high-risk

3070.0.5.1.1.1 Mortgage-Related Securities mortgage securities that are on the balance sheet,
such as collateralized mortgage obligations
The examiner should determine whether the (CMOs), real estate mortgage investment con-
accounting treatment for mortgage-related secu- duits (REMICs), CMO and REMIC residuals,
rities reported on the balance sheet is consistent and stripped mortgage-backed securities (stripped
with SFAS 115. SFAS 115 applies to equity MBSs). See sections 2126.1 and 2190.0.5.
securities having readily determinable fair val-
ues and to all debt securities. It does not apply
to loans purchased.
Under SFAS 115, at acquisition and at each 3070.0.5.1.1.3 Mortgage Loans Held for Sale
subsequent reporting date, all debt and equity
securities that fall under the scope of the state- The examiner should determine whether the
ment should be classified into one of the follow- accounting treatment for mortgage loans held
ing categories: for sale is consistent with SFAS 65, as amended.
Mortgage loans held for sale shall be reported at
trading securities the lower of cost or market value, determined as
available-for-sale securities of the balance-sheet date.5 The amount by which
held-to-maturity securities the cost exceeds market value shall be accounted
for as a valuation allowance. Changes in the
valuation allowance shall be included in net
Both debt and equity securities can be assigned
income of the period in which the change
to the above first two categories. The third clas-
occurs.
sification can only consist of debt securities.
Trading. Mortgage-backed securities that are
held for sale in conjunction with mortgage bank-
ing activities should be classified as trading
3070.0.5.1.1.4 Mortgage Loans Held for
securities and reported at fair value. Debt securi-
Investment
ties not held to maturity and equity securities
that have readily determinable fair values should
be classified as trading securities when (1) they Mortgage loans held for investment may include
are held for short periods of time and (2) they loans that (1) do not meet secondary-market
have been acquired with the expectation of a guidelines and are therefore unsalable, (2) loans
profit from short-term price differences. Securi- that were repurchased from an investor due to
ties that are actively traded should be carried at poor documentation and/or improper servicing,
fair value on the balance sheet, with net unreal- (3) loans put back to the mortgage banking
ized gains or losses included in income. company under recourse agreements, and
Available-for-sale. Debt and equity securities (4) loans intentionally originated for portfolio.
having readily determinable fair values that are SFAS 65 states that a mortgage loan trans-
not otherwise classified, as above, should be ferred to a long-term investment classification
categorized as available-for-sale and carried at shall be transferred at the lower of cost or
fair value on the balance sheet. Unrealized hold- market value as of the transfer date. The securi-
ing gains and losses should be reported in a tization of a mortgage loan held for sale shall be
separate component of shareholders equity and accounted for as the sale of the mortgage loan
should not be included in income.
Held-to-maturity. For a security to qualify as
held-to-maturity under SFAS 115, the mortgage 5. According to SFAS 65, as amended, the capitalized
costs of acquiring rights to service mortgage loans, associated
with the purchase or origination of mortgage loans, shall be
BHC Supervision Manual December 1998 excluded from the cost of mortgage loans for the purpose of
Page 26 determining the lower of cost or market value.
and the purchase of an MBS classified as a the second dealer. This may also require a
trading security at fair value. Any difference rehousing to provide funds to honor the repur-
between the carrying amount of the loan and its chase commitment. Most warehouse lenders
principal balance shall be recognized as an allow traditional warehouse lines to be collater-
adjustment to yield by the interest method. alized by individual mortgages and mortgage-
A mortgage loan shall not be classified as a backed securities.
long-term investment unless the mortgage bank- A mortgage banking company may use repur-
ing company has both the intent and the ability chase agreements in conjunction with sales of
to hold the loan for the foreseeable future or loan pools. The company may use repurchase
until maturity. If the ultimate recovery of the agreements to pledge mortgage loans and/or
carrying amount of the loan is doubtful and the MBSs as collateral for borrowings. In return, it
impairment is considered to be other than tem- receives advanced funds against future deliver-
porary, the carrying amount of the loan shall be ies. The lenders are repaid through the sales of
reduced to its expected collectible amount, which MBSs. The amount outstandings bear interest
becomes the new cost basis. The difference is for the number of days the funds are outstanding.
recognized as a loss. A recovery of the new cost Under repurchase agreements, the same loans
basis shall only be reported as a gain upon sale, or MBSs are generally reacquired when they are
maturity, or disposition of the loan. sold to permanent investors. Mortgages or MBSs
may also be transferred temporarily without a
repurchase agreement. However, some type of
3070.0.5.1.2 Liabilities informal agreement generally exists. Mortgage
loans and MBSs held for sale that are trans-
The liability side of the balance sheet may ferred under either formal or informal repur-
include repurchase agreements, commercial chase agreements shall be accounted for as col-
paper, revolving warehouse lines of credit, long- lateralized financing arrangements and reported
term debt instruments, intercompany payables, as either mortgage loans held for sale or MBSs
and equity capital. classified as trading securities on the mortgage
banking companys balance sheet.
3070.0.5.1.2.1 Repurchase Agreements

3070.0.5.1.2.2 Commercial Paper
A mortgage banking company may finance its
mortgage loans or MBSs held for sale by trans- Another source of short-term funding is the
ferring mortgage loans or MBSs temporarily to issuance of commercial paper. In general, com-
banks, nonbanks, or other financial institutions mercial paper represents unsecured notes with
under formal repurchase agreements that indi- maturities up to 270 days from the date of sale.
cate that control over the future economic bene- Because of its short maturity, proceeds should
fits relating to those assets and the risk of mar- be limited to current transactions with short-
ket loss are retained by the mortgage banking term maturities. Commercial paper proceeds
company. should not be used to fund loans held for sale
Repurchase agreements can provide a cost- for a period greater than one year.
effective method of holding mortgage-backed Commercial paper can be less reliable than
securities before their sale to investors. Securi- warehouse lines of credit. If commercial paper
ties dealers repo the securities for a period of 30 funding is used, examiners should review
to 180 days at a substantial cost advantage to related commercial paper backup lines of credit
warehouse facilities. Repurchase agreements and ratings issued by credit rating agencies. The
involve delivery of the security to the dealer reason for any rating changes during the prior
with an agreement to repurchase it on a speci- year should be investigated. Additional guid-
fied date. Upon receipt, the dealer wires the ance on this topic is set forth in sections 2080.05,
haircut proceeds to the mortgage company. The 2080.1, and 5010.23.
mortgage company then reduces the amount of
its outstanding warehoused loans. If the repo is 3070.0.5.1.2.3 Revolving Warehouse Lines of
being handled by the dealer that is arranging the Credit
ultimate sale of the security, the amount of that
discount should approximate the discount on the Short-term revolving warehouse credit lines are
sale. If another dealer is involved in the ultimate
sale, the haircut may be greater because the BHC Supervision Manual June 1997
security must be repurchased and redelivered to Page 27
often used to fund loans held for sale, which is adequate lines of credit, as needed. Examiners
generally the largest asset on the companys should ascertain whether funding must be regu-
balance sheet. Revolving credit lines may be larly derived from more than one warehouse
obtained from an affiliate bank, the parent bank lender (including whether the warehouse line
holding company, or an unrelated third party. has to be participated out to other lenders) and
The extension of credit for a particular loan is whether the lender has proper internal controls
paid off when the mortgage lender sells the to safeguard collateral documents for pool certi-
mortgage loan to a government-sponsored agency fication. The examiner should also determine
such as GNMA, FannieMae, or FHLMC or to a what managements contingency plans are for
private investor. Lenders who provide ware- the use of alternative financing sources beyond
house lines of credit typically enter into a standard warehouse lines of credit for backup
warehouse credit agreement with the borrower. financing and lower-cost efficiency purposes.
Under the agreement, the warehouse lender agrees Has management (1) explored variations in
to extend credit to the mortgage banking com- existing lines of credit to reduce overall bor-
pany for the purpose of originating loans. The rowing costs and (2) determined what competi-
mortgage banking company agrees to repay tor lenders are paying for similar financing
each extension of credit within the terms of the facilities?
agreement. Each extension of credit is secured Procedures should be in place to monitor
by placing a lien on the originated mortgage compliance with all short-term debt covenants.
loan. The warehouse lender perfects its security Covenants may limit servicing of loans with
interest by taking possession of the original recourse, limit total debt to specified levels,
promissory note executed by the borrower, and/or require minimum tangible net worth,
endorsed in blank, together with an assign- leverage, and current ratios. Most credit agree-
ment of the mortgage securing the loan. To ments also limit the borrowers financial flex-
further protect its security interest, the ware- ibility if the companys long-term debt ratings
house lender usually takes the responsibility of decline or the company becomes unrated or if
delivering the loan package to the secondary certain events occur related to securities.
market investor for purchase. The investor, in
turn, delivers the purchase price of the mortgage
directly to the warehouse borrower (mortgage 3070.0.5.1.2.4 Long-Term Debt
banking company). Each portion of the ware-
house line may be priced separately to reflect Longer-term assets are more appropriately funded
various levels of risk and the documentation through the issuance of longer-term liabilities or
requirements of each. capital. Toward this end, mortgage banking com-
The details of all credit lines should be speci- panies may issue medium- or long-term public
fied in formal, written credit agreements. Re- debt securities (including warrants to purchase
volving credit lines may be either unsecured or debt securities). Debt may be issued in the form
secured by a lien on the underlying mortgages. of fixed-rate or floating-rate notes with various
Under most secured lines, a formula is used to repayment or redemption terms. Loan agree-
calculate the borrowing base, which generally ments should specify all relevant terms and con-
consists of cash, cash equivalents, loans held for ditions and may contain debt covenants simi-
sale, securities, and a percentage of the mortgage- lar to those found in the warehouse funding
servicing portfolio less certain short-term arrangements.
indebtedness. Some credit lines require the main- Long-term debt may incorporate restrictive
tenance of compensating balances. covenants which limit the companys activities
Internal credit arrangements (conducted either in certain respects. These covenants may set
by a mortgage banking subsidiary of a bank or limits on the amount of senior debt outstanding
bank holding company) must comply with sec- and the minimum amount of liquid net worth (as
tions 23A and 23B of the Federal Reserve Act. defined by the documents), and may limit the
See sections 2020.1 and 3070.0.7 of this manual. proportions of specific categories of assets. Such
Examiners should evaluate the adequacy and covenants should be reviewed to make certain
efficiency of warehouse funding operations. The that they are not too restrictive and that they
examiner should determine whether the ware- permit financial flexibility.
house lender is of a sufficient size and whether
it is well positioned financially to provide
3070.0.5.1.3 Equity Capital
Page 28 Funding is also provided through equity capital,
which may be supplemented by capital contribu- the balance sheet should contract, reflecting the
tions from the parent company or the direct lower demand for new loans. Managements
issuance of equity securities. planning efforts should incorporate this type of
economic trend analysis in their growth tar-
gets. Steady annual growth may or may not be
3070.0.5.2 Income Statement anticipated.
Efficiency measures, such as activity ratios
Mortgage banking revenues generally consist of (inventory turnover and efficiency ratios), should
the following: loan servicing/administration be used to determine managements ability to
revenue; loan-origination-fee revenue; interest originate and sell loans efficiently. The inven-
income; gains (losses) on the sale of mortgage tory of loans held for sale is transitory, lasting
loans, mortgage securities, or mortgage- between 45 to 60 days. A buildup of loans on
servicing rights; and management and other fee the balance sheet may indicate processing de-
income. The examiner may find that gross gain lays and/or asset-quality problems that may pre-
(loss) on the sale of mortgage loans or securities vent their ultimate sale to permanent investors.
is reported on the income statement net of loan- Because of the transitory nature of the balance
origination fees and direct loan-origination costs sheet, traditional leverage ratios (asset-to-equity
such as personnel and office expenses. capital) may not be meaningful and should be
Expenses may include interest expense; sala- used sparingly.
ries, commissions, and other personnel costs; Another unique characteristic of a mortgage
interest losses on MBS pools; amortization of banking company is the economic value of its
mortgage-servicing assets and any other pur- mortgage-servicing operations, which consti-
chased intangible assets; electronic data process- tutes an off-balance-sheet item. Failure to incor-
ing and other selling, general, and administrative porate this economic value into the financial
costs; occupancy and equipment; depreciation; analysis may overstate the degree of financial
provision for foreclosure and other loan losses; leverage that is employed within the company.
and a provision for income taxes. Some compa-
nies net amortization of MSAs directly against
loan-servicing revenues.
3070.0.5.4 Asset Quality
3070.0.5.3 Unique Characteristics The quality of assets that are on the balance
sheet is evidenced by the following: compliance
The financial analysis should reflect certain with original underwriting standards; the exist-
operational characteristics that are unique to the ence of effective loan review and quality control
mortgage banking industry. Many of these char- programs; borrower payment and agreement
acteristics are cyclical based on interest rates performance; the fair value of MBSs held for
and economic conditions. sale or investment; the collectibility, indepen-
For example, the cost of funding loans in the dent valuation, nature, volume, and existence of
warehouse is relatively inexpensive during recorded assets; the application of GAAP in
periods of low interest rates, but may increase accounting for the assets; and the degree of
significantly as interest rates rise. Marketing protection afforded by real estate mortgage col-
operations are also highly dependent on the lateral, including any private mortgage insur-
interest-rate cycle. During periods of falling ance. The value afforded by real estate mortgage
interest rates, the company may experience sub- collateral includes the extent of compliance
stantial gains on the sale of mortgage loans and with the Federal Reserve Boards real estate
securities to permanent investors. Alternatively, appraisal regulations and guidelines. (See sec-
during periods of rising interest rates, the com- tion 2231.0.) Asset quality should be analyzed
pany will usually experience losses on the sale in terms of regional and national economic fac-
of mortgages and securities. Interest-rate volatil- tors as well as portfolio and managerial factors.
ity can cause large fluctuations in warehouse For any review of any loan portfolio, a sam-
funding costs and marketing gains and losses. pling of real estate appraisals should be included
The examiner should also consider the impact to determine whether the appraisal results rea-
of current economic conditions on the size and sonably support the amount loaned. If the prop-
composition of the mortgage banking compa- erty appears to be overappraised or if there is a
nys balance sheet. When the economy expands,
loan volume increases and the overall size of the BHC Supervision Manual June 1997
balance sheet tends to grow. During recessions, Page 29
problem with the appraisal (for example, the collections, foreclosure, and ORE are not fully
appraisal is obsolete or the validity of the reimbursable and should be anticipated.
appraisal is in question), the examiner should The mortgage banking company must main-
consider recommending that a new appraisal be tain adequate management reports to measure
performed.6 It may be necessary for the examiner and track the quality of originated, purchased,
to classify the loan (i.e., as a loss) and for the and serviced assets. Proper administration over
parent holding company to increase its allow- loans and other assets held for sale or invest-
ance for loan and lease losses. ment requires the use of aging and other track-
Bank holding companies and/or their non- ing reports. For assets held for sale, the reports
bank subsidiaries should be criticized if initial should identify loans and other marketable assets,
appraised values appear to be inadequate and/or other than marketable securities,7 that have been
not properly supported by proper documenta- in this category longer than 60 days. In such
tion. If corrective action is not taken by manage- instances, a determination should be made as to
ment, formal enforcement action should be con- whether credit quality problems and/or docu-
sidered. Such actions may require the bank mentation deficiencies exist that will prevent the
holding company to revamp its appraisal activi- timely sale of the loan in the secondary market.
ties and/or collection procedures and, if war- If problems are not correctable within a reason-
ranted, to retain the services of an independent able timeframe, the loans and other related
appraiser to conduct an evaluation of loan assets should be revalued and transferred to the
collateral. held-for-investment category. Procedures gov-
With respect to MBSs, the quality characteris- erning the valuation and transfer of poor-quality
tics of the underlying mortgage collateral should assets should be in writing and should be
be considered. If the securities are backed by followed.
GNMA, FannieMae, or FHLMC, the rating agen- The MIS should also generate for manage-
cies consider such securities to be the highest ments review reports on the delinquency status
quality asset because of their linkage to the of loans held for investment and loans serviced
federal government. If the collateral consists of for investors. Such reports provide an early
unsecuritized mortgages, the examiner should warning system and an analysis tool to evaluate
consider the geographic dispersion, type of mort- internal collection activities. If a loan becomes
gage and property, underwriting standards, and delinquent (30 days or two payments past due),
term to maturity of the underlying pool of mort- the borrower should be contacted. Collection
gage loans. External factors can affect the value efforts should be strengthened if the delinquency
of mortgage securities directly, such as the continues. If the loan becomes severely delin-
default or downgrading (by a credit rating agency) quent, foreclosure proceedings should be initi-
of a private mortgage insurer. ated consistent with the investor-servicing agree-
To a large extent, insurance and guaranties ment, and the value of the collateral supporting
provided by government-sponsored agencies and the loans should be assessed. Anticipated short-
other third parties (for example, private mort- falls should be recognized as losses in a timely
gage, bankruptcy protection, fraud, and mort- manner.
gage pool insurers, as well as performance bond MIS should also include an internal loan-
insurers and other guarantors) mitigate credit grading system, which tracks the borrowers
risk for an originator; however, the originator ability to meet its monthly payment obligations.
still remains responsible for the quality of loans Although MIS should be tailored to meet man-
sold to investors for at least the first 90 days, agements needs, information should be consis-
as well as for any loans sold under recourse tent with loan-grading systems that are used by
arrangements. As a servicer, the company also the controlling bank holding company and fed-
can be held liable if it does not initiate collec- eral bank regulatory agencies. Reports should
tion and foreclosure actions in strict accordance also track collection and foreclosure actions ini-
with investor-servicing agreements. In addition, tiated by the servicer and repurchase requests
certain interest losses and expenses relating to initiated by a permanent investor or other third
party.
Examiners should also verify that appraisal
practices are consistent with the Boards
6. For certain credits, the bank holding company should
develop criteria for obtaining reappraisals or revaluations as
part of a prudent portfolio review and monitoring program.
7. For mortgage-backed securities available-for-sale, simi-
BHC Supervision Manual June 1997 lar account classification procedures apply, but those are
Page 30 accounted for in accordance with SFAS 115.
appraisal regulations,8 the interagency appraisal The examiner should also review any off-
and evaluation guidelines (see SR-94-50, balance-sheet exposure for which credit risk is
SR-94-55, SR-95-16, SR-95-27, and SR-99-26), retained. Loans sold to investors on a recourse
and any other state and federal laws and regu- basis have the potential of being put back to the
lations. Mortgage banking companies that are servicer. The portion of the recourse portfolio
subsidiaries of either state member banks or that is severely delinquent should be classified
bank holding companies are subject to the same according to the guidelines provided previously,
appraisal standards and requirements as their since the exercise of this put option is highly
parent companies. likely.
At the end of the classification process, the
examiner should evaluate the level and trend of
3070.0.5.4.1 Classification Procedures classified assets to determine whether asset qual-
ity poses undue financial risk to the mortgage
The classification process begins with an analy- banking company or its parent bank holding
sis of delinquent loans. The examiner should company. A list of total classifications should be
begin by obtaining an aged listing of all delin- compiled and left with management.
quent loans in the held-for-sale and the held-to- As part of the analysis of asset quality, the
maturity portfolios. Clear-cut shortfalls in prop- aggregate of loss classifications plus an amount
erty values compared with loan or investment expected to ultimately be loss should be com-
values should usually be classified unless there pared with the existing allowance for loan and
are mitigating circumstances. Usually loans or lease losses. If the aggregate exceeds the exist-
investments with doubtful or loss elements have ing contra asset balance(s) then additional loan-
other significant weaknesses that will ordinarily loss provisions are needed. In such situations,
justify a classification of substandard for the the parent company should be advised of the
remaining balance. Loans secured by collateral deficiency and reminded of its responsibility to
such as real estate should be classified in accor- ensure that an adequate allowance for loan and
dance with these guidelines and the applicable lease losses, as well as other contra asset valua-
classification guidance found in sections 2060.1 tion balances, is maintained by the subsidiary
and 2090.1 of the Commercial Bank Examina- for its asset portfolio.
tion Manual and sections 2010.2, 2065.1, 2240.0,
and 5010.10 of this manual. Any discrepancies between the classifications
Portions of these loans may warrant a more list and information contained on the companys
severe classification if the value of the under- MIS should also be discussed with manage-
lying collateral is insufficient to fully repay the ment. If asset quality presents undue or exces-
loan. The identification of potential or actual sive risk, appropriate comments should be docu-
loss exposure may warrant the use of either a mented and brought forward on Examiners
split (substandard and loss) or a doubtful Comments and Matters Requiring Special Board
rating. Attention, page one of the report.
The examiner should also review the ORE
portfolio, notes and accounts receivable, and
other investments on the companys balance 3070.0.5.4.2 Presentation of
sheet for potential classifications. ORE may usu- Classifications
ally warrant a substandard classification due to
an investments nonearning status and an As a minimum standard, brief write-ups stating
increased probability of loss on disposal of the the reason for classifications should be provided
underlying assets. for any nonbank subsidiarys asset whose doubt-
Assets that represent illegal or impermissible ful and/or loss classification exceeds the lesser
holdings or those that are subject to some regu- of $100,000 or 5 percent of the subsidiarys
latory concern should not be classified, per se, total assets. In general, substandard assets should
for these factors. Such holdings should be treated be listed without a write-up, regardless of size.
separately within the report. In those instances However, a brief write-up is required for any
where a credit-quality issue is also present, the asset whose classification is challenged by man-
classification and the separate treatment should agement. The examiner has the option to pro-
be cross-referenced. vide a write-up for any classified assets, regard-
less of size.
8. See Regulation Y, subpart G (12 C.F.R. 225.6167), and
its incorporation by reference into Regulation H (12 C.F.R. BHC Supervision Manual January 2007
208.18). Page 31
While the following presentation guidelines ment this analysis, and replenish each reserve as
may be useful in structuring the write-ups, the necessary.
examiner may include any other format appro- The financial presentation for reserves varies.
priate to the situation: Reserves maintained for on-balance-sheet expo-
sure are generally reported as a contra asset.
recapitulation of the status and purpose of the Reserves maintained for contingent liabilities
loan, the lien position, type and appraised relating to the sale of loans and servicing of
value of the collateral, its delinquency and loans for investors may be shown as a liability
accrual status, guarantors and other debit or in practice.
credit balances related to the loan Disclosures relating to valuation reserves
the problems with the loan, borrower, or col- should be consistent with GAAP. Examiners
lateral, presented in a concise, descriptive may wish to confer with the mortgage bank-
narrative ing companys external auditors regarding the
the examiners evaluation of the situation, nature or appropriateness of any reserve accounts
indicating estimated values, major assump- that are unusual.
tions, and mitigating or negative factors
the classification, which should represent a
logical combination of the relevant factors 3070.0.5.5 Earnings Performance
presented in the first three elements
Earnings performance should be assessed in
Within the elements presented, the examiner terms of the level, composition, quality, and
should stress accuracy, brevity, and clarity in the trend of net income. The earnings analysis should
presentation, as well as a logical pattern leading consider internal factors such as the companys
to the classification. Historical information and business orientation and managements growth
financial data that are not pertinent or that are plans, as well as relevant external factors such
too stale to have a direct bearing on the present as interest rates and economic trends.
situation should not be included. Unusual aspects of origination and servicing-
Presentations for OREO properties need not fee income, marketing gains and losses, the net
include the original loan date, history, and finan- interest margin, provisions for losses, salaries
cial information, unless there is some relevance and overhead items, or income taxes should be
to the current condition (for example, the prop- discussed with management, as well as with
erty has been foreclosed on for the second time internal or external auditors. Large write-downs
or some circumstance before foreclosure contin- or amortization adjustments relating to mortgage-
ues to have an impact). For those companies in servicing rights should also be investigated. (See
which numerous loans and OREO properties are section 3070.0.6.)
classified, a summary of classifications, seg- Current and historical ratio trend analysis,
mented by loans and real estate owned and compared with published industry results (for
indexed to the pages containing the classifica- example, see the Mortgage Bankers Associa-
tions, presents clear benefits to the users of tions annual statistics in the Mortgage Bank-
the report. This becomes more pertinent when ing Performance Report), should also be incor-
numerous assets below the write-up line are porated into the profitability analysis, where
included in total classifications. In addition, both appropriate. This includes income structure, ex-
management and the subsequent examiners will pense structure, and operating performance ratios.
have an official listing of the classifications. However, ratios that compare earnings to aver-
age assets or equity may be of limited use unless
the examiner also considers the transitory nature
3070.0.5.4.3 Reserves of the balance sheet and the impact of off-
balance-sheet servicing activities on the compa-
Management should establish and maintain nys use of financial leverage. Finally, the exam-
adequate contra asset allowances and other con- iner should consider the companys ability to
tingency reserves to cover identified loss expo- generate sustainable positive earnings consis-
sure. Policies and procedures, and financial state- tently over time, as well as the proportionate
ment disclosures, should clearly state the purpose share of consolidated earnings (or losses).
of and intended accounting treatment for each
reserve. Management should evaluate the level
of each reserve account at least quarterly, docu- 3070.0.5.6 Liquidity and Funding
BHC Supervision Manual January 2007 Managements ability to satisfy the companys
Page 32 liquidity needs and plan for contingencies with-
out placing undue strain on affiliate bank or tions, cash flows from investing activities, and
nonbank resources or reliance on the parent cash flows from financing activities on a year-
bank holding company is crucial. Liquidity needs by-year trend basis. The examiners analysis of
depend on the size of the warehouse, the nature cash flows may reveal transactional trends
and extent of longer-term assets, opportunities between cash inflows and outflows. For exam-
to issue debt at a reasonable price, and manage- ple, within the Cash Flows from Operating
ments ability to forecast and plan for contin- Activities, cash flow from the sale and principal
gencies. Liquidity is often dependent on cash repayments on mortgage loans held for sale may
generated through short-term liquid assets and correlate with originations and purchases of
on short-term borrowings to fund operations. mortgage loans available for sale. With regard
Earnings performance, capital adequacy, the to investing activities, attention should be given
degree of market contact with underwriters and to the differences between short-term purchases
credit rating agencies, maintenance of debt cov- of mortgage loans held for investment versus
enants, and contingent liquidity plans are all principal repayments on mortgage loans held for
significant factors in the evaluation of liquidity. short-term investment. In addition, purchases of
Liquidity can quickly erode if investor percep- real estate owned from the loan-servicing port-
tions of a companys credit standing change. folio may correlate with net sales of real estate
Consequently, the ability to fund mortgage owned. A review of the financing activities
operations under economic duress and access should indicate if there is sufficient cash flow
to alternate liquidity sources become key provided from revolving warehouse lines of
considerations. credit, commercial paper, proceeds from the
Funding needs are driven by the need to issuance of any other short-term debt, and net
temporarily finance mortgage loans and MBSs changes in advances payable to affiliates.
before their sale to a permanent investor. The The summary analysis of the cash-flow state-
examiners should do a trend review of external ment should convey how the underlying transac-
liquidity to assess how easy it is to sell mortgage- tions collectively contribute to a positive cash
backed securities by the firm in the secondary flow and liquidity. When analyzing liquidity, the
market. The analysis should include the normal examiner needs to consider the principles and
trading volume in MBS securities, the volume guidelines set forth in section 2080.05, Fund-
of loans held for sale and their market value, ing (Bank Holding Company Funding and
and the size of the floating supply of mort- Liquidity) of this manual.
gage securities or loans that are not closely held.
Liquidity needs must also take into consider-
ation longer-term assets such as fixed assets, 3070.0.5.6.3 Asset/Liability Management
mortgage-servicing rights, and permanent loan
In general, funding liability maturities should
and MBS portfolios. (See section 2080.05.)
closely approximate the maturities of under-
lying assets to mitigate the risk of a funding
3070.0.5.6.1 Financial Flexibility mismatch. Otherwise, the company is exposed
to short-term interest-rate fluctuations unless
The liquidity analysis should include a determi- appropriately hedged. Funding mismatches can
nation as to the companys financial flexibility. lead to significant earnings volatility in the event
Financial flexibility is the ability to obtain the that interest rates change rapidly. Managements
cash required to make payments as needed. Cash asset/liability management program should be
can be obtained from (1) business operations; evaluated in terms of the degree of matching,
(2) liquid assets already held by the company risk aversion, and the accuracy of information
either in the form of cash or marketable securi- that is provided to the holding company through
ties or by selling liquid assets such as receiv- daily, weekly, or monthly management reports.
ables or inventories for cash; and (3) external
lines of credit, bank borrowings, or the issu-
ance of debt or equity securities in the capital 3070.0.5.7 Capital Adequacy
markets.
Capital must be adequate to absorb potential
operating losses, provide for liquidity needs and
3070.0.5.6.2 Cash-Flow Analysis expected growth, and meet minimum require-
ments set by third-party creditors and investors.
The liquidity analysis should also include a
review of the net current items on the cash-flow BHC Supervision Manual June 1997
statement pertaining to cash flow from opera- Page 33
At a minimum, a mortgage banking company of-strength doctrine, the parent company must
must meet the nominal capital levels required be prepared to support its subsidiaries should
by investors such as FannieMae ($250,000) or the financial need arise. If the parent is not
FHLMC ($1 million, based on financial report- prepared to inject capital and capital levels have
ing under GAAP, or $500,000, adjusted for cer- declined, the examiner should comment on the
tain assets and any deferred-tax liability). Addi- mortgage banking companys extended lever-
tional capital is required based on the outstanding aged position on page one of the inspection
principal balance of loans serviced for investors. report. Under extreme circumstances, the exam-
If these requirements are not met, the company iner should also recommend that its leverage be
may not be able to sell mortgages to and/or reduced and its capital structure augmented to
service mortgages for these investors. ensure that mortgage operations are conducted
As noted above, these are minimum capital in a safe, sound, and prudent manner.
requirements. Management should identify the
level of capital that is required to support cur-
rent operations and projected future growth, 3070.0.5.8 Overall Assessment
given the risk tolerance preferences of manage-
ment and the board. Capital levels, dividend The overall financial condition of the mortgage
payments, and capital planning should be ad- banking company should reflect its financial
dressed in a written capital plan that is reviewed statement presentation, asset quality, earnings,
and approved by the board at least annually in liquidity and funding practices, and capital ade-
conjunction with the budgeting and strategic quacy. Report comments should be prepared to
planning activities. the extent necessary.
There also may be a need to meet minimum
leverage ratios established by the parent bank
holding company or to meet debt covenants set 3070.0.5.9 Inspection Objectives
forth in either warehouse credit facilities or
long-term debt instruments. Companies that have 1. To evaluate the financial condition of the
excessive off-balance-sheet risk or high growth mortgage banking company based on a review
expectations may require additional capital. In of the following:
addition, risk-based capital guidelines impose
certain reporting requirements and limitations primary balance-sheet and income-
regarding the amount of MSA mortgage bank- statement levels and trends
ing companies may include in their regulatory off-balance-sheet exposure such as the ser-
capital. vicing portfolio
Capital levels should be monitored and reported asset quality
to the companys board of directors regularly to earnings performance
mitigate the risk of inadequate or eroding capi- funding sources and liquidity needs
tal. Management and the board are further encour- capital adequacy
aged to adopt a capital policy that specifically
addresses the particular needs of the company. 2. To determine the accuracy of regulatory
The examiner should evaluate capital ade- reporting (regulatory accounting practices (RAP)
quacy, the amount of dividends that are up- and GAAP) and compliance with applicable
streamed to the parent bank holding company, state and federal laws and regulations.
and the extent to which the parent company can 3. To evaluate the quality of the mortgage
be relied on to augment the ongoing capital banking companys assets for collateral suffi-
needs of its bank and nonbank subsidiaries. In ciency, performance, credit quality, and
some instances, the parent company may oper- collectibility.
ate on the premise that the mortgage banking 4. To assess earnings performance through
company requires little capital of its own as the analysis of the level, composition, and trend
long as the parent company remains adequately of net income. If material, interest income,
capitalized.9 Under the Federal Reserves source- impairment of mortgage-servicing assets, gains
and losses on asset sales, and personnel and
other expenses should be factored into the
9. When MSAs are valued for inclusion in capital, the
risk-based capital guidelines for banks and BHCs require the
analysis.
discount rate to be not less than the original discount rate
inherent in the intangible asset at the time of its acquisition,
BHC Supervision Manual June 1997 based on the estimated future net cash flows and price paid at
Page 34 the time of purchase.
5. To assess the funding and liquidity needs c. Determine accounting policies and prac-
of the mortgage banking company through ratio tices with respect to these loans. Review aging
analysis and a review of the funding instruments reports for loans held for sale and for invest-
used. ment. Discuss the frequency of reviews for loans
6. To assess capital adequacy by ensuring held for sale, revaluation practices, and transfers
that investor minimum requirements are met among accounts. Verify that accounting prac-
and by comparing capital levels with peer and tices are consistent with GAAP and RAP.
industry data. Consideration of the capital needs 3. Obtain a listing of loans in the process of
of the individual mortgage banking company foreclosure and bankruptcy and discuss these
should override any comparison with peers. with management for potential classification.
4. Reconcile all other real estate owned by
the mortgage banking company to the general
ledger and classify based on risks and any
3070.0.5.10 Inspection Procedures income-producing characteristics of the proper-
ties. Compare current appraisals to carrying
Financial Statement Level and Trends value for potential write-downs.
5. Obtain a list of loans sold under recourse
1. Review the mortgage banking companys arrangements and assess for potential classifica-
financial statements and related notes over the tion.
previous three-year period. 6. Discuss the methodology used to establish
2. Discuss significant balance-sheet and foreclosure reserves and related accounting pro-
income-statement categories with management, cedures. Review analysis used to project future
as well as with internal and external auditors. foreclosures.
3. Determine whether financial trends are
consistent with the economic environment, Evaluate the adequacy of foreclosure reserves
interest-rate movements, the companys busi- based on the volume of projected foreclo-
ness orientation, and managements intended sure actions, average foreclosure costs, and
growth strategy. the past history of reinstated loans.
4. Determine whether reports filed with regu-
latory agencies are prepared accurately and sub- 7. Review other reserve accounts and assess
mitted in a timely manner, with particular atten- for reasonableness.
tion paid to the reporting for mortgage-servicing
assets and recourse obligations retained by the
mortgage banking company. Earnings Performance
1. Assess earnings performance in terms of
Asset Quality the level, composition, and trend of net income.
Consider internal factors, such as the companys
business orientation and managements growth
1. Spread past-due and nonaccrual loans by
plans, and external factors, such as interest rates
balance-sheet asset category (for example, mort-
and the economic environment, when evaluat-
gage loans held for sale, mortgage loans held
ing earnings trends.
for investment), product type, and delinquency
2. Discuss any unusual aspects of origination
status (for example, 3190 days, 91180 days,
and servicing-fee income, marketing gains and
and 181 days and over). Include any loans in the
losses, the net interest margin, reserves, write-
process of foreclosure.
downs or adjustments in MSA amortization,
2. Obtain a trial balance and delinquency list- salaries and overhead items, or income taxes
ing for loans held for sale and loans held for with management, as well as with internal or
investment. external auditors.
a. Reconcile balances of the real estate 3. Incorporate ratio and industry compari-
held for sale and investment to the respective sons into the earnings analysis, where appropri-
general ledger accounts. ate. Bear in mind that ratios that compare earn-
b. Classify severely delinquent loans as ings to total assets or equity are of limited use
required based on the financial condition of the unless the transitory nature of the balance sheet
borrower, his or her inability to make monthly and the impact of off-balance-sheet servicing
payments as required, and the protection afforded
by current collateral values. BHC Supervision Manual June 1997
Page 35
activities on the companys use of financial cant earnings volatility in the event that interest
leverage are taken into consideration. rates change rapidly?
Liquidity and Funding Capital Adequacy
1. Determine the mortgage banking compa- 1. Determine whether capital levels are ade-
nys liquidity needs based on a review of the quate to absorb potential operating losses, pro-
size of its warehouse and the nature and extent vide for liquidity needs and expected growth,
of other longer-term assets. and meet minimum requirements set by inves-
2. Determine whether sources of liquidity are tors whose loans are serviced and other external
adequate, both under current conditions and eco- parties.
nomic duress. Consider earnings performance, 2. Review policies and procedures to deter-
capital adequacy, the degree of market contact mine whether management adequately monitors
with underwriters and credit rating agencies, and reports capital levels to the board of direc-
maintenance of debt covenants, and contingent tors. Review the capital plan to determine whether
liquidity-planning capabilities. it adequately addresses the particular needs of
the company.
3. Evaluate financial instruments used to fund 3. Evaluate the amount of dividends that are
mortgage operations. Financial instruments may upstreamed to the parent bank holding com-
include repurchase agreements, commercial pany, as well as the extent to which the parent
paper, revolving warehouse lines of credit, and/or company can be relied on to augment the ongo-
long-term debt. Review related credit agreeing capital needs of its bank and nonbank sub-
ments and systems used to monitor compliance sidiaries. Is the parent company prepared to
with debt covenants. support its subsidiaries should the financial need
4. Establish whether excessive borrowing arise? Are cash dividends paid by the mort-
activities have led to a highly leveraged finan- gage banking subsidiary to the parent company
cial condition that exposes the company to money reasonable?
market changes in the cost of funds. Evaluate
the impact a change in the companys cost of
funds would have on its net interest margin and Accounting
earnings.
5. Determine the degree of financial flexibil- 1. Review accounting procedures for retail
ity the company maintains. Financial flexibility loans. Determine whether loan fees in excess of
is the ability to obtain the cash required to make cost are deferred in accordance with SFAS 91.
payments as needed. Does the company possess Verify that income is recognized over the esti-
adequate financial strength and have access to mated life of the asset and not in the current
lines of credit and/or assets that can be easily period and that fees and costs are allowable
collateralized? under SFAS 91. Are controls in place to ensure
6. Review the net current items on the cash- proper recognition for net fee income when
flow statement pertaining to cash flow from loans are sold? (SFAS 91 applies to loans held
operations, cash flows from investing activities, in portfolio, as well as to loans swapped for
and cash flows from financing activities on a securities when the securities are retained.)
year-by-year trend basis. Determine whether 2. Determine if the accounting for recogniz-
sufficient positive cash flow exists from the level ing sales of loans and mortgage-backed securi-
of current transactions. The summary analysis ties (including participation agreements) is in
of the cash-flow statement should convey how accordance with the three conditions for true
the underlying transactions collectively contrib- sales recognition specified in SFAS 77, Re-
ute to a positive cash flow and liquidity. porting for Transfers of Receivables with
7. Review asset/liability management prac- Recourse.10 Also determine if the sales price
tices to determine whether funding maturities
closely approximate the maturities of under- 10. A transfer is recognized as a sale if
lying assets or whether a funding mismatch a. The transferor surrenders control of the future eco-
exists. Is the company exposed to short-term nomic benefits of the receivables;
b. The transferors obligation, under the recourse provi-
interest-rate fluctuations that may lead to signifi- sions of the sale agreement, can be reasonably estimated. The
transferor should have had past experience with the recourse
BHC Supervision Manual June 1997 provisions so that a reasonable estimate can be made. The
Page 36 current transferred receivables should possess characteristics
was adjusted for all probable adjustments (as as an amendment to SFAS Nos. 65, 76, 77, and
defined in SFAS 5, Accounting for Contingen- 115. The provisions of SFAS 125 supersede
cies). If the mortgage banking company is a SFAS 122 and are to be applied prospectively in
subsidiary of a bank, refer to the bank call fiscal years beginning after December 31, 1996.
report, glossary entry on sales of assets. The statement requires that a liability be derec-
3. If servicing is retained, determine if a ognized when either (1) the debtor pays the
normal servicing fee is set and how it con- creditor and is relieved of its obligation for the
forms to FannieMae/FHLMC fees and to FASB liability or (2) the debtor is legally released
Technical Bulletin 87-3, Accounting for from being the primary obligor under the liabil-
Mortgage-Servicing Fees and Rights.11 If the ity either judicially or by the creditor.
mortgage banking subsidiary is a subsidiary of Under SFAS 125, a mortgage banking com-
a bank, see the reporting instructions for Sched- pany is required to recognize as separate assets
ule F of the bank call report (Schedule RC-F or liabilities the right to service mortgage loans
for Other Assets, Item 3Excess residential for others, however those servicing rights are
mortgage-servicing fees receivable). acquired. Servicing of mortgage loans includes,
but is not limited to, collecting principal, inter-
est, and escrow payments from borrowers; pay-
Overall Financial Condition ing taxes and insurance from escrowed funds;
monitoring delinquencies; executing foreclosure
1. Evaluate the overall financial condition of if necessary; temporarily investing funds pend-
the mortgage banking company, considering its ing distribution; remitting fees to guarantors,
asset quality, earnings, liquidity, and capital ade- trustees, and others providing services; and
quacy. Update the financial component of the accounting for and remitting principal and inter-
supervisory rating and prepare report comments est payments to the holders of beneficial interest
as necessary. in the mortgage loans. Servicing is inherent in
all mortgage loans; however, it becomes a dis-
tinct asset or liability only when contractually
3070.0.6 MORTGAGE-SERVICING separated from the underlying assets by sale
ASSETS AND LIABILITIES or securitization of the assets with servicing
retained or separate purchase or assumption of
This subsection discusses mortgage-servicing the servicing.
assets (MSAs) and liabilities and provides
guidance with respect to the measurement,
impairment testing, and financial reporting
requirements of MSAs. The subsection con- 3070.0.6.1 Measurement
cludes with a discussion of MSA hedging prac-
tices and instruments. A mortgage banking company initially acquires
SFAS No. 125 Accounting for Transfers and MSAs either by (1) purchasing the right to
Servicing of Financial Assets and Extinguish- service mortgage loans separately or (2) pur-
ments of Liabilities, was issued in June 1996 chasing or originating mortgage loans and sell-
ing those loans with servicing rights retained.
When a mortgage banking company purchases
similar to previously transferred receivables evidencing the or originates mortgage loans, the cost of acquir-
transferors relevant prior experience. ing those loans includes the cost of the related
c. The transferor cannot require the transferee to repur- MSAs.
chase the receivables, except as stated in the agreements
recourse provisions. With respect to SFAS 125, when an entity
11. According to FASB Technical Bulletin No. 87-3, the incurs an obligation to service financial assets, it
servicing-fee rates set by GNMA, FHLMC, and FannieMae in must record servicing assets or a servicing lia-
servicing agreements should be considered a normal servicing-
fee rate for transactions with those agencies. If the normal
bility for each servicing contract, unless it secu-
service fees are expected to be less than the estimated servic- ritizes the assets and retains all of the resulting
ing costs, the expected loss should be recognized at the time securities, classifying them as debt securities
the loans are sold. If a seller/servicer sells mortgage loans that are to be held to maturity. When servicing
directly to private-sector investors and retains servicing on the
loans, the seller/servicer should consider the normal servicing-
assets or liabilities are assumed, rather than
fee rate that would have been specified in comparable servic- being acquired by a sale or undertaken in a
ing agreements if the loans had been sold to or securitized by securitization of the financial assets that are to
one of the federally sponsored secondary market makers. As
of May 1995, normal servicing-fee rates established by GNMA,
FHLMC, and FannieMae were 44, 25, and 37.5 basis points, BHC Supervision Manual June 1997
respectively. Page 37
be serviced, they are measured initially at fair the servicing function and appropriate alloca-
value (that is, the price paid). A servicing asset tions of other costs. Estimated future servicing
or liability is amortized in proportion to and costs may be determined on an incremental-
over the period of estimated net servicing income cost basis.
(loss). Any impairment of a servicing asset or MSAs are highly subject to interest-rate and
liability is determined based on fair value. prepayment-rate risk since the amount of future
When the mortgage banking company sells or cash flows that are provided to the holder is
securitizes the loans and retains the MSAs, man- derived from, and is thus dependent on, the
agement shall allocate the total cost of the mort- outstanding balances of the underlying mort-
gage loans (the recorded investment in the mortgage loans.12 Prepayments of underlying mort-
gage loans including net deferred loan fees or gage loans accelerate during periods of declin-
costs and any purchase premium or discount) to ing interest rates as borrowers take advantage
the MSAs and the loans (without the MSAs) of the option they hold to refinance their loans.
based on their relative fair values if it is practi- As interest rates decline, holders of MSAs are
cable to estimate those fair values. If a mortgage exposed to a risk of prepayment of the under-
banking organization undertakes a servicing lia- lying loans, and thus a diminished amount of
bility in a sale or securitization, the servicing cash flow from their investment. Holders of
liability should initially be measured at fair interest-only stripped securities (I/O strips) are
value. exposed to similar interest-rate and prepayment
The fair value of an asset is the amount at risks when interest rates decline. I/O strips possess
which the asset could be bought or sold in a very similar prepayment risk characteristics.
current transaction between willing parties, that A particular mortgage companys exposure to
is, other than in a forced or liquidation sale. prepayment risk can also be influenced by port-
Quoted market prices in active markets are the folio composition factors such as geographical
best evidence of fair value and shall be used as mix, loan-to-value ratios, and the proportion of
the basis for measurement, if available. If quoted government (FHA/VA) and conventional loans
market prices are not available, the estimate of in the portfolio. Government loans that may be
fair value shall be based on the best information assumable by the purchaser of a home are gener-
that is available, including prices for similar ally for smaller amounts and may be extended
assets and the results of valuation techniques to borrowers with limited financial resources.
used by management. Valuation techniques may As a result, government loans tend to prepay
include the present value of estimated expected more slowly than conventional loans.
future cash flows using a discount rate commen- Unanticipated changes in interest rates, pre-
surate with the risks involved; option-pricing payment speed, or other valuation assumptions
models; matrix pricing; option-adjusted spread may impair the carrying value of MSAs and
models; and fundamental analysis. Valuation require accelerated amortization or a write-
techniques for measuring MSAs should be con- down. Therefore, the recoverability of the
sistent with the objective of measuring fair value unamortized balance should be evaluated peri-
and should incorporate assumptions that market odically, and amortization and/or the value of
participants would use in their estimates of the asset should be adjusted accordingly. To the
future servicing income and expense, including extent that impairment is not recognized, MSA
assumptions about prepayment, default, and inter- values may be inflated. As a result, assets, earn-
est rates. If it is not practicable to estimate the ings, and capital may be overstated.
fair values of the MSAs and the mortgage loans
(without the MSAs), the entire cost of acquiring 12. Several conventions exist for quantifying prepayment
the mortgage loans shall be allocated to the speed. The most common convention is a measure developed
mortgage loans (without the MSAs) and no cost by the Public Securities Association (PSA). The PSA measure
was based on actual historical experience of FHA mortgages,
shall be allocated to the MSAs. but it is not predictive. The PSA measure assumes that mort-
The amount capitalized as MSAs shall be gages prepay at a rate of .2 percent per year in the first month,
amortized in proportion to and over the period increase by .2 percent each subsequent month up to
30 months, and remain at 6 percent per year thereafter until
of estimated net servicing income. Estimates of maturity. This 6 percent level is referred to as 100 percent
future servicing revenue shall include expected PSA. Mortgages that prepay at 200 percent PSA pay off twice
late charges and other ancillary revenue. Esti- as fast as a mortgage that is performing at 100 percent PSA.
mates of expected future servicing costs shall Another convention is known as the conditional prepayment
rate (CPR) measure. CPR assumes that a constant fraction of
include direct costs associated with performing the remaining principal is prepaid each period, conditional
on the previous periods remaining balance. Typically, CPR is
BHC Supervision Manual June 1997 computed over a one-month time period. The PSA model
Page 38 simply represents a series of stable CPR assumptions.
3070.0.6.2 Impairment Testing including the aggregate balance of the allow-

ances at the beginning and end of each period,
SFAS 125 states that a mortgage banking com- aggregate additions charged and reductions cred-
pany shall measure impairment of capitalized ited to operations, and aggregate direct write-
MSAs13 based on their fair value. For the pur- downs charged against the allowances shall be
pose of evaluating and measuring impairment of disclosed.
capitalized MSAs, management should stratify
those assets based on one or more of the pre-
dominant risk characteristics of the underlying 3070.0.6.4 Intercompany MSAs
loans.14 Those characteristics may include loan
type, loan size, note rate, date of origination, Intercompany MSAs may arise when a mort-
term, and geographic location. gage banking company originates loans, sells
Impairment shall be recognized through a the loans to an affiliate bank, and the affiliate
valuation allowance for an individual stratum. bank records related MSAs. Intercompany MSAs
The amount of impairment that is recognized should be evaluated closely to determine whether
shall be the amount by which the capitalized a valid business purpose exists, the loans are
MSAs for a given stratum exceed their fair actually sold, the entity holding the MSAs has
value. The fair value of MSAs that have not revalued the rights correctly, and such intercom-
been capitalized shall not be used in the evalua- pany MSAs are eliminated in consolidation. If
tion of impairment. the purpose of the transaction is merely to
Subsequent to the initial measurement of bolster capital levels at the bank, the practice
impairment, management shall adjust the valua- may constitute an unsafe and unsound banking
tion allowance to reflect changes in the measure- practice.
ment of impairment. Fair value in excess of the
capitalized MSAs shall not be recognized. If the
fair value of a mortgage-servicing liability 3070.0.6.5 Table Funding
increases above the book value, the increased
obligation shall be recognized as a loss in cur- One method of acquiring mortgage loans, and
rent earnings. SFAS 125 does not address when recording related MSAs, is through so-called
a mortgage banking company should record a table-funding arrangements. In a table-
direct write-down of capitalized MSAs; there- funding arrangement, the mortgage banking
fore, examiner judgment in this area is required. company provides the original funding when a
mortgage broker or correspondent closes the
mortgage loan with the borrower. Concurrent
3070.0.6.3 Disclosures with the loan closing, the mortgage banking
company acquires the loan and the related MSAs.
SFAS 125 requires that the fair value of capital- Emerging Issues Task Force Issue No. 92-10
ized MSAs, and the methods and significant (EITF 92-10), Loan Acquisitions Involving
assumptions used to estimate that fair value, be Table Funding Arrangements, clarified under
disclosed. If no cost is allocated to certain what conditions these arrangements could be
MSAs, management shall describe those MSAs characterized as loan purchases. According to
and describe the reasons why it is not practi- EITF 92-10, a mortgage banking company may
cable to estimate the fair values of the MSAs account for a loan acquired in a table-funding
and the mortgage loans (without the MSAs). arrangement as a purchase only if all of the
The risk characteristics of the underlying loans following conditions are met:
used to stratify capitalized MSAs for the pur-
poses of measuring impairment shall also be The correspondent is registered and licensed
disclosed. For each period for which results of to originate and sell loans under the applica-
operations are presented, the activity in the ble laws of the states or other jurisdictions in
valuation allowances for capitalized MSAs, which it conducts business.
The correspondent originated, processed, and
13. The term capitalized mortgage-servicing rights closed the loan in its own name and is the first
refers to the cost originally allocated to the MSAs less the titled owner of the loan, with the mortgage
amount amortized. banking company becoming a holder in due
14. SFAS 65, as amended, applies to impairment evalua-
tions of all capitalized MSAs. However, a mortgage banking
course.
company may continue to apply its previous accounting poli-
cies for stratifying MSAs to MSAs that were capitalized BHC Supervision Manual December 1998
before the adoption of the amendments to SFAS 65. Page 39
The correspondent is an independent third capital excludes goodwill; amounts of mortgage-

party and not an affiliate of the mortgage servicing assets, nonmortgage-servicing assets,
banking company as defined in SFAS 65. As a and purchased credit-card relationships that, in
nonaffiliate, the correspondent must bear all the aggregate, exceed 100 percent of tier 1
of the costs of its place of business, including capital; amounts of nonmortgage-servicing assets
the costs of its origination operations. and purchased credit-card relationships that, in
The correspondent must sell loans to more the aggregate, exceed 25 percent of tier 1 capi-
than one mortgage banking enterprise and tal;15 all other identifiable intangible assets; and
not have an exclusive relationship with the deferred-tax assets that are dependent upon future
purchaser. taxable income, net of their valuation allow-
The correspondent is not directly or indirectly ance, in excess of certain limitations.
indemnified by the mortgage banking com- The amount of MSAs which may be included
pany for market or credit risks on loans origi- in capital is also limited to the lesser of
nated by the correspondent. However, a com-
mitment by the mortgage banking company the amount recorded on the balance sheet
for the purchase of loans from the correspon- under GAAP, or
dent is not considered to be an indemnifica- 90 percent of their fair market value. If both
tion for purposes of this requirement. the application of the limit on MSAs and
the adjustment of the balance-sheet amount
If any one of the above criteria is not met, for MSAs would result in an amount being
the mortgage banking company must account deducted from capital, the bank holding com-
for the loan as an origination. MSAs that pany would deduct only the greater of the two
were recorded before the adoption of the amounts from its core capital elements in
SFAS 65 amendments should be reviewed to determining tier 1 capital.
ensure that they were originated and funded
consistent with the above requirements. MSAs 3070.0.6.8 Previously Recognized Excess
that are recorded under SFAS 125 may arise in Servicing-Fee Receivables
connection with either originated or purchased
mortgage loan transactions. SFAS No. 125, Accounting for the Transfers
and Servicing of Financial Assets and Extin-
3070.0.6.6 Regulatory Reporting guishments of Liabilities (paragraph 20),
addresses the accounting treatment for excess
The examiner should also determine whether servicing-fee receivables based on contracts that
the method used to value MSAs is in accor- were in existence before January 1, 1997. Previ-
dance with the instructions for the Bank Report ously recognized servicing rights and excess
of Condition and Income (call report) and the servicing-fee receivables are to be combined,
BHC reporting instructions (FR Y-9C). If capi- net of any previous servicing obligations under
talized MSAs are not appropriately valued, they the contract, as a servicing asset or a servicing
cannot be included in capital. Management should liability. Any previously recognized excess
review the carrying amount at least quarterly, servicing-fee receivables that exceed contractu-
adequately document this review, and adjust the ally specified servicing fees are to be reclassi-
book value as necessary. fied as interest-only strips receivables.
3070.0.6.7 Risk-Based Capital 3070.0.6.9 MSA Hedging Practices and

Instruments
Readily marketable MSAs may be included in a
bank or bank holding companys tier 1 capital During the refinancing waves of 1992 and 1993,
subject to certain limitations. Tier 1 capital for several mortgage banking companies experi-
bank holding companies includes common equity,
minority interest in the equity accounts of con-
solidated subsidiaries, qualifying noncumulative 25 percent of tier 1 capital.
15. Amounts of MSAs, non-MSAs, and PCCRs in excess
perpetual preferred stock, and limited qualifying of these limitations, as well as all other identifiable intangible
cumulative perpetual preferred stock.14a Tier 1 assets, including core deposit intangibles and favorable lease-
holds, are to be deducted from an organizations core capital
requirements in determining tier 1 capital. Identifiable intan-
14a. Cumulative perpetual preferred stock is limited to
gible assets, however, exclusive of MSAs and PCCRs, acquired
on or before February 19, 1992, generally will not be deducted
BHC Supervision Manual December 1998 from capital for supervisory purposes. They will, however,
Page 40 continue to be deducted for applications purposes.
enced large losses due to the impact of rising To qualify for hedge-accounting treatment
prepayments on the value of servicing rights. As under SFAS 80, a financial instrument must
a result, many companies have begun to hedge meet two criteria:
MSAs. An effective hedge program should
reflect a solid understanding of the underlying The hedged item exposes the entity to price or
MSA risk characteristics. interest-rate risk.
The financial instrument used as a hedge
reduces that exposure and is designated as a
3070.0.6.9.1 Hedging Practices hedge.
Interest-rate and prepayment-rate risk are often SFAS 80 states that at the inception of the hedge
reduced through the natural offset between the and throughout the hedge period, changes in the
production and servicing functions; however, market value of the financial instrument used as
the degree of protection afforded by this rela- a hedge should correlate highly with changes in
tionship depends on the companys business the fair value of, or interest income or expense
orientation (originations versus purchases) and associated with, the hedged item(s) so that the
can be very difficult to measure.16 Other finan- results of the financial instrument(s) used as a
cial instruments are also used to mitigate interest- hedge will substantially offset the effects of
rate and prepayment-rate risks. The remainder price or interest-rate changes on the exposed
of this subsection discusses existing hedge item(s). Although required correlation levels are
accounting guidance and rudimentary descrip- not specifically defined, the accounting industry
tions of certain customized MSA hedge prod- has determined that 80 percent is a reasonable
ucts. Examiners should also refer to the Federal benchmark.
Reserve Systems Trading Activities Manual for
Before claiming hedge-accounting treatment,
additional guidance on derivatives.
management must obtain an opinion from its
CPA or internal accountant confirming that the
instrument that is proposed would qualify for
3070.0.6.9.2 Hedge Accounting such treatment. If these criteria are not met, the
financial instrument should be carried at its
Existing accounting literature is vague with
market value (i.e., marked to market). Hedge
respect to the accounting treatment for MSA
performance should be monitored daily and
hedge products, particularly in the area of
reported to the responsible management or board
derivatives. However, analogies exist that facili-
committee at least quarterly.
tate the application of existing accounting stan-
dards. SFAS No. 80, Accounting for Futures
Transactions, provides financial reporting stan-
dards for exchange-traded futures contracts on 3070.0.6.9.3 Relevant MSA
both interest-rate products and raw materials Characteristics
(commodities). Several EITF issues releases
provide financial reporting guidance for interest- To evaluate a mortgage banking companys
rate swap transactions. Finally, an issues paper hedge program for MSAs, one must first under-
prepared by the American Institute of Certified stand how MSAs perform. Duration, convexity,
Public Accountants (AICPA), Accounting for and amortization are useful concepts that will be
Options, provides informal but nonauthorita- reviewed as they relate to MSAs. Duration mea-
tive guidance relating to options contracts. The sures the change in the value of MSAs (or their
AICPA issues paper addresses options on all cash flows) for a given change in interest rates.
tangible goods, including both exchange-traded Duration can be either positive or negative. An
options and nonexchange traded options on asset with a positive duration, such as a fixed-
interest-rate caps and floors. income bond, tends to increase in value as inter-
est rates fall. Conversely, an asset with a nega-
tive duration, such as an MSA, tends to decrease
16. When interest rates fall, increases in production vol-
umes and related revenues tend to offset runoff in the servic- in value as interest rates fall.
ing portfolio and reductions in servicing-fee income. Alterna- Convexity measures the rate of change in an
tively, to the extent that the marketing department hedges less instruments duration, or the nonlinearity of its
than 100 percent of its estimated long position (closed loans
plus rate-locked loans that are expected to close) and interest
price/yield curve. Like duration, convexity can
rates fall, the resulting marketing gains on the uncovered
position tend to offset a portion of any required write-downs BHC Supervision Manual December 1998
in the servicing portfolio. Page 41
be either positive or negative. An asset with a accounting treatment which led to accounting
positive convexity will rise more in value for a losses.
given change in interest rates than it will fall if MSA hedge products generally fall into three
interest rates move equally in the opposite direc- categories: bond hedges, short-term option
tion. Conversely, an asset with a negative con- hedges, and long-term option hedges. Bond
vexity will decline more in value for a given hedges use Treasury bonds, plain vanilla
change in interest rates than it will increase in interest-rate swaps, interest amortizing rate swaps,
value if interest rates move equally in the oppo- positive convexity swaps, POs, and SPOs. Bond
site direction. Because of their prepayment char- hedges may be either interest-rate-driven or
acteristics, MSAs and most other mortgage- prepayment-rate-driven. Prepayment-rate-driven
related assets are negatively convex within a products reduce more basis risk and are there-
specified range of interest rates. Borrowers can fore more expensive. Although most bond hedges
be expected to exercise their option to prepay a are positively convex, they fail to provide enough
loan at a time that is most disadvantageous to positive convexity to offset the negative convex-
the MSA holder. ity in MSAs. In other words, when interest rates
MSAs are also an amortizing asset. When a decline, the value of the bond hedge will not
prepayment occurs, the loss of value is perma- increase in an amount sufficient to offset the
nent and cannot be recovered. The use of a simultaneous decline in the MSAs. Another dis-
nonamortizing asset as a hedge would necessi- advantage to bond hedges is that the downside
tate an active hedge-management strategy to risk is generally unlimited.
adjust the position as the unamortized balance Short-term option hedges consist of over-
of the MSAs declines. If the position is not the-counter (OTC) Treasury options, options on
adjusted correctly, this strategy may expose futures contracts, and options on OTC mortgage
earnings and capital to additional risks that are securities. Short-term option hedges generally
not within the scope of the companys MSA contain enough positive convexity to offset the
hedge program. negative convexity of MSAs, and the downside
risk is limited to the option premium paid at
inception. However, option strategies using these
3070.0.6.9.4 Hedge Instruments products require frequent rebalancing, are there-
fore expensive, and do not work well in a rap-
An effective MSA hedge instrument will pos- idly changing interest-rate environment because
sess characteristics that mitigate the interest-rate they are not amortizing assets.
and prepayment risks associated with MSAs Long-term option hedges include prepayment
without assuming additional basis risk. Basis caps, interest amortizing rate (IAR) servicing
risk measures how well changes in the value of hedges, LIBOR floors, and swaptions. These
the hedge instrument correlate to changes in the products may protect the servicer and/or seller
value of the MSA. An effective hedge should against changes in either interest rates or pre-
also be reasonable in terms of transaction costs payments. As off-balance-sheet products, they
and managements time. impose very few capital constraints on the MSA
Several types of specialized derivative prod- holder.
ucts have evolved to meet the needs of mort- A prepayment cap is an off-balance-sheet,
gage banking companies. Early MSA hedge prepayment-driven option product that can be
products were interest-rate-driven, utilizing zero- used to hedge a mortgage-servicing portfolio. In
coupon Treasury bonds or interest-rate swaps. exchange for paying a fee, either up-front or
However, the basis risk of such hedges proved over the life of the hedge, the servicer and/or
to be excessive. Next came principal-only (PO) seller receives a payment from the counterparty
and super-principal only (SPO) bonds, which every month that the option is in the money.
were prepayment-driven.17 However, these prod- The option is in the money if the difference
ucts also proved ineffective due to geographic between the strike balance and the actual
basis risk, potential average-life mismatches, balance of a reference portfolio, less the sum
additional capital requirements, and dissimilar of previous balance differences, is positive. Each
month the option is in the money, the counter-
party will pay the strike price, usually the
17. A special class of REMIC securities backed by POs.
book cost of the servicing portfolio, multiplied
SPOs are a more leveraged type of PO. by this balance shortfall. The reference port-
folio, strike price, and strike balance can be
BHC Supervision Manual December 1998 customized to match the servicer and/or sellers
Page 42 risk parameters and individual portfolio.
An IAR servicing hedge is an off-balance- 3070.0.6.11 Inspection Procedures

sheet, interest ratedriven option product that
can be used as either a revenue or a balance- 1. Determine the extent of financial risk asso-
sheet hedge of a mortgage-servicing portfolio. ciated with MSAs through a review of the
In exchange for paying a fee, either up-front or following:
over the life of the hedge, the servicer and/or a. Significant changes in the size of the
seller receives a series of payments from the servicing portfolio. Obtain a reconciliation for
counterparty to the extent that amortization of a the servicing portfolio for the prior fiscal year
reference balance exceeds scheduled amorti- and the most recent interim period. If significant
zation of a strike balance. The main differ- growth has occurred, determine whether loans
ence between an IAR and a prepayment cap is were originated, purchased individually (on a
that with an IAR, option payments are based on flow basis), purchased in bulk transactions, or
the performance of a reference portfolio rather acquired through whole company acquisitions.
than the seller and/or servicers actual portfolio. If the portfolio size has declined, determine the
For an IAR revenue hedge, the option payout is reason for such decline (sales of servicing rights,
based on the current balance shortfall between prepayments) and the impact on the remaining
the reference and strike balances. For an IAR servicing portfolio.
balance-sheet hedge, option payouts are based b. The proportion of capitalized MSAs
on the cumulative excess amortization of the relative to the outstanding principal balance of
reference balance over the strike balance. IAR mortgage loans in the servicing portfolio.
hedges are less expensive than comparable c. Other unusual characteristics of the ser-
prepayment-linked hedges because they contain vicing portfolio that may present undue risk,
basis risk. If actual prepayments occur more such as the weighted average coupon rates,
rapidly than predicted at the onset of the hedge, weighted average maturities, delinquency char-
the servicer and/or seller will be underhedged. acteristics, or mix of government (FHA/VA)
Numerous other types of customized hedge loans versus conventional loans.
products are available. The advantages and If the level of financial risk is sufficient to
disadvantages of each product should be well place earnings and capital at risk, the examiner
understood before it is incorporated into a mort- should complete the remainder of the MSA
gage banking companys interest-rate risk man- procedures.
agement strategies. 2. Review the qualifications of the individu-
als who are responsible for initially recording,
amortizing and evaluating MSAs. Does manage-
ment possess the necessary accounting expertise
3070.0.6.10 Inspection Objectives and experience with respect to valuation
methodologies?
1. To determine whether MSAs pose a sig- 3. Review the accounting systems used to
nificant financial risk to earnings and capital. track MSAs. Is the necessary information being
2. To evaluate managements expertise and maintained in an understandable and useable
the oversight provided by the board of directors. form? Does the adoption of SFAS 65, as amended,
3. To determine whether policies and proce- and 125 pose any system problems for the
dures used to initially record, amortize, and company? Are such problems being addressed
reevaluate MSAs are in conformance with GAAP in a timely manner? At a minimum, MSAs
and risk-based capital requirements, and whether should be tracked by product type and year
actual practice is consistent with stated policies of origination. The following information should
and procedures. be maintained for each pool of loans: the
4. To verify that asset values are fairly stated. original and current principal balance for each
pool; original and current book values of related
5. To evaluate the methods used to hedge MSAs; prepayment speeds, normal servicing
interest-rate and prepayment risks associated fees, and the original discount rate used; and the
with MSAs, the degree of oversight provided by actual historical payment experience for each
management or the board of directors, the ade- pool.
quacy of written policies and procedures, and 4. Review written policies and procedures
the effectiveness of the companys hedge pro- for initially recording, amortizing, and periodi-
gram for MSAs. cally revaluating MSAs. Determine the manage-
6. To identify any excessive risk-taking which
is caused by the companys business mix and/or BHC Supervision Manual June 1997
strategy. Page 43
ment or board committees responsible for flows, and the source of servicing revenue and
approval of such policies, the date of last approval, cost data.
and the frequency of their review. 7. Review the most recent quarterly valua-
5. Determine whether MSA policies and pro- tion process and the related output to determine
cedures are in conformance with GAAP and whether necessary write-downs or amortization
risk-based capital requirements and whether adjustments were made, management or board
actual practice conforms with established poli- oversight was adequate, and actual practice is
cies and procedures. At a minimum, policies consistent with established policies and proce-
and procedures should clearly address the fol- dures. Ensure that any significant changes to the
lowing areas: models parameters and/or output are approved
a. Initial valuation of MSAs and related by the appropriate management or board com-
pricing policies. With respect to MSAs, policies mittee and that such changes are adequately
and procedures should describe the method for documented.
allocating the total cost of originated and pur- 8. Verify that disclosures are accurate with
chased mortgage loans to the MSAs and the respect to the following:
related loans (without the MSAs) based on their
relative fair values at the date of origination or the fair value of capitalized MSAs
purchase; procedures to be followed if a defini- the methods and significant assumptions
tive plan for sale of the loans does not exist and used to estimate that fair value
loans are sold at a later date; procedures to be a description of MSAs for which no cost
followed in the event that it is not practicable to has been allocated and the reasons why it is
estimate the fair value of the MSAs and the not practicable to estimate the fair values of
related loans (without MSAs); and MSAs those MSAs and the mortgage loans (with-
recorded under table funding relationships with out the MSAs)
correspondents and/or brokers. the risk characteristics of the underlying
b. The method for amortizing MSAs over loans used to stratify capitalized MSAs for
the estimated lives of the assets, and instances the purposes of measuring impairment
where amortization lives may be adjusted. the activity in the valuation allowances for
c. The method for measuring impairment capitalized MSAs, including the aggregate
of capitalized MSAs based on their fair value. balance of the allowances at the beginning
Policies and procedures should address the basis and end of each period; aggregate additions
for stratification of MSAs based on the risk charged and reductions credited to opera-
characteristics of the underlying loans; the types tions; and aggregate direct write-downs
of valuation allowances used to reflect changes charged against the allowances
in the measurement of impairment; the method
used to arrive at the fair value of assets (quoted 9. Obtain a list of intercompany MSAs as of
market prices, estimated prices for similar assets, the close of business for the most recent quarter-
and the results of valuation techniques); the end. Determine whether a valid business pur-
frequency of revaluation tests; the presentation pose exists, the loans are actually sold, the
of valuation test results to senior management entity holding the MSAs has revalued the rights
and the board of directors; instances where correctly, and such intercompany MSAs are
write-downs would be required; disclosures; and eliminated in consolidation. If the purpose of
the basis for assumptions used. the transaction is merely to bolster capital lev-
6. Verify that the valuation techniques for els at the bank, the practice may constitute an
measuring MSAs are consistent with the objec- unsafe and unsound banking practice.
tive of measuring fair value. Review model 10. Review policies and practices regarding
output and related manuals and/or marketing the sale of MSAs and liabilities to investors.
materials. Evaluate the reasonableness of all key 11. If the company sells loans with recourse,
parameters and assumptions, with an emphasis are recourse reserves established at the time of
on the source for prepayment speed estimates, sale? Are estimated losses factored into the
the number of interest-rate paths used (vec- calculation of gain/loss on sale of loans?
toring or binomial models being more desirable 12. Obtain an organizational chart to deter-
than a single interest-rate projection path), the mine the individuals responsible for hedging
basis for the interest rate used to discount cash MSAs. Review biographies to ensure that staff
members responsible for this function are knowl-
BHC Supervision Manual June 1997 edgeable regarding accounting guidance, hedge
Page 44 products, and related strategies.
13. Review methods used to hedge the interest- member banks and later extended to all feder-
rate and prepayment-rate risk associated with ally insured banks.18 Section 23A defines com-
MSAs. Verify the management or board companies that control or are under common control
mittee responsible for approving hedge instru- with the bank as affiliates of the bank. For
ments, the list of approved products, and the example, the term affiliates includes bank
frequency and date of last review. holding companies and their subsidiaries as well
14. Review management reports to deter- as banks and nonbanking companies that are
mine the correlation between hedge instruments under common individual control.19 The two
and the underlying assets, the accounting treat- primary aspects of section 23Aquantitative
ment for hedges, related gains and losses, and restrictions and collateral requirementsare dis-
the overall effectiveness of the companys hedge cussed next.
program. If hedge accounting treatment is being
used, management and/or the companys exter-
nal accountants must perform the appropriate 3070.0.7.1.1 Quantitative Restrictions
level of due diligence and maintain adequate
supporting documentation. In determining the The quantitative restrictions imposed by sec-
effectiveness of the hedging program, the exam- tion 23A generally limit the aggregate amount
iner should compare the actual results of hedge of so-called covered transactions to 10 per-
performance with the expected results. cent of the banks capital and surplus for trans-
15. Evaluate the quality of information that actions with a given affiliate, and 20 percent of
is communicated to senior management, the the banks capital and surplus for transactions
board of directors (if applicable), and the parent with all of its affiliates.20 Covered transactions
companys senior management and board of include
directors to determine whether management
and directors are adequately informed regarding a loan or extension of credit by a bank to an
the financial risks associated with MSAs, amor- affiliate, such as a warehouse line of credit
tization methods and hedging techniques, and provided to the affiliate;
the degree of risk inherent in the companys the purchase of or investment in securities
strategic focus and business mix with respect to such as a privately issued MBS issued by an
the projected volume of MSAs. affiliate;
the purchase of assets from an affiliate, such
as a loan purchased either as an accommoda-
3070.0.7 INTERCOMPANY tion to a bank customer or for the banks
TRANSACTIONS asset/liability management purposes;
the acceptance by a bank of securities issued
A mortgage banking company that is organized
by an affiliate as collateral for a loan or exten-
as a nonbank subsidiary of a bank holding com-
sion of credit by the bank to any person or
pany often sells assets to, receives funding from,
company (Securities might include either the
or services loans for its bank affiliates. Given
stock of a publicly held affiliate or the stock
the trend toward managing mortgage banking
from one of its officers own business enter-
activities as a line function rather than by legal
prises.); or
entity, such intercompany transactions have
become an area of heightened supervisory
concern.
In general, sections 23A and 23B of the Fed- 18. As originally enacted, the Banking Act of 1933 cov-
eral Reserve Act are designed to prevent a bank ered only member banks. In 1966, Congress amended section
from being disadvantaged through the purchase 18(j) of the Federal Deposit Insurance Act, 12 U.S.C. 1828(j),
of low-quality assets from an affiliate, the pres- to extend the coverage of section 23A to include insured
nonmember banks. As a result, section 23A now applies to all
sure to fund the majority of an affiliates working- federally insured banks. (12 U.S.C. 371c)
capital needs, and intercompany transactions 19. Nonbank subsidiaries of banks, as opposed to nonbank
that either inadequately compensate the bank or subsidiaries of bank holding companies, are not affiliates for
are not conducted on an arms-length basis. purposes of section 23A, unless the Board of Governors of the
Federal Reserve System determines otherwise. Banks that are
part of a chain banking organization are subject to the restric-
tions of section 23A.
3070.0.7.1 Section 23A of the Federal 20. For section 23A purposes, the definition for capital and
Reserve Act surplus includes the allowance for loan and lease losses.
Section 23A was enacted as part of the Banking BHC Supervision Manual June 1997
Act of 1933 (the Glass-Steagall Act) for state Page 45
the issuance by a bank of a guaranty, accep- ingly, the nonbank affiliate must have ade-
tance, or letter of credit, including an endorse- quate and independent working capital to fund
ment or standby letter of credit, on behalf its operations.
of an affiliate (A letter of credit might be
posted by the bank to cover an excessive The Board stated that if the bank followed
number of GNMA pools that lack final pool these procedures, then the bank would be taking
certification.). advantage of an individual investment oppor-
tunity and thus should be exempt from sec-
The examiner should determine the banks tion 23A. However, the Board was concerned
method for identifying covered transactions and that the bank should not be allowed to set up a
applying the quantitative limits for section 23A business relationship with any affiliate which
purposes. If a covered transaction is found that could create the opportunity for the bank, at
exceeds these quantitative limits, either on an some time in the future, to engage in unsafe
individual or an aggregate basis, an apparent transactions because the bank felt impelled by
violation of section 23A has occurred. All such an improper incentive to alleviate the working-
apparent violations of law should be discussed capital needs of the affiliate. Accordingly, the
with management and cited in the report. banks transactions with the affiliate should not
Particular attention should be paid to inter- be of such a volume as to create pressure on the
company asset transfers and funding arrange- bank to relax its sound credit judgment concern-
ments to determine whether they constitute ing the individual loans involved and thereby
covered transactions under section 23A. In result in an inappropriate risk to the soundness
Interpretation 250.250 (12 C.F.R. 250.250) 21 the of the bank.
Board determined that a member banks pur-
chase, without recourse, and at face value, of a
mortgage note, or a participation therein, from a 3070.0.7.1.2 Collateral Requirements
mortgage banking subsidiary of the parent bank
holding company, which had no financial inter- In addition to the quantitative restrictions, cer-
est in the underlying asset on which it had tain covered transactions between a bank and an
granted credit through the note, did not involve affiliate must also be secured at the time of the
a loan or extension of credit22 from the transaction by collateral having a certain market
member bank to the seller of the mortgage note value. Unless otherwise exempted, covered trans-
within the meaning of section 23A if actions that must be adequately secured include
loans or extensions of credit, guaranties, accep-
the member banks commitment to purchase tances, and letters of credit issued on behalf of
the loan or participation therein was obtained the affiliate.
by the affiliate within the context of a pro- Collateralization requirements range from
posed transaction or series of proposed trans- 100 percent to 130 percent depending on the
actions in anticipation of the affiliates com- type of collateral used. Acceptable forms
mitment to make such loan(s), of collateral include U.S. government or U.S.
the commitment to purchase the loan was governmentguaranteed obligations, instru-
based on the banks independent credit evalu- ments that are acceptable at the Federal Reserves
ation of the creditworthiness of the mort- discount window, bank deposits that are segre-
gagor(s),23 and gated into accounts specifically earmarked for
there could be no blanket advance commit- this purpose, other debt instruments, stock, leases,
ment by the member bank to purchase a stipu- or other real or personal property. According to
lated amount of loans that bore no reference an August 31, 1987, Board interpretation (at
to specific proposed transactions. Accord- FRRS 31164.3), mortgage-servicing rights do
not constitute a permissible form of collateral
for purposes of section 23A because of (1) their
21. See also Federal Reserve Regulatory Service, 31133.
22. Under section 23A, as amended by the GarnSt Germain
inherent volatility, making it difficult to accu-
Act in 1982, a member banks purchase of a loan from its rately value the rights, and (2) the need to secure
nonbank affiliate that was made to an unaffiliated party is now permission to transfer servicing rights from the
considered a purchase of an asset from the affiliate unless it is legal owner of the underlying mortgage.24
excepted under interpretation 250.250.
23. Dual employees may not be used to satisfy the indepen-
dent credit evaluation requirement.
BHC Supervision Manual June 1997 24. Item (2) refers to the banks ability to sell the mortgage-
Page 46 servicing rights if the affiliate defaults on its loan.
An example of a covered transaction that is immediate credit given to an affiliate for

subject to both the quantitative restrictions and uncollected items received in the ordinary
the collateral requirements of section 23A would course of business
be an overdraft in the mortgage companys loans, extensions of credit, guaranties, accep-
checking account with an affiliate bank, which tances, or letters of credit issued on behalf of
is considered an extension of credit. A line of the affiliate that are fully secured by obliga-
credit by a bank to a nonbank affiliate also tions issued or guaranteed by the U.S. govern-
constitutes a covered transaction. It is important ment or a segregated earmarked account in
to remember that the full value of the line, not the bank
just the portion drawn down, must satisfy the the purchase of assets having a readily and
quantitative and the collateral requirements of identifiable market price at the time of
section 23A at all times. The examiner should purchase
review checking accounts and funding arrange- transactions that are deemed to be in the pub-
ments to ensure that the appropriate level and lic interest and consistent with the purposes of
type of collateral is maintained. Collateral val- the act
ues should be monitored regularly so that depre-
ciated or matured collateral is replaced as needed. Internal controls should be in place to ensure
that all transactions are adequately reviewed.
Documentation should be maintained for inter-
3070.0.7.1.3 Prohibited Transactions company transactions that are exempted from
the requirements of section 23A.
In addition to the quantitative and collateral
requirements, section 23A also prohibits certain
affiliate transactions altogether. Most impor-
tantly, a bank and its subsidiaries may not pur- 3070.0.7.2 Section 23B of the Federal
chase a low-quality asset (generally a classified Reserve Act
or past-due asset) from an affiliate or accept a
low-quality asset as collateral for a loan. Sec- The Competitive Equality Banking Act of 1987
tion 23A also requires that all covered transac- amended the Federal Reserve Act to add a new
tions be conducted on terms that are consistent provision, known as section 23B. In general,
with safe and sound banking practices. section 23B provides that covered transactions
between a bank and its affiliates must be on
terms and under circumstances, including credit
3070.0.7.1.4 Exemptions from standards, that are substantially the same or at
Section 23A of the FRA least as favorable to the bank as those prevailing
at the time for comparable transactions with or
As mentioned previously, several types of inter- involving nonaffiliated companies. If no compa-
company transactions are exempted from the rable transactions exist, the transaction must be
requirements of section 23A. For example, trans- on terms and under circumstances, including
actions between banks in which 80 percent or credit standards, that in good faith would be
more of each banks stock is owned by the same offered to or applied to nonaffiliated companies.
bank holding company (so-called sister banks) A bank is also generally prohibited from pur-
are exempt from most provisions of sec- chasing as a fiduciary securities or assets from
tion 23A.25 Other transactions that are exempt an affiliate except under specified circum-
include the following: stances. Finally, a bank and its affiliate may not
advertise or enter into an agreement that sug-
deposits received from the affiliate during the gests the bank is in any way responsible for the
ordinary course of business (checks in the obligations of the affiliate.
process of collection) Section 23B applies to any covered transac-
tion with an affiliate, as that term is defined in
25. Foreign banks do not qualify as sister banks for sec-
section 23A. However, section 23B excludes
tion 23A purposes. These transactions are still subject to the banks from the term affiliate. Therefore, trans-
prohibition against the purchase of low-quality assets and to actions between sister banks and banks that are
the requirement that covered transactions be on terms and part of a chain banking organization are exempt
conditions that are consistent with safe and sound banking
practices. It should also be noted that federal savings banks
from section 23B.
do qualify for the sister-bank exemption if all banks in the
corporate chain have met their fully phased-in capital guide- BHC Supervision Manual June 1998
lines, as provided for in the Home Owners Loan Act. Page 47
3070.0.7.3 Management and Service Fees sive dealing arrangements.26 The tying restric-
tions, which have the greatest effect on industry
The Federal Reserve Systems 1979 policy practices, prohibit a bank from restricting the
statement on diversion of bank income practices availability or varying the consideration for one
is intended to prevent excessive or unjustifiable product or service (the tying product) on the
management or service fees, as well as any condition that a customer purchase another prod-
other unwarranted payments or practices that, uct or service offered by the bank or by any of
by diverting bank resources to the parent com- its affiliates (the tied product).
pany or a nonbank affiliate, may have an Section 106 was adopted in 1970 when Con-
adverse financial impact on a subsidiary (pay- gress expanded the authority of the Board to
ing) bank (see section 2020.6). Diversion of approve proposals by bank holding companies
income practices with respect to a mortgage to engage in nonbanking activities. The provi-
banking company might potentially include, but sions of section 106 were based on congres-
are not limited to sional concern that banks unique role in the
economy, in particular their power to extend
servicing fees, or other payments assessed by credit, would allow them to create a competitive
the mortgage banking company and paid by advantage for their affiliates in the new, non-
the bank that bear no reasonable relationship banking markets that they were being allowed
to the fair market value, cost, volume, or to enter.27 Congress therefore imposed special
quality of services rendered by the nonbank limitations on tying by banksrestrictions
subsidiary in its role as servicer and/or seller; beyond those imposed by the antitrust laws.
balances maintained by the bank primarily in Section 106 is a broader prohibition; unlike the
support of mortgage banking company bor- antitrust laws, a plaintiff in action under sec-
rowings without appropriate compensation to tion 106 need not show that (1) the seller has
the bank; market power in the market for the tying prod-
uct, (2) the tying arrangement has had an anti-
prepayment of fees to the mortgage banking competitive effect in the market for the tied
company for services not yet rendered; product, or (3) the tying arrangement has had a
nonreimbursed origination fees, marketing substantial effect on interstate commerce.
costs, or other expenses incurred by the bank Section 106 applies only when a bank offers
that primarily support the mortgage banking the tying product.28 The Board has authority to
companys activities; and grant exceptions to section 106, which it has
loan repurchase agreements between the bank used to allow banking organizations to package
and the mortgage banking company while the their products when doing so would benefit the
mortgage banking company is processing loans organization and its customers without anticom-
in the mortgage pipeline. petitive effects.
Purchase and funding agreements should ade-

quately itemize and document the types of ser- 3070.0.7.4.1 Section 225.7(d) of
vices provided and the basis for fees. Billing Regulation Y
statements and other documentation should
clearly evidence that fees actually charged and The Board originally extended section 106, which
paid are reasonable and consistent with regula- covers tying arrangements by banks only, to
tory policy requirements as described. cover nonbank affiliates and bank holding com-
panies. The Board rescinded this extension of
the statute effective April 21, 1997. Thus, unless
3070.0.7.4 Tie-In Considerations of the subject to another exemption, section 106
BHC Act prohibits
Section 106 of the BHC Act Amendments of a bank from telling a customer that it can only
1970 contains five restrictions intended to pro- receive a loan (or a discount thereon) if it
hibit anticompetitive behavior by banks: two purchases another product from the bank; and
prohibit tying arrangements; two prohibit reci-
procity arrangements; and one prohibits exclu-
26. 12 U.S.C. 1972.
BHC Supervision Manual June 1998 27. See S. Rep. No. 1084, 91st Cong., 2d Sess. (1970).
Page 48 28. See 1997 FRB 275.
a bank from telling a customer that it can only 3070.0.7.4.3 Foreign Transactions Under
receive a loan (or a discount thereon) if it Section 106
purchases another product from an affiliate of
the bank. The Board has adopted a safe harbor from
the anti-tying rules for transactions with corpo-
Section 106 and the Boards regulation allow rate customers that are incorporated or other-
wise organized and that have their principal
a broker-dealer affiliate to tell a customer that place of business outside the United States, or
it can only receive placement services (or a with individuals who are citizens of a foreign
discount thereon) if it obtains a loan from an country and are not resident in the United States.
affiliated bank; and However, the safe harbor would not protect
a broker-dealer affiliate to tell a customer that tying arrangements in which the customer is a
it can only receive placement services (or a U.S.-incorporated division of a foreign com-
discount thereon) if it obtains a loan from a pany. Furthermore, the safe harbor would not
nonbank affiliate. shelter a transaction from other antitrust laws if
they were otherwise applicable.33
These distinctions make sense if one keeps in
mind the concern of the statute: banks (not
nonbanks) have special power over credit and, 3070.0.7.4.4 Technical Change
thus, are able to induce or coerce their custom-
ers into purchasing products that they would The Board also has adopted a definition of
otherwise prefer not to purchase or to purchase bank for purposes of the anti-tying rules. The
from someone else.29 definition clarifies that any exemptions afforded
to banks generally also would be applicable to
credit card and other limited-purpose institu-
3070.0.7.4.2 Interaffiliate Tying tions and to U.S. branches and agencies of for-
Arrangements Treated the Same as eign banks.34
Intrabank Arrangements
Section 106 contains an explicit exception (the 3070.0.7.5 Inspection Objective
statutory traditional bank product exception)
that permits a bank to tie any product or service 1. To evaluate transactions between a mort-
to a loan, discount, deposit, or trust service gage banking company organized as a direct
offered by that bank.30 For example, a bank subsidiary of a bank holding company and affili-
could condition the use of its messenger service ated banks for compliance with federal laws and
on a customers maintaining a deposit account regulations, and related policy guidance.
at the bank. Although the statutory traditional
bank product exception appears to have been
effective in preserving traditional relationships 3070.0.7.6 Inspection Procedures
between a customer and bank, the exception is
limited in an important wayit does not extend 1. Review managements method for moni-
to transactions involving products offered by toring and identifying section 23A and 23B
affiliates. covered transactions and applying the quantita-
The Board has adopted a regulatory tradi- tive limitations. Determine whether
tional bank product exception that extends the a. all covered transactions have been
statutory exception to transactions involving identified;
affiliates.31 Although the Board has previously b. quantitative limits are calculated
limited the scope of this extension, interaffiliate correctly;
arrangements are now exempt to the same extent c. covered transactions, including any
as intrabank arrangements.32 overdrafts and lines of credit, meet both the
providing to the bank some product or service related to and

29. The Boards rule also includes a limited prohibition on
usually provided in connection with a loan, discount, deposit,
tying arrangements involving electronic benefit transfer ser-
or trust service (12 U.S.C. 1972(1)(C)).
vices (12 C.F.R. 225.7(d)).
33. See 12 C.F.R. 225.7(b)(3).
30. 12 U.S.C. 1972(1)(A).
34. See 12 C.F.R. 225.7(e).
31. See 12 C.F.R. 225.7(b)(1).
32. A similar action was taken for interaffiliate reciprocity
arrangements, in which section 106 permits a bank to condi- BHC Supervision Manual December 2000
tion the availability of a product or service on the customers Page 49
quantitative limits and collateral requirements against stipulated public benefits cited in Board
of section 23A; and orders, and reviews of various activities for
d. adequate collateral values have been technical compliance.
maintained over the life of the covered transac- While not specifically detailed in this guid-
tions (For example, collateral is maintained for ance, the examiner may find it necessary to
the full amount of any credit lines with the conduct a review of the companys ledgers and
bank, and any depreciated or matured collateral accounts that is sufficient to disclose possible
has been replaced as required.). impermissible activities and potential violations
2. Review purchase and funding contracts of law. The audit function, both internal and
between the mortgage banking company and the external, should not be solely relied on for this
bank, as well as the substance of actual transac- disclosure because the auditors program may
tions, to determine that emphasize other areas of concern. As a nonbank
a. asset purchases by the bank are either subsidiary of a bank holding company, refer-
within the quantitative limits of section 23A or ence should be made to part 225 of the Code of
meet the exemption requirements of C.F.R. sec- Federal Regulations (such as section 225.28(b)
tion 250.250, of Regulation Y) and other relevant sections
b. all purchases are at fair market value thereof.
and consistent with market terms as required by Concurrent with the review of assets for credit
section 23B, quality, the examiner should undertake a review
c. no low-quality assets were transferred of asset-related activities for compliance with
to the bank since the previous inspection, the subsidiarys approval orders. In mortgage
d. the method of compensating the bank banking firms, it is possible that the company is
for balances maintained and net interest income engaging unknowingly in certain impermissible
earned on warehouse loans or lines is reason- activities, such as those described by 12 C.F.R.
able and based on market terms. 225.126 (i.e., real estate brokerage, land devel-
3. Review servicing contracts between the opment, real estate syndication, and property
mortgage banking company and the bank, as management) and those deemed impermissible
well as the substance of actual transactions, to by Board order (see sections 3000.0.4 and 3700.0
determine to 3700.12). The Board of Governors has ruled
a. the capacity in which the affiliate is (1972 FRB 429) that the purchase and develop-
acting (for example, is it acting as principal on ment of land for sale to third parties constitutes
its own behalf or as an agent for the affiliate land development by a nonbank subsidiary. How-
bank?); ever, the completion of a foreclosed property to
b. the nature of all services provided; and facilitate the recovery of funds advanced under
c. billing arrangements, the frequency of the loan appears to be permissible, provided that
billing, the method of computation, and the the additional work brings the project underway
basis for such fees. at foreclosure up to a saleable condition. The
4. Review the bank holding companys pol- Board has also ruled that property management
icy statement on the prohibition of tie-in for third parties is impermissible (1972 FRB
arrangements, the adequacy of training provided 652). However, property management as a fidu-
to employees, and whether its respective subsid- ciary, for operating premises of affiliates, or for
iaries are in full compliance with internal policy. properties acquired for debts previously con-
tracted (DPC) is permissible. In addition to the
other impermissible activities, engaging in real
3070.0.8 REGULATION Y estate joint ventures has also been ruled imper-
COMPLIANCE missible. If such impermissible activities are
found, they represent violations and should be
During the course of the on-site inspection, the appropriately treated. The servicing agreements
examiner is expected to conduct sufficient tests should be reviewed to determine that no addi-
and inquiries to determine whether the company tional liabilities, real or contingent, are imposed
is in compliance with Regulation Y and the act. on the company beyond its responsibilities as a
Such tests and inquiries would include a listing servicing agent.
of company offices which can be compared The usual source of growth in the servicing
with the approved offices, comparisons of credit- portfolio is the companys own origination
related insurance policies and rate schedules activity. However, it is not uncommon for a
company to supplement this growth with bulk
BHC Supervision Manual December 2000 purchases of serviced mortgages from other
Page 50 companies. Under certain circumstances, usu-
ally relating to the relative percentage of the Board also determined by regulation that per-
sellers portfolio, these transactions may not forming real estate appraisals is an activity that
comply with 12 C.F.R. 225.132. Since these is usual in connection with making, acquiring,
transactions may represent the effective acquisi- brokering, or servicing loans or other extensions
tion of a going concern subject to prior approval of credit. (See 12 C.F.R. 225.28(b)(2)(i).) The
by the Federal Reserve System, servicing port- Board had not specifically addressed whether
folio acquisitions should be reviewed for providing flood zone determinations is an activ-
compliance. ity that is usual in connection with lending
Section 225.22(d)(1) of Regulation Y pro- activities.
vides an exemption from required Board The proposed flood zonedetermination ser-
approval for DPC property acquired in good vices are considered to be a necessary aspect of
faith and divested within two years of acquisi- mortgage lending in the United States. As noted,
tion. The Board may permit additional exten- federal law prohibits a federally regulated lender
sions that can result in the property being held from making, increasing, extending, or renew-
by a bank holding company for a total of 10 years, ing a loan that is secured by improved real
if the property has value and marketability char- estate or a mobile home located in an area
acteristics similar to real estate. In conjunction designated by the Federal Emergency Manage-
with the review of real estate owned, the exam- ment Agency (FEMA) as a special flood hazard
iner should determine if any subsidiary holds area unless the borrower obtains flood insur-
title to any property that should have been dis- ance.36 (See 12 C.F.R. 208.25(c).) Further, fed-
posed of within the time limits of Regulation Y, eral law also provides that if a federally regu-
the book value of which has been reduced to lated lender determines, at any time during the
zero and the property is not disclosed on the life of a loan, that the improved real estate or
balance sheet. See section 3030.0 Acquisition mobile home securing the loan is located in a
of DPC Shares or Assets, for additional infor- special flood hazard area and is not covered by
mation on DPC property acquired. flood insurance, the lender must instruct the
Legal counsel representing a BHC requested borrower to obtain flood insurance and must
an opinion as to whether certain proposed flood purchase flood insurance on the borrowers behalf
zonedetermination activities, to be conducted if the borrower fails to promptly purchase the
through a majority-owed (50 percent) joint ven- required insurance. (See 12 C.F.R. 208.25(g).)
ture company, would be within the scope of In addition, federal law requires the Federal
activities related to extending credit as defined National Mortgage Association, the Federal Home
in section 225.28(b)(2) of Regulation Y. The Loan Mortgage Corporation, and the Govern-
BHC proposes to engage in a variety of lending- ment National Mortgage Association (the
related activities, including providing real estate government-sponsored enterprises or GSEs) to
appraisals and flood zone determinations. have procedures reasonably designed to ensure
The Board has determined, in section that flood insurance is in place where required at
225.28(b)(2) of Regulation Y, that it is permis- the initiation of, and during the lives of, the
sible for bank holding companies to engage in mortgage loans they purchase. (See 12 U.S.C.
[a]ny activity usual in connection with mak- 4012a(b).) The GSEs meet this requirement by
ing, acquiring, brokering, or servicing loans or requiring lenders that sell loans to them, and
other extensions of credit, as determined by the companies that service loans for them, to moni-
Board.35 (See 12 C.F.R. 225.28(b)(2).) The tor on an ongoing basis the flood zone status of
any loans sold to, or serviced for, the GSEs. To
35. The Gramm-Leach-Bliley Act (the GLB Act) amended comply with the requirements of federal law
the Bank Holding Company Act to limit bank holding compa- and the GSEs, mortgage lenders must obtain an
nies that are not financial holding companies to engaging only initial flood zone determination before the origi-
in activities which had been determined by the Board by
regulation or order under this paragraph as of the day before
the date of the enactment of the Gramm-Leach-Bliley Act on
36. Statutory authority to issue flood insurance policies
November 12, 1999, to be so closely related to banking as to
under the National Flood Insurance Program (NFIP) expired
be a proper incident thereto (subject to such terms and condi-
on December 31, 2002, after Congress adjourned without
tions contained in such regulation or order, unless modified by
extending the FEMA authority. On January 13, 2003, the
the Board) (12 U.S.C. 1843(c)(8)). Before November 12,
National Flood Insurance Program Reauthorization Act was
1999, the Board had determined that [a]ny activity usual in
approved, extending the authorization of the NFIP to Decem-
connection with making, acquiring, brokering, or servicing
ber 31, 2003; this authorization was also made retroactive to
loans or other extensions of credit, as determined by the
December 31, 2002.
Board was closely related to banking. Accordingly, the
Board retains authority after the GLB Act to define the scope
of this section 4(c)(8) activity and to modify the terms and BHC Supervision Manual June 2003
conditions that apply to the activity. Page 51
nation of each mortgage loan and must take ing the material available at the parent company
steps to monitor, throughout the life of the loan, level, including the audit review, a decision
the flood zone status of any improved real estate whether or not to go on-site is in order. Some of
or mobile home collateral securing the loan.37 the determinants of this decision would include
The joint venture company proposes to pro- relative size, current earnings performance, over-
vide initial flood zone determinations to mort- all contribution to the corporations condition,
gage lenders and to provide mortgage lenders asset quality as indicated by nonaccrual and
with ongoing flood zonetracking services with delinquency reports, the level of risk exposure
respect to their mortgage loans. The companys to the organization (see section 4030.2), and the
activities would be limited to making determina- condition of the company when last inspected.
tions as to whether particular parcels of real From the information provided, it might be
estate are in designated flood zones, preparing determined that the company is operating prop-
the FEMA standard flood zonedetermination erly and is in sound condition. In such a case, an
form, and communicating flood zone determina- on-site inspection may not be warranted. Con-
tions to customers. The company committed to versely, a deteriorating condition might be
not be involved in placing, underwriting, or detected that would require a visit, even though
issuing flood insurance or in the collection of a satisfactory condition had been determined
flood insurance premiums. The proposed flood during the previous inspection. Mortgage sub-
zone determinations would be provided in con- sidiaries in unsatisfactory condition should be
nection with providing real estate appraisals and inspected each time the parent company is
as a separate service. In addition, the joint ven- inspected. All significant mortgage banking sub-
ture company may assist customers who wish to sidiaries should be fully inspected at least once
request that FEMA amend its flood maps to every three years.
remove a property from a designated special
flood hazard area.
The proposed flood zonedetermination ser-
vices were found to be an essential part of
mortgage lending, designed to assist mortgage
lenders in complying with the requirements of
federal law and the GSEs. The services gener-
ally would be provided to mortgage lenders,38
thus usual in connection with making mortgage
loans. Board staff therefore issued the opinion
on July 9, 2002, concluding that the proposed
flood zonedetermination services are within the
scope of permissible activities related to extend-
ing credit under section 225.28(b)(2) of Regula-
tion Y (12 C.F.R. 225.28(b)(2)).
3070.0.9 ON-SITE INSPECTION OF

MORTGAGE BANKING
SUBSIDIARIES
Scheduling of on-site inspections of mortgage
banking nonbank subsidiaries of bank holding
companies should be done in accordance with
the Board policy for frequency and scope of
inspections. (See section 5000.0.2.) After review-
37. Lenders are specifically permitted to charge a reason-

able fee to borrowers for flood zone determinations and
life-of-the-loan tracking. For example, see 12 C.F.R. 208.25(h).
38. It was represented that the joint venture company
would only market its services to mortgage lenders and that it
would rarely provide services to nonlenders.

Page 52
Loans to affiliates 371c

section 23A of the FRA
Restrictions on 371c 371c

transactions with
affiliates
Purchase of affiliates notes 31131

from a third party
Activities not closely 225.126 4184

related to banking
Acquisition of assets 225.132 4175.1
Purchase by member bank 250.250 31133

of loans originated by a
mortgage banking firm
Mortgage companies 225.122 4196

acquired under sections
4(c)(1) or 4(c)(8) of the act
Activities closely related 225.131 4176

to banking
Investments in community 225.127 4178

welfare projects
Staff opinion on engaging in 225.28(b)(2) 4318.4

certain proposed flood
zonedetermination activities

Page 52.1
3070.0.11 APPENDIX AFIRST DAY LETTER
FEDERAL RESERVE BANK

OF BOSTON
P. O. BOX 2076
BOSTON, MASSACHUSETTS 02106-2076
June 15, 19x9

Mr. John Doe
President
XYZ Mortgage Bank Corporation
Boston, Massachusetts 02107
Dear Mr. Doe:
In conjunction with the inspection of the XYZ Bank Holding Company, we plan to begin an
inspection of XYZ Mortgage Bank Corporation on July 15, 19x9. To facilitate this inspection,
please provide a copy of or make available the following information relative to your organizations
mortgage banking activities. Information should be as of xx/xx/xx and should be delivered to the
examiner-in-charge as soon as it is available. Whenever possible, standardized management reports
should be provided. Please include the name and telephone extension of the appropriate persons to
contact, by department, if additional information is necessary.
Board Oversight and Management

1. Provide a listing of the mortgage banking companys board of directors that includes each
individuals name, place of employment, title and position, age, management responsibilities (if
any), and the length of time he or she has served on the board.
2. List significant management and board committees and have minutes from these meetings
available for examiner review. Provide a copy of standardized reports that are provided before
each meeting.
3. Provide an organizational chart that highlights individuals who are responsible for the follow-
ing functional areas: production, warehousing and funding, marketing, servicing, finance,
mortgage-servicing asset (MSA) valuations, internal audit, quality control, loan review, compli-
ance, and legal. Include biographies and salary information.
4. Describe any organizational changes that have taken place at the mortgage banking company
since xx/xx/xx, including any mergers, acquisitions, or consolidation of mortgage banking
activities. Describe any management changes at or above the senior vice president level and
provide details on managements new responsibilities.
5. Provide a copy of standardized management reports that are used to monitor compliance with
established policies, operating procedures, and controls within each functional area.
6. Provide a copy of the mortgage banking companys most recent operating budget and its
long-term strategic plan. Evaluate how interest-rate movements, competition, and other external
factors have affected product mix, staffing levels, and the allocation of capital.
7. Describe the internal control environment and the internal control programs that are in place
within the mortgage banking company. Have available for examiner review the following
reports that were conducted since xx/xx/xx:
a. internal and external audits
b. loan reviews

Page 53
c. internal control and compliance audits completed by or on behalf of agencies such as HUD,
FHA, GNMA, FannieMae, FHLMC, state agencies, and private investors
Also have available managements response to each report and the most recent copy of any
management reports that monitor the status of outstanding issues or problems.
8. Provide an organization chart for the internal audit department. Indicate the scope and
frequency of internal audits for the mortgage banking company, highlighting any weaknesses or
problem areas noted. Upon request, make internal audit workpapers available for examiner
review.
9. Provide an organization chart for the loan review department. Indicate the scope and frequency
of loan reviews for the mortgage banking company, highlighting any weaknesses or problem
areas noted. Upon request, make loan review workpapers available for examiner review.
10. Provide details on the nature and scope of the quality control program for loans originated
and/or serviced for investors. Include an organization chart for the unit(s) involved in such
activities, details on any outsourcing programs used since the previous inspection, copies of
quality control reports submitted to senior management, and management responses.
11. Describe the method for ensuring compliance with state and federal laws and regulations. Make
available for examiner review the procedures manual, work programs, and workpapers com-
piled by the person/department responsible for compliance.
12. Describe the insurance coverage in effect for the mortgage banking company and its officers
and the date it was last reviewed by the board of directors.
13. Recap all mortgage bankingrelated legal claims/lawsuits in excess of $1 million. Indicate the
nature of any legal reserve that is maintained and the method used to assess reserve adequacy.
14. Describe the system for logging, tracking, and responding to customer complaints. The
customer complaint file should be made available for examiner review while on-site.
15. Provide a copy of the disaster recovery plan and describe safeguards in place to protect loan
documents and data processing input records.
Production and Correspondent Lending Data
16. Provide detailed organization charts for departments within the company which relate to the
production function (i.e., retail originations, wholesale purchases, processing, underwriting,
closing, shipping).
17. Provide information on the total number and dollar amount of loans generated by the following
sources during the two most recent fiscal years and the interim year-to-date period. For
purchased loans, please specify the method of purchase (i.e., bulk versus flow), program name,
and amount subject to recourse back to either the seller or the investor):
a. originated by the mortgage banking company
b. purchased from affiliates
c. purchased from nonaffiliated third parties
18. Provide written policies and procedures manuals that describe traditional and nontraditional
mortgage products, underwriting standards, closing and funding procedures, exception report-
ing practices, management and employee compensation methods, and training programs for
loan production personnel. State methods used to establish ongoing compliance with written
policies and procedures and provide copies of relevant management exception reports.
19. Describe the credit approval process used for in-house originations. Include information on rate
commitment options extended to the borrower, the average length of the commitment period,

Page 54
controls that are in place to monitor fallout caused by processing backlogs, and procedures for
expired commitments.
20. Provide details on the correspondent lending program, including a list of approved institutions
and copies of the most recent loan-quality reports. Describe the credit review process before
purchase and any controls that are in place to protect the mortgage banking company against
future losses on loans purchased from affiliates and from correspondents.
21. Determine whether rate-locks are provided to correspondents on best effort production pro-
grams. What methods are used to verify reported loan fallout?
22. Provide information on the average income and cost per origination and compare with industry
standards. Describe the method of accounting used for origination fees and other related
noninterest income and expenses.
23. If the mortgage banking company is a subsidiary of a state member bank or sells loans to a bank
affiliate that is subject to Regulation O, furnish a list of extensions of credit to an executive
officer, director, or principal shareholder (as defined in section 215.2 of Regulation O) of
a. the state member bank;
b. a bank holding company of which the state member bank is a subsidiary;
c. any other subsidiary of that bank holding company;
d. a company controlled by an insider, as defined by Regulation O; and
e. a political or campaign committee that benefits or is controlled by an insider as defined by
Regulation O.
For all such extensions of credit, include the amount, date the loan(s) was originated or
renewed, interest rate, collateral requirements, total amount of loans outstanding to that
individual or company, and date of approval by the board of directors. Also include the
aggregate amount of loans outstanding to all such insiders as of the inspection date in relation to
the banks unimpaired capital and unimpaired surplus as defined in Regulation O. (See
subsection 2050.0.3.2.)
Marketing and Hedging Data
24. Provide detailed organization charts for departments within the company that relate to the
marketing and hedging functions. Describe managements roles and responsibilities with
respect to the sale of loans in the secondary market, asset securitization, funding, liquidity risk
management, interest-rate risk management, and interaction with the asset/liability management
function at the parent company.
25. Provide a copy of written policies and procedures used to hedge interest-rate risk associated
with the pipeline and closed-loan warehouse. Describe any parameters and limits that are in
place and provide a list of securities dealers with whom management is authorized to conduct
business.
26. Provide management reports on pipeline and closed-loan (warehouse) inventory volume, mix,
yield, age, and turnover as of the inspection date. Describe the method used to project fallout
and any models that are used to determine the sensitivity of the pipeline to interest-rate
fluctuations.
27. Indicate the methods used to securitize loans for sale in the secondary market, including the use
of third-party guaranties and other forms of credit enhancement. Are securities generally sold or
retained on the balance sheet?
28. Provide information on the number and volume of securities that lacked final pool certification
as of the inspection date. State whether this volume is in compliance with investor guidelines. If

Page 55
applicable, indicate whether the requirements for obtaining a letter of credit or other guaranty
have been satisfied.
Servicing Data
29. Provide a detailed organization chart for the servicing department.

30. List subservicers and vendors who are employed to perform servicing functions. Briefly
describe the nature of the services provided.
31. Indicate whether any contracts with subservicers and/or vendors have been terminated for cause
since the prior inspection.
32. Provide the monthly servicing management reports since the prior inspection, including the
number of loans serviced, dollar volume, and composition of the servicing portfolio in terms of
product mix, average loan size, weighted average coupon rates, weighted average maturities,
geographic location, and delinquencies and foreclosures.
33. Provide a list of investors for whom servicing was performed as of the most recent quarter-end.
Identify any recourse or repurchase provisions and/or forbearance requirements.
34. State whether any investors have terminated servicing contracts with the mortgage company
and/or its affiliates for cause since the prior inspection, or if any are likely to be terminated in
the near future.
35. Provide a list of all major bulk purchases and sales of servicing since the prior inspection.
Identify the terms of each sale and any resulting gains or losses.
36. Provide a list and aging of all outstanding advances to investors as of the date of inspection.
37. Provide access to the servicing policies and procedures manual. Indicate the frequency with
which manuals are updated. How does management ensure that subservicers and vendors
comply with these same policies and procedures?
38. Provide a servicing-fee schedule (in basis points) for conventional, government, and nontradi-
tional loans serviced for third parties.
39. Provide copies of management reports used to track portfolio runoff.
40. Provide a loan delinquency report segmented into 30, 60, 90, 120, and 180 foreclosure
categories. Indicate the volume and number of loans in each segment by loan type. Also include
information on the number and dollar volume of delinquent loans that were purchased out of
investor pools.
41. Detail the number and dollar volume of other real estate (ORE) parcels segregated by
company-owned and investor-owned. Provide a list of loans in foreclosure for which action has
been delayed, if applicable.
42. Provide access to the customers complaint file so that examiners can review it while on-site.
Financial Data
43. Provide copies of the Report of Condition and Income and/or Y-series report that was filed by
the mortgage banking company for the two previous fiscal years and the most recent interim
period.
44. Provide an internally prepared balance sheet and income statement that reconcile with the most
recent Report of Condition and Income and/or Federal Reserve Board Y-series report.

Page 56
45. Provide the latest published financial statements, if applicable, including the annual report, SEC
10K, 10Qs, and any press releases.
46. Provide copies of the accounting policies pertaining to mortgage loans, securities, and other
assets held for sale and held for investment. Also provide copies of management reports that
monitor compliance with SFAS No. 115 (securities), the current SFAS No. 65 (loans), SFAS
No. 125 (mortgage-servicing assets), and internal policies as of the close of business of the
most recent quarter.
47. Provide details on all formal and informal funding mechanisms, including but not limited to
repurchase agreements, commercial paper programs, and debt issuance facilities. Indicate the
counterparties, where applicable; the amount uncommitted; and the amount outstanding under
each facility as of the close of the most recent quarter. Provide copies of all formal and informal
written agreements.
48. Provide copies of credit agreements for all funding lines from affiliated and nonaffiliated
institutions. Describe methods used to monitor the credit quality of all funding sources. The
following information should be included:
a. lending bank (include copies of confirmation letters)
b. total credit line
c. amount in use as of the inspection date
d. amount available for use and by whom
e. expiration date
f. compensating balance and/or fee arrangements
g. purpose
h. whether the credit lines are contractual obligations of the lenders
i. reciprocity arrangements, if any
j. collateral requirements
k. legal opinions evidencing compliance with sections 23A and 23B of the Federal Reserve
Act, as amended
49. Provide copies of any contingency planning documents that outline alternative courses of action
should the condition of traditional funding sources deteriorate.
50. Provide a copy of any standardized financial presentations made to the executive management
team and to the board of directors.
51. Provide a copy of standardized management reports used to measure and track the quality of
originated, purchased, and serviced assets. Include an aging report that identifies loans that are
past due 30, 60, 90, 120, and 180 or more days and indicate whether such loans are held for
sale, held for investment, or serviced for investors.
52. Provide a copy of internal policies that apply to loans held for investment. Indicate the date
each loan that was on the books as of the most recent quarter-end was transferred to this
account, its amortized cost, market value, and any write-downs or adjustments to yield at the
date of transfer. Indicate the person responsible for reviewing these loans for collectibility, the
frequency of such reviews, and any adjustments or write-downs taken over the past year.
53. Provide detail pertaining to the transfer or sale of assets between the nonbank mortgage banking
company and affiliated entities since the last inspection and that supports the FR Y-8 Reports.
Also provide related documentation evidencing methods for asset valuation and credit-quality
determination.
54. Provide detail on the allowance for loan and lease losses, contra asset valuation allowances, and

Page 57
other reserve accounts as of xx/xx/xx (fiscal) and xx/xx/xx (interim). For each account in use,
provide a copy of the most recent analysis and a description of the applicable loan and other
losses provisions reserving methodology.
55. Provide a copy of the companys policy with respect to real estate appraisals.
56. Provide a copy of management reports that are used for liquidity, funding, and asset/liability
management. If these activities are coordinated with affiliate bank or parent bank holding
company personnel, provide copies of the information that is routinely provided.
57. Indicate the method for assessing capital adequacy at the mortgage company level. Provide a
copy of the companys capital and dividend policies, as well as a list of dividends paid to
shareholders during the two previous fiscal years and the most recent interim period. Are any
changes in the level of dividends planned or anticipated?
Mortgage-Servicing Assets
58. Provide an organization chart highlighting those areas and individuals responsible for the
recording, measurement, and impairment testing for originated and purchased mortgage-
servicing rights (MSAs).
59. Provide an inventory listing of all MSAs as of the close of business of the most recent quarter.
60. Discuss the various loan-origination and -purchase programs that give rise to MSAs; the
method for calculating and communicating the price paid to correspondents and brokers for
service release premiums; whether MSAs are recorded on table-funded loans; and the details on
any bulk purchases since the previous inspection, including the price paid and yield realized.
61. Discuss the various loan-sale programs that give rise to MSAs, the method for calculating and
recording the initial value of MSAs.
62. Provide a copy of detailed written policies and procedures regarding the initial recording,
amortization, and periodic revaluation and impairment testing for MSAs. Indicate the manage-
ment and/or board committee responsible for approving such policies and the date of last
approval.
63. Provide detailed information on any valuation models used for MSA revaluations and a copy of
the output as of the most recent quarter-end. Indicate whether such revaluations are performed
in-house or by an outside vendor and the frequency of such revaluations.
64. Reconcile fair market values of MSAs to their respective book values as of the most recent
quarter-end. Provide a copy of management reports and related journal entries used to record
amortization adjustments and/or write-downs.
65. Provide copies of worksheets used to calculate the amount of MSAs included in Tier 1 capital
for regulatory reporting purposes as of the most recent quarter-end.
66. Furnish copies of any management reports or presentations to the board of directors or a
committee thereof regarding the risk characteristics of MSAs, business risk analysis, and
methods used to hedge the interest-rate and prepayment-rate risks associated with capitalized
MSAs.
67. Provide an organization chart highlighting those areas and individuals responsible for hedging
the interest-rate and prepayment-rate risk associated with MSAs.
68. Provide information on any financial instruments used to hedge interest-rate and prepayment-
risk associated with MSAs. Include a detailed prospectus on any customized hedge products
that are purchased from investment bankers and a statement from either internal or external
accountants on whether such instruments qualify for hedge accounting treatment under SFAS
No. 80.

Page 58
69. Provide a copy of management reports that identify the number of contracts or instruments
used, their current market value, and the degree of correlation between the hedge instrument
and the underlying MSAs being hedged. Such reports should demonstrate the effectiveness of
the hedge under varying market conditions.
70. Provide information on the number and dollar volume of servicing rights sold during the most
recent fiscal year and interim period.
71. If mortgage-servicing assets are sold, provide information on the number and dollar volume
sold during the most recent fiscal year and interim period.
72. Provide an organizational chart on a legal-entity basis that includes the bank holding company
and all directly held bank and nonbank affiliates.
73. If the mortgage banking company is a direct nonbank subsidiary of the bank holding company,
describe the method for identifying transactions that constitute covered transactions under
sections 23A and 23B of the Federal Reserve Act, as well as the method for applying
quantitative limits for section 23A and 23B purposes.
74. Provide a current listing of collateral that is maintained for covered transactions. Indicate
whether collateral is maintained for the full amount of any credit lines with the bank and
whether any depreciated or matured collateral has been replaced since the previous review.
75. Provide copies of any purchase and funding contracts between the mortgage banking company
and affiliated bank(s). Please address whether any or all of the following conditions are met
and/or provide written support, where applicable:
a. asset purchases by the bank have been reviewed by management and are either within the
quantitative limits of section 23A or meet the exemption requirements of section 250.250
b. all purchases are at fair market value and consistent with market terms as required by sec-
tion 23B
c. no low-quality assets were transferred to a bank affiliate since the previous inspection
d. the method of compensating bank affiliates for balances maintained by the parent company
or its nonbank subsidiaries and the net interest income earned on warehouse loans or lines is
reasonable and based on market terms
76. Provide copies of any servicing contracts between the mortgage banking company and affiliate
bank(s). If not so stated, indicate the following information:
a. the capacity in which the affiliate is acting (for example, is it acting as principal on its own
behalf or as an agent for the affiliate bank?)
b. the nature of all services provided
c. billing arrangements, the frequency of billing, the method of computation and the basis for
such fees
d. the date of last review and approval by the mortgage banking companys board of directors
77. Provide a copy of the bank holding companys policy statement on the prohibition of tie-in
arrangements, a description of training that is provided to employees in this area, and an
attestation as to whether the nonbank subsidiary is in full compliance with internal policy.
78. If the mortgage banking company charges management or other fees, describe the nature of the

Page 59
fees, the method of computation for such fees, and the settlement procedures. Include a listing
of fees charged for the prior two fiscal years and the most recent interim period.
79. Provide a copy of the bank holding companys intercompany tax allocation policy. Indicate the
amount and timing of intercompany tax payments and credits received during the two previous
fiscal years and the most recent interim period. If credits are due, please indicate the amount
owed to the subsidiary and the date the intercompany receivable originated.
Sincerely yours,
Vice President,
Federal Reserve Bank of Boston

Page 60
3070.0.12 APPENDIX BACCOUNTING LITERATURE

The following is a list of generally accepted Accounting standards may change over time.
accounting principles (GAAP) governing the Current accounting literature should be reviewed
mortgage banking industry that are in the form with management during each inspection.
of accounting standards and interpretations.
Statements of Financial Accounting Standards (SFAS)

SFAS No. 5, Accounting for Contingencies
SFAS No. 65, Accounting for Certain Mortgage Banking Activities, as amended
SFAS No. 77, Reporting by Transferors for Transfers of Receivables with Recourse
SFAS No. 80, Accounting for Futures Transactions
SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities
SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities
FASB Technical Bulletin

Technical Bulletin No. 87-3, Accounting for Mortgage Servicing Fees and Rights
Emerging Issues Task Force (EITF)

Issue No. 85-13, Sale of Mortgage Service Rights on Mortgages Owned by Others
Issue No. 85-26, Measurement of Servicing Fee under FASB Statement No. 65When a Loan Is
Sold with Servicing Retained
Issue No. 85-28, Consolidation Issues Relating to Collateralized Mortgage Obligations
Issue No. 86-38, Implications of Mortgage Prepayments on Amortization of Servicing Rights
Issue No. 86-39, Gains from the Sale of Mortgage Loans with Servicing Rights Retained
Issue No. 87-25, Sale of Convertible, Adjustable-Rate Mortgages with Contingent Repayment
Agreement
Issue No. 87-34, Sale of Mortgage Servicing Rights with a Subservicing Agreement
Issue No. 88-11, Allocation of Recorded Investment When a Loan or Part of a Loan Is Sold
Issue No. 89-4, Accounting for a Purchased Investment in a Collateralized Mortgage Obligation
Instrument or in a Mortgage-Backed Interest-Only Certificate
Issue No. 89-5, Sale of Mortgage Loan Servicing Rights
Issue No. 90-21, Balance Sheet Treatment of a Sale of Mortgage Servicing Rights with a
Subservicing Agreement
Issue No. 92-10, Loan Acquisitions Involving Table Funding Arrangements

Page 61
3070.0.13 APPENDIX CREGULATORY GUIDANCE

The following is a list of sections in this manual latory guidance also evolves over time. This list
that examiners may find particularly useful in is not all inclusive.
the review of mortgage banking activities. Regu-
2010.0.1 Policy Statement on the Responsibility of Bank Holding Companies to Act as

Sources of Strength to Their Subsidiary Banks
2020.0.7 Intercompany Transactions
2060.0.6 Management Information Systems
2065.2 Determining an Adequate Level for the Allowance for Loan and Lease Losses
2080.0.3 BHC Funding Practices
2126.0 Nontrading Activities of Banking Organizations
2126.1 Investment Securities and End-User Derivatives Activities
3070.0 Section 4(c)(8)Mortgage Banking
3080.0 Section 4(c)(8)Servicing Loans
4000 sections Financial Analysis
4030.0.2 Nonbanks (Analysis of Financial Condition and Risk Assessment)
4070.0 BHC Rating System

Page 62
Section 4(c)(8) of the BHC Act (Nontraditional Mortgages
Associated Risks) Section 3070.3
WHATS NEW IN THIS REVISED While some institutions have offered nontra-
SECTION ditional mortgages for many years with appro-
priate risk management and sound portfolio per-
Effective July 2015, this section is revised to formance, the market for these products and the
delete a footnote reference to SR letter 02-16, number of institutions offering them has expanded
Interagency Questions and Answers on Capi- rapidly. Nontraditional mortgage loan products
tal Treatment of Recourse, Direct Credit Substi- are now offered by more lenders to a wider
tutes, and Residual Interests in Asset Securitiza- spectrum of borrowers; these borrowers may not
tions and its attachment, superseded by SR otherwise qualify for more traditional mortgage
letter 15-6 Interagency Frequently Asked loans and may not fully understand the risks
Questions on the Regulatory Capital Rule. associated with nontraditional mortgage loans.
Refer to subsection 3070.3.2.5., Second- Many of these nontraditional mortgage loans
ary Market Activity. are underwritten with less stringent income and
The Federal Reserve and the other federal bank- asset verification requirements (reduced docu-
ing and thrift regulatory agencies (the agen- mentation) and are increasingly combined with
cies)1 issued the Interagency Guidance on Non- simultaneous second-lien loans.4 Such risk lay-
traditional Mortgage Product Risks on September ering, combined with the broader marketing of
29, 2006. The guidance addresses both risk- nontraditional mortgage loans, exposes financial
management and consumer disclosure practices institutions to increased risk relative to tradi-
that institutions2 should employ to effectively tional mortgage loans.
manage the risks associated with closed-end Given the potential for heightened risk levels,
residential mortgage products that allow bor- management should carefully consider and
rowers to defer repayment of principal and, appropriately mitigate exposures created by these
sometimes, interest (referred to as nontradi- loans. To manage the risks associated with non-
tional mortgage loans). (See SR-06-15.) traditional mortgage loans, management should
Residential mortgage lending has tradition-
ally been a conservatively managed business ensure that loan terms and underwriting stan-
with low delinquencies and losses and reason- dards are consistent with prudent lending prac-
ably stable underwriting standards. However, tices, including consideration of a borrowers
during the past few years consumer demand has repayment capacity;
been growing, particularly in high-priced real ensure that consumers have sufficient infor-
estate markets, for nontraditional mortgage loans. mation to clearly understand loan terms and
These mortgage products include such products associated; and
as interest-only mortgages, where a borrower recognize that many nontraditional mortgage
pays no loan principal for the first few years of loans, particularly when they have risk-
the loan, and payment-option adjustable-rate layering features, are untested in a stressed
mortgages (ARMs), where a borrower has flex- environment. As evidenced by experienced
ible payment options with the potential for nega- institutions, these products warrant strong risk-
tive amortization.3 management standards, capital levels com-
mensurate with the risk, and an allowance for
loan and lease losses (ALLL) that reflects the
the Office of the Comptroller of the Currency, the Federal
collectibility of the portfolio.
Deposit Insurance Corporation, the Office of Thrift Supervi-
sion, and the National Credit Union Administration. The Federal Reserve expects institutions to
2. The term institution(s), as used in this interagency guid- effectively assess and manage the risks associ-
ance, applies to Federal Reserve-supervised state member
banks and their subsidiaries, bank holding companies, and the
ated with nontraditional mortgage loan products.5
nonbank subsidiaries of bank holding companies. It also refers Institutions should use the guidance to ensure
to all other federally supervised banks and their subsidiaries, that risk-management practices adequately
savings associations and their subsidiaries, savings and loan
holding companies and their subsidiaries, and credit unions. 4. Refer to the appendix for additional information on
3. Interest-only and payment-option ARMs are variations reduced documentation and simultaneous second-lien loans.
of conventional ARMs, hybrid ARMs, and fixed-rate prod- 5. Refer to the Interagency Guidelines Establishing Stan-
ucts. Refer to the appendix at 3060.3.4 for additional informa- dards for Safety and Soundness in 12 C.F.R. 208, appendix
tion on interest-only and payment-option ARM loans. This D-1.
guidance does not apply to reverse mortgages; home equity
lines of credit (HELOCs), other than as discussed in the
Simultaneous Second-Lien Loans section; or fully amortizing BHC Supervision Manual July 2015
residential mortgage loan products. Page 1
Section 4(c)(8) of the BHC Act (Nontraditional MortgagesAssociated Risks) 3070.3
address these risks. Risk-management pro- Nevertheless, an institutions qualifying stan-

cesses, policies, and procedures in this area will dards should recognize the potential impact of
be carefully scrutinized. Institutions that do not payment shock, especially for borrowers with
adequately manage these risks will be asked to high loan-to-value (LTV) ratios, high debt-to-
take remedial action. income (DTI) ratios, and low credit scores. Rec-
This guidance focuses on the higher risk ele- ognizing that an institutions underwriting crite-
ments of certain nontraditional mortgage prod- ria are based on multiple factors, an institution
ucts, not the product type itself. Institutions with should consider these factors jointly in the quali-
sound underwriting, adequate risk management, fication process and potentially develop a range
and acceptable portfolio performance will not of reasonable tolerances for each factor. How-
be subject to criticism merely for offering such ever, the criteria should be based upon prudent
products. and appropriate underwriting standards, consid-
ering both the borrowers characteristics and the
products attributes.
3070.3.1 NONTRADITIONAL LOAN For all nontraditional mortgage loan prod-
TERMS AND UNDERWRITING ucts, an institutions analysis of a borrowers
STANDARDS repayment capacity should include an evalua-
tion of the borrowers ability to repay the debt
When an institution offers nontraditional mort- by final maturity at the fully indexed rate,7
gage loan products, underwriting standards should assuming a fully amortizing repayment sched-
address the effect of a substantial payment increase ule.8 In addition, for products that permit nega-
on the borrowers capacity to repay when loan tive amortization, the repayment analysis should
amortization begins. Underwriting standards be based upon the initial loan amount plus any
should also comply with the Federal Reserves balance increase that may accrue from the nega-
real estate lending standards and appraisal regu- tive amortization provision.9
lations and associated guidelines.6
Central to prudent lending is the internal dis-
7. The fully indexed rate equals the index rate prevailing at
cipline to maintain sound loan terms and under- origination plus the margin that will apply after the expiration
writing standards despite competitive pressures. of an introductory interest rate. The index rate is a published
Institutions are strongly cautioned against ced- interest rate to which the interest rate on an ARM is tied.
ing underwriting standards to third parties that Some commonly used indices include the 1-Year Constant
Maturity Treasury Rate (CMT), the 6-Month London Inter-
have different business objectives, risk toler- bank Offered Rate (LIBOR), the 11th District Cost of Funds
ances, and core competencies. Loan terms should (COFI), and the Moving Treasury Average (MTA), a 12-
be based on a disciplined analysis of potential month moving average of the monthly average yields of U.S.
exposures and compensating factors to ensure Treasury securities adjusted to a constant maturity of one
year. The margin is the number of percentage points a lender
that risk levels remain manageable. adds to the index value to calculate the ARM interest rate at
each adjustment period. In different interest-rate scenarios, the
fully indexed rate for an ARM loan based on a lagging index
3070.3.1.1 Qualifying Borrowers for (for example, the MTA rate) may be significantly different
from the rate on a comparable 30-year fixed-rate product. In
Nontraditional Loans these cases, a credible market rate should be used to qualify
the borrower and determine repayment capacity.
Payments on nontraditional loans can increase 8. The fully amortizing payment schedule should be based
significantly when the loans begin to amortize. on the term of the loan. For example, the amortizing payment
for a loan with a 5-year interest-only period and a 30-year
Commonly referred to as payment shock, this term would be calculated based on a 30-year amortization
increase is of particular concern for payment- schedule. For balloon mortgages that contain a borrower
option ARMs where the borrower makes mini- option for an extended amortization period, the fully amortiz-
mum payments that may result in negative ing payment schedule can be based on the full term the
borrower may choose.
amortization. Some institutions manage the 9. The balance that may accrue from the negative amortiza-
potential for excessive negative amortization tion provision does not necessarily equate to the full negative
and payment shock by structuring the initial amortization cap for a particular loan. The spread between the
terms to limit the spread between the introduc- introductory or teaser rate and the accrual rate will deter-
mine whether a loan balance has the potential to reach the
tory interest rate and the fully indexed rate. negative amortization cap before the end of the initial payment-
option period (usually five years). For example, a loan with a
115 percent negative amortization cap but only a small spread
6. Refer to 12 C.F.R. 208.51 subpart E and appendix C and
between the introductory rate and the accrual rate may reach a
12 C.F.R. 225 subpart G.
moderate 109 percent maximum loan balance before the end
of the initial payment-option period, even if only minimum
BHC Supervision Manual July 2015 payments are made. The borrower could be qualified based on
Page 2 this lower maximum loan balance.
Furthermore, the analysis of repayment rrowers income and debt-reduction capacity.

capacity should avoid overreliance on credit Clear policies should govern the use of reduced
scores as a substitute for income verification in documentation. For example, stated income
the underwriting process. The higher a loans should be accepted only if there are mitigating
credit risk, either from loan features or borrower factors that clearly minimize the need for direct
characteristics, the more important it is to verify verification of repayment capacity. For many
the borrowers income, assets, and outstanding borrowers, institutions generally should be able
liabilities. to readily document income using recent W-2
statements, pay stubs, or tax returns.
3070.3.1.2 Collateral-Dependent Loans

3070.3.1.5 Simultaneous Second-Lien
Institutions should avoid the use of loan terms Loans
and underwriting practices that may heighten
the need for a borrower to rely on the sale or Simultaneous second-lien loans reduce owner
refinancing of the property once amortization equity and increase credit risk. Historically, as
begins. Loans to individuals who do not combined loan-to-value ratios rise, so do defaults.
demonstrate the capacity to repay, as structured, A delinquent borrower with minimal or no equity
from sources other than the collateral pledged in a property may have little incentive to work
are generally considered unsafe and unsound.10 with a lender to bring the loan current and avoid
Institutions that originate collateral-dependent foreclosure. In addition, second-lien HELOCs
mortgage loans may be subject to criticism, cor- typically increase borrower exposure to increas-
rective action, and higher capital requirements. ing interest rates and monthly payment burdens.
Loans with minimal or no owner equity gener-
ally should not have a payment structure that
3070.3.1.3 Risk Layering allows for delayed or negative amortization
without other significant risk-mitigating factors.
Institutions that originate or purchase mortgage
loans that combine nontraditional features, such
as interest-only loans with reduced documenta- 3070.3.1.6 Introductory Interest Rates
tion or a simultaneous second-lien loan, face
increased risk. When features are layered, an As a marketing tool for payment-option ARM
institution should demonstrate that mitigating products, many institutions offer introductory
factors support the underwriting decision and interest rates set well below the fully indexed
the borrowers repayment capacity. Mitigating rate. When developing nontraditional mortgage
factors could include higher credit scores, lower product terms, an institution should consider the
LTV and DTI ratios, significant liquid assets, spread between the introductory rate and the
mortgage insurance, and other credit enhance- fully indexed rate. Since initial and subsequent
ments. While higher pricing is often used to monthly payments are based on these low intro-
address elevated risk levels, it does not replace ductory rates, a wide initial spread means that
the need for sound underwriting. borrowers are more likely to experience nega-
tive amortization, severe payment shock, and an
earlier-than-scheduled recasting of monthly pay-
3070.3.1.4 Reduced Documentation ments. Institutions should minimize the likeli-
hood of disruptive early recastings and extraor-
Institutions increasingly rely on reduced docu- dinary payment shock when setting introductory
mentation, particularly unverified income, to rates.
qualify borrowers for nontraditional mortgage
loans. Because these practices essentially substi-
tute assumptions and unverified information for 3070.3.1.7 Lending to Subprime
analysis of a borrowers repayment capacity and Borrowers
general creditworthiness, they should be used
with caution. As the level of credit risk increases, Mortgage programs that target subprime bor-
the Federal Reserve expects an institution to rowers through tailored marketing, underwriting
more diligently verify and document a bo- standards, and risk selection should follow the
10. A loan will not be determined to be collateral- BHC Supervision Manual July 2015
dependent solely through the use of reduced documentation. Page 3
applicable interagency guidance on subprime folio limits, sales and securitization practices,
lending.11 Among other things, the subprime and risk-management expectations;
guidance discusses circumstances under which design enhanced performance measures and
subprime lending can become predatory or abu- management reporting that provide early warn-
sive. Institutions designing nontraditional mort- ing for increasing risk;
gage loans for subprime borrowers should pay establish appropriate ALLL levels that con-
particular attention to this guidance. They should sider the credit quality of the portfolio and
also recognize that risk-layering features in loans conditions that affect collectibility; and
to subprime borrowers may significantly increase
risks for the institution and the borrower. maintain capital at levels that reflect portfolio
characteristics and the effect of stressed eco-
nomic conditions on collectibility. Institutions
should hold capital commensurate with the
3070.3.1.8 Non-Owner-Occupied Investor
risk characteristics of their nontraditional mort-
Loans
gage loan portfolios.
Borrowers financing non-owner-occupied invest-
ment properties should qualify for loans based
on their ability to service the debt over the life 3070.3.2.1 Policies
of the loan. Loan terms should reflect an appro-
priate combined LTV ratio that considers the
An institutions policies for nontraditional mort-
potential for negative amortization and main-
gage lending activity should set acceptable lev-
tains sufficient borrower equity over the life of
els of risk through its operating practices, account-
the loan. Further, underwriting standards should
ing procedures, and policy exception tolerances.
require evidence that the borrower has sufficient
Policies should reflect appropriate limits on risk
cash reserves to service the loan, considering
layering and should include risk-management
the possibility of extended periods of property
tools for risk-mitigation purposes. Further, an
vacancy and the variability of debt service
institution should set growth and volume limits
requirements associated with nontraditional mort-
by loan type, with special attention for products
gage loan products.
and product combinations in need of heightened
attention due to easing terms or rapid growth.
3070.3.2 PORTFOLIO AND
RISK-MANAGEMENT PRACTICES
3070.3.2.2 Concentrations
Institutions should ensure that risk-management
practices keep pace with the growth and chang-
ing risk profile of their nontraditional mortgage Institutions with concentrations in nontraditional
loan portfolios and changes in the market. Active mortgage products should have well-developed
portfolio management is especially important monitoring systems and risk-management prac-
for institutions that project or have already expe- tices. Monitoring systems should keep track of
rienced significant growth or concentration lev- concentrations in key portfolio segments such as
els. Institutions that originate or invest in nontra- loan types, third-party originations, geographic
ditional mortgage loans should adopt more robust area, and property occupancy status. Concentra-
risk-management practices and manage these tions also should be monitored by key portfolio
exposures in a thoughtful, systematic manner. characteristics such as non-owner-occupied
To meet these expectations, institutions should investor loans and loans with (1) high combined
LTV ratios, (2) high DTI ratios, (3) the potential
develop written policies that specify accept- for negative amortization, (4) credit scores of
able product attributes, production and port- borrowers that are below established thresholds,
and (5) risk-layered features. Further, institu-
tions should consider the effect of employee
11. See SR-99-6, Subprime Lending and its attachment,
incentive programs that could produce higher
Interagency Guidance on Subprime Lending, March 1, 1999, concentrations of nontraditional mortgage loans.
and SR-01-4, Subprime Lending and its attachment, inter- Concentrations that are not effectively managed
agency Expanded Guidance for Subprime Lending Programs, will be subject to elevated supervisory attention
January 31, 2001.
and potential examiner criticism to ensure timely
remedial action.
Page 4
3070.3.2.3 Controls 3070.3.2.5 Secondary-Market Activity
An institutions quality control, compliance, and The sophistication of an institutions secondary-

audit procedures should focus on mortgage lend- market risk-management practices should be
ing activities posing high risk. Controls to moni- commensurate with the nature and volume of
tor compliance with underwriting standards and activity. Institutions with significant secondary-
exceptions to those standards are especially im- market activities should have comprehensive,
portant for nontraditional loan products. The formal strategies for managing risks. Contin-
quality control function should regularly review gency planning should include how the institu-
a sample of nontraditional mortgage loans from tion will respond to reduced demand in the
all origination channels and a representative secondary market.
sample of underwriters to confirm that policies While third-party loan sales can transfer a
are being followed. When control systems or portion of the credit risk, an institution remains
operating practices are found deficient, business- exposed to reputation risk when credit losses on
line managers should be held accountable for sold mortgage loans or securitization transac-
correcting deficiencies in a timely manner. tions exceed expectations. As a result, an institu-
tion may determine that it is necessary to repur-
Since many nontraditional mortgage loans
chase defaulted mortgages to protect its reputation
permit a borrower to defer principal and, in
and maintain access to the markets.
some cases, interest payments for extended
periods, institutions should have strong controls
over accruals, customer service, and collections.
Policy exceptions made by servicing and collec- 3070.3.2.6 Management Information and
tions personnel should be carefully monitored to Reporting
confirm that practices such as re-aging, payment
Reporting systems should allow management to
deferrals, and loan modifications are not inad-
detect changes in the risk profile of its nontradi-
vertently increasing risk. Customer service and
tional mortgage loan portfolio. The structure
collections personnel should receive product-
and content should allow the isolation of key
specific training on the features and potential
loan products, risk-layering loan features, and
customer issues with these products.
borrower characteristics. Reporting should also
allow management to recognize deteriorating
performance in any of these areas before it has
3070.3.2.4 Third-Party Originations progressed too far. At a minimum, information
should be available by (1) loan type (for exam-
Institutions often use third parties, such as mort- ple, interest-only mortgage loans and payment-
gage brokers or correspondents, to originate option ARMs); (2) risk-layering features (for
nontraditional mortgage loans. Institutions should example, payment-option ARMs with stated
have strong systems and controls in place for income and interest-only mortgage loans with
establishing and maintaining relationships with simultaneous second-lien mortgages); (3) under-
third parties, including procedures for perform- writing characteristics (for example, LTV, DTI,
ing due diligence. Oversight of third parties and credit score); and (4) borrower performance
should involve monitoring the quality of origi- (for example, payment patterns, delinquencies,
nations so that they reflect the institutions lend- interest accruals, and negative amortization).
ing standards and compliance with applicable Portfolio volume and performance should be
laws and regulations. tracked against expectations, internal lending
standards, and policy limits. Volume and perfor-
Monitoring procedures should track the qual- mance expectations should be established at the
ity of loans by both origination source and key subportfolio and aggregate portfolio levels. Vari-
borrower characteristics. This will help institu- ance analyses should be performed regularly to
tions identify problems such as early payment identify exceptions to policies and prescribed
defaults, incomplete documentation, and fraud. thresholds. Qualitative analysis should occur
If problems involving appraisals, loan documen- when actual performance deviates from estab-
tation, credit problems, or consumer complaints
are discovered, the institution should take imme-
diate action. Remedial action could include more 12. Reserved footnote.
13. Reserved footnote.
thorough application reviews, more frequent
re-underwriting, and even termination of the
third-party relationship. Page 5
lished policies and thresholds. Variance analysis fying attributes. Segments could also differenti-
is critical to the monitoring of a portfolios risk ate loans by payment and portfolio characteris-
characteristics and should be an integral part of tics, such as loans on which borrowers usually
establishing and adjusting risk-tolerance levels. make only minimum payments, mortgages with
existing balances above original balances, and
mortgages subject to sizable payment shock.
3070.3.2.7 Stress Testing The objective is to identify credit quality indica-
tors that affect collectibility for ALLL measure-
Based on the size and complexity of their lend- ment purposes. In addition, understanding char-
ing operations, institutions should perform sen- acteristics that influence expected performance
sitivity analysis on key portfolio segments to also provides meaningful information about future
identify and quantify events that may increase loss exposure that would aid in determining
risks in a segment or the entire portfolio. The adequate capital levels.
scope of the analysis should generally include Institutions with material mortgage banking
stress tests on key performance drivers such as activities and mortgage servicing assets should
interest rates, employment levels, economic apply sound practices in valuing the mortgage
growth, housing value fluctuations, and other servicing rights for nontraditional mortgages.
factors beyond the institutions immediate con- The valuation process should follow generally
trol. Stress tests typically assume rapid deterio- accepted accounting principles and use reason-
ration in one or more factors and attempt to able and supportable assumptions.14
estimate the potential influence on default rates
and loss severity. Stress testing should aid an
institution in identifying, monitoring, and man-
3070.3.3 CONSUMER PROTECTION
aging risk, as well as developing appropriate
ISSUES
and cost-effective loss-mitigation strategies. The
stress testing results should provide direct feed- While nontraditional mortgage loans provide
back in determining underwriting standards, prod- flexibility for consumers, the Federal Reserve is
uct terms, portfolio concentration limits, and concerned that consumers may enter into these
capital levels. transactions without fully understanding the prod-
uct terms. Nontraditional mortgage products
3070.3.2.8 Capital and Allowance for have been advertised and promoted based on
Loan and Lease Losses their affordability in the near term; that is, their
lower initial monthly payments compared with
Institutions should establish an appropriate ALLL traditional types of mortgages. In addition to
for the estimated credit losses inherent in their apprising consumers of the benefits of nontradi-
nontraditional mortgage loan portfolios. They tional mortgage products, institutions should
should also consider the higher risk of loss take appropriate steps to alert consumers to the
posed by layered risks when establishing their risks of these products, including the likelihood
ALLL. of increased future payment obligations. This
Moreover, institutions should recognize that information should be provided in a timely
their limited performance history with these mannerbefore disclosures may be required
products, particularly in a stressed environment, under the Truth in Lending Act or other lawsto
increases performance uncertainty. Capital lev- assist the consumer in the product selection
els should be commensurate with the risk char- process.
acteristics of the nontraditional mortgage loan
portfolios. Lax underwriting standards or poor
portfolio performance may warrant higher capi- 3070.3.3.1 Concerns and Objectives
tal levels.
When establishing an appropriate ALLL and More than traditional ARMs, mortgage products
considering the adequacy of capital, institutions such as payment-option ARMs and interest-only
should segment their nontraditional mortgage mortgages can carry a significant risk of pay-
loan portfolios into pools with similar credit- ment shock and negative amortization, neither
risk characteristics. The basic segments typi- of which may be fully understood by consum-
cally include collateral and loan characteristics, ers. For example, consumer payment obliga-
geographic concentrations, and borrower quali-
14. See SR-03-4, dated February 25, 2003, Interagency
BHC Supervision Manual July 2015 Advisory on Mortgage Banking and its attachment, which has
Page 6 the same title.
tions may increase substantially at the end of an (2) with an application,15 (3) before loan con-
interest-only period or upon the recast of a summation, and (4) when interest rates change.
payment-option ARM. The magnitude of these Section 5 of the FTC Act prohibits unfair or
payment increases may be affected by factors deceptive acts or practices.16
such as the expiration of promotional interest Other federal laws, including the fair-lending
rates, increases in the interest-rate index, and laws and the Real Estate Settlement Procedures
negative amortization. Negative amortization Act (RESPA), also apply to these transactions.
also results in lower levels of home equity as Moreover, the Federal Reserve notes that the
compared with a traditional amortizing mort- sale or securitization of a loan may not affect an
gage product. When borrowers go to sell or institutions potential liability for violations of
refinance the property, they may find that nega- TILA, RESPA, the FTC Act, or other laws in
tive amortization has substantially reduced or connection with its origination of the loan. State
eliminated their equity in the propertyeven laws, including laws regarding unfair or decep-
when the property has appreciated. The concern tive acts or practices, also may apply.
that consumers may not fully understand these
products is exacerbated by marketing and pro-
motional practices that emphasize potential bene- 3070.3.3.3 Recommended Practices
fits without also providing clear and balanced
information about material risks. Recommended practices for addressing the risks
In light of these considerations, communica- raised by nontraditional mortgage products
tions with consumers, including advertisements, include the following:17
oral statements, promotional materials, and
monthly statements, should provide clear and
balanced information about the relative benefits 3070.3.3.4 Communications with
and risks of these products, including the risks Consumers
of payment shock and of negative amortization.
Clear, balanced, and timely communication to When promoting or describing nontraditional
consumers of the risks of these products will mortgage products, institutions should provide
provide consumers with useful information at consumers with information that is designed to
crucial decision-making points, such as when help them make informed decisions when
they are shopping for loans or deciding which selecting and using these products. Meeting this
monthly payment amount to make. Such com- objective requires appropriate attention to the
munication should help minimize potential con- timing, content, and clarity of information pre-
sumer confusion and complaints, foster good sented to consumers. Thus, institutions should
customer relations, and reduce legal and other provide consumers with information at a time
risks to the institution. that will help consumers select products and
choose among payment options. For example,
institutions should offer clear and balanced prod-
uct descriptions when (1) a consumer is shop-
3070.3.3.2 Legal Risks ping for a mortgage (such as when the consumer
makes an inquiry to the institution about a mort-
Institutions that offer nontraditional mortgage gage product and receives information about
products must ensure that they do so in a man- nontraditional mortgage products) or (2) market-
ner that complies with all applicable laws and
regulations. With respect to the disclosures and
15. These program disclosures apply to ARM products and
other information provided to consumers, appli- must be provided at the time an application is provided or
cable laws and regulations include the following: before the consumer pays a nonrefundable fee, whichever is
earlier.
16. The Board of Governors enforces this provision under
Truth in Lending Act (TILA) and its imple- the FTC Act and section 8 of the Federal Deposit Insurance
menting regulation, Regulation Z Act. See the joint Board and FDIC guidance titled Unfair or
Section 5 of the Federal Trade Commission Deceptive Acts or Practices by State-Chartered Banks, March
11, 2004.
Act (FTC Act) 17. Institutions should review the recommendations relat-
ing to mortgage lending practices set forth in other supervi-
TILA and Regulation Z contain rules governing sory guidance from their respective primary regulators, as
applicable, including guidance on abusive lending practices.
disclosures that institutions must provide for
closed-end mortgages (1) in advertisements, BHC Supervision Manual January 2007
Page 7
ing relating to nontraditional mortgage products points in time due to factors such as negative
is provided by the institution to the consumer. amortization or increases in the interest-rate
Clear and balanced information should not be index.
offered by the institution only upon the submis-
sion of an application or at consummation.18 Negative Amortization. When negative amorti-
The provision of such information would serve zation is possible under the terms of a nontradi-
as an important supplement to the disclosures tional mortgage product, consumers should be
currently required under TILA and Regulation apprised of the potential for increasing principal
Z, as well as other laws.19 balances and decreasing home equity, as well as
other potential adverse consequences of nega-
tive amortization. For example, product descrip-
3070.3.3.4.1 Promotional Materials and tions should disclose the effect of negative am-
Product Descriptions ortization on loan balances and home equity,
and could describe the potential consequences
To assist consumers in their product selection to the consumer of making minimum payments
decisions, promotional materials and other prod- that cause the loan to negatively amortize. (One
uct descriptions should provide information about possible consequence is that it could be more
the costs, terms, features, and risks of nontradi- difficult to refinance the loan or to obtain cash
tional mortgages (including information about upon a sale of the home.)
the matters discussed below).
Prepayment Penalties. If the institution may
Payment Shock. Institutions should apprise con- impose a penalty in the event that the consumer
sumers of potential increases in payment obliga- prepays the mortgage, consumers should be
tions for these products, including circum- alerted to this fact and to the need to ask the
stances in which interest rates or negative lender about the amount of any such penalty.
amortization reach a contractual limit. For exam-
ple, product descriptions could state the maxi-
mum monthly payment a consumer would be Cost of Reduced Documentation Loans. If an
required to pay under a hypothetical loan exam- institution offers both reduced and full docu-
ple once amortizing payments are required and mentation loan programs and there is a pricing
the interest rate and negative amortization caps premium attached to the reduced documentation
have been reached.20 Such information also program, consumers should be alerted to this
could describe when structural payment changes fact.
will occur (for example, when introductory rates
expire or when amortizing payments are re-
quired) and what the new payment amount 3070.3.3.4.2 Monthly Statements on
would be or how it would be calculated. As Payment-Option ARMs
applicable, these descriptions could indicate that
a higher payment may be required at other Monthly statements that are provided to con-
sumers on payment-option ARMs should pro-
vide information that enables consumers to make
18. Institutions also should strive to (1) focus on informa- informed payment choices, including an expla-
tion important to consumer decision making; (2) highlight key
information to make it more prominent; (3) employ a user- nation of each payment option available and the
friendly and readily navigable format for presenting the infor- impact of that choice on loan balances. For
mation; and (4) use plain language, with concrete and realistic example, the monthly payment statement should
examples. Comparative tables and information describing key contain an explanation, as applicable, next to
features of available loan products, including reduced docu-
mentation programs, also may be useful for consumers who the minimum payment amount that making this
are considering the nontraditional mortgage products and payment would result in an increase to the con-
other loan features described in this guidance. sumers outstanding loan balance. Payment state-
19. Institutions may not be able to incorporate all of the ments also could provide the consumers current
practices recommended in this guidance when advertising
nontraditional mortgages through certain forms of media, loan balance, what portion of the consumers
such as radio, television, or billboards. Nevertheless, institu- previous payment was allocated to principal and
tions should provide clear and balanced information about the to interest, and, if applicable, the amount by
risks of these products in all forms of advertising. which the principal balance increased. Institu-
20. Consumers also should be apprised of other material
changes in payment obligations, such as balloon payments. tions should avoid leading payment-option ARM
borrowers to select a non-amortizing or nega-
BHC Supervision Manual January 2007 tively amortizing payment (for example, through
Page 8 the format or content of monthly statements).
3070.3.3.4.3 Practices to Avoid should receive additional training, as necessary.

Lending personnel should be monitored to deter-
Institutions also should avoid practices that mine whether they are following these policies
obscure significant risks to the consumer. For and procedures. Institutions should review con-
example, if an institution advertises or promotes sumer complaints to identify potential compli-
a nontraditional mortgage by emphasizing the ance, reputation, and other risks. Attention should
comparatively lower initial payments permitted be paid to appropriate legal review and to using
for these loans, the institution also should pro- compensation programs that do not improperly
vide clear and comparably prominent informa- encourage lending personnel to direct consum-
tion alerting the consumer to the risks. Such ers to particular products.
information should explain, as relevant, that With respect to nontraditional mortgage loans
these payment amounts will increase, that a that an institution makes, purchases, or services
balloon payment may be due, and that the loan using a third party, such as a mortgage broker,
balance will not decrease and may even increase correspondent, or other intermediary, the institu-
due to the deferral of interest or principal pay- tion should take appropriate steps to mitigate
ments. Similarly, institutions should avoid pro- risks relating to compliance and consumer infor-
moting payment patterns that are structurally mation concerns discussed in this guidance.
unlikely to occur.21 Such practices could raise These steps would ordinarily include, among
legal and other risks for institutions, as described other things, (1) conducting due diligence and
more fully above. establishing other criteria for entering into and
Institutions also should avoid such practices maintaining relationships with such third par-
as (1) giving consumers unwarranted assurances ties, (2) establishing criteria for third-party com-
or predictions about the future direction of inter- pensation designed to avoid providing incen-
est rates (and, consequently, the borrowers future tives for originations inconsistent with this
obligations); (2) making one-sided representa- guidance, (3) setting requirements for agree-
tions about the cash savings or expanded buying ments with such third parties, (4) establishing
power to be realized from nontraditional mort- procedures and systems to monitor compliance
gage products in comparison with amortizing with applicable agreements, bank policies, and
mortgages; (3) suggesting that initial minimum laws, and (5) implementing appropriate correc-
payments in a payment-option ARM will cover tive actions in the event that the third party fails
accrued interest (or principal and interest) charges; to comply with applicable agreements, bank
and (4) making misleading claims that interest policies, or laws.
rates or payment obligations for these products
are fixed.
3070.3.4 APPENDIX (TERMS USED IN
THIS DOCUMENT)
3070.3.3.5 Control Systems
Interest-Only Mortgage Loan. An interest-only
Institutions should develop and use strong con- mortgage loan refers to a nontraditional mort-
trol systems to monitor whether actual practices gage in which, for a specified number of years
are consistent with their policies and procedures (for example, three or five years), the borrower
relating to nontraditional mortgage products. is required to pay only the interest due on the
Institutions should design control systems to loan, during which time the rate may fluctuate
address compliance and consumer information or may be fixed. After the interest-only period,
concerns as well as the safety and soundness the rate may be fixed or it may fluctuate based
considerations discussed in this guidance. Lend- on the prescribed index and payments, including
ing personnel should be trained so that they are both principal and interest.
able to convey information to consumers about
product terms and risks in a timely, accurate, Payment-Option ARM. A payment-option ARM
and balanced manner. As products evolve and is a nontraditional adjustable-rate mortgage that
new products are introduced, lending personnel allows the borrower to choose from a number of
different payment options. For example, each
21. For example, marketing materials for payment-option month, the borrower may choose a minimum
ARMs may promote low predictable payments until the recast payment option based on a start or introduc-
date. Such marketing should be avoided in circumstances in
which the minimum payments are so low that negative amor-
tory interest rate, an interest-only payment option
tization caps would be reached and higher payment obliga-
tions would be triggered before the scheduled recast, even if BHC Supervision Manual January 2007
interest rates remain constant. Page 9
based on the fully indexed interest rate, or a 4. To evaluate whether the banking organiza-
fully amortizing principal and interest payment tions management carefully considers and
option based on a 15- or 30-year loan term, plus appropriately assesses and mitigates the risk
any required escrow payments. The minimum exposures created by the nontraditional mort-
payment option can be less than the interest gage loans by ensuring that
accruing on the loan, resulting in negative amor- a. its loan terms and underwriting stan-
tization. The interest-only option avoids nega- dards are consistent with prudent lending
tive amortization but does not provide for prin- practices, including consideration of a
cipal amortization. After a specified number of borrowers repayment capacity;
years, or if the loan reaches a certain negative b. its nontraditional mortgage loan prod-
amortization cap, the required monthly payment ucts have strong risk-management stan-
amount is recast to require payments that will dards, capital levels commensurate with
fully amortize the outstanding balance over the the risk, and an allowance for loan and
remaining loan term. lease losses that reflects the collectibility
of the portfolio; and
Reduced Documentation. Reduced documenta- c. its consumers have sufficient informa-
tion is a loan feature that is commonly referred tion to clearly understand the loan terms
to as low doc/no doc, no income/no asset, and associated risks prior to making a
stated income, or stated assets. For mort- nontraditional mortgage loan product
gage loans with this feature, an institution sets choice.
reduced or minimal documentation standards to 5. To determine if the banking organization
substantiate the borrowers income and assets. has borrower qualification criteria that
include an evaluation of a borrowers repay-
Simultaneous Second-Lien Loan. A simulta- ment capacity and ability to repay the debt
neous second-lien loan is a lending arrangement the full amount of the credit extended, includ-
where either a closed-end second lien or a home ing any balance increase that may accrue
equity line of credit (HELOC) is originated from negative amortizationby the final
simultaneously with the first-lien mortgage loan, maturity date at the fully indexed rate.
typically in lieu of a higher down payment.
3070.3.5
3070.3.5 INSPECTION OBJECTIVES Risk Mitigation
1. To ascertain if the banking organization22 1. Assess the banking organizations manage-

has adequate risk-management processes, ment procedures to mitigate the risk created
policies, and procedures to address the risk by nontraditional mortgage products. Deter-
associated with its nontraditional mortgage mine that
loans. a. underwriting standards and terms are
2. To evaluate whether the banking organiza- consistent with prudent lending prac-
tions nontraditional mortgage loan terms tices, including consideration of each
are supported by a disciplined analysis of borrowers repayment capacity;
its potential exposures versus the mitigating b. products are supported by strong risk-
factors that ensure that risk levels are ad- management standards, capital levels that
equately managed. are commensurate with their risk, and an
3. To determine if the underwriting standards allowance for loan and lease losses that
for nontraditional mortgage loans comply reflects the collectiblity of the portfolio;
with the Federal Reserves real estate lend- and
ing standards and appraisal regulations and c. borrowers have sufficient information to
associated guidelines. clearly understand the terms of their loans
and their associated risks.
22. Going forward in this section (for bank holding com-

pany inspection purposes) banking organization refers to
the bank holding company and its nonbank subsidiaries that
Underwriting Standards
are supervised by the Federal Reserve System.
1. Determine if the banking organizations
BHC Supervision Manual January 2007 underwriting standards
Page 10 a. address the effect of a substantial pay-
ment increase in the borrowers capacity of disruptive early recastings and extraor-
to repay when loan amortization begins, dinary payment shock when setting
b. comply with the Federal Reserves real introductory rates),
estate lending standards and appraisal d. subprime lending (adherence to the inter-
regulations and associated guidelines, and agency guidance on subprime lending),23
c. require that loan terms are based on a and
disciplined analysis of potential expo- e. non-owner-occupied investor loans (quali-
sures and mitigating factors, which will fications should be based on the borrow-
ensure that risk levels remain manageable. ers ability to service the debt over the
2. Verify that the banking organizations non- life of the loan, which would include a
traditional mortgage loan qualification stan- combined LTV ratio that considers nega-
dards recognize the potential impact of pay- tive amortization and sufficient borrower
ment shock (particularly for borrowers with equity, and continuing cash reserves).
high loan-to-value ratios, high debt-to-
income ratios, and low credit scores).
3. Ascertain that the analysis of a borrowers Portfolio and Risk-Management Practices
repayment capacity include
a. an evaluation of the borrowers ability to 1. If the banking organization originates or
repay the debt by final maturity at the invests in nontraditional mortgage loans,
fully indexed rate, assuming a fully amor- determine if more robust risk-management
tizing repayment schedule; practices have been adopted to manage the
b. a repayment schedule that is based on exposures.
the initial loan amount plus any balance a. Verify that there are appropriate written
increase that may accrue from a negative lending policies that have been adopted
amortization provision; and and are being used and monitored, speci-
c. avoiding an overreliance on credit scores fying acceptable product attributes, pro-
as a substitute for income verification or duction and portfolio limits (growth and
reliance on the sale or refinancing of the volume limits by loan type), sales and
property (pledged as collateral) when securitization practices, and risk-
amortization begins. management expectations (acceptable lev-
4. Determine whether originated or purchased els of risk).
mortgage loans that combine nontraditional b. Determine if enhanced performance mea-
features (such as interest-only loans with sures have been designed and if there is
reduced documentation and second-lien management reporting that provides an
loans) have mitigating factors (that is, higher early warning for increasing risk.
credit scores, lower LTVs and DTI repay- c. Find out if the appropriate ALLL levels
ment ratios, significant liquid assets, mort- have been established that consider the
gage insurance, or other credit enhance- credit quality of the portfolio and the
ments) that support the underwriting conditions that affect collectibility.
decisions and the borrowers repayment d. Evaluate whether adequate capital is main-
capacities. tained at levels that reflect portfolio char-
5. Verify that the banking organization has acteristics and the effect of stressed eco-
clear loan underwriting policies governing nomic conditions on collectibility.
the use of e. Determine if capital is held commensu-
a. reduced documentation of the borrow- rate with the risk characteristics of the
ers financial capacity (for example, nonbanking organizations nontraditional
verification of reported income when the mortgage loan portfolios.
borrowers income can be documented 2. If the banking organization has concentra-
based on recent W-2 statements, pay tions in nontraditional mortgage products,
stubs, or tax returns), determine if there are
b. minimal or no owners equity for second- a. well-developed monitoring systems and
lien home equity lines of credit (such risk-management practices, which moni-
loans generally should not have a pay- tor and keep track of concentrations in
ment structure allowing for delayed or
negative amortization without other sig- 23. See SR-01-4 and SR-99-6.
nificant risk-mitigating factors),
c. introductory interest rates (banking orga- BHC Supervision Manual January 2007
nizations should minimize the likelihood Page 11
key portfolio segments, such as by loan b. Ascertain if contingency planning includes

type, third-party originations, geographic how the banking organization will respond
area, and property occupancy status, and to a decline in loan demand in the sec-
b. systems that also monitor key portfolio ondary market.
characteristics: non-owner-occupied c. Determine if there were any repurchases
investor loan and loans with (1) high of defaulted mortgages and if the bank-
combined LTV ratios, (2) high DTI ing organization complies with its risk-
ratios, (3) the potential for negative am- based capital guidelines.
ortization, (4) credit scores of borrowers 6. Evaluate the appropriateness of manage-
that are below established thresholds, ment information and reporting systems for
and (5) risk-layered features. the level and nature of the banking organi-
3. Determine if the banking organization has zations mortgage lending activity.
adequate quality controls and compliance a. Verify that the reporting allows manage-
and audit procedures that focus on mort- ment to detect changes in the risk profile,
gage lending activities posing high risk. or deteriorating performance, of its non-
a. Determine if the banking organization traditional mortgage loan portfolio.
has strong internal controls over accruals, b. Determine if management information is
customer service, and collections. reported and available by loan type, risk-
b. Verify that policy exceptions made by layering features, underwriting charac-
servicing and collections personnel are teristics, and borrower performance.
carefully monitored and that practices c. Find out if
such as re-aging, payment deferrals, and 1) portfolio volume and performance are
loan modifications are not inadvertently tracked against expectations, internal
increasing risk. lending standards, and policy limits;
c. Find out if the quality control function 2) volume and performance expecta-
regularly reviews (1) a sample of nontra- tions are established at the subportfo-
ditional mortgage loans from all origina- lio and aggregate portfolio levels;
tion channels and (2) a representative 3) variance analyses are regularly per-
sample of underwriters confirming that formed to identify exceptions to poli-
underwriting policies are followed. cies and prescribed thresholds; and
4. Bank oversight of third-party originators 4) qualitative analyses are performed
a. determine if the banking organization when actual performance deviates
has strong systems and controls in place from established policies and
for establishing and maintaining relation- thresholds.
ships with third-party nontraditional mort- 7. Determine if the banking organization, based
gage loan originators, including proce- on the size and complexity of its lending
dures for due diligence, and operations, performs sensitivity analysis on
b. find out if the oversight of third-party its key portfolio segments to identify and
mortgage loan origination lending prac- quantify events that may increase its risks
tices includes monitoring the quality of in a segment or the entire portfolio.
originations (that is, the quality of origi- 8. Verify that the scope of the sensitivity analy-
nation sources, key borrower characteris- sis includes stress tests on key performance
tics, appraisals, loan documentations, and drivers such as interest rates, employment
credit repayment histories) so that they levels, economic growth, housing value fluc-
are reflective of the banking organiza- tuations, and other factors beyond the bank-
tions lending standards and in compli- ing organizations immediate control.
ance with applicable laws and regulations. 9. Find out if the stress testing results provide
5. Determine if the banking organizations direct feedback for determining underwrit-
risk-management practices are commensu- ing standards, product terms, portfolio con-
rate with the nature, volume, and risk of its centration limits, and capital levels.
secondary-market activities. 10. Determine if the banking organization has
a. Find out if there are comprehensive for- established an appropriate ALLL for the
mal strategies for managing the risks estimated credit losses and commensurate
arising from significant secondary- capital levels for the risk inherent in its
market activities. nontraditional mortgage loan portfolios (con-
sidering the higher risk of loss posed by the
BHC Supervision Manual January 2007 layered risks).
Page 12 11. If the banking organization has material
mortgage banking activities and mortgage b. ascertain if the valuation process fol-
servicing assets lowed the nontraditional mortgage and
a. evaluate whether sound practices were other interagency guidance and gener-
applied in valuing the mortgage servic- ally accepted accounting principles, and
ing rights for its nontraditional mort- whether reasonable and supportable
gages and assumptions were used.

Page 13
Section 4(c)(8) of the BHC Act (Mortgage BankingDerivative
Commitments to Originate and Sell Mortgage Loans) Section 3071.0
3071.0.1 INTERAGENCY ADVISORY the application of FAS 133. Financial institu-
ON ACCOUNTING AND REPORTING tions, including those that are not required to file
FOR COMMITMENTS TO ORIGINATE reports with the Securities and Exchange Com-
AND SELL MORTGAGE LOANS mission (SEC), are expected to follow the guid-
ance in SEC Staff Accounting Bulletin No. 105,
On May 3, 2005, the Federal Reserve and the Application of Accounting Principles to Loan
other federal financial institution regulatory agen- Commitments (SAB 105).3
cies1 (the agencies) issued an Interagency A financial institution is expected to account
Advisory on Accounting and Reporting for Com- for and report derivative loan commitments and
mitments to Originate and Sell Mortgage forward loan-sales commitments as derivatives
Loans.2 (See SR-05-10.) in accordance with generally accepted account-
The advisory provides guidance on the appro- ing principles (GAAP), which include the use of
priate accounting and reporting for commit- valuation techniques that are reasonable and
ments to supportable in the determination of fair value.
An institutions failure to account for and report
originate mortgage loans that will be held for derivative loan commitments and forward loan-
resale, and sales commitments in regulatory reports in
sell mortgage loans under mandatory-delivery accordance with GAAP may be an unsafe and
and best-efforts contracts. unsound practice.
Commitments to originate mortgage loans

that will be held for resale are derivatives and 3071.0.1.1 Accounting and Reporting
must be accounted for at fair value on the bal-
ance sheet by the issuer. All loan-sales agree- 3071.0.1.1.1 Accounting Policies
ments, including both mandatory-delivery and
Well-managed financial institutions have writ-
best-efforts contracts, must be evaluated to deter-
ten and consistently applied accounting policies
mine whether the agreements meet the defini-
for commitments to originate mortgage loans
tion of a derivative under Statement of Financial
that will be held for resale and to sell mortgage
Accounting Standards No. 133, Accounting for
loans under mandatory-delivery and best-efforts
Derivative Instruments and Hedging Activities,
contracts, including approved valuation method-
as amended by Statement of Financial Account-
ologies and procedures to formally approve
ing Standards No. 149, Amendment of State-
changes to those methodologies. The method-
ment 133 on Derivative Instruments and Hedg-
ologies should be reasonable, objectively sup-
ing Activities (collectively, FAS 133). A
ported, and fully documented. Procedural disci-
financial institution should also account for loan-
pline and consistency are key concepts in any
sales agreements that meet the definition of a
valuation-measurement technique. Institutions
derivative at fair value on the balance sheet.
should ensure that internal controls, including
The advisory discusses the characteristics that
effective independent review or audit, are in
should be considered in determining whether
place to provide integrity to the valuation pro-
mandatory-delivery and best-efforts contracts
cess. Institutions practices should, therefore,
are derivatives and the accounting and regula-
reflect these concepts to ensure the reliability of
tory reporting treatment for both commitments
their valuations of derivative loan commitments
to originate mortgage loans that will be held for
and forward loan-sales commitments.
resale and those loan-sales agreements that meet
the definition of a derivative. The advisory also
addresses the guidance that should be consid-
ered in determining the fair value of derivatives. 3071.0.1.1.2 Derivative Loan
The advisory provides additional guidance on Commitments
A financial institution should account for deriva-
1. The agencies are the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation, 3. Staff accounting bulletins (SABs) summarize the views
the National Credit Union Administration, the Office of the of the SECs staff regarding the application of generally
Comptroller of the Currency, and the Office of Thrift Supervi- accepted accounting principles.
sion.
2. The guidance in the interagency advisory is also in-
tended to apply to financial-statement reporting by bank hold- BHC Supervision Manual January 2006
ing companies. Page 1
Mortgage BankingDerivative Commitments to Originate and Sell Mortgage Loans 3071.0
tive loan commitments at fair value on the bal- 3071.0.1.1.4 Netting of Contracts
ance sheet, regardless of the manner in which
the intended sale of the mortgage loans will be For balance-sheet-presentation purposes, FAS
executed (e.g., under a best-efforts contract, a 133 does not provide specific guidance on
mandatory-delivery contract, or the institutions financial-statement presentation.7 A financial
own securitization). An institution should report institution may not offset derivatives with nega-
each fixed, adjustable, and floating derivative tive fair values (liabilities) against those with
loan commitment as an other asset or an positive fair values (assets), unless the criteria
other liability in their regulatory reports based for netting under GAAP have been satis-
upon whether the individual commitment has a fied.8 In addition, an institution may not offset
positive (asset) or negative (liability) fair value.4 the fair value of forward loan-sales commit-
With respect to floating derivative loan comments against the fair value of derivative loan
mitments, because the interest rate on such a commitments (the pipeline) or mortgage loans
commitment floats on a daily basis with mar- held for sale (warehouse loans). Rather, forward
ket interest rates, the fair value of a floating loan-sales commitments must be accounted for
derivative loan commitment approximates zero separately at fair value, and warehouse loans
as long as the creditworthiness of the borrower must be accounted for at the lower of cost or fair
has not changed. However, as with other deriva- value (commonly referred to as LOCOM)9
tive loan commitments, an institution must report with certain adjustments to the cost basis of the
the entire gross notional amount of floating loans if hedge accounting is applied.
derivative loan commitments in its regulatory
reports.
Commitments to originate mortgage loans 3071.0.1.1.5 Hedge Accounting
that will be held for investment purposes and
commitments to originate other types of loans A financial institution should follow the guid-
are not within the scope of FAS 133 and, there- ance in FAS 133 when applying hedge account-
fore, are not accounted for as derivatives.5 An ing to its mortgage banking activities. If the
institution should report the unused portion of FAS 133 qualifying criteria are met, an institu-
these types of commitments, which are not con- tion may apply
sidered derivatives, as unused commitments
in its regulatory reports. fair-value hedge accounting in a hedging
relationship between forward loan-sales com-
mitments (the hedging instrument) and fixed-
3071.0.1.1.3 Forward Loan-Sales rate warehouse loans (the hedged item), or
Commitments cash-flow hedge accounting in a hedging
relationship between forward loan-sales com-
A financial institution should account for for-
ward loan-sales commitments for mortgage loans
as derivatives at fair value on the balance sheet. mandatory-delivery contracts or best-efforts contracts are
derivatives if, upon evaluation, the contracts meet the defini-
Each forward loan-sales commitment should be tion of a derivative under FAS 133. An institution should
reported as an other asset or an other liabil- report its loan-purchase commitments that meet the definition
ity based upon whether the individual commit- of a derivative at fair value on the balance sheet.
ment has a positive (asset) or negative (liability) 7. That is, FAS 133 does not provide specific guidance
where, in the financial statements, the fair value of derivatives
fair value.6 or the changes in the fair value of derivatives should be
classified and presented on the financial statement.
8. When an institution has two (or more) derivatives with
4. When preparing Reports of Condition and Income (Call
the same counterparty, contracts with positive fair values and
Reports) and the Consolidated Financial Statements for Bank
negative fair values may be netted if the conditions set forth in
Holding Companies (BHC reports), fixed, adjustable, and
FASB Interpretation No. 39, Offsetting of Amounts Related
floating derivative loan commitments should not be reported
to Certain Contracts (FIN 39), are met. Those conditions are
as unused commitments in Schedule RC-L, Derivatives and
as follows: (1) each of the parties owes the other determinable
Off-Balance Sheet Items (Schedule HC-1 for bank holding
amounts; (2) the reporting party has the right to set off the
companies), because such commitments are to be reported as
amount owed with the amount owed by the other party;
derivatives in this schedule.
(3) the reporting party intends to set off; and (4) the right of
5. See FAS 133, paragraph 10(i).
setoff is enforceable at law. In addition, without regard to the
6. Regardless of whether the underlying mortgage loans
third condition, fair-value amounts recognized for derivative
will be held for investment or for resale, commitments to
contracts executed with the same counterparty under a master
purchase mortgage loans from third parties under either
netting arrangement may be offset.
9. See Statement of Financial Accounting Standards No.
BHC Supervision Manual January 2006 65, Accounting for Certain Mortgage Banking Activities
Page 2 (FAS 65), paragraph 4.
mitments (the hedging instrument) and the lowed in determining the fair value of deriva-
forecasted sale of the warehouse loans and/or tives.12 That guidance provides that quoted market
the loans to be originated under derivative prices are the best evidence of the fair value of
loan commitments (the forecasted financial instruments. However, when quoted
transaction).10 market prices are not available, which is typi-
cally the case for derivative loan commitments
If a financial institution does not apply hedge and forward loan-sales commitments, estimates
accounting, either because the FAS 133 hedge of fair value should be based on the best infor-
criteria are not met or the institution chooses not mation available in the circumstances (e.g., valu-
to apply hedge accounting, forward loan-sales ation techniques based on estimated expected
commitments should be treated as nonhedging future cash flows). When expected future cash
derivatives. If hedge accounting is not applied, flows are used, they should be the institutions
an institution will account for its warehouse best estimate based on reasonable and support-
loans at the lower of cost or fair value. Because able assumptions and projections.
nonhedging forward loan-sales commitments Estimates of fair value should consider prices
are accounted for at fair value through earnings, for similar assets or similar liabilities and the
such an approach causes volatility in reported results of valuation techniques to the extent
earnings if the fair value of the warehouse loans available in the circumstances. In the absence of
increases above their cost basis. In this situa- (1) quoted market prices in an active market,
tion, the volatility is a result of recognizing the (2) observable prices of other current market
full amount of any decline in the fair value of transactions, or (3) other observable data sup-
the forward loan-sales commitments in earnings porting a valuation technique, the transaction
while not adjusting the carrying amount of the price represents the best information available
warehouse loans above their cost basis. with which to estimate fair value at the incep-
tion of an arrangement.
A financial institution should not recognize
3071.0.1.1.6 Income-Statement Effect an unrealized gain or loss at inception of a
derivative instrument unless the fair value of
Unless cash-flow hedge accounting is applied, a
that instrument is obtained from a quoted mar-
financial institution should include the periodic
ket price in an active market or is otherwise
changes in the fair value of derivative loan
evidenced by comparison to other observable
commitments and forward loan-sales commit-
current market transactions or based on a valua-
ments in current-period earnings. An institution
tion technique incorporating observable market
should report these changes in fair value in
data.13 Based on this guidance, derivative loan
either other non-interest income or other
commitments generally would have a zero fair
non-interest expense, but not as trading rev-
value at inception.14 However, subsequent
enue, in their regulatory reports. However, an
changes in the fair value of a derivative loan
institutions decision as to whether to report the
commitment must be recognized in financial
changes in fair value in its regulatory reports in
statements and regulatory reports (e.g., changes
an income or expense line item should be con-
in fair value attributable to changes in market
sistent with its presentation of these changes in
interest rates).
its general-purpose external financial statements
When estimating the fair value of derivative
(including audited financial statements)11 and
loan commitments and those best-efforts con-
should be consistent from period to period.
tracts that meet the definition of a derivative, a
3071.0.1.2 Valuation 12. See FAS 133, paragraph 17.

13. See footnote 3 in Emerging Issues Task Force Issue
3071.0.1.2.1 Fair Value No. 02-3 (EITF 02-3), Issues Involved in Accounting for
Derivative Contracts Held for Trading Purposes and Contracts
Involved in Energy Trading and Risk Management Activi-
FAS 133 indicates that the guidance in State- ties.
ment of Financial Accounting Standards No. 14. If a potential borrower pays the lender a fee upon
107, Disclosures About Fair Value of Finan- entering into a derivative loan commitment (e.g., a rate-lock
cial Instruments (FAS 107), should be fol- fee), there is a transaction price, and the lender should recog-
nize the derivative loan commitment as a liability at inception
using an amount equal to the fee charged to the potential
10. See FAS 133, paragraphs 2021, and related FAS 133
borrower.
guidance for hedging instruments, hedged items, and fore-
casted transactions that qualify for fair-value and cash-flow
hedge accounting. BHC Supervision Manual January 2006
11. See footnote 7. Page 3
financial institution should consider predicted Further, no other internally developed intangible
pull-through (or, conversely, fallout) rates. assets (such as customer-relationship intangible
A pull-through rate is the probability that a assets) should be recognized as part of deriva-
derivative loan commitment will ultimately result tive loan commitments. Recognition of such
in an originated loan. Some factors that may be assets would only be appropriate in a third-party
considered in arriving at appropriate pull- transaction (for example, the purchase of a
through rates include (but are not limited to) the derivative loan commitment either individually,
origination channel (which may be either inter- in a portfolio, or in a business combination).
nal [retail] or external [wholesale or correspon-
dent, to the extent the institution rather than the
correspondent closes the loan]),15 current mort- 3071.0.1.3 Standard-Setter Activities
gage interest rates in the market versus the
interest rate incorporated in the derivative loan Financial institutions should be aware that the
commitment, the purpose of the mortgage (pur- SEC or the Financial Accounting Standards
chase versus refinancing), the stage of comple- Board (FASB) may issue additional fair-value,
tion of the underlying application and under- measurement, or recognition guidance in the
writing process, and the time remaining until the future (e.g., a fair-value measurement state-
expiration of the derivative loan commitment. ment). To the extent that additional guidance is
Estimates of pull-through rates should be based issued, institutions must also consider the guid-
on historical information for each type of loan ance in developing fair-value-estimate method-
product adjusted for potential changes in market ologies for derivative loan commitments and
interest rates that may affect the percentage of forward loan-sales commitments as well as mea-
loans that will close. An institution should not suring and recognizing such derivatives.
consider the pull-through rate when reporting
the notional amount of derivative loan commit-
ments in regulatory reports but, rather, must 3071.0.1.4 Changes in Accounting for
report the entire gross notional amount. Derivative Loan Commitments and
Loan-Sales Agreements
3071.0.1.2.2 SAB 105 Financial institutions should follow Accounting
Principles Board Opinion No. 20 (APB 20),
In March 2004, the SEC issued SAB 105 to Accounting Changes,17 if a change in their
provide guidance on the proper accounting and accounting for derivative loan commitments,
disclosures for derivative loan commitments. best-efforts contracts, or mandatory-delivery con-
SAB 105 is effective for derivative loan com- tracts is necessary. APB 20 defines various types
mitments entered into after March 31, 2004. of accounting changes and addresses the report-
SAB 105 indicates that the expected future cash ing of corrections of errors in previously issued
flows related to the associated servicing of loans financial statements. APB 20 states, Errors in
should not be considered in recognizing deriva- financial statements result from mathematical
tive loan commitments. Incorporating expected mistakes, mistakes in the application of account-
future cash flows related to the associated ser- ing principles, or oversight or misuse of facts
vicing of the loan essentially results in the that existed at the time the financial statements
immediate recognition of a servicing asset. Ser- were prepared.
vicing assets should only be recognized when For regulatory reporting purposes, a financial
the servicing asset has been contractually sepa- institution must determine whether the reason
rated from the underlying loan by sale or securi- for a change in its accounting meets the APB 20
tization of the loan with servicing retained.16 definition of an accounting error. If the reason
for the change meets this definition, the error
should be reported as a prior-period adjustment
15. If an institution commits to purchase a loan that will be
closed by a correspondent in the correspondents name, the
if the amount is material. Otherwise, the effect
institution would have a loan-purchase commitment rather of the correction of the error should be reported
than a derivative loan commitment. See footnote 6. in current earnings.
16. See Statement of Financial Accounting Standards No. If the effect of the correction of the error is
140 (FAS 140), Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, para-
graph 61.
17. Effective December 15, 2005, APB 20 will be replaced
by FASB Statement No. 154, Accounting Changes and Error
BHC Supervision Manual January 2006 CorrectionsA Replacement of APB Opinion No. 20 and
Page 4 FASB Statement No. 3.
material, a financial institution should also con- lock in the current market rate for a fixed-
sult with its primary federal regulatory agency rate loan (i.e., a fixed derivative loan
to determine whether any of its prior regulatory commitment),
reports should be amended. If amended regula- lock in the current market rate for an
tory reports are not required, the institution adjustable-rate loan that has a specified for-
should report the effect of the correction of the mula for determining when and how the inter-
error on prior years earnings, net of applicable est rate will adjust (i.e., an adjustable deriva-
taxes, as an adjustment to the previously reported tive loan commitment), or
beginning balance of equity capital. For the Call wait until a future date to set the interest rate
Report, the institution should report the amount and allow the interest rate to float with
of the adjustment in Schedule RI-A, item 2, market interest rates until the rate is set (i.e., a
Restatements due to corrections of material floating derivative loan commitment).
accounting errors and changes in accounting
principles, with an explanation in Schedule Derivative loan commitments vary in term and
RI-E, item 4. expire after a specified time period (e.g., 60
The effect of the correction of the error on days after the commitment date). Additionally,
income and expenses since the beginning of the derivative loan commitments generally do not
year in which the error is corrected should be bind the potential borrower to obtain the loan,
reflected in each affected income and expense nor do they guarantee that the lender will approve
account on a year-to-date basis beginning in the the loan once the creditworthiness of the poten-
next quarterly income statement (Call Report) to tial borrower has been determined.
be filed and not as a direct adjustment to retained
earnings.
3071.0.1.5.2 Forward Loan-Sales
Commitment
3071.0.1.5 Definitions of Terms Used in The term forward loan-sales commitment refers
the Advisory to either (1) a mandatory-delivery contract or
3071.0.1.5.1 Derivative Loan (2) a best-efforts contract that, upon evaluation
Commitment under FAS 133, meets the definition of a
derivative.
The term derivative loan commitment refers to a
lenders commitment to originate a mortgage 3071.0.1.5.3 Mandatory-Delivery
loan that will be held for resale. Notwithstand- Contract
ing the characteristics of a derivative set forth in
FAS 133, these commitments to originate mort- A mandatory-delivery contract is a loan-sales
gage loans must be accounted for as derivatives agreement in which a financial institution com-
by the issuer under FAS 133 and include, but mits to deliver a certain principal amount of
are not limited to, those commonly referred to mortgage loans to an investor at a specified
as interest-rate-lock commitments. price on or before a specified date. If the institu-
In a derivative loan commitment, the lender tion fails to deliver the amount of mortgages
agrees to extend credit to a borrower under necessary to fulfill the commitment by the speci-
certain specified terms and conditions in which fied date, it is obligated to pay a pair-off fee,
the interest rate and the maximum amount of the based on then-current market prices, to the
loan18 are set prior to or at funding. Under the investor to compensate the investor for the short-
agreement, the lender commits to lend funds to fall. Variance from the originally committed
a potential borrower (subject to the lenders principal amount is usually permitted, but typi-
approval of the loan) on a fixed- or adjustable- cally may not exceed 10 percent of the commit-
rate basis, regardless of whether interest rates ted amount.
change in the market, or on a floating-rate basis. All loan-sales agreements must be evaluated
In a typical derivative loan commitment, the to determine whether they meet the definition of
borrower can choose to a derivative under FAS 133.19 A mandatory-
19. See FAS 133, paragraph 6, for the characteristics of a

18. In accordance with the Background Information and financial instrument or other contract that meets the definition
Basis for Conclusions in Statement of Financial Accounting of a derivative.
Standards No. 149 (FAS 149), the notional amount of a
derivative loan commitment is the maximum amount of the BHC Supervision Manual January 2006
borrowing. See FAS 149, paragraph A27. Page 5
delivery contract has a specified underlying (the lent thereof (for example, the seller is contrac-
contractually specified price for the loans) and tually obligated to either (1) deliver the loan
notional amount (the committed loan-principal to the investor if the loan closes or (2) pay a
amount), and requires little or no initial net pair-off fee, based on then-current market
investment. Additionally, a mandatory-delivery prices, to the investor to compensate the in-
contract requires or permits net settlement or the vestor if the loan closes and is not delivered.
equivalent thereof as the institution is obligated Since the option to pay a pair-off fee accom-
under the contract to either deliver mortgage plishes net settlement, it is irrelevant as to
loans or pay a pair-off fee (based on the then- whether the loan to be delivered is considered
current market prices) on any shortfall on the readily convertible to cash.).
delivery of the committed loan-principal amount.
Since the option to pay a pair-off fee accom-
plishes net settlement, it is irrelevant as to 3071.0.1.5.5 Master Agreement
whether the mortgage loans to be delivered are
considered readily convertible to cash.20 Based A financial institution may enter into one of
on these characteristics, a mandatory-delivery several types of arrangements with an investor
contract meets the definition of a derivative at to govern the relationship between the institu-
the time an institution enters into the commitment. tion and the investor and set the parameters
under which the institution will deliver indi-
vidual mortgage loans through separate best-
3071.0.1.5.4 Best-Efforts Contract efforts contracts. Such an arrangement might
include, for example, a master agreement or an
The term best-efforts contract refers to a loan- umbrella contract. These arrangements may
sales agreement in which a financial institution specify an overall maximum principal amount
commits to deliver an individual mortgage loan of mortgage loans that the institution may deliver
of a specified principal amount and quality to an to the investor during a specified time period,
investor if the loan to the underlying borrower but generally they do not specify the price the
closes. Generally, the price the investor will pay investor will pay for individual loans. Further,
the seller for an individual loan is specified prior while these arrangements may include pair-off-
to the loan being funded (e.g., on the same day fee provisions for loans to be sold under indi-
the lender commits to lend funds to a potential vidual best-efforts contracts covered by the
borrower). A best-efforts contract that has all of arrangements, the seller is neither contractually
the following characteristics would meet the obligated to deliver the amount of mortgages
definition of a derivative: necessary to fulfill the maximum principal amount
specified in the arrangement nor required to pay
an underlying (e.g., the price the investor will a pair-off fee on any shortfall. Because these
pay the seller for an individual loan is speci- arrangements generally either do not have a
fied in the contract) specified underlying or determinable notional
a notional amount (e.g., the contract specifies amount or do not require or permit net settle-
the principal amount of the loan as an exact ment or the equivalent thereof, the arrangements
dollar amount or as a principal range with a typically do not meet the definition of a deriva-
determinable maximum amount)21 tive. As discussed above, an individual best-
requires little or no initial net investment (e.g., efforts contract governed by one of these
no fees are exchanged between the seller and arrangements may, however, meet the definition
investor upon entering into the agreement, or of a derivative.
a fee that is similar to a premium on other
As the terms of individual best-efforts con-
option-type contracts is exchanged)
tracts and master agreements or umbrella con-
requires or permits net settlement or the equiva-
tracts vary, a financial institution must carefully
evaluate such contracts to determine whether
20. See FAS 133, paragraph 57(c)(1), for a description of
contracts that have terms that implicitly or explicitly require
the contracts meet the definition of a derivative
or permit net settlement. in FAS 133.
21. The use of a maximum amount as the notional amount
of a best-efforts contract is consistent with the loan-
commitment discussion in the Background Information and
Basis for Conclusions in FAS 149. See FAS 149, paragraph
A27.

Page 6
3071.0.1.6 Example of the Accounting tive loan commitments to originate mortgage

for Commitments to Originate and Sell loans that it intends to sell. The institution
Mortgage Loans22 accounts for the commitments as derivative
financial instruments as required under FAS
3071.0.1.6.1 ABC Mortgage Financial 133.
Institution (Best-Efforts Contracts and No ABC enters into best-efforts contracts with a
Application of Fair-Value Hedge mortgage investor under which it commits to
Accounting) deliver certain loans that it expects to originate
under derivative loan commitments (i.e., the
The following simplified example was devel- pipeline) and loans that it has already originated
oped to provide a financial institution that has a and currently holds for sale (i.e., warehouse
limited number of derivative loan commitments loans). ABC and the mortgage investor agree on
general guidance on one approach that may be the price that the investor will pay ABC for an
used to value such commitments.23 This exam- individual loan with a specified principal amount
ple also illustrates the regulatory reporting prior to the loan being funded. Once the price
requirements for derivative loan commitments that the mortgage investor will pay ABC for an
and forward loan-sales commitments. individual loan and the notional amount of the
The guidance in this example is for illustra- loan are specified, and ABC is obligated to
tive purposes only, as there are several ways that deliver the loan to the investor if the loan closes,
a financial institution might estimate the fair the contract represents a forward loan-sales com-
value of its derivative loan commitments. A mitment. Under FAS 133, ABC accounts for
second approach to valuing derivative loan com- these forward loan-sales commitments as
mitments is described in Derivative Loan Com- derivative financial instruments.
mitments Task Force Illustrative Disclosures on On December 31 of a given year, the notional
Derivative Loan Commitments, a practice aid amounts of ABCs mortgage banking derivative
developed by staff of the American Institute of loan commitments and forward loan-sales com-
Certified Public Accountants (AICPA) and a mitments are as follows:
task force comprising representatives from the
financial services, mortgage banking, and public
accounting communities.24 As indicated in the Table 1Notional Amounts of Derivative
body of the interagency advisory, a financial Loan Commitments and Forward
institution must consider the guidance in FAS Loan-Sales Commitments
133, FAS 107, EITF 02-3, and SAB 105 in Notional
measuring and recognizing derivative loan com- amount
mitments and forward loan-sales commitments.
In addition, an institution should be aware that Derivative loan
the SEC or FASB may issue additional guidance commitments
in the future that may alter certain aspects of Fixed-rate $ 8,500,000
this example. commitments
Adjustable-rate
3071.0.1.6.1.1 Background commitments 1,500,000
Floating-rate 2,000,000
ABC Mortgage Financial Institution (ABC) en- commitments
ters into fixed, adjustable, and floating deriva-
Total derivative loan
22. This example uses the definitions and concepts pre- commitments $12,000,000 [A]25
sented in the body of the Interagency Advisory on Accounting
and Reporting for Commitments to Originate and Sell Mort-
gage Loans (the interagency advisory). Refer to the inter-
agency advisory for clarification of the terms and concepts
used in this example.
23. Estimating fair values when quoted market prices are
unavailable requires considerable judgment. Valuation tech-
niques using simplified assumptions may sometimes be used
(with appropriate disclosure in the financial statements) to
25. Alpha references in table 1 and the text of this example
provide a reliable estimate of fair value at a reasonable cost.
refer to the Reference column in table 3.
See FAS 107, paragraphs 6061.
24. The practice aid is available at www.aicpa.org/download/
members/div/acctstd/Illustrative_Disclosure_on_Derivative_ BHC Supervision Manual January 2006
Loan_Commitments.pdf. Page 7
Table 1continued available in the circumstances because quoted

market prices are not available. In this case,
Notional ABC uses valuation techniques that take into
amount account current secondary-market loan pricing
Forward loan-sales information.26 ABC had noted the appropriate
commitments reference price for the underlying loans on the
day that each derivative loan commitment was
Pipeline loan $12,000,000 given to a borrower, and assigned an initial fair
commitments value of zero to each loan commitment consis-
Warehouse loan tent with the guidance in SAB 105 and EITF
commitments 8,000,000 02-3. At the end of the month, ABC compares
the current reference price of each underlying
Total forward loan- loan with its initial reference price and calcu-
sales commitments $20,000,000 [B] lates the price difference. ABC then calculates
the fair value of these derivatives by multiply-
ing the price difference by the estimated pull-
Market interest rates have changed through- through rate. This approach is illustrated in
out the time period that ABCs derivative loan table 2.
commitments and forward loan-sales commit- As illustrated in table 2, ABC excludes time
ments have been outstanding. Some of the fixed- value from its fair-value-estimate methodology
rate commitments are at rates above current due to the short-term nature of the derivative
market rates while others are at rates at or below loan commitments. As the exclusion of time
current market rates. All of ABCs adjustable- value is not appropriate for all fair-value esti-
rate commitments are at rates below current mates, an institution must consider the terms of
market rates. its specific agreements in determining an appro-
Based on its past experience, ABC estimates priate estimation methodology.
a pull-through rate of 70 percent on its fixed- In the example in table 2, ABC estimated the
rate commitments for which the locked-in rate initial reference price of the underlying loan to
is above current market rates (i.e., 70 percent of be originated under the commitment, excluding
the commitments will actually result in loan the value of the associated servicing rights, to be
originations) and a pull-through rate of 85 per- $100,000. That is, at the date it entered into the
cent for its fixed-rate commitments for which fixed derivative loan commitment with the bor-
the locked-in rate is at or below current market rower, ABC estimated it would receive $100,000,
rates. ABC also estimates a pull-through rate of excluding the value of the associated servicing
85 percent for all of its adjustable-rate commit- rights, if the underlying loan was funded and
ments that are below market rates. sold in the secondary market on that day. Because
The pull-through-rate assumptions in this this amount is equal to the notional amount of
example have been simplified for illustrative the loan, ABC would not experience a gain or
purposes. In determining appropriate pull- loss on the sale of the underlying loan (before
through rates, a financial institution must con- considering the effect of the loan-origination
sider all factors that affect the probability that fees and costs associated with the loan). As
derivative loan commitments will ultimately such, the fair value of this derivative loan com-
result in originated loans. Therefore, an institu- mitment would be zero, and there would not be
tion is expected to have more granularity (i.e., any unrealized gain or loss at the inception of
stratification) in its application of pull-through- the derivative loan commitment. This may not
rate assumptions to its derivative loan be true for all derivative loan commitments.
commitments. ABC defers all unrealized gains and losses at
the inception of its derivative loan commitments
until the underlying loans are sold. ABCs pol-
3071.0.1.6.1.2 Discussion of ABCs Approach icy is based on the short-term nature of its
to Valuing Derivative Loan Commitments and
Forward Loan-Sales Commitments 26. In general, source data for secondary-market loan-
pricing information may include, for example, quotations
ABC estimates the fair value of its derivative from rate sheets; brokers; or electronic systems such as those
provided by third-party vendors, market makers, or mortgage
loan commitments using the best information loan investors. When secondary-market loan-pricing informa-
tion that includes the value of servicing rights is used, the fair
BHC Supervision Manual January 2006 value of the derivative loan commitments ultimately must
Page 8 exclude any value attributable to servicing rights.
Table 2ABCs Calculation of the Fair Value of Derivative Loan Commitments: An

Example of a Fixed Derivative Loan Commitment for Which the Locked-In Rate Is
Above the Current Market Rate*
Initial reference Current reference
price of loan price of loan
to be to be
originated under originated under
Notional commitment commitment Fair value of
amount excluding excluding Pull- derivative
of servicing servicing Price through loan
loan rights rights difference rate commitment
(1) (2) (3) [(3) - (2)] (4) [(3) - (2)] (4)
$100,000 $100,000 $100,500 $500 70% $350
* The example in this table presents the fair-value calculation for one derivative loan commitment. The fair value of this
derivative, which is positive, would be added to all the other derivative loan commitments with positive fair values. Netting
derivatives with positive fair values (assets) against derivatives with negative fair values (liabilities) is not permitted unless the
conditions stipulated in FIN 39 are met. Refer to footnote 8.
derivative loan commitments and was adopted warehouse loans with above-market rates is
in order to not accelerate the timing of gain approximately ($45,000) [F], which represents a
recognition. As this practice may not be appro- liability, because current market interest rates
priate for all derivative loan commitments or for comparable mortgage loans are lower than
other derivatives initially accounted for under the rates in effect when the derivative loan com-
EITF 02-3, and due to the lack of authoritative mitments were initiated. (Consequently, current
guidance in this area, an institution should con- offered delivery prices for similar commitments
sult with its accounting advisers concerning the are greater than the delivery prices of ABCs
appropriate accounting for its specific agreements. existing forward loan-sales commitments. There-
After applying the methodology described fore, the change in the fair value of ABCs
above to individual derivative loan commit- forward loan-sales commitments since they were
ments, ABC aggregates the fair values of the entered into represents a loss.) The fair value of
derivative loan commitments by type (i.e., fixed, ABCs forward loan-sales commitments related
adjustable, and floating) and by whether the to its derivative loan commitments and ware-
commitments have above-, at-, or below-market house loans with at- or below-market rates is
rates. The fair values of the fixed derivative loan estimated to be $50,000, which is an asset.27
commitments with above-market rates, adjusted
for the appropriate pull-through rate, total $21,000
3071.0.1.6.1.3 Regulatory Reporting
[C], which represents an asset. The aggregate
fair value of the fixed derivative loan commit-
The following table illustrates the regulatory
ments that have at- or below-market rates, adjusted
reporting requirements for the derivative-related
for the appropriate pull-through rate, sums to
dollar amounts cited in the example.
($31,000) [D], which represents a liability. For
As illustrated in table 3, depending upon par-
the adjustable derivative loan commitments, the
ticular market circumstances, individual deriva-
aggregate fair value, adjusted for the pull-
tive loan commitments and forward loan-sales
through rate, is approximately ($2,000) [E],
which is also a liability. The fair value of the
floating derivative loan commitments 27. The absolute value of the fair value of the forward
loan-sales commitments is greater than the absolute value of
approximates zero. the fair value of the related derivative loan commitments
ABC also estimates the fair value of its for- because the forward loan-sales commitments also apply to,
ward loan-sales commitments outstanding at the and act as an economic hedge of, ABCs warehouse loans.
end of the month using a similar methodology ABC accounts for its warehouse loans at the lower of cost or
fair value in accordance with FAS 65. In this example, ABC
as that described above. Based upon this infor- does not apply hedge accounting to its warehouse loans.
mation, ABC determines that the estimated fair
value of the forward loan-sales commitments BHC Supervision Manual January 2006
related to its derivative loan commitments and Page 9
Table 3Regulatory Reporting Implications for Derivative Loan Commitments and

Forward Loan-Sales Commitments
Amount Reference
Derivative loan commitments
Notional amount of over-the-counter written options28 $12,000,000 [A]
Derivatives with a positive fair value held for purposes
other than trading (asset) $21,000 [C]
Derivatives with a negative fair value held for purposes
other than trading (liability) $33,000 [D + E]
Forward loan-sales commitments

Notional amount of forward contracts $20,000,000 [B]
Derivatives with a positive fair value held for purposes
other than trading (asset) $50,000 [G]
Derivatives with a negative fair value held for purposes
other than trading (liability) $45,000 [F]
Derivative loan commitments and forward loan-sales

commitments
Total notional amount of derivative contracts held for
purposes other than trading $32,000,000 [A + B]
commitments may have either positive or nega- accounted for and reported
tive fair values, which ABC properly reports a. in accordance with the instructions for the
gross as assets or liabilities on its balance sheet. BHC reports (for example, the FR Y-9C);
In addition, for regulatory reporting purposes, GAAP; and SR-05-10 and its attached
ABC consistently reports the periodic changes May 3, 2005, Interagency Advisory on
in the fair value of its derivative contracts in Accounting and Reporting for Commit-
other non-interest expense in its income statements to Originate and Sell Mortgage
ment. Alternatively, ABC could have chosen to Loans and
consistently report these fair-value changes in b. based on reasonable and supportable valu-
other non-interest income in its regulatory ation techniques as prescribed by the May
reports. 3, 2005, interagency advisory.
3071.0.2 INSPECTION OBJECTIVE

1. To find out if the bank holding company
accounted for and reported the following 1. Determine whether the bank holding com-
transactions at their fair value: (1) its company has written and consistently applied
mitments to originate mortgage loans that accounting policies to its commitments to
were held for resale (derivatives) and (2) its (1) originate mortgage loans that were held
loan-sales agreements that are derivatives. If for resale and (2) sell mortgage loans under
so, ascertain if these transactions were mandatory-delivery and best-efforts contracts.
2. Find out if the bank holding company has
developed and uses approved valuation meth-
28. Because derivative loan commitments are in certain odologies and procedures to obtain formal
respects similar to options, they are reported with over-the-
counter written options for regulatory reporting purposes. approval for changes to those methodologies.
a. Ascertain whether the valuation method-
BHC Supervision Manual January 2006 ologies are reasonable, objectively sup-
Page 10 ported, and fully documented.
b. Determine if the bank holding company Reporting for Commitments to Originate

has internal controls, including an effec- and Sell Mortgage Loans and with GAAP.
tive independent review or audit, in place d. Ascertain if periodic changes in the fair
that give integrity to the valuation process. value of derivative loan commitments and
3. If the bank holding company issues fixed-, forward loan-sales commitments are
adjustable-, and floating-rate derivative loan reported in current-period earnings as either
commitments or forward loan-sales commit- other non-interest income or non-
ments, review an adequate sample that evi- interest expense, as appropriate.
dences the full coverage of these types of 4. Report to the central point of contact or
transactions. examiner-in-charge any failure by the bank
a. Ascertain if these transactions were prop- holding companys management to follow
erly reported on the balance sheet as an (1) the bank holding companys accounting
other asset or an other liability, based and valuation policies for its commitments to
on whether the individual commitment originate mortgage loans that are held for
has a positive (asset) or negative (liabil- resale and its commitments to sell mortgage
ity) fair value in accordance with the loans, (2) the instructions for the Consoli-
instructions for the BHC reports. dated Financial Statement for Bank Holding
b. Determine if the floating-rate derivative Companies, (3) the May 3, 2005, interagency
loan commitments and other derivative advisory, or (4) GAAP.
loan commitments were reported at their 5. When additional inspection scrutiny is
entire gross notional amount in the BHCs neededbased on the examinations find-
reports (such as the FR Y-9C). ings; the supervisory concerns discussed in
c. Find out if the balance sheet correctly section 3071.0; the February 23, 2003, Inter-
presents accounts for all such transac- agency Advisory on Mortgage Banking (see
tions, including the netting of contracts, SR-03-4 and its attachment); and the May 3,
the application of hedge accounting to 2005, Interagency Advisory on Accounting
mortgage banking activities, the valuation and Reporting for Commitments to Originate
of derivatives, and any material or other and Sell Mortgage Loans (see SR-05-10 and
accounting changes for derivative loan its attachment)consider using the compre-
commitments and loan-sales agreements. hensive mortgage banking examination pro-
Also determine if the bank holding com- cedures in the appendix section A.2040.3 of
pany complies with the May 3, 2005, the Commercial Bank Examination Manual.
Interagency Advisory on Accounting and

Page 11
Section 4(c)(8) of the BHC Act (Activities Related to Extending
Credit) Section 3072.0
In 1997, the Board amended Regulation Y to
include activities related to extending credit
in section 225.28(b)(2), which includes the fol-
lowing permissible nonbanking activities:
Section No.
1. real estate and personal property
appraising 3270.0
2. arranging commercial real estate
equity financing 3220.0
3. check-guaranty services 3320.0
4. collection agency services 3330.0
5. credit bureau services 3340.0
6. asset-management, servicing, and
collection activities 3084.0
7. acquiring debt in default 3104.0
8. real estate settlement services1 3072.8
1. Real estate settlement services do not include providing

title insurance as principal, agent, or broker.

Page 1
Section 4(c)(8) of the BHC Act Real Estate Settlement Services
Section 3072.8
In 1997, the Board incorporated real estate ser- for another property of a like kind. In a
vicing into section 225.28(b)(2) as one of the forward 1031 exchange transaction, the tax-
activities related to extending credit. (See 12 payer first sells his or her existing property and
C.F.R. 225.28(b)(2)(viii).) Real estate settle- later purchases a replacement property.1 In order
ment services do not include providing title to complete a forward 1031 exchange transac-
insurance as principal, agent, or broker. Previ- tion successfully, a taxpayer must satisfy certain
ously, the Board had approved the activity by conditions in section 1031 of the Internal Rev-
Board order. In the order, the Board found that enue Code and the U.S. Treasury regulations
real estate settlement services consist of that implement section 1031. For example, in a
forward 1031 exchange transaction, at the clos-
1. reviewing the status of the title in the title ing of the sale of the initial property, the pro-
commitment, resolving any exceptions to the ceeds of the sale must be held by an individual
title, and reviewing the purchase agreement or entity otherwise unrelated to the transaction
to identify any requirements that need to be (the qualified intermediary). In addition, the tax-
complied with; payer engaging in the forward 1031 exchange
2. verifying payoffs on existing loans secured transaction may not receive the sale proceeds
by the real estate and verifying the amount of during the period in which a replacement prop-
and then calculating the prorating of special erty is identified (up to 45 days) and acquired
assessments and taxes on the property; (up to 180 days). In this request, the BHC was
3. obtaining an updated title insurance commit- proposing to acquire a subsidiary that would act
ment to the date of closing; preparing the as a qualified intermediary in forward 1031
required checks, deeds, and affidavits; and exchange transactions involving real property.
obtaining any authorization letters needed; The 1031 exchange subsidiary would engage
4. establishing a time and place for the closing, in several activities in order to facilitate forward
conducting the closing, and ensuring that all 1031 exchange transactions. First, the subsidi-
parties properly execute all appropriate docu- ary would provide its customer with documents
ments and meet all commitments; related to the exchange to ensure that the exchange
5. collecting and disbursing funds for the par- qualified as a valid forward 1031 exchange
ties, holding funds in escrow pending satis- transaction. Specifically, the subsidiary would
faction of certain commitments, and prepar- provide an exchange agreement, an assignment
ing the HUD settlement statement, the deed agreement, and a notice. The exchange agree-
of trust, mortgage notes, the Truth-in- ment is a contract between the customer and the
Lending statement, and purchasers affida- subsidiary that, among other features, notes the
vits; and requirements for the successful completion of
6. recording all of the documents required under the transaction. The assignment agreement trans-
law. (See 1990 FRB 1058.) fers from the customer to the subsidiary certain
responsibilities for the sale of the initial prop-
erty and the receipt of sales proceeds in order to
3072.8.1 REAL PROPERTY ensure that the customer does not construc-
EXCHANGE TRANSACTIONS UNDER tively receive the proceeds of the initial prop-
SECTION 1031 OF THE INTERNAL erty sale for tax purposes. These responsibilities
REVENUE CODE may include taking the transitory title to the
initial property and replacement property as they
A request submitted to the Board on behalf of a are transferred from seller to buyer. The notice
bank holding company (BHC) requested an informs the purchaser of the initial property that
advisory opinion pursuant to section 225.27 of the transaction is part of a forward 1031 exchange
Regulation Y (12 C.F.R. 225.27). The BHC was transaction; it helps establish that the mecha-
proposing the acquisition of a subsidiary (the
1031 exchange subsidiary) that provided ser-
vices to customers seeking to make exchanges 1. In a reverse 1031 exchange transaction, the taxpayer
first purchases a replacement property and later sells his or her
of real property pursuant to section 1031 of the property. The proposal did not include the provision of ser-
Internal Revenue Code (1031 exchange vices to customers seeking to make reverse 1031 exchange
transactions). transactions.
Section 1031 of the Internal Revenue Code
provides a U.S. taxpayer with deferral of gain BHC Supervision Manual July 2006
when the taxpayer exchanges his or her property Page 1
Section 4(c)(8) of the BHC Act Real Estate Settlement Services 3072.8
nism for the forward 1031 exchange transaction property sale and purchase transactions that con-
is in place at the time of the sale. stitute the forward 1031 exchange transaction
Second, the 1031 exchange subsidiary would and (2) would not assist the customer in locating
invest the proceeds of the sale of the initial a buyer of the initial property or a seller of the
property on behalf of the customer until the replacement property. The requestor also asserted
customer acquired the replacement property. that the proposed services are permissible non-
The proceeds would be invested at the discre- banking activities for BHCs under section
tion of the subsidiary but would typically be 225.28(b) of Regulation Y (12 C.F.R. 225.28(b)).
deposited into deposit accounts at the BHCs In view of all the facts of the record, Board
subsidiary state-chartered commercial bank.2 The staff opined that the proposed activities of the
subsidiary would also transfer the necessary 1031 exchange subsidiary would be permissible
funds to the appropriate party to effect the cus- real estate settlement services under section
tomers purchase of the replacement property. If 225.28(b)(2)(viii) of Regulation Y (12 C.F.R.
the customer does not identify a replacement 225.28(b)(2)(viii)); would be trust company func-
property or purchase the replacement property tions under section 225.28(b)(5) of Regulation
within the required time periods set forth in Y (12 C.F.R. 225.28(b)(5)); and would be finan-
section 1031 of the Internal Revenue Code or cial advisory services, including tax-planning
U.S. Treasury regulations implementing section and tax-preparation services, under section
1031, the proceeds of the sale of the initial 225.28(b)(6) of Regulation Y (12 C.F.R.
property would be transferred to the customer. It 225.28(b)(6)).3
was represented that the subsidiary would act in The opinion is limited to the activities relat-
a fiduciary capacity in holding, investing, and ing to the 1031 exchange transaction described
disbursing the customers funds and that a state- in the opinion and in the correspondence
chartered nondepository trust company would exchanged between the requestor and Board
be allowed to engage in the activities of the staff. See the Board staffs February 9, 2006,
subsidiary. legal interpretation.
The 1031 exchange subsidiary (1) would not
participate in negotiating the terms of the real
2. The BHCs commercial bank subsidiary also may be a

lender with respect to real properties involved in the 1031 3. The Office of the Comptroller of the Currency (OCC)
exchange transaction. Any lending relationship between the authorized national banks to provide a wide range of services
bank and the customer would depend on the ability of the to facilitate their customers 1031 exchange transactions. See
customer and the loan transaction to meet the banks standard OCC Interpretive Letter No. 880 (December 16, 1999) and
underwriting terms and conditions. OCC Corporate Decision No. 200130 (October 10, 2001).

Page 2
(Education-Financing Activities) Section 3073.0
3073.0.1 EXPANDED STUDENT- ally to purchase student loans from eligible
LOAN-SERVICING ACTIVITIES lenders.
The proposed activities were regarded as being
A bank holding company applied for the Boards equivalent to the activities of a mortgage bank-
approval under section 4(c)(8) of the Bank Hold- ing subsidiary of a bank holding company,
ing Company Act (BHC Act) and section 225.23 authorized under section 225.28(b)(1) of Regu-
of Regulation Y to expand the student-loan- lation Y, with respect to acquiring and servicing
servicing activities of its nonbank subsidiary. mortgage loans for institutional investors or in
The activities would consist of connection with the secondary-mortgage mar-
ket. The activities proposed and currently con-
ducted by the applicant, to the extent that they
1. providing student-loan authorities (the author-
were different from the services performed by
ity) with regular reports that include informa-
any institution that services loans for others,
tion in the aggregate and by individual lend-
were perceived as being different only in that
ers concerning the volume of loans being
they related to servicing student loans for a
serviced for the authority and the volume of
governmental authority. Banks and their non-
loans outstanding;
bank subsidiaries generally provide comprehen-
2. preparing projections for approval by the sive loan-acquisition and -servicing packages
authority of student loans to be purchased for investors in mortgage and other loans. The
and commitments to be issued in the future, bank holding companys nonbank subsidiary
based on the volume of loans being serviced was the nations largest servicer of student
and commitments outstanding, consistent with loans, and was thus particularly well equipped
the amount of funds available to the author- to perform the proposed expanded services.
ity as the result of its sale of bonds; In addition to determining that the proposed
3. advising eligible lenders, borrowers, and other activities were closely related to banking to
interested parties of the authoritys student- approve the application, the Board had to con-
loan-purchase program, including the criteria clude that the proposed activities would produce
used by the authority in purchasing student benefits to the public that would outweigh any
loans and the extent to which the authority possible adverse effects, such as unsound bank-
will be purchasing loans in the future based ing practices, unfair competition, conflicts of
on the availability of funds; and interests, or undue concentration of resources.
4. meeting regularly with the authority to advise The Board made that conclusion in addition to
it of the nonbank subsidiarys efforts in con- determining that the balance of public interest
nection with the student-loan activities. factors that it is required to consider under sec-
tion 4(c)(8) of the BHC Act was favorable.
Under no circumstances would the nonbank Accordingly, the application was approved on
subsidiary be authorized to bind the authority or July 1, 1985 (1985 FRB 725).
its bank trustee to commit to purchase or actu-

Page 1
(Servicing Loans) Section 3080.0
A bank holding company or its subsidiary may sidiary, should focus on adequacy of documen-
engage in the activity of servicing loans or other tation and controls, and on the quality and mar-
extensions of credit for either affiliated compa- ketability of the warehoused loans. The examiner
nies or for persons or institutions not affiliated should obtain a past due report for the portfolio
with the holding company. The service will and note in the inspection report significant
often be carried on as an additional activity of a credits which are past due together with the
credit-extending subsidiary, such as a mortgage period of delinquency, the type of loan, and the
company, where the loan serviced was origi- asset classification, if any. The nature of the
nated by the subsidiary and subsequently sold to servicing business is such that the number of
an investor. A servicing company provides the past dues should be small because loans are
collection vehicle through receipt and disburse- only warehoused for a short period of time until
ment of funds for investors who may not pos- they can be sold to an investor. As a rule, a past
sess the resources to accomplish the activity. due loan or a current loan which has been ware-
The purpose of servicing is to keep a sound loan housed for more than several months is indica-
in good standing for a passive investor. The tive of some problem with the credit. Each loan
servicing companys remuneration is usually should be evaluated to determine the reason it
based upon a percentage of the outstanding bal- has not been sold.
ance of the loan. During periods of rising long-term interest
The traditional servicing arrangement arises rates, the warehouse portfolio becomes subject
from the normal business of a mortgage com- to the risk that a loan may not be marketable,
pany. The company grants extensions of credit except at a discount, because of its relatively
to qualified borrowers and subsequently pack- low yield. This affects both the servicers income
ages and sells these loans, normally without and liquidity.
recourse, to individuals or institutional investors In the case of the parent company acting as a
who contract the collection of the credit to the servicer, the inspection should also determine
mortgage company. The company may also pur- whether the activity is being carried on under
chase mortgages or other extensions of credit in the proper exemption. A bank holding company
the open market with the intention of reselling may act as a servicer under section 4(c)(8) of
the credit and retaining the servicing or can the Act or under the provisions of sections
simply purchase servicing portfolios (12 C.F.R. 4(a)(2) and/or 4(c)(1) of the Act. If carried on
225.132). The collection itself is basically a under Section 4(a)(2) of the BHC Act, the hold-
bookkeeping function. ing company is limited to servicing loans only
Servicing loans for others is relatively risk- for its own account or its banking and nonbank-
free to the company when the credits are sold ing subsidiaries. If carried under Section
without recourse to investors. A credit which 4(c)(1)(C) of the BHC Act, the bank holding
has been sold with recourse represents an unusual company is limited to servicing loans only for
circumstance and should, therefore, be reviewed its own account or its banking subsidiaries.
in detail. The serviced loans will generally be Finally, the income of the company should be
high quality mortgages which are in turn pur- subject to scrutiny. A servicing company should
chased from the company by passive investors be a profitable business. The servicer receives a
desiring a fixed rate of return on their funds. fee based upon a percentage of the outstanding
The risk to a servicing company lies in its balance of the loan. In the early years of the
portfolio of unsold loans, or its warehouse. payback period, the fee should significantly
The risk is two-fold: (1) the loan may not be of exceed the cost of the service, and because
high enough quality to attract an investor so that much of the portfolio will be refinanced either
the servicing company will have to continue to prior to its maturity or prepaid, the fee income
carry the credit for its own account, and (2) the should be sufficient to cover the servicers cost
loan was made at an interest rate which is below plus profit. The reason for poor earnings in this
current market rates. In the latter case, the ser- activity is generally either inefficiency in the
vicing company must either sell the loan at a collection area, failure to attain the breakeven
discount or continue to hold the credit for its point of servicing volume, or the inability to
own account. In either case, the loan is treated turnover the warehouse portfolio often enough
as an asset of the company and involves credit to maintain new fee generation. In the event that
risk.
The inspection of a servicing company, or a BHC Supervision Manual December 1992
servicing department of a credit-extending sub- Page 1
Section 4(c)(8) of the BHC Act (Servicing Loans) 3080.0
the servicer is unprofitable, the examiner should 2. To determine the level of exposure to
determine the reasons and clearly set them forth credit risk of loans held for the firms own
in the inspection report. account.
The servicing arrangement is of a fiduciary 3. To determine if the firms earnings are
nature and as such it gives rise to certain contin- sufficient so as not to be a burden on the parent
gent liabilities. In the situation where the ser- or subsidiary bank.
vicer is not fully and properly discharging its
servicing responsibilities in accordance with the
servicing agreement, the holder of the serviced 3080.0.2 INSPECTION PROCEDURES
notes might bring legal claims against the ser-
vicer. The inspection process should direct 1. Review the balance sheet to determine the
attention to this area including a review of the volume of credits held for the firms own account
servicing agreement and verification that the and evaluate their asset quality.
servicer is fulfilling its obligations. Manage- 2. Review internal controls and evaluate their
ment should be reminded of the significant loss adequacy.
exposure which can result from improper atten- 3. Review earnings and appraise the impact
tion to its fiduciary responsibilities. on the parent and bank subsidiaries.
4. Review servicing agreements and evaluate
the potential or contingent risks to which the
3080.0.1 INSPECTION OBJECTIVES firm is exposed in the event of failure by a
borrower to service its loan properly.
1. To determine that internal controls are 5. Determine whether mortgage servicing
adequate to administer effectively the servicing rights are recorded as an asset and whether they
of the loan portfolio. are being amortized over the average life of the
loans being serviced.

Page 2
Section 4(c)(8) of the BHC Act (Asset-Management,
Asset-Servicing, and Collection Activities) Section 3084.0
A bank holding company may engage under orders about providing asset-management ser-
contract with a third party in the management, vices were approved on March 25, 1991 (1991
servicing, and collection1 of the types of assets FRB 331 and 334).
that an insured depository institution may origi-
nate and own. The company cannot engage in
real property management or real estate broker- 3084.0.2 ASSET-MANAGEMENT
age services as part of these services. See Regu- SERVICES FOR ASSETS
lation Y, section 225.28(b)(2)(vi). Provided below ORIGINATED BY NONFINANCIAL
are some initial historical examples of Board INSTITUTIONS
orders that involve asset-management services
related to this nonbanking activity. The commit- Two bank holding companies (the applicants)
ments and conditions provided for within the applied jointly for the Boards approval under
Board orders should not be considered to be section 4(c)(8) of the BHC Act to engage de
currently applicable. novo in collection-agency activities pursuant to
Regulation Y through a joint venture. The Board
concluded that the collection activities were
3084.0.1 ASSET-MANAGEMENT permissible.
SERVICES TO CERTAIN The bank holding companies also applied for
GOVERNMENTAL AGENCIES AND the Boards approval to engage in asset-
UNAFFILIATED FINANCIAL management, asset-servicing, and collection
INSTITUTIONS WITH TROUBLED activities through a nonbank of the joint venture
ASSETS located in New Jersey. The subsidiary would
provide asset-management services to the Reso-
Three bank holding companies (the applicants) lution Trust Corporation (RTC) and the Federal
applied for the Boards approval under section Deposit Insurance Corporation (FDIC). It would
4(c)(8) of the BHC Act to engage de novo in also provide these services to unaffiliated third-
providing asset-management services to the Reso- party investors that purchase pools of assets
lution Trust Corporation and the Federal Deposit assembled by the RTC or the FDIC. Under the
Insurance Corporation, and generally to unaffili- proposal, neither the applicants nor this non-
ated financial institutions with troubled assets. bank subsidiary would acquire an ownership
The applicants committed to conduct these interest in the assets that they manage or in the
activities under the same terms and conditions institutions for which they provide the asset-
as set out in 1988 FRB 771.

BHC

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

BHC

Caricato da

Copyright:

Formati disponibili

Bank Holding Company

Division of Banking Supervision and Regulation

Division of Banking Supervision and Regulation

Send comments to:

Copies of this manual may be obtained from:

BHC Supervision Manual January 2017

3000 Table of Contents, pages 78 3000 Table of Contents, pages 78

BHC Supervision Manual January 2017

BHC Supervision Manual July 2016

BHC Supervision Manual July 2016

1050.2, pages 14 1050.2, pages 14, 4.1

2124.0, pages 34 2124.0, pages 34

2124.01, pages 910 2124.01, pages 910

3070.0, pages 34 3070.0, pages 34

4000 Table of Contents, pages 58 4000 Table of Contents, pages 5-8

4066.0, pages 111 4066.0, pages 116

5000.0, pages 16 5000.0, pages 16

BHC Supervision Manual July 2016

1. The Board of Governors of the Federal Reserve System,

Section 4060.7 for Large and Noncomplex Firms, The Federal

BHC Supervision Manual January 2016

1050.2, pages 910 1050.2, pages 910

2010.2, pages 12 2010.2, pages 12

2500.0, pages 12 2500.0, pages 12

3111.0, pages 15 3111.0, pages 15

3130.1, pages 12 3130.1, pages 12, 2.1

4020.3, pages 12 4020.3, pages 12

4061.0, pages 13 4061.0, pages 13

4065.0, pages 116

6000.0 Index, pages 771 6000.0 Index, pages 771

BHC Supervision Manual January 2016

Section 2010.2 Section 2500.0

Section 2128.03 This section, Section 4(c)(8) of the BHC Act

BHC Supervision Manual July 2015

2010.2, pages 12, 2.1 2010.2, pages 12, 2.1

2128.03, pages 18 2128.03, pages 18

2500.0, pages 12 2500.0, pages 12

3070.3, pages 16 3070.3, pages 16

3111.0, pages 34 3111.0, pages 34

6000.0 Index, pages 12 6000.0 Index, pages 12

BHC Supervision Manual July 2015

1050.0, pages 18 1050.0, pages 18

1050.1, pages 14 1050.1, pages 14, 4.1

1050.2, pages 14 1050.2, pages 14

2010.2, pages 12, 2.1 2010.2, pages 12, 2.1

2124.01, pages 12 2124.01, pages 12

3111.0, pages 15 3111.0, pages 15

3900.0, pages 17 3900.0, pages 17

4000 Table of Contents, pages 58 4000 Table of Contents, pages 58

6000.0 Index, pages 1771 6000.0 Index, pages 1771

BHC Supervision Manual January 2015

Section 3070.0 on the periodic on- and off-site inspections that

Section 4080.1 Except for the addition of SLHCs, the inspec-

BHC Supervision Manual July 2014

1010.0 Table of Contents, pages 12 1010.0 Table of Contents, pages 12

BHC Supervision Manual July 2014

BHC Supervision Manual January 2014

5000.0, pages 1920 5000.0, pages 1920

BHC Supervision Manual January 2014

6000.0 Index, pages 12 6000.0 Index, pages 12

BHC Supervision Manual July 2013

BHC Supervision Manual January 2013

BHC Supervision Manual January 2013