Bank Holding Company Act Supervision Manual

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 38—July 2010
This supplement reflects decisions of the Board Section 2090.05
of Governors, new and revised statutory and
regulatory provisions, and new and revised This section on ‘‘Control and Ownership (Quali-
supervisory guidance and instructions issued by fied Family Partnerships)’’ has been revised to
the Division of Banking Supervision and Regu- include a May 10, 2010, Board staff interpreta-
lation since the publication of the January 2010 tion. The interpretation states that an assignment
supplement. of an economic interest in the partnership inter-
ests of a Qualified Family Partnership (QFP)
under section 2(o)(10) of the Bank Holding
Company Act to a non-qualified person (assignee
SUMMARY OF CHANGES is a nonfamily member) would be inconsistent
with the ‘‘relationship’’ requirement of the stat-
ute. Such an assignment would cause the part-
Section 2020.2 nership to lose its status as a QFP, and the QFP
This section on ‘‘Intercompany Transactions would be required to register as a bank holding
(Loan Participations)’’ has been revised for sec- company (BHC).
tion 223.42(k) of Regulation W with regard to
purchasing (without recourse) an extension of
credit (that is, in this instance, a loan participa- Section 2100.0
tion) from an affiliate that is exempt from the
quantitative limitations (12 C.F.R. 223.11- This section on ‘‘International Banking Activi-
223.12)), collateral requirements (12 C.F.R. ties’’ (previously titled, ‘‘Foreign Banking Orga-
223.14), and low-quality asset prohibition (12 nizations’’) is substantially revised to discuss
C.F.R. 223.15). References in the table of Laws, the Federal Reserve’s supervision and regula-
Regulations, Interpretations, and Orders have tion of the international operations of banking
been updated. The manual’s section on loan organizations headquartered in the United States,
participations (section 2010.2.7 ) is also as well as the domestic activities of foreign
referenced. banking organizations.
Section 2068.0 Section 4066.0
This new section conveys the June 25, 2010, This new section, ‘‘Consolidated (Funding and
interagency ‘‘Guidance on Sound Incentive Com- Liquidity Risk Management)’’ conveys the
pensation Policies.’’ The guidance is based on May 21, 2010, Interagency Policy Statement on
the following key principles: (1) incentive com- Funding and Liquidity Risk Management. The
pensation arrangements at a banking organiza- policy statement summarizes the sound prac-
tion1 should provide employees incentives that tices for managing the funding and liquidity
appropriately balance risk and financial results risks of depository institutions. The guidance
in a manner that does not encourage employees articulates the process that depository institu-
to expose their organizations to imprudent risk; tions should follow in appropriately identifying,
(2) these arrangements should be compatible measuring, monitoring, and controlling their
with effective controls and risk management; funding and liquidity risks. In particular, the
and (3) these arrangements should be supported guidance re-emphasizes the importance of cash
by strong corporate governance, including active flow projections; diversified funding sources;
and effective oversight by the organization’s stress testing; a cushion of liquid assets; and a
board of directors. The guidance was issued to formal, well-developed contingency funding plan
help ensure that incentive compensation policies as primary tools for measuring and managing
at banking organizations (1) do not encourage funding and liquidity risks. The Federal Reserve
imprudent risk taking and (2) are consistent expects all supervised financial institutions to
with the safety and soundness of the organization. manage their liquidity risk using processes and
systems that are commensurate with their com-
plexity, risk profile, and scope of operations.
1. As used in the guidance, the term ‘‘banking organiza-
tion’’ includes U.S. bank holding companies as well as other BHC Supervision Manual July 2010
institutions supervised by the Federal Reserve. Page 1
Bank Holding Company Supervision Manual Supplement 38—July 2010
The basic principles presented in this policy distinctions and possible obstacles to cash move-
statement also apply to BHCs, which should ments among subsidiaries. See SR-10-6 and its
manage and control aggregate risk exposures on attachment.
a consolidated basis, while recognizing legal
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1010.0 General Table of Contents, 1010.0 General Table of Contents,

pages 3–6, 6.1 pages 3–6, 6.1
pages, 11–12, 12.1 pages, 11–12, 12.1
2000 Table of Contents, pages 9–12, 12.1 2000 Table of Contents, pages 9–12, 12.1–12.2
pages 13–14 pages 13–14
2020.2, pages 1–2 2020.2, pages 1–3
2068.0, pages 1–14

2080.05, pages 1–2 2080.05, pages 1–2
2090.0, pages 1–5 2090.0, pages 1–6

2090.05, page 1 2090.05, pages 1–2
2100.0, page 1 2100.0, pages 1–2
2100.1, pages 1–3
4000 Table of Contents, pages 3–7 4000 Table of Contents, pages 3–8
4060.5, page 1
4066.0, pages 1–11
6000.0 Alphabetical Subject Index, 1–68 6000.0 Alphabetical Subject Index, pages 1–68
BHC Supervision Manual July 2010

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Supplement 37—January 2010
This supplement reflects decisions of the Board The sale and purchase of loan participations
of Governors, new and revised statutory and should adhere to established sound banking
regulatory provisions, and new and revised practices. Sound controls should include (1) an
supervisory guidance and instructions issued by independent analysis of credit quality by the
the Division of Banking Supervision and Regu- purchasing BHC or subsidiary; (2) an agreement
lation since the publication of the July 2009 by the lead BHC or lead subsidiary (seller) to
supplement. make full credit information available about the
obligor (borrower) to those acquiring the partici-
pating interests in the loan before finalizing the
transaction; (3) written documentation fully sup-
SUMMARY OF CHANGES porting the transaction, its terms, recourse
arrangements, and the rights and obligations of
Section 2010.2 each party; and (4) a documented analysis as to
the value and lien status of collateral pledged on
This section was revised to include a discussion the loan.
of ‘‘Loan Participations, the Agreements and The revised section provides one primary
Participants.’’ A loan participation is an agree- location for a discussion of supervisory guid-
ment that transfers a stated ownership interest in ance on loan participation agreements, their
a loan to one or more other bank holding compa- terms and components, the parties involved, as
nies (BHCs), banks, groups of banks, or other well as the FAS 166 accounting guidance on
entities. The transferred portion represents an balance sheet and income statement treatment
ownership interest in an individual financial for such agreements. Inspection objectives and
asset. The lead bank holding company (BHC) or inspection procedures are included.
lead subsidiary (transferor) retains a partial inter-
est in the loan, holds all loan documentation in
its own name, services the loan, and deals Section 2127.0
directly with the customer for the benefit of all
participants. If the transaction satisfies the require- This section, ‘‘Interest-Rate Risk (Risk Manage-
ments of Statement of Financial Accounting ment and Internal Controls)’’ was revised to
Standards No. 166 (FAS 166), ‘‘Accounting for include a brief overview of the January 6, 2010,
Transfers of Financial Assets,’’ an amendment interagency ‘‘Advisory on Interest Rate Risk
of FASB Statement No. 140, the lead BHC or Management’’ that targets interest-rate risk man-
lead subsidiary (as transferor) may derecognize agement at insured depository institutions. The
the portion of the loan transferred and record a advisory does not constitute new guidance. The
gain on its sale of the participating interests in principles and supervisory expectations dis-
the loan.1 Loan participation agreements are cussed within the guidance also apply to bank
helpful to smaller BHCs or community banks holding companies, which should manage and
that are trying to satisfy the lending needs of control aggregate risk exposures on a consoli-
their business customers when they may be con- dated basis. See SR-10-1.
strained by their maximum lending limits.
1. In June 2009, the Financial Accounting Standards Board

(FASB) issued FAS 166, which established conditions for
reporting a transfer of a portion (or portions) of a financial
asset as a sale. It defines a participating interest as a portion of
a financial asset that meets specific criteria, including a
requirement that the receipt of loan payments must be distrib-
uted on a pro rata basis. (See paragraph 8.) In addition to
meeting the criteria within the definition of a participating
interest, loan participations must meet three specific condi-
tions (see paragraph 9) for sale accounting treatment. FAS
166 is effective for the first annual reporting period beginning BHC Supervision Manual January 2010
after November 15, 2009. Page 1
Bank Holding Company Supervision Manual Supplement 37—January 2010
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2000 Table of Contents, pages 1–4, 4.1–4.3 2000 Table of Contents, pages 1–4, 4.1–4.4
pages, 17–18 pages, 17–18
2010.2, pages 1–2, 2.1 2010.2, pages 1–2, 2.1
2010.11, pages 1–2 2010.11, pages 1–2
2030.0, pages 1–2 2030.0, pages 1–2

2090.6, pages 1–4 2090.6, pages 1–4
2127.0, page 1 2127.0, pages 1–2

3250.0, pages 1–2 3250.0, pages 1–2
BHC Supervision Manual January 2010

Page 2
regulatory provisions, and new and revised The section, ‘‘Consolidated Capital (Examin-
supervisory guidance and instructions issued by ers’ Guidelines for Assessing the Capital
the Division of Banking Supervision and Regu- Adequacy of BHCs)’’ was revised to include a
lation since the publication of the January 2009 reference to the guidance issued in SR-09-1,
supplement. ‘‘Application of the Market-Risk Rule in Bank
Holding Companies and State Member Banks.’’
The guidance in this section is intended to assist
BHCs in assessing market risk, but primarily
SUMMARY OF CHANGES ensures that they apply the market-risk rule (12
C.F.R. 225, appendix E) appropriately and
Section 2020.1 consistently.
The market-risk rule emphasizes the need for
This section on ‘‘Intercompany Transactions appropriate stress testing and independent market-
(Transactions Between Member Banks and Their risk management that is commensurate with the
Affiliates—Sections 23A and 23B of the Fed- organization’s risk profiles. Banking organiza-
eral Reserve Act)’’ has been revised substan- tions are to periodically reassess and adjust their
tially to discuss the statutory provisions of these market-risk management programs to account
statutes and to also include their respective for changing firm strategies, market develop-
Regulation W requirements. The section includes ments, organizational incentive structures, and
a discussion of the permissibility of certain evolving risk-management techniques. Specifi-
transactions and also any interpretations thereof cally, SR-09-1 discusses (1) the core require-
(including certain transactions that may involve ments of the market-risk rule, (2) the market
bank holding companies when they are affiliates risk rule capital computational requirements,
of insured depository institutions (IDIs)). and (3) the communication and Federal Reserve
Sections 23A and 23B of the Federal Reserve requirements for a banking organization to use
Act (FRA) and Regulation W limit the risks to its value-at-risk measurement models.
an IDI as a result of transactions between the
IDI and its affiliates, including the bank holding
company (BHC) and its subsidiaries. The stat- Section 4060.9
utes and regulation limit the ability of an IDI to
transfer to its affiliates the subsidy arising from This new section, ‘‘Consolidated Capital Plan-
the bank’s access to the federal safety net (i.e., ning Processes (Payment of Dividends, Stock
lower-cost insured deposits, the payment sys- Redemptions, and Stock Repurchases at Bank
tem, and the discount window). The statute and Holding Companies)’’ conveys the supervisory
rule accomplish these purposes by imposing guidance found in SR-09-4 and its attachments,
quantitative and qualitative limits on the ability which is directed to supervisory staff and BHCs.
of a bank to extend credit to, or engage in The guidance heightens the Federal Reserve’s
certain other transactions with, an affiliate. Trans- expectations that a BHC will inform and consult
actions between an IDI and a nonaffiliate that with Federal Reserve supervisory staff suffi-
benefit an affiliate of the IDI are covered by the ciently in advance of (1) declaring and paying a
statute and regulation as well, through the well- dividend that could raise safety-and-soundness
established ‘‘attribution’’ rule. Certain transac- concerns (for example, declaring and paying a
tions that generally do not expose an IDI to dividend that exceeds earnings for the period for
undue risk or abuse the safety net are exempted which the dividend is being paid); (2) redeem-
from coverage under Regulation W. ing or repurchasing regulatory capital instru-
This section emphasizes that examiners and ments when the BHC is experiencing financial
other supervisory staff should review intercom- weaknesses; or (3) redeeming or repurchasing
pany transactions for compliance with these common stock or perpetual preferred stock that
statutes and Regulation W. This section includes would result in a net reduction as of a quarter
examiner guidance on an inspection’s review of end in the amount of such equity instruments
affiliate transactions and also revised inspection outstanding compared with the beginning of the
objectives and inspection procedures that incor-
porate and give recognition to the rule’s BHC Supervision Manual July 2009
provisions. Page 1
quarter in which the redemption or repurchase workpapers related to supervisory activities. The
occurred. section includes inspection objectives and inspec-
Supervisory staff should document their analy- tion procedures that are derived from the issued
ses of the issues discussed in SR-09-4 (and in guidance.
this section) and include such documentation in
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pages 11–12, 12.1 pages 11–12, 12.1
1020.0, pages 1–5 1020.0, pages 1–6
2000 Table of Contents, pages 4.1, 5–6 2000 Table of Contents, pages 4.1–4.3, 5–6
2010.6, pages 1–2 2010.6, pages 1–2
2010.9, pages 1–2 2010.9, pages 1–2
2020.1, pages 1–14 2020.1, pages 1–39
2020.8, page 1
2128.0, pages 1–2 2128.0, pages 1–2
2129.05, pages 1–2 2129.05, pages 1–2, 2.1
2231.0, pages 1–2 2231.0, pages 1–2
3901.0, pages 1–2 3901.0, pages 1–2
4060.3, pages 1–6, 6.1–6.7 4060.3, pages 1–6, 6.1–6.8
4060.9, pages 1–7


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regulatory provisions, and new and revised su- This section, ‘‘Control and Ownership (Policy
pervisory guidance and instructions issued by Statements on Equity Investments in Banks and
the Division of Banking Supervision and Regu- BHCs),’’ has been revised to include the Board’s
lation since the publication of the July 2008 September 22, 2008, policy statement on this
supplement. subject. The 2008 Policy Statement provides
additional guidance on the Board’s position
regarding minority equity investments in banks
SUMMARY OF CHANGES and BHCs that generally do not constitute ‘‘con-
trol’’ for purposes of the Bank Holding Com-
Sections 1050.0, 1050.1 and 1050.2 pany Act, and supplements the Board’s 1982
‘‘Policy Statement on Nonvoting Equity Invest-
These new sections provide a comprehensive ments by BHCs.’’ The 2008 Policy Statement
discussion of the Federal Reserve’s program on provides the Board’s views on some of the
the consolidated supervision of bank holding specific approaches to avoid control with respect
companies (BHCs). Section 1050.0, ‘‘Consoli- to (1) director representation; (2) total voting
dated Supervision of Bank Holding Companies and nonvoting equity investments in a banking
and the Combined U.S. Operations of Foreign organization; (3) consultations with manage-
Banking Organizations,’’ provides a summary ment by a minority investor; and (4) other indi-
of the Federal Reserve’s Consolidated Supervi- cia of control—business relationships and cov-
sion Program. The primary objective of this enants. The policy statement discusses some of
supervisory guidance is to specify principal the most significant factors and principles the
areas of focus for consolidated supervision Board will consider in determining whether
activities. This should provide for more consis- investments in a banking organization are non-
tent Federal Reserve supervisory practices and controlling for the purposes of the BHC Act.
assessments across organizations with similar See the Board’s September 22, 2008, press
activities and risks. Specific expectations are release.
outlined for Federal Reserve staff for under-
standing and assessing a number of areas, includ-
ing primary governance functions and risk con- Section 2124.07
trols, material business lines, nonbank operations,
financial condition, and other key activities and This new section, ‘‘Compliance Risk-
risks at banking organizations. Management Programs and Oversight at Large
This guidance highlights the supervisory atten- Banking Organizations with Complex Compli-
tion that should be paid to risk-management ance Profiles,’’ sets forth the Board’s guidance
systems and internal controls used by BHCs and and expectations on the management and over-
FBOs. In addition, the guidance reiterates the sight of compliance risk for larger, more com-
importance of coordination with, and reliance plex banking organizations. The guidance focuses
on, the work of other relevant primary supervi- on (1) organizations that should implement a
sors and functional regulators. firmwide approach to compliance risk manage-
The Federal Reserve’s enhanced approach to ment and oversight, (2) independence of compli-
consolidated supervision emphasizes several ance staff, (3) compliance monitoring and test-
elements intended to make the financial system ing, and (4) the responsibilities of boards of
more resilient. These include a focus on corpo- directors and senior management regarding com-
rate governance, capital adequacy, funding and pliance risk management and oversight.
liquidity management, and the supervision of A firmwide approach to compliance risk man-
material nonbank subsidiaries. Section 1050.1 agement and oversight is generally expected of
details the program for the ‘‘Consolidated Super- banking organizations having $50 billion or
vision of Large Complex BHCs,’’ and section more in total consolidated assets and multiple
1050.2 provides the program for the ‘‘Consoli- legal entities. These organizations are expected
dated Supervision of Regional Banking Organi- to have a corporate compliance function that
zations.’’ The latter sections address the unique plays a key role in overseeing and supporting
aspects of supervising the combined U.S. opera-
tions of foreign banking organizations (FBOs). BHC Supervision Manual January 2009
See SR-08-9/CA-08-12 and its attachments. Page 1
the implementation of the compliance risk- detection, prevention, and mitigation of identity
management program—one that appropriately theft (implementation of a Program); and
controls compliance risks that transcend busi- (3) duties of (credit and debit) card issuers to
ness lines, legal entities, and jurisdictions of validate notifications of changes of address
operation. The guidance also discusses an alter- under certain circumstances. The sections have
native approach for such large organizations been revised to incorporate the rule’s provi-
that may be less complex and engage in a very sions that focus on an institution’s safety and
limited range of business activities. The expec- soundness (in particular, item 2 above). To
tations of compliance programs of FBOs, includ- obtain information on items 1 and 3 above,
ing those with large, complex U.S. operations, examiners may reference the Federal Reserve’s
also are discussed. (See SR-08-8/CA-08-11.) Consumer Compliance Handbook. The joint
final rules and guidelines were effective on
January 1, 2008. The mandatory compliance
Section 2124.5 date for the rules was November 1, 2008. See
SR-08-7/CA-08-10 and its interagency attach-
This new section, ’’Identity Theft Red Flags ments. Safety and soundness-focused inspec-
Program and Address Discrepancies,’’ discusses tion objectives and inspection procedures are
the November 9, 2007, adoption of interagency provided.
rules, ’’Identity Theft Red Flags and Address
Discrepancies Under the Fair and Accurate
Credit Transactions Act of 2003,’’ (the FACT Section 4090.0
Act) and guidelines issued by the federal finan-
cial institution regulatory agencies and the Fed- This section, ‘‘Country Risk,’’ has been revised
eral Trade Commission (FTC). The rules and to update the definitions of ‘‘country risk’’ and
guidelines (appendix A) implement sections 114 ‘‘transfer risk’’ to coincide with their definitions
and 315 of the FACT Act. (See 72 Fed. Reg. in SR-08-12, ‘‘Revisions to the Guide to the
63718-63775, November 9, 2007.) Under the Interagency Country Exposure Review Commit-
FACT Act, BHCs and their nonbank sub- tee (ICERC) Process.’’ The new guidance dis-
sidiaries are subject to the FTC’s regulations.1 cusses the November 2008 changes to the ICERC
These regulations require financial institutions country rating process, whose main feature is
or creditors that offer or maintain one or more the rating of countries only when in default.
‘‘covered accounts’’ to develop and implement Default occurs when a country is not complying
a written Identity Theft Prevention Program with its external debt-service obligations or is
(Program). A Program is to be designed to unable to service the existing loan according to
detect, prevent, and mitigate identity theft in its terms (that is, the failure to pay principal and
connection with the opening of a covered interest fully and on time), arrearages, forced
account or any existing covered account. The restructuring, or rollovers. The Federal Reserve
Program must be tailored to the entity’s size, and the other banking agencies also have elimi-
complexity, and the nature and scope of its nated the rating categories of Other Transfer
operations and activities. Risk Problems, Weak, Moderately Strong, and
The rules and guidelines address the Strong. See SR-08-12 and its attachments.
(1) duties of users of credit reports regarding
address discrepancies; (2) duties regarding the
1. The FACT Act authorized the Board to write rules for

state member banks (section 222 of the Board’s Regulation V
(12 C.F.R 222)), but not BHCs. Nonetheless, the Board retains
its supervisory and enforcement authority over BHCs, pursu-
ant to section 1818 of the Federal Deposit Insurance Act. The
Board’s and FTC’s Red Flags Rules are substantially the
same. See 16 C.F.R. 681 for the FTC’s Red Flags Rules.

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1050.0, pages 1–12
1050.1, pages 1–19
1050.2, pages 1–17

2000 Table of Contents, page 12.1 2000 Table of Contents, page 12.1
pages 15–16 pages 15–16, 16.1
2090.4, pages 1–3 2090.4, pages 1–10
2124.01, pages 1–2 2124.01, pages 1–2

2124.07, pages 1–6
2124.5, pages 1–4
4000 Table of Contents, page 7 4000 Table of Contents, page 7

4090.0, pages 1–9 4090.0, pages 1–10
6000.0 Alphabetical Subject Index, pages 1–62 6000.0 Alphabetical Subject Index, pages 1–64

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regulatory provisions, and new and revised The section on ‘‘Permissible Activities for FHCs
supervisory guidance and instructions issued by (Section 4(k) of the BHC Act)’’ was revised to
the Division of Banking Supervision and Regu- include brief discussions of several 2007 and
lation since the publication of the January 2008 2008 Board orders for FHCs’ nonbank activi-
supplement. ties, those that complement certain financial
activities. The Board determined, on September
7, 2007, that disease management and mail-
order pharmacy activities complement the finan-
SUMMARY OF CHANGES cial activity of underwriting and selling health
insurance (see 2007 FRB C133).
The section also discusses the Board’s approval
of notices by FHCs to provide energy manage-
Section 1040.0 ment services under energy management agree-
ments and energy tolling. The Board deter-
The section on ‘‘Bank Holding Company Inspec-
mined, on December 4, 2007, that an FHC’s
tion Authority’’ discusses the authority of the
provision of energy management services is
Federal Reserve to conduct bank holding com-
complementary to the financial activities of
pany (BHC) inspections under section 5 of the
engaging as principal in limited physical com-
BHC Act. This authority includes the review of
modity derivatives and the providing of finan-
all books and records of the organization by
cial and investment advisory services for deriva-
Federal Reserve supervisory staff.
tive transactions. (See 2008 FRB C20.) The
Board also determined, on March 27, 2008, that
an FHC’s providing of energy tolling is comple-
Section 2060.05 mentary to the financial activity of engaging in
commodity derivatives activities (see 2008 FRB
The section on the ‘‘Policy Statement on the 60).
Internal Audit Function and Its Outsourcing
(Management and Information Systems)’’ is
revised to include a provision of the FDIC’s
November 28, 2005, rule amendment (effective
Section 3906.0
December 28, 2005) for part 363 of its regula- This new section, ‘‘Disease Management and
tions (12 C.F.R. 363). For insured institutions Mail-Order Pharmacy Activities (Section 4(k)
having total assets of more than $3 billion, the of the BHC Act),’’ discusses, in more detail, the
audit committee must have independent mem- September 7, 2007, Board order, which con-
bers with (1) banking or related financial man- cludes that disease management and mail-order
agement expertise, (2) access to legal counsel, pharmacy activities complement the financial
and (3) not include any large customers of the activity of underwriting and selling health insur-
institution. ance (see 2007 FRB C133).
Section 2128.06 Section 3920.0

This section, ‘‘Valuation of Retained Interests The section on ‘‘Limited Physical Commodity
and Risk Management of Securitization Activi- Trading Activities (Section 4(k) of the BHC
ties (Risk Management and Internal Controls),’’ Act)’’ was revised to discuss, in more detail, the
was revised to replace, as appropriate, the refer- Board’s March 27, 2008, consideration, and
ences to the Financial Accounting Standards approval by order, of an FHC’s limited trading
Board’s FAS 125 with either FAS 140 or FAS in certain physical commodities that are not
157. FAS 140, ‘‘Accounting for Transfers and approved by the Commodities Futures and Trad-
Servicing of Financial Assets and Extinguish- ing Commission (CFTC) for trading in the U.S.
ments of Liabilities,’’ was issued in September or on non-U.S. futures exchanges. To trade in
2000. FAS 157, ‘‘Fair Value Measurements,’’
was issued in September 2006 (effective Novem- BHC Supervision Manual July 2008
ber 15, 2007). Page 1
such commodities, the FHC must be able to the Federal Reserve’s adoption of an economet-
demonstrate that the derivative contracts on the ric framework, which is referred to as the Super-
commodity satisfy the specified standards that vision and Regulation Statistical Assessment of
are stated in the order. The section also dis- Bank Risk model, or SR-SABR. This model
cusses the Board’s approval of the same FHC’s replaced the former SEER (the System to Esti-
request to make and take delivery in nickel, a mate Examination Ratings) surveillance model.
metal that is traded on the London Metal The SR-SABR model assigns a two-component
Exchange—a CFTC-comparable regulatory surveillance rating to each subsidiary bank of
entity. the BHC. The first component is the current
Included also is an FHC’s Board-approved composite CAMELS rating assigned to the bank.
request to permit the refining, blending, or alter- The second component is a letter (A, B, C, D, or
ing of Board-approved commodities by a third F) that reflects the model’s assessment of the
party. The same Board order includes the Board’s relative strength or weakness of the bank com-
approval of the FHC’s request to engage in pared with other institutions within the same
limited physically settled energy tolling by CAMELS rating category. (See SR-06-2.)
entering into tolling agreements with power
plant owners. The Board determined that the
activity is complementary to the financial activ- Section 5000.0
ity of engaging, as principal, in commodity
derivatives transactions. The FHC nonbank This section on ‘‘BHC Inspection Program (Gen-
activity had not been previously approved by eral)’’ has been revised to incorporate new super-
the Board. (See 2008 FRB C60.) visory guidance on the written communication
For another Board order, this section dis- of inspection findings. (See SR-08-01.) To
cusses the Board’s December 4, 2007, approval improve the consistency and clarity of written
by order of an FHC’s request to engage in communications, Federal Reserve staff is to use
providing Energy Management Services (EMS) the prescribed standardized terminology and
to owners of power generation facilities. The definitions, to differentiate among (1) Matters
EMS are to be provided under energy manage- Requiring Immediate Attention (MRIA), (2) Mat-
ment agreements as a complement to the finan- ters Requiring Attention (MRA), and (3) Obser-
cial activities of engaging as principal in com- vations. See subsection 5000.0.9.3.
modity derivatives and providing financial and
investment advisory services for derivative trans-
actions. (See 2008 FRB C20.) Section 5010.4
This section on ‘‘Procedures for Inspection Report
Section 4070.5 Preparation (Core Page 1—Examiner’s Com-
ments; Matters Requiring Special Board Atten-
This section on ‘‘Nondislosure of Supervisory tion)’’ incorporates and references the guidance
Ratings’’ has been revised to include the Federal in SR-08-01, which may involve this inspection
Reserve’s statement and clarification of its report page or section (continuous flow report-
expectations regarding confidentiality provi- ing). To improve the consistency and clarity of
sions that are contained in agreements between written communications, Federal Reserve staff
a banking organization and its counterparties is to use the prescribed standardized terminol-
(for example, mutual funds, hedge funds, and ogy and definitions, to differentiate among any
other trading counterparties) or other third par- (1) MRIA, (2) MRA, and (3) Observations. As a
ties. See subsection 4070.5.3. (See also SR- general rule, examiners should expect fewer
07-19 and SR-97-17.) MRIA or MRA among stronger organizations.
Section 4080.0
This section on ‘‘Federal Reserve System BHC
Surveillance Program’’ was revised to reflect

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2060.05, pages 1–4, 4.1, 7–8 2060.05, pages 1–4, 4.1, 7–8
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3600.21, pages 1–6 3600.21, pages 1–6
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3905.0, pages 1–2, 2.1–2.3, 3–5 3905.0, pages 1–9
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JOBNAME: No Job Name PAGE: 1 SESS: 284 OUTPUT: Tue Mar 4 15:32:20 2008
/frb3/bsr/bhc/bhc_92−1/sup33

This supplement reflects decisions of the Board 4(k) of the BHC Act),’’ includes the previously
of Governors, new and revised statutory and mentioned October 12, 2007, Board order, which
regulatory provisions, and new and revised was issued after consultation with the Secretary
supervisory guidance and instructions issued by of the Treasury. The order authorized a financial
the Division of Banking Supervision and Regu- holding company (FHC) to engage in these
lation since the publication of the July 2007 activities that are deemed to be ‘‘financial in
supplement. nature,’’ which are to be established and main-
tained by unaffiliated third parties in stand-alone
transactions and which are permissible for an
SUMMARY OF CHANGES FHC. The activity is to be conducted by or
through a nonbank subsidiary of the FHC to
Sections 2020.0 engage in under section 4 of the Bank Holding
Company Act. The nonbank subsidiary of the
The section on ‘‘Intercompany Transactions’’ FHC that directly acquires a third-party UK
discusses generally section 23A and 23B of the pension plan would assume the responsibilities
Federal Reserve Act. The section is revised to of the plan’s sponsor under applicable UK law.
incorporate the provisions of Regulation W, The order also determined that when a deposi-
which facilitates compliance with those statutes. tory institution is secondarily liable for a finan-
The regulation applies to transactions between cial obligation of an affiliate, even if the deposi-
insured depository institutions and their affili- tory institution’s liability is created by statute or
ates. The Board approved the regulation on regulatory action, the institution has issued a
November 27, 2002 (effective April 1, 2003). guarantee on behalf of an affiliate for purposes
(See SR-03-2.) of section 23A of the Federal Reserve Act and
the Board’s Regulation W.
Section 3905.0
Section 4060.3
This section, ‘‘Permissible Activities for FHCs’’
(Section 4(k) of the BHC Act), has been revised The section on Consolidated Capital (Examiners
to include a brief discussion and reference to an Guidelines for Assessing the Capital Adequacy
October 12, 2007, Board order authorizing an of BHCs) was revised to include an exception to
FHC to engage in the acquisition, management, the Board’s risk-based capital guidelines for
and operation, in the United Kingdom, of cer- capital held against Regulation T margin loans.
tain defined benefit pension plans established by The first exception was approved by the Board
unaffiliated third parties in stand-alone transac- on June 15, 2007. The Board approved the
tions. This is the only Board order that has been exception, initially, under the reservation-of-
issued, after consultation with the Secretary of authority provision of the guidelines (12 C.F.R.
the Treasury, which authorized an FHC to engage 225, appendix A, III.A). The exception permits
in activities deemed to be ‘‘financial in nature.’’ a BHC, upon receiving specific Board approval,
See the next summary for 3912.0. to apply a 10 percent risk weight to its Regula-
tion T margin loans. To qualify for the capital
treatment, Regulation T margin loans must com-
Section 3912.0 ply with certain specified conditions. Several
BHCs subsequently have received approval for
This new section, ‘‘To Acquire, Manage, and this exception.
Operate Defined Pension Benefit Plans in the
UK Permissible Activities for FHCs (Section

Page 1
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2000 Table of Contents, page 4.1 2000 Table of Contents, page 4.1
2020.0, pages 1–2 2020.0, pages 1–2
2128.09, pages 1–2 2128.09, pages 1–2
3905.0, pages 1–2, 2.1–2.2 3905.0, pages 1–2, 2.1–2.3
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4010.2, pages 1–6 4010.2, pages 1–6

4020.4, pages 1–3 4020.4, pages 1–4
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This supplement reflects decisions of the Board The guidance notes that risk characteristics
of Governors, new and revised statutory and vary among CRE loans secured by different
regulatory provisions, and new and revised property types. A manageable level of CRE
supervisory guidance and instructions issued by concentration risk will vary depending on the
the Division of Banking Supervision and Regu- portfolio risk characteristics and the quality of
lation since the publication of the January 2007 risk-management processes. The guidance, there-
supplement. fore, does not establish a CRE concentration
limit that applies to all institutions. Rather, the
guidance encourages institutions to perform
SUMMARY OF CHANGES ongoing risk assessments to identify and moni-
tor CRE concentrations.
Section 2010.2 The guidance provides numerical indicators
as supervisory monitoring criteria to identify
The ‘‘Supervision of Subsidiaries’’ section has institutions that may have CRE concentrations
been revised to include a new subsection, ‘‘Over- that warrant greater supervisory scrutiny. The
sight of Concentrations in Commercial Real monitoring criteria should serve as a starting
Estate Lending, Sound Risk-Management Prac- point for a dialogue between the supervisory
tices.’’ It sets forth the December 6, 2006, inter- staff and an institution’s management about the
agency supervisory guidance, which was issued level and nature of the institution’s CRE con-
jointly by the Federal Reserve and the other centration risk. (See SR-07-1 and its attachments.)
federal bank regulatory agencies. The guidance,
effective December 12, 2006, is applicable to
state member banks and also broadly applicable Section 2050.0
to bank holding companies and their nonbank
subsidiaries. For the purposes of the section, The ‘‘Extensions of Credit to BHC Officials’’
references to banks, institutions, or banking section was revised as the result of the Financial
organizations is confined to these entities for Services Relief Act of 2006 (Relief Act) and the
which the Federal Reserve System has supervi- Board’s approval of the December 6, 2006,
sory authority. interim rule amendment and the May 25, 2007,
The guidance was developed to reinforce final rule (without change) amendment to Regu-
sound risk-management practices for institu- lation O, which were effective on December 11,
tions with high and increasing concentrations of 2006, and June 1, 2007, respectively. The Relief
commercial real estate loans on their balance Act eliminated certain statutory reporting and
sheets. As part of a bank holding company disclosure requirements pertaining to insider
inspection, the examiner should make an assess- lending by federally insured financial institu-
ment of the parent company’s supervision and tions. Sections 215.9 and 215.10 and subpart B
control over its subsidiaries, which includes of Regulation O were deleted as a result of the
administering, monitoring, and assuring adher- rule’s changes. (See 71 Fed. Reg. 71,472,
ence to its lending policies and practices for December 11, 2006, and 72 Fed. Reg. 30,470,
controlling ‘‘concentration risk.’’ An institu- June 1, 2007.)
tion’s strong risk-management practices and its
maintenance of appropriate levels of capital are
important elements of a sound commercial real Section 2065.3
estate (CRE) lending program, particularly when
an institution has a concentration in CRE or a This ‘‘Maintenance of an Appropriate Allow-
CRE lending strategy leading to a concentration. ance for Loan and Lease Losses’’ section has
The guidance applies to concentrations in been fully revised to incorporate the December
CRE loans sensitive to the cyclicality of CRE 13, 2006, Interagency Policy Statement on the
markets. For purposes of this guidance, CRE Allowance for Loan and Lease Losses (ALLL).
loans include loans where repayment is depen- (See SR-06-17.) The guidance updates the 1993
dent on the rental income or the sale or refinanc- Interagency Guidance on the ALLL (SR-93-70).
ing of the real estate held as collateral. The The revised policy statement emphasizes that
guidance does not apply to loans secured by each banking organization (including bank hold-
owner-occupied properties and loans where real
estate is taken as a secondary source of repay- BHC Supervision Manual July 2007
ment or through an abundance of caution. Page 1
ing companies and their subsidiaries) is respon- CSFTs.’’ Such transactions are typically con-
sible for developing, maintaining, and docu- ducted by a limited number of large financial
menting a comprehensive, systematic, and institutions. (See SR-07-5 and 72 Fed. Reg.
consistently applied process for determining the 1,372, January 11, 2007.)
amounts of the ALLL and the provision for loan
and lease losses. Each banking organization
should ensure that the adequate controls are in Sections 4060.3
place to consistently determine the appropriate
balance of the ALLL in accordance with The ‘‘Consolidated Capital (Examiners’ Guide-
(1) GAAP, (2) its stated policies and procedures, lines for Assessing the Capital Adequacy of
and (3) management’s best judgment and rel- BHCs)’’ section was revised to include an in-
evant supervisory guidance. The policy empha- terim interagency decision on the impact of the
sizes also that a banking organization should Financial Accounting Standards Board’s issu-
provide reasonable support and documentation ance of its September 2006 Statement of Finan-
of its ALLL estimates, including adjustments to cial Accounting Standards No. 158 (FAS 158),
the allowance for qualitative or environmental ‘‘Employers Accounting for Defined Benefit
factors and unallocated portions of the allowance. Pension and Other Postretirement Plans.’’ The
decision was announced in a December 14,
2006, press release that was issued by the Fed-
Section 2128.09 eral Reserve Board and the other federal bank-
ing and thrift regulatory agencies (the agencies).
This new section, ‘‘Elevated-Risk Complex Struc- FAS 158 provides that a banking organization
tured Financing Activities,’’ sets forth the Janu- that sponsors a single-employer defined benefit
ary 11, 2007, Interagency Statement on Sound postretirement plan, such as a pension plan or
Practices Concerning Elevated-Risk Complex health care plan, must recognize the overfunded
Structured Finance Activities. This statement or underfunded status of each such plan as an
sets forth supervisory guidance that addresses asset or a liability on its balance sheet with
risk-management principles that should assist corresponding adjustments recognized as accu-
institutions to identify, evaluate, and manage the mulated other comprehensive income (AOCI).
heightened legal and reputational risks that may The agencies issued an interim decision, which
arise from their involvement in complex struc- conveyed that banks and bank holding compa-
tured financing transactions (CSFTs). The guid- nies should exclude from regulatory capital any
ance is focused on those CSFTs that may present amounts recorded in AOCI that have resulted
heightened levels of legal or reputational risk to from their adoption and application of FAS 158.
the institution and are defined as ‘‘elevated-risk
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pages 9–12, 12.1 pages 9–12, 12.1
2010.2, pages 1–2 2010.2, pages 1–2, 2.1
2050.0, pages 1–2, 2.1, 3–6 2050.0, pages 1–6, 6.1
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2065.4, pages 1–2, 2.1 2065.4, pages 1–2
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Page 3
This supplement reflects decisions of the Board assets that are 90 days or more past due, in
of Governors, new and revised statutory and default, or below investment grade, because the
regulatory provisions, and new and revised institution providing the ABCP liquidity facility
supervisory guidance and instructions issued by should not be exposed to the credit risk associ-
the Division of Banking Supervision and Regu- ated with such assets. The interagency statement
lation since the publication of the July 2006 indicates that an ABCP liquidity facility will
supplement. meet the asset-quality test if, at all times through-
out the transaction, (1) the liquidity provider has
access to certain types of acceptable credit
SUMMARY OF CHANGES enhancements that support the liquidity facility
and (2) the notional amount of such credit
Section 2050.0 enhancements exceeds the amount of under-
lying assets that are 90 days or more past due,
The ‘‘Extensions of Credit to BHC Officials’’ defaulted, or below investment grade for which
section has been revised to incorporate a May the liquidity provider may be obligated to fund
22, 2006, Board staff interpretation of Regula- under the facility. (See SR-05-13.)
tion O pertaining to the use of bank-owned or
bank-issued credit cards by bank insiders for the
bank’s business purposes. The interpretation Section 2231.0
also is concerned with the extension of credit
provisions and the market-terms requirement of The ‘‘Real Estate Appraisals and Evaluations’’
Regulation O when a bank insider uses the section has been revised to incorporate the June
bank-owned or bank-issued credit card to acquire 22, 2006, interagency statement, The 2006 Revi-
goods and services for personal purposes. The sions to Uniform Standards of Professional
inspection procedures have been revised to include Appraisal Practice (USPAP), issued by the fed-
provisions of this interpretation. eral banking agencies. Under the appraisal regu-
lations, institutions must ensure that their apprais-
als supporting federally related transactions
Section 2126.0 adhere to USPAP. The interagency statement
provides an overview of the USPAP revisions
The ‘‘Nontrading Activities of Banking Organi- and the ramifications of these revisions to regu-
zations’’ section involving risk management and lated institutions. The 2006 USPAP, effective
internal controls has been deleted. This section July 1, 2006, incorporates certain prominent
was based on SR-95-17, which was superseded revisions made by the Appraisal Standards Board.
by SR-98-12 (section 2126.1). These revisions include a new Scope of Work
Rule as well as the deletion of the Departure
Rule and some of its associated terminology.
Section 2128.03 (See SR-06-9.)
The ‘‘Credit-Supported and Asset-Backed Com-

mercial Paper’’ section has been revised to Section 3070.3
incorporate the August 4, 2005, Interagency
Guidance on the Eligibility of Asset-Backed This new section, ‘‘Nontraditional
Commercial Paper (ABCP) Liquidity Facilities Mortgages—Associated Risks’’ pertaining to
and the Resulting Risk-Based Capital Treat- section 4(c)(8) of the BHC Act, has been devel-
ment. The guidance clarifies the application of oped based on the September 29, 2006, Inter-
the asset-quality test for determining the eligibil- agency Guidance on Nontraditional Mortgage
ity or ineligibility of an ABCP liquidity facility Product Risks. (See SR-06-15.) The guidance
and the resulting risk-based capital treatment of addresses both the risk-management and con-
such a facility for banking organizations. The sumer disclosure practices that institutions (Fed-
guidance also re-emphasizes that the primary eral Reserve System-supervised state member
function of an eligible ABCP liquidity facility banks and their subsidiaries, and bank holding
should be to provide liquidity—not credit companies and their nonbank subsidiaries) should
enhancement.
An eligible liquidity facility must have an BHC Supervision Manual January 2007
asset-quality test that precludes funding against Page 1
employ to effectively manage the risks associ- securities-lending arrangements, the bank sought
ated with closed-end residential mortgage loan the Board’s permission to apply a loan equiva-
products that allow borrowers to defer payment lent methodology to the arrangements using its
of principal and, sometimes, interest. The sec- internal value-at-risk (VaR) model, subject to
tion includes safety-and-soundness-oriented the certain specified conditions. The May 14,
inspection objectives and inspection procedures 2003, interpretation concerned an inquiry regard-
to be used when conducting inspections of bank ing the risk-based capital treatment of certain
holding companies and their nonbank subsidi- European agency securities-lending arrange-
aries that are engaged in this type of lending. ments that the bank had acquired. For these
transactions (the cash-collateral transactions),
the bank, acting as agent for its clients, lends its
Section 3600.7 clients’ securities and then receives cash collat-
eral in return. The bank then reinvests the cash
The section ‘‘Acting as a Certification Authority collateral in a reverse-repurchase agreement and
for Digital Signatures (Permissible Activities by receives securities collateral in return. The August
Board Order)’’ has been amended to include a 15, 2006, interpretation was issued regarding
summary of a recent Board order in which the the bank’s risk-based capital treatment of cer-
Board approved a notice for a foreign bank to tain other securities-lending transactions. For
act, under sections 4(c)(8) and 4(j) of the BHC these transactions, the bank, acting as agent for
Act, as a certification authority (CA) in connec- clients, lends its clients’ securities and receives
tion with financial and nonfinancial transactions liquid securities collateral in return (the securities-
and to engage in related data processing activi- collateral transactions).
ties. The foreign bank planned to engage in the For both types of transactions, the Board,
CA activities by entering into an agreement using its reservation of authority, determined
with a newly organized, wholly owned indirect that under its current risk-based capital guide-
subsidiary of the bank. (See 2006 FRB C150.) lines the capital charge for these specific types
The proposed CA nonbanking activities are of securities-lending arrangements would exceed
slightly different, but are consistent with the CA the amount of economic risk posed to the bank,
nonbanking activities previously approved by which would result in capital charges that would
the Board. (See 2000 FRB 56.) be significantly out of proportion to the risk.
The Board separately approved these exceptions
to its risk-based capital guidelines. The bank is
Section 3920.0 to compute its regulatory capital for these trans-
actions using its internal VaR model by assign-
The ‘‘Limited Physical-Commodity-Trading ing the risk weight of the counterparty to the
Activities’’ section, pertaining to section 4(k) of exposure amount of all such transactions with
the BHC Act, has been revised to include addi- the counterparty. The bank will calculate the
tional Board orders for financial holding compa- exposure amount as the sum of its current unse-
nies engaging in limited physical-commodity- cured exposure on its portfolio of transactions
trading activities, including energy-related with the counterparty, plus an add-on amount
commodities such as natural gas, crude oil, elec- for potential future exposure.
tricity, and emissions allowances. (See 2006
FRB C54, 2006 FRB C57, and 2006 FRB C113.)
Section 4060.8
Section 4060.3 A new section titled ‘‘Consolidated Risk-Based

Capital—Direct-Credit Substitutes Extended to
This section, ‘‘Examiners’ Guidelines for Assess- ABCP Programs’’ consists of March 2005 inter-
ing the Capital Adequacy of BHCs,’’ pertains to agency guidance that is based on the Board’s
consolidated capital and has been revised to adoption of the November 29, 2001, amended
include discussions of the May 14, 2003, and risk-based capital standards. The standards estab-
August 15, 2006, Board interpretations that were lished a new capital framework for banking
issued in response to separate inquiries received organizations that are engaged in securitization
from the same bank. To lessen the risk-based activities. The interagency guidance clarifies
capital treatment for certain indemnified how banking organizations are to use internal
ratings that they assign to asset pools purchased
BHC Supervision Manual January 2007 by their ABCP programs in order to appropri-
Page 2 ately risk weight any direct-credit substitutes
(for example, guarantees) that are extended to zation provides to an ABCP program it spon-
such programs. sors. Specific information is provided within the
The guidance provides an analytical frame- guidance on evaluating direct-credit substitutes
work for assessing the broad risk characteristics issued in the form of program-wide credit
of direct-credit substitutes that a banking organi- enhancements. (See SR-05-6.)
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2126.0, pages 1–12
2126.1, pages 1–4 2126.1, pages 1–4
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2231.0, pages 1–2, 2.1, 3–24 2231.0, pages 1–24, 24.1–24.2
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3070.0, pages 1–2 3070.0, pages 1–2, 2.1
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5000.0, pages 1–2 5000.0, pages 1–2
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Page 3
This supplement reflects decisions of the Board The section also provides examples of unsafe
of Governors, new and revised statutory and and unsound limitation-of-liability provisions,
regulatory provisions, and new and revised and it discusses frequently asked questions and
supervisory guidance and instructions issued by answers that were posed to the Securities and
the Division of Banking Supervision and Regu- Exchange Commission (Office of the Chief
lation since the publication of the January 2006 Accountant). The answers confirm that an accoun-
supplement. tant (auditor) is not independent when an accoun-
tant and a client enter into an agreement of
indemnity, directly or through an affiliate, that
seeks to assure the accountant immunity from
SUMMARY OF CHANGES liability for the accountant’s own negligent acts,
whether they are acts of omission or commis-
Section 2060.05 sion. (See SR-06-4.)
This revised section, ‘‘Policy Statement on the

Internal Audit Function and Its Outsourcing
(Management Information Systems),’’ incorpo- Section 2090.2
rates the FDIC’s November 28, 2005, amend-
ment (effective December 28, 2005) to part 363 The section ‘‘Control and Ownership (BHC For-
of its regulations (12 C.F.R. 363). The amend- mations)’’ has been revised to incorporate the
ment raised the asset-size threshold from Board’s February 22, 2006, revisions of its
$500 million to $1 billion for internal control Small BHC Policy Statement—Policy State-
assessments by management and the institu- ment on Assessment of Financial and Manage-
tion’s external auditors. For institutions between rial Factors (12 C.F.R. 225, appendix C). The
$500 million and $1 billion in assets, only a revised rule increases the applicable consoli-
majority, rather than all, of the members of the dated asset-size threshold to less than $500 mil-
audit committee—who must be outside lion from less than $150 million and also included
directors—must be independent of management. other criteria for determining whether a BHC
may qualify for the policy statement, including
an exemption from the capital guidelines. For
BHCs that are under the qualifying asset-size
Section 2060.1 threshold, the revised rule also (1) modified
certain qualitative criteria for determining when
The section ‘‘Audit (Management Information
a BHC would not qualify for the policy state-
Systems)’’ has been revised to incorporate the
ment or the exemption from the capital guide-
February 9, 2006, Interagency Advisory on the
lines and (2) clarified the treatment under the
Unsafe and Unsound Use of Limitation of Lia-
policy statement of subordinated debt associated
bility Provisions in External Audit Engagement
with trust preferred securities. The inspection
Letters. The advisory informs financial institu-
objectives and inspection procedures have been
tions that it is unsafe and unsound to enter into
revised to incorporate key provisions of this
external audit contracts (that is, engagement
policy statement.
letters) for the performance of auditing or attes-
tation services when the contracts (1) indemnify
the external auditor against all claims made by
third parties, (2) hold harmless or release the Section 2090.7
external auditor from liability for claims or
potential claims that might be asserted by the ‘‘Control and Ownership (Nonbank Banks)’’ has
client financial institution (other than claims for been revised to include a March 21, 2006, Board
punitive damages), or (3) limit the remedies staff legal opinion. The opinion confirms that a
available to the client financial institution (other direct conversion from a state-chartered bank to
than punitive damages). Such limits on external a national bank and its merger with a newly
auditors’ liability weaken the auditor’s indepen- formed limited-purpse trust company that would
dence and performance, thus reducing the super- not be a bank for purposes of the BHC Act,
visory agency’s ability to rely on the auditor’s would not, by itself, cause a parent company to
work. The inspection objectives and inspection
procedures incorporate certain key provisions of BHC Supervision Manual July 2006
the advisory. Page 1
lose its grandfather rights maintained under sec- posed ‘‘commodity purchase and forward sale’’
tion 4(f) of the BHC Act. (CPFS) transactions are a form of lending activ-
ity permissible for BHCs under section
225.28(b)(1) of the Board’s Regulation Y. The
Section 3072.0 BHC inquired whether it would be permissible
under the BHC Act and the Board’s Regulation
This new section, ‘‘Activities Related to Extend- Y for the BHC to engage in proposed CPFS
ing Credit,’’ provides a list of sections in the transactions in a manner that provided for the
manual that discuss permissible nonbanking financing of its customers’ commodity inven-
activities related to extending credit, provided tories. Board legal staff noted that the Board
for in section 225.28(b)(2) of Regulation Y. previously found a three-party commodity financ-
Each listed section includes a description of the ing arrangement (similar to the proposed three-
activity and any supervisory guidance or require- party CPFS transactions) to be within the scope
ments that should be considered. Several of the of permissible lending activities for BHCs under
sections include inspection objectives and inspec- Regulation Y. (See 1973 FRB 698.) Based on
tion procedures. the BHC’s representations and the information
it provided, the cited Board precedents, and the
limitations included within the Board staff’s
Section 3072.8 response (interpretation), Board legal staff opined
that the proposed CPFS transactions are within
This new section, ‘‘Real Estate Settlement Ser- the scope of permissible lending activities for
vices,’’ discusses those activities that are related BHCs under section 225.28(b)(1) of Regulation
to extending credit, as found in Regulation Y, Y.
section 225.28(b)(2). Included is a February 9,
2006, Board staff legal opinion on the permissi-
bility of providing services to customers that are Section 3610.2
seeking to make exchanges of real property
through a ‘‘section 1031 exchange subsidiary,’’ This new section, ‘‘Certain Volumetric-
pursuant to section 1031 of the U.S. Internal Production-Payment Transactions Involving
Revenue Code. Section 1031 provides a U.S. Physical Commodities,’’ consists of a May 15,
taxpayer with a deferred gain when the taxpayer 2006, Board staff legal opinion that responded
exchanges his or her property for another prop- to a request from a foreign bank (a foreign bank
erty of ‘‘like kind.’’ A BHC planned to acquire a that qualifies as a financial holding company
subsidiary that would act as a qualified interme- under section 4(k) of the BHC Act and also
diary in forward section 1031 exchange under section 4(c)(9) of the BHC Act) that
transactions. sought confirmation that certain volumetric-
Board staff concluded that this section 1031 production-payment (VPP) transactions involv-
exchange subsidiary’s proposed activities would ing physical commodities would be permissible
be permissible real estate settlement services extensions of credit for a bank holding company
under section 225.28(b)(2)(viii) of Regulation under section 225.28(b)(1) of the Board’s Regu-
Y. (See 12 C.F.R. 225.28 (b)(2)(viii).) Also, the lation Y (12 C.F.R. 225.28(b)(1)).
activities would be considered permissible Regu- The Board had approved a previous proposal
lation Y trust company functions (12 C.F.R. by the BHC to engage in physical commodity
225.28(b)(5)) and financial advisory services, trading as an activity that is complementary to
including tax-planning and tax-preparation ser- the BHC’s commodity derivatives activities (See
vices (12 C.F.R. 225.28(b)(6)). 2004 FRB 215, section 3920.0, and section
3905.0.) In response to the current request,
Board staff noted that the Board had previously
Section 3610.1 concluded that ownership of commodities in
connection with a financing transaction does not
This new section, ‘‘Financing Customers’ Com- prevent the transaction from being treated as a
modity Purchase and Forward Sales,’’ consists form of credit extension permissible for a
of a May 15, 2006, Board staff legal interpreta- BHC—as long as the economics of the transac-
tion that responded to a request from a BHC. tion are substantially the same as those of a
The BHC sought confirmation that certain pro- loan. (See 1973 FRB 698.) Based on the infor-
mation provided by the BHC, Board legal staff
BHC Supervision Manual July 2006 opined that the described VPP transactions are a
Page 2 form of permissible lending activity for BHCs
under section 225.28(b)(1) of Regulation Y those transactions with the risk involved. It pro-
when entered into and for the purpose of provid- vides a capital treatment for U.S. banking orga-
ing financing to a third-party customer. The nizations that is more in line with the capital
opinion also stated that any commodities that treatment to which their domestic and foreign
the BHC receives pursuant to a VPP transaction, competitors are subject. (See 71 Fed. Reg. 8,937,
and that are not sold immediately to third par- February 22, 2006.)
ties, would be subject to a limit of 5 percent of This section has also been revised to include
tier 1 capital on the value of commodities that a January 23, 2006, Board staff legal interpreta-
the BHC may hold under its physical commod- tion. The interpretation conveys the Board’s
ity trading authority. determination that qualifying mandatory con-
vertible preferred securities (that convert to non-
cumulative perpetual preferred securities) qualify
Section 4060.3 for inclusion in the tier 1 capital of internation-
ally active BHCs (and other BHCs) in excess of
‘‘Consolidated Capital (Examiners’ Guidelines the 15 percent limit applicable to the restricted
for Assessing Capital Adequacy of BHCs)’’ was core capital elements of internationally active
revised to incorporate the Board’s February 22, BHCs, if all other terms and conditions of the
2006, revision of Regulation Y (12 C.F.R. 225). securities meet the Board’s requirements.
The rule’s appendix A was revised to raise the
asset threshold to which the risk-based capital
guidelines apply on a consolidated basis. The Section 4060.4
asset threshold was raised for BHCs having
consolidated assets of $500 million or more ‘‘Consolidated Capital (Leverage Measure)’’ was
from $150 million or more. The risk-based capi- revised to incorporate revisions to Regulation Y
tal guidelines also apply to any bank holding for the tier 1 leverage measure. (See 12 C.F.R.
company with consolidated assets of less 225, appendix D.) The changes were included in
than $500 million if the holding company (1) is the Board’s February 22, 2006, revision to the
engaged in significant nonbanking activities either Small Bank Holding Company Policy Statement
directly or through a nonbank subsidiary; (2) con- (12 C.F.R. 225, appendix C). The tier 1 leverage
ducts significant off-balance-sheet activities measure’s asset threshold was raised for those
(including securitization and asset management BHCs having consolidated assets of $500 mil-
or administration), either directly or through a lion or more from $150 million or more. The
nonbank subsidiary; or (3) has a material amount tier 1 leverage guidelines also apply to any BHC
of debt or equity securities outstanding (other that has consolidated assets of less than $500 mil-
than trust preferred securities) that are registered lion if the BHC (1) is engaged in significant
with the Securities and Exchange Commission nonbanking activities, either directly or indi-
(SEC). BHCs with consolidated assets of less rectly through a nonbank subsidiary (a new pro-
than $500 million would generally be exempt vision); (2) conducts significant off-balance-
from the calculation and analysis of risk-based sheet activities (including securitization and asset
capital ratios on a consolidated holding com- management or administration); or (3) has a
pany basis, subject to certain terms and conditions. material amount of debt securities outstanding
This section also was revised for the Board’s (other than trust preferred securities) that are
February 6, 2006, revision (effective February registered with the SEC. (Previously, the rule
22, 2006) to the market risk measure in Regula- referred only to debt outstanding held by the
tion Y (12 C.F.R. 225, appendix E), which general public; SEC-registered equity securities
reduced the capital requirements for certain cash were not included.) The Federal Reserve may
collateralized securities borrowing transactions apply the tier 1 leverage guidelines at its discre-
of BHCs that have adopted the market risk rule. tion to any BHC, regardless of asset size, if such
This action aligns the capital requirements for action is warranted for supervisory purposes.

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This supplement reflects decisions of the Board with respect to inter-District coordination of
of Governors, new and revised statutory and banking supervision. (See SR-05-27/CA-05-11.)
regulatory provisions, and new and revised
supervisory guidance and instructions issued by
the Division of Banking Supervision and Regu- Section 2124.4
lation since the publication of the July 2005
supplement. ‘‘Interagency Guidelines Establishing Standards
for Information Security’’ has been revised to
conform it to the December 21, 2004, inter-
agency rules that implement section 216 of the
SUMMARY OF CHANGES Fair and Accurate Credit Transactions Act of
2003. (See 12 C.F.R. 225, appendix F.) To
Section 2010.11 address the risks associated with identity theft,
the information security standards generally
‘‘Supervision of Subsidiaries—Private-Banking require each financial institution to develop,
Functions and Activities’’ has been revised to implement, and maintain, as part of its existing
incorporate the USA Patriot Act’s new and information security program, appropriate mea-
enhanced statutory requirements, which are sures to properly dispose of consumer informa-
designed to prevent, detect, and prosecute money tion derived from consumer reports. The amend-
laundering and terrorism. For banking organiza- ments to the information security standards were
tions, the act’s provisions are implemented effective July 1, 2005.
through regulations issued by the U.S. Depart- The section has also been revised to incorpo-
ment of the Treasury (31 C.F.R. 103). Section rate the Interagency Guidance on Response Pro-
326 of the Patriot Act (codified in the Bank grams for Unauthorized Access to Customer
Secrecy Act [BSA] at 31 U.S.C. 5318(l)) requires Information and Customer Notice (the guid-
financial institutions to have customer identifi- ance). The federal banking agencies jointly issued
cation programs that collect and maintain cer- the guidance on March 23, 2005 (effective March
tain records and documentation on customers. 29, 2005). The guidance, which interprets sec-
Institutions also should develop and use identity tion 501(b) of the Gramm-Leach-Bliley Act,
verification procedures to ensure the identity of amended the information security standards.
their customers. SR-04-13 describes the BSA (See 12 C.F.R. 225, appendix F, supplement A.)
examination procedures for customer identifica- The guidance describes the response programs,
tion programs; examiners should follow these including customer notification procedures, that
procedures when evaluating an institution’s com- certain banking organizations should develop
pliance with the regulation. (See also SR-03-17 and implement to address unauthorized access
and SR-01-29.) Relevant interagency interpre- to or the use of customer information that could
tive guidance, in a question-and-answer format, result in substantial harm or inconvenience to a
addresses the customer identification rules. (See customer. (See SR-05-23/CA-05-10.)
SR-05-9.) This section also has been revised to
include general and specific references to the
relevant supervisory guidance in the Federal Section 2231.0
Financial Institutions Examination Council’s
Bank Secrecy Act/Anti–Money Laundering ‘‘Real Estate Appraisals and Evaluations’’ has
Examination Manual, which was issued in June been revised to include a summary of the inter-
2005. (See SR-05-12 and its attachments.) agency responses to questions on both the agen-
cies’ appraisal regulations and the October 2003
interagency statement titled Independent
Section 2124.01 Appraisal and Evaluation Functions. The agen-
cies’ March 22, 2005, interpretive responses
‘‘Risk-Focused Supervision Framework for Large address common questions on the requirements
Complex Banking Organizations’’ reaffirms the of the appraisal regulations and the October
definition of the responsible Reserve Bank (RRB) 2003 interagency statement. (See SR-05-5 and
and specifies the RRB’s responsibilities for con- its attachment.) The section also has been updated
ducting inter-District inspection and supervision
activities for a banking organization. The sec- BHC Supervision Manual January 2006
tion highlights and clarifies the role of the RRB Page 1
to include a summary of the September 8, 2005, developed to incorporate the interagency

interagency interpretive responses to frequently guidance.
asked questions; the agencies jointly issued the
responses to help regulated institutions comply
with the agencies’ appraisal regulation and real Section 3111.0
estate lending requirements when financing resi-
dential construction in a tract development. (See ‘‘Section 4(c)(8) of the BHC Act—Acquisition
SR-05-14 and its attachment.) of Savings Associations’’ has been revised to
indicate that bank holding companies acquiring
savings associations under this statutory provi-
sion must conform the acquired associations’
Section 3005.0 nonbanking activities to those that are permis-
sible under section 4 of the BHC Act. (See also
‘‘Section 2(c)(2)(F) of the BHC Act—Credit
section 225.28(b)(4)(ii) of Regulation Y.) The
Card Bank Exemption from the Definition of a
revised section discusses a more recent Board
Bank’’ has been revised to add a table of laws,
order and lists other Board orders that have
regulations, interpretations, and orders concern-
authorized the acquisition of savings associa-
ing the credit card bank exemption found in
tions.
section 2(c)(2)(F) of the BHC Act.
Section 5000.0
Section 3071.0
‘‘BHC Inspection Program—General’’ has been
‘‘Section 4(c)(8) of the BHC Act (Mortgage revised to briefly discuss the reconfirmation of
Banking—Accounting and Reporting for Com- the Federal Reserve’s policy on the coordination
mitments to Originate and Sell Mortgage Loans)’’ of inspection and supervisory activities among
is a new section that has been added to incorpo- the Reserve Banks. When banking organiza-
rate the May 3, 2005, Interagency Advisory on tions operate in more than one District, it is
Accounting and Reporting for Commitments to important that (1) inspection and supervisory
Originate and Sell Mortgage Loans, which was staff assess and weigh all relevant and signifi-
issued by the Federal Reserve and the other cant supervisory findings when evaluating the
federal bank and thrift supervisory agencies. consolidated banking organization and (2) a
The advisory provides guidance on the appropri- consistent and coordinated supervisory message
ate accounting and reporting for both derivative is communicated to the banking organization.
loan commitments (commitments to originate To achieve this objective, the System follows
mortgage loans that will be held for resale) and the principle that there is one RRB for each
forward loan-sales commitments (commitments fully consolidated banking organization (i.e.,
to sell mortgage loans). When accounting and each top-tier consolidated banking organiza-
reporting for derivative loan commitments, insti- tion). Section 5000.0.6 defines the RRB for a
tutions (and bank holding companies) are banking organization, highlights the role of the
expected to use generally accepted accounting RRB in inter-District coordination of banking
principles. Institutions (and bank holding com- supervision, and briefly discusses the roles and
panies) also must correctly report derivative duties of the RRBs in conducting multi-District
loan commitments in accordance with their fed- inspection and supervision activities. The classi-
eral bank and thrift supervisory agency’s forms fication of out-of-District nonbank subsidiary
and instructions. (See SR-05-10.) An inspection assets is also discussed. See also section 5000.0.7.
objective and inspection procedures were also (See SR-05-27/CA-05-11.)

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This supplement reflects decisions of the Board the Division of Banking Supervision and Regu-
of Governors, new and revised statutory and lation since the publication of the December
regulatory provisions, and new and revised su- 2004 supplement.
pervisory guidance and instructions issued by
LIST OF CHANGES
New Previous
Section Section
Number Number Description of the Change
2010.2 2010.2 The section ‘‘Supervision of Subsidiaries—Loan Administration

and Lending Standards’’ has been revised to include the May 16,
2005, interagency Credit Risk Management Guidance for Home
Equity Lending. The federal supervisory agencies issued the guid-
ance to promote greater focus on sound risk-management practices
at banking organizations (that is, at credit-extending bank and
nonbank subsidiaries of bank holding companies) with home
equity lending programs, including open-end home equity lines of
credit and closed-end home equity loans. The agencies are con-
cerned that some banking organizations’ credit-risk management
practices for home equity lending have not kept pace with the
product’s rapid growth and the easing of underwriting standards.
The guidance highlights the sound risk-management practices that
a banking organization should follow to align the growth with the
risk within its home equity portfolio. The guidance should be
considered in the context of existing regulations and supervisory
guidelines. (See SR-05-11 and its attachment.) The inspection
objectives and procedures have been revised to incorporate this
interagency guidance.
2124.01 2124.01 The section ‘‘Risk-Focused Supervision Framework for Large
Complex Banking Organizations’’ has been revised to incorporate
the risk-management rating definitions, as they are discussed in
SR-99-15, SR-97-24, and SR-95-51. SR-04-18 (and its attach-
ment) made revisions to the rating definitions for risk manage-
ment. A banking organization’s risk-management assessment is
deemed to be strong, acceptable, or weak. The central point of
contact or designated examiner(s) should use the revised risk-
management assessment definitions to develop a risk matrix,
which should be used primarily for planning supervisory activities.
The risk matrix does not have the fine gradations involved in
rating a risk-management system on a function-by-function or
activity basis, an approach that would be used in conducting and
completing a bank holding company inspection.
2129.05 2129.05 The ‘‘Risk and Capital Management—Secondary-Market Credit
Activities’’ section has been revised to incorporate the new bank
holding company RFI/C(D) rating system. Other previously issued
risk-management-oriented SR-letters are also referenced. In addi-
tion, the Board’s July 17, 2004, approval of revisions to the

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risk-based capital rule (effective September 30, 2004) provides for

a limited exclusion from risk-weighted assets for an asset-backed
commercial paper (ABCP) program. A banking organization’s
ABCP program may be excluded from risk-weighted assets (1) when
the banking organization is the program’s sponsor and (2) when it
must consolidate under generally accepted accounting principles
(GAAP) its ABCP program that is defined as a variable interest
entity. (See section 2128.03.)
3005.0 A new section, ‘‘Credit Card Bank Exemption from the Definition
of a Bank,’’ discusses the February 18, 2005, Board staff interpre-
tation involving the credit card bank exemption under section
2(c)(2)(F) of the BHC Act. This statutory provision sets forth the
criteria that an institution must meet to qualify for the so-called
credit card bank exemption. The Board staff’s interpretation con-
cluded that no BHC application to the Board would be required for
a proposed acquisition of a credit card bank if the company
(1) met the statutory criteria and (2) complied with the representa-
tions and commitments it made, including those that were required
by the Board. Board staff also concluded that a related stock
redemption did not require a filing with the Board.
3040.0 3040.0 The ‘‘Section 4(c)(4) of the BHC Act—Interests in Nonbanking
Organizations’’ section has been revised to include a qualifying
foreign banking organization’s (FBO’s) November 24, 2004,
request for a Board staff determination, which is based on section
4(c)(4) of the BHC Act and on the availability of a fiduciary
exemption that is found in the Board’s Regulation K, section
211.23(f)(4) (12 C.F.R. 211.23(f)(4)) and in Regulation Y, section
225.22(d)(3) (12 C.F.R. 225.22(d)(3)). Two of the FBO’s asset-
management subsidiaries proposed to serve as trustee for foreign-
based investment trusts that would invest in U.S. real estate. As
part of this asset-management activity, the two subsidiaries would
each take title to U.S. real estate on behalf of the investment trusts
and exclusively for the account of each trust for the benefit of the
investors in the trusts. The foreign jurisdiction’s law requires the
two subsidiaries to obtain a banking license in order to serve as
trustee for the investment trusts, and the two subsidiaries are
subject to supervision and regulation by the bank supervisory
authority in the foreign jurisdiction. Under the arrangement, the
two subsidiaries are subject to fiduciary duties that closely resemble
those of a trustee in the United States. Under the law of the foreign
jurisdiction, the investment trusts would not be legal entities
separate from the two subsidiaries. In addition, the FBO commit-
ted that neither it nor its subsidiaries or employee benefit plans
would own any beneficial interests in the investment trusts. (See
Federal Reserve Regulatory Service 4–305.2)
3250.0 3250.0 The ‘‘4(c)(8)—Agency Transactional Services (Futures Commis-
sion Merchants and Futures Brokerage)’’ section has been revised
to amend the inspection-scope guidance to emphasize the need for

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examiners to apply a functional-regulatory approach, consistent

with section 111 of the Gramm-Leach-Bliley Act, to conduct a
BHC inspection of a futures commission merchant subsidiary.
(See section 1040.0 and 12 U.S.C. 1844(c).) The section also
references the new bank holding company RFI/C(D) rating system.
3905.0, 3905.0, The section ‘‘Permissible Activities for FHCs—Section 4(k) of the
3920.0 3920.0 BHC Act’’ and the section ‘‘Limited Physical-Commodity-Trading
Activities—Section 4(k) of the BHC Act’’ have been revised to
discuss or reference additional Board orders (see 2004 FRB 215
and 2004 FRB 511) that authorized engaging in limited amounts
and types of commodity-trading activities that complement the
financial activity of engaging regularly as principal in BHC-
permissible commodity derivatives based on a particular commod-
ity. A financial holding company must submit, through the filing of
a notice under section 4 of the BHC Act, a written request to the
Federal Reserve Board in order to engage in a complementary
activity.
4060.3 4060.3 The section ‘‘Consolidated Capital—Examiners’ Guidelines for
Assessing the Capital Adequacy of BHCs’’ incorporates the Board’s
February 28, 2005, revision of its risk-based capital rule that
allows the continued limited inclusion of trust preferred securities
in the tier 1 capital of bank holding companies. Until March 31,
2009, the aggregate amount of qualifying cumulative perpetual
preferred stock (including related surplus) and qualifying trust
preferred securities that a banking organization may include in tier
1 capital is limited to 25 percent of the sum of the following core
capital elements: qualifying common stockholders’ equity, qualify-
ing noncumulative and cumulative perpetual preferred stock (includ-
ing related surplus), qualifying minority interests in the equity
accounts of consolidated subsidiaries, and qualifying trust pre-
ferred securities. The rule limits restricted core capital elements to
25 percent of the sum of the core capital elements (this limit
includes the restricted core capital elements) net of goodwill and
any associated deferred tax liability. The restricted core capital
elements are defined in the rule as qualifying cumulative perpetual
preferred stock (including related surplus), minority interest relat-
ing to qualifying cumulative perpetual preferred stock directly
issued by a consolidated U.S. depository institution or foreign
bank subsidiary, minority interest related to qualifying common
stockholders’ equity or perpetual preferred stock issued by a
consolidated subsidiary that is neither a U.S. depository institution
nor a foreign bank, and qualifying trust preferred securities. Inter-
nationally active BHCs, defined as those having consolidated
assets of $250 billion or more or having on-balance-sheet foreign
exposure of $10 billion or more, will be subject to a 15 percent
limit, effective March 31, 2009. However, internationally active
BHCs may include qualifying mandatory convertible preferred

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securities up to the generally applicable 25 percent limit. Amounts

of restricted core capital elements that are in excess of these limits
generally may be included in tier 2 capital.
The revised rule also addresses supervisory concerns, competi-
tive equity considerations, and the qualifying terms for trust pre-
ferred securities included in tier 1 capital. The rule strengthens the
definition of regulatory capital by incorporating long-standing
Board policies regarding the acceptable terms of capital instru-
ments included in banking organizations’ tier 1 or tier 2 capital.
(See the Board’s March 1, 2005, press release. The final rule was
published in the Federal Register on March 10, 2005.)
4060.4 4060.4 The ‘‘Consolidated Capital—Leverage Measure’’ section has been
revised to incorporate the changes made to allow and accommo-
date in the tier 1 leverage measures (12 C.F.R. 225, appendix D)
the continued limited inclusion of trust preferred securities in the
tier 1 capital of bank holding companies. The previous definition
of tier 1 capital was deleted. For the purposes of the leverage
measure, the definition of tier 1 capital relies on the tier 1 capital
definition that is found in the risk-based capital rule (12 C.F.R.
225, appendix A).
4070.0 4070.0 The ‘‘Bank Holding Company Rating System’’ section has been
totally revised. The section now includes the bank holding com-
pany RFI/C(D) rating system. Approved by the Board on Decem-
ber 1, 2004 (effective January 1, 2005), the rating system is
described in the attachment to SR-04-18. Each inspected BHC is
assigned a ‘‘C’’ composite rating, which is based on an evaluation
and rating of the BHC’s managerial and financial condition and an
assessment of future potential risk to its subsidiary depository
institution(s). The other main components of the rating system are
Risk management (R); Financial condition (F); and potential
Impact (I) of the parent company and nondepository subsidiaries
(collectively nondepository entities) on the subsidiary depository
institution(s). Several component ratings have subcomponent rat-
ings. The composite, component, and subcomponent ratings are
assigned to BHCs on the basis of a numeric scale. A 1 is the
highest rating; a 5 is the lowest. All of the BHC’s numeric ratings,
including the composite, component, and subcomponent ratings,
should be presented in the inspection report in accordance with
Federal Reserve supervisory practices.
4070.1 4070.1 The section ‘‘Rating the Adequacy of Risk-Management Processes
and Internal Controls of Bank Holding Companies,’’ which was
derived from SR-95-51, has been amended for the risk-
management rating classifications and definitions described in the
attachment to SR-04-18. The attachment outlines the Board-
approved RFI/C(D) bank holding company rating system, which
was effective January 1, 2005.

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4070.5 4070.0.9 A new section, ‘‘Nondisclosure of Supervisory Ratings,’’ describes

the Federal Reserve’s long-standing policy of disclosing to the
board of directors and senior management the confidential com-
posite numeric rating and the alphabetic component ratings assigned
under various supervisory rating systems. (See SR-88-37 and
SR-96-26.) The section now references the bank holding company
RFI/C(D) rating system (see section 4070.0 and SR-04-18 and its
attachment), which replaced the BOPEC rating system for BHCs.
Also, the section includes the February 28, 2005, Interagency
Advisory on the Confidentiality of the Supervisory Rating and
Other Nonpublic Supervisory Information. The advisory reminds
banking organizations of the statutory prohibitions on the disclo-
sure of supervisory ratings and other confidential supervisory
information to insurers or other nonrelated third parties without
the permission of the appropriate federal banking agency. (See
SR-05-4.)
1000.0, 1000.0, These sections have been revised to incorporate the Board’s adop-
2124.0, 2124.0, tion of the bank holding company RFI/C(D) rating system. (See
2124.04, 2124.04, SR-04-18 and its attachment.)
2128.05, 2128.05,
4010.2, 4010.2,
4070.3, 4070.3,
4080.0, 4080.0,
5000.0, 5000.0,
5010.1, 5010.1,
5010.4, 5010.4,
5010.6 5010.6
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Supplement 27—December 2004
of Governors, new and revised statutory and lation since the publication of the June 2004
regulatory provisions, and new and revised supplement.
LIST OF CHANGES
New Previous
Section Section
2010.13 The new section ‘‘Establishing Accounts for Foreign Govern-

ments, Embassies, and Political Figures’’ conveys the June 15,
2004, interagency advisory ‘‘Guidance on Accepting Accounts
from Foreign Governments, Foreign Embassies, and Foreign
Political Figures.’’ The advisory was issued by the federal banking
and thrift agencies (the agencies) and the U.S. Department of the
Treasury’s Financial Crimes Enforcement Network (FinCEN).
The advisory responds to inquiries the agencies and FinCEN
received on whether financial institutions should do business and
establish account relationships with those foreign customers cited
in the advisory. Banking organizations are advised that the deci-
sion to accept or reject such foreign-account relationships is theirs
alone to make.
Financial institutions, including a bank holding company’s bank
and thrift subsidiaries, should be aware that there are varying
degrees of risk associated with these accounts, depending on the
customer and the nature of the services provided. Institutions
should take appropriate steps to manage these risks, consistent
with sound practices and applicable anti-money-laundering laws
and regulations. The advisory is primarily directed to financial
institutions 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’ finan-
cial and other services. (See SR-04-10.)
2128.03 2128.03 The section ‘‘Credit-Supported and Asset-Backed Commercial
Paper’’ has been revised to incorporate the Board’s July 17, 2004,
approval (effective September 30, 2004) of a revision to the
risk-based capital requirements for state member banks and bank
holding companies (collectively banking organizations) that spon-
sor asset-backed commercial paper (ABCP) programs. For more
details, see the summary for section 4060.3. The inspection objec-
tives and inspection procedures were also revised to incorporate
the revised rule for ABCP programs.
3140.0 3140.0 The section ‘‘Leasing Personal or Real Property’’ has been revised
to incorporate a Board staff legal opinion that was requested by a
foreign banking organization (FBO) that is treated as a bank
holding company (BHC). The FBO, as a BHC, engages in leasing
activities that the Board has authorized in Regulation Y, section
225.28(b)(3) (12 C.F.R. 225.28(b)(3)). The FBO asked if a BHC
BHC Supervision Manual December 2004

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Bank Holding Company Supervision Manual Supplement 27—December 2004
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may provide, as an incidental nonbank activity, fleet-management

services to some nonleased vehicles in accordance with its Regula-
tion Y–authorized leasing activities. In a December 19, 2003,
opinion, Board staff stated that the provision of fleet-management
services to some nonleased vehicles is an activity incidental to the
BHC’s authorized leasing activities, provided the BHC’s leasing
subsidiary limits its fleet-management services involving vehicles
not subject to a Regulation Y permissible lease to no more than
15 percent of the fleet-management revenues, and to 5 percent of
the total leasing revenues of the leasing subsidiary. (See the
December 19, 2003, Board staff opinion and Regulation Y, 12
C.F.R. 225.28(b)(3), footnote 5.)
3500.0 3500.0 Section 106 of the Bank Holding Company Act Amendments of
1970 generally prohibits a bank from conditioning the availability
or price of one product or service (the ‘‘tying product,’’ or the
‘‘desired product’’) on a requirement that a customer obtain
another product or service (the ‘‘tied product’’) from the bank or
an affiliate of the bank. Section 106 also prohibits a bank from
conditioning the availability or price of one product on a require-
ment that a customer (1) provide another product to the bank or an
affiliate of the bank or (2) not obtain another product from a
competitor of the bank or from a competitor of an affiliate of the
bank. Section 106 contains several exceptions to its general prohi-
bitions, and it authorizes the Board to grant, by regulation or order,
additional exceptions from the prohibitions when the Board deter-
mines an exception ‘‘will not be contrary to the purposes’’ of the
statute.
The section ‘‘Tie-In Considerations of the BHC Act’’ has been
revised to include a Board interpretation and a Board staff interpre-
tation of section 106 on tying arrangements, which were issued on
August 18, 2003, and February 2, 2004. These two interpretations
state that bank customers that receive securities-based credit can
be required to hold their pledged securities as collateral at an
account of a bank holding company’s or bank’s broker-dealer
affiliate.
4060.3 4060.3 The section ‘‘Examiners’ Guidelines for Assessing the Capital
Adequacy of BHCs’’ has been updated to include the revisions to
the Board’s risk-based capital requirements for asset-backed com-
mercial paper (ABCP) programs sponsored by state member banks
and bank holding companies (collectively, banking organizations).
The Board approved the rule changes on July 17, 2004 (effective
September 30, 2004). See appendix A of Regulation Y (12 C.F.R.
225, appendix A).
In January 2003, the Financial Accounting Standards Board
(FASB) issued FASB Interpretation No. 46, ‘‘Consolidation of
Variable Interest Entities’’ (FIN 46). FIN 46 required, for the first
time, the consolidation of variable interest entities (VIEs) onto the
balance sheets of companies deemed to be the primary beneficia-
ries of those entities. In December 2003, FASB revised FIN 46 as

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FIN 46-R. (The interpretation (FIN 46 or FIN 46-R) was effective

for reporting periods that ended as early as December 15, 2003.
However, there are various effective dates, which are determined
on the basis of the nature, size, and type of business entity). FIN
46-R requires the consolidation of many ABCP programs onto the
balance sheets of banking organizations.
Under the Board’s revised risk-based capital rule, a banking
organization that qualifies as a primary beneficiary and must
consolidate an ABCP program that is defined as a variable interest
entity under generally accepted accounting principles (FIN 46-R)
may exclude the consolidated ABCP program’s assets from its
risk-weighted assets, provided that it is the sponsor of the ABCP
program. Such banking organizations must also hold risk-based
capital against eligible ABCP liquidity facilities that have an
original maturity of one year or less that provide liquidity support
to its ABCP by applying a new 10 percent credit-conversion factor
to such facilities. Eligible ABCP liquidity facilities with an origi-
nal maturity exceeding one year remain subject to the rule’s
current 50 percent credit-conversion factor. Ineligible liquidity
facilities are treated as direct-credit substitutes or recourse obliga-
tions, which are subject to a 100 percent credit-conversion factor.
When calculating the banking organization’s tier 1 and total capi-
tal, any associated minority interests must also be excluded from
tier 1 capital. The inspection procedures were also revised to
incorporate the revised risk-based capital requirements for bank
holding companies.
5010.10 5010.10 This section discusses the inspection reporting of consolidated
classified and special-mention assets and other transfer-risk prob-
lems. It has been revised to include the revised Uniform Agree-
ment on the Classification of Assets and Appraisal of Securities
Held by Banks and Thrifts (the uniform agreement) that was
jointly issued by the federal banking and thrift agencies (the
agencies) on June 15, 2004. The revised uniform agreement
amends the 1938 classification of securities agreement (the 1938
accord), which was revised on July 15, 1949, and May 7, 1979.
The uniform agreement sets forth the definitions of the classifica-
tion categories and the specific examination procedures and infor-
mation for classifying bank assets, including securities. The June
2004 revision did not change the classification of loans in the
uniform agreement. The revised uniform agreement addresses,
among other items, the treatment of rating differences, multiple
security ratings, and split or partially rated securities. It also
eliminates the automatic classification for sub-investment-grade
debt securities. (See SR-04-9.) The uniform agreement’s classifi-
cation categories also apply to the classification of assets held by
the subsidiaries of banks and bank holding companies.

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2010.13, pages 1–2
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pages 15–18 pages 15–18, 18.1
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Page 4
Supplement 26—June 2004
of Governors, new and revised statutory and lation since the publication of the December
regulatory provisions, and new and revised 2003 supplement.
LIST OF CHANGES
New Previous
Section Section
2065.4 2065.4 This section on ALLL methodologies and documentation has been
revised to include a reference to the March 1, 2004, interagency
Update on Accounting for Loan and Lease Losses. The inter-
agency update discusses recent developments in accounting, cur-
rent sources of generally accepted accounting principles, and
supervisory guidance that applies to the ALLL. Other SR-letters
associated with the supervisory guidance for the allowance are
referenced in the interagency update. (See SR-04-5.)
2090.1 2090.1 The Control and Ownership (Change in Control) section has been
revised to emphasize the importance of understanding the require-
ments for filing a notice under the Change in Bank Control Act.
The complexity of an ownership position sometimes does not lend
itself to easy interpretation of the requirements to file a notice.
When it is unclear whether a notice is required, the potential filer
(or filers) or the affected state member bank or BHC is encouraged
to contact staff at a Federal Reserve Bank or the Board for
guidance. Prior notice is required by any person (acting directly or
indirectly) that seeks to acquire control of a state member bank or
BHC. A person may include an individual, a group of individuals
acting in concert, or certain entities (for example, corporations,
partnerships, or trusts) that own shares of banking organizations
but that do not qualify as BHCs. A person acquires control of a
banking organization whenever the person acquires ownership,
control, or the power to vote 25 percent or more of any class of
voting securities of the institution. See section 225.41 of Regula-
tion Y (12 C.F.R. 225.41), which sets forth the specific types of
transactions that require prior notice under the Change in Bank
Control Act. Section 225.41 outlines certain other rebuttable pre-
sumptions of control that may require the filing of a notice,
including (under certain circumstances) a proposed acquisition
that would result in a person owning or controlling the power to
vote 10 percent or more of any class of voting securities. (See
SR-03-19.)
2110.0 2110.0 This section on formal corrective actions has been revised to
briefly discuss the joint rules adopted by the Board and the other
federal bank and thrift regulatory agencies (effective October 1,
2003) for the removal, suspension, and debarment of accountants
from performing audit services. (See the Board’s August 8, 2003,
BHC Supervision Manual June 2004

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Bank Holding Company Supervision Manual Supplement 26—June 2004
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press release.) Section 36 of the Federal Deposit Insurance Act, as

implemented by 12 C.F.R. 363, requires each federally insured
depository institution with total assets of $500 million or more to
obtain an annual audit of its financial statements prepared by an
independent public accountant, as well as an attestation on man-
agement’s assertions concerning internal controls. The joint rules
established the practices and procedures under which each agency
can, for good cause, remove, suspend, or bar an accountant or
accounting firm from performing audit and attestation services for
federally insured depository institutions that have total assets of
$500 million or more.
2124.01 2124.01 The Board’s Division of Banking Supervision and Regulation and
its Division of Consumer and Community Affairs have developed
an enhanced framework for the supervision of consumer compli-
ance risk. The section on the risk-focused supervisory framework
for large, complex banking organizations (LCBOs) has been
revised to incorporate this guidance. For LCBOs and large bank-
ing organizations (LBOs) that are subject to the Federal Reserve
System’s continuous supervision program, safety-and-soundness
examiners are to incorporate the consumer compliance risk assess-
ment into the overall risk assessment and planned supervisory
activities for LCBOs and LBOs. When performing the consumer
compliance risk assessment, consumer compliance examiners are
to rely on the work conducted by the dedicated supervisory team,
the primary bank regulator, or both. In addition, the consumer
compliance examiner is to discuss any identified areas of signifi-
cant consumer compliance risk with the Federal Reserve’s central
point of contact (CPC) assigned to the organization. In coordina-
tion with the CPC and the supervisory team, the consumer compli-
ance examiner is to evaluate how consumer compliance risk
affects the reputational, legal, and operational risk profiles of the
LCBO or LBO. For other BHCs that have multiple federally
insured depository institution subsidiaries or nonbank subsidiaries,
surveillance and other information will be used as the basis for
assessing consumer compliance risk. Consumer compliance risk
will not be assessed in shell holding companies. (See SR-03-22.)
2178.0 This new section discusses the January 5, 2004, Interagency
Policy on Banks/Thrifts Providing Financial Support to Funds
Advised by the Banking Organization or Its Affiliates. The policy
alerts banking organizations, including their boards of directors
and senior management, to the safety-and-soundness implications
of and the legal impediments to a bank providing financial support
to investment funds advised by the bank, its subsidiaries, or
affiliates (that is, an affiliated investment fund).
The interagency policy emphasizes three core principles: A
bank should not (1) inappropriately place its resources and reputa-
tion at risk for the benefit of an affiliated investment fund’s
investors and creditors; (2) violate the limits and requirements in

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Federal Reserve Act sections 23A and 23B and in Regulation W,

other applicable legal requirements, or any special supervisory
condition imposed by the agencies; or (3) create an expectation
that the bank will support the advised fund (or funds).
In addition, bank-affiliated investment advisers are encouraged
to establish alternative sources of financial support to avoid seek-
ing support from affiliated banks. A bank’s investment advisory
services can pose material risks to the bank’s liquidity, earnings,
capital, and reputation and can harm investors, if the risks are not
effectively controlled. Bank management is expected to notify and
consult with its appropriate federal banking agency before (or
immediately after, in the event of an emergency) providing mate-
rial financial support to an affiliated investment fund. (See SR-04-
1.) Inspection objectives and inspection procedures have been
developed to address the supervisory concerns set forth in the
policy. The objectives and procedures focus on a BHC’s oversight
responsibilities for its bank and nonbank subsidiaries that advise
investment funds.
2231.0 2231.0 The Real Estate Appraisals and Evaluations section has been
updated to add the October 27, 2003, interagency statement on
Independent Appraisal and Evaluation Functions as appendix B. A
banking institution’s board of directors is responsible for review-
ing and adopting policies and procedures that establish and main-
tain an effective, independent real estate appraisal and evaluation
program (the program) for all of its lending functions. Concerns
about the independence of appraisals and evaluations arise from
the risk that improperly prepared appraisals may undermine the
integrity of credit-underwriting processes.
An institution’s lending functions should not have undue influ-
ence that might compromise the program’s independence. Institu-
tions may not use an appraisal prepared by an individual who was
selected or engaged by a borrower. Likewise, institutions may not
use readdressed appraisals—appraisal reports that are altered by
the appraiser to replace any references to the original client with
the institution’s name. Altering an appraisal report in a manner
that conceals the original client or intended users of the appraisal
is misleading and violates the agencies’ appraisal regulations and
the Uniform Standards of Professional Appraisal Practice (USPAP).
(See SR-03-18.)
3160.0, 3160.0, Revisions to these nonbanking sections concern subsidiaries with
3160.2 3160.2 EDP servicing company activities and electronic benefit transfer,
stored-value-card, and electronic data interchange service activi-
ties. The changes incorporate the current revenue limit of 49 per-
cent (previously 30 percent) that the Board approved on
November 26, 2003 (effective January 8, 2004). An EDP servicing
company may provide services to others (outside third parties) if

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the total annual revenues derived from activities involving data

processing, data storage, and data transmission services (that are
not financial, banking, or economic related) do not exceed the
revised limit. BHCs may request permission to administer the
49 percent revenue test on a business-line or multiple-entity basis.
See section 225.28(b)(14) of Regulation Y (12 C.F.R. 225.28(b)(14)).
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2090.1, pages 1–4 2090.1, pages 1–6
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3160.0, pages 1–6 3160.0, pages 1–6
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Supplement 25—December 2003
of Governors, new and revised statutory and lation since the publication of the June 2003
regulatory provisions, and new and revised supplement.
LIST OF CHANGES
New Previous
Section Section
2060.5 2060.05 This section has been revised to incorporate the May 5, 2003,
Statement on Application of Recent Corporate Governance Initia-
tives to Nonpublic Banking Organizations issued by the Federal
Reserve, the Office of the Comptroller of the Currency, and the
Office of Thrift Supervision. The statement announced that the
agencies do not expect to take actions to apply corporate-
governance and other requirements of the Sarbanes-Oxley Act to
nonpublic banking organizations that are not otherwise subject to
them. The agencies, however, encouraged nonpublic banking orga-
nizations to periodically review their policies and procedures
relating to corporate governance, auditing, and other requirements
of the Sarbanes-Oxley Act. Although the act does not require
small, nonpublic banking organizations to strictly adhere to its
provisions, the agencies expect these banking organizations to
ensure that their policies and procedures are consistent with appli-
cable law, regulations, and supervisory guidance and that they
remain appropriate for the organizations’ size, operations, and
resources. (See SR-03-08.)
2110.0 2110.0 This revised section on formal corrective actions discusses the
existing restrictions on, and requirements for, severance payments
made to institution-affiliated parties (so-called golden parachute
payments). The restrictions originated from the Crime Control Act
of 1990, which added section 18(k) to the Federal Deposit Insur-
ance Act (12 U.S.C. 1828(k)). The FDIC’s regulations on golden
parachute payments (or any agreement to make any payment),
found in 12 C.F.R. 359, are discussed in this section. The 30-day
prior-notice requirement for appointing any new directors or senior
executive officers of state member banks and bank holding compa-
nies is also discussed. (See section 32 of the FDI Act (12 U.S.C.
1831i) and subpart H of Regulation Y (12 C.F.R. 225.71).) This
notice requirement also applies to any change in the responsibili-
ties of any current senior executive officer that proposes to assume
a different position. (See SR-03-06.)
3120.0 3120.0 The trust services section is revised to discuss the oversight
responsibilities of the board of directors and senior management
for operating the fiduciary activities of their financial holding
company (FHC) or bank holding company (BHC) in a safe and
sound manner. This oversight at the consolidated level is impor-

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tant because the risks associated with financial activities as well as

fiduciary activities can cut across legal entities and business lines.
Relying on the examination findings of the appropriate trust activi-
ties regulator, the examiner is to review and assess the internal
policies, reports, and procedures and the effectiveness of the
BHC’s or FHC’s consolidated risk-management process for trust
activities. The revision includes a discussion of the available
reported supervisory information and analytical support tools that
an examiner can use to evaluate the trust services of the holding
company and its subsidiaries. (See SR-00-13.)
3000.0.2 3000.0.2 Appendix 1 of subsection 3000.0.2 (the detailed list of Board-
3260.0 3260.0 approved nonbanking activities in section 225.28(b) of Regulation
Y) and section 3260.0 have been revised to include the Board’s
June 27, 2003, approval of a Regulation Y amendment (effective
August 4, 2003) to permit BHCs to (1) take and make delivery of
title to commodities underlying commodity derivative contracts on
an instantaneous, pass-through basis and (2) enter into certain
commodity derivative contracts that do not require cash settlement
or specifically provide for assignment, termination, or offset before
delivery.
3600.30 3600.30 The nonbanking activities section on real estate title abstracting
has been revised to include an October 7, 2002, staff opinion on
BHC-conducted title abstracting activities for U.S.-registered air-
craft. The title abstracting services are limited to (1) performing a
title search of aircraft records and (2) reporting factual information
on the ownership history of the relevant aircraft and the existence
of liens and encumbrances affecting title to the aircraft. Staff
opined that the described title abstracting activities for U.S.-
registered aircraft would be within the scope of title abstracting
activities for real estate previously determined to be permissible
under section 4(c)(8) of the BHC Act on June 30, 1995. (See 1995
FRB 806.)
3920.0 This new section discusses the Board’s October 2, 2003, approval
of an FHC’s notice under section 4(k) of the BHC Act to engage in
physical commodity trading activities on a limited basis as an
activity that is complementary to the financial activity of engaging
regularly as principal in commodity derivative activities. (The
effective date of the Board’s order is also October 2, 2003.)
3950.0 This new section provides inspection guidance on insurance sales
activities and consumer protection in sales of insurance as the
guidance pertains to FHCs, BHCs, or state member banks. Exam-
iner guidance is provided on (1) conducting risk assessments of
BHC or state member bank insurance and annuity sales activities
in accordance with the Federal Reserve’s risk-focused supervisory
approach and (2) examining a state member bank’s compliance
with the new Consumer Protection in Sales of Insurance (CPSI)
regulation contained in subpart H of the Board’s Regulation H (12
C.F.R. 208.81–86). The CPSI regulation (effective October 1,

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2001) applies only to insured depository institutions. It imple-

ments section 305 of the Gramm-Leach-Bliley Act (the GLB Act)
(12 U.S.C. 1831x). The guidance provides a comprehensive review
of these insurance and annuity sales activities as they pertain to a
BHC or bank and discusses the Federal Reserve’s responsibility
for enforcing a depository institution’s compliance with the CPSI
regulation. Consistent with the GLB Act, the guidance incorpo-
rates applicable restrictions on examining a functionally regulated
subsidiary. The CPSI regulation’s supervisory guidance is pro-
vided for the BHC examiner’s, the board of directors’, and senior
management’s information. The information is made available in
this manual to BHC directors and management so they can fulfill
their respective responsibilities in overseeing the operations of the
BHC and its insured depository institution subsidiaries.
The CPSI regulation requires certain disclosures in connection
with the retail sale or solicitation of insurance products and
annuities by a bank, any other person at bank offices where retail
deposits are accepted from the public, or any person ‘‘acting on
behalf of the bank.’’ Appendix A summarizes the banking agen-
cies’ joint statement in which they responded to a request to clarify
whether the disclosure requirements apply to renewals of pre-
existing insurance policies sold before October 1, 2001. Appendix
B is a glossary of terms associated with insurance and annuity
sales activities. Inspection objectives, inspection procedures, and
an internal control questionnaire are also provided.
4020.4 4020.4 This revised section on bank liquidity incorporates the July 25,
2003, Interagency Advisory on the Use of the Federal Reserve’s
Primary Credit Program in Effective Liquidity Management. The
interagency advisory provides guidance on the appropriate use of
primary credit in effective liquidity management. The board of
directors and senior management of BHCs and state member
banks are advised to consider the Federal Reserve’s primary credit
program as part of their contingency funding plans and to provide
for adequate diversified potential sources of funds to satisfy liquid-
ity needs, which includes planning for certain significant liquidity
events. (See SR-03-15.)
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Page 4
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 Reserve’s 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- organization’s publicly available reports, such
ture, the manual enhances the staff’s ability to as annual and other periodic reports and infor-
implement the Board’s 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 tion’s 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 organization’s 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 organization’s condition and verify-
tional risks. Inspections also focus on evaluating ing its adherence to internal policies, proce-
the organization’s 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 organization’s risk- instruments and markets allows institutions to
management program. To determine whether rapidly reposition their portfolio risk exposures.
the organization’s 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 organization’s 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 organization’s 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
organization’s 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 organization’s 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 organization’s management or boards of management, resulting in a more open and
directors, as well as to the banking organiza- informed dialogue between management and
tion’s 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 organization’s program for manual is also available on the Board’s 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 Transactions—Introduction
2020.1 Transactions Between Affiliates—Sections 23A and

23B of the Federal Reserve Act
2020.2 Loan Participations—Intercompany 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 Rights—Retention 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
2060.1 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
2068.0 Sound Incentive Compensation Policies
2070.0 Taxes—Consolidated Tax Filing
2080.0 Funding—Introduction
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 Ownership—General
2090.05 Qualified Family Partnerships
2090.1 Change in Control
2090.2 BHC Formations

Page 3
Tabs Sections Title
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
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
2124.03
2124.04 Ongoing Risk-Focused Supervision Program for Large
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
2124.2– Reserved
2124.3
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

Page 4
Tabs Sections Title
2126.0 Nontrading Activities of Banking Organizations—

2126.1 Investment Securities and End-User Derivatives

Activities
2126.2 Reserved
2126.3 Counterparty Credit Risk Management Systems
2127.0 Interest-Rate Risk—Risk Management and Internal

Controls
2128.0 Structured Notes—Risk 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
2129.0 Credit Derivatives—Risk Management and Internal

Controls
2129.05 Risk and Capital Management—Secondary-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

Page 5
Tabs Sections Title
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
3000 NONBANKING ACTIVITIES
3000.0 Introduction to BHC Nonbanking and FHC Activities
3001.0 Section 2(c) of the BHC Act—Savings Bank Subsidiaries

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

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

from Prohibitions on Acquiring Nonbank Interests
3020.0 Section 4(c)(1) of the BHC Act—Investment in

Companies Whose Activities Are Incidental to
Banking
3030.0 Section 4(c)(2) and (3) of the BHC Act—Acquisition

of DPC Shares, Assets, or, Real Estate
3040.0 Section 4(c)(4) of the BHC Act—Interests in

Nonbanking Organizations
3050.0 Section 4(c)(5) of the BHC Act—Investments Under

Section 5136 of the Revised Statutes
3060.0 Section 4(c)(6) and (7) of the BHC Act—Ownership

of Shares in Any Nonbank Company of
5 Percent or Less

Page 6
Tab Sections Title
3070.0 Section 4(c)(8) of the BHC Act—Mortgage Banking
3071.0 Section 4(c)(8) of the BHC Act—Mortgage Banking—

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

Activities
3080.0 Section 4(c)(8) of the BHC Act—Servicing Loans
3084.0 Section 4(c)(8) of the BHC Act—Asset-Management,

Asset-Servicing, and Collection Activities
3090.0 Section 4(c)(8) of the BHC Act—Receivables
3090.1 Factoring
3090.2 Accounts Receivable Financing
3100.0 Section 4(c)(8) of the BHC Act—Consumer Finance
3104.0 Section 4(c)(8) of the BHC Act—Acquiring Debt in Default
3105.0 Section 4(c)(8) of the BHC Act—Credit Card Authorization

and Lost/Stolen Credit Card Reporting Services
3107.0 Section 4(c)(8) of the BHC Act—Stand-Alone Inventory
Inspection Services
3110.0 Section 4(c)(8) of the BHC Act—Industrial Banking
3111.0 Section 4(c)(8) of the BHC Act—Acquisition

of Savings Associations
3120.0 Section 4(c)(8) of the BHC Act—Trust Services
3130.0 Section 4(c)(8) of the BHC Act—General 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 6.1
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 Act—Leasing Personal

or Real Property
3150.0 Section 4(c)(8) of the BHC Act—Community Welfare
Projects
3160.0 Section 4(c)(8) of the BHC Act—EDP Servicing

Company
3160.1 EDP Servicing—Network for the Processing and

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

and Electronic Data Interchange Services
3160.3 Data Processing Activities: Obtaining Traveler’s 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 Services—Printing and Selling MICR-Encoded

Items
3170.0 Section 4(c)(8) of the BHC Act—Insurance Agency

Activities of Bank Holding Companies
3180.0 Section 4(c)(8) of the BHC Act—Insurance

Underwriters
3190.0 Section 4(c)(8) of the BHC Act—Courier Services
3200.0 Section 4(c)(8) of the BHC Act—Management

Consulting and Counseling
3202.0 Section 4(c)(8) of the BHC Act—Employee Benefits

Consulting Services
3204.0 Section 4(c)(8) of the BHC Act—Career Counseling

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

Savings Bonds, and Traveler’s Checks
3210.1 Payment Instruments
3220.0 Section 4(c)(8) of the BHC Act—Arranging

Commercial Real Estate Equity Financing
3230.0 Section 4(c)(8) of the BHC Act—Agency 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 Act—Underwriting and

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

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

Orders
3255.0 Section 4(c)(8) of the BHC Act—Agency Transactional

Services for Customer Investments
3260.0 Section 4(c)(8) of the BHC Act—Investment Transactions

as Principal
3270.0 Section 4(c)(8) of the BHC Act—Real Estate and

Personal Property Appraising
3320.0 Section 4(c)(8) of the BHC Act—Check-Guaranty

and Check-Verification Services

Page 8
Tab Sections Title
3330.0 Section 4(c)(8) of the BHC Act—Operating a

Collection Agency
3340.0 Section 4(c)(8) of the BHC Act—Operating 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 Act—Grandfather

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

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

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

3560.0 Section 4(c)(14) of the BHC Act—Export 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
3600.22 Reserved for future use
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 Act—Board Staff Legal

Interpretation—Financing Customers’ Commodity
Purchase and Forward Sales
3610.2 Section 4(c)(8) of the BHC Act—Board Legal Staff
Interpretation—Certain 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 Act—Financial 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
4000 FINANCIAL ANALYSIS
4000.0 Financial Factors—Introduction
4010.0 Parent Only: Debt-Servicing Capacity—Cash Flow
4010.1 Leverage
4010.2 Liquidity

Page 11
Tab Sections Title
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 Extending—Classifications
4030.2 Nonbanks: Credit Extending—Earnings
4030.3 Nonbanks: Credit Extending—Leverage
4030.4 Nonbanks: Credit Extending—Reserves
4040.0 Nonbanks: Noncredit Extending
4050.0 Nonbanks: Noncredit Extending—Service Charters
4060.0 Consolidated—Earnings
4060.1 Consolidated: Asset Quality
4060.2 Reserved
4060.3 Consolidated Capital—Examiners’ Guidelines for

Assessing the Capital Adequacy of BHCs
4060.4 Consolidated Capital—Leverage Measure
4060.5 Capital Adequacy—Advanced 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 Capital—Direct-Credit

Substitutes Extended to ABCP Programs

Page 12
Tabs Sections Title
4060.9 Consolidated Capital Planning Processes—Payment of

Dividends, Stock Redemptions, and Stock
Repurchases at Bank Holding Companies
4066.0 Consolidated—Funding and Liquidity Risk Management
4070.0 BHC Rating System
4070.1 Rating the Adequacy of Risk-Management

Processes and Internal Controls of Bank
Holding Companies
4070.2 Reserved
4070.3 Revising Supervisory Ratings
4070.4 Reserved
4070.5 Nondisclosure of Supervisory Ratings
4080.0 Federal Reserve System BHC Surveillance Program
4080.1 Surveillance Program for Small Bank Holding Companies
4090.0 Country Risk
5000 BHC INSPECTION PROGRAM
5000.0 BHC Inspection Program—General
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 i—Table of Contents
5010.4 Core Page 1—Examiner’s Comments and Matters

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

Balance Sheet
5010.9 Appendix Page 6—Comparative Statement of Income

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

Special Mention Assets and OTRP
5010.11 Appendix Page 8—Consolidated Comparative Balance

Sheet
5010.12 Appendix Page 9—Comparative Consolidated

Statement of Income and Expenses
5010.13 Capital Structure
5010.14 Page—Policies and Supervision
5010.15 Page—Violations
5010.16 Page—Other Matters
5010.17 Page—Classified Assets and Capital Ratios of

Subsidiary Banks
5010.18 Page—Organization Chart
5010.19 Page—History and Structure
5010.20 Page—Investment in and Advances to Subsidiaries
5010.21 Page—Commercial Paper (Parent)
5010.22 Page—Lines of Credit (Parent)
5010.23 Page—Questions on Commercial Paper and Lines of

Credit (Parent)
5010.24 Page—Contingent Liabilities and Other Accounts

Page 13
Tabs Sections Title
5010.25 Page—Statement of Changes in Stockholders’ Equity

(Parent)
5010.26 Page—Income from Subsidiaries
5010.27 Page—Cash Flow Statement (Parent)
5010.28 Page—Parent Company Liquidity Position
5010.29 Page—Classified Parent Company and Nonbank

Assets
5010.30 Page—Bank Subsidiaries
5010.31 Page—Nonbank Subsidiary
5010.32 Page—Nonbank Subsidiary Financial Statements
5010.33 Page—Fidelity and Other Indemnity Insurance
5010.34 Reserved
5010.35 Page—Other Supervisory Issues
5010.36 Page—Extensions of Credit to BHC Officials . . .
5010.37 Page—Interest Rate Sensitivity—Assets and Liabilities
5010.38 Treasury Activities/Capital Markets
5010.39 Reserved
5010.40 Confidential Page A—Principal Officers and Directors
5010.41 Confidential Page B— Condition of BHC
5010.42 Confidential Page C—Liquidity and Debt Information
5010.43 Confidential Page D—Administrative 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

Preparation—General Instructions
5050.0 Procedures for ‘‘Targeted’’ Inspection Report

Preparation—General Instructions

Page 14
Tabs Sections Title
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 Board’s 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 industries—telephone, 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 organization’s 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 Reserve’s 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 nation’s 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 company’s 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 organization’s 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 BHC’s 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 Board’s
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
agement’s 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-
agement’s 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); zation’s 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 institution’s risk-based capital is calcu- Banking Act of 1978. The Federal Reserve’s
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 stockholder’s 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 activity—activities 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 institution’s 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 BHCs—focusing 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 risks—serves as the foun- subsidiaries (collectively nondepository enti-
dation for Federal Reserve System’s 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 regulator’s 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 Reserve’s 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 Reserve’s 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 ‘‘Examiner’s 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 report—‘‘Examiner’s Comments and Mat-
Part V discusses the methods used to prepare ters Requiring Special Board Attention’’—as
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 II–IV 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 Manual’s 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 II—Topics for Supervisory 2000.0
tives and procedures that provide guidance to Review
the examiner and enhance the supervisory pro- Section 6—Management Information 60.0
cess, the content of the sections within Parts System
II–IV are grouped into broad categories. They Subsection l—Audit .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
WHAT’S NEW IN THIS REVISED bank holding company and nonbank subsidiary
SECTION thereof. Within those limitations, the Federal
Reserve System’s supervisory staff (includes
Effective July 2008, this section has been revised BHC inspection and examination staff) may
to discuss further the authority for the Federal review all books and records of a banking orga-
Reserve to conduct BHC inspections under sec- nization that is subject to Federal Reserve
tion 5 of the Bank Holding Company Act of Supervision.2
1956.
1040.0.2 FOCUS AND SCOPE OF BHC
1040.0.1 BHC INSPECTIONS INSPECTIONS
The Gramm-Leach-Bliley Act (GLB Act) The focus and scope of an inspection is to be
amended section 5(c) of the Bank Holding Com- limited, to the fullest extent possible, to the
pany Act (BHC Act) pertaining to BHC reports BHC and any subsidiary of the BHC that could
and examinations (or inspections, in the case of have a materially adverse effect on the safety
BHCs). The GLB Act provides specific supervi- and soundness of any DI subsidiary of the hold-
sory guidance to the Board of Governors of the ing company due to (1) the size, condition, or
Federal Reserve System (and the Federal Reserve activities of the subsidiary, or (2) the nature or
Banks via delegated authority) with respect to size of the transactions between the subsidiary
the breadth of BHC inspections. It also empha- and any DI subsidiary of the BHC.
sized the focus and scope of BHC inspections The Board is to use, to the fullest extent
and the inspections of BHC subsidiaries. An possible, the bank examination reports of DIs
inspection is to be conducted to— prepared by the appropriate federal or state DI
supervisory authority. The Board also is to use,
1. inform the board of the nature of the opera- to the fullest extent possible, the examination
tions and financial condition of each BHC reports for non-DIs prepared by the following:
and its subsidiaries, including—
a. the financial and operational risks within 1. the Securities and Exchange Commission
the holding company system that may (SEC) for any registered broker or dealer
pose a threat to the safety and soundness 2. the SEC or any state for any investment
of any depository institution (DI) subsidi- adviser registered under the Investment Com-
ary of such bank holding company, and pany Act of 1940
b. the systems for monitoring and control- 3. any state insurance regulatory authority for
ling such financial and operational risks; any licensed insurance company
and 4. any federal or state authority for any other
2. monitor compliance by any entity with the subsidiary that the Board finds to be compre-
provisions of the BHC Act or any other hensively supervised
federal law that the Board has specific juris-
diction to enforce against the entity, and to 1040.0.3 EXAMINATIONS OF
monitor compliance with any provisions of FUNCTIONALLY REGULATED
federal law governing transactions and rela- SUBSIDIARIES
tionships between any DI subsidiary of a
BHC and its affiliates. The Board’s ability to examine a functionally
regulated subsidiary (FRS) is limited. The Board
can examine an FRS only if the Board—
1040.0.1.1 Authority for Bank Holding
Company Inspections 1. has reasonable cause to believe that the sub-
sidiary is engaged in activities that pose a
Section 5 of the BHC Act of 1956 authorizes the material risk to an affiliated DI;
Board to require reports and to conduct inspec-
tions of bank holding companies and their affili- 2. Supervisory staff includes individuals that are on and/or
ates.1 Subject to the limitations discussed below, off site.
Section 5 authorizes the Board to examine each
1. See 12 U.S.C. 1844. Page 1
Bank Holding Company Examination-Inspection Authority 1040.0
2. has reasonably determined, after reviewing a subsidiary is not in compliance with the
relevant reports, that an examination of the BHC Act or any other federal law that the
subsidiary is necessary to be adequately Board has specific jurisdiction to enforce
informed of the systems for monitoring and against such subsidiary. This includes provi-
controlling the operational and financial risks sions relating to transactions with an affili-
posed to any DI; or ated DI, when the Board cannot make its
3. has reasonable cause to believe, based on determination by examining the affiliated DI
reports and other available information, that or the BHC.

Page 2
Consolidated Supervision of Bank Holding Companies and the Combined
U.S. Operations of Foreign Banking Organizations Section 1050.0
The continuing growth in the size and complex- corporate governance, capital adequacy, funding
ity of many banking organizations exposes and liquidity management, and the supervision
these firms to a wide array of potential risks, of material nonbank subsidiaries,2 as well as
while at the same time making it more challeng- other aspects of the Federal Reserve’s consoli-
ing for a single supervisor to have a complete dated supervision activities designed to further
view of firmwide risks and controls. In response the objectives of fostering financial stability and
to these trends, and to better fulfill both its deterring or managing financial crises. In addi-
responsibilities as consolidated supervisor and tion, the Federal Reserve continues to work,
its other central bank objectives, the Federal both independently and in conjunction with
Reserve continues to refine and enhance its other domestic and foreign bank supervisors and
programs for the consolidated supervision of functional regulators, on a number of other ini-
bank holding companies (BHCs) and the tiatives to strengthen supervisory approaches
combined U.S. operations of foreign banking and reinforce expectations for sound practices in
organizations (FBOs). response to recent lessons learned.
The Federal Reserve has set forth its consoli-
dated supervision program for bank holding
companies and the combined U.S. Operations of 1050.0.1 SUPERVISION AND
Foreign Banking Organizations in SR-08-9/CA- REGULATION FRAMEWORK FOR
08-12 and its attachments. (See sections 1050.1 COMPANIES THAT CONTROL A
for the consolidated supervision of large com- BANK AND THE SUBSIDIARIES OF
plex banking organizations and see 1050.2 for SUCH COMPANIES
the consolidated supervision of regional bank-
ing organizations.) The primary objectives of The Bank Holding Company Act (BHC Act),
this supervisory guidance are to specify princi- originally enacted in 1956, provides a federal
pal areas of focus for consolidated supervision framework for the supervision and regulation of
activities and thereby provide for consistent all domestic and foreign companies that control
Federal Reserve supervisory practices and assess- a bank and the subsidiaries of such companies.
ments across organizations with similar activi- Among the principal purposes of the BHC Act
ties and risks. Consistent with these objectives, is to protect the safety and soundness of corpo-
the SR letter and its attached guidance detail rately controlled banks. Financial trouble in one
specific expectations for Federal Reserve staff part of an organization can spread rapidly to
for understanding and assessing primary gover- other parts of the organization; moreover, large
nance functions and risk controls, material busi- BHCs increasingly operate and manage their
ness lines, nonbank operations, financial condi- businesses on an integrated basis across corpo-
tion, and other key activities and risks at banking rate boundaries. Risks that cross legal entities or
organizations; address unique aspects of super- that are managed on a consolidated basis cannot
vising the combined U.S. operations of FBOs; be monitored properly through supervision
and highlight the supervisory attention that should directed at any one of the legal entity subsidi-
be paid to risk-management systems and inter- aries within the overall organization.
nal controls used by BHCs and FBOs that pro- The BHC Act provides for all BHCs, includ-
vide core clearing and settlement services (core ing financial holding companies formed under
clearing and settlement organizations) or that the Gramm-Leach-Bliley Act (GLBA), to be
have a significant presence in critical or key supervised on a consolidated basis by the Fed-
financial markets.1 The guidance also reiterates eral Reserve. Consolidated supervision of a
the importance of coordination with, and reli- BHC encompasses the parent company and its
ance on, the work of other relevant primary subsidiaries, and allows the Federal Reserve to
supervisors and functional regulators. understand the organization’s structure, activi-
The Federal Reserve’s enhanced approach to ties, resources, and risks, as well as to address
consolidated supervision emphasizes several financial, managerial, operational, or other defi-
elements that should help make the financial
system more resilient. These include focus on
2. The term ‘‘nonbank subsidiaries’’ as used in SR-08-
9/CA-08-12 and its attachments does not include savings
associations.
1. See Attachment C to SR-08-9/CA-08-12 or this sec-
tion’s appendix for the definitions of ‘‘core clearing and
settlement organizations,’’ ‘‘critical financial markets,’’ and BHC Supervision Manual January 2009
‘‘key financial markets.’’ Page 1
Consolidated Supervision of BHCs and the Combined U.S. Operations of FBOs 1050.0
ciencies before they pose a danger to the BHC’s and domestic banking organizations. The For-
subsidiary depository institutions. eign Bank Supervision Enhancement Act of
To carry out these responsibilities, the BHC 1991 established uniform federal standards for
Act grants the Federal Reserve broad authority entry, expansion, and supervision of FBOs in
to inspect and obtain reports from a BHC and its the United States and increased the Federal
subsidiaries concerning, among other things, the Reserve’s supervisory responsibility and author-
company’s financial condition, systems for ity over the U.S. operations of FBOs. This act
monitoring and controlling financial and also introduced the requirement that the Federal
operational risks, and compliance with the BHC Reserve approve the establishment of all U.S.
Act and other federal law (including consumer banking offices of foreign banks and, in that
protection laws) that the Board has specific regard, take into account whether the foreign
jurisdiction to enforce. In addition, federal law bank is subject to comprehensive, consolidated
authorizes the Federal Reserve to take action supervision by its home-country supervisor.
against a BHC or nonbank subsidiary to prevent The Federal Reserve’s consolidated supervi-
these entities from engaging in unsafe or sion activities closely complement its other cen-
unsound practices or to address violations of tral bank responsibilities, including the objec-
law that occur in connection with their own tives of fostering financial stability and deterring
business operations even if those operations are or managing financial crises. The information,
not directly connected to the BHC’s subsidiary expertise, and powers that the Federal Reserve
depository institutions. Using its authority, the derives from its supervisory authority enhance
Federal Reserve also has established consoli- its ability to help prevent financial crises and to
dated capital standards for BHCs, helping to manage such crises (in consultation and con-
ensure that a BHC maintains adequate capital to junction with the Treasury Department and other
support its groupwide activities, does not U.S. and foreign authorities) should they occur.
become excessively leveraged, and is able to Similarly, the supervisory responsibilities of the
serve as a source of strength for its depository Federal Reserve benefit from its responsibilities
institution subsidiaries. for financial stability. For example, knowledge
The Federal Reserve’s consolidated supervi- gained about financial market developments
sion program has served as the benchmark for through interactions with primary dealers in
many of the current and evolving international government securities and capital market exper-
standards for the consolidated supervision of tise derived from nonsupervisory activities
financial groups. Key concepts that have been improve the Federal Reserve’s ability to under-
part of the Federal Reserve’s approach to con- stand and evaluate the activities of banking
solidated supervision for many years are reflected organizations and otherwise enhance its contri-
in the Basel Committee on Banking Supervi- butions to supervisory and regulatory policy
sion’s Minimum Standards for Internationally initiatives.
Active Banks (1992), capital accords (1988 and Effective consolidated supervision requires
2006), and Core Principles for Effective Bank- strong, cooperative relationships between the
ing Supervision (1997 and 2006), and are now Federal Reserve and relevant primary supervi-
used by the International Monetary Fund and sors and functional regulators.4 These relation-
the World Bank in connection with their assess- ships respect the individual statutory authorities
ments of countries’ bank supervisory regimes.
In addition to its role as consolidated supervi- 4. The term ‘‘primary supervisor’’ as used in this document
sor of BHCs, the Federal Reserve also is respon- refers to the primary federal banking or thrift supervisor (for
example, the Office of the Comptroller of the Currency for a
sible for the overall supervision of the U.S. nationally chartered bank) of a depository institution subsidi-
operations of foreign banks that have a banking ary of a BHC, or of a U.S. banking office of an FBO. For
presence in the United States. This role was state-chartered depository institutions or banking offices, this
established by the International Banking Act of term also includes the relevant bank supervisory authority of
the institution’s chartering/licensing state. Where a BHC has
1978, which introduced a policy of national multiple depository institution subsidiaries or an FBO has
treatment3 promoting competitive equality multiple U.S. banking offices, there may also be multiple
between FBOs operating in the United States primary banking supervisors, depending on how the subsidi-
aries are chartered/licensed. The term ‘‘functional regulator’’
as used in this document refers to the appropriate federal
3. ‘‘National treatment’’ refers to a policy that generally
(examples include the U.S. Securities and Exchange Commis-
gives foreign banks operating in the United States the same
sion and the U.S. Commodity Futures Trading Commission)
powers as U.S. banking organizations and subjects them to the
or state regulator for a functionally regulated nondepository
same restrictions and obligations.
subsidiary or affiliate of a BHC or FBO. (See SR-00-13,
‘‘Framework for Financial Holding Company Supervision.’’)
BHC Supervision Manual January 2009 For U.S. operations of FBOs, the U.S. supervisor of a U.S.
Page 2 banking office is referred to as a domestic primary supervisor.
and responsibilities of the respective supervisors 1050.0.2 KEY OBJECTIVES FOR, AND
and regulators and provide for appropriate infor- APPROACHES TO, CONSOLIDATED
mation flows and coordination so that individual SUPERVISION
responsibilities can be carried out effectively,
while limiting the potential for duplication or The Federal Reserve uses a systematic approach
undue burden. Information sharing among domes- to develop an assessment of a BHC on a consoli-
tic and foreign supervisors, consistent with appli- dated basis and of the combined U.S. operations
cable law and the jurisdiction of each supervi- of an FBO. These assessments are reflected in
sor, is essential to ensure that a banking the RFI (Risk-Management, Financial Condi-
organization’s global activities are supervised tion, and Impact) rating assigned to a BHC6 and
on a consolidated basis. the combined U.S. operations rating assigned to
These concepts underlie the provisions of the an FBO with multiple U.S. operations.7 The
GLBA governing the interaction between the Federal Reserve utilizes three principal pro-
Federal Reserve, as consolidated supervisor, and cesses to understand, supervise, and assess BHCs
the other primary supervisors or functional regu- and FBOs: continuous monitoring activities,8
lators that may be involved in supervising one discovery reviews,9 and testing.10
or more subsidiaries of a BHC.5 Under these
provisions, the Federal Reserve, in conducting 6. The RFI rating system for BHCs is discussed in SR-04-
its consolidated supervisory responsibilities, relies 18, ‘‘Bank Holding Company Rating System’’ and section
to the fullest extent possible on (1) the reports 4070.0. RFI ratings are assigned at least annually for BHCs
that a BHC or subsidiary has provided to another with $1 billion or more in consolidated assets, and are com-
federal or state supervisor or to an appropriate municated via a comprehensive summary supervisory report
that supports the BHC’s assigned ratings and encompasses the
self-regulatory organization, (2) information that results of the entire supervisory cycle (as described in SR-99-
is otherwise required to be reported publicly, 15, ‘‘Risk-Focused Supervision of Large Complex Banking
and (3) externally audited financial statements. Organizations’’ and section 2124.04).
In addition, the Federal Reserve relies to the 7. SR-00-14, ‘‘Enhancements to the Interagency Program
for Supervising the U.S. Operations of Foreign Banking Orga-
fullest extent possible on the reports of examina- nizations,’’ discusses the U.S. combined operations rating for
tion of a depository institution made by its an FBO and other aspects of the FBO Supervision Program.
appropriate federal or state bank supervisor, of a The Federal Reserve’s rating and assessment, as well as a
broker–dealer or investment adviser made by or summary of condition analysis describing the strengths and
weaknesses of the FBO’s combined U.S. operations, are pro-
on behalf of the SEC or relevant state regulatory vided to the head office of each FBO. This information is also
authority, or of a licensed insurance company shared with the FBO’s home-country supervisor so that it may
made by or on behalf of its appropriate state assess the impact of U.S. operations on the parent banking
regulatory authority. In developing its overall organization in its role as consolidated supervisor of the
banking organization’s global operations.
assessment of a BHC or the combined U.S. 8. ‘‘Continuous monitoring activities’’ are nonexamination/
operations of an FBO, the Federal Reserve also inspection supervisory activities primarily designed to develop
relies to the fullest extent possible on the infor- and maintain an understanding of the organization, its risk
mation gathered and assessments developed by profile, and associated policies and practices. These activities
also provide information that is used to assess inherent risks
these other supervisors and regulators. and internal control processes. Such activities include meet-
Similarly, the Federal Reserve seeks to assist ings with banking organization management; analysis of man-
relevant primary supervisors and functional regu- agement information systems (MIS) and other internal and
lators in performing their supervisory responsi- external information; review of internal and external audit
findings; and other efforts to coordinate with, and utilize the
bilities with respect to regulated subsidiaries by work of, other relevant supervisors and functional regulators
sharing pertinent information that relates to these (including analysis of reports filed with, or prepared by, these
regulated subsidiaries consistent with each agen- supervisors or regulators, or appropriate self-regulatory orga-
cy’s supervisory responsibilities and applicable nizations, as well as related surveillance results).
9. A ‘‘discovery review’’ is an examination/inspection
law. Examples include shared information relat- activity designed to improve the understanding of a particular
ing to the financial condition, risk-management business activity or control process—for example, to address
policies, and operations of a banking organiza- a knowledge gap identified during the risk assessment or other
tion that may have a material impact on regu- supervisory process.
10. ‘‘Testing’’ is an examination/inspection activity to
lated subsidiaries, as well as information con- assess whether a control process is appropriately designed and
cerning transactions or relationships between achieving its objectives or to validate a management assertion
regulated subsidiaries and their affiliates. about an organization’s operations. Activities may include the
review and validation of internal MIS, such as business
records related to an internal control process; audit findings
and processes; or a sample of transactions that have been

5. See SR-00-13. Page 3
The Federal Reserve’s supervisory objectives BHC and the combined U.S. operations of each
are the same for all BHCs and FBOs. However, FBO. Key elements in developing this under-
the type and amount of information and the standing include
scope and extent of Federal Reserve supervisory
and examination11 work that are necessary to • corporate strategy and significant activities;
understand, supervise, and develop an assess- • business line, legal entity, and regulatory struc-
ment of an individual BHC or the U.S. opera- ture, including interrelationships and depen-
tions of an individual FBO vary. Federal Reserve dencies across multiple legal entities;
supervisory activities are tailored for each orga- • corporate governance, risk management, and
nization based on a variety of factors, including internal controls for managing risks; and
the organization’s legal entity and regulatory • for certain organizations, presence in critical
structure;12 the risks posed by the organization’s or key financial market activities.
specific activities and systems; and the potential
effect of weaknesses in control functions on the
organization, its subsidiary depository institu- 1050.0.2.1.2 Assessing the Bank Holding
tions, or key financial markets. For example, Company on a Consolidated Basis and
additional supervisory activities, including trans- the Combined U.S. Operations of an FBO
action testing in appropriate circumstances, may
be conducted when there are information gaps Supervisory Objective: The Federal Reserve
relating to material risks or activities, indica- supervises each BHC on a consolidated basis
tions of weaknesses in risk-management sys- and assigns an RFI rating through an evaluation
tems or internal controls, or indications of viola- and assessment of the following areas
tions of consumer protection or other laws, or
when a consolidated organization or subsidiary • key corporate governance, risk management,
depository institution is in less-than-satisfactory and control functions (including, where appli-
condition. cable, such functions as they relate to core
clearing and settlement activities and activi-
ties where the organization has a significant
1050.0.2.1 Key Supervisory Objectives presence in critical or key financial markets);
• the adequacy of the financial condition of the
In fulfilling its responsibilities for supervising a consolidated organization; and
BHC on a consolidated basis and the combined • the potential negative impact of nonbank enti-
U.S. operations of an FBO, the Federal Reserve ties on subsidiary depository institutions.
is guided by the following key supervisory
objectives. The Federal Reserve also supervises and
assesses the combined U.S. operations of each
FBO and assigns a U.S. combined operations
1050.0.2.1.1 Understanding the Bank rating based on analysis of these same elements.
Holding Company on a Consolidated
Basis and the Combined U.S. Operations
of an FBO 1050.0.2.1.3 Interagency Coordination
Supervisory Objective: The Federal Reserve Supervisory Objective: As noted earlier, effec-
develops a comprehensive understanding of each tive consolidated supervision requires strong,
cooperative relationships between the Federal
entered into by a banking organization.
Reserve and relevant domestic and foreign super-
11. While by definition ‘‘examination’’ activities are appli- visors and functional regulators. To achieve this
cable to the supervision of banks and other depository institu- objective, while limiting the potential for dupli-
tions, as well as U.S. banking offices of FBOs, and ‘‘inspec- cation or undue burden, the nature and scope of
tion’’ activities are applicable to the supervision of BHCs and
nonbank subsidiaries and affiliates, the term ‘‘examination’’ is
Federal Reserve work is tailored to the organiza-
generally used throughout this guidance to refer to both tion’s legal entity and regulatory structure as
examination and inspection activities. well as the risks associated with the organiza-
12. An organization’s ‘‘regulatory structure’’ refers to the tion’s activities. In this regard, the Federal Reserve
various legal entities within the organization that are subject
to oversight by different domestic and foreign supervisors or
functional regulators. • relies to the fullest extent possible on assess-
ments and information developed by other
BHC Supervision Manual January 2009 relevant domestic and foreign supervisors and
Page 4 functional regulators;
• 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 Reserve’s 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
zation’s global activities. nonbank subsidiaries of a banking organization
reflects these differences. The Federal Reserve’s
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-
Reserve’s 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 BHC’s or FBO’s 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 organization’s 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 compliance with specific consumer laws enforced
supervisory attention on the risk-management primarily by other supervisors regarding non-
systems and internal controls used by core clear- bank subsidiaries of BHCs and FBOs. When
ing and settlement organizations or organiza- consumer compliance-related deficiencies are
tions that have a significant presence in key noted as part of the ongoing supervision of a
financial markets. In light of the potential for BHC or FBO, however, consumer compliance
problems in these areas to transmit an adverse examiners may conduct onsite examinations
impact across the banking and financial system,
these activities pose special legal, reputational, 13. For more information on the prompt-corrective-action
framework for banks, see section 4133.1 of the Federal
and other risks to the banking organization and Reserve’s Commercial Bank Examination Manual, or see
its depository institution subsidiaries. The Fed- 12 C.F.R. 208, Subpart D.
eral Reserve has unique expertise and perspec-
tive in these areas based on its broader central BHC Supervision Manual January 2009
bank responsibilities and functions. Page 5
(including transaction testing, if appropriate) of 2124.04). LCBOs are characterized by the scope
nonbank subsidiaries to resolve significant issues and complexity of their domestic and interna-
that have the potential for widespread violations tional operations; their participation in large vol-
or harm to consumers.14 ume payment and settlement systems; the extent
The Federal Reserve also seeks to reinforce of their custody operations and fiduciary activi-
market discipline by encouraging public disclo- ties; and the complexity of their regulatory
sures that balance quantitative and qualitative structures, both domestically and in foreign
information with clear discussions about risk- jurisdictions. To be designated as an LCBO, a
management processes and that reflect evolving banking organization must meet specified crite-
disclosure practices for peer organizations. ria to be considered a significant participant in
at least one key financial market.
Banking organizations that are not designated
1050.0.2.3 Supervisory Portfolios as LCBOs belong to the portfolios of regional or
community BHCs, or multi-office or single-
An important aspect of the Federal Reserve’s office FBOs. While there is considerable variety
consolidated supervision programs for BHCs among organizations across these portfolios, the
and the combined U.S. operations of FBOs is simpler regulatory structure of most non-LCBO
the assessment and evaluation of practices across organizations increases the likelihood that a
groups of organizations with similar characteris- single primary supervisor has a substantially
tics and risk profiles. This ‘‘portfolio approach’’ complete view of, and ability to address, signifi-
to consolidated supervision facilitates greater cant areas of firmwide (or combined U.S. opera-
consistency of supervisory practices and assess- tions for FBOs) activities, risks, risk manage-
ments across comparable organizations and ment, and controls.
enhances the Federal Reserve’s ability to iden-
tify outlier organizations among established peer
groups. The supervisory portfolios that the Fed-
eral Reserve currently uses in structuring its 1050.0.3 SUPERVISORY GUIDANCE
supervisory programs for BHCs and the U.S.
operations of FBOs are as follows: The guidance attached to SR-08-9/CA-08-12
(e.g., sections 1050.1 and 1050.2) describes how
BHC Portfolios: Federal Reserve staff will develop an under-
standing and assessment of a BHC or the U.S.
• large complex banking organizations (LCBO operations of an FBO through continuous moni-
BHCs) toring activities, discovery reviews, and testing
• regional bank holding companies (regional activities, as well as through interaction with,
BHCs) and reliance to the fullest extent possible on,
• community bank holding companies (commu- other relevant primary supervisors and func-
nity BHCs) tional regulators. Because the Federal Reserve’s
supervisory activities are tailored in the manner
FBO Portfolios: described above, separate guidance documents
are provided for four different supervisory port-
• large complex foreign banking organizations folios to promote appropriate and consistent
(LCBO FBOs) supervision of organizations that broadly share
• multi-office foreign banking organizations similar characteristics and risk profiles. The
(multi-office FBOs) documents’ guidance addresses
• single-office foreign banking organizations
(single-office FBOs) • consolidated supervision of LCBO BHCs
(Attachment A.1) (See section 1050.1);
In 1999, the Federal Reserve formally estab- • consolidated supervision of regional BHCs
lished its supervision program for both domestic (Attachment A.2) (See section 1050.2);
and foreign LCBOs (see SR-99-15 and section • supervision of the combined U.S. operations
of LCBO FBOs (Attachment B.1); and
• supervision of the combined U.S. operations
14. See SR-03-22/CA-03-15, ‘‘Framework for Assessing
Consumer Compliance Risk at Bank Holding Companies,’’
of multi-office FBOs (Attachment B.2).
and section 2124.01.6.1.2.
As a supplement to these four guidance docu-
BHC Supervision Manual January 2009 ments, definitions of key terms for consolidated
Page 6 supervision are provided in Attachment C to
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 areas—such as the risk management and
financial condition of significant nonbank sub-
The Federal Reserve will maintain for each sidiaries that are not functionally regulated—will
BHC and the combined U.S. operations of each typically require more independent Federal
FBO Reserve supervisory work. Other areas—such
as primary firmwide risk management and con-
• an understanding of key elements of the bank- trol functions—typically will require a greater
ing organization’s 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 organization’s activities in order to determine whether a con-
activities, (2) the organization’s 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 Reserve’s 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 letter’s attachments
functional regulators and the organization’s 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 • where applicable, core clearance and settle-
utilities; ment activities; and,
4. for LCBOs, activities in critical or key finan- • where applicable, activities in critical finan-
cial markets in which the organization plays
a significant role, as well as related risk BHC Supervision Manual January 2009
management and internal controls; Page 7
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 zation’s 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-
cy’s 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
ary if, after reviewing relevant reports, it reason- not address or limit the circumstances under
ably determines that the examination is neces- which the Federal Reserve may take formal or
sary to adequately inform the Federal Reserve informal enforcement action against a banking
organization or other person.
15. For these activities, the three-year testing cycle focuses This supervisory guidance is not intended to
on adherence with expectations of the Interagency Paper on comprehensively describe all elements of an
Sound Practices to Strengthen the Resilience of the U.S. effective supervision program for BHCs or U.S.
Financial System (see SR-03-9), including the geographic
diversity and resiliency of data centers and operations, and
operations of FBOs. Rather, the guidance supple-
testing of recovery and resumption arrangements. ments, and should be used in conjunction with,
16. For these purposes, a ‘‘specialized report’’ means a existing Federal Reserve guidance, including
report that the functionally regulated subsidiary is not required among others the Bank Holding Company Super-
to prepare for another federal or state regulatory authority or
an appropriate self-regulatory organization. Consistent with
vision Manual; the Examination Manual for
the GLBA, if the Federal Reserve seeks to obtain a special- U.S. Branches and Agencies of Foreign Banking
ized report from a functionally regulated subsidiary, the Fed- Organizations; SR-04-18; SR-03-22/CA-03-15;
eral Reserve will first request that the subsidiary’s appropriate SR-00-14; and SR-00-13.
regulatory authority or self-regulatory organization obtain the
report and make it available to the Federal Reserve.

Page 8
1050.0.4 APPENDIX—DEFINITIONS 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 process—for 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 institution’s
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 organization’s 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-
zation’s 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 FBO’s
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 Reserve’s 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 externalities—or that consolidated credit-risk management). When
are capable of contributing to financial instabil- identifying these areas during the development
ity if not adequately managed—require 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 organization’s significant nondeposi-
effectiveness is essential to sustaining the con- tory subsidiaries are regulated by a functional
solidated organization as well as a firm’s 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
institution’s 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
1050.1.1 ACTIVITIES OF THE ment and financial condition of significant non-

FEDERAL RESERVE AND OTHER bank subsidiaries that are not functionally
SUPERVISORS AND REGULATORS, regulated—typically will require more indepen-
AND FUNCTIONAL REGULATION dent Federal Reserve supervisory work. Other
areas—such as primary firmwide risk-
In 1999, the Federal Reserve established its management and control functions—typically
supervisory program for large complex banking will require a greater degree of coordination
organizations (LCBOs).1 LCBOs are character- with other relevant primary supervisors or func-
ized by the scope and complexity of their domes- tional regulators, who will likely have informa-
tic and international operations; their participation or assessments upon which the Federal
tion in large volume payment and settlement Reserve can draw.
systems; the extent of their custody operations The following sections provide further detail
and fiduciary activities; and the complexity of on how the Federal Reserve will develop, work-
their regulatory structure, both domestically and ing in coordination with other relevant primary
in foreign jurisdictions. To be designated as an supervisors and functional regulators, an under-
LCBO, a banking organization must meet speci- standing and assessment of a large complex
fied criteria to be considered a significant par- BHC. In conducting the activities described
ticipant in at least one key financial market.2 throughout this document, the Federal Reserve
As outlined in the following sections, a range will, to the fullest extent possible
of continuous monitoring activities is utilized,
along with discovery reviews and testing activi- • rely on the information and assessments of
ties (examination/inspection activities),3 to relevant primary supervisors and functional
develop and maintain an understanding and regulators, including the information and
assessment of each domestic bank holding com- assessments reflected in the reports of exami-
pany (BHC) that is an LCBO.4 These organiza- nation of such supervisors and regulators;
tions are collectively referred to as large com- • focus its supervisory activities on the bank
plex BHCs. holding company, as well as on those of its
nonbank subsidiaries that could have a direct
or indirect materially adverse effect on the
1050.1.1.1 Federal Reserve Activities and safety and soundness of a depository institu-
Those Activities of Other Supervisors and tion subsidiary of the BHC due to the size,
Regulators condition, or activities of the nonbank subsid-
iary, or the nature or size of its transactions
The nature and scope of independent Federal with the depository institution; and
Reserve supervisory work required to develop • use publicly reported information (including
and maintain an understanding and assessment externally audited financial statements), as
of a large complex BHC depends largely on the well as reports that a large complex BHC or a
extent to which other relevant primary supervi- subsidiary prepares for other primary supervi-
sors or functional regulators have information or sors, functional regulators, or self-regulatory
assessments upon which the Federal Reserve organizations.
can draw. By their nature, understanding and
assessing some areas—such as the risk manage-
1050.1.1.2—Functionally Regulated
1. See SR-99-15, ‘‘Risk-Focused Supervision of Large Subsidiaries
Complex Banking Organizations,’’ or section 2124.04.
2. See section 1050.0.4, Appendix, for the definitions of
terms commonly used in this section and sections 1050.1 and
As discussed below, in certain situations, the
1050.2. Federal Reserve may find it necessary to con-
3. The term ‘‘examination’’ is generally used throughout duct an examination of a functionally regulated
this guidance to refer to both commercial bank examination nonbank subsidiary in order to fulfill the Federal
and BHC inspection activities.
4. The term ‘‘domestic BHC’’ refers to a BHC incorpo-
Reserve’s responsibilities as supervisor of the
rated in the United States that is not controlled by a foreign consolidated organization. In any such case, the
banking organization (FBO). Attachment B.1. to SR-08-9/CA- Federal Reserve will continue to adhere to the
08-12 addresses—in the context of supervising the combined procedural and other requirements governing
U.S. operations of FBOs—how 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 2009
LCBO. Page 1
1050.1 Guidance for the Consolidated Supervision of Domestic BHCs That Are LCBOs
examinations of, or requests for a specialized tion necessary to gain this understanding may
report from, a functionally regulated subsidiary be obtained from the organization’s manage-
as discussed in SR-00-13 and sections 1040.0 ment, public reports, regulatory reports, surveil-
and 3900.0. Under these provisions, for exam- lance screens, third-party sources (e.g., credit
ple, the Federal Reserve may conduct an exami- rating agency and market analyst reports), and
nation of a functionally regulated subsidiary if, other relevant primary supervisors or functional
after reviewing relevant reports, it reasonably regulators. Key elements that should be identi-
determines that the examination is necessary to fied and understood include the following:
adequately inform the Federal Reserve about the
systems used to monitor and control financial • Corporate strategy. Primary business strate-
and operational risks within the consolidated gies; institutional risk tolerance; key changes
organization that may pose a direct or indirect in strategic direction or risk profile; signifi-
threat to the safety and soundness of a deposi- cant new business activities, areas of growth
tory institution subsidiary.5 and emerging areas with potential to become
primary drivers of risk or revenue; and plans
for expansion through mergers or acquisitions.
1050.1.2 UNDERSTANDING THE • Significant activities. Key revenue and risk
ORGANIZATION drivers; primary business lines; product mix;
budget and internal capital allocations; market
For each large complex BHC, the Federal Reserve share for revenue and customers served; key
will develop an understanding of the legal, oper- external trends, including competitive pres-
ating, and corporate governance structure of the sures; and areas that are vulnerable to volatil-
organization and its primary strategies, business ity in revenue, earnings, capital, or liquidity.
lines, and risk-management and internal control • Structure. Business line and legal entity struc-
functions.6 This understanding will inform the ture; domestic and foreign regulatory respon-
development of a risk assessment and supervi- sibilities for legal entities and business lines;
sory plan for the BHC. Typically, the informa- key interrelationships and dependencies
between depository institution subsidiaries and
5. The Federal Reserve also may examine a functionally nonbank affiliates; material business lines op-
regulated subsidiary of a large complex BHC if, after review- erated across multiple legal entities for account-
ing relevant reports and other information, it has reasonable
cause to believe that the subsidiary is engaged in an activity ing or risk-management purposes; and the
that poses a material risk to an affiliated depository institution, activities and risk profiles of Edge and agree-
or that the subsidiary is not in compliance with any federal ment corporation subsidiaries.
law that the Federal Reserve Board has specific jurisdiction to • Corporate governance, risk management, and
enforce against the subsidiary (and the Federal Reserve can-
not determine compliance by examining the BHC or its affili- internal controls for primary risks. Board of
ated depository institutions). directors (board) and executive-level commit-
Similarly, before requiring a specialized report from a func- tees; senior management and management
tionally regulated subsidiary, the Federal Reserve first will committees; key risk-management and inter-
request that the subsidiary’s appropriate functional regulator
obtain the report and make it available to the Federal Reserve. nal control functions, and associated manage-
In the event that the report is not obtained or made available ment information systems (MIS), relied upon
as requested, the Federal Reserve may, consistent with the by the board, senior management, and senior
Bank Holding Company Act, obtain the report directly from risk managers and committees; and consis-
the functionally regulated subsidiary if the report is necessary
to allow the Federal Reserve to adequately assess (1) a mate- tency of public disclosures with how the board
rial risk to the BHC or any of its depository institution and senior management assess and manage
subsidiaries, (2) the systems used to monitor and control risks.
financial and operational risks within the consolidated organi- • Presence in critical or key financial markets.7
zation that may pose a threat to the safety and soundness of a
depository institution subsidiary, or (3) compliance with any Core clearing and settlement activities; busi-
federal law that the Federal Reserve Board has specific juris- ness lines with a significant presence in criti-
diction to enforce against the BHC or a subsidiary. cal or key national or global financial mar-
6. This understanding is formally documented during devel- kets; and related risk-management and
opment of the institutional overview, which coincides with
creation of the annual risk assessment. SR-99-15 and SR-97- disclosure practices.
24, ‘‘Risk-Focused Framework for Supervision of Large Com-
plex Institutions’’ (see section 2124.01), describe processes To ensure the quality and consistency of con-
for developing an institutional overview, risk assessment, and solidated supervision across the large complex
supervisory plan. Each of these products is kept current to
reflect significant changes in an organization’s risks or activities. BHC portfolio, it also is necessary to understand
BHC Supervision Manual January 2009 7. See sections 1050.1.3.1.6 and 1050.1.3.1.7 for defini-
Page 2 tions of ‘‘critical financial markets’’ and ‘‘key financial markets.’’
how these key elements compare with industry 4. demonstrating leadership, expertise, and
trends and with evolving practices of well- effectiveness;
managed organizations with similar 5. ensuring the organization has an effective
characteristics. and independent internal audit function;
6. ensuring the organization has appropriate
policies governing the segregation of duties
1050.1.3 ASSESSING THE and avoiding conflicts of interest; and
LARGE COMPLEX BHC ON A 7. ensuring that public disclosures
CONSOLIDATED BASIS • are consistent with how the board and
senior management assess and manage the
The Federal Reserve uses a systematic approach risks of the organization,
to develop an assessment of a BHC on a consoli- • balance quantitative and qualitative infor-
dated basis. This assessment is reflected in the mation with clear discussions about risk-
RFI (Risk Management, Financial Condition, management processes, and
and Impact) rating assigned to a BHC.8 • reflect evolving disclosure practices for
peer organizations.
1050.1.3.1 Risk Management A large complex BHC’s senior management

and its committees should be able to clearly
1050.1.3.1.1 Key Corporate Governance communicate risk tolerances and measures, con-
Functions trol risks, hire and retain competent staff, and
respond to changes in the organization’s risk
Objectives: One of the primary areas of focus
profile and the external environment. Members
for consolidated supervision of large complex
of senior management are expected to have
BHCs is the adequacy of governance provided
qualifications and experience commensurate with
by the board and senior management. The cul-
the size and complexity of the organization.
ture, expectations, and incentives established by
Primary expectations for senior management
the highest levels of corporate leadership set the
include
tone for the entire organization and are essential
determinants of whether a banking organization
1. establishing effective oversight and an appro-
is capable of maintaining fully effective risk-
priate risk culture;
management and internal control processes.
2. appropriately delegating authority and over-
The board and its committees should have an
seeing the establishment and implementation
ongoing understanding of key inherent risks,
of effective policies for the proper segrega-
associated trends, primary control functions, and
tion of duties and for the avoidance or man-
senior management capabilities. Primary expec-
agement of conflicts of interest;
tations for the board and its committees include
3. establishing and implementing an effective
risk-management framework capable of iden-
1. selecting competent senior managers, ensur-
tifying and controlling both current and emerg-
ing that they have the proper incentives to
ing risks, and effective independent control
operate the organization in a safe and sound
functions that ensure risk taking is consistent
manner, and regularly evaluating senior man-
with the organization’s established risk
agers’ performance;
appetite;
2. establishing, communicating, and monitoring
4. establishing and implementing incentives for
(for example, by reviewing comprehensive
personnel that are consistent with institu-
MIS reports produced by senior manage-
tional risk tolerances, compliance with the
ment) institutional risk tolerances and a cor-
law, and ethical business practices;
porate culture that emphasizes the impor-
5. promoting a continuous dialogue between
tance of compliance with the law and ethical
and across business areas and risk-
business practices;
management functions to help align the orga-
3. approving significant strategies and policies;
nization’s established risk appetite and risk
controls;
8. The RFI rating system for BHCs is discussed in SR-04-
18, ‘‘Bank Holding Company Rating System’’ (see section 6. ensuring that the board and its committees
4070.0). RFI ratings are assigned for BHCs that are complex are provided with timely, accurate, and com-
or that have $1 billion or more in consolidated assets, and are prehensive MIS reports that are adaptive to
communicated via a comprehensive summary supervisory
report that supports the BHC’s assigned ratings and encom-
passes the results of the entire supervisory cycle (as described BHC Supervision Manual January 2009
in SR-99-15 and section 2124.04). Page 3
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 audit’s 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. audit’s 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 audit’s 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 organization’s 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 activities—which 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 sor or functional regulator leads the examina-
results—will be used to understand and assess tion activities, the Federal Reserve will par-
the effectiveness of board and senior manage- ticipate as actively as appropriate in those
ment resources and oversight. activities.9
The results of continuous monitoring activi- If the area of concern is not within the
ties, as documented in the institutional over- oversight of another primary supervisor or
view, risk assessment, and other supervisory functional regulator, or if the supervisor or
products, may identify certain corporate gov- regulator does not conduct or coordinate the
ernance functions that will require more inten- examination activities in a reasonable period
sive supervisory focus due to (1) significant
changes in corporate strategy, activities, orga- 9. Active participation by the Federal Reserve in an exami-
nizational structure, oversight mechanisms, or nation led by another primary supervisor or functional regula-
tor includes having input into determining the examination
key personnel; (2) potential concerns regard- objectives, final conclusions, and related communications to
ing the adequacy of a specific governance the organization’s management. In the event that a material
function; or (3) the absence of sufficiently aspect of the Federal Reserve’s input is not reflected in the
examination’s objectives, conclusions, or related communica-
tions with the organization, the Federal Reserve will review
BHC Supervision Manual January 2009 the situation to determine whether additional steps are appro-
Page 4 priate to address any remaining concerns.
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
tion’s 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- organization’s 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 organization’s 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 organization’s 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 company’s 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 BHC’s strategic initiatives—as 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 factors—to identify significant activities
implementation of the organization’s 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 BHC’s 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 controls—including
monitoring or examination activities in a reason- credit risk-management practices—related 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 Reserve’s 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
Reserve’s 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 organization’s
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 organization’s 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 organization’s 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 BHC’s 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 conduct—in 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 relevant—testing and
ties will focus on the organization’s 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
peers—such 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
market—that 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 focus—such as mary supervisors and functional regulators to
counterparty credit risk-management the fullest extent possible and in accordance
practices—to further the Federal Reserve’s 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 Reserve’s 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 Reserve’s evaluation of
capital markets that is obtained through its a large complex BHC’s consolidated financial
supervisory activities with information condition focuses on the ability of the organiza-
obtained through the Federal Reserve’s mone- tion’s 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 Reserve’s primary focus is on developing an
LCBO supervision to further the Federal understanding and assessment of
Reserve’s understanding of risks and activities
that could adversely affect LCBOs or the stabil- 1. the sufficiency of the BHC’s 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 organization’s 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 organization’s 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 to unanticipated, evolving, and potentially

below. correlated market conditions for the organi-
zation and/or across financial markets; and
In assessing consolidated regulatory capital, 3. the sufficiency of liquidity planning tools,
the Federal Reserve looks to ensure that the such as stress testing, scenario analysis, and
BHC demonstrates the effectiveness of its contingency planning efforts, including
framework for complying with relevant capital (1) whether liquidity buffers—comprised of
adequacy guidelines and meeting supervisory unencumbered liquid assets as well as access
expectations, and focuses on analyzing key to stable funding sources—adequately reflect
models and processes16 that influence this the possibility and duration of severe liquid-
assessment. This assessment utilizes results ity shocks; (2) the reasonableness of assump-
from examinations led by the Federal Reserve tions about the stability of secured funding in
or other primary supervisors or functional circumstances in which the liquidity of
regulators, as well as information gained from markets for the underlying collateral
the BHC’s internal control functions and from becomes impaired; and (3) whether these
market-based assessments. efforts adequately reflect the potential for the
Capital planning activities for large complex organization to be called on in stressed
BHCs should be forward looking and provide environments to provide contingent liquid-
for a sufficient range of stress scenarios com- ity support to off-balance-sheet entities or
mensurate with the organization’s activities. bring additional assets on the balance sheet
Many LCBOs require more rigorous and (even if not legally or contractually obligated
structured internal processes for assessing to do so).
capital adequacy beyond regulatory capital
measures, as these measures often do not Beyond capital adequacy and liquidity, the
adequately capture the full spectrum of risk- nature of independent Federal Reserve supervi-
taking activities for these organizations.17 For sory work required to evaluate a large complex
these organizations, the Federal Reserve focuses BHC’s consolidated financial condition depends
on whether internal processes for assessing largely on the extent to which other relevant
capital adequacy ensure that all risks are primary supervisors or functional regulators have
properly identified, reliably quantified (where information or assessments upon which the Fed-
possible) across the entire organization, and eral Reserve can draw. For example, more inde-
supported by adequate capital. pendent Federal Reserve work typically will be
When assessing the adequacy of a BHC’s required to assess consolidated asset quality or
liquidity levels and funds management prac- earnings for large complex BHCs with signifi-
tices, areas of focus include18 cant nonbank activities that are not functionally
regulated. However, where all material holding
1. the extent to which the treasury function is company assets are concentrated in a single
aligned with risk-management processes, and depository institution subsidiary, a minimal level
whether incentives are in place for business of incremental Federal Reserve efforts typically
lines to compile and provide information on will be required to assess consolidated asset
expected liquidity needs and contingency quality and earnings.
funding plans so that the treasury function is
able to develop a firmwide perspective and Supervisory Activities: The Federal Reserve will
incorporate business-line information into primarily utilize continuous monitoring activi-
assessments of actual and contingent liquid- ties to assess a large complex BHC’s financial
ity risk; strength. Such activities will include periodic
2. whether funds management practices pro- meetings with BHC management (such as the
vide sufficient funding flexibility to respond chief financial officer); review of regulatory
reports, surveillance screens, and internal MIS;
16. ‘‘Key models and processes’’ are those where evalua- and analysis of market indicators, including
tion of the model/process will influence the Federal Reserve’s external debt ratings, subordinated debt spreads,
assessment of the activity or control area that is supported by and credit default swap spreads. Testing and
the model/process.
17. See SR-99-18, ‘‘Assessing Capital Adequacy in Rela- discovery activities will be used as necessary to
tion to Risk at Large Banking Organizations and Others with assist in the understanding and assessment of
Complex Risk Profiles’’ (see section 4060.7). areas of concern.
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 2009
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 BHC’s 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 methodologies19 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 Reserve’s 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 risks—where 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 subsidiary—by 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
zation’s legal entities. Common interactions
the parent and significant nonbank subsidi-
between a large complex BHC’s 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 4. identify and assess any intercompany rela-
things, regular verification that these organizations continue
to meet on an ongoing basis all applicable requirements tionships, dependencies, or exposures—or
associated with internal estimates. See, for example, the capi- aggregate firmwide concentrations—with 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 tory institution affiliate; and
adequacy framework for BHCs (Regulation Y: 12 C.F.R. 225,
Appendix G). 5. evaluate the effectiveness of the policies,
procedures, and systems that the holding
BHC Supervision Manual January 2009 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

company’s 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 company’s 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 Reserve’s 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 organization’s 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 BHC’s ability to act as a
7. identify intercompany transactions subject to source of strength to the organization’s deposi-
Regulation W—utilizing 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 sources—and 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 Reserve’s 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 leverage’’21 and the If significant changes or potential concerns
organization’s 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 company’s 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 BHC’s 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 activities—including
monitoring market conditions and indicators 1050.1.4 INTERAGENCY
where available—and 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 Board’s 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 BHC’s 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 agency’s 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 President’s Working Group on
areas of the consolidated BHC’s 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 BHC’s 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 Reserve’s understanding or assessment
and regulations.24 of the consolidated organization’s 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 Board’s 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 BHC’s inter- supervisory systems and seeks to understand
nal MIS, to determine whether such informa- how these systems affect supervised banking
tion addresses the Federal Reserve’s 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 supervisor’s or functional regu- ‘‘colleges of supervisors’’ and other multilateral
lator’s 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
Reserve’s 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 Reserve’s 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 company’s 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 BHC’s 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 BHC’s 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 company’s 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 bank’s or BHC’s 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 BHC’s 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 BHC’s 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 BHC’s international institution’s 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 BHC’s management of its interna- to review the supervisor’s 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 BHC’s 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 BHC’s 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
Reserve’s 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 organization’s operations in the host of the primary supervisor.
country, should be considered when assessing
whether the organization’s 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 company’s 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 Reserve’s 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 BHC’s continuing
sidiary and does not take actions that may ability to serve as a source of strength to its
further weaken the parent company’s 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 company’s 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 subsidiary’s 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 Reserve’s 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 institution’s 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 BHC’s condition, and Reserve’s 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 organization’s 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 entity’s 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 Reserve’s 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 Reserve’s
tion’s 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 corporation’s parent bank
pliance with all applicable laws and regula- relies on the Federal Reserve’s understanding
tions imposed by host-country supervisors and assessment in order to develop its CAMELS
for the Edge or agreement corporation’s inter- rating,28 the Federal Reserve will work to fulfill
national operations. that supervisor’s 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
1050.2.1 ACTIVITIES OF THE 1050.2.1.1 Federal Reserve Activities and

FEDERAL RESERVE AND OTHER Those Activities of Other Supervisors and
SUPERVISORS AND REGULATORS, Regulators
AND FUNCTIONAL REGULATION
The nature and scope of independent Federal
The objectives of the Federal Reserve’s consoli- Reserve supervisory work required to develop
dated supervision program for the portfolio of and maintain an understanding and assessment
regional bank holding companies (‘‘regional of a regional BHC depend largely on the extent
BHCs,’’ defined as non-LCBO BHCs with $10 bil- to which other relevant primary supervisors or
lion or more in total consolidated assets, includ- functional regulators have information or assess-
ing nontraditional organizations1) are the same ments upon which the Federal Reserve can
as those applicable to other portfolios. The man- draw. Many regional BHCs conduct the major-
ner in which the Federal Reserve achieves these ity of their business operations through a single
objectives, however, is tailored to the character- bank subsidiary, increasing the likelihood that a
istics and risk profiles of regional bank holding single primary supervisor has a complete view
companies.2 of, and ability to address, major aspects of the
As outlined in the following sections, a range organization’s business activities and related
of continuous monitoring activities is utilized, risks, risk management, and controls. In these
along with discovery reviews and testing activi- instances, the Federal Reserve typically will be
ties (examination activities),3 to develop and able to use the information and assessments
maintain an understanding and assessment of developed by this primary supervisor to develop
each regional BHC. For organizations within its understanding and assessment of significant
this portfolio, continuous monitoring activities aspects of the consolidated organization. Simi-
typically take the form of meetings with BHC larly, for regional BHCs with limited nonbank
management, analysis of internal management activities, the Federal Reserve typically will
information system (MIS) reports and regula- need to conduct less work to understand and
tory reports, review of surveillance screens, and assess the risk-management systems and finan-
discussions and coordination with other relevant cial condition of nonbank subsidiaries than the
primary supervisors and functional regulators level of monitoring and examination work
and review of their work. The scale and fre- required for organizations with more-extensive
quency of monitoring activities will differ by or complex nonbank activities.
organization. For many regional BHCs that are By their nature, understanding and assessing
in sound condition, monitoring activities typi- some areas—such as the risk management and
cally are performed on a periodic or quarterly financial condition of significant nonbank
basis, supplemented by more frequent or inten- subsidiaries that are not functionally
sive activities as necessary, and, in most instances, regulated—typically will require more indepen-
Federal Reserve staff do not maintain a day-to- dent Federal Reserve supervisory work. Other
day onsite presence at the organization. areas—such as primary firmwide risk-
management and control functions—typically
will require a greater degree of coordination with
other relevant primary supervisors or functional
regulators, who will likely have information or
assessments upon which the Federal Reserve can
draw.
1. Nontraditional BHCs, as defined in SR-04-18, ‘‘Bank
Holding Company Rating System,’’ (see section 4070.0) are
The following sections provide further detail
bank holding companies where most or all of the organiza- on how the Federal Reserve will develop, work-
tion’s significant nondepository subsidiaries are regulated by ing in coordination with other relevant primary
a functional regulator, and subsidiary depository institution(s) supervisors and functional regulators, an under-
are small in relation to nondepository subsidiaries.
2. See section 1050.0.4, appendix, for definitions of terms
standing and assessment of a regional BHC. In
commonly used in this section. conducting the activities described throughout
3, While by definition ‘‘examination’’ activities are appli- this document, the Federal Reserve will, to the
cable to the supervision of banks and other depository institu- fullest extent possible
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
generally used throughout this section to refer to both exami- BHC Supervision Manual January 2009
nation and inspection activities. Page 1
Consolidated Supervision of Regional BHCs 1050.2
• rely on the information and assessments of 1050.2.2 UNDERSTANDING THE

relevant primary supervisors and functional ORGANIZATION
regulators, including the information and
assessments reflected in the reports of exami- For each regional BHC, the Federal Reserve
nation of such supervisors and regulators; will develop an understanding of the legal,
• focus its supervisory activities on the bank operating, and corporate governance structure
holding company, as well as on those of its of the organization and its primary strategies,
nonbank subsidiaries that could have a direct business lines, and risk-management and
or indirect materially adverse effect on the internal control functions.5 This understanding
safety and soundness of a depository institu- will inform the development of a risk-
tion subsidiary of the BHC due to the size, assessment and supervisory plan for the BHC.
condition, or activities of the nonbank subsid- The extent of information necessary to gain this
iary, or the nature or size of its transactions understanding is tailored to the scope and
with the depository institution; and complexity of the regional BHC’s operations,
• use publicly reported information (including and typically may be obtained from the
externally audited financial statements) as well organization’s management, public reports,
as reports that a large complex BHC or a regulatory reports, surveillance screens, third-
subsidiary prepares for other primary supervi- party sources (e.g., credit-rating agency and
sors, functional regulators, or self-regulatory market analyst reports), and other relevant
organizations. primary supervisors or functional regulators.
Key elements that should be identified and
understood include the following:
1050.2.1.2 Functionally Regulated
Subsidiaries • Corporate strategy. Primary business strate-
gies; institutional risk tolerance; key changes
As discussed below, in certain situations, the in strategic direction or risk profile; signifi-
Federal Reserve may find it necessary to con- cant new business activities; areas of growth
duct an examination of a functionally regulated and emerging areas with potential to become
nonbank subsidiary in order to fulfill the Federal primary drivers of risk or revenue; and plans
Reserve’s responsibilities as supervisor of the for expansion through mergers or acquisitions.
consolidated organization. In any such case, the • Significant activities. Key revenue and risk
Federal Reserve will continue to adhere to the drivers; primary business lines; product mix;
procedural and other requirements governing budget and internal capital allocations (as
examinations of, or requests for a specialized applicable); market share for revenue and cus-
report from, a functionally regulated subsidiary tomers served; key external trends, including
as discussed in SR-00-13 and sections 1040.0 competitive pressures; and areas that are vul-
and 3900.0. Under these provisions, for exam-
ple, the Federal Reserve may conduct an exami- not determine compliance by examining the BHC or its affili-
nation of a functionally regulated subsidiary if, ated depository institutions).
after reviewing relevant reports, it reasonably Similarly, before requiring a specialized report from a
functionally regulated subsidiary, the Federal Reserve first
determines that the examination is necessary to will request that the subsidiary’s appropriate functional regu-
adequately inform the Federal Reserve about the lator obtain the report and make it available to the Federal
systems used to monitor and control financial Reserve. In the event that the report is not obtained or made
and operational risks within the consolidated available as requested, the Federal Reserve may, consistent
with the Bank Holding Company Act, obtain the report
organization that may pose a direct or indirect directly from the functionally regulated subsidiary if the report
threat to the safety and soundness of a deposi- is necessary to allow the Federal Reserve to adequately assess
tory institution subsidiary.4 (1) a material risk to the BHC or any of its depository
institution subsidiaries, (2) the systems used to monitor and
control financial and operational risks within the consolidated
organization that may pose a threat to the safety and sound-
4. The Federal Reserve also may examine a functionally
ness of a depository institution subsidiary, or (3) compliance
regulated subsidiary of a regional BHC if, after reviewing
with any federal law that the Federal Reserve Board has
relevant reports and other information, it has reasonable cause
specific jurisdiction to enforce against the BHC or a subsidiary.
to believe that the subsidiary is engaged in an activity that
5. This understanding is formally documented during devel-
poses a material risk to an affiliated depository institution, or
opment of the institutional overview, which coincides with
that the subsidiary is not in compliance with any federal law
creation of the annual risk assessment. SR-97-24, ‘‘Risk-
that the Federal Reserve Board has specific jurisdiction to
Focused Framework for Supervision of Large Complex Insti-
enforce against the subsidiary (and the Federal Reserve can-
tutions,’’ (see section 2124.01) describes processes for devel-
oping an institutional overview, risk assessment, and supervisory
BHC Supervision Manual January 2009 plan. Each of these products is kept current to reflect signifi-
Page 2 cant changes in an organization’s risks or activities.
nerable to volatility in revenue, earnings, capi- board and senior management. The culture,
tal, or liquidity. expectations, and incentives established by the
• Structure. Business line and legal entity struc- highest levels of corporate leadership set the
ture; domestic and foreign regulatory respon- tone for the entire organization and are essential
sibilities for legal entities and business lines; determinants of whether a banking organization
key interrelationships and dependencies is capable of maintaining fully effective risk-
between depository institution subsidiaries and management and internal control processes.
nonbank affiliates; material business lines The board and its committees should have an
operated across multiple legal entities for ongoing understanding of key inherent risks,
accounting or risk-management purposes; and associated trends, primary control functions,
the activities and risk profile of Edge and and senior management capabilities. Primary
agreement corporation subsidiaries. expectations for the board and its committees
• Corporate governance, risk management, and include
internal controls for primary risks. Board of
directors (board) and executive-level commit- 1. selecting competent senior managers, ensur-
tees; senior management and management ing that they have the proper incentives to
committees; key risk-management and inter- operate the organization in a safe and sound
nal control functions and associated MIS relied manner, and regularly evaluating senior man-
upon by the board, senior management, and agers’ performance;
senior risk managers and committees; and 2. establishing, communicating, and monitoring
consistency of public disclosures with how (for example, by reviewing comprehensive
the board and senior management assess and MIS reports produced by senior manage-
manage risks. ment) institutional risk tolerances and a cor-
porate culture that emphasizes the impor-
To ensure the quality and consistency of con- tance of compliance with the law and ethical
solidated supervision across the regional BHC business practices;
portfolio, it also is necessary to understand how 3. approving significant strategies and policies;
these key elements compare with industry trends 4. demonstrating leadership, expertise, and
and with evolving practices of well-managed effectiveness;
organizations with similar characteristics. 5. ensuring the organization has an effective
and independent internal audit function;
6. ensuring the organization has appropriate
1050.2.3 ASSESSING THE REGIONAL policies governing the segregation of duties
BHC ON A CONSOLIDATED BASIS and avoiding conflicts of interest; and
7. for publicly held organizations, ensuring that
The Federal Reserve uses a systematic approach public disclosures
to develop an assessment of a BHC on a consoli- • are consistent with how the board and
dated basis. This assessment is reflected in the senior management assess and manage the
RFI (Risk Management, Financial Condition, risks of the organization,
and Impact) rating assigned to a BHC.6 • balance quantitative and qualitative infor-
mation with clear discussions about risk-
management processes, and
1050.2.3.1 Risk Management • reflect evolving disclosure practices for
peer organizations.
1050.2.3.1.1 Key Corporate Governance
Functions A regional BHC’s senior management and its
committees should be able to clearly communi-
Objectives: One of the primary areas of focus
cate risk tolerances and measures, control risks,
for consolidated supervision of regional BHCs
hire and retain competent staff, and respond to
is the adequacy of governance provided by the
changes in the organization’s risk profile and
the external environment. Members of senior
6. The RFI rating system for BHCs is discussed in SR- management are expected to have qualifications
04-18 and section 4070.0. RFI ratings are assigned at least
annually for BHCs that are complex or that have $1 billion or and experience commensurate with the size and
more in consolidated assets, and are communicated via a complexity of the organization. Primary expec-
comprehensive summary supervisory report that supports the tations for senior management include
BHC’s assigned ratings and encompasses the results of the
entire supervisory cycle (as described in SR-99-15, ‘‘Risk-
Focused Supervision of Large Complex Banking Organiza- BHC Supervision Manual January 2009
tions,’’ and section 2124.04.) Page 3
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 organization’s 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 activities—which 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 organization’s established risk veillance results—will 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 Reserve’s 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-
nization’s 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 nation activities for a key function by the
7. ensuring timely resolution of audit, compli- Federal Reserve or another primary supervi-
ance, and regulatory issues. sor or functional regulator.
• Internal audit. Continuous monitoring activi-
An effective internal audit function plays an ties will be used to understand and assess key
essential role by providing an independent and elements of internal audit governance for the
objective evaluation of all key governance, risk- organization on a consolidated basis, including
management, and internal control processes. As (1) the adequacy (and, where applicable,
the complexity of financial products and sup- independence9) of the audit committee; (2) the
porting technology has grown, in combination independence, professional competence, and
with greater reliance on third-party service pro- the quality of the internal audit function; (3) the
viders, the importance of internal audit’s role in quality and scope of the audit methodology,
identifying risks and testing internal controls audit plan, and risk-assessment process; and
has increased. (4) the adequacy of audit programs and
In addition, the extent to which supervisors
can rely on or utilize the work of internal audit
is an essential determinant of the risk-focused 7. As discussed further in section 1050.2.4.6, because of
the special structure of nontraditional BHCs and the relatively
supervisory program that is tailored to the activi- small size of their depository institution subsidiaries, much of
ties and risks of individual regional BHCs. the information necessary to develop the assessments of the
risk-management (as described in this section 1050.2.3.1) and
Supervisory Activities: For each regional BHC, financial condition elements (as described in section 1050.2.3.2)
typically may be obtained or drawn from the work of the
the Federal Reserve will understand and assess relevant functional regulator.
the adequacy of oversight provided by the board 8. As noted in section 1050.2.1 above, the scale and fre-
and senior management, as well as the adequacy quency of monitoring activities will differ by organization.
of internal audit and associated MIS. The Fed- For many regional BHCs in sound condition, these activities
are typically performed on a periodic or quarterly basis and
eral Reserve also will understand and assess supplemented as necessary.
other key corporate governance functions (e.g., 9. As outlined in section 2060.05 and SR-02-20, ‘‘The
corporate finance and treasury functions), whose Sarbanes-Oxley Act of 2002,’’ section 301 of the Sarbanes-
Oxley Act requires that each public company (including banks
and bank holding companies that are public companies) have
BHC Supervision Manual January 2009 an audit committee composed entirely of independent direc-
Page 4 tors. (See 15 U.S.C. 78j-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 audit’s recent work in these areas to
the extent possible as a means of validating Objectives: Underlying the risk-focused approach
internal audit’s findings. to consolidated supervision of regional BHCs is
• Additional supervisory activities. If continu- the premise that it is each organization’s 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 developed—or, because of the organization’s
legal, operating, and regulatory structure, is not able to
visors or regulators) on at least a three-year develop—a 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 organization’s 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 BHC’s 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 company’s 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
organization’s compensation structure. reflect the Federal Reserve’s 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
tion’s 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 organization’s 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 BHC’s 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 BHC’s 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 Reserve’s 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 BHC’s strategic provisions described above in section
initiatives—as evidenced by budget and (where 1050.2.1.2.
applicable) internal capital allocations and other
factors—to 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 Reserve’s over-
ple, when evaluating whether retail activities view and risk assessment of the organization,
such as mortgage or automobile lending are the Federal Reserve’s 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 BHC’s 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 BHC’s
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 Reserve’s evaluation of
able to develop a firmwide perspective and
a regional BHC’s consolidated financial condi-
incorporate business line information into
tion focuses on the ability of the organization’s
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
Reserve’s 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 BHC’s consolidated
(1) whether liquidity buffers—comprised of
capital to support the level of risk associated
unencumbered liquid assets as well as access
with the organization’s activities and provide
to stable funding sources—adequately 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 organization’s 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 BHC’s
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 Reserve’s
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- to analyze key capital and liquidity models or
mation or assessments upon which the Federal processes of a depository institution or function-
Reserve can draw. For example, more indepen- ally regulated subsidiary that are of such signifi-
dent Federal Reserve work typically will be cance that they will influence the Federal
required to assess consolidated asset quality or Reserve’s assessment of these areas. In all cases
earnings for regional BHCs with significant involving a functionally regulated subsidiary,
nonbank activities that are not functionally regu- the Federal Reserve will conduct its activities in
lated. However, where all material holding com- accordance with the provisions described above
pany assets are concentrated in a single deposi- in section 1050.2.1.2.
tory institution subsidiary, a minimal level of
incremental Federal Reserve efforts typically
will be required to assess consolidated asset 1050.2.3.3 Impact
quality and earnings.
Supervisory Activities: The Federal Reserve will 1050.2.3.3.1 Risk Management and
primarily utilize continuous monitoring activi- Financial Condition of Significant
ties to assess a regional BHC’s financial strength. Nonbank Subsidiaries
Such activities will include periodic meetings
with BHC management (such as the chief finan- Objectives: Many regional BHCs engage in
cial officer); review of regulatory reports, sur- activities and manage control functions on a
veillance screens, and internal MIS; and analy- firmwide basis, spanning depository institution
sis of market indicators (where available), and nonbank legal entities. In some instances,
including external debt ratings, subordinated these BHCs have intra-group exposures and ser-
debt spreads, and credit default swap spreads. vicing arrangements across affiliates, presenting
Testing and discovery activities will be used as increased potential risks for depository institu-
necessary to assist in the understanding and tion subsidiaries and a higher likelihood of
assessment of areas of concern. aggregate risk concentrations across the organi-
Testing and discovery activities also will be zation’s legal entities. Common interactions
used to understand and assess the sufficiency of between a regional BHC’s depository institution
the BHC’s consolidated capital and liquidity subsidiaries and their nonbank affiliates (includ-
positions to support the level of risk associated ing the parent company) include assets originat-
with its activities, including (1) regulatory capi- ing in, or being marketed by, a nonbank affiliate
tal calculation methodologies16 and, where appli- that are booked in the depository institution; a
cable, internal assessments of capital adequacy17 depository institution providing funding for non-
and (2) funds-management and liquidity plan- bank affiliates; and risk-management or internal
ning tools and practices. The Federal Reserve control functions being shared between deposi-
will work with other relevant primary supervi- tory and nonbank operations.
sors and functional regulators to participate in Due to these interrelationships, financial, legal,
or, if necessary, to coordinate activities designed compliance, or reputational troubles in one part
of a BHC can spread rapidly to other parts of the
16. Assessments of the adequacy of regulatory capital for organization. Even absent these interactions, the
BHCs that have received Federal Reserve supervisory approval parent or nonbank subsidiaries of an organiza-
to use internal estimates of risk in their regulatory capital
calculations should include, among other things, regular veri-
tion may present financial, legal, compliance, or
fication that these organizations continue to meet on an ongo- reputational risk to the consolidated entity, and
ing basis all applicable requirements associated with internal thus directly or indirectly to its depository insti-
estimates. See, for example, the capital adequacy guidelines tution subsidiaries. As the federal banking agency
for market risk at BHCs (Regulation Y: 12 C.F.R. 225, Appen-
dix E) and the new advanced capital adequacy framework for
charged with supervising the organization on a
BHCs (Regulation Y: 12 C.F.R. 225, Appendix G). consolidated basis, the Federal Reserve is respon-
17. Capital planning activities for all BHCs should be sible for understanding and assessing the risks
forward looking and provide for a sufficient range of stress that the parent bank holding company and its
scenarios commensurate with the organization’s activities.
For those regional BHCs that utilize more-rigorous and struc-
nonbank subsidiaries may pose to the BHC itself
tured internal processes for assessing capital adequacy beyond or its depository institution subsidiaries.
regulatory capital measures, the Federal Reserve focuses on The primary objectives of Federal Reserve
whether such internal processes ensure that all risks are prop- supervision of the nonbank subsidiaries of a
erly identified, reliably quantified (where possible) across the
entire organization, and supported by adequate capital. See
bank holding company are to
SR-99-18, ‘‘Assessing Capital Adequacy in Relation to Risk
at Large Banking Organizations and Others with Complex BHC Supervision Manual January 2009
Risk Profiles,’’ and section 4060.7. Page 9
1. identify significant nonbank activities and tional risks, as well as the extent to which
risks—where 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 subsidiary—by 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 exposures—or activities that functionally operate as sepa-
aggregate firmwide concentrations—with 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 W—utilizing 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 sources—and
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.
company’s 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 Reserve’s 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 include financial or operational risks that pose a
BHC currently are under review, and additional or modified
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 2009 ing company’s 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 profile—including 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 Risk’’20—and 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 BHC’s 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 Reserve’s 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 activities—including
impact on the organization’s depository institu- monitoring market conditions and indicators
tion subsidiaries. To meet this objective, the where available—and 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 BHC’s ability to act as a tive impact these policies and practices might
source of strength to the organization’s 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 leverage’’19 and the intended objectives.
organization’s 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 company’s ability to provide finan- impact on the BHC’s 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 Board’s 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- BHC’s 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
BHC’s 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 agency’s
Council, the President’s 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 BHC’s 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 Board’s 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 BHC’s
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
Reserve’s understanding or assessment of the provisions for cooperation during the licensing
consolidated organization’s 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 BHC’s 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 Reserve’s ‘‘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 supervisor’s or functional regu- The Federal Reserve also is a member of the
lator’s 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
Reserve’s 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 Reserve’s 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 company’s 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- Reserve’s 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 organization’s operations in the host
ments. In some instances, privacy concerns country, should be considered when assessing
have led to limits on the information a BHC’s whether the organization’s activities in that juris-
foreign office may share with its parent com- diction are appropriate.
pany, thereby limiting the parent company’s
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 bank’s or BHC’s 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 BHC’s depository institution sub-
will be used to understand and assess each sidiaries, the Federal Reserve will follow up
BHC’s 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 institution’s 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
BHC’s management of its international opera- to review the supervisor’s 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 BHC’s 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 BHC’s 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 BHC’s 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-
company’s 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
Reserve’s 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 BHC’s 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 company’s 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 company’s 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 subsidiary’s 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 Reserve’s 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 Reserve’s 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 institution’s 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 Reserve’s 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 Reserve’s
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 entity’s 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 corporation’s parent bank
trends; relies on the Federal Reserve’s 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
tion’s primary activities on a standalone basis, that supervisor’s 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 corporation’s inter- be commensurate with the level of risk posed by
national operations. the organization’s 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 BHC’s 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 organization’s 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 organization’s
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 In addition to continuous monitoring, discov-
controls. Therefore, assessments and informa- ery reviews and periodic testing will be used to
tion developed by the primary functional regula- maintain an understanding and assessment of the
tor typically will be the main tool utilized by the potential negative impact of nonbank entities on
Federal Reserve in developing and assigning the subsidiary depository institutions as discussed
‘‘R’’ and ‘‘F’’ components of the consolidated above in sections 1050.2.3.3.1 and 1050.2.3.3.2
RFI rating. More independent Federal Reserve on, respectively, ‘‘Risk Management and
work typically will be required to understand Financial Condition of Significant Nonbank
and assess the impact of the nondepository enti- Subsidiaries’’ and ‘‘Parent Company and
ties on the subsidiary depository institutions in Nonbank Funding and Liquidity.’’ In all cases
order to assign the ‘‘I’’ rating. involving a functionally regulated subsidiary, the
Federal Reserve will conduct its activities in
Supervisory Activities: The Federal Reserve will accordance with the provisions described above
primarily utilize continuous monitoring activi- in section 1050.2.1.2.
ties to maintain its assessments of risk manage-
ment and financial condition for nontraditional
BHCs, relying on the assessments and informa-
tion developed by the primary functional regula-
tor to the fullest extent possible.

Page 17
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 Board’s
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 Borrower’s Financial Capacity
2010.2.2.1.6 Management and Lender Information
2010.2.3 Leveraged Financing
2010.2.3.1 Interagency Statement on Leveraged Financing
2010.2.3.1.1 Risk-Management Guidelines
2010.2.3.1.2 Distributions
2010.2.3.1.3 Participations Purchased
2010.2.3.1.4 Process to Identify Potential Conflicts
2010.2.3.1.5 Examination Risk-Rating Guidance for
Leveraged Financing
2010.2.4 Credit-Risk Management Guidance for Home Equity
Lending
2010.2.4.1 Credit-Risk Management Systems
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

Page 1
Table of Contents 2000 Supervisory Policy and Issues
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 Reserved
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
2010.3 Investments

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

Page 2
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
2010.6.1.3.6 Compliance
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
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

Page 3
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 Subsidiaries—Required 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
2010.11.2.2 Risk Management
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 Transfer—Tracking Transaction Flows
2010.11.2.4.6 Custody—Detection of ‘‘Free-Riding’’

Page 4
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 Transactions—Introduction
2020.0.1 Analysis of Intercompany Transactions

2020.0.2 Role of the Examiner
2020.1 Transactions Between Affiliates—Sections 23A and

23B of the Federal Reserve Act
2020.1.01 What’s 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
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

Page 4.1
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 and Intraday
Extensions of Credit to Affiliates
2020.1.7.1 Derivative Transactions between Insured Depository
Institutions and Their Affiliates
2020.1.7.1.1 Regulation W 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 Board 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

Page 4.2
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 Affiliate—Exemptions
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 Credit—the 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 Interpretation—Loans to a Nonaffiliate that Purchases
Securities or Other Assets Through a Depository
Institution Affiliate Agent or Broker
2020.1.12.3 Exemption—Loans to a Nonaffiliate that Purchases
Securities from a Depository Institution Securities
Affiliate That Acts as a Riskless Principal
2020.1.12.4 Exemption—Depository Institution Loan to a Nonaffiliate
Pursuant to a Preexisting Line of Credit and the
Proceeds Are Used to Purchase Securities from the
Institution’s Broker-Dealer Affiliate
2020.1.12.5 Exemption—Credit Card Transactions
2020.1.13 An IDI’s Acquisition of an Affiliate that Becomes an
Operating Subsidiary
2020.1.14 Step-Transaction Exemption (Section 223.31(d) and (e))
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

Page 4.3

2020.1.18 Laws, Regulations, Interpretations, and Orders
2020.2 Loan Participations—Intercompany 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 Rights—Retention 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 1—Expansion 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 Bank’s
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
2060.05.1.1.5 Contingency Planning
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 SEC’s 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 Additional Aspects of the Examiner’s Review of an
Outsourcing Arrangement
2060.05.6.3 Assessment of Auditor Independence
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
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 Advisory’s 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
SEC’s Auditor-Independence Rules
2060.2 Budget

2060.3 Records and Statements

2060.4 Structure and Reporting

2060.5 Insurance
2060.5.1 Introduction
2060.5.2 Banker’s 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

Page 8

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
2065.1.4.1 Troubled-Debt Restructuring—Returning 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 1—Loan-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 2—International Transfer Risk Considerations
2065.4 ALLL Methodologies and Documentation
2065.4.1 2001 Policy Statement on ALLL Methodologies

and Documentation

Page 9
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
2065.4.1.8 Appendix—Application of GAAP
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 Taxes—Consolidated 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 Funding—Introduction
2080.05.1 Funding and Liquidity

2080.05.2 Additional Supervisory Considerations
2080.05.3 Examiner’s Application of Principles in Evaluating
Liquidity and in Formulating Corrective Action
Programs
2080.1 Commercial Paper and Other Short-Term Uninsured

Debt Obligations and Securities

Page 10
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 Profits 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 Ownership—General
2090.0.1 Conclusive Presumptions of Control

2090.0.2 Direct Control
2090.0.3 Indirect Control

Page 11
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 Institution’s 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 Applying the Capital Adequacy Guidelines
to the Policy Statement on the Formation of
Small Bank Holding Companies
2090.2.3 Small Bank 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
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

Page 12
2090.2.3.4.2 Waiver of Stock-Redemption Filing

2090.2.4 Capital Considerations in Small Multibank and Chain
Bank Holding Company Applications
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 Board’s 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 Board’s 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

2090.7 Nonbank Banks
2090.7.1 CEBA and FIRREA Provisions for Nonbank Banks


Page 12.1
2090.8 Control and Ownership—Liability 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
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 12.2
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 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 Publication
2110.0.2.9 Public Hearings
2110.0.2.10 Subpoena Power
2110.0.2.11 Interagency Notification
2110.0.3 Golden Parachute Payments and Indemnification 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 A—Definitions 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 Institution’s 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

Page 14
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
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 A—Risk-Focused Supervisory Letters with BHC
Supervision Manual Section Number References
2124.01.12 Appendix B—Risk-Assessment Questionnaire
2124.01.13 Appendix C—Federal Reserve Bank Cover Letter and BHC
Inspection Questionnaire
2124.02– Reserved
2124.03
2124.04 Ongoing Risk-Focused Supervision Program for Large

2124.04.1 Continued Understanding of an LCBO and Its Major Risks

2124.04.2 Design and Execution of a Current Supervisory Plan
2124.04.3 Communication and Coordination Among Supervisors
to Develop and Administer a Supervisory Plan
2124.04.3.1 Information Sharing and Coordination with Supervisory
Authorities and External and Internal Auditors
2124.04.3.2 Enhanced Use of Information Technology
2124.04.4 Organization of Federal Reserve Supervisory Teams
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
2124.07.1.2.2 Large Banking Organizations with Less-Complex
Compliance Profiles
2124.07.1.2.3 Foreign Banking Organizations

Page 15
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 A—Examples of Information Technology
Elements That Should Be Considered in Assessing
Business Risks of Particular Situations
2124.2– Reserved
2124.3
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 A—Interagency 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
2124.5.1.2 Elements of the Program
2124.5.1.3 Guidelines
2124.5.1.3.1 Identification of Red Flags

Page 16
2124.5.1.3.2 Categories of Red Flags

2124.5.1.3.3 Detect the Program’s Red Flags
2124.5.1.3.4 Respond Appropriately to any Detected Red Flags
2124.5.1.3.5 Periodically Updating the Program’s Relevant Red Flags
2124.5.1.4 Administration of Program
2125.0 Trading Activities of Banking Organizations—

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 Management’s 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 Reserved
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

Page 16.1
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 Reserved
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
2127.0 Interest-Rate Risk—Risk Management and Internal

Controls
2127.0.1 Assessing the Management and Internal Controls Over
Interest-Rate Risk
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 Policy—Structured 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

Page 17
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 Exclusion of Asset-Backed Commercial
Paper Program Assets and Related Minority Interests
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

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
2128.06.10 Concentration Limits Imposed on Retained Interests

2128.07 Reserved
2128.08 Subprime Lending
2128.08.1 Interagency Guidance on Subprime Lending

2128.08.1.1 Risk Management
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 Loans—Not 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 Appendix—Questions 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 Asset–Liability 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 Appraisal and Evaluation Policy

2231.0.1.1 Appraisal and Evaluation Programs
2231.0.1.2 Real Estate Appraisal Compliance Procedures
2231.0.1.3 Reappraisals and Re-evaluations
2231.0.2 Transactions Not Requiring the Services of a Licensed
or Certified Appraiser
2231.0.3 Obtaining an Appraisal
2231.0.4 Useful Life of an Appraisal
2231.0.5 Appraisal Requirements
2231.0.5.1 Interagency Statement on the 2006 USPAP
2231.0.5.2 Appraisal Standards
2231.0.5.3 Appraisal Reports
2231.0.5.4 Appraisal Content
2231.0.6 Appraisal Valuation Approaches
2231.0.6.1 Value Correlation
2231.0.6.1.1 Cost Approach
2231.0.6.1.2 Comparable-Sales Approach

Page 23
2231.0.6.1.3 Income Approach

2231.0.7 Other Definitions of Value
2231.0.8 Evaluation Requirements
2231.0.8.1 Form and Content of Evaluations
2231.0.9 Selection and Qualifications Criteria for Appraisers
and Evaluators
2231.0.9.1 Appraiser Qualifications
2231.0.9.2 Selection of an Appraiser
2231.0.9.3 Appraisals Performed by Certified or Licensed
Appraisers
2231.0.9.4 Other Appraiser Designations
2231.0.9.5 Qualifications of Individuals Who Can Perform
Evaluations
2231.0.10 Examiner Review of Appraisal and Evaluation Policies
2231.0.11 Interagency Responses to Questions on the Agencies’
Appraisal Regulations and on the Interagency Statement
on Independent Appraisal and Evaluation Functions
2231.0.14 Internal Control Questionnaire
2231.0.14.1 Appraisal and Evaluation Policies
2231.0.14.2 Appraisals
2231.0.14.3 Appraisers
2231.0.14.4 Evaluations
2231.0.14.5 Evaluators
2231.0.14.6 Reappraisals and Re-evaluations
2231.0.16 Appendix A—Guidelines for Real Estate Appraisal
and Evaluation Programs
2231.0.17 Appendix B—Interagency Statement on Independent
Appraisal and Evaluation Functions
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 Guarantor’s Financial
Capacity
2240.0.3.2 Considerations Relating to a Guarantor’s 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 1—Venture Capital Company Sample
Balance Sheet
2260.0.10 Appendix 2—Venture Capital Company Sample Income
Statement

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-

Page 1
Supervision of Subsidiaries
Section 2010.0
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 ex- formance. The bank holding company might act
tremes: a tightly controlled, centralized network only in a minor advisory capacity. In such a
similar to a branch system, or a loosely con- decentralized system each subsidiary operates
trolled, decentralized system with each subsidi- as a relatively autonomous unit, with authority
ary 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 notwith-
meetings held between the officers of the lead standing the availability of resources to its par-
bank or holding company and those of the sub- ent bank holding company. In order to assure
sidiary organizations. While this is an efficient that the Board’s policy that bank holding com-
method of operation, this type of organization panies serve as sources of financial strength to
builds in the potential for conflicts of interest for subsidiary banks is understood by bank holding
those individuals who serve in dual capacities. companies, the Board has issued a general pol-
Corporate policies should recognize this poten- icy statement reaffirming and articulating these
tial and provide guidance for resolution. The principles, and confirming that the policy ap-
overriding principle should be that no member plies to failing bank situations. This long-
of the bank holding company organization standing policy has been recognized by the
should be disadvantaged by a transaction with Supreme Court in its decision in Board of Gov-
another affiliate. Management of the investment ernors v. First Lincolnwood Corp., 439 U.S.
portfolio, budgets, tax planning, personnel, cor- 234 (1978), and has been incorporated explicitly
respondent relationships, loans and loan partici- in the Board’s Regulation Y, 12 C.F.R.
pations, and liability management are usually 225.4(a)(1).
controlled by the parent or lead bank in a cen- A fundamental and long-standing principle
tralized system.
A decentralized system is one in which the BHC Supervision Manual December 1992
banks act independently of the parent company, Page 1
Supervision of Subsidiaries 2010.0
underlying the Federal Reserve’s supervision of a commercial bank, bank holding companies
and regulation of bank holding companies is have an obligation to serve as a source of
that bank holding companies should serve as strength and support to their subsidiary banks.
sources of financial and managerial strength to An important determinant of a bank’s finan-
their subsidiary banks. It is the policy of the cial strength is the adequacy of its capital base.
Board that in serving as a source of strength to Capital provides a buffer for individual banking
its subsidiary banks, a bank holding company organizations to absorb losses in times of finan-
should stand ready to use available resources to cial strain, promotes the safety of depositors’
provide adequate capital funds to its subsidiary funds, helps to maintain confidence in the bank-
banks during periods of financial stress or adver- ing system, and supports the reasonable expan-
sity and should maintain the financial flexibility sion of banking organizations as an essential
and capital-raising capacity to obtain additional element of a strong and growing economy. A
resources for assisting its subsidiary banks in a strong capital cushion also limits the exposure
manner consistent with the provisions of this of the federal deposit insurance fund to losses
policy statement. experienced by banking institutions. For these
Since the enactment of the Bank Holding reasons, the Board has long considered adequate
Company Act in 1956, the Board has formally capital to be critical to the soundness of individ-
stated on numerous occasions that a bank hold- ual banking organizations and to the safety and
ing company should act as a source of financial stability of the banking and financial system.
and managerial strength to its subsidiary banks. Accordingly, it is the Board’s policy that a
As the Supreme Court recognized, in the 1978 bank holding company should not withhold
First Lincolnwood decision, Congress has ex- financial support from a subsidiary bank in a
pressly endorsed the Board’s long-standing view weakened or failing condition when the holding
that holding companies must serve as a ‘‘source company is in a position to provide the support.
of strength to subsidiary financial institutions.’’1 A bank holding company’s failure to assist a
In addition to frequent pronouncements over the troubled or failing subsidiary bank under these
years and the 1978 Supreme Court decision, this circumstances would generally be viewed as an
principle has been incorporated explicitly in unsafe and unsound banking practice or a viola-
Regulation Y since 1983. In particular, Section tion of Regulation Y or both.
225.4(a)(1) of Regulation Y provides that: Where necessary, the Board is prepared to
take supervisory action to require such assis-
‘‘A bank holding company shall serve as a tance. Finally, the Board recognizes that there
source of financial and managerial strength to may be unusual and limited circumstances
its subsidiary banks and shall not conduct its where flexible application of the principles set
operations in an unsafe or unsound manner.’’ forth in this policy statement might be neces-
sary, and the Board may from time to time
The important public policy interest in the sup- identify situations that may justify exceptions to
port provided by a bank holding company to its the policy.
subsidiary banks is based upon the fact that in This statement is not meant to establish new
acquiring a commercial bank, a bank holding principles of supervision and regulation; rather,
company derives certain benefits at the corpo- as already noted, it builds on public policy con-
rate level that result, in part, from the ownership siderations as reflected in banking laws and
of an institution that can issue federally-insured regulations and long-standing Federal Reserve
deposits and has access to Federal Reserve supervisory policies and practices. A bank hold-
credit. The existence of the federal ‘‘safety net’’ ing company’s failure to meet its obligation to
reflects important governmental concerns reserve as a source of strength to its subsidiary
garding the critical fiduciary responsibilities of bank(s), including an unwillingness to provide
depository institutions as custodians of deposi- appropriate assistance to a troubled or failing
tors’ funds and their strategic role within our bank, will generally be considered an unsafe
economy as operators of the payments system and unsound banking practice or a violation of
and impartial providers of credit. Thus, in seek- Regulation Y, or both, particularly if appropriate
ing the advantages flowing from the ownership resources are on hand or are available to the
bank holding company on a reasonable basis.
1. Board of Governors v. First Lincolnwood Corp., 439 Consequently, such a failure will generally re-
U.S. 234, 252 (1978), citing S. Rep. No. 95–323, 95th Cong.,
1st Sess. 11 (1977). sult in the issuance of a cease and desist order or
other enforcement action as authorized under
BHC Supervision Manual December 1992 banking law and as deemed appropriate under
Page 2 the circumstances.
Supervision of Subsidiaries 2010.0
2010.0.2 BOARD ORDER 2010.0.4 INSPECTION PROCEDURES

REQUESTING A WAIVER FROM THE
BOARD’S SOURCE OF STRENGTH 1. Determine if the holding company main-
POLICY tains its own staff, or whether the holding com-
pany management and directorate are the same
On December 23, 1991, the Board approved an as those of a subsidiary.
application of a BHC to eventually acquire 2. Determine whether the board of directors
100 percent of the outstanding stock of another of the parent company reviews the audit reports,
BHC under a 5 year option. Initially, the BHC regulatory examination reports, and board min-
would acquire approximately 26 percent of the utes of its subsidiaries.
acquiree’s total capital by purchasing a 15-year 3. Determine the extent to which subsidiaries
subordinated capital note agreement. It would rely upon the parent for investment and lending
then have the option to acquire all of the remain- guidance.
ing stock within 5 years. The acquiring BHC 4. Determine which specific functions and
requested that the Board waive any requirement decisions are performed only at the parent com-
of the Board that it serve as a source of financial pany level.
strength to the subsidiary bank (the Board’s 5. Determine the extent to which repre-
‘‘Source of Strength’’ policy) of the BHC ac- sentatives of the parent company serve as offi-
quired until such time that the option is exer- cers and/or directors of subsidiaries.
cised to acquire the actual ownership of all the 6. Review minutes of the board and execu-
shares. The Board considered the request and tive committees of the parent to determine
determined that it would not be appropriate to whether the parent company reviews loan de-
waive the responsibility to serve as a source of linquency reports, comparative balance sheets
financial strength to the bank in this case. The and comparative income statements of the
Board noted that the option agreement and the subsidiaries.
capital note agreement together provide a mech- 7. Review the extent of influence and control
anism for the acquiring BHC to exert control over both bank and nonbank subsidiaries.
over the future ownership of the acquired BHC 8. Determine the degree of influence by the
and many of the most important management parent company over:
decisions. Refer to 1992 FRB 159 and the a. Appointment of officers;
F.R.R.S. at 4-271.3. b. Salary administration;
c. Budget and tax planning;
d. Capital expenditures;
2010.0.3 INSPECTION OBJECTIVES e. Dividend policy;
f. Investment portfolio management;
1. To determine whether the board of direc- g. Loan portfolio management;
tors of the parent company is cognizant of and h. Asset/liability and interest rate/risk
performing its duties and responsibilities. management.
2. To determine the adequacy of written poli- 9. Determine the degree to which man-
cies and compliance with such policies by the agement of the subsidiary companies interfaces
parent and its subsidiaries. with management of the parent company to
3. To determine whether the board is prop- discuss policies.
erly informed as to the financial conditions,
trends and policies of its subsidiaries.
4. To determine the level of supervision over
subsidiaries and whether the supervision as
structured has a beneficial or detrimental effect
upon the subsidiaries.

Page 3
(Funding Policies) Section 2010.1
The responsibility for the performance of the calculate dividends based strictly on the parent’s
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 Management—The holding
vent funding practices that put at risk the wel- company’s 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 parent’s 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 parent’s 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 organization’s 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 parent’s 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 parent’s fund- to monitor the parent’s ability to service its debt
ing policies should address the following areas: in the face of changing interest rates. The policy
1. Capitalization—The holding company’s 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 Board’s 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 company’s capital for each entity through its advances to these subsidiaries. The
should address what measures would be taken holding company’s 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 parent’s source of funding. The policies
to accept. The parent’s 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 subsidiary’s 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 company’s policies ad-
tity. The amount of dividends from subsidiaries dressing interest rate futures and forwards
to the parent is affected by the parent’s philoso- should be consistent with the Board’s 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 company’s asset/liability manage-
is considered appropriate. ment policies. The policy should include contin-
3. Funding of Nonbank Subsidiaries—The 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 parent’s 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. parent’s 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 parent’s 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
WHAT’S NEW IN THIS REVISED 5. market conditions.
SECTION
Following are the components that generally
Effective January 2010 this section was revised form the basis for a sound loan policy:
to include supervisory guidance on loan partici-
pation agreements, their terms and components, 1. Geographic limits. The trade area should be
and the parties involved. The guidance includes clearly defined and loan officers should be
the accounting requirements of the Financial fully aware of specific geographic limita-
Accounting Standards Board’s Statement of tions for lending purposes. Such a policy
Financial Accounting Standards No. 166 for the avoids approval of loans to customers out-
balance sheet and income statement treatment side the trade area in opposition to primary
for such agreement transactions. The inspection objectives. The primary trade area should
objectives and inspection procedures for these be distinguished from any secondary trade
transactions are included. area so that emphasis for each trade area
may be properly placed.
2. Distribution of loans by category. Limita-
2010.2.05 LOAN ADMINISTRATION tions based on aggregate percentages of
total loans in commercial, real estate, con-
The examiner should make a qualitative assess- sumer, and other categories are common.
ment of the parent’s supervision and control of Such policies are beneficial; however, they
subsidiary lending activities. The System’s abil- should contain provisions for deviations
ity to evaluate the effectiveness of a company’s that are approved by the directorate or a
supervision and control of subsidiary lending committee. This allows credit to be distrib-
activities can be strengthened not only by evalu- uted in relation to the market conditions of
ating the parent’s role in light of efficiency and the trade area. During times of heavy loan
operating performance, but also by evaluating demand in one category, an inflexible loan-
the quality of control and supervision. distribution policy would cause that cate-
In order to assess quality, there must be a gory to be slighted in favor of another.
standard measure against which a company’s Deviations from loan distributions by cate-
policies can be evaluated. Establishing the mini- gory may be beneficial but are appropriate
mum areas that a company’s loan-administration only until the risk of further increasing the
policies should address will create a standard loan concentration outweighs the benefits to
that will aid in evaluating the quality of the be derived from expanding the portfolio to
company’s control and its supervision of that satisfy credit demand. See component 11,
activity. ‘‘Concentrations of credit,’’ below.
Current inspection procedures include the 3. Types of loans. The lending policy should
testing of subsidiaries’ compliance with a parent state the types of loans that will be made
company’s policies. This section summarizes and the maximum amount for each type of
the parent’s responsibilities with regard to loan. The policy should also set forth guide-
supervising subsidiary lending. It defines the lines to follow in making specific loans.
internal and external factors that should be con- Decisions about the types of loans to be
sidered in the formulation of loan policies and a granted should be based on the expertise of
strategic plan. It also outlines the minimum the lending officers, the deposit structure,
elements that the lending policies should and anticipated creditworthy demands of
include. the trade area. Sophisticated credits or loans
Internal and external factors that a banking secured by collateral that require more than
organization should consider when formulating normal supervision should be avoided
its loan policies and strategic plan are— unless or until there are the necessary per-
sonnel to properly administer them. Infor-
1. the size and financial condition of the credit- mation systems and internal controls should
extending subsidiaries, be in place to identify, monitor, and control
2. the expertise and size of the lending staff, the types of credit that have resulted in
3. the need to avoid undue concentrations of abnormal loss. The amount of real estate
risk,
4. compliance with all respective laws and BHC Supervision Manual January 2010
regulations, and Page 1
Loan Administration and Lending Standards 2010.2
and other types of term loans should be securities. In addition to the legal restric-
considered in relation to the amount of tions imposed by Federal Reserve Regula-
stable funds. tion U, the lending policy should set forth
4. Maximum maturities. The loan policy margin requirements for all types of securi-
should call for underwriting standards that ties acceptable as collateral. Margin require-
ensure realistic repayment plans. Loan ments should be related to the marketability
maturities should be set by taking into con- of the security (for example, closely held,
sideration the anticipated source of repay- over-the-counter, actively traded). The pol-
ment, the purpose of the loan, the type of icy should assign responsibility and set a
property, and the useful life of the collat- frequency for the periodic pricing of the
eral. For term loans, the lending policy collateral.
should state the maximum time within 8. Financial information. Extension of credit
which loans may be amortized. Specific on a safe and sound basis depends on com-
procedures should be developed for situa- plete and accurate information regarding
tions requiring balloon payments and/or the borrower’s credit standing. One pos-
modification of the original terms of the sible exception is when the loan is predi-
loan. If a clean-up period1 cated on readily marketable collateral, the
5. Loan pricing. Rates on various loan types disposition of which was originally desig-
must be sufficient to cover the cost of funds nated as the source of repayment for the
loaned and the servicing of the loan, advance. Current and complete financial
including overhead and possible losses, information is necessary, including second-
while providing an acceptable margin of ary sources of repayment, not only at the
profit over the long run. These costs must inception of the loan, but also throughout
be known and taken into consideration the term of the advance. The lending policy
before rates are established. Periodic should define the financial-statement
reviews should be conducted to determine requirements for businesses and individuals
whether adjustments are necessary to reflect at various borrowing levels and should
changes in costs or competitive factors. include requirements for audited, nonau-
Specific guidelines for other factors, such as dited, fiscal, interim, operating, cash-flow,
compensating balances and commitment and other statements.3 It should include
fees, are also germane to loan pricing. external credit checks required at various
6. Loan amount to appraised value. The pol- intervals. 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
should be described. The maximum ratio of 3. On March 30, 1993, federal bank regulators set forth an
the loan amount to appraised value,2 the expanded interagency policy to encourage small-business
lending. Under the policy, banks and thrifts that are well or
method of valuation, and differences for adequately capitalized and that are rated CAMELS 1 or 2 may
various types of property should be make small-business and agricultural loans, the aggregate
detailed. The policy should contain a sched- value of which cannot exceed 20 percent of their total capital.
ule listing the downpayment requirements To qualify for the exemption, each loan may not exceed the
lesser of $900,000 or 3 percent of the institution’s total
for financing consumer goods and business capital. Further, the loans selected for this exemption by the
equipment. institution may not be delinquent as of the selection date and
7. Loan amount to market value of pledged 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 institution’s 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 2010 classified by an examiner based on its credit quality, not the
Page 2 level of loan documentation.
from any one source and also place an

aggregate limit on such loans. The policy
should set forth credit standards for any
loan purchased as well as require that com-
plete documentation be maintained by the
purchasing entities. The policy should
define the extent of contingent liability,
holdback and reserve requirements, and the
manner in which the loan will be handled
and serviced.
10. Loans to insiders. Lending policies should
address loans to insiders. Such policies
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 time—in some cases
those loans that often have been included several years—to 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 rower’s 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 organization’s
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 ‘‘director’s 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 BHC’s 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 institution’s 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,
Board’s 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 institution’s 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 SR-
policy that is appropriate to its size and the 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 institution’s 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 institution’s
regarding lending standards and credit-approval lending process, especially when the institu-
processes for commercial loans.5 tion’s 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 institution’s appetite for
Federal Reserve supervisory staff report, ‘‘The Significance of
Recent Changes in Bank Lending Standards: Evidence from BHC Supervision Manual December 1999
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 organization’s (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 BO’s 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 rower’s revenue as the ‘‘most likely’’ case
to be imposed for specific loan types. When 2. heavy reliance on favorable collateral
designed and enforced properly, financial cov- appraisals and valuations that may not be
enants can help significantly to reduce credit sustainable over the longer term
losses by communicating clear thresholds for 3. greater willingness to make loans without
financial performance and potentially triggering scheduled amortization prior to the loan’s
corrective or protective action at an early stage. final maturity
Often, however, loan-approval documents do 4. willingness to readily waive violations of
not describe the key financial covenants even key covenants, to release collateral or guar-
when discussions with institutional staff dis- antee requirements, or even to restructure
close that such covenants are present. The staff loan agreements, without corresponding con-
and/or management of many institutions cessions on the part of the borrower, on the
acknowledge that they have a ‘‘common prac- assumption that a favorable environment will
tice’’ of imposing certain types of covenants on allow the borrower to recover quickly
various types of loans. They indicate that such a
practice is well known to lenders and others at Among the adverse effects of undue reliance
the institution (but not articulated in their writ- on a continued favorable economy is the possi-
ten loan policies), so that describing the actual bility that problem loans will not be identified
covenants in the loan-approval document would properly or in a timely manner. Timely identifi-
be redundant. However, management and other cation of problem loans is critical for providing
approving authorities within an institution then a full awareness of the BO’s risk position,
receive no formal positive indication that ‘‘com- informing management and directors of that
mon practice’’ controls have been imposed and position, taking steps to mitigate risk, and pro-
no indication of the level of financial perfor- viding a proper assessment of the adequacy of
mance that the covenants require of the bor- the allowance for credit losses and capital.6
rower. As such, management and other approv- Similarly, an overreliance on continued ready
ing authorities may be inadequately informed as access to financial markets on favorable terms
to the risks and controls associated with the loan can originate from the following situations:
under consideration. In contrast, loan policies
can create a clear expectation that (1) all key
covenants should be described in loan-approval 6. See section 2122.0 and SR-98-25, ‘‘Sound Credit-Risk
documents, (2) certain covenant types should be Management and the Use of Internal Credit-Risk-Rating Sys-
applied to all loans meeting certain criteria, and tems at Large Banking Organizations,’’ and section 4060.7
and SR-99-18, ‘‘Assessing Capital Adequacy in Relation to
(3) explicit approval of any exception to these Risk at Large Banking Organizations and Others with Com-
plex Risk Profiles.’’ Federal Reserve guidance on credit-risk
BHC Supervision Manual December 1999 management and mitigation covers both loans and other forms
Page 6 of on- and off-balance-sheet credit 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 market’s 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 loan’s 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 borrower’s 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 institution’s 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 borrower’s 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 institution’s 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 borrower’s financial condition, significantly to asset-quality problems in the
key characteristics and trends in the borrower’s 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 institution’s
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 borrower’s 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 institution’s 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 borrower’s 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 institution’s loan portfolio. As such, applying
complacency and, in particular, the temptation formal forward-looking analysis even on a basic
to base expectations of a borrower’s future level assists the institution in identifying and
financial performance almost exclusively on that managing the overall risk of its lending
borrower’s 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 borrower’s 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 borrower’s alternatives for
Borrower’s 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 borrower’s 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 bor-
rower’s ability to meet its obligations is a vital
part of a sound credit decision. Failure to recog- 2010.2.2.1.6 Management and Lender
nize the potential for adverse events—whether Information
specific to the borrower or its industry (for
example, a change in the regulatory climate or Management information systems that support
the emergence of new competitors) or, alterna- the loan-approval process should clearly indi-
tively, to the economy as a whole (for example, cate the composition of the institution’s current
a recession)—can prove costly to a banking portfolio or exposure to allow for consideration
organization. of whether a proposed new loan—regardless of
Mechanical reliance on threshold financial its own merits—might affect this composition
ratios (and the ‘‘cushion’’ they imply) alone is sufficiently to be inconsistent with the institu-
generally not sufficient, particularly for complex tion’s 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 loan’s structure. ing on the nature of an institution’s 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 FINANCING
type and magnitude that would normally be
experienced during a recession Leveraged financing is an important financing
2. unfavorable movements in market interest vehicle for mergers and acquisitions, business
rates, especially for firms with high debt recapitalizations, and business expansions.
burdens These transactions are characterized by a degree
3. unplanned increases in capital expenditures of financial leverage that significantly exceeds
due to technological obsolescence or com- industry norms, as measured by various debt,
petitive factors cash-flow, or other ratios. Consequently, lever-
4. deterioration in the value of collateral, guar-
antees, or other potential sources of principal BHC Supervision Manual December 2001
repayment Page 9
aged borrowers generally have a diminished Institutions participate in leveraged financing on

ability to respond to changing economic condi- a number of levels. In addition to providing
tions or unexpected events, creating significant senior secured financing, they extend credit on a
implications for an institution’s overall credit- subordinated basis (mezzanine financing). Insti-
risk exposure and challenges for bank risk- tutions and their affiliates also may take equity
management systems. positions in leveraged companies with direct
Leveraged-finance activities can be con- investments through affiliated securities firms,
ducted in a safe and sound manner if a risk- small business investment companies (SBICs),
management structure provides appropriate and venture capital companies or take equity
underwriting, pricing, monitoring, and controls. interests via warrants and other equity ‘‘kick-
To better understand and manage the inherent ers’’ received as part of a financing package.
risk in leveraged-finance portfolios, the board of Institutions also may invest in leveraged loan
directors and senior management must ensure funds managed by investment banking compa-
that credit-analysis processes are comprehen- nies or other third parties. Although leveraged
sive, monitoring is frequent, and portfolio financing is far more prevalent in large institu-
reports are detailed. tions, this type of lending can be found in insti-
Many leveraged transactions are underwritten tutions of all sizes* * * The extent to which
with reliance on the imputed value of a business institutions should apply these sound practices
(enterprise value), which is often highly vola- will depend on the size and risk profile of their
tile. Sound valuation methodologies and ongo- leveraged exposures relative to assets, earnings,
ing stress testing and monitoring of enterprise and capital and the nature of their leveraged-
values for these types of transactions must be financing activities (i.e., origination and distri-
emphasized. The following interagency state- bution, participant, equity investor, etc.)* * *
ment provides supervisory guidance on lever-
aged financing, including guidance about risk
rating leveraged-finance loans and how enter- 2010.2.3.1.1 Risk-Management Guidelines
prise value should be evaluated in the risk-
rating process. The statement is directly applica- Institutions substantively engaged in leveraged
ble to federally insured depository institutions. financing are expected to adequately risk-rate,
The boards of directors and senior management track, and monitor these transactions and to
of financial holding companies and bank hold- maintain policies specifying conditions that
ing companies should consider the guidance as would require a change in risk rating, accrual
they supervise nonbanking subsidiaries engaged status, loss recognition, or reserves. In general,
in leveraged-financing activities. The Federal the risk-management framework for leveraged
Reserve, along with the Office of the Comptrol- finance is no different from that which should be
ler of the Currency, the Federal Deposit Insur- applied to all lending activities. However,
ance Corporation, and the Office of Thrift because of the potential higher level of risk, the
Supervision, issued the guidance on April 9, degree of oversight should be more intensive.
2001.8 (See SR-01-9.)
2010.2.3.1 Interagency Statement on 2010.2.3.1.1.1 Loan Policy

Leveraged Financing
The loan policy should specifically address the
(The introductory paragraphs have been omit- institutions’ leveraged-lending activities by
ted here, as indicated by a line of asterisks. including—
Some other wording has been slightly altered,
as indicated by asterisks and brackets .) • a definition of leveraged lending;
• an approval policy that requires sufficient
* * * * * senior-level oversight;
• pricing policies that ensure a prudent tradeoff
8. This guidance augments previously issued supervisory between risk and return; and
statements on sound credit-risk management. See SR-99-23, • a requirement for action plans whenever cash
‘‘Recent Trends in Bank Lending Standards for Commercial
Loans,’’ and SR-98-18, ‘‘Lending Standards for Commercial
flow, asset-sale proceeds, or collateral values
Loans.’’ See also sections 2010.2.2, 2010.10, and 4060.7. decline significantly from projections. Action
plans should include remedial initiatives and
BHC Supervision Manual December 2001 triggers for rating downgrades, changes to
Page 10 accrual status, and loss recognition.
2010.2.3.1.1.2 Underwriting Standards sis during the approval process and after the
loan is advanced. At a minimum, analysis of
Either the loan policy or separate underwriting leveraged-financing transactions should ensure
guidelines should prescribe specific underwrit- that—
ing criteria for leveraged financing. The stan-
dards should avoid compromising sound bank- • cash-flow analyses do not rely on overly opti-
ing practices in an effort to broaden market mistic or unsubstantiated projections of sales,
share or realize substantial fees. The policy margins, and merger and acquisition
should— synergies;
• projections provide an adequate margin for
• describe appropriate leveraged loan structures; unanticipated merger-related integration costs;
• require reasonable amortization of term loans • projections are stress-tested for one or two
(i.e., allow a moderate time period to realize downside scenarios;
the benefit of synergies or augment revenues • transactions are reviewed quarterly to deter-
and institute meaningful repayment); mine variance from financial plans, the risk
• specify collateral policies including accept- implications thereof, and the accuracy of risk
able types of collateral, loan-to-value limits, ratings and accrual status;
collateral margins, and proper valuation meth- • collateral valuations are derived with a proper
odologies; degree of independence and consider poten-
• establish covenant requirements, particularly tial value erosion;
minimum interest and fixed-charge coverage • collateral-liquidation and asset-sale estimates
and maximum leverage ratios; are conservative;
• describe how enterprise values and other • potential collateral shortfalls are identified and
intangible business values may be used; and factored into risk-rating and accrual decisions;
• establish minimum documentation require- • contingency plans anticipate changing condi-
ments for appraisals and valuations, including tions in debt or equity markets when expo-
enterprise values and other intangibles. sures rely on refinancing or recapitalization;
and
• the borrower is adequately protected from
2010.2.3.1.1.3 Limits interest-rate and foreign-exchange risk.
Leveraged-finance and other loan portfolios

with above-average default probabilities tend to 2010.2.3.1.1.5 Enterprise Value
behave similarly during an economic or sectoral
downturn. Consequently, institutions should Enterprise value is often relied upon in the
take steps to avoid undue concentrations by underwriting of leveraged loans to evaluate the
setting limits consistent with their appetite for feasibility of a loan request, determine the debt-
risk and their financial capacity. Institutions reduction potential of planned asset sales, assess
should ensure that they monitor and control as a borrower’s ability to access the capital mar-
separate risk concentrations those loan segments kets, and to provide a secondary source of
most vulnerable to default. Institutions may repayment. Consideration of enterprise value is
wish to identify such concentrations by the appropriate in the credit-underwriting process.
leveraged characteristics of the borrower, by the However, enterprise value and other intangible
institution’s internal-risk grade, by particular values can be difficult to determine, are fre-
industry or other factors that the institution quently based on projections, and may be sub-
determines are correlated with an above-average ject to considerable change. Consequently, reli-
default probability. In addition, sublimits may ance upon them as a secondary source of
be appropriate by collateral type, loan purpose, repayment can be problematic.
industry, secondary sources of repayment, and Because enterprise value is commonly
sponsor relationships. Institutions should also derived from the cash flows of a business, it is
establish limits for the aggregate number of closely correlated with the primary source of
policy exceptions. repayment. This interdependent relationship
between primary and secondary repayment
sources increases the risk in leveraged financ-
2010.2.3.1.1.4 Credit Analysis ing, especially when credit weaknesses develop.
Effective management of leveraged-financing BHC Supervision Manual December 2001

risk is highly dependent on the quality of analy- Page 11
Events or changes in business conditions that through valuations that fully consider the effect
negatively affect a company’s cash flow will of the borrower’s distressed circumstances and
also negatively affect the value of the business, potential changes in business and market condi-
simultaneously eroding both the lender’s pri- tions. For such borrowers, where a portion of
mary and secondary source of repayment. Con- the loan is not protected by pledged assets or a
sequently, lenders that place undue reliance well-supported enterprise value, examiners will
upon enterprise value as a secondary source of generally classify the unprotected portion of the
repayment or that utilize unrealistic assumptions loan doubtful or loss.
to determine enterprise value are likely to In addition, institutions need to ensure that
approve unsound loans at origination or experi- the risks in leveraged-lending activities are fully
ence outsize losses upon default. incorporated in the allowance-for-loan-and-
It is essential that institutions establish sound lease-loss and capital-adequacy analysis. For
valuation methodologies for enterprise value, allowance purposes, leverage exposures should
apply appropriate margins to protect against be taken into account either through analysis of
potential changes in value, and conduct ongoing the expected losses from the discrete portfolio
stress testing and monitoring. or as part of an overall analysis of the portfolio
utilizing the institution’s internal risk grades or
other factors. At the transaction level, exposures
2010.2.3.1.1.6 Rating Leveraged-Finance heavily reliant on enterprise value as a second-
Loans ary source of repayment should be scrutinized
to determine the need for and adequacy of spe-
Institutions need thoroughly articulated policies cific allocations.
that specify requirements and criteria for risk-
rating transactions, identifying loan impairment,
and recognizing losses. Such specificity is criti- 2010.2.3.1.1.7 Problem-Loan Management
cal for maintaining the integrity of an institu-
tion’s risk-management system. Institutions’ For adversely rated borrowers and other high-
internal rating systems should incorporate both risk borrowers who significantly depart from
the probability of default and loss given default planned cash flows, asset sales, collateral val-
in their ratings to ensure that the risk of the ues, or other important targets, institutions
borrower and the risk of the transaction struc- should formulate individual action plans with
ture itself are clearly evaluated. This is particu- critical objectives and time frames. Actions may
larly germane to leverage-finance-transactions include working with the borrower for an
structures, which in many recent cases have orderly resolution while preserving the institu-
resulted in large losses upon default. tion’s interests sale in the secondary market, and
In cases where a borrower’s condition or liquidation. Regardless of the action, examiners
future prospects have significantly weakened, and bankers need to ensure such credits are
leveraged-finance loans will likely merit a sub- reviewed regularly for risk-rating accuracy,
standard classification based on the existence of accrual status, recognition of impairment
well-defined weaknesses. If such weaknesses through specific allocations, and charge-offs.
appear to be of a lasting nature and it is probable
that a lender will be unable to collect all princi-
pal and interest owed, the loan should be placed 2010.2.3.1.1.8 Portfolio Analysis
on nonaccrual and will likely have a doubtful
component. Such loans should be reviewed for Higher-risk credits, including leveraged-finance
impairment in accordance with FAS 114, transactions, require frequent monitoring by
‘‘Accounting by Creditors for Impairment of a banking organizations. At least quarterly, man-
Loan.’’ agement and the board of directors should
If the primary source of repayment is inad- receive comprehensive reports about the charac-
equate and a loan is considered collateral- teristics and trends in such exposures. These
dependent, it is generally inappropriate to con- reports at a minimum should include—
sider enterprise value unless the value is well
supported. Well-supported enterprise values • total exposure and segment exposures, includ-
may be evidenced by a binding purchase and ing subordinated debt and equity holdings,
sale agreement with a qualified third party or compared to established limits;
• risk-rating distribution and migration data;
BHC Supervision Manual December 2001 • portfolio performance—noncompliance with
Page 12 covenants, restructured loans, delinquencies,
nonperforming assets, and impaired loans; and • identification of any sales made with recourse
• compliance with internal procedures and the and procedures for fully reflecting the risk of
aggregate level of exceptions to policy and any such sales;
underwriting standards. • a process to ensure that purchasers are pro-
vided with timely, current financial
Institutions with significant exposure levels to information;
higher-risk credits should consider additional • a process to determine the portion of a trans-
reports covering— action to be held in the portfolio and the
portion to be held for sale;
• collateral composition of the portfolio, e.g. • limits on the length of time transactions can
percentages supported by working assets, be held in the held-for-sale account and poli-
fixed assets, intangibles, blanket liens, and cies for handling items that exceed those
stock of borrower’s operating subsidiaries; limits;
• unsecured or partially secured exposures, • prompt recognition of losses in market value
including potential collateral shortfalls caused for loans classified as held-for-sale; and
by defaults that trigger pari passu [equable] • procedural safeguards to prevent conflicts of
collateral treatment for all lender classes; interest for both bank and affiliated securities
• absolute amount and percentage of the port- firms.
folio dependent on refinancing, recapitaliza-
tion, asset sales, and enterprise value;
• absolute amounts and percentages of sched- 2010.2.3.1.3 Participations Purchased
uled and actual annual portfolio amortiza-
tions; and Institutions purchasing participations and
• secondary-market pricing data and trading assignments in leveraged finance must make
volume for loans in the portfolio. a thorough, independent evaluation of the trans-
action and the risks involved before committing
any funds. They should apply the same stan-
2010.2.3.1.1.9 Internal Controls dards of prudence, credit assessment and
approval criteria, and ‘‘in-house’’ limits that
Institutions engaged in leveraged finance need would be employed if the purchasing organiza-
to ensure their internal-review function is appro- tion were originating the loan. At a minimum,
priately staffed to provide timely, independent policies should include requirements for—
assessments of leveraged credits. Reviews
should evaluate risk-rating integrity, valuation • obtaining and independently analyzing full
methodologies, and the quality of risk manage- credit information both before the participa-
ment. Because of the volatile nature of these tion is purchased and on a timely basis
credits, portfolio reviews should be conducted thereafter;
on at least an annual basis. For many institu- • obtaining from the lead lender copies of all
tions, the risk characteristics of the leveraged executed and proposed loan documents, legal
portfolio, such as high reliance on enterprise opinions, title insurance policies, UCC
value, concentrations, adverse risk-rating trends searches, and other relevant documents;
or portfolio performance, will dictate more fre- • carefully monitoring the borrower’s perfor-
quent reviews. mance throughout the life of the loan; and
• establishing appropriate risk-management
guidelines as described in this [statement].
2010.2.3.1.2 Distributions
Asset sales, participations, syndication, and 2010.2.3.1.4 Process to Identify Potential
other means of distribution are critical elements Conflicts
in the rapid growth of leveraged financing.
[Lead and purchasing institutions are expected] Examiners should determine whether an institu-
to adopt formal policies and procedures address- tion’s board of directors and management have
ing the distribution and acquisition of leveraged- established policies for leveraged finance that
financing transactions. The policies should minimize the risks posed by potential legal
include— issues and conflicts of interest.
• procedures for defining, managing, and BHC Supervision Manual December 2001
accounting for distribution fails; Page 13
2010.2.3.1.4.1 Conflicts of Interest 2010.2.3.1.5 Examination Risk-Rating

Guidance for Leveraged Financing
When a banking company plays multiple roles
in leveraged finance, the interests of different When evaluating individual borrowers, examin-
customers or the divisions of the institution may ers should pay particular attention to—
conflict. For example, a lender may be reluctant
to employ an aggressive collection strategy with • the overall performance and profitability of a
a problem borrower because of the potential borrower and its industry over time, including
impact on the value of the organization’s equity periods of economic or financial adversity;
interest. A lender may also be pressured to • the history and stability of a borrower’s mar-
provide financial or other privileged client infor- ket share, earnings, and cash flow, particu-
mation that could benefit an affiliated equity larly over the most recent business cycle and
investor. Institutions should develop appropriate last economic downturn; and
policies to address potential conflicts of interest. • the relationship between a borrowing compa-
Institutions should also track aggregate totals ny’s projected cash flow and debt-service
for borrowers and sponsors to which it has both requirements and the resulting margin of debt-
a lending and equity relationship. Appropriate service coverage.
limits should be established for such
relationships.
2010.2.3.1.5.1 Cash Flow/Debt-Service
Coverage
2010.2.3.1.4.2 Securities Laws Particular attention should be paid to the
adequacy of the borrower’s cash flow and the
Equity interests and certain debt instruments reasonableness of projections. Before entering
used in leveraged lending may constitute ‘‘secu- into a leveraged-financing transaction, bankers
rities’’ for the purposes of federal securities should conduct an independent, realistic assess-
laws. When securities are involved, institutions ment of the borrower’s ability to achieve the
should ensure compliance with applicable secu- projected cash flow under varying economic and
rities law requirements, including disclosure and interest-rate scenarios. This assessment should
regulatory requirements.9 Institutions should take into account the potential effects of an
also establish procedures to restrict the internal economic downturn or other adverse business
dissemination of material nonpublic information conditions on the borrower’s cash flow and col-
about leveraged-finance transactions. lateral values. Normally bankers and examiners
should adversely rate a credit if material ques-
tions exist as to the borrower’s ability to achieve
the projected necessary cash flows, or if orderly
2010.2.3.1.4.3 Compliance Function
repayment of the debt is in doubt. Credits with
only minimal cash flow for debt service are
The legal and regulatory issues raised by lever- usually subject to an adverse rating.
aged transactions are numerous and complex.
To ensure that potential conflicts are avoided
and laws and regulations are adhered to, an 2010.2.3.1.5.2 Enterprise Value
independent compliance function should review
all leveraged-financing activity. Many leveraged-financing transactions rely on
‘‘enterprise value’’ as a secondary source of
* * * * * repayment. Most commonly, enterprise value is
based on a ‘‘going concern’’ assumption and
derived from some multiple of the expected
9. Institutions also should ensure that any acquired equity
positions are consistent with any applicable equity ownership
income or cash flow of the firm. The methodol-
restrictions imposed by federal and state laws, such as those in ogy and assumptions underlying the valuation
the Bank Holding Company Act or Federal Reserve Act. should be clearly disclosed, well supported, and
Institutions need to take special care to aggregate all the understood by appropriate decision makers and
equity positions held throughout the entire organization,
including those held in all banking and nonbanking subsidi-
risk-oversight units. Examiners should ensure
aries. [footnote added] that the valuation approach is appropriate for
the company’s industry and condition.
BHC Supervision Manual December 2001 Enterprise value is often viewed as a second-
Page 14 ary source of repayment and as such would be
relied upon under stressful conditions. In such guidance on May 16, 2005. The guidance is
cases the assumptions used for key variables intended to promote sound credit-risk manage-
such as cash flow, earnings, and sale multiples ment practices at banking organizations10 that
should reflect those adverse conditions. These have home equity lending programs, including
variables can have a high degree of open-end home equity lines of credit (HELOCs)
uncertainty—sales and cash-flow projections and closed-end home equity loans (HELs).
may not be achieved; comparable sales may not Banking organizations’ credit-risk management
be available; changes can occur in a firm’s practices for home equity lending need to keep
competitive position, industry outlook, or the pace with the rapid growth in home equity lend-
economic environment. Because of these uncer- ing and should emphasize compliance with
tainties, changes in the value of a firm’s assets sound underwriting standards and practices.
need to be tested under a range of stress sce- The risk factors listed below, combined with
narios, including business conditions more an inherent vulnerability to rising interest rates,
adverse than the base-case scenario. Stress test- suggest that banking organizations need to fully
ing of enterprise values and their underlying recognize the risk embedded in their home
assumptions should be conducted upon origina- equity portfolios. Following are the specific
tion of the loan and periodically thereafter, product, risk-management, and underwriting
incorporating the actual performance of the bor- risk factors and trends that deserve scrutiny:
rower and any adjustments to projections. The
bank should in all cases perform its own dis- 1. interest-only features that require no amorti-
counted cash-flow analysis to validate ‘‘enter- zation of principal for a protracted period
prise value’’ implied by proxy measures such as 2. limited or no documentation of a borrower’s
multiples of cash flow, earnings, or sales. assets, employment, and income (known as
Finally, it must be recognized that valuations ‘‘low do’’ or ‘‘no doc’’ lending)
derived with even the most rigorous valuation 3. higher loan-to-value (LTV) and debt-to-
procedures are imprecise and may not be real- income (DTI) ratios
ized when needed by an institution. Therefore, 4. lower credit-risk scores for underwriting
institutions relying on enterprise value or illiq- home equity loans;
uid and hard-to-value collateral must have lend- 5. greater use of automated valuation models
ing policies that provide for appropriate loan-to- (AVMs) and other collateral-evaluation tools
value ratios, discount rates, and collateral for the development of appraisals and
margins. evaluations
6. an increase in the number of transactions
generated through a loan broker or other
2010.2.3.1.5.3 Deal Sponsors third party
Deal sponsors can be an important source of Home equity lending can be conducted in a
financial support for a borrower that fails to safe and sound manner if pursued with the
achieve cash-flow projections. However, sup- appropriate risk-management structure, includ-
port from this source should only be considered ing adequate allowances for loan and lease
positively in a risk-rating decision when the losses and appropriate capital levels. Sound
sponsor has a history of demonstrated support practices call for fully articulated policies that
as well as the economic incentive, capacity, and address marketing, underwriting standards,
stated intent to continue to support the transac- collateral-valuation management, individual-
tion. Even with capacity and a history of sup- account and portfolio management, and
port, a sponsor’s potential contributions should servicing.
not mitigate criticism unless there is clear rea-
son to believe it is in the best interests of the
sponsor to continue that support or unless there 10. The agencies are the Board of Governors of the Federal
Reserve System, the Office of the Comptroller of the Cur-
is a formal guarantee. rency, the Federal Deposit Insurance Corporation, the Office
of Thrift Supervision, and the National Credit Union Admin-
istration. The interagency guidance frequently uses the term
2010.2.4 CREDIT-RISK ‘‘financial institutions.’’ Bank holding companies have finan-
cial institutions and various credit-extending nonbanking sub-
MANAGEMENT GUIDANCE FOR sidiaries. The combined entity is being referred to in this
HOME EQUITY LENDING guidance as a banking organization.
The federal bank and thrift regulatory agencies BHC Supervision Manual July 2005
collectively issued the following interagency Page 15
Banking organizations should ensure that sure the performance of various marketing ini-
risk-management practices keep pace with the tiatives, including offers to increase a line,
growth and changing risk profile of home equity extend the interest-only period, or adjust the
portfolios. Management should actively assess a interest rate or term.
portfolio’s vulnerability to changes in consum-
ers’ ability to pay and the potential for declines
in home values. Active portfolio management is 2010.2.4.1.2 Origination and
especially important for banking organizations Underwriting
that project or have already experienced signifi-
cant growth or concentrations, particularly in All relevant risk factors should be considered
higher-risk products such as high-LTV, ‘‘low when establishing product offerings and under-
doc’’ or ‘‘no doc,’’ interest-only, or third-party- writing guidelines. Generally, these factors
generated loans. (See SR-05-11.) should include a borrower’s income and debt
levels, credit score (if obtained), and credit his-
tory, as well as the loan size, collateral value
2010.2.4.1 Credit-Risk Management (including valuation methodology), lien posi-
Systems tion, and property type and location.
Consistent with the Federal Reserve’s regula-
2010.2.4.1.1 Product Development and tions on real estate lending standards, prudently
Marketing underwritten home equity loans should include
an evaluation of a borrower’s capacity to
In the development of any new product offering, adequately service the debt.12 Given the home
product change, or marketing initiative, manage- equity products’ long-term nature and the large
ment should have a review and approval process credit amount typically extended to a consumer,
that is sufficiently broad to ensure compliance an evaluation of repayment capacity should con-
with the banking organization’s internal policies sider a borrower’s income and debt levels and
and applicable laws and regulations11 and to not just a credit score.13 Credit scores are based
evaluate the credit, interest-rate, operational, upon a borrower’s historical financial perfor-
compliance, reputation, and legal risks. In par- mance. While past performance is a good indi-
ticular, risk-management personnel should be cator of future performance, a significant change
involved in product development, including an in a borrower’s income or debt levels can
evaluation of the targeted population and the adversely alter the borrower’s ability to pay.
product(s) being offered. For example, material How much verification these underwriting fac-
changes in the targeted market, origination tors require will depend upon the individual
source, or pricing could have a significant loan’s credit risk.
impact on credit quality and should receive
HELOCs generally do not have interest-rate
senior management approval.
caps that limit rate increases.14 Rising interest
When HELOCs or HELs are marketed or
rates could subject a borrower to significant
closed by a third party, banking organizations
payment increases, particularly in a low-
should have standards that provide assurance
interest-rate environment. Therefore, underwrit-
that the third party also complies with applica-
ing standards for interest-only and variable-rate
ble laws and regulations, including those on
HELOCs should include an assessment of the
marketing materials, loan documentation, and
borrower’s ability to amortize the fully drawn
closing procedures. (For further details on agent
line over the loan term and to absorb potential
relationships, see section 2010.2.4.1.3, ‘‘Third-
increases in interest rates.
Party Originations.’’) Finally, management
should have appropriate monitoring tools and
management information systems (MIS) to mea-
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
11. Applicable laws include the Federal Trade Commis-
Estate Lending Policies. See subsection 2010.2.1. See also 12
sion Act; the Equal Credit Opportunity Act (ECOA); the
C.F.R., section 208.51 and appendix C.
Truth in Lending Act (TILA), including the Home Ownership
13. The Interagency Guidelines Establishing Standards for
and Equity Protection Act (HOEPA); the Fair Housing Act;
Safety and Soundness also call for documenting the source of
the Real Estate Settlement Procedures Act (RESPA); and the
repayment and assessing the ability of the borrower to repay
Home Mortgage Disclosure Act (HMDA), as well as applica-
the debt in a timely manner. See 12 C.F.R. 208, appendix D-1.
ble state consumer protection laws.
14. While there may be periodic rate increases, the lender
must state in the consumer credit contract the maximum
BHC Supervision Manual July 2005 interest rate that may be imposed during the term of the
Page 16 obligation. See 12 C.F.R. 226.30(b).
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 borrower’s 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, Reserve’s appraisal regulations16 and the Inter-
and close loans according to the delegator’s 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 organization’s 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 TILA’s 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- erty’s 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 validation’s 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, eral’s 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 borrower’s 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 borrower’s current financial
When tax-assessment valuations are used as a condition.18
BHC Supervision Manual July 2005 18. Under the Federal Reserve’s risk-based capital guide-
Page 18 lines, an unused HELOC commitment with an original matu-
When appropriate, banking organizations that the banking organization’s 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 organization’s 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 borrower’s comparing them with actual experience.
financial circumstances.19 In order to freeze or
reduce credit lines due to deterioration in a
borrower’s 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 borrower’s 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 plan’s 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 portfolio’s 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
organization’s 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 organization’s
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 Reserve’s real estate lending stan-

dards regulations require that a banking organi- 2010.2.4.1.7.3 Management Information
zation’s 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 organization’s 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, zation’s 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 nization’s 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.
lio’s 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 real–estate 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 organization’s 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 loan’s 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. mechanic’s 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 FFIEC’s 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 portfo- for various workout programs including
lio 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 borrower’s 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 organization’s 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 2007
senior liens prior to closing the loan. This infor- Page 21
banking organization’s risk-management sys- the examiner should make an assessment of the
tems should address the risks of HELOC parent company’s supervision and control over
securitizations.21 its subsidiary lending activities, which includes
an overall assessment of the banking organiza-
tion’s credit-risk concentrations, including the
2010.2.4.1.10 Portfolio Classifications, risk concentrations in commercial real estate
Allowance for Loan and Lease Losses, lending. (See also section 2010.2.) Banking
and Capital organizations, including bank holding compa-
nies, are responsible for establishing the neces-
The FFIEC’s Uniform Retail Credit Classifica- sary and appropriate management oversight of
tion and Account Management Policy governs their bank and nonbank subsidiaries by adminis-
the classification of consumer loans and estab- tering, monitoring, and assuring adherence to
lishes general classification thresholds that are the organization’s lending policies and practices
based on delinquency. Banking organizations for controlling ‘‘concentration risk.’’ Banking
and the Federal Reserve’s examiners have the organizations should therefore have adequate
discretion to classify entire retail portfolios, or management information systems (including the
segments thereof, when underwriting weak- appropriate accounting and internal control
nesses or delinquencies are pervasive and systems) in place to accomplish their supervi-
present an excessive level of credit risk. Portfo- sory oversight and to control such credit
lios of high-LTV loans to borrowers who exhibit concentrations.
inadequate capacity to repay the debt within a The following guidance, Concentrations in
reasonable time may be subject to classification. Commercial Real Estate (CRE) Lending, Sound
Banking organizations should establish Risk-Management Practices (the guidance) was
appropriate ALLL and hold capital commensu- issued on December 6, 2006 (effective on
rate with the riskiness of their portfolios. In December 12, 2006).23 The guidance was devel-
determining the ALLL adequacy, a banking oped to reinforce sound risk-management prac-
organization should consider how the interest- tices for institutions (includes banking organiza-
only and draw features of HELOCs during the tions) with high and increasing concentrations
lines’ revolving period could affect the loss of commercial real estate loans on their balance
curves for its HELOC portfolio. Those banking sheets. An institution’s strong risk-management
organizations engaging in programmatic practices and its maintenance of appropriate lev-
subprime home equity lending or banking orga- els of capital are important elements of a sound
nizations that have higher-risk products are CRE lending program, particularly when an
expected to recognize the elevated risk of the institution has a concentration in CRE or a CRE
activity when assessing capital and ALLL lending strategy leading to a concentration.
adequacy.22 However, institutions needing to improve their
risk-management processes may have been pro-
2010.2.5 OVERSIGHT OF vided the opportunity for some flexibility on the
CONCENTRATIONS IN time frame for complying with the guidance.
COMMERCIAL REAL ESTATE This time frame will be commensurate with the
LENDING AND SOUND level and nature of CRE concentration risk, the
RISK-MANAGEMENT LENDING quality of the institution’s existing risk-
management practices, and its levels of capital.
As part of a bank holding company inspection, (See 71 Fed. Reg. 74,580 [December 12, 2006],
the Federal Reserve Board’s press release dated
21. See SR-02-16, ‘‘Interagency Questions and Answers
on Capital Treatment of Recourse, Direct Credit Substitutes,
and Residual Interests in Asset Securitizations,’’ (see also
23. The guidance was jointly adopted by the Board of
section 4060.3.5.3.2.3) and the risk management and capital
Governors of the Federal Reserve System, the Office of the
adequacy of exposures arising from secondary-market credit
Comptroller of the Currency, and the Federal Deposit Insur-
activities discussion 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 2007 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 should be reasonable and supportable. The CRE
attachments.) portfolio should not be divided into multiple
segments simply to avoid the appearance of
concentration risk.
2010.2.5.1 Scope of the CRE The Federal Reserve recognizes that risk
Concentration Guidance characteristics vary among CRE loans secured
by different property types. A manageable level
The guidance focuses on those CRE loans for of CRE concentration risk will vary by bank
which the cash flow from the real estate is the depending on the portfolio risk characteristics,
primary source of repayment rather than loans the quality of risk-management processes, and
to a borrower for which real estate collateral is capital levels. Therefore, the guidance does not
taken as a secondary source of repayment or establish a CRE concentration limit that applies
through an abundance of caution. For the pur- to all banks. Rather, banks are encouraged to
poses of this guidance, CRE loans include those identify and monitor credit concentrations and
loans with risk profiles sensitive to the condition to establish internal concentration limits, and all
of the general CRE market (for example, market concentrations should be reported to senior
demand, changes in capitalization rates, vacancy management and the board of directors on a
rates, or rents). CRE loans are land development periodic basis. Depending on the results of the
and construction loans (including one- to four- risk assessment, the bank may need to enhance
family residential and commercial construction its risk-management systems.
loans) and other land loans. CRE loans also
include loans secured by multifamily property,
and nonfarm nonresidential property where the 2010.2.5.3 CRE Risk Management
primary source of repayment is derived from
rental income associated with the property (that The sophistication of a bank’s CRE risk-
is, loans for which 50 percent or more of the management processes should be appropriate to
source of repayment comes from third-party, the size of the portfolio, as well as the level and
nonaffiliated, rental income) or the proceeds of nature of concentrations and the associated risk
the sale, refinancing, or permanent financing of to the bank. Banks should address the following
the property. Loans to real estate investment key elements in establishing a risk-management
trusts and unsecured loans to developers also framework that effectively identifies, monitors,
should be considered CRE loans for purposes of and controls CRE concentration risk:
this guidance if their performance is closely
linked to performance of the CRE markets. The 1. board and management oversight
scope of the guidance does not include loans 2. portfolio management
secured by nonfarm nonresidential properties 3. management information systems
where the primary source of repayment is the 4. market analysis
cash flow from the ongoing operations and 5. credit underwriting standards
activities conducted by the party, or affiliate of 6. portfolio stress testing and sensitivity
the party, who owns the property. Rather than analysis
defining a CRE concentration, the guidance’s 7. credit-risk review function
‘‘Supervisory Oversight’’ section describes the
criteria that the Federal Reserve will use as
high-level indicators to identify banks poten- 2010.2.5.3.1 Board and Management
tially exposed to CRE concentration risk. Oversight of CRE Concentration Risk
A bank’s board of directors has ultimate respon-
2010.2.5.2 CRE Concentration sibility for the level of risk assumed by the
Assessments bank. If the bank has significant CRE concentra-
tion risk, its strategic plan should address the
Banks that are actively involved in CRE lending rationale for its CRE levels in relation to its
should perform ongoing risk assessments to overall growth objectives, financial targets, and
identify CRE concentrations. The risk assess- capital plan. In addition, the Federal Reserve’s
ment should identify potential concentrations by real estate lending regulations require that each
stratifying the CRE portfolio into segments that bank adopt and maintain a written policy that
have common risk characteristics or sensitivities
to economic, financial, or business develop- BHC Supervision Manual July 2007
ments. A bank’s CRE portfolio stratification Page 23
establishes appropriate limits and standards for of the bank’s 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—
1. establish policy guidelines and approve an 2010.2.5.3.3 CRE Management

overall CRE lending strategy regarding the Information Systems
level and nature of CRE exposures accept-
able to the bank, including any specific com- A strong management information system
mitments to particular borrowers or property (MIS) is key to effective portfolio management.
types, such as multifamily housing; The sophistication of the MIS will necessarily
2. ensure that management implements proce- vary with the size and complexity of the CRE
dures and controls to effectively adhere to portfolio and level and nature of concentration
and monitor compliance with the bank’s risk. The MIS should provide management with
lending policies and strategies; sufficient information to identify, measure,
3. review information that identifies and quanti- monitor, and manage CRE concentration risk.
fies the nature and level of risk presented by This includes meaningful information on CRE
CRE concentrations, including reports that portfolio characteristics that is relevant to the
describe changes in CRE market conditions bank’s lending strategy, underwriting standards,
in which the bank lends; and and risk tolerances. A bank should periodically
4. periodically review and approve CRE risk assess the adequacy of the MIS in light of
exposure limits and appropriate sublimits growth in CRE loans and changes in the CRE
(for example, by nature of concentration) to portfolio’s size, risk profile, and complexity.
conform to any changes in the bank’s strate- Banks are encouraged to stratify the CRE
gies and to respond to changes in market portfolio by property type, geographic market,
conditions. tenant concentrations, tenant industries, devel-
oper concentrations, and risk rating. Other use-
ful stratifications may include loan structure (for
2010.2.5.3.2 CRE Portfolio Management example, fixed-rate or adjustable), loan purpose
(for example, construction, short-term, or per-
Banks with CRE concentrations should manage manent), loan-to-value (LTV) limits, debt ser-
not only the risk of individual loans but also vice coverage, policy exceptions on newly
portfolio risk. Even when individual CRE loans underwritten credit facilities, and affiliated loans
are prudently underwritten, concentrations of (for example, loans to tenants). A bank should
loans that are similarly affected by cyclical also be able to identify and aggregate exposures
changes in the CRE market can expose a bank to a borrower, including its credit exposure relat-
to an unacceptable level of risk if not properly ing to derivatives.
managed. Management regularly should evalu- Management reporting should be timely and
ate the degree of correlation between related in a format that clearly indicates changes in the
real estate sectors and establish internal lending portfolio’s risk profile, including risk-rating
guidelines and concentration limits that control migrations. In addition, management reporting
the bank’s overall risk exposure. should include a well-defined process through
Management should develop appropriate which management reviews and evaluates con-
strategies for managing CRE concentration lev- centration and risk-management reports, as well
els, including a contingency plan to reduce or as special ad hoc analyses in response to poten-
mitigate concentrations in the event of adverse tial market events that could affect the CRE loan
CRE market conditions. Loan participations, portfolio.
whole loan sales, and securitizations are a few
examples of strategies for actively managing
concentration levels without curtailing new 2010.2.5.3.4 Market Analysis
originations. If the contingency plan includes
selling or securitizing CRE loans, management Market analysis should provide the bank’s man-
should assess periodically the marketability of agement and board of directors with information
the portfolio. This should include an evaluation to assess whether its CRE lending strategy and
policies continue to be appropriate in light of
BHC Supervision Manual July 2007 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 bank’s 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 bank’s 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 bank’s 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- bank’s internal lending standards and the Fed-
ing in nonmetropolitan markets may have access eral Reserve’s 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 bank’s established risk tolerance limits.
factors influencing its lending markets. Credit analysis should reflect both the bor-
rower’s 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 bank’s lending policies should reflect the bank’s 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
bank’s 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 Reserve’s 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 bank’s records and reported to the
board at least quarterly.
24. Refer to the Federal Reserve’s 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 bank’s total
acquisition, development, and construction capital, and the outstanding balance of the
loans. bank’s 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 bank’s CRE portfolio, taking into consider- monitoring criteria do not constitute limits on a
ation the prevailing market environment and the bank’s lending activity but rather serve as high-
bank’s 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 bank’s 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 bank’s Concentrations
credit-risk review function to assess credit qual-
ity and, ultimately, to identify problem loans. The effectiveness of a bank’s 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 bank’s CRE concentra-
loans underwritten by the bank. Further, risk tions. Examiners will engage in a dialogue with
ratings should be reviewed regularly for the bank’s 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 bank’s 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 bank’s 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-R—Regulatory 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 in its own name, services the loan, and
Adequacy for CRE Concentration Risk deals directly with the customer for the benefit
of all participants. The lead BHC or lead subsid-
The Federal Reserve’s existing capital adequacy iary should ensure that comprehensive participa-
guidelines note that a bank should hold capital tion agreements with originating institutions are
commensurate with the level and nature of the in place for each loan facility before they con-
risks to which it is exposed. Accordingly, banks sider purchasing any participating interest.
with CRE concentrations are reminded that their Many BHCs and their subsidiaries purchase
capital levels should be commensurate with the loans or participate in loans originated by oth-
risk profile of their CRE portfolios. In assessing ers. In some cases, such transactions are con-
the adequacy of a bank’s capital, the Federal ducted with BHC affiliates, groups of BHCs or
Reserve will consider the level and nature of chain banks, or other subsidiaries. Alternatively,
inherent risk in the CRE portfolio as well as a purchasing BHC or subsidiary may also wish
management expertise, historical performance, to supplement its loan portfolio when loan
underwriting standards, risk-management prac- demand is weak. In still other cases, a BHC or
tices, market conditions, and any loan loss subsidiary may purchase or participate in a loan
reserves allocated for CRE concentration risk. A to accommodate another unrelated bank with
bank with inadequate capital to serve as a buffer which it has established an ongoing business
against unexpected losses from a CRE concen- relationship.
tration should develop a plan for reducing its Purchasing or selling loans, if done properly,
CRE concentrations or for maintaining capital can have a legitimate role in a BHC’s or bank’s
appropriate to the level and nature of its CRE overall asset and liability management and can
concentration risk. contribute to the efficient functioning of the
financial system. In addition, these activities
[Section 2010.2.6 is reserved.] help a BHC or bank diversify its risks and
improve its liquidity.
2010.2.7 LOAN PARTICIPATIONS,

THE AGREEMENTS AND 2010.2.7.1 Board Policies on Loan
PARTICIPANTS Participations
This subsection provides supervisory and
accounting guidance for examiners to use in BHCs and their subsidiaries should have suffi-
their inspection (or examination) and review of cient board-approved policies in place that gov-
a bank holding company’s (BHC’s) or bank’s ern their loan participation activities. At a mini-
use, purchase, or sale of loan participation mum, the policy should include (1) the
agreements.29 BHCs should manage and control requirements for entering into a loan participa-
aggregate credit and other risk exposures on a tion agreement, (2) limits for the aggregate
consolidated basis while recognizing legal dis- amount of loans purchased from and sold to an
tinctions and possible obstacles to asset move- outside source, (3) limits of all loans purchased
ments within the parent company or its subsidi- and sold, (4) limits for the aggregate amount of
aries. Additional guidance, research, and loans to particular industries, (5) comprehensive
information on loan participations and loan par- participation agreements with originating BHCs
ticipation agreements will be developed and or banks, (6) complete analysis and documenta-
considered for future issuance and tion of the credit quality of obligations pur-
implementation. chased, (7) an analysis of the value and lien
A loan participation is an agreement that status of the collateral, (8) appraisal guidelines,
transfers a stated ownership interest in a loan to (9) the maintenance of full independent credit
one or more other BHCs or subsidiaries, or information on the borrower throughout the
other entities. The transfer represents an owner- term of the loan, (10) guidelines for the timely
ship interest in an individual financial asset. The transfer of all financial and nonfinancial credit
lead BHC (or lead subsidiary) retains a partial information to participant BHCs or banks, and
interest in the loan, holds all loan documenta- (11) collection procedures.
29. As determined by the Board, it is permissible for a

BHC or its subsidiary to make, acquire, broker, or service
loans or other extensions of credit (12 CFR 225.28(b)(1) and BHC Supervision Manual January 2010
(2)). Page 27
2010.2.7.2 Loan Participation Agreement ment is achieved by structuring the loan partici-
pation agreement so that interests sold to a
A loan participation agreement may enable a purchaser meet the definition of a ‘‘participating
smaller lead BHC or lead subsidiary, acting as interest’’ and the transaction satisfies all condi-
transferor, to originate a large loan in excess of tions for transfer of control over the interests. In
its legal lending limit. Participants having an general, FAS 166 (paragraph 8B) briefly defines
ownership interest are able to offset low local a participating interest as a portion of a financial
loan demand or invest in large loans without the asset that
burden of servicing the loan or incurring origi-
nation costs. A loan participation agreement 1. conveys proportionate ownership rights with
may also allow the originating BHC or subsidi- equal priority to each participating interest
ary to facilitate and grant a larger loan without holder.
causing it to have a concentration of credit (i.e., 2. involves no recourse (other than standard
enabling risk diversification) or an impairment representations and warranties) to, or subor-
of its liquidity position. The participation agree- dination by, any participating interest holder.
ment should contain provisions that require the 3. does not entitle any participating interest
originator to transfer, in a timely manner, all holder to receive cash before any other par-
financial and nonfinancial credit information to ticipating interest holder.
the participant banks upon the loan’s origination
and throughout the term of the loan. The agree-
ment should specify the allocation of payments, A transfer of a participating interest in an
losses, and expenses. It should also state that a entire financial asset in which the transferor
participant has the right to perform its own surrenders control over those interests is to be
independent review of the transaction. The accounted for as a sale if and only if all the
agreement should contain no language indicat- following conditions are met:
ing that the lead BHC or lead subsidiary is a
‘‘lender’’ or that a participating BHC or subsidi- 1. The transferred financial assets have been
ary is a ‘‘borrower.’’ The purchase of loan par- isolated from the transferor—put presump-
ticipations without a comprehensive agreement tively beyond the reach of the transferor and
could be viewed as an unsafe and unsound its creditors, even in bankruptcy or other
banking practice. receivership.31
2. Each purchaser has the right to pledge or
exchange the interests it received, and no
2010.2.7.3 Accounting for Loan condition both constrains the purchaser from
Participations taking advantage of its right to pledge or
exchange and provides more than a trivial
A loan participation agreement usually is struc- benefit to the transferor.
tured to allow the participation transaction to 3. The transferor does not maintain effective
receive sale treatment of a portion of the loan by control over the interests.32
the originating BHC or its subsidiary even
though the participation agreement may restrict
the purchaser when reselling its interest in the Bank Holding Companies’’ (FR Y-9C), and the FFIEC ‘‘Con-
loan, subject to certain conditions.30 Sale treat- solidated Reports of Condition and Income’’ (FFIEC 031)
(bank Call Report).
31. Transferred financial assets are isolated in bankruptcy
30. Three sale recognition conditions denote the transfer-
or other receivership only if the transferred financial assets
or’s surrender of control under Financial Accounting Stan-
would be beyond the reach of the powers of a bankruptcy
dards (FAS) 166, ‘‘Accounting for Transfers of Financial
trustee or other receiver for the transferor or any of its
Assets’’ (an amendment of FAS 140). Those conditions must
consolidated affiliates included in the financial statements
be met in order for the originator (transferor) to account for
being presented.
the transfer of the financial assets to the participating trans-
32. Examples of a transferor’s effective control over the
feree as a sale. When a loan participation is accounted for as a
transferred financial assets include (a) an agreement that both
sale, the seller (transferor) removes the participated interest in
entitles and obligates the transferor to repurchase or redeem
the loan from its financial statements. FAS 166 applies to both
the financial asset (or its third-party beneficial interests) before
the transferor (seller) of the participated assets and the trans-
its maturity, (b) an agreement that provides the transferor with
feree (purchaser). (See the complete text of FAS 166 (para-
both the unilateral ability to cause the holder to return specific
graphs 8B and 9) that defines a ‘‘participating interest’’ and
financial assets and a more-than-trivial benefit attributable to
the conditions for sale recognition). See also the reporting
that ability, other than through a cleanup call, or (c) an
instructions for the ‘‘Consolidated Financial Statements for
agreement that permits the transferee to require the transferor
to repurchase the transferred financial assets at a price that is
BHC Supervision Manual January 2010 so favorable to the transferee that it is probable that the
Page 28 transferee will require the transferor to repurchase them.
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 borrower’s 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 BHC’s or lead subsidiary’s and par- rely solely on the originator’s credit analysis. It
ticipants’ specific rights if the borrower should gather all available relevant credit infor-
defaults; mation, including the details on the collateral’s
• 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 loan’s 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 participant’s ownership tor should monitor the loan’s servicing and
interest. The first principal payment could be repayment status.
applied based on the participant’s ownership
interest while the remaining payments would be
applied according to the lead BHC’s or lead 2010.2.7.6 Sales of Loan Participations in
subsidiary’s 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 interest—no sale. Page 29
sell its participating interests in the secondary borrower—the 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 participant’s accessibility to the
recourse to another subsidiary or correspondent borrower’s 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 participant’s 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 Board’s 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 seller’s 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
agreement’s participants. If participation agree- affiliate acquires the asset.35 Section 223.15 of
ments are not structured properly they can pose the Board’s 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 program’s 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 bank’s proportional operations of a borrower’s 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
bank’s 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 BHC’s or subsidiary’s pur- are significant problems with the management
chases, or they may arise when loans or pur- of the BHC’s or a subsidiary’s 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 entity’s 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 loans—including 1. To determine if the parent’s loan policies are
assessing and controlling environmental
liability—cannot be construed as taking an BHC Supervision Manual January 2010
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 borrower’s 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. nization’s 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 organization’s 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 organization’s 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 organization’s
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 Credit-Risk Management for Home Equity
professionals who are independent of line Lending
lending functions provide adequate internal
control in the loan-approval process. 1. To determine if the banking organization has
4. To evaluate whether loan-approval docu- an appropriate review and approval process
ments provide internal approving authori- for new product offerings, product changes,
ties and management with sufficient infor- and marketing initiatives.
mation on the risks of loans being 2. To ascertain whether the banking organiza-
considered, and that the information is in a tion has appropriate control procedures for
clear and understandable format. third parties that generate loans on its behalf
5. To evaluate whether forward-looking analy- and if the control procedures comply with
sis tools are being adequately and appropri- the laws and regulations that are applicable
ately used as part of the loan-approval to the organization.
process. 3. To determine if the banking organization has
6. To determine whether credit-risk manage- given full recognition to the risks embedded
ment information systems provide adequate in its home equity lending.
information to management and lenders. 4. To determine whether the banking organiza-
7. To incorporate the examiner’s evaluation of tion’s risk-management practices have kept
the bank holding company’s adherence to pace with the growth and changing risk pro-
sound practices into the overall assessment file of its home equity portfolios and whether
of credit-risk management. underwriting standards have eased.
8. To be alert to indications of insufficiently 5. To determine whether the loan policy—
rigorous risk assessment at banking organi- a. ensures prudent underwriting standards
zations, particularly inadequate stress test- for home equity lending, including stan-
ing and excessive reliance on strong eco- dards to ensure that a thorough evaluation
of a borrower’s capacity to service the
BHC Supervision Manual January 2010 debt is conducted (that is, the banking
Page 32 organization is not relying solely on the
borrower’s credit score); the BHC or its subsidiaries as originator of

b. provides risk-management safeguards for loan participations and its participants.
potential declines in home values; 8. To determine if any loan participations have
c. ensures that the standards for interest-only been adversely classified by examiners,
and variable-rate home equity lines of including examiners from other supervisory
credit (HELOCs) include an assessment agencies (includes loan participations held
of a borrower’s ability to (1) amortize the by the other institutions).
fully drawn line of credit over the loan
term and (2) absorb potential increases in
interest rates; and
2010.2.9 INSPECTION PROCEDURES
d. provides appropriate collateral-valuation
policies and procedures and provides for Loan Administration
the use and validation of automated valua-
tion models. 1. Obtain an organizational chart and deter-
mine the various levels of responsibility
and job functions of individuals involved
Loan Participations, the Agreements and with the lending function.
Participants 2. Obtain and review the BHC’s loan policy;
determine if the policy contains the appro-
1. To ascertain if the BHC engages in the pur- priate components, as summarized in this
chase or sale of loans via loan participation section. Determine how the policy is com-
agreements. municated to subsidiaries. Also determine
2. To determine if the BHC’s lending policy whether the loan policy reflects the Decem-
a. places limits on the amount of loan par- ber 1992 uniform interagency real estate
ticipations originated, purchased, or sold lending standards and guidelines as they
based on any one source or in the apply to subsidiary depository institutions.
aggregate; 3. Obtain a copy of the most recent manage-
b. has set credit standards for the BHC’s ment reports concerning the quality of loans
borrowers requesting loans as well as and other aspects of the loan portfolio
third parties acquiring loan participations (delinquency list, concentrations, yield
from the bank as originator; analysis, loan-distribution lists, watch loan
c. requires the same credit standards for loan reports, charge-off reports, participation
participations as it does for other loans; listings, internal and external audit reports,
d. sets the amount of contingent liability, etc.). Determine the scope and sufficiency
holdback (retained ownership), and the of the work performed by any committees
manner in which the loan should be ser- related to the lending function. Determine if
viced; or the information provided to the directorate
e. requires complete loan documentation for and senior management is sufficient for
loan participations. them to make judgments about the quality
3. To assess the impact of any concentrations of of the portfolio and to determine appropri-
credit to a borrower, or in the aggregate, that ate corrective action.
arise from loans involved in loan participa- 4. Determine if an internal process has been
tion agreements. established for the review and approval of
4. To determine if there are any informal repur- loans that do not conform to internal lend-
chase agreements that exist between loan ing policy. Establish whether such loans are
participation acquirers that are designed to supported by written documentation that
circumvent the originating BHC’s or its sub- clearly states all the relevant credit factors
sidiary’s legal lending limits, disguise delin- that culminated in the underwriting deci-
quencies, and avoid adverse classifications. sion. Determine if exception loans of a sig-
5. To determine whether the BHC’s financial nificant size are reported to the board of
condition is compromised by assessing the directors of the subsidiary or to the holding
impact of the BHC’s loan participations with company.
its affiliates. 5. Review internal and external audit reports
6. To ascertain whether loan participation trans- and bank examination reports for critical
actions with affiliates are in compliance with comments concerning loan-policy excep-
sections 23A and 23B of the Federal Reserve
Act and the Board’s Regulation W. BHC Supervision Manual January 2010
7. To determine if there are disputes between Page 33
tions and administration. Determine acceptable loans and (if applicable)

whether action was taken in response to any ‘‘guidance’’ minimum financial ratios,
identified exceptions. Determine who is b. standards for the types of covenants to be
responsible for follow-up and what the time imposed for specific loan types, and
frames are; seek rationale if no action was c. the treatment and reporting of policy
taken or if the action taken was half- exceptions, both for individual loans and
hearted. the entire portfolio.
6. Review the organization’s financial state- 2. Evaluate the role played by independent
ments, the bank Call Reports, and the BHC credit staff in loan approvals and, in particu-
FR Y-series reports submitted to the Fed- lar, whether these credit professionals are
eral Reserve. Determine whether reporting adequately experienced, are independent of
is accurate and disclosure is sufficient to line lending functions, and have authority to
indicate the organization’s financial posi- reject loans either because of specific excep-
tion and the nature of its loan portfolios, tions to policy or because the loan does not
including nonaccrual loans. meet the institution’s credit-risk appetite.
7. When reviewing lending policies, ascertain 3. Review written policies and determine oper-
whether— ating practice in preparing loan-approval
a. the loan policies facilitate extensions of documents to evaluate whether sufficient
credit to sound borrowers and facilitate information is provided on the characteristics
the workout of problem loans, and and risks of loans being considered, and
b. the loan policies control and reduce con- whether such information is provided clearly
centration risk by placing emphasis on and can be easily understood.
effective internal policies, systems, and 4. Based on written policies and review of oper-
controls to monitor the risk. ating practice, evaluate whether loans being
8. Through interviews with, or review of considered are evaluated not only on the
reports submitted by, the internal auditor, basis of the borrower’s current performance
lending officers, loan-review personnel, and but on the basis of forward-looking analysis
senior management, (1) evaluate the effec- of the borrower.
tiveness of the BHC’s self-monitoring of a. Determine whether financial projections
adherence to loan policy, (2) determine how or other forward-looking tools are an inte-
changes to the loan policy occur, (3) deter- gral part of the preapproval analysis and
mine how loans made in contradiction to loan-approval documents.
the loan policy are explained, and (4) deter- b. Determine the extent to which alternative
mine the various circumstances involving or ‘‘downside’’ scenarios are identified,
levels of approval and what specific consid- considered, and analyzed in the loan-
eration occurs at these levels. approval process.
9. Presuming the inspection is concurrent with 5. Review credit-risk management information
a bank’s primary regulator, coordinate, on a systems and reports to determine whether
random basis, the selection of loans subject they provide adequate information to man-
to classification. Determine whether they agement and lenders about—
conform to loan policy. a. the composition of the institution’s cur-
10. Review management’s policies and proce- rent portfolio or exposure, to allow for
dures for their determination of an appropri- consideration of whether proposed loans
ate level of loan-loss reserves. might affect this composition sufficiently
11. On the ‘‘Policies and Supervision’’ or an to be inconsistent with the institution’s
equivalent page of the inspection report, risk appetite, and
evaluate the BHC’s oversight regarding b. data sources, analytical tools, and other
effective lending policy and procedures. information to support credit analysis.
6. When appropriate, coordinate or conduct suf-
Lending Standards for Commercial Loans ficient loan reviews and transaction testing in
the lending function to accurately determine
1. Review formal credit policies for clear the quality of loan portfolios and other credit
articulation of current lending standards, exposures. If deficiencies in lending prac-
including— tices or credit discipline are indicated as a
a. a description of the characteristics of result of the preexamination risk assessment,
the inspection, or bank or other examina-
BHC Supervision Manual January 2010 tions, arrange for the commitment of suffi-
Page 34 cient supervisory resources to conduct
in-depth reviews, including transaction test- standards address all relevant risk factors
ing, that are adequate to ensure that the Fed- (that is, an analysis of a borrower’s income
eral Reserve achieves a full understanding of and debt levels, credit score, and credit
the nature, scope, and implications of the history versus the loan’s size, the collateral
deficiencies. value (including valuation methodology),
7. When reviewing loans, lending policies, and the lien position, and the property type and
lending practices— location.
a. observe and analyze loan-pricing policies 2. Determine whether the banking organiza-
and practices to determine whether the tion’s underwriting standards include—
institution may be unduly weighting the a. a properly documented evaluation of
short-term benefit of retaining or attract- the borrower’s financial capacity to
ing new customers through price conces- adequately service the debt and
sions, while not giving sufficient consi- b. an adequately documented evaluation of
deration to potential longer-term the borrower’s ability to (1) amortize the
consequences; fully drawn line of credit over the loan
b. be alert for indications of insufficiently term and (2) absorb potential increases
rigorous risk assessment, in particular in interest rates for interest-only and
(1) excessive reliance on strong economic variable-rate HELOCs.
conditions and robust financial markets to 3. Assess the reasonableness and adequacy of
support the capacity of borrowers to ser- the analyses and methodologies underlying
vice their debts and (2) inadequate stress the banking organization’s evaluation of
testing; borrowers.
c. be attentive in reviewing an institution’s 4. If the organization uses third parties to
assessment and monitoring of credit risk originate home equity loans, find out—
to ensure that undue reliance on favorable a. if the organization delegates the under-
conditions does not lead that institution to writing function to a broker or corre-
delay recognition of emerging weaknesses spondent;
in some loans or to lessen staff resources b if the banking organization’s internal
assigned to internal loan review;36 and controls for delegated underwriting are
d. give careful consideration to downgrad- adequate;
ing, under the applicable supervisory rat- c. whether the banking organization retains
ing framework, a banking organization’s appropriate oversight of all critical loan-
risk-management, management, and/or processing activities, such as verification
asset-quality ratings and its capital of income and employment and the inde-
adequacy rating (if sufficiently signifi- pendence of the appraisal and evaluation
cant) when there is significant and undue function;
reliance on favorable assumptions about d. if there are adequate systems and con-
borrowers or the economy and financial trols to ensure that a third-party origina-
markets, or when that reliance has slowed tor is appropriately managed, is finan-
the recognition of loan problems. cially sound, provides mortgages that
8. Discuss matters of concern with the senior meet the banking organization’s pre-
management and the board of directors of the scribed underwriting guidelines, and
bank holding company and report those areas adheres to applicable consumer protec-
of concern on core page 1, ‘‘Examiner’s tion laws and regulations;
Comments and Matters Requiring Special e. if the banking organization has a quality-
Board Attention.’’ control unit or function that closely
monitors (monitoring activities should
Credit-Risk Management for Home Equity include post-purchase underwriting
Lending reviews and ongoing portfolio-
performance-management activities) the
1. Review the credit policies for home equity quality of loans that the third party
lending to determine if the underwriting underwrites; and
f. whether the banking organization has
36. Examiners should recognize that an increase in classi- adequate audit procedures and controls
fied or special-mention loans is not per se an indication of lax
lending standards. Examiners should review and consider the
to verify that third parties are not being
nature of these increases and the surrounding circumstances in
reaching their conclusions about the asset quality and risk BHC Supervision Manual January 2010
management of an institution. Page 35
paid to generate incomplete or fraudu- equity loan portfolios or portfolios with

lent mortgage applications or are not high-risk characteristics, determine if the
otherwise receiving referral or unearned organization—
income or fees contrary to RESPA a. periodically refreshes credit-risk scores
prohibitions. on all customers;
5. Evaluate the adequacy of the banking orga- b. uses behavioral scoring and analysis of
nization’s collateral-valuation policies and individual borrower characteristics to
procedures. Ascertain whether the identify potential problem accounts;
organization— c. periodically assesses utilization rates;
a. establishes criteria for determining the d. periodically assesses payment patterns,
appropriate valuation methodology for a including borrowers who make only
particular transaction (based on the risk minimum payments over a period of
in the transaction and loan portfolio); time or those who rely on the credit line
b. sets criteria for determining when a to keep payments current;
physical inspection of the collateral is e. monitors home values by geographic
necessary; area; and
c. ensures that an expected or estimated f. obtains updated information on the col-
value of the property is not communi- lateral’s value when significant market
cated to an appraiser or individual per- factors indicate a potential decline in
forming an evaluation; home values, or when the borrower’s
d. implements policies and controls to prepayment performance deteriorates and
clude ‘‘value shopping’’; greater reliance is placed on the
e. requires sufficient documentation to sup- collateral.
port the collateral valuation in the Determine that the frequency of these
appraisal or evaluation. actions is commensurate with the risk in the
6. If the banking organization uses automated portfolio.
valuation models (AVMs) to support evalu- 10. Verify that annual credit reviews of home
ations or appraisals, find out if the equity line of credit (HELOC) accounts are
organization— conducted. Verify if the reviews of HELOC
a. periodically validates the models, to accounts determine whether the line of
mitigate the potential valuation uncer- credit should be continued, based on the
tainty in the model; borrower’s current financial condition.
b. adequately documents the validation’s 11. Determine that authorizations of over-limit
analysis, assumptions, and conclusions; home equity lines of credit are restricted
c. back-tests a representative sample of and subject to appropriate policies and
evaluations and appraisals supporting controls.
loans outstanding; and a. Verify that the banking organization
d. evaluates the reasonableness and requires over-limit borrowers to repay,
adequacy of its procedures for validating in a timely manner, the amount that
AVMs. exceeds established credit limits.
7. If tax-assessment valuations are used as a b. Evaluate the sufficiency of management
basis for collateral valuation, ascertain information systems (MIS) that enable
whether the banking organization is able to management to identify, measure, moni-
demonstrate and document the correlation tor, and control the risks associated with
between the assessment value of the taxing over-limit accounts.
authority and the property’s market value,
12. Verify that the organization’s real estate
as part of the validation process.
lending policies are consistent with safe and
8. Review the risk- and account-management
sound banking practices and that its board
procedures. Verify that the procedures are
of directors reviews and approves the poli-
appropriate for the size of the banking
cies at least annually.
organization’s loan portfolio, as well as
13. Determine whether the MIS—
for the risks associated with the types of
home equity lending conducted by the a. allows for the segmentation of the loan
organization. portfolios;
9. If the banking organization has large home b. accurately assesses key risk characteris-
tics; and
BHC Supervision Manual January 2010 c. provides management with sufficient
Page 36 information to identify, monitor, mea-
sure, and control home equity concentra- 20. Determine whether policies and procedures
tions. have been established for home equity
14. Determine whether management periodi- problem-loan workouts and loss-mitigation
cally assesses the adequacy of its MIS, in strategies.
light of growth and changes in the banking
organization’s risk appetite.
15. If the banking organization has significant Loan Participations, the Agreements and
concentrations of home equity loans (HELs) Participants
or HELOCs, determine if the MIS includes,
at a minimum, reports and analysis of the These inspection procedures are designed to
following: ensure that originated loans that were trans-
a. production and portfolio trends by prod- ferred via loan participation agreements or cer-
uct, loan structure, originator channel, tificates to state member banks, bank holding
credit score, loan to value (LTV), debt to companies, nonbank affiliates, or other third par-
income (DTI), lien position, documenta- ties were carefully evaluated. The procedures
tion type, market, and property type instruct examiners to determine if the asset
transfers were carried out to avoid or circum-
b. the delinquency and loss-distribution
vent classification and to determine the effect of
trends by product and originator chan-
the transfers on the BHC’s financial condition
nel, with some accompanying analysis
or that of its subsidiaries. In addition, the proce-
of significant underwriting characteris-
dures are designed to ensure that the primary
tics (such as credit score, LTV, or DTI)
regulator of another financial institution
c. vintage tracking involved in the asset transfer of any low-quality
d. the performance of third-party origina- assets is notified.
tors (brokers and correspondents)
e. market trends by geographic area and 1. Review the board of directors’ or their des-
property type, to identify areas of rapidly ignated committees’ policies and proce-
appreciating or depreciating housing dures governing how loan participation
values agreements and activities are created, trans-
16. Determine whether the banking organiza- acted, and administered. Refer to section
tion accurately tracks the volume of high- 2010.2.7 for the minimum items that should
LTV (HLTV) loans, including HLTV home be included in board-approved policies on
equity and residential mortgages, and if the loan participation activities.
organization reports the aggregate of these 2. Determine if managerial reports provide
loans to its board of directors. sufficient information relative to the size
17. Determine whether loans in excess of the and risk profile of the loan participation
supervisory LTV limits are identified as portfolio and evaluate the accuracy and
high-LTV loans in the banking organiza- timeliness of reports produced for the board
tion’s records. Determine whether the orga- and senior management.
nization reports, on a quarterly basis, the 3. For loan participations held (either in whole
dollar value of such loans to its board of or in part) with another lending institution,
directors. review, if applicable,
18. Find out whether the organization has pur- • the participation certificates and agree-
chased insurance products to help mitigate ments, on a test basis, to determine if the
the credit risks of its HLTV residential contractual terms are being adhered to;
loans. If a policy has a coverage limit, • loan documentation to determine if it
determine whether the coverage may be meets the BHC’s (or its subsidiary’s)
exhausted before all loans in the pool underwriting procedures (that is, the
mature or pay off. documentation for loan participations
19. Determine whether the organization’s should meet the same standards as the
credit-risk management function oversees documentation for other loans the respec-
the support function(s). Evaluate the effective entity originates);
tiveness of controls and procedures over • the transfer of loans immediately before
staff persons responsible who are respon- the date of the inspection to determine if
sible for perfecting liens, collecting out- the loan was either nonperforming or
standing loan documents, obtaining insur-
ance coverage (including flood insurance), BHC Supervision Manual January 2010
and paying property taxes. Page 37
classified and if the transfer was made to transferred for any other reason that may
avoid possible criticism during the cur- cause the loans to be considered of ques-
rent inspection; and tionable quality.
• losses to determine if they are shared on a 13. Review the BHC’s policies and procedures
pro rata or other basis according to the to determine whether loan participations
terms of the participation agreement. purchased are required to be given an inde-
4. Check participation certificates or agree- pendent, complete, and adequate credit
ments and records to determine whether the evaluation. Review asset participations sold
parties share in the risks and contractual to affiliates to determine if the asset pur-
payments on a pro rata or other basis. chases were supported by an arm’s-length
5. Determine if loans are purchased on a and independent credit evaluation.
recourse basis and that loans are sold on a 14. Determine that any assets purchased by the
nonrecourse basis. BHC (or its subsidiaries) were properly
6. Ascertain that the BHC (or its subsidiaries) recorded at fair market value at the time of
do not buy back or pay interest on defaulted purchase.
loans in contradiction of the underlying par- 15. Determine that transactions involving trans-
ticipation agreement. fers of low-quality assets to the parent hold-
7. Compare the volume of outstanding origi- ing company or a nonbank affiliate are
nated or purchased loans that were issued in properly reflected at fair market value on
the form of loan participations with the total the books of both the bank and the holding
outstanding loan portfolio. company affiliate.
8. Determine if the BHC (or its subsidiaries) 16. If poor-quality assets were transferred by
has sufficient expertise to properly evaluate the BHC to another financial institution for
the volume of loans originated or purchased which the Federal Reserve is not the pri-
and sold as loan participations. mary regulator, prepare a memorandum to
9. Based on the terms of the loan participation be submitted to the Reserve Bank supervi-
agreements, review the originator’s distri- sory personnel. The Reserve Bank’s appro-
bution of the borrower’s payments received priate staff will then inform the local office
to those entities or persons owning interests of the primary federal regulator of the other
in the loan participations. Ascertain if the institution involved in the transfer. The
agreement’s recourse provisions may memorandum should include the following
require accounting for the transactions as a information, as applicable,
secured borrowing rather than as a sale. • names of originating and receiving
10. Determine if loans are sold primarily to institutions;
accommodate credit overline needs of cus- • type of assets involved;
tomers or to generate fee income. • date (or dates) of transfer;
11. Determine if loans are purchased or sold to • total number and dollar amount of assets
affiliates or other companies; if so, deter- transferred;
mine whether the purchasing companies • status of the assets when transferred (e.g.,
request and are given sufficient information nonperforming, classified, etc.); and
to properly evaluate the credit. (Section • any other information that would be help-
23A of the Federal Reserve Act and the ful to the other regulator. Ascertain
Board’s Regulation W prohibit transfers of whether the bank manages not only the
low-quality assets between affiliates.) See risk from individual participation loans
sections 2020.0, 2020.1, 2020.2. but also portfolio risk.
12. Investigate any situations in which assets 17. Find out if management develops appropri-
were transferred before the date of ate strategies for managing concentration
inspection: levels, including the development of a con-
a. Determine if any were transferred to tingency plan to reduce or mitigate concen-
avoid possible criticism during the trations during adverse market conditions
inspection. (such a plan may include strategies involv-
b. Determine whether any of the loan par- ing not only loan participations, but also
ticipations transferred were nonperform- whole loan sales). Find out if the BHC’s (or
ing at the time of transfer, classified dur- its subsidiaries’) contingency plan includes
ing the previous examination, or selling loans as loan participations.
18. Ascertain if management periodically
BHC Supervision Manual January 2010 assesses the marketability of its loan partici-
Page 38 pation portfolio and evaluates the BHC’s
(or its subsidiaries’) ability to access the 19. Verify whether the BHC (or its subsidi-
secondary market. aries) compare its underwriting standards
for loan participations with those that exist
in the secondary market.

Page 39
(Investments) Section 2010.3
The System’s ability to evaluate the effective- methods and/or process through which prior
ness of a company’s 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 parent’s 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 company’s policies can be evaluated. By es- 4. Assess the adequacy of the level of man-
tablishing the minimum areas that a company’s 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 company’s 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 parent’s 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 parent’s 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 company’s 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.
parent’s 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 organization’s 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 organization’s ability to compete by provid-
jectives, and budgets should be written and ing the entire organization with a fluid consis-
adopted by the parent’s 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 goals—the 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 BHC’s 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 organization’s 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 1950’s to the late • Owns existing, or acquires (by merger or ac-
1970’s. 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, and—prior to tak-
being required to clean up hazardous substance ing title to real property—foreclosures. 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 borrower’s sol- and procedures designed to identify, assess and
vency and jeopardize the banking organization’s 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 borrower’s gen- ing in the management or day-to-day operations
erating or handling of hazardous substances in of the borrower’s 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 borrower’s business, and
stance contamination prior to distribution of a therefore subject the bank to potential liability,
debtor’s 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 borrower’s 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 organization’s 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 borrower’s 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 review—screening of the warranties, representations, and indemnifica-
borrower’s 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 borrower’s 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. tion’s nonlending activities, verify that similar
• Environmental assessment—structured policies and procedures are in place. 5
analysis by a qualified individual that iden-
tifies the borrower’s past practices, regula-
5. A banking organization’s 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 audit—a professional envi-
ronmental engineer performs a similar

Page 5
Supervision of Subsidiaries (Financial Institution Subsidiary
Retail Sales of Nondeposit Investment Products) Section 2010.6
WHAT’S 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 company’s 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 agencies—the
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 Supervision—issued
being followed, particularly with regard to the
the statement to provide uniform guidance to
nature and sufficiency of an institution’s 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 institution’s 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 institution’s fiduciary customers.
ring on the premises of the institution (includ-
ing telephone sales or recommendations by
employees or from the institution’s 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 institution’s lobby area. Sales contains a summary of policies and procedures
of government or municipal securities away outlining the features of the institution’s 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
broker–dealer 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
broker–dealer. 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 institution’s
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- tion’s 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 institution’s 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 bank’s use as fiduciary of the A designation by senior managers of specific
bank’s brokerage service or other entity with which the bank individuals to exercise supervisory responsibil-
has a conflict of interest, including purchases of the bank’s
proprietary and other products, are set out in 12 C.F.R. 9.12. ity for each activity outlined in the institution’s
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 institution’s 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-
institution’s 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 institution’s 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 institution’s loss of the principal amount invested.
premises; terms as to the use of the institu-
tion’s 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 broker–dealer, 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
tomer’s periodic deposit account statement
includes account information concerning the Where applicable, the depository institution
customer’s 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 institution’s 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 tomer’s 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 institution’s 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 management’s 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 institution’s 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 institution’s 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 bank’s policies and
of compliance reviews should be periodically
procedures provide for an operating environ-
reported directly to the institution’s 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
bank’s ability to conduct such sales activities in
also be incorporated into the institution’s 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 bank’s trust department where
Industry Regulatory Authority (FINRA) govern they may purchase nondeposit investment
sales of securities by its member broker–dealers. 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 bank’s premises and, in of the institution’s activities or, when applica-
particular, whether sales of nondeposit invest- ble, address the institution’s 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 organization’s 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 institution’s 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
tion’s 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 customer’s 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 institution’s 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 institution’s 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 broker–dealers, 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 bank’s 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- party’s financial status, management experience,
over, the bank should review the issuer’s 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 bank’s premises. Such
bank holding company (as opposed to a bank) agreements should be approved by a bank’s
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 tion’s 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 party’s 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 acknowledgment—on the customer-account
increased volumes of transactions. agreement or on a separate form—from 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 customer’s 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 bank’s
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 product’s 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 broker–dealer 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 broker–dealer. 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 bank’s 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 institution’s 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 FINRA’s 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 NYSE’s 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 party’s 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 institution’s 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
broker–dealer 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 customer’s
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 institution’s policies and
visory experience and training equivalent to that
procedures. The examiner’s review should
required of a general securities principal as
required by the FINRA for broker–dealers. include a sample of customer files to determine
Supervisory personnel should be responsible for the extent of customer information collected,
the institution’s 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 broker–dealers
Page 12 are subject to FINRA’s 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 FINRA’s 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 bank’s written internal code to the institution’s 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 board’s 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 bank’s
pliance programs for nondeposit investment oversight of the third party’s activities.
products that are similar to those of securities
broker–dealers. 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 association’s 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.
bank’s compliance program should provide for
oversight of the third party’s 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 party’s commitment to correct called for by the interagency statement.
identified problems. Proper follow-up by the The interagency statement disclosures do not
bank’s compliance personnel should verify the need to be provided in the following situations:
third party’s 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-
institution’s 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
audit’s 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— institution’s 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 broker–dealers. 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 broker–dealer resulting
The banking agencies’ joint statement also from a referral of retail customers by the
addressed the following: depository institution to the broker–dealer.
• 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 institution’s 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 institution’s
tion’s 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.
tion’s 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 institution’s 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 institution’s 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:
Act—Investment or Financial Advisers a. disclosure and advertising
• Section 3230.0: Section 4(c)(8) of the BHC b. physical separation from deposit-taking
Act—Securities 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 institution’s structure and
f. restrictions on a mutual fund’s 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 institution’s 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 broker–dealer.
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 broker–dealer and the
tionship is made before the purchase of FINRA or SEC. Review the institution’s
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 bank’s; examination results or other material.
c. bank-advised mutual funds with names 23. Where any retail sales facilities of the insti-
similar to the bank’s 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 arm’s-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 broker–dealers should rely on the
representative. FINRA’s review of sales practices or its exami-
26. Review the training program provided to nation to assess the organization’s 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 bank’s 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— institution’s 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 bank’s 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 bank’s code of con- c. compliance
duct. In so doing, determine whether the d. sales practices and suitability
bank’s 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,
tion’s 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 institution’s nondeposit
a. frequency and scope investment product activities performed
b. workpapers over the past year (including management’s
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 institution’s 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 firm’s 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 staff’s responsibilities should be clearly
ing company an individual is employed, and defined and, when appropriate, disclosed or
members of a banking organization’s 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 organization’s 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 entity’s 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 individual’s daily work be level of absence is attained. Some banking orga-
processed by another employee during the nizations, particularly smaller ones, might con-
employee’s 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 individual’s 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 organization’s 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 organization’s 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 employee’s 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—
tion’s 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 employee’s 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.

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
organization’s 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 organization’s
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 organization’s 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 bank’s primary ous and disciplined in their credit-analysis and
regulator will normally want to evaluate the lending decisions. A banking organization’s
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
company’s 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 examiners—and
process. management—that 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 organization’s 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 System’s responsibility to evalu- will normally function within the subsidiary
ate top management’s 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 company’s 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 ‘‘Examiner’s 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 zation’s 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, ‘‘Examiner’s 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
WHAT’S NEW IN THIS REVISED private-banking activities is (1) to evaluate man-
SECTION agement’s ability to measure and control the
risks associated with such activities and (2) to
Effective January 2006, this section has been determine if the proper internal control and audit
revised to incorporate the statutory require- infrastructures are in place to support effective
ments of the USA Patriot Act. The requirements compliance with relevant laws and regulations.
of the USA Patriot Act are designed to prevent, In this regard, the supervisors may determine
detect, and prosecute money laundering and that certain risks have not been identified or
terrorist financing. For banking organizations, adequately managed by the institution, a poten-
the act’s provisions are implemented through tially unsafe and unsound banking practice.
regulations issued by the U.S. Department of the Private-banking functions may be performed
Treasury (31 C.F.R. 103). Section 326 of the in a specific department of a commercial bank
Patriot Act (codified in the Bank Secrecy Act or nonbank subsidiary of a commercial bank, a
(BSA) at 31 U.S.C. 5318(l)) requires financial bank holding company (including a financial
institutions to have customer identification pro- holding company), an Edge corporation or its
grams, that is, programs to collect and maintain foreign subsidiaries, a branch or agency of a
certain records and documentation on custom- foreign banking organization, or within multiple
ers. Institutions are to develop and use identity areas of an institution. Private banking may be
verification procedures to ensure the identity of the sole business of an institution. Regardless of
their customers. Bank holding companies, as a how an institution is organized or where it is
matter of safety and soundness, should take located, the results of the private-banking
appropriate measures to ensure that their finan- review should be reflected in the entity’s overall
cial institution subsidiaries are in compliance supervisory assessment.1
with the customer identification program (CIP) This section provides examiners with guid-
rule. ance for reviewing private-banking activities at
The CIP rule for banks (see 31 C.F.R. all types and sizes of banking organizations,
103.121) applies only to a bank, not to a bank including financial institutions. It is intended to
holding company solely because it owns a bank. supplement, not replace, existing guidance on
Also, a nonbank subsidiary of a bank holding the inspection or examination of private-banking
company is not subject to the CIP rule for banks activities and to broaden the examiner’s review
solely as a result of being affiliated with a bank of general risk-management policies and prac-
in a holding company structure. Even though tices governing private-banking activities. In
this rule is not applicable to bank holding com- addition to providing an overview of private
panies and their nonbank subsidiaries (or to banking, the general types of customers, and the
savings and loan holding companies and their various products and services typically pro-
non–savings association subsidiaries), bank vided, the ‘‘Functional Review’’ subsection
holding companies should, as a matter of safety describes the critical functions that constitute a
and soundness, take appropriate measures private-banking operation and identifies certain
throughout the organization to ensure that each safe and sound banking practices. These critical
of their entities is in compliance with any appli- functions are supervision and organization, risk
cable CIP rule. New accounts must receive management, fiduciary standards, operational
appropriate due diligence, and a holding com- controls, management information systems,
pany should generally protect the consolidated audit, and compliance. Included in the risk-
organization from any risks associated with
money laundering and financial crime. The bank 1. Throughout this section, the word institution will be
holding company may still be subject to other used to mean all types of banking organizations, including
bank holding companies, their bank and other financial institu-
CIP rules if it has ownership in a functionally tion subsidiaries, nonbank subsidiaries, and those entities
regulated entity, for example, a securities authorized to operate under section 4(k) of the Bank Holding
broker-dealer. (See 31 C.F.R. 103.22) Company Act. Institution also includes branches and agencies
of foreign banks and any other types of financial institutions
and entities supervised by the Federal Reserve System. The
term ‘‘board of directors’’ will be interchangeable with refer-
2010.11.1 OVERVIEW OF PRIVATE ences to the ‘‘senior management’’ of branches and agencies
BANKING AND ITS ASSOCIATED of foreign banks.
ACTIVITIES
The role of bank regulators in supervising Page 1
Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11
management portion is a discussion of the basic vices, technologies, and distribution channels
‘‘customer-due-diligence’’ (CDD) principle that are still evolving. A range of private-banking
is the foundation for the safe and sound opera- products and services may be offered to custom-
tion of a private-banking business. The ‘‘Prepa- ers throughout an institution’s global network of
ration for Inspection’’ subsection assists in affiliated entities—including branches, subsidi-
defining the inspection scope and provides a list aries, and representative offices—in many dif-
of core requests to be made in the first-day ferent regions of the world, including offshore
letter. Additional inspection and examination secrecy jurisdictions.
guidance can be found in this manual, the Fed- Typically, private-banking customers are high
eral Financial Institutions Examination Coun- net worth individuals or institutional investors
cil’s (FFIEC) Bank Secrecy Act/Anti–Money who have minimum investible assets of $1 mil-
Laundering (BSA/AML) Examination Manual, lion or more. Institutions often differentiate
the Federal Reserve System’s Trading and domestic from international private banking,
Capital-Markets Activities Manual, and in the and they may further segregate the international
FFIEC’s Information Technology Examination function on the basis of the geographic location
Handbook. of their international client base. International
In reviewing specific functional and product- private-banking clients may be wealthy indi-
inspection procedures (as found in the private- viduals who live in politically unstable nations
banking activities module that is part of the and are seeking a safe haven for their capital.
framework for risk-focused supervision of large Therefore, obtaining detailed background infor-
complex institutions), all aspects of the private- mation and documentation about the interna-
banking review should be coordinated with the tional client may be more difficult than it
rest of the inspection to eliminate unnecessary is for the domestic customer. Private-banking
duplication of effort. Furthermore, this section accounts may, for example, be opened in the
has introduced the review of trust activities and name of an individual, a commercial business, a
fiduciary services, critical components of most law firm, an investment adviser, a trust, a per-
private-banking operations, as part of the over- sonal investment company (PIC), or an offshore
all private-banking review. Although the prod- mutual fund.
uct nature of these activities differs from that of In 2001, the USA Patriot Act (the Patriot Act)
products generated by other banking activities, established new and enhanced measures to pre-
such as lending and deposit taking, the func- vent, detect, and prosecute money laundering
tional components of private banking (supervi- and terrorist financing. In general, these mea-
sion and organization, risk management, opera- sures were enacted through amendments to the
tional controls and management information Bank Secrecy Act (BSA). The measures directly
systems, audit, compliance, and financial affecting banking organizations are imple-
condition/business profile) should be reviewed mented primarily through regulations issued by
across product lines. the U.S. Department of the Treasury (31 C.F.R.
Private banking offers the personal and dis- 103).2 Section 326 of the Patriot Act (see the
crete delivery of a wide variety of financial BSA at 31 U.S.C. 5318(l)) requires financial
services and products to an affluent market, institutions (such as banks, savings associations,
primarily to high net worth individuals and their trust companies, and credit unions) to have cus-
corporate interests. A private-banking operation tomer identification programs that include mea-
typically offers its customers an all-inclusive sures to—
money-management relationship, including
investment portfolio management, financial- 1. require that certain information be obtained
planning advice, offshore facilities, custodial at account opening (for individuals, the infor-
services, funds transfer, lending services, over- mation would generally include their name,
draft privileges, hold mail, letter-of-credit address, tax identification number, and date
financing, and bill-paying services. As the afflu- of birth);
ent market grows, both in the United States and
globally, competition to serve it is becoming
more intense. Consequently, the private-banking 2. For banking organizations, the regulation implementing
marketplace includes banks, nonbanks, and the requirements of section 326 of the Patriot Act was jointly
other types of banking organizations and finan- issued by the U.S. Department of the Treasury, through the
Financial Crimes Enforcement Network (FinCEN), and the
cial institutions. Private-banking products, ser- Board of Governors of the Federal Reserve System, the Office
of the Comptroller of the Currency, the Federal Deposit
BHC Supervision Manual January 2010 Insurance Corporation, the Office of Thrift Supervision, and
Page 2 the National Credit Union Administration.
2. verify the identity of new account holders of the RM’s procedures. Policy guidelines and
within a reasonable time period; management supervision should provide param-
3. ensure that a banking organization has a rea- eters for evaluating the appropriateness of all
sonable belief that it knows each customer’s products, especially those involving market risk.
identity; Moreover, because of the discretion given to
4. maintain records of the information used to RMs, management should develop effective pro-
verify a person’s identity; and cedures to review the activity of client accounts
5. compare the names of new customers against in order to protect the client from any unautho-
government lists of known or suspected ter- rized activity. In addition, ongoing monitoring
rorists or terrorist organizations. of account activity should be conducted to
detect activity that is inconsistent with the client
A customer identification program is an impor- profile (for example, frequent or sizable unex-
tant component of a financial institution’s over- plained transfers flowing through the account).
all anti-money-laundering and BSA compliance Finally, as clients develop a return-on-assets
program. (ROA) outlook to enhance their returns, the use
SR-04-13 disseminated the interagency BSA of leveraging and arbitrage is becoming more
examination procedures that should be used to evident in the private-banking business. Exam-
evaluate banking organizations’ compliance iners should be alert to the totality of the client
with the regulation. The scope of the examina- relationship product by product, in light of
tion or inspection can be tailored to the relia- increasing client awareness and use of deriva-
bility of the banking organization’s compliance- tives, emerging-market products, foreign
management system and to the level of risk that exchange, and margined accounts.
the organization assumes. Relevant interagency
guidance (in a frequently-asked-question for-
mat) has been issued to address the customer 2010.11.1.1 Products and Services
identification program 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 institution’s 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 custom-
integral part of the inspection process is assess- er’s assets as well as offer confidentiality by
ing the adequacy of managerial oversight of the opening accounts in the PIC’s name. The ‘‘ben-
nature and volume of transactions conducted eficial owners’’ of the shell corporations are
within the private-banking department or with
other departments of the financial institution, as BHC Supervision Manual January 2006
well as determining the adequacy and integrity Page 3
typically foreign nationals. The banking institu- with the client’s profile of usual transactions.
tion should know and be able to document that Suspicious transactions could warrant the fil-
it knows the beneficial owners of such corpora- ing of a Suspicious Activity Report (SAR). A
tions and that it has performed the appropriate bank holding company or any nonbank subsidi-
due diligence to support these efforts. Emphasis ary thereof, or a foreign bank that is subject to
should be placed on verifying the source or the Bank Holding Company Act (or any non-
origin of the customer’s 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 Board’s 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; SR-03-12 and its attached July
established PICs as operating accounts for busi- 2003 SAR form and instructions; and the
ness entities they control in their home coun- expanded examination procedures for private
tries. Accordingly, financial institutions should banking in the FFIEC’s BSA/AML Examination
use extra care when dealing with beneficial Manual.
owners of PICs and associated trusts; these vehi-
cles can be used to conceal illegal activities.
2010.11.1.1.3 Investment Management
2010.11.1.1.2 Deposit-Taking Activities of In private banking, investment management

Subsidiary Institutions usually consists of two types of accounts:
(1) discretionary accounts in which portfolio
A client’s private-banking relationship fre- managers make the investment decisions on the
quently begins with a deposit account and then basis of recommendations from the bank’s
expands into other products. In fact, many insti- investment research resources and (2) nondis-
tutions require private-banking customers to cretionary (investment advisory) accounts in
establish a deposit account before maintaining which clients make their own investment deci-
any other accounts. Deposit accounts serve as sions when conducting trades. For nondiscre-
conduits for a client’s money flows. To distin- tionary clients, the banks typically offer invest-
guish private-banking accounts from retail ment recommendations subject to the client’s
accounts, institutions usually require signifi- written approval. Discretionary accounts consist
cantly higher minimum account balances and of a mixture of instruments bearing varying
assess higher fees. The private-banking function degrees of market, credit, and liquidity risk that
or institution should have account-opening pro- should be appropriate to the client’s investment
cedures and documentation requirements that objectives and risk appetite. Both account types
must be fulfilled before a deposit account can be are governed under separate agreements
opened. (These standards are described in detail between the client and the institution.
in the ‘‘Functional Review’’ subsection.) Unlike depository accounts, securities and
Most private banks offer a broad spectrum of other instruments held in the client’s investment
deposit products, including multicurrency accounts are not reflected on the balance sheet
deposit accounts that are used by clients who of the institution because they belong to the
engage in foreign-exchange, securities, and client. These managed assets are usually
derivatives transactions. The client’s transaction accounted for on a separate ledger that is segre-
activity, such as wire transfers, check writing, gated according to the customer who owns the
and cash deposits and withdrawals, is conducted assets. For regulatory reporting, domestic trust
through deposit accounts (including current departments and foreign trust departments of
accounts). It is very important that the transac- U.S. banks are required to report trust assets
tion activity into and out of these deposit annually using FFIEC Form 001 (Annual Report
accounts (including internal transfers between of Trust Assets) and FFIEC Form 006 (Annual
affiliated deposit accounts) be closely monitored Report of International Fiduciary Activities). On
for suspicious transactions that are inconsistent the other hand, the fiduciary activities of foreign
banking organizations operating in the United
BHC Supervision Manual January 2006 States currently are not reported on any FFIEC
Page 4 regulatory report.
2010.11.1.1.4 Credit 2010.11.1.1.5 Payable-Through Accounts

Private-banking clients may request extensions Another product that may be available in
of credit on either a secured or an unsecured private-banking operations is payable-through
basis. Loans backed by cash collateral or man- accounts (PTAs). PTAs are transaction deposit
aged assets held by the private-banking function accounts through which U.S. banking entities
are quite common, especially in international (‘‘payable-through banks’’) extend check-
private banking. Private-banking clients may writing privileges to the customers of a foreign
pledge a wide range of their assets, including bank. The foreign bank (‘‘master account
cash, mortgages, marketable securities, land, or holder’’) opens a master checking account with
buildings, to securitize their loans. Management the U.S. bank and uses this account to provide
should demonstrate an understanding of the pur- its customers with access to the U.S. banking
pose of the credit, the source of repayment, the system. The master account is divided into
loan tenor, and the collateral used in the financ- ‘‘subaccounts,’’ each in the name of one of the
ing. When lending to individuals with high net foreign bank’s customers. The foreign bank
worths, whether on a secured or an unsecured extends signature authority on its master
basis, the creditworthiness determination is bol- account to its own customers, who may not be
stered by a thorough and well-structured known to the U.S. bank. Consequently, the U.S.
customer-due-diligence process. If that process bank may have customers who have not been
is not thorough, collateral derived from illicit subject to the same account-opening require-
activities may be subject to government ments imposed on its U.S. account holders.
forfeiture. These subaccount customers are able to write
Borrowing mechanisms are sometimes estab- checks and make deposits at the U.S. banking
lished to afford nonresident-alien customers the entity. The number of subaccounts permitted
ability to keep financial assets in the United under this arrangement may be virtually
States and to use such assets (via collateralized unlimited.
borrowing arrangements) to provide operating U.S. banking entities engage in PTAs prima-
capital for businesses they own and operate in rily because they attract dollar deposits from the
their home countries. Such arrangements enable domestic market of their foreign correspondents
these customers to keep the existence of these without changing the primary bank-customer
financial assets secret from their home-country relationship; PTAs also provide substantial fee
authorities and others, while they continue to income. Generally, PTAs at U.S. banking enti-
use the funds (via collateralized borrowings) to ties have the following characteristics: they are
fund their businesses at home. carried on the U.S. banking entity’s books as a
Private bankers need to maintain in the correspondent bank account, their transaction
United States adequate CDD information on volume is high, checks passing through the
such nonresident-alien customers and their pri- account contain wording similar to ‘‘payable
mary business interests. A well-documented through XYZ bank,’’ and the signatures appear-
CDD file may include information on the cus- ing on checks are not those of authorized offi-
tomer from ‘‘who’s who’’ and similar services, cers of the foreign bank. See the expanded
Internet research, foreign tax returns and finan- examination procedures for PTAs in the
cial statements, checks conducted by the Office FFIEC’s BSA/AML Examination Manual.
of Foreign Assets Control (OFAC), and written
and appropriately documented Call Reports pre-
pared by the RM. 2010.11.1.1.6 Personal Trust and Estates
While these lending mechanisms may be used
for legitimate reasons, management needs to In trust and estate accounts, an institution offers
determine whether the arrangements are being management services for a client’s assets. When
used primarily to obfuscate the beneficial own- dealing with trusts under will, or ‘‘testamentary
ership of collateral assets, making it difficult for trusts,’’ the institution may receive an estate
the customer’s home-country government to appointment (executor) and a trustee appoint-
identify who owns the assets. If so, management ment if the will provided for the trust from the
needs to further determine whether the practice probate. These accounts are fully funded at
varies from both the appropriate standards of origination with no opportunity for an outside
international cooperation for transparency issues party to add to the account, and all activities are
and with prudent banking practices, and if so,
whether the institution is exposed to elevated BHC Supervision Manual January 2006
legal risk. Page 5
subject to review by the probate or surrogates’ administration should be established and

court. On the other hand, with living trusts, or reviewed.
‘‘grantor trusts,’’ the customer (grantor) may An escrow account is a form of custody
continually add to and, in some instances, has account in which the institution agrees to hold
control over the corpus of the account. Trusts cash or securities as a middleman, or a third
and estates require experienced attorneys, party. The customer, for example, an attorney or
money managers, and generally well-rounded a travel agency, gives the institution funds to
professionals to set up and maintain the hold until the ultimate receiver of the funds
accounts. In certain cases, bankers may need to ‘‘performs’’ in accordance with the written
manage a customer’s closely held business or escrow agreement, at which time the institution
sole proprietorship. In the case of offshore trust releases the funds to the designated party.
facilities, recent changes in U.S. law have
imposed additional obligations on those banks
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, such as
bank is the fiduciary and the trust officer serves by facsimile machine, telex, telegram, and tele-
as a representative of the institution. Fiduciaries phone, is extremely important. Funds-transfer
are held to higher standards of conduct than requests are quickly processed and, as required
other bankers. Proper administration of trusts by law, funds-transfer personnel may have lim-
and estates includes strict controls over assets, ited knowledge of the customers or the purpose
prudent investment and management of assets, of the transactions. Therefore, strong controls
and meticulous recordkeeping. See the and adequate supervision over this area are
expanded procedures for trust and asset manage- critical.
ment services in the FFIEC’s 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 customer’s 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 bank’s 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-
vice is provided, an agreement between the bank
BHC Supervision Manual January 2006 and the customer should exist. Typically, a cus-
Page 6 tomer may request that the bank debit a deposit
account for credit card bills, utilities, rent, mort- ucts, operations, internal controls, and audits.
gage payments, or other monthly consumer However, management alone must implement
charges. In addition, the increased use of the policies and programs within the organizational
Internet has given rise to the electronic-mail- framework instituted by the board of directors.
only account, whereby customers elect to have
statements, notices, etc., sent to them only by
e-mail. 2010.11.2.2 Risk Management
Sound risk-management processes and strong
2010.11.2 FUNCTIONAL REVIEW internal controls are critical to safe and sound
banking generally and to private-banking activi-
When discussing the functional aspects of a ties in particular. Management’s role in ensuring
private-banking operation, functional refers to the integrity of these processes has become
managerial processes and procedures, such as increasingly important as new products and
reporting lines, quality of supervision (including technologies are introduced. Similarly, the
involvement of the board of directors), informa- client-selection, documentation, approval, and
tion flows, policies and procedures, risk- account-monitoring processes should adhere to
management policies and methodologies, segre- sound and well-identified practices.
gation of duties, management information The quality of risk-management practices and
systems, operational controls (including BSA/ internal controls is given significant weight in
AML monitoring), and audit coverage. The the evaluation of management and the overall
examiner should be able to draw sound conclu- condition of private-banking operations. A
sions about the quality and culture of manage- bank’s failure to establish and maintain a risk-
ment and stated private-banking policies after management framework that effectively identi-
reviewing the functional areas described below. fies, measures, monitors, and controls the risks
Specifically, the institution’s risk-identification associated with products and services should be
process and risk appetite should be carefully considered unsafe and unsound conduct. Fur-
defined and assessed. Additionally, the effective- thermore, well-defined management practices
ness of the overall control environment main- should indicate the types of clients that the
tained by management should be evaluated by institution will and will not accept and should
an internal or external audit. The effectiveness establish multiple and segregated levels of
of the following functional areas is critical to authorization for accepting new clients. Institu-
any private-banking operation, regardless of its tions that follow sound practices will be better
size or product offerings. positioned to design and deliver products and
services that match their clients’ legitimate
needs, while reducing the likelihood that unsuit-
2010.11.2.1 Supervision and Organization able clients might enter their client account base.
Deficiencies noted in this area are weighted in
As part of the examiner’s appraisal of an organi- context of the relative risk they pose to the
zation, the quality of supervision of private- institution and are appropriately reflected in the
banking activities is evaluated. The appraisal of appraisal of management.
management covers the full range of functions The private-banking function is exposed to a
and activities related to the operation of the number of risks, including reputational, fidu-
private bank. The discharge of responsibilities ciary, legal, credit, operational, and market. A
by bank directors should be effected through an brief description of some of the different types
organizational plan that accommodates the vol- of risks follows:
ume and business services handled, local busi-
ness practices and the bank’s competition, and 1. Reputational risk is the potential that nega-
the growth and development of the institution’s tive publicity regarding an institution’s busi-
private-banking business. Organizational plan- ness practices and clients, whether true or
ning is the joint responsibility of senior bank not, could cause a decline in the customer
and private-bank management, should be inte- base, costly litigation, or revenue reductions.
grated with the long-range plan for the institu- 2. Fiduciary risk refers to the risk of loss due to
tion, and should be consistent with any the institution’s failure to exercise loyalty;
enterprise-wide risk-management program. safeguard assets; and, for trusts, to use assets
Both the directors and management have
important roles in formulating policies and BHC Supervision Manual January 2006
establishing programs for private-banking prod- Page 7
productively and according to the appropri- stitute unlawful activities, such as money laun-
ate standard of care. This risk generally dering. The client’s identity, background, and
exists in an institution to the extent that it the nature of his or her transactions should be
exercises discretion in managing assets on documented and approved by the back office
behalf of a customer. before opening an account or accepting client
3. Legal risk arises from the potential of unen- monies. Certain high-risk clients like foreign
forceable contracts, client lawsuits, or politicians or money exchange houses should
adverse judgments to disrupt or otherwise have additional documentation to mitigate their
negatively affect the operations or condition higher risk.
of a banking organization. One key dimen- Money laundering is associated with a broad
sion of legal risk is supervisory action that range of illicit activities: the ultimate intention
could result in costly fines or other punitive is to disguise the money’s true source—from
measures being levied against an institution the initial placement of illegally derived cash
for compliance breakdowns. proceeds to the layers of financial transactions
4. Credit risk arises from the potential that a that disguise the audit trail—and make the funds
borrower or counterparty will fail to perform appear legitimate. Under U.S. money-laundering
on an obligation. statutes, a bank employee can be held person-
5. Operational risk arises from the potential ally liable if he or she is deemed to engage in
that inadequate information systems, opera- ‘‘willful blindness.’’ This condition occurs when
tional problems, breaches in internal con- the employee fails to make reasonable inquiries
trols, fraud, or unforeseen catastrophes will to satisfy suspicions about client account
result in unexpected losses. activities.
Since the key element of an effective CDD
Although effective management of all of the policy is a comprehensive knowledge of the
above risks is critical for an institution, certain client, the bank’s policies and procedures should
aspects of reputational, legal, and fiduciary risks clearly reflect the controls needed to ensure the
are often unique to a private-banking function. policy is fully implemented. CDD policies
In this regard, the following customer-due- should clearly delineate the accountability and
diligence policies and practices are essential in authority for opening accounts and for determin-
the management of reputational and legal risks ing if effective CDD practices have been per-
in the private-banking functions. (In addition, formed on each client. In addition, policies
sound fiduciary practices and conflicts-of- should delineate documentation standards and
interest issues that a private-banking operation accountability for gathering client information
may face in acting as fiduciary are described in from referrals among departments or areas
the subsection on fiduciary standards.) within the institution as well as from accounts
brought to the institution by new RMs.
In carrying out prudent CDD practices on
2010.11.2.2.1 Customer-Due-Diligence potential private-banking customers, manage-
Policy and Procedures ment should document efforts to obtain and
corroborate critical background information.
Sound customer-due-diligence (CDD) policies Private-banking employees abroad often have
and procedures are essential to minimize the local contacts who can assist in corroborating
risks inherent in private banking. The policies information received from the customer. The
and procedures should clearly describe the tar- information listed below should be corroborated
get client base in terms such as ‘‘minimum by a reliable, independent source, when pos-
investable net worth’’ and ‘‘types of products sible:
sought,’’ as well as specifically indicate the type
of clientele the institution will or will not accept. 1. The customer’s current address and tele-
Policies and procedures should be designed to phone number for his or her primary resi-
ensure that effective due diligence is performed dence, which should be corroborated at regu-
on all potential clients, that client files are bol- lar intervals, can be verified through a variety
stered with additional CDD information on an of methods, such as—
ongoing basis, and that activity in client a. visiting the residence, office, factory, or
accounts is monitored for transactions that are farm (with the RM recording the results
inconsistent with the client profile and may con- of the visit or conversations in a memo-
randum);
BHC Supervision Manual January 2006 b. checking the information against the tele-
Page 8 phone directory; the client’s residence, as
indicated on his or her national ID card; a able for examination and inspection at the loca-
mortgage or bank statement or utility or tion where the account is located or where the
property tax bill; or the electoral or tax financial services are rendered. If the bank main-
rolls; tains centralized customer files in locations other
c. obtaining a reference from the client’s than where the account is located or the finan-
government or known employer or from cial services are rendered, complete customer
another bank; information, identification, and documentation
d. checking with a credit bureau or profes- must be made available at the location where
sional corroboration organization; or the account is located or where the financial
e. any other method verified by the RM. services are rendered within 48 hours of a Fed-
2. Sufficient business information about the eral Reserve examiner’s request. Off-site stor-
customer should be gathered so that the RM age of CDD information will be allowed only if
understands the profile of the customer’s 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 customer’s 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
customer’s business account (usually the intermediary’s client, but in
g. ‘‘Who’s 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 client’s wealth, an RM can use his or her not lessen the institution’s CDD responsibilities.
good judgment to derive a reasonable esti- The purpose of all private-banking relation-
mate of the individual’s 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- bank’s CDD procedures should allow for the
tional information about a client’s 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 2010.11.2.2.1.1 Suspicious Activity Reports
to policy and procedures should readily identify
the specific exception and the required due- The proper and timely filing of Suspicious
diligence and approval process for overriding Activity Reports (SARs) is an important compo-
existing procedures.
In most instances, all CDD information and BHC Supervision Manual January 2006
documentation should be maintained and avail- Page 9
nent of a bank’s CDD program. Since 1996, the ately notify an appropriate law enforcement
federal financial institution supervisory agencies authority and the Board by telephone, in addi-
and the Department of the Treasury’s Financial tion to its timely filing of a SAR.
Crimes Enforcement Network (FinCEN) have A banking organization’s internal systems for
required banking organizations to report known capturing suspicious activities should provide
or suspected violations of law as well as suspi- essential information about the nature and vol-
cious transactions on a SAR. See the Board’s ume of activities passing through customer
SAR regulation (Regulation H, section 208.62 accounts. Any information suggesting that sus-
[12 C.F.R. 208.62] and Regulation Y, section picious activity has occurred should be pursued,
225.4(f) [12 C.F.R. 225.4(f)]).3 Law enforce- and, if an explanation is not forthcoming, the
ment agencies use the information reported on matter should be reported to banking organiza-
the form to initiate investigations, and Federal tion’s management. Examiners should ensure
Reserve staff use the SAR information in their that the institution’s approach to SARs is proac-
examination and oversight of supervised tive and that well-established procedures cover
institutions. the SAR process. Accountability should exist
A member bank and a BHC are required to within the organization for the analysis and
file a SAR with the appropriate federal law follow-up of internally identified suspicious
enforcement agencies and the Department of the activity; this analysis should conclude with a
Treasury. A SAR must be prepared in accor- decision on the appropriateness of filing a SAR.
dance with the form’s instructions. (See See SR-03-12 and the attached July 2003 SAR
SR-03-12 and the attached July 2003 SAR form form and instructions. See also the core proce-
and instructions.) The completed SAR is to be dures concerning suspicious-activity-reporting
sent to FinCEN when an institution detects— requirements in the FFIEC BSA/AML Examina-
tion Manual.
1. insider abuse involving any amount;
2. violations aggregating $5,000 or more in
which a suspect can be identified; 2010.11.2.2.2 Credit-Underwriting
3. violations aggregating $25,000 or more Standards
regardless of a potential suspect; or
4. transactions aggregating $5,000 or more that The underwriting standards for private-banking
involve potential money laundering or viola- loans to high net worth individuals should be
tions of the Bank Secrecy Act. consistent with prudent lending standards. The
same credit policies and procedures that are
When a SAR is filed, the management of a applicable to any other type of lending arrange-
member bank must promptly notify its board of ment should extend to these loans. At a mini-
directors or a committee thereof. mum, sound policies and procedures should
A SAR must be filed within 30 calendar days address the following: all approved credit prod-
after the date of initial detection of the facts that ucts and services offered by the institution, lend-
may constitute a basis for filing a SAR. If no ing limits, acceptable forms of collateral, geo-
suspect was identified on the date of detection graphic and other limitations, conditions under
of the incident requiring the filing, a member which credit is granted, repayment terms, maxi-
bank may delay filing a SAR for an additional mum tenor, loan authority, collections and
30 calendar days in order to identify the suspect. charge-offs, and prohibition against capitaliza-
Reporting may not be delayed more than 60 tion of interest.
calendar days after the date of initial detection An extension of credit based solely on collat-
of a reportable transaction. In situations involv- eral, even if the collateral is cash, does not
ing violations requiring immediate attention, ensure repayment. While the collateral enhances
such as when a reportable violation is ongoing, the bank’s position, it should not substitute for
the financial institution is required to immedi- regular credit analyses and prudent lending
practices. If collateral is derived from illegal
3. The Board’s SAR rules apply to state member banks, activities, it is subject to forfeiture through the
bank holding companies and their nonbank subsidiaries that seizure of assets by a government agency. The
do not report on a different SAR form (for example, broker- bank should perform its due diligence by
dealers), Edge and agreement corporations, and the U.S.
branches and agencies of foreign banks supervised by the
adequately and reasonably ascertaining and
Federal Reserve. documenting that the funds of its private-
banking customers were derived from legitimate
BHC Supervision Manual January 2006 means. Banks should also verify that the use of
Page 10 the loan proceeds is for legitimate purposes.
In addition, bank policies should explicitly ness lines). Consequently, management

describe the terms under which ‘‘margin loans,’’ throughout the institution should receive
loans collateralized by securities, are made and training in these matters. For more informa-
should ensure that they conform to applicable tion on the supervision of fiduciary activities,
regulations. Management should review and see section 3120.0 in this manual and section
approve daily MIS reports. The risk of market 4200.0 in the Commercial Bank Examination
deterioration in the value of the underlying col- Manual.
lateral may subject the lender to loss if the 3. Duty to prudently manage discretionary trust
collateral must be liquidated to repay the loan. and agency assets. Since 1994, the majority
In the event of a ‘‘margin call,’’ any shortage of states have adopted laws concerning the
should be paid for promptly by the customer prudent investor rule (PIR) with respect to
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
between fiduciary business lines and other BHC Supervision Manual January 2006
business lines (including other fiduciary busi- Page 11
functions of the private-banking entity should unable to ensure that its payable-through
be similarly independent so that they can oper- accounts are not being used for money launder-
ate autonomously from line management. ing or other illicit purposes.
Omnibus, or general clearing, accounts may
also exist in the private-banking system. They
2010.11.2.4.2 Inactive and Dormant may be used to accommodate client funds
Accounts before an account opening to expedite a new
relationship, or they may fund products such as
Management should be aware that banking laws mutual funds in which client deposit accounts
in most states prohibit banks from offering ser- may not be required. However, these accounts
vices that allow deposit accounts to be inactive could circumvent an audit trail of client transac-
for prolonged periods of time (generally, 12 or tions. Examiners should carefully review a
more months with no externally generated bank’s 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 unautho-
account so that entries cannot be posted to the rized transactions in their accounts in a timely
account without review by more than one mem- manner. Accounts with high volume or signifi-
ber of senior management. cant losses warrant further inquiry. Hold-mail,
no-mail, and e-mail-only account operations
should ensure that client accounts are subject to
2010.11.2.4.3 Pass-Through Accounts and dual control and are reviewed by an indepen-
Omnibus Accounts dent party.
Pass-through accounts (PTAs) extend checking-

account privileges to the customers of a foreign 2010.11.2.4.5 Funds Transfer—Tracking
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 tomer’s activities and should provide guidance
forfeitures brought by law enforcement authori- on the appropriate action required for suspicious
ties. As stated in SR-95-10, it is recommended activity. The following is a checklist to guide
that U.S. banking entities terminate a payable- bank personnel in identifying some potential
through arrangement with a foreign bank in abuses:
situations in which (1) adequate information
about the ultimate users of PTAs cannot be 1. indications of frequent overrides of estab-
obtained, (2) the foreign bank cannot be relied lished approval authority or other internal
on to identify and monitor the transactions of its controls
own customers, or (3) the U.S. banking entity is 2. intentional circumvention of approval
authority by splitting transactions
BHC Supervision Manual January 2006 3. wire transfers to and from known secrecy
Page 12 jurisdictions
4. frequent or large wire transfers for persons To monitor and report transaction activity and to
who have no account relationship with the detect suspicious transactions, management
bank, or funds being transferred into and out reports may be developed to—
of an omnibus or general clearing account
instead of the client’s deposit account 1. monitor a specific transaction criterion, such
5. wire transfers involving cash amounts in as a minimum dollar amount or volume or
excess of $10,000 activity level;
6. inadequate control of password access 2. monitor a certain type of transaction, such as
7. customer complaints or frequent error one with a particular pattern;
conditions 3. monitor individual customer accounts for
variations from established transaction and
activity profiles based on what is usual or
2010.11.2.4.6 Custody—Detection 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 bank’s 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 sophisti-
cated customers are increasing their demand for
data relevant to their investment needs, which is
2010.11.2.5 Management Information fostering the creation of online information ser-
Systems vices. Online information can satisfy customers’
desire for convenience, real-time access to infor-
Management information systems (MIS) should mation, and a seamless delivery of information.
accumulate, interpret, and communicate infor-
mation on (1) the private-banking assets under
management, (2) profitability, (3) business and 2010.11.2.6 Audit
transaction activities, and (4) inherent risks. The
form and content of MIS for private-banking An effective audit function is vital to ensuring
activities will be a function of the size and the strength of a private bank’s internal controls.
complexity of the private-banking organization. As a matter of practice, internal and external
Accurate, informative, and timely reports that auditors should be independently verifying and
perform the following functions may be pre- confirming that the framework of internal con-
pared and reviewed by RMs and senior trols is being maintained and operated in a man-
management: ner that adequately addresses the risks associ-
ated with the activities of the organization.
1. aggregate the assets under management Critical elements of an effective internal audit
according to customer, product or service, function are the strong qualifications and exper-
geographic area, and business unit tise of the internal audit staff and a sound risk-
2. attribute revenue according to customer and assessment process for determining the scope
product type and frequency of specific audits. The audit pro-
3. identify customer accounts that are related to cess should be risk-focused and should ulti-
or affiliated with one another through com- mately determine the risk rating of business
mon ownership or common control lines and client CDD procedures. Compliance
4. identify and aggregate customer accounts by with CDD policies and procedures and the
source of referral
5. identify beneficial ownership of trust, PIC, BHC Supervision Manual January 2006
and similar accounts Page 13
detailed testing of files for CDD documentation activities related to the proliferation of weapons
are also key elements of the audit function. of mass destruction. OFAC acts under presiden-
Finally, examiners should review and evaluate tial wartime and national emergency powers, as
management’s responsiveness to criticisms by well as under authority granted by specific legis-
the audit function. lation, to impose controls on transactions and
freeze foreign assets under U.S. jurisdiction.
Many of the sanctions are based on United
2010.11.2.7 Compliance Nations and other international mandates, are
multilateral in scope, and involve close coopera-
The responsibility for ensuring effective compli- tion with allied governments. Under the Interna-
ance with relevant laws and regulations may tional Emergency Economic Powers Act, the
vary among different forms of institutions, President can impose sanctions, such as trade
depending on their size, complexity, and avail- embargoes, the freezing of assets, and import
ability of resources. Some institutions may have surcharges, on certain foreign countries and the
a distinct compliance department with the cen- ‘‘specially designated nationals’’ of those
tralized role of ensuring compliance institution- countries.
wide, including private-banking activities. This A ‘‘specially designated national’’ is a person
arrangement is strongly preferable to a situation or entity who acts on behalf of one of the
in which an institution delegates compliance to countries under economic sanction by the
specific functions, which may result in the man- United States. Dealing with such nationals is
agement of private-banking operations being prohibited. Moreover, their assets or accounts in
responsible for its own internal review. Compli- the United States are frozen. In certain cases,
ance has a critical role in monitoring private- the Treasury Department can issue a license to a
banking activities; the function should be inde- designated national. This license can then be
pendent of line management. In addition to presented by the customer to the institution,
ensuring compliance with various laws and allowing the institution to debit his or her
regulations such as the Bank Secrecy Act and account. The license can be either general or
those promulgated by the Office of Foreign specific.
Assets Control, compliance may perform its OFAC screening may be difficult when trans-
own internal investigations and due diligence on actions are conducted through PICs, token
employees, customers, and third parties with names, numbered accounts, or other vehicles
whom the bank has contracted in a consulting or that shield true identities. Management must
referral capacity and whose behavior, activities, ensure that accounts maintained in a name other
and transactions appear to be unusual or suspi- than that of the beneficial owner are subject to
cious. Institutions may also find it beneficial for the same level of filtering for OFAC specially
compliance to review and authorize account- designated nationals and blocked foreign coun-
opening documentation and CDD adequacy for tries as other accounts. That is, the OFAC
new accounts. The role of compliance is a con- screening process must include the account’s
trol function, but it should not be a substitute for beneficial ownership as well as the official
regular and frequent internal audit coverage of account name.
the private-banking function. Following is a Any violation of regulations implementing
description of certain regulations that may be designated national sanctions subjects the viola-
monitored by the compliance function. tor to criminal prosecution, including up to 12
years in prison and $1 million in corporate fines
and $250,000 in individual fines, per incident.
2010.11.2.7.1 Office of Foreign Assets Any funds frozen because of OFAC orders
Control should be placed in a blocked account. Release
of those funds cannot occur without a license
The Office of Foreign Assets Control (OFAC) of 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- 2010.11.2.7.2 Bank Secrecy Act
rity goals. Sanctions are imposed against tar-
geted foreign countries, terrorists, international Guidelines for compliance with the Bank
narcotics traffickers, and those engaged in Secrecy Act (BSA) can be found in the FFIEC
BSA/AAML Examination Manual. See also
BHC Supervision Manual January 2006 SR-04-13, SR-03-17, SR-01-29 (the customer
Page 14 identification program requirements), and the
question-and-answer format interpretations (SR- mine if there have been changes to the strate-
05-9) of the U.S. Department of the Treasury’s gic plan; senior management; or the level
regulation (31 C.F.R. 103) for banking organiza- and type of private-banking activities, prod-
tions, which is based on section 326 of the ucts, and services offered. If there is no men-
Patriot Act. In addition, the procedures for con- tion of private banking in the prior inspection
ducting BSA examinations of foreign offices of report, management should be asked at this
U.S. banks are detailed in SR-96-5. The SAR time if they have commenced or plan to
filing requirements for nonbank subsidiaries of commence any private-banking activities.
bank holding companies and state member 6. Follow these inspection procedures and also
banks are also set forth in SR-02-24. consider the core examination procedures in
the FFIEC BSA/AML Examination Manual
in order to establish the base scope for the
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
bank’s 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 institution’s
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 management’s 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- company’s 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 institution’s management to private-banking activities an institution con-
ascertain what changes have occurred since
the last inspection or are planned in the near BHC Supervision Manual January 2006
future. For example, examiners should deter- Page 15
ducts in the United States and abroad. This 2. business or strategic plan
broad view is needed to maintain the ‘‘big pic- 3. income and expense statements for the prior
ture’’ impact of private banking for a particular fiscal year and current year to date, with
institution. projections for the remainder of the current
For bank holding company inspections, and the next fiscal year, and income by
examiners must consider the provisions of the product division and marketing region
Gramm-Leach Bliley Act, which amended sec- 4. balance-sheet and total assets under man-
tion 5(c) of the Bank Holding Company Act, agement (list the most active and profitable
that concern examinations and inspections. In accounts by type, customer domicile, and
particular, examiners must adhere to those statu- responsible account officer)
tory provisions that pertain to the inspections of 5. most recent audits for private-banking
bank holding company nobank subsidiaries that activities
are supervised by functional regulators. See sec- 6. copies of audit committee minutes
tion 1040.0. 7. copy of the CDD and SAR policies and
procedures
8. list of all new business initiatives intro-
2010.11.3.4 Risk-Focused Approach duced last year and this year, relevant new-
product-approval documentation that
Examiners reviewing the private-banking opera- addresses the evaluation of the unique char-
tions should implement the risk-focused inspec- acteristics and risk associated with the new
tion approach. The exam scope and degree of activity or product, and an assessment of
testing of private-banking practices should the risk-management oversight and control
reflect the degree of risk assumed, prior exam infrastructures in place to manage the risks
findings on the implementation of policies and 9. list of all accounts in which an intermediary
procedures, the effectiveness of controls, and an is acting on behalf of clients of the private
assessment of the adequacy of the internal audit bank, for example, as financial advisers or
and compliance functions. If initial inquiries money managers
into the institution’s internal audit and other 10. explanation of the methodology for follow-
assessment practices raise doubts about the ing up on outstanding account documenta-
internal system’s effectiveness, expanded analy- tion and a sample report
sis and review are required—and examiners 11. description of the method for aggregating
should perform more transaction testing. Exam- client holdings and activities across busi-
iners will usually need to follow the core exami- ness units throughout the organization
nation procedures in the FFIEC BSA/AML
12. explanation of how related accounts, such
Examination Manual, as well as the expanded
as common control and family link, are
procedures for private banking. Other expanded
identified
procedures should be followed if circumstances
dictate. 13. name of a contact person for information on
compensation, training, and recruiting pro-
grams for relationship managers
14. list of all personal investment company
2010.11.3.5 First-Day Letter accounts
As part of the inspection preparation, examiners 15. list of reports that senior management
should customize the first-day-letter (FDL) receives regularly on private-banking
questionnaire to reflect the structure and type of activities
private-banking activities of the institution and 16. description and sample of the management
the 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 FDL. 17. description of how senior management
Responses to these items should be reviewed in monitors compliance with global policies
conjunction with responses to the BSA, fidu- for worldwide operations, particularly for
ciary, audit, and internal control inquiries: offices operating in secrecy jurisdictions
18. appropriate additional items from the core
1. organizational chart for the private bank on and expanded procedures for private bank-
both a functional and legal-entity basis ing, as set forth in the FFIEC BSA/AML
Examination Manual, as well as any other
BHC Supervision Manual January 2006 items from the expanded procedures that
Page 16 are needed to gauge the adequacy of the
BSA/AML program for private-banking 2. Review the prior report of inspection and the
activities. previous inspection workpapers; description
of the inspection scope; structure and type of
private-banking activities conducted; and
2010.11.4 INSPECTION OBJECTIVES findings, conclusions, and recommendations
of the prior inspection. The prior inspection
1. To determine if the policies, practices, proce- report and inspection plan should also pro-
dures, and internal controls regarding vide information and insight on key contacts
private-banking activities are adequate for at the institution and on the time frame of the
the risks involved. prior private-banking review.
2. To determine if the institution’s officers and 3. Review relevant correspondence exchanged
employees are operating in conformance since the prior inspection, such as manage-
with established guidelines for conducting ment’s 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 institution’s 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 institution’s 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-
ent divisions of each particular institution 2010.11.5.2 Full-Inspection Phase
and throughout each institution’s global
network of affiliated entities.); 1. After reviewing the private-banking func-
b. examiner assignments of the functional tional areas, draw sound conclusions about
areas of private banking; and
c. the supplemental reviews of specific BHC Supervision Manual January 2006
private-banking products and services. Page 17
the quality and culture of management and trust and estates, including strict controls
stated private-banking policies. over assets, prudent investment and man-
2. Evaluate the adequacy of risk-management agement of assets, and meticulous record-
policies and practices governing private- keeping. Review previous trust examination
banking activities. reports and consult with the designated Fed-
3. Assess the organization of the private- eral Reserve System trust examiners.
banking function and evaluate the quality of 8. Ascertain whether the bank holding com-
management’s supervision of private- pany adequately supervises the custody ser-
banking activities. An appraisal of manage- vices of its subsidiaries. The bank holding
ment covers the— company should ensure that each institution
a. full range of functions (i.e., supervision has established and currently maintains pro-
and organization, risk management, fidu- cedures for the proper administration of
ciary standards, operational controls, custody services, including the regular
management information systems, audit, review of the services on a preset schedule.
and compliance) and activities related to 9. Determine whether subsidiary institutions
the operation of the private-banking are required to and actually maintain strong
activities; and controls and supervision over funds
b. discharge of responsibilities by the insti- transfers.
tution’s directors through a long-range 10. Ascertain if institution management and
organizational plan that accommodates staff are required to perform due diligence,
the volume and business services that is, to verify and document that the
handled, local business practices and the funds of its private-banking customers were
institution’s competition, and the growth derived through legitimate means, and
and development of the institution’s when extending credit, to verify that the use
private-banking business. of loan proceeds was legitimate.
4. Determine if management has effective pro- 11. Review the institution’s use of deposit
cedures for conducting ongoing reviews of accounts.
client-account activity to detect, and protect a. Assess the adequacy of the institution’s
the client from, any unauthorized activity controls and whether they are appropri-
and any account activity that is inconsistent ately used.
with the client’s profile (for example, fre- b. Determine if client monies flow through
quent or sizeable unexplained transfers client deposit accounts and whether the
flowing through the account). accounts function as the sole conduit and
5. Determine if the bank holding company has paper trail for client transactions.
initiated and maintained controls and proce- 12. Determine and ensure that each institution’s
dures that require each subsidiary private- approach to Suspicious Activity Reports
banking institution to have account-opening (SARs) is proactive and that the bank hold-
procedures and documentation require- ing company and each institution have well-
ments that must be satisfied before an established procedures covering the SAR
account can be opened. process. Establish whether there is account-
6. Determine if the bank holding company ability within the organization for the analy-
requires its subsidiary institutions to main- sis and follow-up of internally identified
tain and adhere to well-structured CCD suspicious activity (this analysis includes a
procedures. sound decision on whether the bank holding
7. Determine if the bank holding company has company or an institution needs to file, or is
proper controls and procedures to ensure required by regulation to file, a SAR).
each institution’s proper administration of

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 institution’s 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 bank’s 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 con- formed 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-
tion’s 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 investment’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 Treasury’s 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 expenses—for example, payroll, rent, and
nature of the services provided. Financial insti- utilities—to 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 institution’s 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
WHAT’S NEW IN THIS REVISED deteriorate. These dividends may also have a
SECTION negative effect on the subsidiary’s liquidity
position.
This section has been revised to incorporate
references to the Federal Reserve Board’s Regu-
Transactions with affiliates. Transactions
lation W, primarily with regard to the bank
between subsidiary IDI affiliates is another area
holding company (BHC) inspection process. The
of potential abuse of subsidiary banks. Regula-
section includes also a discussion of the manda-
tory concern centers on the quantitative limits
tory reporting of certain intercompany transac-
and collateral restrictions on certain transactions
tions on the FR Y-8, The Bank Holding Com-
by subsidiary banks with their affiliates. These
pany Report of Insured Depository Institutions’
restrictions are designed to protect subsidiary
Section 23A Transactions with Affiliates, and
IDIs from losses resulting from transactions
its instructions. The mandatory report is to be
with affiliates.
submitted quarterly to the Federal Reserve by
(1) all top-tier BHCs, including financial hold-
ing companies, and (2) all foreign banking orga- Fees paid by subsidiaries. Management or ser-
nizations that directly own a U.S. subsidiary vice fees are another cash outflow of bank
bank. The examiner’s inspection responsibilities subsidiaries. These fees may be paid to the
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
2020.0.1 ANALYSIS OF on the financial impact of the fees on the bank
INTERCOMPANY TRANSACTIONS subsidiaries.
The analysis of intercompany transactions Tax allocation. How a bank holding company
between a parent company, its nonbank organization determines to allocate taxes among
subsidiaries, and its bank subsidiaries is its component companies involves questions of
primarily intended to assess the nature of the both the magnitude and timing of the cash-flow
relationships between these entities and the effects. Unreasonable or untimely tax payments
effect of the relationships on the subsidiary or refunds to the bank can have an adverse
insured depository institutions (IDIs). An effect on the financial condition of the banking
insured depository insitution includes any state subsidiaries.
bank, national bank, trust company, or banking
association and any institution that takes
Purchases or swaps of assets. Asset purchases
deposits that are insured by the Federal Deposit
or swaps between a bank and its affiliates can
Insurance Corporation, including savings as-
create the potential for abuse of subsidiary
sociations. Both the legal and financial ramifica-
banks. Regulatory concern focuses on the fair-
tions of such transactions are areas of concern.
ness of such asset transactions and their finan-
Certain intercompany transactions are subject to
cial impact and timing. Fairness and financial
the provisions of section 23A or 23B (or both)
considerations include the quality and collect-
of the Federal Reserve Act and the Federal
ibility and fair values of such assets and their
Reserve Board’s Regulation W. Section 23A of
liquidity effects. IDIs generally are prohibited
the Federal Reserve Act is one of the most
from purchasing low-quality assets from affili-
important statutes on limiting exposures to
ates. Asset exchanges may be a mechanism to
individual institutions and protecting the federal
avoid regulations designed to protect subsidiary
safety net. Several types of intercompany
banks from becoming overburdened with non-
transactions and the primary regulatory
earning assets. Improper timing or certain struc-
concerns of each are presented below.
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 BHC Supervision Manual January 2008
of assets, the subsidiary’s capital ratios will 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 subsid- Act. With regard to the BHC’s inspection, the
iary 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 BHC’s 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 bank’s primary
regulator should determine the bank’s compli-
ance with pertinent banking laws. In reviewing
2020.0.2 ROLE OF THE EXAMINER the subsidiary bank’s 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 affiliate’s 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 Board’s Regulation W. ment’s attention and referred to the bank’s 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 bank’s primary supervisor.
Transactions with Affiliates, and its instructions.

Page 2
Intercompany Transactions (Transactions Between Member Banks and Their
Affiliates—Sections 23A and 23B of the Federal Reserve Act) Section 2020.1
2020.1.01 WHAT’S NEW IN THIS tutions (IDIs)2 to engage in certain covered

REVISED SECTION transactions with an affiliate. Transactions that
are subject to section 23A also are subject to
This section has been substantially revised. It the provisions of section 23B of the FRA. In
discusses sections 23A and 23B of the Federal addition to these statutory provisions, the
Reserve Act (FRA) and their respective Regula- Board issued Regulation W (the rule),3 which
tion W requirements, the permissibility of cer- implements sections 23A and 23B of the FRA.
tain transactions, and examiner guidance on an The rule provides several exemptions and com-
inspection’s review of affiliate transactions. bines the statutory restrictions on transactions
Sections 23A and 23B of the FRA and Regula- between a member bank and its affiliates with
tion W limit the risks to an insured depository numerous previously issued Board
institution (IDI) as a result of transactions interpretations.
between the IDI and its affiliates, including the During a bank holding company inspection,
bank holding company (BHC) and its subsidi- transactions between an IDI and an affiliate (for
aries. The statutes and regulation limit the abil- example, a bank holding company parent or
ity of an IDI to transfer to its affiliates the other nonbank subsidiary) are reviewed for
subsidy arising from the bank’s access to the compliance with sections 23A and 23B and
federal safety net (i.e., lower cost insured depos- Regulation W, as well as other banking regula-
its, the payment system, and the discount win- tions and statutes. Any violations of sec-
dow).1 The statute and rule accomplish these tions 23A and 23B of the FRA or Regulation W
purposes by imposing quantitative and qualita- involving a transaction between an IDI and its
tive limits on the ability of a bank to extend affiliate that are disclosed or found during an
credit to, or engage in, certain other transac- inspection should be reported on the ‘‘Viola-
tions with, an affiliate. Transactions between an tions’’ inspection report page and reported to the
IDI and a nonaffiliate that benefit an affiliate of IDI’s primary supervisor.
the IDI are covered by the statute and regula-
tion as well, through the well-established ‘‘attri-
bution’’ rule. Certain transactions that gener- 2020.1.1 SECTION 23A OF THE
ally do not expose an IDI to undue risk or abuse FEDERAL RESERVE ACT
the safety net are exempted from coverage under
Regulation W. Section 23A of the FRA (12 U.S.C. 371c) is the
The mandatory reporting of certain intercom- primary statute governing transactions between
pany transactions on the quarterly FR Y-8, ‘‘The an IDI and its affiliates. Section 23A (1) desig-
Bank Holding Company Report of Insured nates the types of companies that are affiliates of
Depository Institutions’ Section 23A Transac- an IDI; (2) specifies the types of transactions
tions with Affiliates’’ also is discussed. The covered by the statute; (3) sets the quantitative
report is to be submitted to the Federal Reserve limitations on an IDI’s covered transactions
by (1) all top-tier BHCs, including financial with any single affiliate, and with all affiliates
holding companies and (2) all foreign banking combined; (4) sets forth collateral requirements
organizations that directly own a U.S. subsidiary for certain transactions with affiliates; and
IDI. Revised inspection objectives and inspec-
tion procedures also are included. The examin-
2. By their terms, sections 23A and 23B apply to banks
er’s FR Y-8 inspection responsibilities also are that are members of the Federal Reserve System (‘‘member
discussed. See also SR-03-2. banks’’). Other federal laws subject FDIC-insured nonmem-
ber banks and FDIC-insured thrifts to sections 23A and 23B
in the same manner and to the same extent as if they were
member banks. (See 12 U.S.C. 1828(j) and
2020.1.05 SECTIONS 23A AND 23B 12 U.S.C.1468(a)(4)). The statute also states that most subsid-
OF THE FEDERAL RESERVE ACT, iaries of a member bank are to be treated as part of the
AND REGULATION W member bank itself for purposes of sections 23A and 23B.
Because the statute and regulation apply to all insured deposi-
tory institutions, this section will refer to the subject institu-
Section 23A of the Federal Reserve Act (FRA) tions as insured depository institutions (IDIs).
restricts the ability of insured depository insti- 3. In this section of the manual, Regulation W is referred
to as ‘‘the rule’’ or to a specific numbered section of the rule.
1. Federally insured savings associations also are subject BHC Supervision Manual July 2009
to sections 23A and 23B as if they were banks. Page 1
Transactions Between Member Banks and Their Affiliates—Sections 23A and 23B 2020.1
(5) requires all covered transactions to be con- — in which a majority of its directors or
ducted on terms consistent with safe and sound trustees constitute a majority of the per-
banking practices. sons holding any such office with the
IDI or any company that controls the
IDI;
2020.1.1.1 Definition of an Affiliate 4. any company (including a real estate invest-
ment trust) that is sponsored and advised on
In general, companies that control or are under a contractual basis by the IDI or any subsid-
common control with an IDI are defined by iary or affiliate of the IDI;
section 23A as ‘‘affiliates’’ of the bank. The 5. any investment company, with respect to
definition includes a bank subsidiary of a bank which an IDI or any affiliate thereof is an
and any company that a bank, or its subsidiaries investment adviser as defined in sec-
or affiliates, sponsors and advises on a contrac- tion 2(a)(20) of the Investment Company
tual basis.4 Affiliates, for example, may include Act of 1940;
banks, financial holding companies, savings and 6. any investment fund for which the IDI or
loan holding companies, and their subsidiaries. any affiliate of the IDI serves as an invest-
Banks, savings associations, and nonbanking ment adviser, if the IDI and its affiliates
companies that are under common individual own or control, in the aggregate, more than
control or a group of individuals with the bank 5 percent of any class of voting securities or
also are affiliates for the purposes of sec- of the equity capital of the fund;
tion 23A. In addition, any transaction by an IDI 7. a depository institution that is a subsidiary
with any person is deemed to be a transaction of the IDI;
with an affiliate to the extent that the proceeds 8. a financial subsidiary of the member bank;
of the transaction are transferred to, or used for 9. any company in which a holding company
the benefit of, the affiliate. With respect to any of the IDI owns or controls, directly or
IDI within a holding company, its affiliates indirectly, or acting through one or more
include, among others, its parent, the parent’s other persons, 15 percent or more of the
subsidiaries, and other companies directly or equity capital pursuant to the merchant
indirectly controlled by the bank’s shareholders. banking authority in section 4(k)(4)(H) or
Specifically, Regulation W defines5 an affiliate (I) of the Bank Holding Company Act
as— (12 U.S.C. 1843(k)(4)(H) or (I));
10. any partnership for which the IDI or any
1. any company that controls6 the IDI and any affiliate of the IDI serves as a general part-
other company that is controlled by the ner or for which the IDI or any affiliate of
company that controls the IDI; the IDI causes any director, officer, or
2. any bank subsidiary of the IDI; employee of the member bank or affiliate to
3. any company— serve as a general partner;
— that is controlled directly or indirectly, 11. any subsidiary of an affiliate described in
by a trust or otherwise, by or for the paragraphs (a)(1) through (10) of sec-
benefit of shareholders who beneficially tion 223.2 of Regulation W; and
or otherwise control, directly or indi- 12. any company that the Board, or the appro-
rectly, by trust or otherwise, the mem- priate federal banking agency for the IDI,
ber bank or any company that controls determines by regulation or order to have a
the IDI; or relationship with the IDI or any subsidiary
or affiliate of the member bank, such that
4. The Board has the authority to expand the definition of
covered transactions by the member bank
affiliate to include a company that has a relationship with the or its subsidiary with that company may be
bank so that covered transactions between the company and affected by the relationship, to the detri-
the bank may be affected by the relationship to the detriment ment of the IDI or its subsidiary. .
of the bank.
5. See 12 C.F.R. 223.2.
6. By statute, ‘‘control’’ is defined as the power to (1) vote The following are not considered to be affiliates
25 percent or more of the voting shares of a company, of an IDI:
excluding situations in which the stock is controlled in a
fiduciary capacity; (2) elect a majority of the directors of a
company; or (3) exercise a controlling influence over a com-
1. a nonbank subsidiary of the IDI (other than
pany. Control is discussed in more detail at 2020.1.3.1. a financial subsidiary), unless the Board
determines not to exclude such a subsidiary;
BHC Supervision Manual July 2009 2. a company engaged solely in holding the
Page 2 IDI’s premises;
3. a company engaged solely in conducting a 223.2(a)(6) treats any investment fund as an

safe deposit business; affiliate if the IDI or an affiliate of the IDI serves
4. a company engaged solely in holding obli- as an investment adviser to the fund and owns
gations of the United States or its agencies more than 5 percent of the shares of the fund.
or obligations fully guaranteed by the
United States or its agencies as to principal
and interest; and 2020.1.1.2.2 Financial Subsidiaries
5. a company in which control arises from the
exercise of rights arising out of a bona fide In 1999, the Gramm-Leach-Bliley Act (the GLB
debt previously contracted (for the period Act) authorized banks to own ‘‘financial subsid-
of time specified by section 23A). iaries’’ that engage in activities not permissible
for the parent bank to conduct directly, such as
underwriting and dealing in bank-ineligible
securities. The GLB Act amended section 23A
2020.1.1.2 Definition of Affiliates by to define a financial subsidiary of a bank as an
Type of Entity 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
Section 23A 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 fund—even 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.
Act—for 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 Section 24a(a)(2).)
The GLB Act established several special pro-
visions for the application of section 23A to
7. 12 U.S.C. 371c(b)(1)(E).
8. An investment fund typically escapes from the defini-
pany and entities affiliated with the company’s investment
tion of investment company under the 1940 Act because it
adviser. (See 15 U.S.C. 80a-17.)
(1) sells interests only to a limited number of investors or only
9. 12 U.S.C. 24a(g)(3).
to sophisticated investors or (2) invests primarily in financial
10. 12 U.S.C. 24a(a)(2).
instruments that are not securities. An IDI may face greater
11. 12 U.S.C. 371c(e)(1).
risk from the conflicts of interest arising from its relationships
with an investment fund that is not registered than an invest-
ment company under the 1940 Act because the 1940 Act BHC Supervision Manual July 2009
restricts transactions between a registered investment com- Page 3
financial subsidiaries of a bank. First, the 10 per- between a member bank and any individual
cent quantitative limit of section 23A between a financial subsidiary of the bank. A member
bank and any individual affiliate does not apply bank’s aggregate amount of covered transactions
to covered transactions between a bank and a with any individual financial subsidiary of the
financial subsidiary of the bank. A bank’s cov- bank may exceed 10 percent of the bank’s capital
ered transactions with a financial subsidiary, stock and surplus.12 A member bank’s covered
however, are subject to the statutory 20 percent transactions with its financial subsidiaries,
quantitative limit. Accordingly, a bank may however, are subject to the 20 percent
engage in covered transactions with any indi- quantitative limit in section 23A. Thus, a member
vidual financial subsidiary up to 20 percent of bank may not engage in a covered transaction
the bank’s capital stock and surplus. In addition, with any affiliate (including a financial subsidi-
for purposes of section 23A, the amount of a ary) if the bank’s aggregate amount of covered
bank’s investment in its financial subsidiary transactions with all affiliates (including financial
does not, however, include the retained earnings subsidiaries) would exceed 20 percent of the
of the financial subsidiary. bank’s capital stock and surplus.
Section 23A generally applies only to transac- The Board notes that the exemption from the
tions between (1) a bank and an affiliate of the 10 percent limit for investments by a member
bank and (2) a bank and a third party in which bank in its own financial subsidiary does not
some benefit of the transactions accrues to an apply to investments by a bank in the financial
affiliate of the bank. The statute generally does subsidiary of an affiliated depository institution.
not apply to transactions between two affiliates. Although the financial subsidiary of an affiliated
Section 23A establishes two special anti-evasion depository institution is an affiliate of the bank
provisions, however, that govern transactions for purposes of sections 23A and 23B, the GLB
between a financial subsidiary of a bank and Act states that only ‘‘covered transactions
another affiliate of the bank. First, the FRA between a bank and any individual financial
provides that any purchase of, or investment in, subsidiary of the bank’’ are not subject to the
the securities of a bank’s financial subsidiary by 10 percent limit in section 23A.13 A bank may
an affiliate of the bank will be deemed to be a not engage in a covered transaction with the
purchase of, or investment in, such securities by financial subsidiary of an affiliated depository
the bank itself. Second, the GLB Act authorizes institution if the aggregate amount of the bank’s
the Board to deem a loan or other extension of covered transactions with that financial subsidi-
credit made by a bank’s affiliate to any financial ary would exceed 10 percent of the bank’s capi-
subsidiary of the bank to be an extension of tal stock and surplus.
credit by the bank to the financial subsidiary, if
the Board determines that such action is neces- Valuation of investments in securities issued
sary or appropriate to prevent evasion. by a financial subsidiary. Because financial sub-
sidiaries of a member bank are considered affili-
ates of the bank for purposes of section 23A, a
2020.1.1.2.2.1 Regulation W Provisions for member bank’s purchases of, and investments
Financial Subsidiaries in, the securities of its financial subsidiary are
covered transactions under the statute. The GLB
Regulation W (1) defines a financial subsidiary Act provides, however, that a member bank’s
of a bank, (2) exempts certain companies from investment in its own financial subsidiary, for
the definition, and (3) sets forth special valua- purposes of section 23A, shall not include the
tion and other rules for financial subsidiaries. retained earnings of the financial subsidiary.14
(See sections 223.2(a)(8), 223.3(p), and 223.32 In light of this statutory provision, sec-
of the rule.) Regulation W also includes several tion 223.32(b) of the rule contains a special
special rules that apply to transactions with valuation provision for investments by a mem-
financial subsidiaries. ber bank in the securities of its own financial
subsidiary.15 Such investments must be valued
Applicability of the 10 percent quantitative
limit to transactions with a financial subsidiary. 12. Section 223.11 also indicates that covered transactions
Section 223.32(a) of the rule provides that the between a member bank and its financial subsidiary are
10 percent quantitative limit in section 23A does exempt from the 10 percent limit.
13. See 12 U.S.C. 371c(e)(3)(A).
not apply with respect to covered transactions 14. GLB Act section 121(b)(1) (12 U.S.C. 371c(e)(3)(B)).
15. The rule’s special valuation formula for investments by
BHC Supervision Manual July 2009 a member bank in its own financial subsidiary does not apply
Page 4 to investments by a member bank in a financial subsidiary of
at the greater of (1) the price paid by the mem- carrying value of the shares on the bank’s
ber bank for the securities or (2) the carrying parent-only GAAP financial statements.
value of the securities on the financial state- Under GAAP, the bank’s initial carrying
ments of the member bank (determined in accor- value of the shares would be $500.
dance with generally accepted accounting prin- 2. Carrying value not adjusted for earnings and
ciples (GAAP) but without reflecting the bank’s losses of the financial subsidiary. A bank and
pro rata share of any earnings retained, or losses its parent holding company engage in a trans-
incurred by, the financial subsidiary after the action whereby the member bank acquires
bank’s acquisition of the securities).16 100 percent of the shares of a securities
This valuation rule differs from the general underwriter in a transaction valued at $500.
valuation rule for investments in securities The bank initially values the investment at
issued by an affiliate in that the financial subsid- $500. In the following year, the securities
iary rule permits, consistent with the GLB Act, underwriter earns $25 in profit, which is
that the carrying value of the investment be added to its retained earnings. The bank’s
computed without consideration of the retained investment of the shares of the underwriter is
earnings or losses of the financial subsidiary not adjusted for purposes of section 23A and
since the time of the member bank’s investment. Regulation W, and the bank’s investment
As a result of this rule, the covered transaction continues to be valued at $500. If, however,
amount for a member bank’s investment in the member bank contributes $100 of addi-
securities issued by its financial subsidiary gen- tional capital to the securities underwriter,
erally would not increase after the investment the bank must value the aggregate invest-
was made except if the member bank made an ment at $600.
additional capital contribution to the subsidiary
or purchased additional securities of the Anti-evasion rules as they pertain to financial
subsidiary. subsidiaries. Section 23A generally applies only
The following examples were designed to to transactions between a bank and an affiliate
assist banks in valuing investments in securities of the bank and transactions between a member
issued by a financial subsidiary of the bank. bank and a third party when some benefit of the
Each example involves a securities underwriter transaction accrues to an affiliate of the bank.
that becomes a financial subsidiary of the bank The statute generally does not apply to transac-
after the transactions described below. tions between two affiliates. The GLB Act estab-
lishes two special anti-evasion rules, however,
1. Initial valuation. that govern transactions between a financial sub-
a. Direct acquisition by a bank. A bank pays sidiary of a member bank and another affiliate
$500 to acquire 100 percent of the shares of the bank.17 First, the GLB Act provides that
of a securities underwriter. The initial car- any purchase of, or investment in, securities
rying value of the shares on the member issued by a member bank’s financial subsidiary
bank’s parent-only GAAP financial state- by an affiliate of the bank will be deemed to be a
ments is $500. The member bank initially purchase of, or investment in, such securities by
must value the investment at $500. the bank itself. Second, the GLB Act authorizes
b. Contribution of a financial subsidiary to a the Board to deem an extension of credit made
member bank. The parent holding com- by a member bank’s affiliate to any financial
pany of a bank acquires 100 percent of subsidiary of the bank to be an extension of
the shares of a securities underwriter in a credit by the bank to the financial subsidiary, if
transaction valued at $500 and immedi- the Board determines that such action is neces-
ately contributes the shares to the member sary or appropriate to prevent evasions of the
bank. The bank gives no consideration in FRA or the GLB Act. Section 223.32(c) of the
exchange for the shares. The bank ini- rule incorporates both of these provisions.
tially must value the investment at the The Board exercised its authority under the
second anti-evasion rule by stating that an
an affiliated depository institution. Such investments must be extension of credit to a financial subsidiary of a
valued using the general valuation formula set forth in sec- bank by an affiliate of the bank would be treated
tion 223.23 for investments in securities issued by an affiliate
and, further, may trigger the anti-evasion rule contained in
section 223.32(c)(1) of the rule.
17. GLB Act section 121(b)(1), codified at 12 U.S.C.
16. The rule also makes clear that if a financial subsidiary
371c(e)(4).
is consolidated with its parent bank under GAAP, the subsidi-
ary under the carrying value of the bank’s investment in the
financial subsidiary shall be determined based on parent-only BHC Supervision Manual July 2009
financial statements of the bank. Page 5
as an extension of credit by the bank itself to the ate of the IDI. The Board and the federal bank-
financial subsidiary if the extension of credit is ing agencies can thus protect IDIs in their
treated as regulatory capital of the financial sub- transactions with associated companies. An IDI
sidiary. An example of the kind of credit exten- may petition the Board to review any such affili-
sion covered by this provision would be a subor- ate determination made by the institution’s
dinated loan to a financial subsidiary that is a appropriate federal banking agency under the
securities broker-dealer in which the loan is general procedures established by the Board for
treated as capital of the subsidiary under the review of actions taken under delegated
SEC’s net capital rules. Treating such an exten- authority.18
sion of credit as a covered transaction is appro-
priate because the extension of credit by the
affiliate has a similar effect on the subsidiary’s 2020.1.1.2.6 Merchant Banking
regulatory capital as an equity investment by the
affiliate, which is treated as a covered transac- The GLB Act also amended the Bank Holding
tion by the terms of the GLB Act (as described Company Act (BHC Act) to permit BHCs and
above). The rule generally does not prevent a foreign banks that qualify as financial holding
BHC or other affiliate of a member bank from companies (FHCs) to engage in merchant bank-
providing financial support to a financial subsid- ing and insurance company investment activi-
iary of the bank in the form of a senior or ties.19 If an FHC owns or controls more than
secured loan. 25 percent of a class of voting shares of a
company under the merchant banking or insur-
ance company investment authority, the com-
2020.1.1.2.3 Partnerships pany is an affiliate of any member bank con-
trolled by the FHC by operation of the statutory
IDIs fund legitimate commercial transactions definitions contained in section 23A. The GLB
through partnerships. Partnerships for which an Act also added paragraph (b)(11) to sec-
IDI or an affiliate(s) serves as a general partner tion 23A, which creates a rebuttable presump-
are affiliates. Regulation W also defines an affili- tion that a company (‘‘portfolio companies’’) is
ate of an IDI as any partnership, if the IDI or an an affiliate of a member bank, for purposes of
affiliate of the IDI causes any director, officer, or section 23A, if the bank is affiliated with an
employee of the IDI or affiliate to serve as a FHC and the FHC owns or controls 15 percent
general partner of the partnership (unless the or more of the equity capital of the other com-
partnership is an operating subsidiary of the pany pursuant to the FHC’s merchant banking
bank.) Also, if a company, such as a bank hold- or insurance company investment authority20
ing company, controls more than 25 percent of (section 4(k)(4)(H) or (I) of the BHC Act). (See
the equity through a partnership, that company 12 U.S.C. 371c(b)(11).)
is an affiliate under Regulation W. The rule also provides three specific regula-
tory safe harbors from the 15 percent presump-
tion. These safe harbors apply in situations
2020.1.1.2.4 Subsidiaries of Affiliates where the holding company owns or controls
more than 15 percent of the total equity of the
Regulation W deems a subsidiary of an affiliate company under the merchant banking or insur-
as an affiliate of the IDI. ance company investment authority (thereby
triggering the statutory presumption) and less
2020.1.1.2.5 Companies Designated by than 25 percent of any class of voting securities
the Appropriate Federal Banking Agency of the company (thereby not meeting the statu-
Under section 223.2(a)(12), the Board or the 18. See 12 C.F.R. 265.3.
appropriate federal banking agency for the rel- 19. GLB Act, section 103(a); 12 U.S.C. 1843(k)(4)(H) and
evant IDI (under authority delegated by the (I).
20. GLB Act, section 121(b)(2). As noted above, this
Board) can determine that any company that has rebuttable presumption applies only if the affiliated FHC
a relationship with an IDI or an affiliate of the owns or controls 15 percent or more of the company’s equity
IDI, such that covered transactions by the IDI capital under the merchant banking or insurance company
with that company may be affected by the rela- investment authorities. The Board noted, however, that under
existing Board precedents, a BHC may not own any shares of
tionship to the detriment of the IDI, is an affili- a company in reliance on section 4(c)(6) or 4(c)(7) of the
BHC Act where the holding company owns or controls, in the
BHC Supervision Manual July 2009 aggregate under a combination of authorities, more than 5 per-
Page 6 cent of any class of voting securities of the company.
tory definition of control). The three situations the fund has invested unless the FHC controls
are substantially identical to those listed in the the private equity fund (as described in the
Board’s merchant banking regulation.21 Board’s merchant banking rule).
The first exemption applies where no director,
officer, or employee of the holding company
serves as a director (or individual exercising 2020.1.1.2.7 Companies that are not
similar functions) of the company. The second Affiliates
exemption applies where an independent third
party controls a greater percentage of the equity Under the terms of section 23A, subsidiaries of
capital of the company than is controlled by the an IDI generally are not treated as affiliates of
holding company, and no more than one officer the member bank.23 The statute contains two
or employee of the holding company serves as a specific exceptions to this general rule: finan-
director (or individual exercising similar func- cial subsidiaries of an IDI and IDI subsidiaries
tions) of the company. The third exemption of an IDI are treated as affiliates of the parent
applies where an independent third party con- IDI. The statute provides that the Board may
trols more than 50 percent of the voting shares determine that other subsidiaries of an IDI
of the company, and officers and employees of should be treated as affiliates in appropriate
the holding company do not constitute a major- circumstances.24
ity of the directors (or individuals exercising Under section 223.2(b)(1)(iii) of the rule, cer-
similar functions) of the company.22 tain joint venture subsidiary companies of an
These safe harbors do not require Board IDI are treated as affiliates. A subsidiary of an
review or approval of the exclusion from affili- IDI is treated as an affiliate if one or more
ate status. Moreover, the safe harbors are not affiliates of the IDI, or one or more controlling
intended to be a complete list of circumstances shareholders of the IDI, directly control the joint
in which the 15 percent presumption may be venture. For example, if an IDI controls 30 per-
rebutted. The rule also provides, consistent with cent of company A and an affiliate controls
the GLB Act, that a holding company may rebut 70 percent of Company A, then Company A is
the presumption with respect to a portfolio com- an affiliate. This expansion also covers situa-
pany by presenting information to the Board tions in which a controlling natural-person
that demonstrates, to the Board’s satisfaction, shareholder or group of controlling natural-
that the holding company does not control the person shareholders of the IDI (who, as natural
portfolio company. The Board notes that a com- persons, are not themselves section 23A affili-
pany that qualifies as an affiliate under the ates of the IDI) exercise direct control over the
15 percent presumption and under another prong joint venture company. The rule’s treatment of
of the regulation’s definition of affiliate cannot certain IDI-affiliate joint ventures as affiliates
avoid affiliate status through a rebuttal of the does not apply to joint ventures between an IDI
15 percent presumption (either by qualifying for and any affiliated IDIs. For example, if two
one of the three regulatory safe harbors or by affiliated IDIs each own 50 percent of the voting
obtaining an ad hoc rebuttal of the presumption common stock of a company, the company
from the Board). would continue to qualify as a subsidiary and
An FHC generally is considered to own or not an affiliate of each IDI (despite the fact that
control only those shares or other ownership an affiliate of each IDI owned more than 25 per-
interests that are owned or controlled by itself or cent of a class of voting securities of the com-
by a subsidiary of the holding company. The pany). The Board has retained its authority to
rule clarifies that, for purposes of applying the treat such joint ventures as affiliates under sec-
presumption of affiliation described above, an tion 23A on a case-by-case basis.
FHC that has an investment in a private equity
fund (as defined in the Board’s merchant bank- 23. See 12 U.S.C. 371c(b)(1)(A) and (b)(2)(A). Section
ing rule) will not be considered indirectly to 23A defines a subsidiary of a specified company as a com-
own the equity capital of a company in which pany that is controlled by the specified company. Under the
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
21. See 12 C.F.R. 225.176(b)(2) and (3).
a majority of the directors of the other company, or exercises
22. For purposes of these safe harbors, the rule provides
a controlling influence over the policies of the other company
that the term ‘‘holding company’’ includes any subsidiary of
(12 U.S.C. 371c(b)(3) and (4)).
the holding company, including any subsidiary bank of the
24. 12 U.S.C. 371c(b)(2)(A).
holding company. Accordingly, if a director of a subsidiary
bank or nonbank subsidiary of an FHC also serves as a
director of a portfolio company, the first safe harbor, for BHC Supervision Manual July 2009
example, would be unavailable. Page 7
2020.1.1.2.8 Employee Benefit Plans to 20 percent of the IDI’s capital stock and
surplus.
Regulation W clarifies, under section
223.2(b)(1)(iv), that an employee stock option The rule’s interpretation of the 10 percent limit
plan (ESOP), of an IDI or an affiliate of the IDI is consistent with the statutory language.25 An
cannot itself avoid classification as an affiliate IDI that has crossed the 10 percent threshold
of the member bank by also qualifying as a with one affiliate may still conduct additional
subsidiary of the member bank. Many, but not covered transactions with other affiliates, if
all, ESOPs, trusts, or similar entities that exist to transactions with all affiliates would not exceed
benefit shareholders, members, officers, direc- 20 percent of the IDI’s capital stock and surplus.
tors, or employees of an IDI or its affiliates are An IDI is prohibited from engaging in a new
treated as affiliates of the IDI for purposes of covered transaction with that affiliate if the IDI’s
sections 23A and 23B. The ESOP’s share own- transactions would exceed the 10 percent thresh-
ership or the interlocking management between old with that affiliate or if the level of covered
the ESOP and its associated IDI (or BHC), in transactions with all its affiliates exceeded the
many cases, exceeds the statutory thresholds for 20 percent threshold. The rule generally does
determining that a company is an affiliate. For not require an IDI to unwind existing covered
example, if an ESOP controls more than 25 per- transactions if the member bank exceeds the
cent of the voting shares of the member bank or 10 percent or 20 percent limit because its capital
bank holding company, the ESOP is an affiliate. declined or a preexisting covered transaction
The relationship between an IDI and its (or increased in value.
its) affiliate’s ESOP generally warrants cover- The Board strongly encourages IDIs with
age by sections 23A and 23B. IDIs have made covered transactions in excess of the 10 percent
unsecured loans to their ESOPs or their affili- threshold with any affiliate to reduce those trans-
ates’ ESOP or have guaranteed loans to such actions before expanding the scope or extent of
ESOPs that were made by a third party. These the member bank’s relationships with other
ESOPs, however, generally have no means to affiliates. Section 223.11 of the rule also clari-
repay the loans other than with funds provided fies that transactions between a member bank
by the IDI. In addition, even if the ESOP’s and a financial subsidiary of the member bank
ownership control does not warrant treatment as are not subject to the 10 percent limit of sec-
an affiliate, the issuance of holding company tion 23A but instead are subject to the 20 per-
shares to an ESOP that is funded by a loan from cent limitation.
the holding company’s subsidiary IDI could be
used as a vehicle by the IDI to provide funds to
its parent holding company when the IDI is 2020.1.3 CAPITAL STOCK AND
unable to pay dividends or is otherwise SURPLUS
restricted in providing funds to its holding com-
pany. The attribution rule (12 C.F.R. 223.16) Under section 23A, the quantitative limits on
subjects such transactions to the restrictions of covered transactions are based on the ‘‘capital
sections 23A and 23B. stock and surplus’’ of the IDI. An IDI’s capital
stock and surplus for purposes of section 23A of
the FRA is—
2020.1.2 QUANTITATIVE LIMITS 1. the sum of tier 1 and tier 2 capital included in
an institution’s risk-based capital under the
Section 23A(a)(1)(A) states that an IDI may capital guidelines of the appropriate federal
engage in a covered transaction with an affiliate banking agency, based on the institution’s
only if in the case of any affiliate most recent consolidated FFIEC Reports of
Condition and Income (Call Report) filed
1. the IDI limits the aggregate amount of cov- under 12 U.S.C. 1817(a)(3);
ered transactions to that particular affiliate to 2. the balance of an institution’s allowance for
not more than 10 percent of the IDI’s capital loan and lease losses not included in its tier 2
stock and surplus and capital for purposes of the calculation of
2. the IDI limits the aggregate amount of all risk-based capital by the appropriate federal
covered transactions with all of its affiliates banking agency (based on the institution’s
BHC Supervision Manual July 2009 25. Sections 223.11 and 223.12 of the rule set forth these
Page 8 quantitative limits.
most recent consolidated Call Report of Con- owns or controls 25 percent or more of the
dition and Income that is filed under equity capital of another company controls the
12 U.S.C. 1817(a)(3)); and other company, unless the company or share-
3. the amount of any investment in a financial holder demonstrates otherwise to the Board
subsidiary that counts as a covered transac- based on the facts and circumstances of the
tion that is required to be deducted from the particular case.31 Such a presumption of control
IDI’s regulatory capital.26 is particularly appropriate in the section 23A
context because a BHC may have incentives to
Examiners can determine the amount of the divert the resources of a subsidiary IDI to any
quantitative limits based on the IDI’s most company in which the holding company has a
recent Call Report or Thrift Financial Report.27 substantial financial interest, regardless of
whether the holding company owns any voting
securities of the company.
2020.1.3.1 Determination of Control Section 23A and the rule provide that no
company shall be deemed to own or control
The definition of ‘‘control’’ is similar to the another company by virtue of its ownership or
definition used in the BHC Act. Under the rule, control of shares in a fiduciary capacity except
a company or shareholder shall be deemed to (1) when a company that is controlled, directly
have control over another company if— or indirectly, by a trust for the benefit of share-
holders who beneficially or otherwise control,
• such company or shareholder, directly or indi- directly or indirectly, a member bank, or (2) if
rectly, or acting through one or more other the company owning or controlling such shares
persons, owns, controls, or has power to vote is a business trust.
25 percent or more of any class of voting
securities of the other company;
• such company or shareholder controls in any
2020.1.4 COVERED TRANSACTIONS
manner the election of a majority of the direc-
tors or trustees (or general partners or indi- The restrictions of section 23A do not apply to
viduals exercising similar functions), of the every transaction between an IDI and its affili-
other company; or ates; section 23A only applies to ‘‘covered trans-
• the Board determines, after notice and oppor- actions’’ between an IDI and its affiliates.32
tunity for hearing, that such company or A covered transaction under section 23A of
shareholder, directly or indirectly, exercises a the FRA means—
controlling influence over the management or
policies of the other company.28 1. a loan or extension of credit by an IDI to an
affiliate;
In addition, three additional presumptions of 2. a purchase of, or an investment in, the securi-
control are provided under the rule. First, a ties issued by an affiliate of an IDI;33
company will be deemed to control securities, 3. an IDI’s purchase of assets from an affiliate,
assets, or other ownership interests controlled including assets subject to recourse, or an
by any subsidiary of the company.29 Second, a agreement to repurchase, except for pur-
company that controls instruments (including chases of real and personal property as may
options and warrants) that are convertible or be specifically exempted by the Board by
exercisable, at the option of the holder or owner, order or regulation;
into securities, will be deemed to control the 4. the acceptance by an IDI of securities issued
securities.30 Third, a rebuttable presumption by an affiliate as collateral security for a loan
provides that a company or shareholder that or extension of credit by the member bank to
26. See section 223.3(d) of the rule (12 C.F.R. 223.3(d)).

27. A savings association submits periodic Thrift Financial
31. See, for example, 12 C.F.R. 225.144 (Board Policy
Reports in accordance with the requirements of its federal
Statement on Equity Investments in Banks and Bank Holding
supervisor, the Office of Thrift Supervision.
Companies).
28. See section 223.3(g) of the rule (12 C.F.R. 223.3(g)).
32. 12 U.S.C. 371c(b)(7).
29. See 12 C.F.R. 225.2(e)(2)(i).
33. The investment by an IDI or its affiliate in a financial
30. See 12 C.F.R. 225.31(d)(1)(i). The rule refers more
subsidiary of the bank excludes the retained earnings of the
generically to convertible ‘‘instruments.’’ It clarifies that the
financial subsidiary.
convertibility presumption applies regardless of whether the
right to convert resides in a financial instrument that techni-
cally qualifies as a ‘‘security’’ under section 23A or the BHC Supervision Manual July 2009
federal securities laws. Page 9
any person or company,34 or 2020.1.4.2 Credit Transactions with an

5. the issuance by an IDI of a guarantee, accep- Affiliate
tance, or letter of credit, including an
endorsement or standby letter of credit, on 2020.1.4.2.1 Extension of Credit to an
behalf of an affiliate. Affiliate or Other Credit Transaction with
an Affiliate
If a transaction between an IDI and an affiliate is Section 23A includes a ‘‘loan or extension of
not within one of the above categories, it is not a credit’’ to an affiliate as a covered transaction,
covered transaction for the purposes of sec- but does not define these terms. Section 223.3(o)
tion 23A and is not subject to its limitations. All of the rule defines ‘‘extension of credit’’ to an
covered transactions must be made on terms and affiliate to mean the making or renewal of a loan
conditions that are consistent with safe and to an affiliate, the granting of a line of credit to
sound banking practices.35 an affiliate, or the extending of credit to an
Among the transactions that generally are not affiliate in any manner whatsoever, including on
subject to section 23A are dividends paid by an an intraday basis. Transactions that are defined
IDI to its holding company, sales of assets by an as extensions of credit include but are not lim-
IDI to an affiliate for cash, an affiliate’s pur- ited to the following:
chase of securities issued by an IDI, and many
service contracts between an IDI and an affili- 1. an advance to an affiliate by means of an
ate.36 Certain classes of transactions between a overdraft, cash item, or otherwise;
member bank and an affiliate are discussed 2. a sale of federal funds to an affiliate;
below as to whether they are covered transac- 3. a lease that is the functional equivalent of an
tions for purposes of section 23A. (See sec- extension of credit to an affiliate;37
tion 223.3(h).) 4. an acquisition by purchase, discount,
exchange, or otherwise of a note or other
obligation, including commercial paper or
other debt securities, of an affiliate;
2020.1.4.1 Attribution Rule
5. any increase in the amount of, extension of
the maturity of, or adjustment to the interest-
The ‘‘attribution rule,’’ found in section 223.16, rate term or other material term of, an exten-
prevents an IDI from evading its restrictions of sion of credit to an affiliate;38 and
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. Any covered transaction by money (or its equivalent) to an IDI.39
an IDI or its subsidiary with any person is
deemed to be a transaction with an affiliate of An IDI’s purchase of a debt security issued
the IDI if any of the proceeds of the transaction by an affiliate is an extension of credit by the
are used for the benefit of, or are transferred to, IDI to the affiliate for purposes of section 23A
the affiliate. For example, an IDI’s loan to a under the rule. An IDI that buys debt securities
customer for the purpose of purchasing securi- issued by an affiliate has made an extension of
ties from the inventory of a broker-dealer affili- credit to an affiliate under section 23A and must
ate of the member bank would be a covered collateralize the transaction in accordance with
transaction under section 23A. the collateral requirements of section 23A. An
37. The Board would consider a full-payout, net lease

permissible for a national bank under 12 U.S.C. 24 (seventh)
34. The acceptance of an affiliate’s securities for a loan
and 12 C.F.R. 23 to be the functional equivalent of an exten-
when proceeds are transferred to, or used for the benefit of, an
sion of credit.
affiliate is prohibited. (See section 223.3(h)(2).)
38. A floating-rate loan does not become a new covered
35. Board staff has taken the position that safety and
transaction whenever there is a change in the relevant index
soundness requires that the transaction be conducted on mar-
(for example, LIBOR or the member bank’s prime rate) from
ket terms.
which the loan’s interest rate is calculated. If the member
36. A transaction when an IDI receives assets from an
bank and the borrower, however, amend the loan agreement to
affiliate and the IDI pays a dividend or returns capital to an
change the interest-rate term from ‘‘LIBOR plus 100 basis
affiliate may result in a purchase of assets for the purposes of
points’’ to ‘‘LIBOR plus 150 basis points,’’ the parties have
section 23A. Although these transactions are not subject to
engaged in a new covered transaction.
section 23A, they may be subject to section 23B or other laws.
39. The definition of extension of credit would cover,
among other things, situations in which an affiliate fails to pay
BHC Supervision Manual July 2009 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.
exemption from the collateral requirements is affiliate has drawn down), and a guarantee back-
provided for situations in which an IDI pur- stopping a $500 debt issuance of the affiliate is a
chases an affiliate’s debt securities from a third $500 covered transaction.
party in a bona fide secondary-market Under section 23A and the rule, a member
transaction. bank has made an extension of credit to an
affiliate if the IDI purchases from a third party a
loan previously made to an affiliate of the IDI.
2020.1.4.2.2 Valuation of Credit A different valuation formula is provided for
Transactions with an Affiliate these indirect credit transactions: The IDI must
value the transaction at the price paid by the IDI
A credit transaction between an IDI and an for the loan plus any additional amount that the
affiliate initially must be valued at the amount of IDI could be required to provide to, or on behalf
funds provided by the IDI to, or on behalf of, of, the affiliate under the terms of the credit
the affiliate plus any additional amount that the agreement.
IDI could be required to provide to, or on behalf For example, if an IDI pays a third party $90
of, the affiliate. The section 23A value of a for a $100 term loan that the third party previ-
credit transaction between an IDI and an affili- ously made to an affiliate of the IDI (because,
ate is the greater of (1) the principal amount of for example, the loan was at a fixed rate and has
the credit transaction; (2) the amount owed by declined in value because of a rise in the general
the affiliate to the member bank under the credit level of interest rates), the covered-transaction
transaction; or (3) the sum of (a) the amount amount is $90 rather than $100. The lower
provided to, or on behalf of, the affiliate in the covered-transaction amount reflects the fact that
transaction and (b) any additional amount that the IDI’s maximum loss on the transaction is
the member bank could be required to provide $90 rather than the original principal amount of
to, or on behalf of, the affiliate under the terms the loan. For another example, if an IDI pays a
of the member transaction. (See 223.21) third party $70 for a $100 line of credit to an
The first prong of the rule’s valuation formula affiliate, of which $70 had been drawn down by
for credit transactions (‘‘the principal amount of the affiliate, the covered-transaction amount
the credit transaction’’) would likely determine would be $100 (the $70 purchase price paid by
the valuation of a transaction in which an IDI the IDI for the credit plus the remaining $30 that
purchased a zero-coupon note issued by an the IDI could be required to lend under the
affiliate. An IDI should value such an extension credit line).
of credit at the principal, or face amount of the In another example, an IDI makes a term loan
note (that is, at the amount that the affiliate to an affiliate that has a principal amount of
ultimately must pay to the IDI) rather than at the $100. The affiliate pays $2 in up-front fees to
amount of funds initially advanced by the IDI. the member bank, and the affiliate receives net
For example, assume an IDI purchased from an loan proceeds of $98. The IDI must initially
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 IDI’s purchase
$100. The rule’s 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 rule’s 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 23A’s quantitative limits) items Transaction with an Affiliate
such as accrued interest not yet due on an IDI’s
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 rule’s 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
credit facility is a $300 covered transaction BHC Supervision Manual July 2009
(regardless of how much of the facility the Page 11
affiliate. A covered transaction occurs at the ered transaction has two classes: one in which
moment that the IDI executes a legally valid, the only collateral for the loan is solely affiliate
binding, and enforceable credit agreement or securities and another in which the loan is
guarantee and does not occur only when an IDI secured by a combination of affiliate securities
funds a credit facility or makes payment on a and other collateral.
guarantee. Consistent with section 23A, the rule Under the rule, if the credit extension is
only requires an IDI to compute compliance secured exclusively by affiliate securities, then
with its quantitative limits when the IDI is about the transaction is valued at the full amount of
to engage in a new covered transaction. The rule the extension of credit. This approach reflects
does not require an IDI to compute compliance the difficulty of measuring the actual value of
with the rule’s quantitative limits on a continu- typically untraded and illiquid affiliate securities
ous basis. See section 223.21(b)(1) of the rule. and conservatively assumes that the value of the
The burden of the timing rule is mitigated securities is equal to the full value of the loan
significantly by the exemption for intraday that the securities collateralize. An exception is
extensions of credit found in section 223.42(l). provided to the general rule when the affiliate
The intraday credit exemption generally applies securities held as collateral have a ready market
only to extensions of credit that an IDI expects (as defined by section 223.42 of the rule). In that
to be repaid, sold, or terminated by the end of its case, the transaction may be valued at the fair
U.S. business day. The IDI must have policies market value of the affiliate securities. The
and procedures to manage and minimize the exception grants relief in those circumstances
credit exposure. Any such extension of credit when the value of the affiliate securities is inde-
that is outstanding at the end of the IDI’s busi- pendently verifiable by reference to transactions
ness day must be treated as an extension of occurring in a liquid market.41
credit and must meet the regulatory quantitative Covered transactions of the second class, in
and collateral requirements. which the credit extension is secured by affiliate
securities and other collateral, are valued at the
lesser of (1) the total value of the extension of
2020.1.4.2.4 Leases credit minus the fair market value of the other
collateral or (2) the fair market value of the
Lease transactions that constitute the functional affiliate securities (if the securities have a ready
equivalent of a loan or an extension of credit may market). The rule’s ready-market requirement
be subject to section 23A. Such lease applies regardless of the amount of affiliate
arrangements, in effect, are equivalent to a loan collateral.42
by the IDI and are essentially financing
arrangements. Some of the characteristics that
would normally cause a lease to be construed as 2020.1.4.2.6 Extensions of Credit Secured
a loan equivalent include the lessee’s having by Affiliate Securities—Mutual Fund
responsibility for the servicing, maintenance, Shares
insurance, licensing, or risk of loss or damage,
and the lessee’s having the option to purchase the Section 23A(b)(7)(D) of the FRA defines as a
equipment. covered transaction a member bank’s accep-
Under section 23A, the securities issued by an affiliate are not

acceptable collateral for a loan or extension of credit to any
2020.1.4.2.5 Extensions of Credit Secured affiliate. (See 12 U.S.C. 371(c)(4)) If the proceeds of a loan
by Affiliate Securities—General Valuation that is secured by an affiliate’s securities are transferred to an
Rule (Section 223.24(a) and (b)) affiliate by the unaffiliated borrower (for example, to purchase
assets or securities from the inventory of an affiliate), the loan
Section 23A defines as a covered transaction an should be treated as a loan to the affiliate and the affiliates
securities cannot be used to meet the collateral requirements
IDI’s acceptance of securities issued by an affili- of sections 23A. The loan must then be secured with other
ate as collateral for a loan or extension of credit collateral in an amount and of a type that meets the require-
to any person or company.40 This type of cov- ments of section 23A for loans by an IDI to an affiliate.
41. In either case, the transaction must comply with sec-
tion 23B; that is, the IDI must obtain the same amount of
affiliate securities as collateral on the credit extension that the
40. See 12 U.S.C. 371c(b)(7)(D). This covered transaction
IDI would obtain if the collateral were not affiliate securities.
only arises when the member bank’s loan is to a nonaffiliate.
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 2009 IDI does not have the procedures and systems in place to
Page 12 verify the fair market value of affiliate securities.
tance of securities issued by an affiliate as collat- that such reductions are consistent with GAAP
eral security for a loan or extension of credit to and are reflected on the IDI’s financial
any person or company. statements.
Section 223.24(c) of the rule provides an Certain asset purchases by an IDI from an
exemption for extensions of credit by a member affiliate are not valued in accordance with the
bank that are secured by shares of an affiliated general asset-purchase valuation formula. First,
mutual fund. To qualify for the exemption, the if the IDI buys from one affiliate a loan made to
transaction must meet several conditions. First, a second affiliate, the IDI must value the trans-
to ensure that the affiliate collateral is liquid and action as a credit transaction with the second
trades at a fair price, the affiliated mutual fund affiliate under section 223.21. Second, if the IDI
must be an open-end investment company that buys from one affiliate a security issued by a
is registered with the SEC under the 1940 Act. second affiliate, the IDI must value the transac-
Second, to ensure that the IDI can easily estab- tion as an investment in securities issued by the
lish and monitor the value of the affiliate collat- second affiliate under section 223.23. Third, if
eral, the affiliated mutual fund’s shares serving the IDI acquires the shares of an affiliate that
as collateral for the extension of credit must becomes an operating subsidiary of the IDI after
have a publicly available market price. Third, to the acquisition, the IDI must value the transac-
reduce the IDI’s incentives to use these exten- tion under section 223.31.
sions of credit as a mechanism to support the A special valuation rule applies to an IDI’s
affiliated mutual fund, the IDI and its affiliates purchase of a line of credit or loan commitment
must not own more than 5 percent of the fund’s from an affiliate. An IDI initially must value
shares (excluding certain shares held in a fidu- such asset purchases at the purchase price paid
ciary capacity). Finally, the proceeds of the by the IDI for the asset plus any additional
extension of credit must not be used to purchase amounts that the IDI is obligated to provide
the affiliated mutual fund’s shares serving as under the credit facility.43 This special valuation
collateral or otherwise used to benefit an affili- rule ensures that there are limits on the amount
ate. In such circumstances, the IDI’s extension of risk a company can shift to an affiliated IDI.
of credit would be covered by section 23A’s Section 23A(d)(6) provides an exemption for
attribution rule. For example, an IDI proposes to purchasing assets having a readily identifiable
lend $100 to a nonaffiliate secured exclusively and publically available market quotation. Sec-
by eligible affiliated mutual fund securities. The tion 224.42(e) of the rule codified this exemp-
IDI knows that the nonaffiliate intends to use all tion. Section 223.42(f) expands the statutory
the loan proceeds to purchase the eligible affili- (d)(6) exemption to allow an IDI to purchase
ated mutual fund securities that would serve as securities from an affiliate based on price quotes
collateral for the loan. Under the attribution rule obtained from certain electronic screens so long
in section 223.16, the IDI must treat the loan to as, among other things, (1) the selling affiliate is
the nonaffiliate as a loan to an affiliate, and a broker-dealer registered with the SEC, (2) the
because securities issued by an affiliate are ineli- securities are traded in a ready market and eli-
gible collateral under section 223.14, the loan gible for purchase by state IDIs, (3) the securi-
would not be in compliance with section 223.14. ties are not purchased within 30 days of an
underwriting (if an affiliate of the IDI is an
underwriter of the securities), and (4) the securi-
2020.1.4.3 Asset Purchases ties are not issued by an affiliate. See sec-
tion 2020.1.10.2 for a further discussion of this
2020.1.4.3.1 Purchase of Assets under exemption.
Regulation W In contrast with credit transactions, an asset
purchase from a nonaffiliate that later becomes
Regulation W provides that a purchase of assets an affiliate generally does not become a cov-
by an IDI from an affiliate initially must be
valued at the total amount of consideration 43. A member bank would not be required to include
given by the IDI in exchange for the asset. (See unfunded, but committed, amounts in the value of the covered
section 223.22.) This consideration can take any transaction if (1) the credit facility being transferred from the
form and includes an assumption of liabilities affiliate to the bank is unconditionally cancelable (without
cause) at any time by the IDI and (2) the IDI makes a separate
by the IDI. Asset purchases are a covered trans- credit decision before each drawing under the facility (see
action for an IDI for as long as the IDI holds the 12 C.F.R. 223.31).
asset. The value of the covered transaction after
the purchase may be reduced to reflect amortiza- BHC Supervision Manual July 2009
tion or depreciation of the asset, to the extent Page 13
ered transaction for the purchasing IDI. How- consideration in exchange for affiliate securities
ever, if an IDI purchases assets from a nonaf- has to value the covered transaction at no less
filiate in contemplation that the nonaffiliate will than the IDI’s carrying value of the securities. In
become an affiliate of the IDI, the asset pur- addition, if the IDI’s carrying value of the affili-
chase becomes a covered transaction at the ate securities increased or decreased after the
time the nonaffiliate becomes an affiliate. In IDI’s initial investment (due to profits or losses
addition, the IDI must ensure that the aggregate at the affiliate), the amount of the IDI’s covered
amount of the IDI’s covered transactions transaction would increase or decrease to reflect
(including any such asset purchase from the the IDI’s changing financial exposure to the
nonaffiliate) would not exceed the quantitative affiliate. However, the amount of the IDI’s cov-
limits of section 23A at the time the nonaffili- ered transaction cannot decline below the
ate becomes an affiliate. amount paid by the IDI for the securities.
The following examples are provided to assist Several important considerations support the
IDIs in valuing purchases of assets from an general carrying-value approach of this valua-
affiliate. An IDI’s receipt of an encumbered tion rule. First, the approach would require an
asset from an affiliate ceases to be a covered IDI to reflect its investment in securities issued
transaction when, for example, the IDI sells the by an affiliate at carrying value throughout the
asset. life of the investment, even if the IDI paid no
consideration for the securities. Second, the
• Cash purchase of assets. An IDI purchases a approach is supported by the terms of the stat-
pool of loans from an affiliate for $10 million. ute, which defines both a ‘‘purchase of’’ and an
The IDI initially must value the covered trans- ‘‘investment in’’ securities issued by an affiliate
action at $10 million. Going forward, if the as a covered transaction. The statute’s ‘‘invest-
borrowers repay $6 million of the principal ment in’’ language indicates that Congress was
amount of the loans, the IDI may value the concerned with an IDI’s continuing exposure to
covered transaction at $4 million. an affiliate through an ongoing investment in the
• Purchase of assets through an assumption of affiliate’s securities.
liabilities. An affiliate of an IDI contributes Third, GLB Act amendments to section 23A
real property with a fair market value of support the approach. The GLB Act defines a
$200,000 to the IDI. The IDI pays the affiliate financial subsidiary of an IDI as an affiliate of
no cash for the property, but assumes a the IDI, but specifically provides that the sec-
$50,000 mortgage on the property. The IDI tion 23A value of an IDI’s investment in securi-
has engaged in a covered transaction with the ties issued by a financial subsidiary does 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 IDI’s 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 IDI’s
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 sec-
mortgage). tion 23A—imiting the financial exposure of
IDIs to their affiliates and promoting safety and
soundness. The valuation rule requires an IDI to
2020.1.4.3.2 IDI’s Purchase of revalue upwards the amount of an investment in
Securities Issued by an Affiliate affiliate securities only when the IDI’s exposure
to the affiliate increases (as reflected on the
Section 23A includes as a covered transaction IDI’s financial statements) and the IDI’s capital
an IDI’s 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 IDI’s 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 IDI’s ability to
the greater of the IDI’s purchase price or carry- engage in additional transactions with an affili-
ing value of the securities. An IDI that paid no ate as the IDI’s exposure to that affiliate
increases.
BHC Supervision Manual July 2009 The valuation rule also provides that the
Page 14 covered-transaction amount of an IDI’s invest-
ment in affiliate securities can be no less than the shares increases to $500, the IDI must
the purchase price paid by the IDI for the value the investment at $500.
securities, even if the carrying value of the
securities declines below the purchase price.
This aspect of the valuation rule uses the IDI’s 2020.1.4.5 Issuance of a Letter of Credit
purchase price for the securities as a floor for or Guarantee
valuing the covered transaction. First, it ensures
that the amount of the covered transaction never 2020.1.4.5.1 Confirmation of a Letter of
falls below the amount of funds actually Credit Issued by an Affiliate
transferred by the IDI to the affiliate in connec-
tion with the investment. In addition, the Section 23A includes as a covered transaction
purchase-price floor limits the ability of an IDI the issuance by an IDI of a letter of credit on
to provide additional funding to an affiliate as behalf of an affiliate, including the confirmation
the affiliate approaches insolvency. If invest- of a letter of credit issued by an affiliate as a
ments in securities issued by an affiliate were covered transaction. (See section 223.3(h)(5).)
valued strictly at carrying value, then the IDI When an IDI confirms a letter of credit, it
could lend more funds to the affiliate as the af- assumes the risk of the underlying transaction to
filiate’s financial condition worsened. As the af- the same extent as if it had issued the letter of
filiate declined, the IDI’s carrying value of the credit.44 Accordingly, a confirmation of a letter
affiliate’s securities would decline, the sec- of credit issued by an affiliate is treated in the
tion 23A value of the IDI’s investment likely same fashion as an issuance of a letter of credit
would decline, and, consequently, the IDI would on behalf of an affiliate.
be able to provide additional funding to the
affiliate under section 23A. This type of increas-
ing support for an affiliate in distress is what 2020.1.4.5.2 Credit Enhancements
section 23A was intended to restrict. Supporting a Securities Underwriting
The following examples are designed to assist
IDIs in valuing purchases of, and investments The definition of guarantee in section 23A does
in, securities issued by an affiliate: not include an IDI’s issuance of a guarantee in
support of securities issued by a third party and
• Purchase of the debt securities of an affiliate. underwritten by a securities affiliate of the IDI.45
The parent holding company of an IDI owns Such a credit enhancement would not be issued
100 percent of the shares of a mortgage com- ‘‘on behalf of’’ the affiliate. Although the guar-
pany. The IDI purchases debt securities issued antee does provide some benefit to the affiliate
by the mortgage company for $600. The ini- (by facilitating the underwriting), this benefit is
tial carrying value of the securities is $600. indirect. The proceeds of the guarantee would
The IDI initially must value the investment at not be transferred to the affiliate for purposes of
$600. the attribution rule of section 23A.46 Section
• Purchase of the shares of an affiliate. The 23B would apply to the transaction and, where
parent holding company of an IDI owns an affiliate was issuer as well as underwriter, the
51 percent of the shares of a mortgage com- transaction would be covered by section 23A
pany. The IDI purchases an additional 30 per- because the credit enhancement would be on
cent of the shares of the mortgage company behalf of the affiliate.
from a third party for $100. The initial carry-
ing value of the shares is $100. The IDI
initially must value the investment at $100. 2020.1.4.5.3 Cross-Guarantee
Going forward, if the IDI’s carrying value of Agreements and Cross-Affiliate Netting
the shares declines to $40, the IDI must con- Arrangements
tinue to value the investment at $100.
• Contribution of the shares of an affiliate. The A cross-guarantee agreement among an IDI, an
parent holding company of an IDI owns affiliate, and a nonaffiliate in which the nonaffili-
100 percent of the shares of a mortgage com- ate may use the IDI’s assets to satisfy the obliga-
pany and contributes 30 percent of the shares
44. See UCC 5-107(2).
to the IDI. The IDI gives no consideration in 45. See 62 Fed. Reg. 45295, August 27, 1997.
exchange for the shares. If the initial carrying 46. See 12 U.S.C. 371c(a)(2).
value of the shares is $300, then the IDI
initially must value the investment at $300. BHC Supervision Manual July 2009
Going forward, if the IDI’s carrying value of Page 15
tions of a defaulting affiliate is a guarantee for 2020.1.4.5.5 Prohibition on the Purchase

purposes of section 23A. The cross-guarantee of Low-Quality Assets
arrangements among IDIs and their affiliates are
subject to the quantitative limits and collateral Section 23A generally prohibits the purchase by
requirements of section 23A. (See sec- an IDI of a low-quality asset from an affiliate.47
tion 223.3(h)(5).) In addition, an IDI and its subsidiaries cannot
As for cross-affiliate netting arrangements purchase or accept as collateral a low-quality
(CANAs), such arrangements involve an IDI, asset from an affiliate. Section 23A defines a
one or more affiliates of the IDI, and one or low-quality asset to include (1) an asset classi-
more nonaffiliates of the IDI, where a nonaffili- fied as ‘‘substandard,’’ ‘‘doubtful,’’ or ‘‘loss,’’ or
ate is permitted to deduct obligations of an treated as ‘‘other loans specially mentioned,’’ in
affiliate of the IDI to the nonaffiliate when set- the most recent report of examination or inspec-
tling the nonaffiliate’s obligations to the IDI. tion by a federal or state supervisory agency (a
These arrangements also would include agree- ‘‘classified asset‘‘), (2) an asset in nonaccrual
ments in which an IDI is required or permitted status, (3) an asset on which payments are more
to add the obligations of an affiliate of the IDI to than 30 days past due in the payment of princi-
a nonaffiliate when determining the IDI’s obli- pal or interest, or (4) an asset whose terms have
gations to the nonaffiliate. These types of been renegotiated or compromised due to the
CANAs expose an IDI to the credit risk of its deteriorating financial condition of the obligor.
affiliates because the IDI may become liable for Any asset meeting one of the above four crite-
the obligations of its affiliates. Because the ria, including securities and real property, is a
exposure of an IDI to an affiliate in such an low-quality asset.
arrangement resembles closely the exposure of Regulation W expands the definition of low-
an IDI when it issues a guarantee on behalf of quality assets in several respects. (See 12 C.F.R.
an affiliate, the rule explicitly includes such 223.3(v).) First an asset may be identified by
arrangements in the definition of covered trans- examiners as a low-quality asset if they repre-
action. Accordingly, the quantitative limits of sent credits to countries that are not complying
section 23A would prohibit an IDI from enter- with their external debt-service obligations but
ing into such a CANA to the extent that the are taking positive steps to restore debt service
netting arrangement does not cap the potential through economic adjustment measures, gener-
exposure of the IDI to the participating affiliate ally as part of an International Monetary Fund
(or affiliates). Program. Although such assets may not be con-
sidered classified assets, examiners are to con-
sider these assets in their assessment of an IDI’s
2020.1.4.5.4 Keepwell Agreements asset quality and capital adequacy.
Second, the rule considers a financial institu-
tion’s 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
institution’s 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
assets and will view as an evasion of sec-
tion 23A any company’s deferral or alteration of
47. 12 U.S.C. 371c(a)(3). Section 23A does not prohibit an

affiliate from donating a low-quality asset to a member bank,
BHC Supervision Manual July 2009 so long as the bank provides no consideration for the asset and
Page 16 no liabilities are associated with the asset.
an asset’s rating to facilitate sale of the asset to 2020.1.5 COLLATERAL FOR

an affiliated institution. CERTAIN TRANSACTIONS WITH
Finally, the rule defines low-quality asset to AFFILIATES
include foreclosed property designated ‘‘other
real estate owned’’ (OREO), until it is reviewed Section 23A requires a member bank’s use of
by an examiner and receives a favorable classi- collateral for certain transactions between an
fication. It further defines as a low-quality asset IDI and its affiliates.49 Each loan or extension of
any asset (not just real estate) that is acquired in credit to an affiliate,50 or guarantee, acceptance,
satisfaction of a debt previously contracted (not or letter of credit issued on behalf of its subsidi-
just through foreclosure) if the asset has not yet ary must be secured at the time of the transac-
been reviewed in an examination or inspection. tion by collateral. The required collateral var-
Under the rule, if a particular asset is good ies,51 depending on the type of collateral used to
collateral taken from a bad borrower, the asset secure the transaction.52 The specific collateral
should cease to be a low-quality asset upon requirements are—
examination.
Section 23A provides a limited exception to 1. 100 percent of the amount of such loan or
the general rule prohibiting purchase of low- extension of credit, guarantee, acceptance, or
quality assets if the IDI performs an indepen- letter of credit, if the collateral is composed
dent credit evaluation and commits to the pur- of—
chase of the asset before the affiliate acquires a. obligations of the United States or its
the asset.48 Section 223.15 of the rule also pro- agencies;
vides an exception from the prohibition on the b. obligations fully guaranteed by the United
purchase by an IDI of a low-quality asset from States or its agencies as to principal and
an affiliate for certain loan renewals. The rule interest;
allows an IDI that purchased a loan participa- c. notes, drafts, bills of exchange, or bank-
tion from an affiliate to renew its participation in er’s acceptances that are eligible for redis-
the loan, or provide additional funding under the count or purchase by a Federal Reserve
existing participation, even if the underlying Bank;53 or
loan had become a low-quality asset, so long as d. a segregated, earmarked deposit account
certain criteria were met. These renewals or with the member bank that is for the sole
additional credit extensions may enable both the purpose of securing credit transactions
affiliate and the participating IDI to avoid or between the member bank and its affili-
minimize potential losses. The exception is ates and is identified as such.
available only if (1) the underlying loan was not 2. 110 percent of the amount of such loan or
a low-quality asset at the time the IDI purchased extension of credit, guarantee, acceptance, or
its participation and (2) the proposed transaction letter of credit if the collateral is composed
would not increase the IDI’s proportional share of obligations of any state or political subdi-
of the credit facility. The IDI must also obtain vision of any state;
the prior approval of its entire board of directors 3. 120 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 other debt instruments, including receiv-
increase its proportionate share in a restructured ables; or
loan by 5 percent (or by a higher percentage 4. 130 percent of the amount of such loan or
with the prior approval of the IDI’s 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
loans originated by any affiliate of the IDI (not
49. The IDI must perfect the security interest in the collat-
just affiliated IDIs). eral (Fitzpatrick v. FDIC, 765 F.2d 569 (6th Cir. 1985). A
purchase of assets from an affiliate does not require collateral.
50. 12 U.S.C. 371c(b)(7).
51. ‘‘Credit extended’’ means the loan or extension of
credit, guarantee, acceptance, or letter of credit.
52. 12 U.S.C. 371c(c)(1).
53. Regulation A includes a representative list of accept-
able government obligations (12 C.F.R. 201.108).

48. 12 U.S.C. 371c(a)(3). Page 17
of stock, leases, or other real or personal of the credit extended.55 IDIs may secure cov-
property. ered transactions with omnibus deposit accounts
so long as the IDI takes steps to ensure that the
For example, an IDI makes a $1,000 loan to omnibus deposit accounts fully secure the rel-
an affiliate. The affiliate posts as collateral for evant covered transactions. Such steps might
the loan $500 in U.S. Treasury securities, $480 include substantial overcollateralization or the
in corporate debt securities, and $130 in real use of subaccounts or other recordkeeping
estate. The loan satisfies the collateral require- devices to match deposits with covered transac-
ments of section 23A because $500 of the loan tions. To obtain full credit for any deposit
is 100 percent secured by obligations of the accounts taken as section 23A collateral, IDIs
United States, $400 of the loan is 120 percent must ensure that they have a perfected, first-
secured by debt instruments, and $100 of the priority security interest in the accounts. (See
loan is 130 percent secured by real estate. The section 223.14(b)(1)(i)(D).)
statute prohibits an IDI from counting a low-
quality asset toward section 23A’s collateral
requirements for credit transactions with affili- 2020.1.5.1.2 Ineligible Collateral
ates.54 An IDI must maintain a perfected secu-
rity interest at all times in the collateral that The purpose of section 23A’s collateral require-
secures the credit transaction. ments is to ensure that IDIs that engage in credit
Each loan or extension of credit to an affiliate transactions with affiliates have legal recourse,
or guarantee, acceptance, or letter of credit in the event of affiliate default, to tangible assets
issued on behalf of an affiliate (herein referred with a value at least equal to the amount of the
to as credit transactions) by an IDI or its subsid- credit extended. The statute recognizes that cer-
iary must be secured at the time of the transac- tain types of assets are not appropriate to serve
tion by collateral. as collateral for credit transactions with an affili-
ate. In particular, the statute provides that low-
quality assets and securities issued by an affili-
2020.1.5.1 Collateral Requirements in ate are not eligible collateral for such covered
Regulation W transactions.
Under section 223.14(c) of the rule, intan-
The collateral requirements for credit transac- gible assets also are not deemed acceptable to
tions are found in section 223.14 of the rule. meet the collateral requirements imposed by
Section 223.14(a) requires that an IDI meet the section 23A.56 Intangible assets, including ser-
collateral requirements only at the inception of a vicing assets, are particularly hard to value, and
credit transaction with an affiliate. Although the an IDI may have significant difficulty in collect-
section only requires that an IDI meet the collat- ing and selling such assets in a reasonable
eral requirements at the inception, section 23B period of time.
may require the collateral to be increased if the Section 23A(c) requires that credit transac-
value of the collateral decreases and the IDI tions with an affiliate be ‘‘secured’’ by collat-
would require additional collateral from a third eral. A credit transaction between an IDI and an
party. A low-quality asset can be used as extra affiliate supported only by a guarantee or letter
collateral, but cannot satisfy the statute’s or of credit from a third party does not meet the
regulation’s collateral requirements. statutory requirement that the credit transac-
tion be secured by collateral. Guarantees and
letters of credit often are subject to material
2020.1.5.1.1 Deposit Account Collateral adverse change clauses and other covenants that
allow the issuer of the guarantee or letter of
Under section 23A, an IDI may satisfy the col- credit to deny coverage. Letters of credit and
lateral requirements of the statute by securing a guarantees are not balance-sheet assets under
credit transaction with an affiliate with a ‘‘segre- GAAP and, accordingly, would not constitute
gated, earmarked deposit account’’ maintained ‘‘real or personal property’’ under sec-
with the IDI in an amount equal to 100 percent tion 23A. There is a particularly significant risk
that an IDI may have difficulty collecting on a
guarantee or letter of credit provided by a
54. 12 U.S.C. 371c(c)(3).
55. 12 U.S.C. 371c(c)(1)(A)(iv).
BHC Supervision Manual July 2009 56. The rule does not confine the definition of intangible
Page 18 assets by reference to GAAP.
nonaffiliate on behalf of an affiliate of the IDI. an affiliate. The affiliate grants the IDI a second-
Accordingly, guarantees and letters of credit are priority security interest in a piece of real estate
not acceptable section 23A collateral. valued at $3,000. Another institution that previ-
As noted above, section 23A prohibits an IDI ously lent $1,000 to the affiliate has a first-
from accepting securities issued by an affiliate priority security interest in the entire parcel of
as collateral for an extension of credit to any real estate. This transaction is not in compliance
affiliate. The rule clarifies that securities issued with the collateral requirements of this section.
by the IDI itself also are not eligible collateral to Because of the existence of the prior third-party
secure a credit transaction with an affiliate. lien on the real estate, the effective value of the
Equity securities issued by a lending IDI, and real estate collateral for the IDI for purposes of
debt securities issued by a lending IDI that this section is only $2,000—$600 less than the
count as regulatory capital of the IDI, are not amount of real estate collateral required by this
eligible collateral under section 23A. If an IDI section for the transaction ($2,000 × 130 percent
was forced to foreclose on a credit transaction = $2,600).
with an affiliate secured by such securities, the
IDI may be unwilling to liquidate the collateral
promptly to recover on the credit transaction 2020.1.5.1.4 Unused Portion of an
because the sale might depress the price of the Extension of Credit
IDI’s outstanding securities or result in a change
in control of the IDI. In addition, to the extent Section 23A requires that the ‘‘amount’’ of an
that an IDI is unable or unwilling to sell such extension of credit be secured by the statutorily
securities acquired through foreclosure, the prescribed levels of collateral. Under the statute,
transaction would likely result in a reduction in an IDI provides a line of credit to an affiliate, it
the IDI’s capital, thereby offsetting any poten- must secure the full amount of the line of credit
tial benefit provided by the collateral. throughout the life of the credit. Section
223.14(f)(2) of the rule, however, provides an
exemption to the collateral requirements of sec-
2020.1.5.1.3 Perfection and Priority tion 23A for the unused portion of an extension
of credit to an affiliate so long as the IDI does
Under section 223.14(d) of the rule, an IDI’s not have any legal obligation to advance addi-
security interest in any collateral required by tional funds under the credit facility until the
section 23A must be perfected in accordance affiliate has posted the amount of collateral
with applicable law to ensure that an IDI has required by the statute with respect to the entire
good access to the assets serving as collateral used portion of the extension of credit.57 In such
for its credit transactions with affiliates. This credit arrangements, securing the unused por-
requirement ensures that the IDI has the legal tion of the credit line is unnecessary from a
right to realize on the collateral in the case of safety-and-soundness perspective because the
default, including a default resulting from the affiliate cannot require the IDI to advance addi-
affiliate’s insolvency or liquidation. An IDI also tional funds without posting the additional col-
is required to either obtain a first-priority secu- lateral required by section 23A. If an IDI volun-
rity interest in the required collateral or deduct tarily advances additional funds under such a
from the amount of collateral obtained by the credit arrangement without obtaining the addi-
IDI the lesser of (1) the amount of any security tional collateral required under section 23A to
interests in the collateral that are senior to that secure the entire used amount (despite its lack
obtained by the IDI or (2) the amount of any of a legal obligation to make such an advance),
credits secured by the collateral that are senior the Board views this action as a violation of the
to that of the IDI. For example, if an IDI lends collateral requirements of the statute. The entire
$100 to an affiliate and takes as collateral a amount of the line counts against the IDI’s
second lien on a parcel of real estate worth quantitative limit, even if the line of credit does
$200, the arrangement would only satisfy the not need to be secured.
collateral requirements of section 23A if the
affiliate owed the holder of the first lien $70 or
less (a credit transaction secured by real estate
57. This does not apply to guarantees, acceptances, and
must be secured at 130 percent of the amount of letters of credit issued on behalf of an affiliate. These instru-
the transaction). ments must be fully collateralized at inception.
The rule includes the following example of
how to compute the section 23A collateral value BHC Supervision Manual July 2009
of a junior lien: An IDI makes a $2,000 loan to Page 19
2020.1.5.1.5 Purchasing Affiliate Debt rule’s section 223.11 or 223.12 at the time of the
Securities in the Secondary Market stock acquisition. The IDI is, however, prohib-
ited from engaging in any additional covered
An IDI’s investment in the debt securities issued transactions with the new affiliate at least until
by an affiliate is an extension of credit by the such time as the value of the loan transaction
IDI to the affiliate and thus is subject to sec- falls below 10 percent of the IDI’s capital stock
tion 23A’s collateral requirements. Section and surplus, and the transaction counts toward
223.14(f)(3) of the rule provides an exemption the 20 percent limit for transactions with all
that permits IDIs in certain circumstances to affiliates. In addition, the IDI must bring the
purchase debt securities issued by an affiliate loan into compliance with the collateral require-
without satisfying the collateral requirements of ments of section 223.14 promptly after the stock
section 23A. The exemption is available where acquisition. Transactions with nonaffiliates in
an IDI purchases an affiliate’s debt securities contemplation of the nonaffiliate becoming an
from a third party in a bona fide secondary- affiliate must meet the quantitative and collat-
market transaction. When an IDI buys an affili- eral requirements of the rule at the time of the
ate’s debt securities in a bona fide secondary- inception of the credit transaction and of the
market transaction, the risk that the purchase is affiliation.
designed to shore up an ailing affiliate is
reduced. Any purchase of affiliate debt securi-
ties that qualifies for this exemption would still
remain subject to the quantitative limits of sec-
2020.1.6 LIMITATIONS ON
tion 23A and the market-terms requirement of
COLLATERAL
section 23B. In analyzing an IDI’s good faith
under this exemption transaction, examiners IDIs may accept as collateral for covered trans-
should look at (1) the time elapsed between the actions receivables, leases, or other real or per-
original issuance of the affiliate’s debt securities sonal property.58 The following are limitations
and the IDI’s purchase, (2) the existence of any and collateral restrictions:
relevant agreements or relationships between
the IDI and the third-party seller of the affili- 1. Any collateral that is subsequently retired or
ate’s debt securities, (3) any history of IDI amortized must be replaced by additional
financing of the affiliate, and (4) any other rel- eligible collateral. This is done to keep the
evant information. percentage of the collateral value relative to
the amount of the outstanding loan or exten-
sion of credit, guarantee, acceptance, or letter
of credit equal to the minimum percentage
2020.1.5.1.6 Credit Transactions with that was required at the inception of the
Nonaffiliates that Become Affiliates transaction.
2. A low-quality asset is not acceptable as col-
IDIs sometimes lend money to, or issue guaran- lateral for a loan or extension of credit to, or
tees on behalf of, unaffiliated companies that for a guarantee, acceptance, or letter of credit
later become affiliates of the IDI. Section issued on behalf of, an affiliate.
223.21(b)(2) provides transition rules that 3. Securities issued by an affiliate of an IDI
exempt credit transactions from the collateral shall not be acceptable as collateral for a loan
requirements in situations in which the IDI or extension of credit to, or for a guarantee,
entered into the transactions with the nonaffili- acceptance, or letter of credit issued on
ate at least one year before the nonaffiliate behalf of, that affiliate or any other affiliate
became an affiliate of the IDI. For example, an of the IDI.
IDI with capital stock and surplus of $1,000 and
no outstanding covered transactions makes a The above collateral requirements are not appli-
$120 unsecured loan to a nonaffiliate. The IDI cable to an acceptance that is already fully
does not make the loan in contemplation of the secured either by attached documents or by
nonaffiliate becoming an affiliate. Nine months other property that is involved in the transaction
later, the bank holding company purchases all and has an ascertainable market value.
the stock of the nonaffiliate, thereby making the
nonaffiliate an affiliate of the IDI. The IDI is not
in violation of the quantitative limits of the 58. As noted above, letters of credit and mortgage-
servicing rights may not be accepted as collateral for purposes
BHC Supervision Manual July 2009 of section 23A. See section 223.14(c)(4)(5) of the rule
Page 20 (12 C.F.R. 223.14(c )(4) and (5).
2020.1.7 DERIVATIVE 2020.1.7.1.1 Regulation W on Derivatives

TRANSACTIONS WITH AFFILIATES Transactions
AND INTRADAY EXTENSIONS OF
CREDIT TO AFFILIATES Regulation W does not require most derivative
transactions to meet the quantitative and collat-
The GLB Act required the Board to adopt rules eral requirements of section 23A. Instead, the
under section 23A of the FRA that would rule requires the IDI to establish and maintain
address as covered transactions (1) credit expo- policies and procedures designed to manage the
sure arising out of derivative transactions credit exposure arising from the derivative.
between member banks and their affiliates and These policies and procedures require, at a
(2) intraday extensions of credit by member minimum, that the institution monitor and con-
banks to their affiliates (12 U.S.C. 371c(f)(3)). trol its exposure to its affiliates by imposing
appropriate credit controls and collateral
requirements. Regulation W provides that
credit derivatives between an institution and an
2020.1.7.1 Derivative Transactions unaffiliated third party that reference the obli-
between Insured Depository Institutions gations of an affiliate of the institution and that
and Their Affiliates are the functional equivalent of a guarantee by
the institution on behalf of an affiliate should
Derivative transactions between an IDI and its be treated as a guarantee by the institution on
affiliates generally arise from the risk- behalf of an affiliate for the purposes of sec-
management needs of the institution or the affili- tion 23A.
ate. Transactions arising from the institution’s
needs typically occur when an institution enters
into a swap or other derivative contract with a 2020.1.7.1.2 Section 23B and
customer but chooses not to hedge directly the Regulation W Regarding Derivative
market risk generated by the derivative contract, Transactions
or when the institution is unable to hedge the
risk directly because it is not authorized to hold Derivative transactions between an IDI and an
the hedging asset. To manage the market risk, affiliate are subject to section 23B of the FRA
the institution may have an affiliate acquire the under the express terms of the statute.59 In
hedging asset. The institution would then do a many respects, derivative transactions between
bridging derivative transaction between itself an IDI and an affiliate resemble section 23A
and the affiliate maintaining the hedge. covered transactions. Such transactions may
Other derivative transactions between an IDI expose an IDI to the credit risk of its affiliates.
and its affiliate are affiliate-driven. To accom- Although the typical institution-affiliate deriva-
plish its asset-liability-management goals, an tive transaction does not create actual credit
institution’s affiliate may enter into an interest- exposure for the institution at the inception of
rate or foreign-exchange derivative with the the transaction, an institution may incur actual
institution. For example, an institution’s holding credit exposure to an affiliate during the term
company may hold a substantial amount of of a derivative transaction, and it nearly always
floating-rate assets but issue fixed-rate debt faces some amount of potential future exposure
securities to obtain cheaper funding. The hold- on the transaction. The credit exposure of a
ing company may then enter into a fixed-to- derivative transaction with an affiliate may
floating interest-rate swap with its subsidiary pose a risk to the safety and soundness of the
member bank to reduce the holding company’s IDI that is similar in many respects to the risk
interest-rate risk. posed by a loan to an affiliate. In fact, this
IDIs and their affiliates that seek to enter into
derivative transactions for hedging (or risk- 59. In addition to applying to covered transactions, as
taking) purposes could enter into the desired defined in section 23A of the FRA, the market-terms require-
derivatives with unaffiliated companies. IDIs ment of section 23B of the FRA applies broadly to, among
other things, ‘‘[t]he payment of money or the furnishing of
and their affiliates often choose to use each services to an affiliate under contract, lease, or otherwise’’
other as their derivative counterparties, how- (12 U.S.C. 371c-1(a)(2)(C)). Institution-affiliate derivatives
ever, to maximize the profits of, and manage generally involve a contract or agreement to pay money to the
risks within, the consolidated financial group. affiliate or furnish risk-management services to the affiliate.

Page 21
credit exposure may be more volatile and inde- 2020.1.7.1.3 Covering Derivatives That
terminate than the credit exposure created by a Are the Functional Equivalent of a
loan. Guarantee
Regulation W clarifies further that the trans-
actions are subject to the market-terms require- Although most derivatives are not treated as
ment of section 23B of the FRA (see sec- covered transactions, section 223.33 of the rule
tion 223.51). The rule requires IDIs to comply provides that credit derivatives between an IDI
strictly with section 23B in their derivative and a nonaffiliate in which the IDI protects the
transactions with affiliates. Section 23B requires nonaffiliate from a default on, or a decline in the
an institution to treat an affiliate no better than a value of, an obligation of an affiliate of the IDI
similarly situated nonaffiliate. To comply with are covered transactions under section 23A.
section 23B of the FRA, each institution should Such derivative transactions are viewed as guar-
have in place credit limits on its derivatives antees by a member bank on behalf of an affili-
exposure to affiliates that are at least as strict as ate (and, hence, are covered transactions) under
the credit limits the institution imposes on unaf- section 23A.
filiated companies that are engaged in similar The rule provides that these credit derivatives
businesses and are substantially equivalent in are covered transactions under section 23A and
size and credit quality. Similarly, each institu- gives several examples.60 An IDI is not allowed
tion should monitor derivatives exposure to to reduce its covered transaction amount for
affiliates at least as rigorously as it monitors these derivatives to reflect hedging positions
derivatives exposure to comparable unaffiliated established by the IDI with third parties. A
companies. In addition, each institution should credit derivative is treated as a covered transac-
price and require collateral in its derivative tion only to the extent that the derivative pro-
transactions with affiliates in a way that is at vides credit protection with respect to obliga-
least as favorable to the institution as the way in tions of an affiliate of the IDI.
which it would price or require collateral in a
derivative transaction with comparable unaffili-
ated counterparties. 2020.1.8 INTRADAY EXTENSIONS OF
Section 23B generally does not allow an IDI CREDIT
to use with an affiliate the terms and conditions
it uses with its most creditworthy unaffiliated An extension of credit under section 23A of the
customer unless the institution can demonstrate FRA includes the credit exposure arising from
that the affiliate is of comparable creditworthi- intraday extensions of credit by IDIs to their
ness as its most creditworthy unaffiliated cus- affiliates. IDIs regularly provide transaction
tomer. Instead, section 23B requires that an accounts to their affiliates in conjunction with
affiliate be treated comparably (with respect to providing payment and securities clearing ser-
terms, conditions, and credit limits) to the vices. As in the case of unaffiliated commercial
majority of third-party customers engaged in the customers, these accounts are occasionally sub-
same business, and having comparable credit ject to overdrafts during the day that are repaid
quality and size as the affiliate. Because an IDI in the ordinary course of business.
generally has the strongest credit rating within a Intraday extensions of credit by an IDI to an
holding company, the Board generally would affiliate are subject to the market-terms require-
not expect an affiliate to obtain better terms and ment of section 23B under the rule. The rule
conditions from an IDI than the institution also requires that, under section 23A, institu-
receives from its major unaffiliated counterpar- tions establish and maintain policies and
ties. In addition, market terms for derivatives procedures that are reasonably designed to man-
among major financial institutions generally age the credit exposure arising from an
include daily marks to market and two-way institution’s intraday extensions of credit to
collateralization above a relatively small expo- affiliates. The policies and procedures must, at a
sure threshold. minimum, provide for monitoring and control-
ling the institution’s intraday credit exposure to
each affiliate, and to all affiliates in the aggre-
gate, and ensure that the institution’s intraday
60. In most instances, the covered-transaction amount for

BHC Supervision Manual July 2009 such a credit derivative would be the notional principal
Page 22 amount of the derivative.
credit extensions to affiliates comply with sec- fies these exemptions and exempts a number of
tion 23B. additional types of transactions. The Board
Section 223.42(l) of the rule provides that reserves the right to revoke or modify any addi-
intraday credit extensions by an IDI to an affili- tional exemption granted by the Board in Regu-
ate are section 23A covered transactions but lation W, if the Board finds that the exemption is
exempts all such intraday credit extensions resulting in unsafe or unsound banking prac-
from the quantitative and collateral require- tices. The Board also reserves the right to termi-
ments of section 23A if the IDI (1) maintains nate the eligibility of a particular IDI to use any
policies and procedures for the management of such exemption if the IDI’s use of the exemp-
intraday credit exposure and (2) has no reason tion is resulting in unsafe or unsound banking
to believe that any affiliate receiving intraday practices.
credit would have difficulty repaying the credit
in accordance with its terms. The policies and
procedures are to be established and main- 2020.1.9.1 Covered Transactions Exempt
tained for— from the Quantitative Limits and
Collateral Requirements
1. monitoring and controlling the credit expo-
sure arising at any one time from the IDI’s Under the rule’s section 223.41, the quantitative
intraday extensions of credit to each affiliate limits (sections 223.11 and 223.12) and the col-
and all affiliates in the aggregate and lateral requirements (section 223.14) do not
2. ensuring that any intraday extensions of apply to the following transactions. The transac-
credit by the IDI to an affiliate comply with tions are, however, subject to the safety-and-
the market-terms requirement of sec- soundness requirement (section 223.13) and the
tion 223.51 of the rule. prohibition on the purchase of a low-quality
asset (section 223.15).
2020.1.8.1 Standard under Which the

Board May Grant Additional Exemptions 2020.1.9.1.1 Parent Institution/Subsidiary
Institution Transactions
Section 23A and Regulation W authorize the
Board to exempt transactions or relationships by Transactions with an IDI are exempt from the
regulation or Board order if the exemption quantitative limits and collateral requirements
would be in the public interest and consistent (section 223.14) if the member bank controls
with the purposes of section 23A. Section 80 percent or more of the voting securities of
223.43 of the rule provides that exemption the IDI or the depository institution controls
requests should be filed with the Board’s Gen- 80 percent or more of the voting securities of
eral Counsel and should describe in detail the the IDI.
transaction or relationship for which the
member bank seeks exemption, The exemption
request also should explain why the Board 2020.1.9.1.2 Sister-Bank Exemption
should exempt the transaction or relationship, (section 223.41(b))
and why it meets the public interest standard of
the statute. The Board has approved a number Regulation W exempts transactions with an IDI
of exemptions, most of which involve corporate if the same company controls 80 percent or
reorganizations. These exemptions are avail- more of the voting securities of the member
able on the Board’s website, www.federal bank and the IDI.62 In addition, the statute pro-
reserve.gov/boarddocs/legalint/FederalReserve vides that covered transactions between sister
Act.
62. Banks that are affiliated in this manner are referred to
as ‘‘sister banks.’’ Sister banks can improve their efficiency
2020.1.9 EXEMPTIONS FROM through intercorporate transfers under this exception. Also,
SECTION 23A ‘‘company’’ in this context is not limited to a bank holding
company. For example, if a retail corporation owns two credit
Section 23A exempts seven transactions or rela- card banks, the two credit card banks would be sister banks,
and the sister-bank exception could be used for transactions
tions from its quantitative limits and collateral between two credit card banks.
requirements.61 Regulation W, subpart E, clari-
61. See 12 U.S.C. 371c(d) Page 23
banks must be consistent with safe and sound pany to achieve the same efficiency as sister
banking practices.63 banks.
The sister-bank exemption generally applies
only to transactions between IDIs.64 The rule’s
definition of affiliate excludes uninsured deposi- 2020.1.9.1.4 Internal Corporate
tory institution subsidiaries of a member bank. Reorganizations
Covered transactions between a member bank
and a parent uninsured depository institution or Section 223.41(d) of the rule provides an
a commonly controlled uninsured depository exemption for asset purchases by an IDI from
institution, under the rule, generally would be an affiliate that is part of a one-time internal
subject to section 23A, whereas covered transac- corporate reorganization of a holding com-
tions between a member bank and a subsidiary pany.66 The exemption includes purchases of
uninsured depository institution would not be assets in connection with a transfer of securities
subject to section 23A.65 issued by an affiliate to an IDI, as described in
The sister-bank exemption, by its terms, only section 223.31(a).
exempts transactions by a member bank with a Under this exemption, an IDI would be per-
sister-bank affiliate; hence, the sister-bank mitted to purchase assets (other than low-quality
exemption cannot exempt a member bank’s assets) from an affiliate (including in connection
extension of credit or other covered transaction with an affiliate share transfer that sec-
to an affiliate that is not a sister bank (even if the tion 223.31 of the rule treats as a purchase of
extension of credit was purchased from a sister assets) that are exempt from the quantitative
bank). For example, an IDI purchases from limits of section 23A if the following conditions
Sister-Bank Affiliate A a loan to Affiliate B in a are met.
purchase that qualifies for the sister-bank First, the purchase must be part of an internal
exemption in section 23A. The IDI’s asset pur- corporate reorganization of a holding company
chase from Sister-Bank Affiliate A would be an that involves the transfer of all or substantially
exempt covered transaction under sec- all of the shares or assets of an affiliate or of a
tion 223.41(b), but the member bank also would division or department of an affiliate. The asset
have acquired an extension of credit to Affiliate purchase must not be part of a series of periodic,
B, which would be a covered transaction ordinary-course asset transfers from an affiliate
between the IDI and Affiliate B under sec- to an IDI.67 Second, the IDI’s holding company
tion 223.3(h)(1) that does not qualify for the must provide the Board with contemporaneous
sister-bank exemption. notice of the transaction and must commit to the
Board to make the IDI whole, for a period of
two years, for any transferred assets that become
2020.1.9.1.3 Purchase of Loans on a low-quality assets.68 Third, a majority of the
Nonrecourse Basis from an Affiliated IDI
66. See 1998 Fed. Res. Bull. 985 and 1013-14.
Banks that are commonly controlled (i.e., at 67. The IDI must provide the Board, as well as the appro-
least 25 percent common ownership) can priate federal agency, a notice that describes the primary
business activities of the affiliate whose shares or assets are
purchase loans on a nonrecourse basis. This being transferred to the IDI and must indicate the anticipated
allows chain banks and banks in companies that date of the reorganization.
are not owned 80 percent by the same com- 68. The holding company can meet these criteria by either
repurchasing the assets at book value plus any write-down
that has been taken or by making a quarterly cash contribution
to the bank equal to the book value plus any write-downs that
63. 12 U.S.C. 371c(a)(4).
have been taken by the bank. The purchase or payment must
64. A member bank and its operating subsidiaries are
be made within 30 days of each quarter end. In addition, if a
considered a single unit for purposes of section 23A. Under
cash payment is made, the IDI will hold an amount of risk-
the statute and the regulation, transactions between a member
based capital equal to the book value of any transferred assets
bank (or its operating subsidiary) and the operating subsidiary
that become low-quality so long as the IDI retains ownership
of a sister-insured depository institution generally qualify for
or control of the transferred asset. For example, under this
the sister-bank exemption.
dollar-for-dollar capital requirement, the risk-based capital
65. The sister-bank exemption in section 23A does not
charge for each transferred low-quality loan asset would be
allow a member bank to avoid any restrictions on sister-bank
100 percent (equivalent to a 1250 percent risk weight), rather
transactions that may apply to the bank under the prompt
than the 8 percent requirement (equivalent to a 100 percent
corrective-action framework set forth in section 38 of the FDI
risk weight) that would apply to a similar defaulted loan asset
Act (12 U.S.C. 1831o) and regulations adopted by the bank’s
that is not a part of the transferred asset pool. See the Board’s
appropriate federal banking agency.
letter dated December 21, 2007, to Andres L. Navarette
(Capital One Financial Corp.). Once the capital pool has been
BHC Supervision Manual July 2009 allocated to specific assets as described above, the capital
Page 24 cannot be applied to other low-quality assets if the initial
IDI’s directors must review and approve the 9. Asset purchases from an affiliate by a newly
transaction before consummation. Fourth, the formed IDI, if the appropriate federal bank-
section 23A value of the covered transaction ing agency for the IDI has approved the
must be less than 10 percent of the IDI’s capital asset purchase in writing in connection with
stock and surplus (or up to 25 percent of the the review of the formation of the IDI
IDI’s capital stock and surplus with the prior 10. Transactions approved under the Bank
approval of the appropriate federal banking Merger Act that involve affiliated IDIs or an
agency) for the IDI. Fifth, the holding company IDI and the U.S. branches and agencies of a
and all its subsidiary depository institutions foreign bank
must be well capitalized and well managed and 11. Purchasing, on a nonrecourse basis, an
must remain well capitalized upon consumma- extension of credit from an affiliate under
tion of the transaction. certain conditions
12. Intraday extensions of credit
13. Riskless-principal transactions
2020.1.9.2 Other Covered Transactions
Exempt from the Quantitative Limits,
Collateral Requirements, and 2020.1.9.2.1 Correspondent Banking
Low-Quality-Asset Prohibition
Section 23A exempts from its quantitative lim-
The quantitative limits (sections 223.11 and its and collateral requirements a deposit by an
223.12), the collateral requirements (sec- IDI in an affiliated IDI or affiliated foreign bank
tion 223.14), and the prohibition on the pur- that is made in the ordinary course of correspon-
chase of a low-quality asset (section 223.15) do dent business, subject to any restrictions that the
not apply to the following exempted transac- Board may impose.69 Section 223.42(a) of the
tions (see section 223.42) and certain condi- rule further provides that such deposits must
tions. The transactions are, however, subject to represent ongoing, working balances maintained
the safety-and-soundness requirement (sec- by the IDI in the ordinary course of conducting
tion 223.13). Detailed conditions or restrictions the correspondent business.70 Although not
pertaining to these exemptions are discussed specified by section 23A or the Home Owners’
after this list. Loan Act (HOLA), the rule also provides that
correspondent deposits in an affiliated insured
1. Making correspondent banking deposits in savings association are exempt if they otherwise
an affiliated depository institution (as meet the requirements of the exemption.
defined in section 3 of the FDI Act
(12 U.S.C. 1813) or in an affiliated foreign
bank that represents an ongoing, working 2020.1.9.2.2 Secured Credit Transactions
balance maintained in the ordinary course
of correspondent business Section 23A and section 223.42(c) of the rule
2. Giving immediate credit to an affiliate for exempt any credit transaction by an IDI with an
uncollected items received in the ordinary affiliate that is ‘‘fully secured’’ by obligations of
course of business the United States or its agencies, or obliga-
3. Transactions secured by cash or U. S. gov- tions that are fully guaranteed by the United
ernment securities States or its agencies, as to principal and
4. Purchasing securities of a servicing affiliate, interest.71
as defined by section 4(c)(1) of the BHC A deposit account meets the ‘‘segregated,
Act earmarked’’ requirement only if the account
5. Purchasing certain liquid assets exists for the sole purpose of securing credit
6. Purchasing certain marketable securities
7. Purchasing certain municipal securities
8. Purchasing from an affiliate an extension of 69. 12 U.S.C. 371c(d)(2).
70. Unlike the sister-bank exemption, the exemption for
credit subject to a repurchase agreement correspondent banking deposits applies to deposits placed by
that was originated by an IDI and sold to a member bank in an uninsured depository institution or
the affiliate subject to a repurchase agree- foreign bank.
ment or with recourse 71. 12 U.S.C. 371c(d)(4). A partial list of such obligations
can be found in the rules’s section 201.108 (12 C.F.R.
201.108).
low-quality asset returns to performing status. The IDI can
only apply the allocated capital pool to new assets if the initial BHC Supervision Manual July 2009
assets are fully paid or sold. Page 25
transactions between the member bank and its 2020.1.10.2 Purchases of Assets with
affiliates and is so identified. Under sec- Readily Identifiable Market Quotes
tion 23A, if U.S. government obligations or
deposit accounts are sufficient to fully secure a Section 23A(d)(6) exempts the purchase of
credit transaction, then the transaction is com- assets by an IDI from an affiliate if the assets
pletely exempt from the quantitative limits of have a ‘‘readily identifiable and publicly avail-
the statute. If, however, the U.S. government able market quotation’’ and are purchased at
obligations or deposit accounts represent less their current market quotation. The rule (sec-
than full security for the credit transaction, then tion 223.42(e)) limits the availability of this
the amount of U.S. government obligations or exemption (the (d)(6) exemption) to purchases
deposits counts toward the collateral require- of assets with market prices that are recorded in
ments of section 23A, but no part of the trans- widely disseminated publications that are
action is exempt from the statute’s quantitative readily available to the general public, such as
limits. newspapers with a national circulation. Because
The exemption provides that a credit transac- as a general matter only exchange-traded assets
tion with an affiliate will be exempt ‘‘to the are recorded in such publications, this test has
extent that the transaction is and remains ensured that the qualifying assets are traded
secured’’ by appropriate (d)(4) collateral. If an actively enough to have a true ‘‘market quota-
IDI makes a $100 nonamortizing term loan to tion’’ and that examiners can verify that the
an affiliate that is secured by $50 of U.S. Trea- assets are purchased at their current market quo-
sury securities and $75 of real estate, the value tation. The rule applies if the asset is purchased
of the covered transaction will be $50. If the at or below the asset’s current market
market value of the U.S. Treasury securities quotation.73
falls to $45 during the life of the loan, the value The (d)(6) exemption may apply to a pur-
of the covered transaction would increase to chase of assets that are not traded on an
$55. The Board expects IDIs that use this exchange. In particular, purchases of foreign
expanded (d)(4) exemption to review the market exchange, gold, and silver, and purchases of
value of their U.S. government obligations col- over-the-counter (OTC) securities and deriva-
lateral regularly to ensure compliance with the tive contracts whose prices are recorded in
exemption. widely disseminated publications, may qualify
for the (d)(6) exemption.
If an IDI purchases from one affiliate, the
securities issued by another affiliate, the IDI has
engaged in two types of covered transactions:
2020.1.10 ASSET PURCHASES FROM
(1) the purchase of securities from an affiliate
AN AFFILIATE—EXEMPTIONS
and (2) the investment in securities issued by an
affiliate. Under the rule, although the
2020.1.10.1 Purchase of a Security by an (d)(6) exemption may exempt the one-time
Insured Depository Institution from an asset purchase from the first affiliate, it would
Affiliate not exempt the ongoing investment in securi-
ties being issued by a second affiliate.
Section 23A of the FRA restricts the ability of
a member bank to fund its affiliates through
asset purchases, loans, or certain other transac- 2020.1.10.3 Purchasing Certain
tions (referred to as ‘‘covered transactions’’). Marketable Securities
Paragraph (d)(6) of section 23A contains an
exemption from the statute (the (d)(6) exemp- Regulation W provided an additional exemp-
tion) for ‘‘purchasing assets having a readily tion from section 23A for certain purchases of
identifiable and publicly available market quo- securities by a member bank from an affiliate.
tation,’’ if the purchase is at or below such The rule expanded the statutory (d)(6) exemp-
quotation.72 tion to allow a member bank to purchase secu-
73. The rule provides that a U.S. government obligation is

an eligible (d)(6) asset only if the obligation’s price is quoted
routinely in a widely disseminated publication that is readily
72. 12 U.S.C. 371c(d)(6).
available to the general public. Although all U.S. government
obligations have low credit risk, not all U.S. government
BHC Supervision Manual July 2009 obligations trade in liquid markets at a publicly available
Page 26 market quotation.
rities from an affiliate based on price quotes ing an underwriting, or within 30 days of an
obtained from certain electronic services so underwriting, if an affiliate of the IDI is an
long as, among other things, the selling affiliate underwriter of the securities. This provision
is a broker-dealer registered with the SEC, the applies unless the security is purchased as part
securities have a ready market and are eligible of an issue of obligations of, or obligations fully
for purchase by state member banks, the securi- guaranteed as to principal and interest by, the
ties are not purchased within 30 days of an United States or its agencies. The rule includes
underwriting (if an affiliate of the bank is an the 30-day requirement because of the uncertain
underwriter of the securities), and the securities and volatile market values of securities during
are not issued by an affiliate. and shortly after an underwriting period and
because of the conflicts of interest that may
arise during and after an underwriting period,
2020.1.10.3.1 Broker-Dealer Requirement especially if an affiliate has difficulty selling its
and Securities Purchases from Foreign allotment.
Broker-Dealers
Under the Regulation W exemption, the selling 2020.1.10.3.4 No Securities Issued by an
affiliate must be a broker-dealer securities Affiliate
affiliate that is registered with the Securities
and Exchange Commission (SEC). Broker- If an IDI purchases from one affiliate securities
dealers that are registered with the SEC are issued by another affiliate, it would not exempt
subject to supervision and examination by the the investment in securities issued by the sec-
SEC and are required by SEC regulations to ond affiliate, even though the exemption may
keep and maintain detailed records concerning exempt the asset purchase from the first affili-
each securities transaction conducted by the ate. The transaction would be treated as a pur-
broker-dealer. In addition, SEC-registered chase of, or an investment in, securities issued
broker-dealers have experience in determining by an affiliate.
whether a security has a ‘‘ready market’’ under
SEC regulations. The rule does not expand the
exemption to include securities purchases from 2020.1.10.3.5 Price-Verification Methods
foreign broker-dealers. The rule explicitly pro-
vides, however, that an IDI may request that The exemption applies only in situations in
the Board exempt securities purchases from a which the IDI is able to obtain price quotes on
particular foreign broker-dealer, and the Board the purchased securities from an unaffiliated
would consider these requests on a case-by- electronic, real-time pricing service. The Board
case basis in light of all the facts and reaffirmed its position that it would not be
circumstances. appropriate to use independent dealer quotations
or economic models to establish a market price
for a security under the (d)(6) exemption. A
2020.1.10.3.2 Securities Eligible for security that is not quoted routinely in a widely
Purchase by a State Member Bank disseminated news source or a third-party elec-
tronic financial network may not trade in a
The exemption requires that the IDI’s purchase sufficiently liquid market to justify allowing an
of securities be eligible for purchase by a state IDI to purchase unlimited amounts of the secu-
member bank. For example, the Board deter- rity from an affiliate.
mined that a member bank may purchase equity
securities from an affiliate, if the purchase is
made to hedge the member bank’s permissible 2020.1.10.3.6 Record Retention
customer-driven equity derivative transaction.
The purchase must be treated as a purchase of a The rule expressly includes a two-year record-
security on the Call Report. retention and supporting information require-
ment that is sufficient to enable the appropriate
federal banking agencies to ensure that the IDI
2020.1.10.3.3 No Purchases Within 30 is in compliance with the terms of the
Days of an Underwriting exemption.
The exemption generally prohibits an IDI from BHC Supervision Manual July 2009
using the exemption to purchase securities dur- Page 27
2020.1.10.4 Purchasing Municipal tions of section 23A, even if the transactions

Securities does not qualify for the sister-bank exemp-
tion.76 The rule clarifies that the scope of the
Section 223.42(g) of the rule exempts an IDI’s exemption parallels that of the sister-bank
purchase of municipal securities from an affili- exemption by stating that this exemption
ate if the purchase meets certain require- applies only to a member bank’s purchase of a
ments.74 First, the IDI must purchase the loan from an affiliated IDI.
municipal securities from a broker-dealer affili-
ate that is registered with the SEC. Second, the
municipal securities must be eligible for pur- 2020.1.10.6 Purchases of Assets by
chase by a state member bank, and the IDI Newly Formed Institutions
must report the transaction as a securities pur-
chase in its Call Report. Third, the municipal Section 223.42(i) of the rule exempts a purchase
securities must either be rated by a nationally of assets by a newly formed IDI from an affiliate
recognized statistical rating organization if the appropriate federal banking agency for the
(NRSRO) or must be part of an issue of securi- IDI has approved the purchase. This exemption
ties that does not exceed $25 million in size. allows companies to charter a new IDI and to
Finally, the price for the securities purchased transfer assets to the IDI free of the quantitative
must be (1) quoted routinely on an unaffiliated limits and low-quality-asset prohibition of sec-
electronic service that provides indicative data tion 23A.
from real-time financial networks; (2) verified
by reference to two or more actual independent
dealer quotes on the securities to be purchased 2020.1.10.7 Transactions Approved under
or securities that are comparable to the securi- the Bank Merger Act
ties to be purchased; or (3) in the case of secu-
rities purchased during the underwriting period, The Bank Merger Act exemption applies to
verified by reference to the price indicated in transactions between an IDI and a certain IDI
the syndicate manager’s written summary of affiliate. Section 223.42(j) exempts transactions
the underwriting.75 Under any of the three pric- between IDIs that are approved pursuant to the
ing options, the IDI must purchase the munici- Bank Merger Act. The rule also makes the Bank
pal securities at or below the quoted or verified Merger Act exemption available for merger and
price. other related transactions between an IDI and a
U.S. branch or agency of an affiliated foreign
bank, if the transaction has been approved by
the responsible federal banking agency pursuant
2020.1.10.5 Purchase of Loans on a to the Bank Merger Act. There is no regulatory
Nonrecourse Basis exemption for merger transactions between an
Section 223.41(c) of the rule exempts the pur- IDI and its nonbank affiliate. Any IDI merging
chase of loans on a nonrecourse basis from an or consolidating with a nonbank affiliate may be
affiliated depository institution. Under sec- able to take advantage of the regulatory exemp-
tions 23A(d)(6), a member bank may purchase tion for internal-reorganization transactions con-
loans on a nonrecourse basis from an affiliated tained in section 223.41(d) of the rule.
‘‘bank’’ exempt from the quantitative limita-
2020.1.11 PURCHASES OF
74. Municipal securities are defined by reference to sec-
tion 3(a)(29) of the Securities Exchange Act. That Act defines
EXTENSIONS OF CREDIT—THE
municipal securities as direct obligations of, or obligations PURCHASE EXEMPTION
guaranteed as to principal or interest by, a state or agency,
instrumentality, or political subdivision thereof, and certain Regulation W codified, with changes, the
tax-exempt industrial development bonds. (See 17 U.S.C. exemption that was previously found at sec-
78c(a)(29).)
75. Under the Municipal Securities Rulemaking Board’s tion 250.250 (12 C.F.R. 250.250). In general,
Rule G-11, the syndicate manager for a municipal bond
underwriting is required to send a written summary to all 1. The purchase of an extension of credit on a
members of the syndicate. The summary discloses the aggre- nonrecourse basis from an affiliate is exempt
gate par values and prices of bonds sold from the syndicate
account. from section 23A’s quantitative limits pro-
vided that—
Page 28 76. See 12 U.S.C. 371c(d)(6).
a. the extension of credit is originated by the before giving a purchase commitment to its
affiliate; affiliate.
b. the IDI makes an independent evaluation 5. Purchase of loans from an affiliate must be
of the creditworthiness of the borrower without recourse. In connection with an IDI’s
before the affiliate makes or commits to purchase of loans from an affiliate, the affili-
make the extension of credit; ate cannot retain recourse on the loans. The
c. the IDI commits to purchase the exten- rule (section 223.42(k)) specifies that the
sions of credit before the affiliate makes exemption does not apply in situations where
or commits to the extensions of credit; the affiliate retains recourse on the loans
and purchased by the IDI. The rule also specifies
d. the IDI does not make a blanket advance that the purchase exemption only applies in
commitment to purchase extensions of situations where the IDI purchases loans
credit from the affiliate. (See sec- from an affiliate that were originated by the
tion 223.42(k) of the rule.) affiliate. The exemption cannot be used by an
2. The rule also includes a 50 percent limit on IDI to purchase loans from an affiliate that
the amount of loans an IDI may purchase the affiliate purchased from another lender.
from an affiliate under the purchase exemp- The exemption is designed to facilitate an
tion. When an IDI purchases more than half IDI’s using its affiliate as an origination
of the extensions of credit originated by an agent, not to permit an IDI to take loans off
affiliate, the purchases represent the principal an affiliate’s books that the affiliate pur-
ongoing funding mechanism for the affiliate. chased from a third party.
The IDI’s status as the predominant source
of financing for the affiliate calls into ques-
tion the availability of alternative funding
sources for the affiliate, places significant
2020.1.12 OTHER BOARD-
pressure on the IDI to continue to support the
APPROVED EXEMPTIONS FROM
affiliate through asset purchases, and reduces
SECTION 23A
the IDI’s ability to make independent credit
decisions with respect to the asset purchases.
3. ‘‘Substantial, ongoing funding’’ test. The rule Section 23A gives the Board the authority to
allows the appropriate federal banking grant exemptions from the statute’s restrictions
agency for an IDI to reduce the 50 percent if such exemptions are ‘‘in the public interest
threshold prospectively, on a case-by-case and consistent with the purposes of this section’’
basis, in those situations in which the agency (12 U.S.C. 371c(f)(2)). Regulation W includes
believes that the IDI’s asset purchases from several exemptions that are available to qualify-
an affiliate under the exemption may cause ing IDIs.
harm to the IDI.
4. Independent credit review by the IDI. To
qualify for the purchase exemption under 2020.1.12.1 Exemptions and
section 223.42(k), an IDI must independently Interpretation from the Attribution Rule
review the creditworthiness of the borrower of Section 23A
before committing to purchase each loan.
Under established Federal Reserve guidance,
The attribution rule of section 23A provides that
an IDI is required to have clearly defined
‘‘a transaction by a member institution with any
policies and procedures to ensure that it per-
person shall be deemed a transaction with an
forms its own due diligence in analyzing the
affiliate to the extent that the proceeds of the
credit and other risks inherent in a proposed
transaction are used for the benefit of, or trans-
transaction.77 This function is not delegable
ferred to, that affiliate’’ (12 U.S.C.
to any third party, including affiliates of the
371c(a)(2)). One respective interpretation and
IDI. Also, an IDI cannot rely on the stan-
three exemptions are discussed below.
dards of a government-sponsored enterprise.
Accordingly, to qualify for this exemption,
the IDI, independently and using its own
credit policies and procedures, must itself
review and approve each extension of credit

77. See, for example, SR-97-21. Page 29
2020.1.12.2 Interpretation—Loans to a that prevailing at the same time for comparable

Nonaffiliate that Purchases Securities or agency transactions the affiliate enters into with
Other Assets Through a Depository persons who are neither affiliates nor borrowers
Institution Affiliate Agent or Broker from an affiliated depository institution. (See
Regulation W at 12 C.F.R. 223.16(b).)
In Regulation W, the Board issued an interpreta-
tion (12 C.F.R. 223.26(b)) regarding an IDI’s
loan to a nonaffiliate that purchases assets 2020.1.12.3 Exemption—Loans to a
through an institution’s affiliate that is acting as Nonaffiliate that Purchases Securities
agent. This interpretation confirms that sec- from a Depository Institution Securities
tion 23A of the FRA does not apply to exten- Affiliate that Acts as a Riskless Principal
sions of credit an IDI grants to customers that
use the loan proceeds to purchase a security or The Board has granted an exemption in Regula-
other asset through an affiliate of the depository tion W from section 23A of the FRA for exten-
institution, so long as (1) the affiliate is acting sions of credit by an IDI to customers who use
exclusively as an agent or broker in the transac- the loan proceeds to purchase a security that is
tion and (2) the affiliate retains no portion of the issued by a third party through a broker-dealer
loan proceeds as a fee or commission for its affiliate of the institution that acts as riskless
services. principal. The exemption for riskless-principal
Under this interpretation, the Board con- transactions would not apply if the broker-dealer
cluded that when the affiliated agent or broker affiliate sold to the third-party borrower securi-
retains a portion of the loan proceeds as a fee or ties that were issued or underwritten by, or sold
commission, the portion of the loan not retained out of the inventory of, an affiliate of the deposi-
by the affiliate as a fee or commission would tory institution. Riskless-principal trades,
still be outside the coverage of section 23A. although the functional equivalent of securities
However, the portion of the loan retained by the brokerage transactions, involve the purchase of
affiliate as a fee or commission would be subject a security by the depository institution’s broker-
to section 23A because it represents proceeds of dealer affiliate. Accordingly, the broker-dealer
a loan by a depository institution to a third party retains the loan proceeds at least for some
that are transferred to, and used for the benefit moment in time.
of, an affiliate of the institution. The Board, There is negligible risk that loans that a
however, granted an exemption from sec- depository institution makes to borrowers to
tion 23A for that portion of a loan to a third engage in riskless-principal trades through a
party that an affiliate retains as a market-rate broker-dealer affiliate of the depository institu-
brokerage or agency fee. (See 12 C.F.R. tion would be used to fund the broker-dealer.
223.16(c )(2).) For this reason, the Board adopted an exemption
The interpretation would not apply if the from section 23A to cover riskless-principal
securities or other assets purchased by the third- securities transactions engaged in by depository
party borrower through the affiliate of the institution borrowers through broker-dealer
depository institution were issued or underwrit- affiliates of the depository institution. This
ten by, or sold from the inventory of, another exemption is applicable even if the broker-
affiliate of the depository institution. In that dealer retains a portion of the loan proceeds as a
case, the proceeds of the loan from the deposi- market-rate markup for executing the riskless-
tory institution would be transferred to, and principal securities trade. (See Regulation W at
used for the benefit of, the affiliate that issued, 12 C.F.R. 223.16(c)(1) and (2).)
underwrote, or sold the assets on a principal
basis to the third party.
The above-mentioned transactions are subject 2020.1.12.4 Exemption—Depository
to the market-terms requirement of section 23B, Institution Loan to a Nonaffiliate Pursuant
which applies to ‘‘any transaction in which an to a Preexisting Line of Credit and the
affiliate acts as an agent or broker or receives a Proceeds Are Used to Purchase Securities
fee for its services to the institution or any other from the Institution’s Broker-Dealer
person’’ (12 U.S.C. 371c-1(a)(2)(D)). A market- Affiliate
rate brokerage commission or agency fee refers
to a fee or commission that is no greater than The Board approved an exemption in Regula-
tion W from section 23A for loans by an IDI to
BHC Supervision Manual July 2009 a nonaffiliate pursuant to a preexisting line of
Page 30 credit, in which the loan proceeds are used to
purchase securities from a broker-dealer affili- with the 25 percent test. Most BHCs and FHCs
ate. In more detail, the Board exempted exten- should meet this test. If an IDI has commercial
sions of credit by an IDI to its customers that affiliates (beyond those permitted for an FHC
use the credit to purchase securities from a reg- under section 4 of the BHC Act), the institution
istered broker-dealer affiliate of the institution, would be deemed to satisfy the 25 percent test
so long as the extension of credit is made pur- if—
suant to, and consistent with any conditions
imposed in, a preexisting line of credit. This 1. the institution establishes systems to verify
line of credit should not have been established compliance with the 25 percent test on an
in expectation of a securities purchase from or ongoing basis and periodically validates its
through an affiliate of the institution. The pre- compliance with the test or
existing requirement is an important safeguard 2. the institution presents information to the
to ensure that the depository institution did not Board demonstrating that its card would
extend credit for the purpose of inducing a bor- comply with the 25 percent test. (One way
rower to purchase securities from or issued by that a member institution could demonstrate
an affiliate. The preexisting line of exemption that its card would comply with the 25 per-
may not be used in circumstances in which the cent test would be to show that the total sales
line has merely been preapproved. (See Regu- of the institution’s affiliates are less than
lation W at 12 C.F.R. 223.16(c)(3).) 25 percent of the total purchases by
cardholders.)
2020.1.12.5 Exemption—Credit Card Second, for those member institutions that

Transactions fall out of compliance with the 25 percent test,
there is a three-month grace period to return to
Regulation W also provides an exemption from compliance before extensions of credit under
section 23A’s attribution rule for general- the card become covered transactions. Third,
purpose credit card transactions that meet member institutions that are required to validate
certain criteria. (See section 223.16(c)(4).) The their ongoing compliance with the 25 percent
rule defines a general-purpose credit card as a test have a fixed method, time frames, and
credit card issued by a member institution that examples for computing compliance.
is widely accepted by merchants that are not Example of calculating compliance with the
affiliates of the institution (such as a Visa card 25 percent test. A member institution seeks to
or Mastercard) if less than 25 percent of the qualify a credit card as a general-purpose credit
aggregate amount of purchases with the card are card under section 223.16, paragraph
purchases from an affiliate of the institution. (c)(4)(ii)(A), of the rule. The member institu-
Extensions of credit to unaffiliated borrowers tion assesses its compliance under paragraph
pursuant to special-purpose credit cards (that is, (c)(4)(iii) of this section on the 15th day of
credit cards that may only be used or are every month (for the preceding 12 calendar
substantially used to buy goods from an affili- months). The credit card qualifies as a general-
ate of the member institution) are subject to the purpose credit card for at least three consecu-
rule. tive months. On June 15, 2008, however, the
The credit card exemption includes several member institution determines that, for the 12-
different methods that are provided for a mem- calendar-month period from June 1, 2007,
ber institution to demonstrate that its credit card through May 31, 2008, 27 percent of the total
meets the 25 percent test. First, if a member value of products and services purchased with
institution has no commercial affiliates (other the card by all cardholders were purchases of
than those permitted for an FHC under section 4 products and services from an affiliate of the
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 institution’s 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-
ber institution would not be obligated to estab- BHC Supervision Manual July 2009
lish systems to verify strict, ongoing compliance Page 31
affiliate of the member institution would asset that would represent a separate covered
become covered transactions at such time. transaction for the IDI upon consummation of
the share transfer. As a result of the transaction,
the mortgage company becomes an operating
subsidiary of the IDI. The transaction is treated
2020.1.13 AN IDI’S ACQUISITION OF as a purchase of the assets of the mortgage
AN AFFILIATE THAT BECOMES AN company by the IDI from an affiliate under
OPERATING SUBSIDIARY paragraph (a) of section 223.31. The IDI ini-
tially must value the transaction at $100,000,
Section 223.31 (a)-(c) of the rule provides the total amount of the liabilities of the mort-
guidance to an IDI that acquires an affiliate. The gage company. Going forward, if the member
first situation is when an IDI directly purchases bank pays off the liabilities, the member bank
or otherwise acquires the affiliate’s assets and must continue to value the covered transaction
assumes the affiliate’s liabilities. In this case, the at $100,000. However, if the member bank sells
transaction is treated as a purchase of assets, and $15,000 of the transferred assets of the mort-
the covered-transaction amount is equal to the gage company or if $15,000 of the transferred
amount of any consideration paid by the IDI for assets amortize, the IDI may value the covered
the affiliate’s assets (if any) plus the amount of transaction at $85,000.
any liabilities assumed by the IDI in the A similar situation is when an IDI acquires an
transaction. affiliate by merger. Because a merger with an
Regulation W provides that the acquisition by affiliate generally results in the IDI’s acquiring
an IDI of a company that was an affiliate of the all the assets of the affiliate and assuming all the
IDI before the acquisition is treated as a pur- liabilities of the affiliate, this transaction is effec-
chase of assets from an affiliate if (1) as a result tively equivalent to the purchase and assump-
of the transaction, the company becomes an tion transaction described in the previous para-
operating subsidiary of the IDI and (2) the com- graph. Accordingly, the merger transaction also
pany has liabilities, or the IDI gives cash or any is treated as a purchase of assets, and the
other consideration in exchange for the securi- covered-transaction amount is equal to the
ties. The rule also provides that these transac- amount of any consideration paid by the IDI for
tions must be valued initially at the sum of the affiliate’s assets (if any) plus the amount of
(1) the total amount of consideration given by any liabilities assumed by the IDI in the
the IDI in exchange for the securities and (2) the transaction.78
total liabilities of the company whose securities The assets and liabilities of an operating sub-
have been acquired by the IDI. In effect, the rule sidiary of an IDI are treated in the rule as
requires IDIs to treat such share donations and assets and liabilities of the IDI itself for pur-
purchases in the same manner as if the IDI had poses of section 23A.79 The rule only imposes
purchased the assets of the transferred company asset-purchase treatment on affiliate share
at a purchase price equal to the liabilities of the transfers when the company whose shares are
transferred company (plus any separate consid- being transferred to the IDI was an affiliate of
eration paid by the IDI for the shares). See the IDI before the transfer. If the transferred
12 C.F.R. 223.31. company was not an affiliate before the trans-
Similarly, when an affiliate donates a control- fer, it would not be appropriate to treat the
ling block of an affiliate’s shares to an IDI, a share transfer as a purchase of assets from an
covered transaction occurs if the affiliate has affiliate. Similarly, the rule only requires asset-
liabilities that the IDI assumes. For example, the purchase treatment for affiliate share transfers
parent holding company of an IDI contributes when the transferred company becomes a sub-
between 25 percent and 100 percent of the vot- sidiary and not an affiliate of the IDI through
ing shares of a mortgage company to the IDI. the transfer.
The parent holding company retains no shares
of the mortgage company. The IDI gives no 78. As noted, section 223.3(dd) of the rule makes explicit
the Board’s view that these merger transactions generally
consideration in exchange for the transferred involve the purchase of assets by a member bank from an
shares. The mortgage company has total assets affiliate.
of $300,000 and total liabilities of $100,000. 79. Because an IDI usually can merge a subsidiary into
The mortgage company’s assets do not include itself, transferring all the shares of an affiliate to an IDI often
is functionally equivalent to a transaction in which the bank
any loans to an affiliate of the IDI or any other directly acquires the assets and assumes the liabilities of the
affiliate. In a direct acquisition of assets and assumption of
BHC Supervision Manual July 2009 liabilities, the covered-transaction amount would be equal to
Page 32 the total amount of liabilities assumed by the IDI.
If an IDI purchases, or receives a donation, of ment of section 23B, and the IDI must notify its
a partial interest in an entity that remains an appropriate federal banking agency and the
affiliate, that transaction is treated as a purchase Board, at or before the time that the target com-
of, or investment in securities issued by an pany becomes an affiliate of the IDI, of its intent
affiliate. This type of transaction is valued ultimately to acquire the target company.
according to its purchase price or carrying value. Regulation W requires that the IDI consum-
(See 12 C.F.R. 223.23.) mate the step transaction immediately to ensure
the quality and fairness of the transaction. To
the extent that the IDI acquires the target com-
2020.1.14 STEP-TRANSACTION pany some time after the company becomes an
EXEMPTION (SECTION 223.31(d) affiliate, the transaction looks less like a single
AND (e)) transaction in which the IDI acquires the target
company and more like two separate transac-
Under section 223.31(d) of the rule, an exemptions, the latter of which involves the IDI acquir-
tion is provided for certain step transactions that ing assets from an affiliate.
are treated as asset purchases under sec- The Board recognized, however, that bank-
tion 223.31(a) when an affiliate owned the trans- ing organizations may need a reasonable
ferred company for a limited period of time. amount of time to address legal, tax, and busi-
Regulation W provides an exemption when a ness issues relating to an acquisition. Regula-
company acquires the stock of an unaffiliated tion W thus permits IDIs to avail themselves of
company and, immediately after consummation the step-transaction exemption if the IDI
of the acquisition, transfers the shares of the acquires the target company within three
acquired company to the holding company’s months after the target company becomes an
subsidiary IDI. For example, a bank holding affiliate so long as the appropriate federal bank-
company acquires 100 percent of the shares of ing agency for the IDI has approved the longer
an unaffiliated leasing company. At that time, time period.
the subsidiary IDI of the holding company noti- The 100 percent ownership requirement (that
fies its appropriate federal banking agency and the IDI must acquire the entire ownership posi-
the Board of its intent to acquire the leasing tion in the target company that its holding com-
company from its holding company. On the day pany acquired) prevents a holding company
after consummation of the acquisition, the hold- from keeping the good assets of the target com-
ing company transfers all of the shares of the pany and transferring the bad assets to the hold-
leasing company to the IDI. No material change ing company’s subsidiary IDI. If a banking
in the business or financial condition of the organization cannot meet the terms of the step-
leasing company occurs between the time of the transaction exemption, the organization may be
holding company’s acquisition and the IDI’s able to satisfy the conditions of the rule’s
acquisition. The leasing company has liabilities. internal-corporate-reorganization exemption or
The leasing company becomes an operating sub- may be able to obtain a case-by-case exemption
sidiary of the IDI at the time of the transfer. This from the Board.
transfer by the holding company to the IDI,
although deemed an asset purchase by the IDI
from an affiliate under paragraph (a) of sec- 2020.1.15 SECTION 23B OF THE
tion 223.31, would qualify for the exemption in FEDERAL RESERVE ACT
paragraph (d) of section 223.31.
The rule exempts these ‘‘step’’ transactions Section 23B of the FRA became law on
under certain conditions. First, the IDI must August 10, 1987, as part of the Competitive
acquire the target company immediately after Equality Banking Act of 1987. This section also
the company became an affiliate (by being regulates transactions with affiliates. Section
acquired by the bank’s holding company, for 23B applies to any covered transaction with an
example). The IDI must acquire the entire affiliate, but excludes banks from the term
ownership position in the target company that ‘‘affiliate’’ as that term is defined in section 23A.
its holding company acquired. Also, there must Regulation W, subpart F, sets forth the princi-
be no material change in the business or finan- pal restrictions of section 23B. These include
cial condition of the target company during the (1) a requirement that most transactions between
time between when the company becomes an an IDI and its affiliates be on terms and circum-
affiliate of the IDI and when the IDI is in receipt
of the company. Finally, the entire transaction BHC Supervision Manual July 2009
must comply with the market-terms require- Page 33
stances that are substantially the same as those 1. An IDI or its subsidiary cannot purchase as
prevailing at the time for comparable transac- fiduciary any securities or other assets from
tions with nonaffiliates; (2) a restriction on an any affiliate unless the purchase is permitted
IDI’s purchase, as fiduciary, of assets from an (1) under the instrument creating the fidu-
affiliate unless certain criteria are met; (3) a ciary relationship, (2) by court order, or
restriction on an IDI’s purchase, during the (3) by law of the jurisdiction creating the
existence of an underwriting syndicate, of any fiduciary relationship.
security if a principal underwriter of the security 2. An IDI or its subsidiary, whether acting as
is an affiliate; and (4) a prohibition on publish- principal or fiduciary, cannot knowingly pur-
ing an advertisement or entering into an agree- chase or acquire, during the existence of any
ment stating that an IDI will be responsible for underwriting or selling syndicate, any secu-
the obligations of its affiliates. For the most part, rity if a principal underwriter of that security
subpart F restates the operative provisions of is an affiliate of the institution. This limita-
section 23B. tion applies unless the purchase or acquisi-
The following transactions with affiliates are tion of the security has been approved before
covered by section 23B: it is initially offered for sale to the public by
a majority of the directors of the institution.
1. Any covered transaction with an affiliate. The purchase should be based on a determi-
2. The sale of securities or other assets to an nation that it is a sound investment for the
affiliate, including assets subject to an agree- institution, irrespective of the fact that an
ment to repurchase. affiliate is a principal underwriter of the
securities.
3. The payment of money or the furnishing of
services to an affiliate under contract, lease,
or otherwise.
4. Any transaction in which an affiliate acts as
2020.1.15.1 Transactions Exempt from
an agent or broker or receives a fee for its
Section 23B of the Federal Reserve Act
services to the institution or to any other The market-terms requirement of section 23B
person. applies to, among other transactions, any ‘‘cov-
5. Any transaction or series of transactions with ered transaction’’ between an IDI and an affili-
a nonaffiliate if an affiliate ate.80 Section 23B(d)(3) makes clear that the
• has a financial interest in the third party term ‘‘covered transaction’’ in section 23B has
or the same meaning as the term ‘‘covered transac-
• is a participant in the transaction or series tion’’ in section 23A, but does not include any
of transactions. transaction that is exempt under section 23A(d).
For example, transactions between sister banks
Any transaction by an IDI or its subsidiary with and IDIs that are part of a chain banking organi-
any person is deemed to be a transaction with an zation are exempt from section 23B;81 Also
affiliate of the institution if any of the proceeds exempt are transactions that are fully secured by
of the transaction are used for the benefit of, or a deposit account or U.S. government obliga-
transferred to, the affiliate. An IDI and its sub- tions, and purchases of assets from an affiliate at
sidiaries may engage in transactions covered by a readily identifiable and publicly available mar-
section 23B of the FRA, but only on terms and ket quotation.82 Consistent with the statute,
under certain circumstances, including credit Regulation W’s section 223.52(a)(1) exempts
standards, that are substantially the same or at from section 23B any transaction that is exempt
least as favorable to the institution as those under section 23A(d).83
prevailing at the time for comparable transac- The rule also excludes from section 23B any
tions with or involving nonaffiliated companies. covered transaction that is exempt from sec-
If comparable transactions do not exist, the tion 23A under section 223.42(i) or (j) (that is,
transaction must be on terms and under circum-
stances, including credit standards, that in good 80. 12 U.S.C. 371c-1(a)(2)(A).
81. Although transactions between banks are exempt from
faith would be offered to or applied to nonfinan- section 23B, the safety-and-soundness provisions of sec-
cial companies. tion 23A(a)(4) apply and generally require that transactions be
Section 23B restricts the following transac- conducted on terms similar to those terms and standards
outlined in section 23B.
tions with affiliates: 82. 12 U.S.C. 371c-1(d)(3).
83. Regulation W will again be subsequently referred to as
BHC Supervision Manual July 2009 the ‘‘rule’’ or by its specified section-numbered discussion of
Page 34 section 23B provisions.
asset purchases by a newly formed IDI and director-approval requirement in this fashion,
transactions approved under the Bank Merger and there is no indication that Congress in the
Act). The Board excluded from section 23B this GLB Act intended to alter the procedures that a
additional set of transactions because, in each member bank could use to obtain the requisite
case, the appropriate federal banking agency for director approval. The rule codifies staff’s pre-
the IDI involved in the transaction should ensure existing approach to the director-approval
that the terms of the transaction are not unfavor- requirement.
able to the IDI.
2020.1.15.3 Definition of Affiliate under

2020.1.15.2 Purchases of Securities for Section 23B
Which an Affiliate Is the Principal
Underwriter Section 23B states that the term ‘‘affiliate’’
under section 23B has the meaning given to
The GLB Act amended section 23B to permit an such terms in section 23A, except that the term
IDI to purchase securities during an underwrit- ‘‘affiliate’’ under section 23B does not include a
ing conducted by an affiliate if the following ‘‘bank,’’ as defined in section 23A. In the case
two conditions are met. First, a majority of the of the sister-bank exemption, the rule’s sec-
directors of the IDI (with no distinction drawn tion 223.2(c) clarifies that the only companies
between inside and outside directors) must that qualify for the ‘‘bank’’ exception to sec-
approve the securities purchase before the secu- tion 23B’s definition of affiliate are IDIs.
rities are initially offered to the public. Second,
such approval must be based on a determination
that the purchase would be a sound investment 2020.1.15.4 Advertising and Guarantee
for the IDI regardless of the fact that an affiliate Restriction
of the IDI is a principal underwriter of the
securities.84 Section 223.53(b) includes this In section 23B(c), the ‘‘advertising restriction’’
standard and clarifies that if an IDI proposes to prohibits an IDI from publishing any advertise-
make such a securities purchase in a fiduciary ment or entering into any agreement stating or
capacity, then the directors of the IDI must base suggesting that the IDI shall in any way be
their approval on a determination that the pur- responsible for the obligations of its affiliates.
chase is a sound investment for the person on Regulation W clarifies this restriction to permit
whose behalf the IDI is acting as fiduciary. such guarantees and similar transactions if the
An IDI may satisfy this director-approval transaction satisfies the quantitative and collat-
requirement by obtaining specific prior director eral restrictions of section 23A. The rule also
approval of each securities acquisition other- clarifies that section 23B(c) does not prohibit an
wise prohibited by section 23B(b)(1)(B). The IDI from making reference to such a guarantee,
rule clarifies, however, that an IDI also satisfies acceptance, or letter of credit in a prospectus or
this director-approval requirement if a majority other disclosure document, for example, if oth-
of the IDI’s directors approve appropriate stan- erwise required by law.
dards for the IDI’s acquisition of securities oth-
erwise prohibited by section 23B(b)(1)(B), and
each such acquisition meets the standards 2020.1.16 INSPECTION OBJECTIVES
adopted by the directors. In addition, a majority
of the IDI’s directors must periodically review 1. To analyze and assess the financial impact
such acquisitions to ensure that they meet the of transactions (including loans and pur-
standards and must periodically review the chases of assets) between the IDIs and their
standards to ensure they meet the ‘‘sound subsidiaries and all affiliates.
investment’’ criterion of section 23B(b)(2). The 2. To ascertain if all:
appropriate period of time between reviews a. credit transactions are properly secured;
would vary depending on the scope and nature and
of the IDI’s program, but such reviews should b. covered transactions are consistent with
be conducted by the directors at least annually. the quantitative limits of section 23A.
Before the passage of the GLB Act, Board staff 3. To determine if an IDI has engaged in a
informally allowed IDIs, based on the legisla- transaction with a third party when the pro-
tive history of section 23B, to meet the
84. See 12 U.S.C. 371c-1(b)(2). Page 35
ceeds are used for the benefit of, or trans- 12. To determine if the subsidiary IDI and its
ferred to, an affiliate. subsidiaries have conducted transactions
4. To determine if an IDI has procedures for with their parent holding company or any
allowing intraday credit derivatives. other company affiliated in the holding
5. 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
6. To determine if transactions between a sub-
sidiary IDI and its affiliates in the holding 1. During the pre-inspection, perform the fol-
company are on terms and conditions and lowing activities:
under circumstances, including credit stan- a. Review examination reports of sub-
dards, are consistent with safe and sound sidiary IDIs for comments on loans to
banking practices and whether the terms affiliates, intercompany transactions,
and conditions of the transactions are the other transactions with affiliates, and
same as those that would be offered or violations of the restrictions of sec-
applied to nonaffiliated companies. tions 23A or 23B of the FRA, or Regula-
7. To determine whether a subsidiary IDI or tion W.
its subsidiary b. Review the most current FR Y-8 (The
a. has purchased low-quality assets or Bank Holding Company Report of
b. has purchased, as fiduciary, any securi- Insured Depository Institutions’ Section
ties or other assets from an affiliate in the 23A Transactions with Affiliates).
holding company. 2. In the officer’s questionnaire, request a list
8. To determine whether a subsidiary IDI, or of subsidiary IDIs and their subsidiaries’
any subsidiary or affiliate of the IDI, has transactions with affiliates since the previ-
published any advertisement or has entered ous inspection, including the amounts,
into any agreement that states or suggests types, and any collateral, consisting of—
that it will, in any way, be responsible for a. loans or extensions of credit to an affili-
the obligations of affiliates. ate, and purchases of extensions of credit
9. To determine if securities were purchased from an affiliate;
or acquired by the subsidiary IDI or its b. a purchase or sale of an investment in
subsidiaries from an underwriting or selling securities issued by, or sold to, the affili-
syndicate affiliated with the IDI and, if so, if ate, or purchase or sale of other assets,
the majority of outside directors of the IDI including assets subject to an agreement
approved the purchase or acquisition of to repurchase;
securities before they were offered for sale c. the acceptance of securities issued by the
to the public. affiliate as collateral security for a loan
10. To confirm that the subsidiary IDI or its or extension of credit;
subsidiary has not purchased as fiduciary d. the issuance of a guarantee, acceptance,
any securities or other assets from a non- or letter of credit, including an endorse-
bank affiliate in the holding company ment or standby letter of credit on behalf
unless the purchase was permitted in of an affiliate;
accordance with the instrument creating e. the payment of money or the furnishing
the fiduciary relationship, by court order, of services to an affiliate under contract,
or by the law governing the fiduciary lease, or otherwise;
relationship. f. transactions in which an affiliate acts as
11. To ascertain if any subsidiary IDI (or its agent or broker or receives a fee for its
subsidiary) had knowingly purchased or services to the bank or to any other
acquired any security from an affiliate in person;
which the principal underwriter of that g. any transaction or series of transactions
security was a nonbank affiliate within the with a third party if—
holding company organization. (1) the affiliate has a financial interest in
the third party or
BHC Supervision Manual July 2009 (2) the affiliate is a participant in such
Page 36 transactions; and
h. Any transaction by a subsidiary bank or 12 C.F.R. 223.42(k) provided in response

its subsidiary with any person, if the to the officer’s questionnaire (item 2).
proceeds of that transaction are used for Determine if
the benefit of, or transferred to, the (1) extensions of credit, and purchases
affiliate. of extensions of credit, are supported
3. During the BHC’s inspection, perform the by independent credit evaluations
following activities: and if advance loan commitments
a. Review the bank holding company’s are provided before the affiliates
policies and procedures regarding inter- make loans;
company transactions of subsidiary (2) no blank advance purchase commit-
banks. ments exist to purchase loans; and
b. Determine if the substantive transactions (3) the purchases meet the quantitative
of the holding company organization restrictions of the exemption.
comply with the restrictions on transac- 4. Give additional attention to the following
tions with affiliates in sections 23A and problems involving the BHC and its
23B of the FRA and Regulation W. subsidiaries:
c. Verify that covered transactions count a. The subsidiary IDI would not have made
against Regulation W’s limits and are the loan or would not have made the
collateralized when required. loan with such favorable terms and con-
(1) Ensure that covered transactions are ditions, or engaged in any other covered
properly valued and adequately transaction, except for the parent holding
collateralized; company’s insistence due to the affiliate
(2) Review collateral documentation to relationship.
ensure that a lien is adequately per- b. The IDI’s condition is weakened due to
fected and prioritized. the extension of credit or the nature of
(3) Review all related documentation, the transaction with the affiliate.
terms, conditions, and circumstances c. The affiliate has not provided adequate
for each transaction, including any qualifying collateral to support the loan
resolutions for securities purchased or extension of credit provided by the
(or established standards for securi- subsidiary IDI.
ties purchased from affiliates). d. The IDI does not have a perfected secu-
(4) Determine the purpose and use of rity interest in the collateral.
the transaction’s proceeds. e. The loan, extension of credit, or transac-
d. Review all outstanding guarantees, tion with an affiliate is not in compliance
endorsements, or pledge agreements by with the limits and restrictions in sec-
the bank to support the affiliates’ tions 23A or 23B of the FRA or Regula-
borrowings. tion W.
e. Review, on a test-sample basis, adver- f. Purchases of low-quality assets by a sub-
tisements and written agreements to sidiary bank or its subsidiaries from an
ascertain whether the bank or any sub- affiliate, unless previously exempted by
sidiary or affiliate of the bank has stated the Board’s Regulation W, Board order,
or suggested that it shall be responsible or unless the IDI subsidiary or subsidiary
for the obligations of any affiliates in the affiliate, pursuant to an independent
holding company organization. credit evaluation, had committed itself to
f. If the BHC engages in derivative trans- purchase the low-quality assets before
actions with affiliates, review the BHC’s the time such asset was acquired by the
policies and procedures to determine if affiliate.
credit limits, collateral restrictions, and g. During the existence of any underwriting
other limitations (each affiliate and all or selling syndicate, a subsidiary IDI or
affiliates combined) have been imposed its subsidiary has purchased or acquired
on interaffiliate derivative transaction a security from an IDI affiliate or bank
(IDT) exposures to affiliates. holding company affiliate, including an
(1) Determine if the limits are similar to affiliated broker-dealer, and the principal
those imposed on nonaffiliated underwriter of that security is an affiliate
counterparties. of the IDI.
g. Review the listed transactions of the
BHC or its subsidiary with the affiliates BHC Supervision Manual July 2009
that the IDI claims are exempt under Page 37
h. The purchase or acquisition of securities exposures to affiliates are at least as strict as

(1) was not approved by a majority of those it imposes on unaffiliated companies.
the outside board of directors before the 9. Determine if the IDI has policies and proce-
IDI’s securities were offered for sale to dures to monitor and control its intraday
the public and (2) was not, in the absence credit exposure to each affiliate and to all
of comparable transactions, on terms and affiliates in the aggregate.
under circumstances, including credit 10. Determine if the IDI’s intraday extensions
standards, that in good faith would have of credit to affiliates are on comparable
been offered to, or would have applied market terms and if they comply with sec-
to, nonaffiliated companies. tion 23B of the FRA.
i. The existence of advertisements or 11. Review all other transactions that the hold-
agreements that state or suggest that the ing company organization has engaged in
IDI, its subsidiaries, or affiliate will be with its affiliated IDIs and their subsidi-
responsible for the obligations of its aries, including lease arrangements, to
affiliates. determine whether they are subject to the
5. Review any checking accounts and IDI restrictions in sections 23A and 23B and
statements to check for overdrafts the par- Regulation W, and, if so, whether they are
ent company or any of its nonbank subsidi- in compliance.
aries may have with a subsidiary IDI. 12. Discuss the findings with appropriate senior
6. Review the accounts payable to the sub- management and, if the findings are signifi-
sidiary IDI and other accounts payable cant, the board of directors.
accounts for servicers, contractors, lessors, 13. Determine management’s corrective actions
and other affiliates to determine if they regarding any comments raised by the
arose as the equivalent of an extension of bank’s primary regulator in an examination
credit, purchase of securities or other assets, report.
or as a liability to third parties. Ascertain a. If violations are disclosed in a subsidiary
whether those transactions were listed in bank’s examination report or during an
response to the officer’s questionnaire and inspection of the holding company, the
whether the transactions were in examiner may criticize management on
accordance with the restrictions in sec- the ‘‘Examiner’s Comments and Matters
tions 23A and 23B of the FRA and Regula- Requiring Special Board Attention’’
tion W. page or section of the inspection report
7. Review the accounts receivable from the for causing the bank to be in violation or
subsidiary IDI and other accounts receiv- for engaging in unsafe and unsound
able of other affiliates for sales of securi- practices.
ties or other assets and for the payment of b. If loans to or transactions with affiliates
money or the furnishing of services. within the holding company organiza-
Ascertain whether those transactions were tion appear to adversely affect a subsidi-
reported in response to an officer’s ary bank, request management’s assess-
questionnaire and whether they are in ment of such effects and its rationale for
accordance with section 23A and 23B of the transactions. Use of the ‘‘Examiner’s
the FRA’s and Regulation W’s restrictions Comments and Matters Requiring Spe-
placed on transactions with affiliates. cial Board Attention’’ report page or sec-
8. Ascertain if the IDI’s credit limits, collat- tion may be appropriate.
eral requirements, and monitoring of its

Page 38
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 section 23A
of banks
Limitations on amount— 371c, FRA 223.14(b)(i)(C)

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

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

tions with affiliates section 23B
Market terms 223.33

requirement—derivative
transactions with affiliates
Intraday extensions of 223.42(l)

credit by insured deposi-
tory institutions to their
affiliates
Exemptions-loans and 223.16(c)(3)

extensions of credit by
member bank to a third
party
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 39
(Loan Participations) Section 2020.2
WHAT’S 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 bank’s 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 holder’s 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 bank’s 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 BHC’s or as is imposed by the bank’s appropriate Fed-
bank’s 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 BHC’s 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 bank’s 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 bank’s
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 company’s 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 bank’s 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 officer’s questionnaire to the holding
1. the original extension of credit was not a company, request the BHC’s 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 bank’s 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 bank’s 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 arm’s-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-
ny’s 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.
company’s 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 BHC’s loan participation b. any adverse findings on intercompany
policy. participations.
2. To assess the impact of a subsidiary bank’s 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 bank’s 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-
iary’s examination report, comment on their
BHC Supervision Manual July 2010 current status and the BHC’s 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) 3–1161
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 bank’s 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 bank’s 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 bank’s capital and Section 23A of the Federal Reserve Act.
surplus. In addition, all transactions must be
conducted on market terms.
A bank’s 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 bank’s purchase of the affiliate’s 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 officer’s 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 bank’s deferred taxes, together with an a. Whether the transaction required and
equivalent amount of cash or earning assets, to received the approval of the bank’s primary
the parent. In such a transaction, a subsidiary regulator; and
bank’s 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 bank’s 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 arm’s-length transaction.
discussion on transfers of a bank’s 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 bank’s 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 BHC’s 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 bank’s 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 bank’s
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-
bank’s 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 bank’s 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 bank’s 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.
10–K reports filed with the SEC, which may 5. Review the subsidiary bank’s historical
describe compensating balance agreements. level of correspondent balances to assess trends.
FR Y–8 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 bank’s 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
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 in-
pay dividends to its shareholders and to meet its stitutions that are experiencing earnings
debt service requirements and other obligations. weaknesses, 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,
subsidiary’s level of capital and its ability to • The payment of dividends from unusual or
meet future capital needs through earnings re- nonrecurring gains, such as the sale of prop-
tention. erty or other assets.
Although there are no specific regulations
restricting dividend payments by bank holding It is the Federal Reserve’s view that an orga-
companies other than State corporate laws, su- nization experiencing earnings weaknesses or
pervisory concern focuses on the holding com- other financial pressures should not maintain a
pany’s 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 tion’s 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- tion’s 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 company’s 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 tions and to the safety and stability of the bank-
funds to be paid by the bank to the parent is ing system. A major determinant of a bank’s or
through dividends. This principle applies, in bank holding company’s capital adequacy is the
general, to bank payments of funds to service strength of its earnings and the extent to which
holding company debt, even when the debt was its earnings are retained and added to capital or
initially incurred to raise equity capital for the paid out to shareholders in the form of cash
subsidiary bank. It is not considered an appro- dividends.
priate banking practice for the subsidiary bank
to pay management fees for the purpose of BHC Supervision Manual December 1992
servicing holding company debt. Funds for ser- Page 1
Intercompany Transactions (Dividends) 2020.5
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 organization’s net earnings to additional borrowings or other arrangements
its shareholders. However, the payment of cash that may undermine the bank holding compa-
dividends that are not fully covered by earnings, ny’s 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
organization’s capital at a time when circum- is unable to pay dividends to its parent
stances may indicate instead the need to company—as a consequence of statutory limi-
strengthen capital and concentrate financial tations, intervention by the primary supervisor,
resources on resolving the organization’s or noncompliance with regulatory capital
problems. requirements—the 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 organization’s 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 organization’s capi- cial practice. Boards of directors should contin-
tal needs, asset quality, and overall financial ually 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 organization’s 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 im- formulating corrective action programs for
prove, 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 ade- that are otherwise subject to unusual financial
quate 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 Board’s 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 organization’s 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 de- bership in the Federal Reserve, all insured com-
rived from such transactions could be better mercial banks are subject to certain legal restric-
employed to strengthen the organization’s 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
eral Reserve’s supervision and regulation of statements discussed, which apply to dividend
bank holding companies is that bank holding payments. State corporate laws would apply.
companies should serve as a source of manage- One objective of the inspection process is to
rial and financial strength to their subsidiary check for compliance with these laws and to
banks. The Board believes, therefore, that a follow-up on any violations.
bank holding company should not maintain a In some cases dividends which comply with
level of cash dividends to its shareholders that the regulations still may not be in the best
interest of the bank. It is the examiner’s respon-
BHC Supervision Manual December 1992 sibility to assess the reasonableness of dividend
Page 2 payments in relation to each subsidiary’s capital
needs. Evaluation of the holding company’s div- augment capital through earnings is also impor-
idend policy and payment requires a review at tant. If a bank, nonbank or holding company has
both the parent company and the consolidated a consistently strong earnings record and its
levels. On a consolidated basis the holding com- capital position is healthy, a higher dividend
pany’s capital level in relation to the quantity payout may be acceptable than would be other-
and quality of total assets, earnings history and wise. In analyzing the strength of earnings both
potential, and growth rates are important in the quantity and quality must be considered. The
assessment of a reasonable dividend payout. At actual quality of earnings and earnings potential
the parent level, the method of funding divi- are related to operating income rather than ex-
dends should be reviewed. For example, a well traordinary items, significant capital or securi-
capitalized corporation with strong earnings ties gains, or substantial increases resulting from
might pay dividends which could be considered tax considerations.
unreasonable if the organization were in a 3. Review the funding of dividends paid by
strained liquidity position. the holding company. Analyze the parent’s cash
flow and income statements in accordance with
section 4010.0 of this manual. Discuss any inap-
2020.5.3 INSPECTION PROCEDURES propriate funding with management and com-
ment on, based on their severity, either on the
1. Review dividend payments by subsidiaries ‘‘Cash Flow Statement (Parent),’’ or the ‘‘Analy-
and the parent company. Check for compliance sis of Financial Factors’’ and the ‘‘Examiner’s
with appropriate statutes and the Board’s No- Comments’’ pages.
vember 14, 1985 policy statement on the Pay- An analysis of the parent company’s cash
ment of Cash Dividends. Discuss violations with flow statement supplemented by the income
management and comment on the ‘‘Examiner’s statement will identify the source of cash for
Comments’’ page. dividend payments. The parent company has
This step will often require a review of net cash inflow from various sources including: div-
earnings and changes in the capital accounts in idends from subsidiaries, income from activities
the past years, as legal restrictions on dividends conducted for its own account, interest income
often apply to cumulative income for several on advances to subsidiaries, management and
years rather than just the year the dividend is service fees, borrowings, and tax savings result-
actually paid. For this reason detailed working ing from filing a consolidated tax return. Divi-
papers are important, as these can help to avoid dends should be internally funded from divi-
duplications of effort at future inspections. In dends paid by the subsidiaries, the parent
some situations the regulations provide that div- company’s earnings from activities for its own
idends may be paid in excess of current year’s account or from interest income on advances to
earnings. If prior approval from the bank’s pri- subsidiaries. Should the analysis of the cash
mary regulator is necessary, verify that it has flow statement indicate that dividends paid by
been obtained. Any violations of dividend stat- the parent exceed cash inflow from these
utes should be discussed with management and sources, further attention to the area is required
cited in the ‘‘Examiner’s Comments’’ page of to determine the actual underlying source of
the inspection report. dividend funding. As discussed in the section on
2. Analyze dividend payouts of subsidiaries management and service fees, these are properly
and the parent in terms of capital adequacy, assessed at market value or cost of services
earnings and earnings potential. rendered. They are not to be charged simply to
Discuss excessive dividend payouts at any divert income from subsidiaries in order to pay
level with management and comment on the dividends. Borrowing to fund dividends is fun-
‘‘Examiner’s Comments’’ page of the inspection damentally an unsound practice.
report. In assessing the reasonableness of divi- When dividends paid by the holding com-
dend payments by subsidiaries and the holding pany are funded by the bank subsidiary, it is
company, the organization’s capital adequacy possible to control indirectly the holding compa-
and future capital needs must be judged with the ny’s dividend payout level when it is deter-
following in mind: the volume of total assets; mined to be detrimental to the bank subsidiary.
asset quality (the percentage of weighted classi- It is important to remember that the primary
fied assets to gross capital could be used as an responsibility of bank regulators is the promo-
indicator of quality); asset mix and liquidity; tion of safe and sound banking operations. Other
asset growth rates and projections; and plans for
expansion and development of new areas. The BHC Supervision Manual December 1992
subsidiary’s or the holding company’s ability to Page 3
than the mentioned policy statement there are dend payments at the subsidiary level or parent
no specific federal laws restricting dividends level are not reasonable, are not in the best
paid by bank holding companies; however, the interest of the organization, or are not funded in
System’s cease and desist authority over bank a proper manner, discussion with management
holding companies does afford the ability to and a close look at its philosophy are essential.
curb excessive dividend payouts. Remarks on the matter should appear on the
Whenever the examiner determines that divi- ‘‘Examiner’s Comments’’ page of the report.
Dividend limits for national 5199(b)

banks R.S.A.
Dividend limits 5204

R.S.A.
Dividend limits for State Section

member banks 9, F.R.
Act
Capital limitations and 208.19 3–400.81

earnings limitations
on the payment of
dividends by state
member banks
Board policy statement on 4–855 1980 FRB 320

assessment of financial
factors, one bank holding
companies (para. 4
dividend restrictions)
Board policy statement on 4–877 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 company’s 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 company’s investor/shareholder relations,
regulatory reporting requirements, acquisitions,
Examiners should review the fees charged by formations, applications, board of directors, and
a holding company’s 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 parent’s might reasonably be expected to have a severe
financial needs if those needs are unrelated to impact given the bank’s 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 bank’s 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 arm’s 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
year’s fees for services to be rendered through- holding company’s 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 subsidiary’s 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 arm’s-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 company’s policy, valua-
order to suit the parent’s 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 management’s 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 company’s 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 company’s 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 management’s 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 company’s 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 4–876

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 company’s 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
company’s 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 83–24 (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 institution’s 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 bank’s capital and surplus.
gotiated because of a borrower’s 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 bank’s 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 Reserve’s 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,
benefit—usually 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
eficiary—the 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 pany’s 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 Currency’s
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 FDIC’s
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 company’s 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-
ny’s 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 parent’s 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 BHC’s 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
bank’s 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 Rights—Retention 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 company’s 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 company’s 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 company’s 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 Rights—Retention 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 seller’s 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 company’s
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 Board’s or Reserve Bank’s ap-
proval, the Board or Reserve Bank may approve 1. If necessary, examine the subsidiary
the application subject to the condition that the bank’s 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 activity’s 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 bank’s 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 company’s
1. To determine when the company acquired grandfather privileges with the Reserve Bank’s
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,
assets—charitable trust Vermont;
involved September
13, 1977
Companies going out of Senate Report
business are not going 90–1084,
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
acquisition—‘‘successor’’
Acquisition of assets 225.132
2030.0.10 APPENDIX 1—EXPANSION 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 Board’s 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
WHAT’S NEW IN THIS REVISED In addition to the above supervisory consider-
SECTION ations, the Sarbanes-Oxley Act of 2002 (Pub. L.
No. 107-204) (the act) imposed certain insider
This section was updated with minor revisions lending restrictions on public companies,
that resulted from the Financial Services Relief including BHCs that are public companies. A
Act of 2006 (Relief Act) and the Board’s approval BHC generally is considered a public company
of a final amendment of Regulation O on May 25, for these purposes if it has a class of securities
2007 (effective July 2, 2007). (See 72 Fed. Reg. registered under section 12 of the Securities
30,470, June 1, 2007.) The Relief Act eliminated Exchange Act of 1934 (the 1934 act) or is
certain statutory reporting and disclosure required to file reports with the Securities and
requirements pertaining to insider lending by Exchange Commission (SEC) under section 15
federally insured financial institutions. Sections of the 1934 act. The Sarbanes-Oxley Act1 pro-
215.9, 215.10, and subpart B (sections 215.20 hibits a publicly owned BHC (public BHC) and
through 215.23) of Regulation O were deleted its subsidiaries from extending credit, or arrang-
also as a result of the changes. (See 12 U.S.C. ing for another entity to extend credit, in the
375a and 375b, 12 U.S.C. 1972(2), and 12 C.F.R. form of a personal loan to any director or execu-
215.) 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 Board’s Regulation
a BHC official or a BHC official’s 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 bank’s 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 credit (1) is extended in the ordinary course of
nonbank subsidiary to a BHC official or related the company’s consumer credit business, (2) is a
interest to ensure that the terms of the credit, kind of credit generally made available to the
particularly interest-rate and collateral terms, public, and (3) is made on market terms or on
are not preferential and that the credit does not terms that are no more favorable than those
involve more than a normal risk of repayment. offered to the general public. 2a
An extension of credit by a BHC or nonbank
subsidiary may be considered abusive or self-
1. See 15 U.S.C. 78m (section 402 of the act).
serving if its terms are unfavorable to the lender, 2. The act does not restrict lending by a subsidiary of a
or if the credit would not have been extended on public BHC to the subsidiary’s own directors and executive
the same terms absent the official relationship; officers, so long as these persons are not also directors or
that is, it would be improbable that each party to executive officers of the public BHC.
2a. A registered broker-dealer that is a public company, or
the credit would have entered into the credit a subsidiary of a public company, also is not prohibited from
transaction under the same terms if the relation- providing margin credit to its employees to buy, trade, or
ship did not exist. When a transaction appears carry securities if the credit is made in accordance with the
questionable, a complete inquiry into the facts
and circumstances should be undertaken so that BHC Supervision Manual July 2007
a legal determination can be obtained. Page 1
Extensions of Credit to BHC Officials 2050.0
2050.0.2 TRANSACTIONS official who normally places a very high billing

INVOLVING OTHER PROPERTY value on time provided, the benefits to the BHC
OR SERVICES must be assessed in order to form a basis for
determining a fair price. The BHC official may
Other transactions involving BHC officials, their be a highly regarded professional whose time
related interests, and the BHC and nonbank and services have great value to the organiza-
subsidiary that should be reviewed by the exam- tion. However, when the BHC requires routine
iner include the— clerical services, officials should not charge the
BHC a professional-level rate for such services.
1. purchase of assets or services from the BHC Under these or similar circumstances, the BHC
or nonbank subsidiary, particularly if at a would be considered imprudent in paying such
discount or on preferential terms; rates and could be subject to critical comment.
2. sale of assets or services to the BHC
or nonbank subsidiary, particularly if at a
premium; 2050.0.3 REGULATION O
3. lease of property to or from the BHC or
nonbank subsidiary; and For ease of reference, certain Regulation O defi-
4. use of BHC or nonbank subsidiary property nitions and limitations, as revised by the Fed-
or personnel by a BHC official or related eral Deposit Insurance Corporation Improve-
interest. ment Act of 1991 (FDICIA), are presented here,
some in abbreviated form. A thorough review of
As with loans and other extensions of credit the entire regulation (found at FRRS 3–960),
to BHC officials on preferential terms, abusive and the Board’s press releases pertaining to
or self-serving insider transactions involving Regulation O, is necessary for a complete
other property or services deprive the BHC or
understanding of the regulation. (Note that sec-
nonbank subsidiary of higher returns or gains
tion 108 of the Financial Institutions Regulatory
that may have been achieved had the same
transaction been at a fair market price. A fair Act of 1978 amended section 18(j) of the Fed-
market price would be that price charged or eral Deposit Insurance Act to make section
received from an unaffiliated party. 22(h) of the Federal Reserve Act applicable to
A fair market price is often difficult to deter- nonmember insured banks.)
mine because the assets or services involved Purpose of Regulation O. Regulation O gov-
may be unique to a given situation and individu- erns any extension of credit by a member bank
als. In general, the fair market price of even and its subsidiaries (based on amendments con-
unique assets or services can be approximated tained in FDICIA, Regulation O also applies to
by the cost of the assets or services to the party nonmember insured depository institutions) to
selling or furnishing them, if appropriate. The an executive officer, director, or principal share-
value of services or properties provided by a holder of (1) the member bank, (2) a bank
BHC or nonbank subsidiary should be estab- holding company of which the member bank is
lished and justified either by policy or on a a subsidiary, and (3) any other subsidiary of that
case-by-case basis, and appropriate documenta- bank holding company. It also applies to any
tion should be available to the examiner. extension of credit by a member bank to (1) a
Services provided by a BHC official or a company controlled by such a person and (2) a
related interest to a BHC or nonbank subsidiary, political or campaign committee that benefits or
while not unusual, may be most difficult to is controlled by such a person.
value. In part because of the problem of valua-
Supervision of BHCs and their nonbank sub-
tion, this type of transaction is among the most
sidiaries. Regulation O deals exclusively with
susceptible to abuse. The cost of providing ser-
vices is frequently derived by placing value on extensions of credit by banks and their subsid-
the time of the individuals providing the ser- iaries, not extensions of credit by BHCs and
vices. When services are provided by a BHC their nonbank subsidiaries. However, because
the regulations curtail or eliminate abusive
transactions, they can be used as a guide or
margin rules; is not made to purchase stock of the broker- model in providing standards for the supervi-
dealer; and complies with the requirements set forth in (1),
(2), and (3) above.
sory review of extensions of credit by BHCs
and nonbank subsidiaries. Although a direct
BHC Supervision Manual July 2007 extension of credit by a BHC could not be
Page 2 determined to be a violation of Regulation O, if
the credit fails to meet the requirements that interests (section 215.4(c)). Loans to directors
Regulation O establishes for banks, it may be (and their related interests) are subject to the
possible to conclude that the BHC is engaging same lending limit that is applicable to execu-
in either an unsafe or unsound practice that tive officers and principal shareholders (and
exposes the entire banking organization to their related interests).
undue risk and exposure to loss. Regulation O 3. Credit standards (section 215.4(a)). When
limits credit extensions by a bank to officials of lending to an insider 2c a bank must follow credit
that bank and their related interests; therefore, underwriting procedures that are as stringent as
examiners should be especially alert to credit those applicable to comparable transactions by
extensions from BHCs and nonbank subsidiar- the bank with persons outside the bank.
ies. If credit extensions appear to circumvent the 4. Definition of ‘‘principal shareholder’’ (sec-
intent of Regulation O, they should be identified tion 215.2(m)(1)). The definition of principal
and discussed with management and noted in shareholder was tightened for banks located in
the inspection report for follow-up review and small communities. The previously existing
possible formal corrective action by regulatory 10 percent limitation was made applica-ble to
authorities. all banks, regardless of the size of the communi-
ties 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
On April 22, 1992, the Board adopted amend- from a subsidiary of a member bank is subject
ments to Regulation O, effective May 18, 1992, to the same insider restrictions as an extension
to implement the changes required by section of credit from a member bank itself.
6. Coverage of all companies that own banks
306 of FDICIA. Section 306 amended section
(section 215.2(b)). All companies that own
22(h) of the Federal Reserve Act and replaced
banks became subject to Regulation O, regard-
the language of section 22(h) with the provi-
less of whether they are technically bank hold-
sions of the Board’s Regulation O. Section 306
ing companies.
also made several substantive modifications to 7. Prohibition on knowingly receiving unau-
section 22(h) that required revisions to Regula- thorized extensions of credit (section 215.6).
tion O. These changes are outlined in the Insiders are prohibited from knowingly receiv-
Board’s press release and Federal Register ing (or permitting their related interests to
notice of May 28, 1992 (57 Fed. Reg. 22,417). receive) any extension of credit not authorized
The following are some of the more signifi- by section 22(h) of the Federal Reserve Act.
cant changes that were made effective May 18, 8. Reporting requirement for certain credit
1992: 2b (section 215.12). Executive officers and direc-
1. Aggregate lending limit (section 215.4(d)). tors of member banks that do not have publicly
The aggregate limit on the total amount that a traded stock are required to report annually to
bank can lend to its insiders and their related their institutions the outstanding amount of
interests as a class was changed. In general, this
amount is equal to the bank’s unimpaired capi- 2c. The term insider refers to an executive officer, director,
tal and unimpaired surplus. The Board also or principal shareholder, and includes any related interest of
decided as a one-year interim measure to permit such a person.
3. The Board amended the definition of principal share-
banks with deposits under $100 million to adopt holder of a member bank, effective December 17, 1992, so
a higher limit, not to exceed 200 percent of the that it does not include a company of which a member bank is
bank’s unimpaired capital and unimpaired sur- a subsidiary. This amendment excludes from Regulation O
loans to a company that owns, controls, or exercises a control-
plus. (This interim period was extended twice ling influence over a member bank, as those relationships are
by the Board, extending the higher limit through defined in section 2(d) of the Bank Holding Company Act, as
February 18, 1994, when the higher limit well as the related interests of such a parent bank holding
became permanent. The board of directors must company. The definition of principal shareholder for pur-
poses of reporting obligations under section 215.11 of Regula-
provide an annual resolution authorizing the use tion O was not changed as a result of the Housing and
of this higher limit. Other conditions also apply.) Community Development Act of 1992 because those portions
2. Lending limits for directors and related of Regulation O implement provisions of law in addition to
section 22(h) of the Federal Reserve Act.
2b. The Regulation O cites are to the February 18, 1994, BHC Supervision Manual July 2007
amendment. Page 3
any credit secured by shares of the insider’s owned and used by the executive officer as a
institution. residence after the loan is made. The Board’s
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 regulation’s 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 rule’s primary provisions. cial loans, one of two acceptable methods is
1. Aggregate lending limit—exception 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 bank’s 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’’
ment or agency of the United States; or found in section 23A. However, the definition of
c. a segregated deposit account with the extension of credit in section 22(h) is no longer
lending bank. tied to section 23A. The Board has therefore
An exception is also made for loans arising revised the tangible-economic-benefit rule to
from the discount of installment consumer paper clarify that it does not reach certain transactions
by an insider with full or partial recourse that may benefit an insider. The Board explicitly
endorsement or guarantee by the insider, if the provided that the rule does not apply to an
maker of the paper is not an insider and the arm’s-length extension of credit by a bank to a
loan was made relying primarily on the maker third party where the proceeds of the credit are
and this is properly documented. Such loans used to finance the bona fide acquisition of
continue to be subject to the prohibitions against property, goods, or services from an insider or
preferential lending. an insider’s related interest.
3. Including closing costs in the refinancing
of home mortgage loans (section 215.5(c)(2)).
Section 22(g) of the Federal Reserve Act allows 2050.0.3.2 Definitions in Regulation O
a bank to make a loan to its executive officer, (abbreviated listing)
without restrictions on the amount, if the loan is
secured by a first lien on a dwelling that is Note: Regulation O definitions, prohibitions,
exceptions, and exemptions are particularly
BHC Supervision Manual July 2007 detailed and complex. Therefore, inspection staff
Page 4 should consult with Reserve Bank or Board
supervisory or legal staff before discussing with director is not considered a director if the advi-
management or presenting in an inspection sory director (1) is not elected by the sharehold-
report any BHC inspection findings that rely ers of the bank or company, (2) is not authorized
upon Regulation O. to vote on matters before the board of directors,
(a) ‘‘Affiliate’’ means any company of which and (3) provides solely general policy advice to
a member bank is a subsidiary or any other the board of directors.
subsidiary of that company. (e)(1) ‘‘Executive officer’’ of a company or
(b) ‘‘Company’’ means any corporation, part- bank means a person who participates or has
nership, trust (business or otherwise), associa- authority to participate (other than in the capac-
tion, joint venture, pool syndicate, sole propri- ity of a director) in major policymaking func-
etorship, unincorporated organization, or any tions of the company or bank, whether or not
other form of business entity. The term, how- the officer has an official title; the title desig-
ever, does not include (1) an insured bank (as nates the officer an assistant; or the officer is
defined in 12 U.S.C. 1813) or (2) a corporation serving without salary or other compensation.4
the majority of the shares of which are owned The chairman of the board, the president, every
by the United States or by any state. vice president, the cashier, the secretary, and the
(c)(1) ‘‘Control of a company or bank’’ treasurer of a company or bank are considered
means that a person directly or indirectly, or executive officers, unless the officer is excluded,
acting through or in concert with one or more by resolution of the board of directors or by the
persons (i) owns, controls, or has the power to bylaws of the bank or company, from participa-
vote 25 percent or more of any class of voting tion (other than in the capacity of a director) in
securities of the company or bank; (ii) controls major policymaking functions of the bank or
in any manner the election of a majority of the company, and the officer does not actually par-
directors of the company or bank; or (iii) has the ticipate therein.
power to exercise a controlling influence over (2) Extensions of credit to an executive
the management or policies of the company or officer of an affiliate of a member bank (other
bank. (Note: If a company does not have voting than a company that controls the bank) are not
securities (that is, a partnership), review the
degree of interest in the company to determine
control.) extensions of credit (section 215.6), and the alternative record-
keeping procedures (section 215.8) if—
(2) A person is presumed to have control, (1) the director of the affiliate is excluded, by resolution of
including the power to exercise a controlling the board of directors or by the bylaws of the bank, from
influence over the management or policies, of a participation in major policymaking functions of the bank,
company or bank if (i) the person is an execu- and the director does not actually participate in those
functions;
tive officer or director of the company or bank (2) the affiliate does not control the bank; and
and directly or indirectly owns, controls, or has (3) as determined annually, the assets of the affiliate do not
the power to vote more than 10 percent of any constitute more than 10 percent of the consolidated assets of
class of voting securities of the company or the company that controls the bank and is not controlled by
any other company, and the director of the affiliate is not
bank or (ii) the person directly or indirectly otherwise subject to sections 215.4, 215.6, and 215.8 of
owns, controls, or has the power to vote more Regulation O.
than 10 percent of any class of voting securi- If the director of the affiliate is excluded, by resolution of
ties of the company or bank, and no other the board of directors or by the bylaws of the bank, from
participation in major policymaking functions of the bank, a
person owns, controls, or has the power to vote resolution of the board of directors or a corporate bylaw may
a greater percentage of that class of voting (1) include the director (by name or by title) in a list of
securities. persons excluded from participation in such functions or
(3) An individual is not considered to have (2) not include the director in a list of persons authorized (by
name or by title) to participate in such functions.
control, including the power to exercise a con- 4. The term ‘‘executive officer’’ is not intended to include
trolling influence over the management or poli- persons who may have official titles and may exercise a
cies, of a company or bank solely by virtue of certain measure of discretion in the performance of their
the individual’s position as an officer or director duties, including discretion in the making of loans, but who
do not participate in determining major policies of the bank or
of the company or bank. company and whose decisions are limited by policy standards
(d) ‘‘Director’’ of a company or bank means fixed by the senior management of the bank or company. For
any director of the company or bank, whether or example, the term does not include a manager or assistant
not receiving compensation.3a An advisory manager of a branch of a bank unless that individual partici-
pates, or is authorized to participate, in major policymaking
functions of the bank or company.
3a. Extensions of credit to a director of an affiliate of a
bank are not subject to the general prohibitions (section BHC Supervision Manual July 2007
215.4), the prohibitions on knowingly receiving unauthorized Page 5
subject to sections 215.4, 215.6, and 215.8 of amounts that are permitted by section 5200 of
Regulation O if— the Revised Statutes for the types of obligations
(i) the executive officer of the affiliate is listed therein as exceptions to the limit.
excluded, by resolution of the board of directors A member bank’s unimpaired capital and
or by the bylaws of the bank, from participation unimpaired surplus equals the (1) member
in major policymaking functions of the bank, bank’s tier 1 and tier 2 capital included in the
and the executive officer does not actually par- bank’s risk-based capital, under the capital
ticipate in those functions; guidelines of the appropriate federal banking
(ii) the affiliate does not control the agency, and (2) balance of the member bank’s
bank; and allowance for loan and lease losses that was not
(iii) as determined annually, the assets included in the bank’s tier 2 capital. This com-
of the affiliate do not constitute more than putation is based on the bank’s risk-based capi-
10 percent of the consolidated assets of the tal under the capital guidelines of the appropri-
company that controls the bank and is not con- ate federal banking agency, based on the bank’s
trolled by any other company, and the execu- most recent consolidated report of condition
tive officer of the affiliate is not otherwise filed under 12 U.S.C. 1817(a)(3).
subject to sections 215.4, 215.6, and 215.8 of (i) ‘‘Member bank’’ means any banking insti-
Regulation O. tution that is a member of the Federal Reserve
If the executive officer of the affiliate is System, including any subsidiary of a member
excluded, by resolution of the board of directors bank. The term does not include any foreign
or by the bylaws of the bank, from participation bank that maintains a branch in the United
in major policymaking functions of the bank, a States, whether or not the branch is insured
resolution of the board of directors or a corpo- (within the meaning of 12 U.S.C. 1813(s)) and
rate bylaw may (i) include the executive officer regardless of the operation of 12 U.S.C. 1813(h)
(by name or by title) in a list of persons and 12 U.S.C. 1828(j)(3)(B).
excluded from participation in such functions or
(j) ‘‘Person’’ means an individual or a
(ii) not include the executive officer in a list of
company.
persons authorized (by name or by title) to
participate in such functions. (k) ‘‘Principal shareholder’’ 6 means an indi-
(f) ‘‘Immediate family’’ means the spouse of vidual or a company (other than an insured
an individual, the individual’s minor children, bank) that directly or indirectly, or acting
and any of the individual’s children (including through or in concert with one or more persons,
adults) residing in the individual’s home. owns, controls, or has the power to vote more
(g) ‘‘Insider’’ means an executive officer, than 10 percent of any class of voting securities
director, principal shareholder, and any related of a member bank or company. Shares owned or
interest of such person. controlled by a member of an individual’s
(h) The ‘‘lending limit’’ for a member bank immediate family are considered to be held by
is an amount equal to the limit on loans to a the individual. A principal shareholder of a
single borrower established by section 5200 of member bank includes (1) a principal share-
the Revised Statutes,5 12 U.S.C. 84. This holder of a company of which the member bank
amount is 15 percent of the bank’s unimpaired is a subsidiary and (2) a principal shareholder of
capital and unimpaired surplus in the case of any other subsidiary of that company, exclusive
loans that are not fully secured, and an addi- of nonbank subsidiaries of member banks.
tional 10 percent of the bank’s unimpaired capi- (l) ‘‘Related interest’’ means (1) a company
tal and unimpaired surplus in the case of loans that is controlled by a person or (2) a political or
that are fully secured by readily marketable campaign committee that is controlled by a per-
collateral having a market value, as determined son or the funds or services of which will ben-
by reliable and continuously available price efit a person.
quotations, at least equal to the amount of the
loan. The lending limit also includes any higher
6. On October 28, 1992, in section 955 of the Housing and
Community Development Act of 1992, Congress amended
5. Where state law establishes a lending limit for a state
section 22(h) of the Federal Reserve Act to exclude from the
member bank that is lower than the amount permitted in
definition of principal shareholder a company of which a
section 5200 of the Revised Statutes, the lending limit estab-
member bank is a subsidiary. Regulation O was amended,
lished by the applicable state laws shall be the lending limit
effective December 17, 1992, to implement this change. As a
for the state member bank.
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 July 2007 are governed solely by sections 23A and 23B of the Federal
Page 6 Reserve Act.
(m) ‘‘Subsidiary’’ has the meaning given in bank or similar organization or (ii) foreclosure
section 2(d) of the BHC Act, but does not on collateral or similar proceeding for the pro-
include a subsidiary of a member bank. tection of the bank, provided that such indebted-
ness is not held for a period of more than three
years from the date of the acquisition, subject to
2050.0.3.2.1 Extension of Credit
For the purposes of Regulation O, an ‘‘exten-
sion of credit’’ is a making or renewal of any
loan, a granting of a line of credit, or an extend-
ing of credit in any manner whatsoever, and
includes—
(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.
An extension of credit does not include—
(1) an advance against accrued salary or
other accrued compensation, or an advance for
the payment of authorized travel or other
expenses incurred or to be incurred on behalf
of the bank;
(2) a receipt by a bank of a check depos-
ited in or delivered to the bank in the usual
course of business unless it results in the carry-
ing of a cash item for or the granting of an
overdraft (other than an inadvertent overdraft in
a limited amount that is promptly repaid under
terms that are not more favorable than those
offered to the general public).
(3) an acquisition of a note, draft, bill of
exchange, or other evidence of indebtedness
through (i) a merger or consolidation of banks
or a similar transaction by which a bank BHC Supervision Manual July 2007
acquires assets and assumes liabilities of another 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 Board’s 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 bank’s business purposes.7
credit plan, or similar open-end credit plan, The FDIC asked whether, and under what cir-
provided— cumstances, an insider’s 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 bank’s 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 bank’s 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 bank’s business purposes or for
of business is not considered to be a loan, an employee’s 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 FDIC’s 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 bank’s 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 staff’s 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 bank’s 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 insider’s 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 if—and to the extent that—the 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 bank’s 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 bank’s 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 Board’s
(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 bank’s 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 bank’s 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 bank’s 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 bank’s 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
bank’s lending to its insiders as a percentage of
the bank’s 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 bank’s 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 bank’s
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 officer’s 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 bank’s
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 bank’s 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 vidual’s 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 officer’s 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 lender’s 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 bank’s 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 Bank’s 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 bank’s affiliates by—
person, equaled or exceeded 5 percent of the (1) a ‘‘survey’’ method, which identifies,
member bank’s capital and unimpaired surplus through an annual survey, each of the insiders of
or $500,000, whichever amount is less. No dis- the member bank’s 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 bank’s 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 bank’s 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 lender’s liquidity or transactions and to provide supporting
otherwise overextend the BHC. In such situa- documentation.
tions, formal or informal remedial measures by 4. Review management’s familiarity with
the Federal Reserve may be necessary. Formal Regulation O’s 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 individual’s 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 BHC’s 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 er’s personal purposes and that the policy
O’s requirements or whether it is an attempt obligates the insider to promptly make
to circumvent Regulation O’s prohibition on reimbursement to the BHC.
various bank extensions of credit to similar b. Determine the BHC’s 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 O’s 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 BHC’s 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 insider’s 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 BHC’s 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) 4–514

market interest rate 3–1094
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 3–1081.5

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
WHAT’S NEW IN THIS REVISED When properly structured and conducted, inter-
SECTION nal audit provides directors and senior manage-
ment with vital information about weaknesses in
Effective July 2008, this section was revised the system of internal control so that manage-
further to include another provision of the ment can take prompt, remedial action. The
FDIC’s November 28, 2005, amended rule federal banking agencies’ 3 (agencies) long-
(effective December 28, 2005) for part 363 of its standing inspection policies call for examiners
regulations (12 C.F.R. 363). For insured institu- to review an institution’s internal audit function
tions having total assets of more than $3 billion, and recommend improvements, if needed. In
the audit committee must have independent addition, pursuant to section 39 of the Federal
members with (1) banking or related financial Deposit Insurance Act (FDI Act) (12 U.S.C.
management expertise, (2) access to legal coun- 1831p-1), the agencies have adopted Inter-
sel, and (3) not include any large customers of agency Guidelines Establishing Standards for
the institution. The audit committee may also be Safety and Soundness that apply to insured
required to satisfy other audit committee mem- depository institutions.4 Under these guidelines
bership criteria. 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-
tion if it is properly structured, carefully con-
1. In summary, internal control is a process designed to ducted, and prudently managed. However, the
provide reasonable assurance that the institution will achieve
the following internal control objectives: efficient and effec-
agencies have concerns that the structure, scope,
tive operations, including safeguarding of assets; reliable and management of some internal audit out-
financial reporting; and compliance with applicable laws and sourcing arrangements do not contribute to the
regulations. Internal control consists of five components that institution’s safety and soundness. Furthermore,
are a part of the management process: control environment,
risk assessment, control activities, information and communi-
the agencies want to ensure that these arrange-
cation, and monitoring activities. The effective functioning of ments with outsourcing vendors do not leave
these components, which is brought about by an institution’s directors and senior management with the erro-
board of directors, management, and other personnel, is essen- neous impression that they have been relieved
tial to achieving the internal control objectives. This descrip-
tion of internal control is consistent with the Committee of
of their responsibility for maintaining an effec-
Sponsoring Organizations of the Treadway Commission tive system of internal control and for oversee-
(COSO) report Internal Control—Integrated Framework. In ing the internal audit function.
addition, under the COSO framework, financial reporting is
defined in terms of published financial statements, which, for
purposes of this policy statement, encompass both financial 3. The Board of Governors of the Federal Reserve System
statements prepared in accordance with generally accepted (FRS), Federal Deposit Insurance Corporation (FDIC), Office
accounting principles and regulatory reports (such as the of the Comptroller of the Currency (OCC), and Office of
Reports of Condition and Income). Institutions are encour- Thrift Supervision (OTS).
aged to evaluate their internal control against the COSO 4. For national banks, appendix A to part 30; for state
framework. member banks, appendix D-1 to part 208; for insured state
2. The term ‘‘institution’’ includes depository institutions nonmember banks and insured state-licensed branches of for-
insured by the Federal Deposit Insurance Corporation (FDIC), eign banks, appendix A to part 364; for savings associations,
U.S. financial holding companies and bank holding companies appendix A to part 570.
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 July 2008
organizations. Page 1
Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05
The Sarbanes-Oxley Act of 2002 (the act) organizations to periodically review their poli-
became law on July 30, 2002.5 The act addresses cies and procedures relating to corporate-
weaknesses in corporate governance and the governance and auditing matters. This review
accounting and auditing professions, and should ensure that such policies and procedures
includes provisions addressing audits, financial are consistent with applicable law, regulations,
reporting and disclosure, conflicts of interest, and supervisory guidance and remain appropri-
and corporate governance at publicly owned ate in light of the organization’s size, opera-
companies. The act, among other things, tions, and resources. Furthermore, the agencies
requires public companies to have an audit com- stated that a banking organization’s policies and
mittee composed entirely of independent direc- procedures for corporate governance, internal
tors. Public banking organizations that are listed controls, and auditing will be assessed during
on the New York Stock Exchange (NYSE) and the supervisory process, and the agencies may
Nasdaq must also comply with those exchanges’ take appropriate supervisory action if there
listing requirements, which include audit com- are deficiencies or weaknesses in these areas
mittee requirements. that are inconsistent with sound corporate-
The act also established a Public Company governance practices or safety-and-soundness
Accounting Oversight Board (PCAOB) that has considerations.
the authority to set and enforce auditing, attesta-
tion, quality control, and ethics (including inde-
pendence) standards for auditors of public com-
panies, subject to SEC review. (See SR-02-20.) 2060.05.06 INTERAGENCY POLICY
Accounting firms that conduct audits of public STATEMENT ON THE INTERNAL
companies (i.e., registered accounting firms) AUDIT FUNCTION AND ITS
must register with the PCAOB and be subject to OUTSOURCING
its supervision. The PCAOB is also empowered
to inspect the auditing operations of public
The Federal Reserve and other federal banking
accounting firms that audit public companies, as
agencies 6 adopted on March 17, 2003, an inter-
well as impose disciplinary and remedial sanc-
agency policy statement addressing the internal
tions for violations of its rules, securities laws,
audit function and its outsourcing (See SR
and professional auditing and accounting
03-5). The policy statement revises and replaces
standards.
the former 1997 policy statement and incorpo-
rates recent developments in internal auditing.
In addition, the revised policy incorporates guid-
[Sections 2060.05.02–2060.05.04 are ance on the independence of accountants who
reserved.] provide institutions with both internal and exter-
nal audit services in light of the Sarbanes-Oxley
Act of 2002 and associated SEC rules. (See also
2060.05.05 APPLICATION OF THE sections 2124.0.2.4, 2060.1, 3230.0.10.2.5,
SARBANES-OXLEY ACT TO 5010.7, and 5030.0 [page 7] pertaining to inter-
NONPUBLIC BANKING nal and external audits.)
ORGANIZATIONS
The act prohibits an accounting firm from
In May 2003, the Federal Reserve, the Office of acting as the external auditor of a public com-
the Comptroller of the Currency, and the Office pany during the same period that the firm pro-
of Thrift Supervision announced that they did vides internal audit services to the company.
not expect to take actions to apply the corporate- The policy statement discusses the applicability
governance and other requirements of the of this prohibition to institutions that are public
Sarbanes-Oxley Act generally to nonpublic companies, insured depository institutions with
banking organizations that are not otherwise assets of $500 million or more that are subject
subject to them. 5a (See SR-03-08.) The agen- to the annual audit and reporting requirements
cies, however, encouraged nonpublic banking of section 36 of the Federal Deposit Insurance
Act, and also nonpublic institutions that are not
5. Pub. L. No. 107-204. 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 FDIC’s
BHC Supervision Manual July 2008 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 institution’s 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
tion’s 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 institution’s 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 institution’s
tution’s 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 management’s
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 FDIC’s 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 institution’s 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 committee—who
must be outside directors—must 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 FDIC’s 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 management’s responsibili-
363.5(b)). Consistent with the 1999 Interagency Policy State-
ties for preparing the institution’s 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 management’s assessment of the
entirely of outside directors. Where the term ‘‘audit commit-
institution’s 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 institution’s 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 institution’s 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 audit’s 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 institution’s 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 IIA’s 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 IIA’s 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 tor’s understanding of the institution’s 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 institution’s
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 audit’s control risk assessment
Ideally, the internal audit function’s 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
institution’s risk-management, control, and gov- review internal audit’s 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 institution’s 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 institution’s 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
function’s 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 institution’s 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 management’s solutions
encourage internal auditors to follow the IIA’s
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 institution’s 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 institution’s 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 institution’s 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 function’s 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 institution’s 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 office’s 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 party’s 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 institution’s 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 institution’s 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 staff’s 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 institution’s 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
vendor’s 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 institution’s manager external audit and the outsourced internal audit
of internal audit. Decisions not to report the function, the firm risks compromising its inde-
outsourcing vendor’s 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 board’s 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 institution’s 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 institution’s 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 SEC’s 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 SEC’s 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 auditor’s 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 SEC’s pre-Sarbanes-Oxley inde-
company—that 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
company’s 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 company’s 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-
ny’s audit committee must preapprove each of Under section 36, as implemented by part 363
these services. of the FDIC’s regulations, each FDIC-insured
According to the SEC’s final rules (effective depository institution with total assets of
May 6, 2003) implementing the act’s 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
AICPA’s 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 SEC’s 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 auditor’s 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 SEC’s January 2003 audi-
audit client include bookkeeping or other services related to
the client’s 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 institution’s internal audit activities. These ated independence issues. In addition, the insti-
circumstances include, but are not limited to, tution’s 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 institution’s
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 SEC’s 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 AICPA’s Code of Professional
2004, depending on the circumstances, the holding company’s
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 auditor’s 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 manager’s 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 client’s management or as a significant identified internal control
client employee. The AICPA’s guidance weaknesses;
includes illustrations of activities that would be 7. the internal audit function is adequately
considered to compromise a CPA’s 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 AICPA’s Code audit reports;
of Professional Conduct. 9. management and the board of directors use
reasonable standards, such as the IIA’s
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 institution’s internal audit resources, includ-
ing personnel, workpapers, risk assessments, The examiner should assess the competence
work plans, programs, reports, and budgets. A of the institution’s 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 institution’s internal audit function, should determine whether—
regardless of whether it is performed by the
institution’s 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— institution’s internal control;
2. key employees of the institution and the out-
1. the internal audit function’s 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 institution’s 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 institution’s environ-
tion’s 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 institution’s 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 vendor’s 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 examiner’s 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 institution’s
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 institution’s senior
tion’s 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 institution’s external auditing
the system of internal control. If these discus-
program is inadequate and that it does not com-
sions do not resolve the examiner’s 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 sys-
institution corrects the deficiencies. These
tem of internal controls that ensures efficient
actions may include formal and informal
and effective operations, including the safe-
enforcement actions.
guarding of assets, reliable financial report-
The institution’s management and composite
ing, and compliance with applicable laws
ratings should reflect the examiner’s conclu-
and regulations.
sions regarding the institution’s 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 parent company and its subsidi-
function, significant issues or concerns, and rec-
aries are adequately and competently man-
ommended corrective actions.
aged by the board of directors and senior
management.
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 examiner’s 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 institution’s and its vendor’s adher- BHC Supervision Manual June 2003
ence to the independence standards described in Page 11
3. To ascertain that the banking organization’s gaining access to the internal audit resources.
internal audit function monitors, reviews, and Such a delay may subject the institution to
ensures the continued existence and mainte- follow-up supervisory action.
nance of sound and adequate internal con-
trols over the management process: the con-
trol environment, risk assessment, control 2060.05.6.1 Internal Audit Function
activities, information and communication, Inspection Procedures
and monitoring activities.
4. To determine whether the internal audit func- 1. Assess the quality and scope of the internal
tion reports vital information about weak- audit work, regardless of whether it is per-
nesses in the system of internal control to the formed by the institution’s employees or by
board of directors (or its audit committee) an outsourcing vendor. Consider whether—
and senior management and that expeditious a. the board of directors (or audit commit-
remedial action is taken to resolve the inter- tee) promotes the internal audit manager’s
nal control weaknesses as well as any other impartiality and independence by having
exceptions. him or her directly report audit findings to
5. To determine that the audit committee has it;
established and maintains procedures for b. the internal audit function’s risk assess-
employees of the institution to confidentially ment, plans, and programs are appropriate
and anonymously submit concerns to the for the institution’s activities;
committee about questionable accounting, c. the internal audit function is adequately
internal control, or auditing matters, and that managed to ensure that audit plans are
the audit committee has procedures for the accomplished, programs are carried out,
timely investigation of complaints received and results of audits are promptly commu-
and the retention for a reasonable time period nicated to the managers and directors;
of documentation concerning the complaint d. the institution has promptly responded to
and its subsequent resolution. identified internal control weaknesses;
6. To determine the adequacy of the internal e. management and the board of directors
audit function (including its use of out- use reasonable standards when assessing
sourced internal audit vendors) as to organi- the performance of internal audit;
zational structure, prudent management, staff f. the internal audit plan and program have
having sufficient expertise, audit quality, and been adjusted for significant changes in
the ability of auditors to directly and freely the institution’s environment, structure,
communicate internal audit findings to the activities, risk exposures, or systems;
board of directors, its audit committee, and g. the activities of internal audit are consis-
senior management. tent with the long-range goals of the insti-
7. To review and evaluate internal audit out- tution and are responsive to its internal
sourcing arrangements and the actions of the control needs; and
outsourcing vendor, under standards estab- h. the audit function provides high-quality
lished in the Interagency Policy Statement on advice and counsel to management and
the Internal Audit Function and Its the board of directors on current develop-
Outsourcing. ments in risk management, internal con-
trol, and regulatory compliance.
2. Assess the competence of the institution’s
2060.05.6 INSPECTION PROCEDURES internal audit staff and management by con-
sidering the education and professional back-
Examiners should obtain assurances from the ground of the principal internal auditors.
audit committee and senior management that 3. Broaden the scope of the inspection if the
they will have full and timely access to an institution’s internal audit function, whether
institution’s internal audit resources, including or not it is outsourced, does not sufficiently
personnel, workpapers, risk assessments, work meet its internal audit needs, does not satisfy
plans, programs, reports, and budgets. Examin- the Interagency Guidelines Establishing
ers should consider widening the scope of their Standards for Safety and Soundness, or is
inspection work when such assurances are not otherwise inadequate.
provided or if there are any significant delays in 4. Discuss supervisory concerns and outstand-
ing internal-external audit report comments
BHC Supervision Manual June 2003 with the internal audit manager or other per-
Page 12 son responsible for reviewing the system of
internal control. If these discussions do not g. specify the period of time (for example,
resolve the examiner’s comments and con- seven years) that vendors must maintain
cerns, bring these matters to the attention of the workpapers;24
senior management and the board of direc- h. state that outsourced internal audit ser-
tors or audit committee. vices provided by the vendor are subject
5. If material weaknesses in the internal audit to regulatory review and that examiners
function or the internal control system exist, will be granted full and timely access to
discuss them with appropriate Federal the internal audit reports and related
Reserve Bank supervisory staff to determine workpapers prepared by the outsourcing
the appropriate actions that should be taken vendor;
to ensure that the institution corrects the defi- i. prescribe a process (arbitration, media-
ciencies (including formal and informal tion, or other means) for resolving dis-
enforcement actions). putes and for determining who bears the
6. Incorporate conclusions about the institu- cost of consequential damages arising
tion’s internal audit function into its manage- from errors, omissions, and negligence;
ment and composite supervisory ratings. and
7. Include in the inspection report comments j. state that the outsourcing vendor will not
concerning the adequacy of the internal audit perform management functions, make
function, significant issues or concerns, and management decisions, or act or appear to
recommended corrective actions. act in a capacity equivalent to that of a
member of management or an employee
and, if applicable, will comply with
2065.05.6.2 Additional Aspects of the AICPA, SEC, PCAOB, or regulatory inde-
Examiner’s Review of an Outsourcing pendence guidance.
Arrangement 3. Determine whether—
a. the outsourcing arrangement maintains or
1. Review the internal audit outsourcing improves the quality of the internal audit
arrangement and determine if the institution function and the institution’s internal con-
has a written contract or an engagement let- trol;
ter with the vendor. b. key employees of the institution and the
2. Determine whether the written contract or outsourcing vendor clearly understand the
engagement letter includes provisions that— lines of communication and how any
a. define the expectations and responsibili- internal control problems or other matters
ties under the contract for both parties; noted by the outsourcing vendor are to be
b. set the scope and frequency of, and the addressed;
fees to be paid for, the work to be per- c. the scope of work is revised appropriately
formed by the vendor; when the institution’s environment, struc-
c. set the responsibilities for providing and ture, activities, risk exposures, or systems
receiving information, such as the type change significantly;
and frequency of reporting to senior man- d. the directors have ensured that the out-
agement and directors about the status of sourced internal audit function is effec-
contract work; tively managed by the institution;
d. establish the process for changing the e. the arrangement with the outsourcing ven-
terms of the service contract, especially dor satisfies the independence standards
for expansion of audit work if significant described in the Policy Statement on the
issues are found, and establish stipula- Internal Audit Function and Its Outsourc-
tions for default and termination of the ing and thereby preserves the indepen-
contract; dence of the internal audit function,
e. state that internal audit reports are the whether or not the vendor is also
property of the institution, that the institu- the institution’s independent public
tion will be provided with any copies of accountant;
the related workpapers it deems neces-
sary, and that employees authorized by 24. If the workpapers are in electronic format, contracts
often call for the vendor to maintain proprietary software that
the institution will have reasonable and enables the banking organization and examiners to access the
timely access to the workpapers prepared electronic workpapers for a specified time period.
by the outsourcing vendor;
f. specify the locations of internal audit re- BHC Supervision Manual June 2003
ports and the related workpapers; Page 13
f. the institution has performed sufficient Statement on the Internal Audit Function and
due diligence to satisfy itself of the ven- Its Outsourcing, and if the vendor provides
dor’s competence before entering into the both external and internal audit services to
outsourcing arrangement and whether the institution—
there are adequate procedures for ensur- a. question the institution and the outsourc-
ing that the vendor maintains sufficient ing vendor about how the audit committee
expertise to perform effectively through- determined that the vendor was indepen-
out the arrangement; and dent; and
g. the institution has a contingency plan to b. if the vendor is an accounting firm, ask
ensure continuity in audit coverage, espe- the audit committee how it assessed that
cially for high-risk areas. the arrangement has not compromised
4. Adjust the scope of the inspection if the applicable SEC, PCAOB, AICPA, or other
outsourcing arrangement has diminished the regulatory standards concerning auditor
quality of the institution’s internal audit. If independence.
the quality of the internal audit is dimin- 2. If the answers to the above raise supervisory
ished, inform senior management and the concern, or are not adequately addressed,
board of directors and consider it in the insti- discuss the matter with appropriate Reserve
tution’s management and composite ratings. Bank management and supervisory staff.
3. If the Reserve Bank management and super-
visory staff concurs that the independence of
2060.05.6.3 Assessment of Auditor the external auditor or other vendor appears
Independence to be compromised, discuss the examination
findings and what appropriate supervisory
1. If the initial review of an internal audit out- actions the Federal Reserve should take, and
sourcing arrangement, including the actions discuss the actions to be taken with the
of the outsourcing vendor, raises questions bank’s senior management, board of direc-
about the institution’s and its vendor’s adher- tors (or audit committee), and the external
ence to the independence standards discussed auditor or other vendor.
in parts I, II, and III of the Interagency Policy

Page 14
Audit
(Management Information Systems) Section 2060.1
WHAT’S NEW IN THIS REVISED company operation are major determinants in

SECTION the scope and extent of the audit program that is
developed. In the smaller, less sophisticated
Effective July 2006, this section has been organizations, such as holding company shells
revised to incorporate the February 9, 2006, for small banks, it may not be feasible to employ
Interagency Advisory on the Unsafe and an auditor or implement an audit program. In
Unsound Use of Limitation of Liability Provi- some cases, such as those in which banking
sions in External Audit Engagement Letters. assets represent virtually all of the parent com-
The advisory informs financial institutions pany’s assets and a comprehensive, effective
(including bank holding companies) that it is audit program is being implemented in the vari-
unsafe and unsound to enter into external audit ous subsidiaries, neither an internal nor an exter-
contracts (that is, engagement letters) for the nal audit program may be necessary at the par-
performance of auditing or attestation services ent company level.
when the contracts (1) indemnify the external The development and implementation of an
auditor against all claims made by third parties, internal audit program should be delegated to a
(2) hold harmless or release the external audi- qualified staff large enough to meet the func-
tor from liability for claims or potential claims tional requirements of the job under the guid-
that might be asserted by the client financial ance and leadership of the auditor. When evalu-
institution (other than claims for punitive dam- ating the effectiveness of an internal audit
ages), or (3) limit the remedies available to the program, the examiner may want to consider the
client financial institution (other than punitive size of audit staffs of banking organizations of a
damages). Such limits on external auditors’ lia- similar size and complexity. To ensure freedom
bility weaken the auditor’s independence and of access to corporate records and complete
performance, thus reducing the supervisory independence and objectivity in administering
agency’s ability to rely on the auditor’s work. the audit program, the auditor should report
Bank holding companies subject to a multiyear directly to the directorate or a committee
audit engagement letter containing unsafe and thereof. Administratively, the internal auditor is
unsound limitation-of-liability provisions are usually responsible to an officer at a major poli-
encouraged to seek an amendment to an cymaking level.
engagement letter executed prior to February 9, To supplement the internal audit activities,
2006, to be consistent with the advisory. (See external accountants-auditors may be engaged
SR-06-4.) 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
detect control deficiencies. BHC Supervision Manual July 2006
The size and complexity of a bank holding Page 1
Audit 2060.1
work together in establishing the scope and fre- federal banking agency during the period
quency of audits to be performed. In addition to covered by the audit under subsection (a),
performing some of the basic functions of the (b), (c), (e), (g), (i), (s), or (t) of section 8 of
internal auditor, the external auditor should the FDI Act or of any similar action taken by
review the internal auditing program to assess a state banking agency under state law, or
its scope and adequacy. When a bank holding any other civil money penalty assessed under
company is perhaps too small to employ an any other provision of law with respect to the
internal audit staff, but when the complexities depository institution or any affiliated party.
and activities of the organization suggest the
need for an audit, the holding company should External auditors who are serving as agents
consider hiring an external auditor. Indepen- of a bank holding company may, with the
dence and objectivity are mandatory in any audit approval of the organization, review examina-
program, and these are difficult to maintain if tion or inspection reports and supervisory corre-
the audit function is a part-time responsibility. spondence received and communicate with
When external auditors are employed to per- examiners. Examiners should remind external
form the internal audit function, they should be auditors of their responsibility to maintain the
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 Board’s 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. company’s 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— tion’s 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
1. The Board of Governors of the Federal Reserve System
3. a report of any action initiated or taken by a (Board), the Office of the Comptroller of the Currency (OCC),
the Office of Thrift Supervision (OTS), the Federal Deposit
BHC Supervision Manual July 2006 Insurance Corporation (FDIC), and the National Credit Union
Page 2 Administration (NCUA).
Audit 2060.1
soundness concerns that may arise when loan reviews), and

financial institutions enter into external audit 4. other service providers (e.g., software con-
contracts (typically referred to as engagement sultants or legal advisers).
letters) that limit the auditors’ liability for audit
services.2 The advisory informs financial institu- While the agencies have observed several
tions’3 boards of directors, audit committees, types of limitation-of-liability provisions in
management, and external auditors of the safety- external audit engagement letters, this advisory
and-soundness implications that may arise when applies to any agreement that a financial institu-
the financial institution enters into engagement tion enters into with its external auditor that
letters that contain provisions to limit the audi- limits the external auditor’s liability with respect
tors’ liability. to audits in an unsafe and unsound manner.
The advisory does not apply to previously
executed engagement letters. However, any
financial institution subject to a multiyear audit 2060.1.4.2 External Audits and Their
engagement letter containing unsafe and Engagement Letters
unsound limitation-of-liability provisions should
seek an amendment to its engagement letter to A properly conducted audit provides an inde-
be consistent with the advisory for periods end- pendent and objective view of the reliability of a
ing in 2007 or later. (See SR-06-4.) financial institution’s financial statements. The
Limits on external auditors’ liability may external auditor’s objective in an audit is to
weaken the external auditors’ objectivity, impar- form an opinion on the financial statements
tiality, and performance and, thus, reduce the taken as a whole. When planning and perform-
agencies’ ability to rely on audits. Therefore, ing the audit, the external auditor considers the
certain limitation-of-liability provisions financial institution’s internal control over
(described in the advisory and its appendix A; financial reporting. Generally, the external audi-
see section 2060.1.4.7) are unsafe and unsound. tor communicates any identified deficiencies in
In addition, such provisions may not be consis- internal control to management, which enables
tent with the auditor-independence standards of management to take appropriate corrective
the U.S. Securities and Exchange Commission action. In addition, certain financial institutions
(SEC), the Public Company Accounting Over- are required to file audited financial statements
sight Board (PCAOB), and the American Insti- and internal control audit or attestation reports
tute of Certified Public Accountants (AICPA). with one or more of the agencies. The agencies
encourage financial institutions not subject to
mandatory audit requirements to voluntarily
2060.1.4.1 Scope of the Advisory on obtain audits of their financial statements. The
Engagement Letters FFIEC’s September 1999 Interagency Policy
Statement on External Auditing Programs of
The advisory applies to engagement letters Banks and Savings Associations4 notes, ‘‘[a]n
between financial institutions and external audi- institution’s internal and external audit pro-
tors with respect to financial-statement audits, grams are critical to its safety and soundness.’’
audits of internal control over financial report- The policy also states that an effective external
ing, and attestations on management’s assess- auditing program ‘‘can improve the safety and
ment of internal control over financial reporting soundness of an institution substantially and
(collectively, audit or audits). lessen the risk the institution poses to the insur-
The advisory does not apply to— ance funds administered by the FDIC.’’
Typically, a written engagement letter is used
1. nonaudit services that may be performed by to establish an understanding between the exter-
financial institutions’ external auditors, nal auditor and the financial institution regard-
2. audits of financial institutions’ 401(k) plans, ing the services to be performed in connection
pension plans, and other similar audits, with the financial institution’s audit. The
3. services performed by accountants who are engagement letter commonly describes the
not engaged to perform financial institutions’ objective of the audit, the reports to be prepared,
audits (e.g., outsourced internal audits or the responsibilities of management and the
2. The advisory is effective for audit engagement letters

4. See 64 Fed. Reg. 52,319 (September 28, 1999).
issued on or after February 9, 2006.
3. As used in this advisory, the term financial institutions
includes bank holding companies, banks, savings associa- BHC Supervision Manual July 2006
tions, and savings and loan holding companies. Page 3
Audit 2060.1
external auditor, and other significant arrange- institutions to seek punitive damages from their
ments (for example, fees and billing). Boards of external auditor are not treated as unsafe and
directors, audit committees, and management unsound under the advisory. Nevertheless,
are encouraged to closely review all of the pro- agreements by clients to indemnify their audi-
visions in the audit engagement letter before tors against any third-party damage awards,
agreeing to sign. As with all agreements that including punitive damages, are deemed unsafe
affect a financial institution’s legal rights, the and unsound under the advisory. To enhance
financial institution’s legal counsel should care- transparency and market discipline, public
fully review audit engagement letters to help financial institutions that agree to waive claims
ensure that those charged with engaging the for punitive damages against their external audi-
external auditor make a fully informed decision. tors may want to disclose annually the nature of
The advisory describes the types of objection- these arrangements in their proxy statements or
able limitation-of-liability provisions and pro- other public reports.
vides examples.5 Financial institutions’ boards Many financial institutions are required to
of directors, audit committees, and management have their financial statements audited, while
should also be aware that certain insurance poli- others voluntarily choose to undergo such
cies (such as error and omission policies and audits. For example, federally insured banks
directors’ and officers’ liability policies) might with $500 million or more in total assets are
not cover losses arising from claims. required to have annual independent audits.6
Furthermore, financial institutions that are pub-
lic companies7 must have annual independent
2060.1.4.3 Limitation-of-Liability audits. Certain savings associations (for exam-
Provisions ple, those with a CAMELS rating of 3, 4, or 5)
and savings and loan holding companies are
The provisions of an external audit engagement also required by OTS’s regulations to have
letter that the agencies deem to be unsafe and annual independent audits.8 The agencies rely
unsound can be generally categorized as fol- on the results of audits as part of their assess-
lows: a provision within an agreement between ment of a financial institution’s safety and
a client financial institution and its external soundness.
auditor that effectively— For audits to be effective, the external audi-
tors must be independent in both fact and
1. indemnifies the external auditor against appearance, and they must perform all neces-
claims made by third parties; sary procedures to comply with auditing and
2. holds harmless or releases the external audi- attestation standards established by either the
tor from liability for claims or potential AICPA or, if applicable, the PCAOB. When
claims that might be asserted by the client financial institutions execute agreements that
financial institution, other than claims for limit the external auditors’ liability, the external
punitive damages; or auditors’ objectivity, impartiality, and perfor-
3. limits the remedies available to the client mance may be weakened or compromised, and
financial institution, other than punitive the usefulness of the audits for safety-and-
damages. soundness purposes may be diminished.
By their very nature, limitation-of-liability
Collectively, these categories of provisions provisions can remove or greatly weaken exter-
are referred to in this advisory as limitation-of- nal auditors’ objective and unbiased consider-
liability provisions. ation of problems encountered in audit engage-
Provisions that waive the right of financial ments and may diminish auditors’ adherence to
the standards of objectivity and impartiality
5. In the majority of external audit engagement letters required in the performance of audits. The exist-
reviewed, the agencies did not observe provisions that limited ence of such provisions in external audit
an external auditor’s liability. However, for those reviewed engagement letters may lead to the use of less
external audit engagement letters that did have external audi-
tor limited-liability provisions, the agencies noted a signifi- extensive or less thorough procedures than
cant increase in the types and frequency of the provisions. The would otherwise be followed, thereby reducing
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 FDIC’s
advisory’s 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 July 2006 requirements of the Securities Exchange Act of 1934.
Page 4 8. See OTS regulation at 12 C.F.R. 563.4.
Audit 2060.1
the reliability of audits. Accordingly, financial audit engagement letters entered into by—
institutions should not enter into external audit
arrangements that include unsafe and unsound 1. public financial institutions that file reports
limitation-of-liability provisions identified in the with the SEC or with the agencies,
advisory, regardless of (1) the size of the finan- 2. financial institutions subject to part 363,10
cial institution, (2) whether the financial institu- and
tion is public or not, or (3) whether the external 3. certain other financial institutions that are
audit is required or voluntary. required to have annual independent audits.
In addition, certain of these limits on audi-

2060.1.4.4 Auditor Independence tors’ liability may violate the AICPA indepen-
dence standards. Notwithstanding the potential
Currently, auditor-independence standard-setters applicability of auditor-independence standards,
include the SEC, PCAOB, and AICPA. Depend- the limitation-of-liability provisions discussed
ing on the audit client, an external auditor is in the advisory present safety-and-soundness
subject to the independence standards issued by concerns for all financial institution audits.
one or more of these standard-setters. For all
nonpublic financial institutions that are not
required to have annual independent audits, the 2060.1.4.5 Alternative Dispute-Resolution
FDIC’s rules, pursuant to part 363 (or section Agreements and Jury-Trial Waivers
562.4 of the OTS’s regulations) require only
that an external auditor meet the AICPA inde- The agencies observed that a review of the
pendence standards. The rules do not require the engagement letters of some financial institutions
financial institution’s external auditor to comply revealed that they had agreed to submit disputes
with the independence standards of the SEC and over external audit services to mandatory and
the PCAOB. binding alternative dispute resolution, binding
In contrast, for financial institutions subject to arbitration, or other binding nonjudicial dispute-
the audit requirements in part 363 of the FDIC’s resolution processes (collectively, mandatory
regulations (or in section 562.4 of the OTS ADR) or to waive the right to a jury trial. By
regulations), the external auditor should be in agreeing in advance to submit disputes to man-
compliance with the AICPA’s Code of Profes- datory ADR, financial institutions may waive
sional Conduct and meet the independence the right to full discovery, limit appellate
requirements and interpretations of the SEC and review, or limit or waive other rights and pro-
its staff.9 In this regard, in a December 13, 2004, tections available in ordinary litigation
frequently asked question (FAQ) on the applica- proceedings.
tion of the SEC’s auditor-independence rules, Mandatory ADR procedures and jury-trial
the SEC staff reiterated its long-standing posi- waivers may be efficient and cost-effective tools
tion that when an accountant and his or her for resolving disputes in some cases. Accord-
client enter into an agreement that seeks to ingly, the agencies believe that mandatory ADR
provide the accountant immunity from liability or waiver of jury-trial provisions in external
for his or her own negligent acts, the accountant audit engagement letters do not present safety-
is not independent. The SEC’s FAQ also stated and-soundness concerns, provided that the
that including in engagement letters a clause engagement letters do not also incorporate
that would release, indemnify, or hold the limitation-of-liability provisions. Institutions are
auditor harmless from any liability and costs encouraged to carefully review mandatory ADR
resulting from knowing misrepresentations by and jury-trial provisions in engagement letters,
management would impair the auditor’s as well as review any agreements regarding
independence. The FAQ is consistent with the rules of procedure, and to fully comprehend the
SEC’s Codification of Financial Reporting Poli- ramifications of any agreement to waive any
cies, section 602.02.f.i, ‘‘Indemnification by Cli- available remedies. Financial institutions should
ent.’’ (See section 2060.1.4.8.) ensure that any mandatory ADR provisions in
On the basis of the SEC guidance and the audit engagement letters are commercially rea-
agencies’ existing regulations, certain limits on sonable and—
auditors’ liability are already inappropriate in
10. See also the OTS’s regulation (12 C.F.R. 562.4).
9. See part 363 of the FDIC’s regulation (12 C.F.R. 363),
Appendix A—Guidelines and Interpretations, Guideline 14, BHC Supervision Manual July 2006
‘‘Role of the Independent Public Accountant-Independence.’’ Page 5
Audit 2060.1
1. apply equally to all parties, effects is considered an unsafe and unsound

2. provide a fair process (for example, neutral practice.
decision makers and appropriate hearing pro-
cedures), and
3. are not imposed in a coercive manner. 1. ‘‘Release from Liability for Auditor
Negligence’’ Provision
2060.1.4.6 The Advisory’s Conclusion In this type of provision, the financial institu-
tion agrees not to hold the audit firm liable for
Financial institutions’ boards of directors, audit any damages, except to the extent determined to
committees, and management should not enter have resulted from willful misconduct or
into any agreement that incorporates limitation- fraudulent behavior by the audit firm.
of-liability provisions with respect to audits. In
addition, financial institutions should document Example: In no event shall [the audit firm] be
their business rationale for agreeing to any other liable to the financial institution, whether a
provisions that limit their legal rights. claim be in tort, contract or otherwise, for any
The inclusion of limitation-of-liability provi- consequential, indirect, lost profit, or similar
sions in external audit engagement letters and damages relating to [the audit firm’s] services
other agreements that are inconsistent with the provided under this engagement letter, except to
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 institution’s external auditing
program in determining whether (1) the engage-
ment letter covering external auditing activities
raises any safety-and-soundness concerns and 2. ‘‘No Damages’’ Provision
(2) the external auditor maintains appropriate
independence regarding relationships with the In this type of provision, the financial institu-
financial institution under relevant professional tion agrees that in no event will the external
standards. The agencies may take appropriate audit firm’s liability include responsibility for
supervisory action if unsafe and unsound any compensatory (incidental or consequential)
limitation-of-liability provisions are included in damages claimed by the financial institution.
external audit engagement letters or other agree-
ments related to audits that are executed Example: In no event will [the audit firm’s]
(accepted or agreed to by the financial liability under the terms of this agreement
institution). include responsibility for any claimed incidental
or consequential damages.
2060.1.4.7 Examples of Unsafe and

Unsound Limitation-of-Liability 3. ‘‘Limitation of Period to File Claim’’
Provisions Provision
The following information was contained in In this type of provision, the financial institu-
appendix A of the February 9, 2006, inter- tion agrees that no claim will be asserted after a
agency advisory. fixed period of time that is shorter than the
applicable statute of limitations, effectively
Presented below are some of the types of agreeing to limit the financial institution’s rights
limitation-of-liability provisions (with an illus- in filing a claim.
trative example of each type) that the agencies
observed in financial institutions’ external audit Example: It is agreed by the financial institution
engagement letters. The inclusion in external and [the audit firm] or any successors in inter-
audit engagement letters or agreements related est that no claim arising out of services ren-
to audits of any of the illustrative provisions dered pursuant to this agreement by, or on
(which do not represent an all-inclusive list) or behalf of, the financial institution shall be
any other language that would produce similar asserted more than two years after the date of
the last audit report issued by [the audit firm].
Page 6
Audit 2060.1
4. ‘‘Losses Occurring During Periods 6. ‘‘Knowing Misrepresentations by

Audited’’ Provision Management’’ Provision
In this type of provision, the financial institu- In this type of provision, the financial institu-
tion agrees that the external audit firm’s liability tion releases and indemnifies the external audit
will be limited to any losses occurring during firm from any claims, liabilities, and costs attrib-
periods covered by the external audit, and will utable to any knowing misrepresentation by
not include any losses occurring in later periods management.
for which the external audit firm is not engaged.
This provision may not only preclude the collec- Example: Because of the importance of oral and
tion of consequential damages for harm in later written management representations to an effec-
years, but could preclude any recovery at all. It tive audit, the financial institution releases and
appears that no claim of liability could be indemnifies [the audit firm] and its personnel
brought against the external audit firm until the from any and all claims, liabilities, costs, and
external audit report is actually delivered. Under expenses attributable to any knowing misrepre-
such a clause, any claim for liability thereafter sentation by management.
might be precluded because the losses did not
occur during the period covered by the external
audit. In other words, it might limit the external
audit firm’s liability to a period before there 7. ‘‘Indemnification for Management
could be any liability. Read more broadly, the Negligence’’ Provision
external audit firm might be liable for losses that
arise in subsequent years only if the firm contin- In this type of provision, the financial institu-
ues to be engaged to audit the client’s financial tion agrees to protect the external auditor from
statements in those years. third-party claims arising from the external audit
firm’s failure to discover negligent conduct by
Example: In the event the financial institution is management. It would also reinforce the defense
dissatisfied with [the audit firm’s] services, it is of contributory negligence in cases in which the
understood that [the audit firm’s] liability, if financial institution brings an action against its
any, arising from this engagement will be lim- external auditor. In either case, the contractual
ited to any losses occurring during the periods defense would insulate the external audit firm
covered by [the audit firm’s] audit, and shall from claims for damages even if the reason the
not include any losses occurring in later periods external auditor failed to discover the negligent
for which is not engaged as auditors. conduct was a failure to conduct the external
audit in accordance with generally accepted
auditing standards or other applicable profes-
sional standards.
5. ‘‘No Assignment or Transfer’’
Provision Example: The financial institution shall indem-
In this type of provision, the financial institu- nify, hold harmless, and defend and its autho-
tion agrees that it will not assign or transfer any rized agents, partners, and employees from and
claim against the external audit firm to another against any and all claims, damages, demands,
party. This provision could limit the ability of actions, costs, and charges arising out of, or by
another party to pursue a claim against the exter- reason of, the financial institution’s negligent
nal auditor in a sale or merger of the financial acts or failure to act hereunder.
institution, in a sale of certain assets or a line of
business of the financial institution, or in a
supervisory merger or receivership of the finan- 8. ‘‘Damages Not to Exceed Fees Paid’’
cial institution. This provision may also prevent Provision
the financial institution from subrogating a
claim against its external auditor to the financial In this type of provision, the financial institu-
institution’s insurer under its directors’ and offi- tion agrees to limit the external auditor’s liabil-
cers’ liability or other insurance coverage. ity to the amount of audit fees the financial
institution paid the external auditor, regardless
Example: The financial institution agrees that it of the extent of damages. This may result in a
will not, directly or indirectly, agree to assign or
transfer any claim against [the audit firm] aris- BHC Supervision Manual July 2006
ing out of this engagement to anyone. Page 7
Audit 2060.1
substantial unrecoverable loss or cost to the ment of indemnity which seeks to assure to the
financial institution. accountant immunity from liability for his own
negligent acts, whether of omission or commis-
Example: [The audit firm] shall not be liable for sion, one of the major stimuli to objective and
any claim for damages arising out of or in unbiased consideration of the problems encoun-
connection with any services provided herein to tered in a particular engagement is removed or
the financial institution in an amount greater greatly weakened. Such condition must fre-
than the amount of fees actually paid to [the quently induce a departure from the standards of
audit firm] with respect to the services directly objectivity and impartiality which the concept
relating to and forming the basis of such of independence implies. In such difficult mat-
claim.11 ters, for example, as the determination of the
scope of audit necessary, existence of such an
agreement may easily lead to the use of less
2060.1.4.8 Frequently Asked Questions extensive or thorough procedures than would
on the Application of the SEC’s otherwise be followed. In other cases it may
Auditor-Independence Rules result in a failure to appraise with professional
acumen the information disclosed by the exami-
The following information is contained in nation. Consequently, the accountant cannot be
appendix B of the February 9, 2006, inter- recognized as independent for the purpose of
agency advisory. The information is derived certifying the financial statements of the corpo-
from the SEC’s Office of Chief Accountant’s ration.
Codification of Financial Reporting Policies.
Question
Question12
Has there been any change in the commis-
Inquiry was made as to whether an accoun- sion’s long-standing view (Financial Reporting
tant who certifies financial statements included Policies—Section 600—602.02.f.i., ‘‘Indemnifi-
in a registration statement or annual report filed cation by Client’’) that when an accountant
with the commission under the Securities Act or enters into an indemnity agreement with the
the Exchange Act would be considered indepen- registrant, his or her independence would come
dent if he had entered into an indemnity agree- into question?
ment with the registrant. In the particular illus-
tration cited, the board of directors of the
registrant formally approved the filing of a reg- Answer
istration statement with the commission and
agreed to indemnify and save harmless each and No. When an accountant and his or her client,
every accountant who certified any part of such directly or through an affiliate, enter into an
statement ‘‘from any and all losses, claims, dam- agreement of indemnity that seeks to provide
ages or liabilities arising out of such act or acts the accountant immunity from liability for his or
to which they or any of them may become her own negligent acts, whether of omission or
subject under the Securities Act, as amended, or commission, the accountant is not independent.
at ′common law,’ other than for their willful Further, including in engagement letters a clause
misstatements or omissions.’’ that a registrant would release, indemnify, or
hold harmless from any liability and costs
resulting from knowing misrepresentations by
Answer management would also impair the firm’s
independence.
When an accountant and his client, directly or
through an affiliate, have entered into an agree-
11. The agencies also observed a similar provision that
limited damages to a predetermined amount not related to fees 1. To review the operations of the bank holding
paid.
12. The subtitles in this section have been revised for this
company to determine if an audit program
manual. exits.
2. To determine the independence and compe-
BHC Supervision Manual July 2006 tence of those who administer and provide
Page 8 the internal and external audit function.
Audit 2060.1
3. To determine the adequacy of the scope and ments and deficiencies cited concerning internal
frequency of the audit program. controls and the audit function. In addition to
4. To determine with reasonable assurance that providing an input into the overall assessment
the bank holding company has adequate of the audit function, review of the bank exami-
internal audit and external audit functions nation reports may provide a basis for determin-
that ensure efficient and effective operations, ing areas of investigation during the inspection.
including the safeguarding of assets, reliable Further, if matters cited in the latest bank exami-
financial reporting, and compliance with nation report are deemed to be significant and
applicable laws and regulations. indications are that corrective action has not
5. To ascertain if the bank holding company’s been taken, the examiner should mention the
internal audit function monitors, reviews, and facts to senior management of the bank holding
ensures the continued existence and mainte- company and note the details in the inspection
nance of sound and adequate internal con- report.
trols over the bank holding company’s man- To judge the adequacy of the audit program,
agement process—the control environment, including its scope and frequency, the following
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 compa- 2. Review the scope of the audit function to
ny’s external auditing program and to deter- ensure that procedures are in place to cover
mine 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 bank’s 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 audit’s 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
particular bank. The examiner should review the BHC Supervision Manual July 2006
latest bank examination reports to note com- Page 9
Audit 2060.1
3. Review the audit schedule to determine that and any agreements between the board
the audits are satisfactorily spaced and that of directors (and the audit committee)
all functions are audited with adequate and the external auditor, noting any
frequency. qualifications that are contained therein.
4. Review audit workpapers and reports on a b. Review any correspondence exchanged
test-check basis for adequacy of content, between the BHC and the external audi-
satisfactory maintenance, and conformance tor, including any letters requesting opin-
to audit guidelines outlined by the board of ions from external auditors. Determine if
directors. BHC management influenced any of the
5. Determine the qualifications and back- opinions.
ground of the auditor and others participat- c. Ascertain if any of the engagement let-
ing in the audit function. ters restricted the scope of the audit in
6. To establish that the auditor has a direct any way, including whether the letters
communication line to the board of direc- limited the degree of reliance to be
tors and freedom of access to all records for placed on the work of the internal audit
audit purposes, review audit reports and staff.
minutes of meetings held by directors or a 14. Determine if the audit engagement letters or
committee thereof. other agreements include possible unsafe
7. Determine the entity responsible for main- and unsound provisions or practices that—
taining the audit function. If a bank pro- a. indemnify the external auditor against
vides audit services to affiliates, indicate the all claims made by third parties;
manner in which the bank is reimbursed for b. hold harmless, release, or indemnify the
the cost of such services. external auditor from liability for claims
8. Determine whether audit reports are submit- or potential claims that the BHC may
ted on a timely basis to— assert, thus providing relief from liabil-
a. the directors and senior management and ity for the auditors’ own negligent acts,
b. management in the area being audited. 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 BHC’s 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 BHC’s 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 BHC’s
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 management’s assessment of cations. If so, determine if adequate con-
internal control, appraisals of the BHC’s 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 BHC’s external auditors
iner should: received copies of the subsidiary FDIC-
a. Review the engagement letters (includ- insured institution’s examination and other
ing past or pending engagement letters) designated supervisory reports and corre-
spondence required by section 36(h)(1) of
BHC Supervision Manual July 2006 the FDI Act.
Page 10 20. Determine the degree of independence of
Audit 2060.1
the external audit firm by reviewing any are no relationships within the organization that
financial ties between the BHC, audit firm, are incompatible with the internal audit func-
and any of its partners or employees. Also tion; and (3) severe restrictions are not placed
review any other relationships or potential on the program or its scheduling by manage-
conflicts of interest that may exist.13 ment. In order to maintain the degree of objec-
The independence of the internal auditor tivity essential to the audit function, the exam-
should be evaluated by ascertaining whether the iner should establish that the internal auditor
following conditions exist: (1) reports are dis- does not install procedures, originate and
tributed directly to the board or a committee approve entries, or otherwise engage in any
thereof or, less desirably, to an officer not con- activity that would be subject to audit review
nected with the area being reviewed; (2) there and appraisal.
The examiner should consider meeting with
the audit committee and the auditor and, subse-
quently, with senior bank holding company
management to communicate conclusions con-
13. The Securities and Exchange Commission (SEC) has cerning the adequacy of the scope and fre-
also released guidance relating to the independence of audi- quency of the audit program. During the discus-
tors for public institutions. According to SEC Rule 101, the sions, the examiner should concentrate on
independence of an auditor would be impaired if there are
financial, employment, or business relationships between detailing criticisms or deficiencies noted. The
auditors and audit clients, or if there are relationships between auditor and senior bank holding com-pany man-
auditors and audit clients in which the auditors provide certain agement should be made fully cognizant of the
nonaudit services to their audit clients. Much of the language examiner’s analyses and the comments concern-
found in the SEC’s independence rules is incorporated in the
Interagency Policy Statement on the Internal Audit Function ing the audit function that will appear on the
and Its Outsourcing. (See section 2060.05.) relevant pages in the inspection report.

Page 11
(Budget) Section 2060.2
An assessment of management’s 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 BHC’s 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 organization’s 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 tion’s 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 management’s perfor- dures the advantages of adopting a budget.
mance and planning record and its relationship 3. To understand the institution’s decision-
to the organization’s 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 management’s 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
ny’s 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- management’s views, whether or not in concur-
ures without a systematic examination of all of rence with the examiner’s 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, management’s 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 organization’s finan- and expansion, capital injections, debt retire-
cial plans. The extent of senior management’s 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 examiner’s viewpoint, the test of a bank with an appropriate officer to ascertain what
holding company’s 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 firm’s 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 company’s 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
ny’s 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 organization’s 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
place—centralized, 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 corporation’s 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- year’s 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 organization’s 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 management’s
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
company’s 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 officer’s 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 company’s 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
zation’s divisions and units and whether the
whether the management reports are suffi-
reporting systems and reports are adequate to
cient to measure the company’s 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 company’s financial position and
dures for reacting to elevated risk, weak-
performance in all areas, to measure the com-
nesses, or deficiencies disclosed by MIS.
pany’s 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 management’s 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 system’s 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 Lloyd’s 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
ganization’s 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 BANKER’S 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 organization’s claim experience and costs
ABA’s 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.
parent’s and the bank’s coverage.

2060.5.5 NOTIFICATION OF LOSS
1. The prior year’s 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 borrower’s 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 borrower’s condition or in
corporate these policies into the supervision of economic conditions that may affect the bor-
their federally supervised financial institution rower’s ability to repay. Such information may
subsidiaries. reduce the need to rely on the borrower’s 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-
er’s cash flow and debt-service capacity and
Current regulatory reporting requirements do strength, then the borrower’s 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-
borrower’s 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- Restructuring—Returning 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 borrower’s 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 borrower’s 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 institution’s
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 asset’s 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 debtor’s 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
er’s 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 borrower’s 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
borrower’s 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 institution’s
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 loan’s effective interest rate or, as a practical
not be restored to accrual status. expedient, based on the loan’s 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 borrower’s 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 borrower’s 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 organization’s 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 management’s 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 examiner’s analysis will also con-
any) to fulfill their obligations to the institution. sider the quality of the organization’s 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 management’s 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 organization’s 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 management’s 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 Board’s
(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 Loan—Income 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
management’s 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 loan’s effective interest rate (that the collectibility of the loan, including the
is, the contract rate, as adjusted for any net borrower’s 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 loan’s 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 creditor’s 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. ment’s 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
management’s estimate of the ALLL.
experience including the timeliness of
3. To determine the accuracy and reasonable-
charge-offs;
ness of management’s estimate of the overall
d. evaluating the performance of concentra-
ALLL.
tions of credit (related interests, geo-
4. To evaluate the quality of the BHC’s 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 organization’s 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
WHAT’S 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 institution’s 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 institution’s 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 institution’s stated policies and The policy statement also includes guidance
procedures, management’s 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 management’s 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, conservative—but 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-
agement’s 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 institution’s 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 institution’s stated policies and 6. Credit losses on off-balance-sheet credit exposures
should be estimated in accordance with FAS 5. Any allow-
procedures, management’s 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
SEC’s 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 SEC’s 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 standard’s 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 loan’s effective in trends, conditions, and other relevant factors
interest rate,10 (2) the loan’s 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 institution’s 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
bank’s 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 bank’s financial statements may provide useful
information for examiners in reviewing these loans. Refer to warranted, and charge or credit the PLLL to
the AICPA’s 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 management’s 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. Management’s evalua- consistency, the institution should document
tion is subject to review by examiners. An insti- its evaluations and conclusions regarding the
tution’s 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 institution’s
credit approval and ALLL estimation pro-
• The institution’s 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-
institution’s loan review system and controls seeing management’s 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 institution’s
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 management’s 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 management’s 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 institution’s 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 institution’s cross-border
loans under FAS 114 or evaluated on a group lending activities require special consideration.
basis under FAS 5. See this policy statement’s 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
institution’s 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
ment’s 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
tion’s analysis, historical losses—or even recent
determined in accordance with GAAP and is properly sup- trends in losses—do 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 institution’s 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 group’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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, management’s 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 management’s 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.
group’s 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 enterprise’s 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 loan’s 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
institution’s 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 loan’s effective interest rate, the estimates
measurements. Management should maintain of these cash flows should be the institution’s
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 institution’s 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 institution’s 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 management’s 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, institution’s 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 institution’s 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
institution’s 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 institution’s 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 examiner’s knowledge of the collectibility of
as well as the quality of the institution’s 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 institution’s regulatory reports and financial
institution’s 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 institution’s 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 institution’s 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 institution’s ALLL
mate of the ALLL, including whether man- analyses and the institution’s reported ALLL
agement’s 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 management’s 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 institution’s historical loss experience that the institution’s 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 institution’s 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 management’s 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 examiner’s review of an institution’s loan review An institution’s ability to estimate credit
system, the examiner’s loan classifications or credit grades
may differ from those of the institution’s loan review system. losses on specific loans and groups of loans
If the examiner’s 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 management’s 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 statement’s attachment 1
on the institution’s 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 1—Loan Review
tution’s 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 institution’s 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 examiner’s 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 institution’s 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 institution’s 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 institution’s 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 management’s 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 institution’s
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 institution’s 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 institution’s 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 institution’s 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 management’s 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
tion’s 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 institution’s 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 2—International
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 institution’s 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 institution’s 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 institution’s business strategy and its debt-
the board of directors. management plans for each country;
Credit classification or grading differences • each country’s balance of payments position;
between loan officers and loan review personnel • each country’s level of international reserves;
should be resolved according to a prearranged • each country’s 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 country’s 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 country’s current standing with multilat-
lower credit quality classification or grade eral and official creditors;
should prevail unless internal parties identify • the status of each country’s 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
A supplemental interagency Policy Statement complex loan products or portfolios, such as
on Allowance for Loan and Lease Losses Meth- community banks, may use a more streamlined
odologies and Documentation for Banks and approach to implement this guidance.
Savings Institutions1 was issued by the Federal The policy statement is consistent with the
Financial Institutions Examination Council Federal Reserve’s long-standing policy to pro-
(FFIEC) on July 2, 2001.2 The policy statement mote strong internal controls over an institu-
clarifies the agencies’ expectations for docu- tion’s ALLL process. In this regard, the new
mentation that supports the ALLL methodology. policy statement recognizes that determining an
Additionally, the statement emphasizes the need appropriate allowance involves a high degree of
for appropriate ALLL policies and procedures, management judgment and is inevitably impre-
which should include an effective loan-review cise. Accordingly, an institution may determine
system. The guidance also provides examples of that the amount of loss falls within a range. In
appropriate supporting documentation, as well accordance with GAAP, an institution should
as illustrations on how to implement this guid- record its best estimate within the range of
ance. (See SR-01-17.) While this policy state- credit losses. (See also sections 2065.2 and
ment, by its terms, applies only to depository 2065.3.) (See also the March 1, 2004, inter-
institutions insured by the Federal Deposit agency Update on Accounting for Loan and
Insurance Corporation (which includes state Lease Losses (SR-04-5).)
member banks), the Federal Reserve believes The policy statement is provided below.
this guidance is broadly applicable to bank hold- Some wording has been slightly modified for
ing companies. Accordingly, examiners should this manual, as indicated by asterisks or text
apply the policy, as appropriate, in their inspec- enclosed in brackets. Some footnotes have also
tions of bank holding companies and their non- been renumbered.
bank subsidiaries. This policy, however, does
not apply to federally insured branches and
agencies of foreign banks. Federally insured 2065.4.1 2001 POLICY STATEMENT
branches and agencies of foreign banks continue ON ALLL METHODOLOGIES AND
to be subject to separate guidance issued by DOCUMENTATION
their primary supervisory agency.
The guidance requires that a financial institu- Boards of directors of banks * * * are respon-
tion’s ALLL methodology be in accordance sible for ensuring that their institutions have
with generally accepted accounting principles controls in place to consistently determine the
(GAAP) and all outstanding supervisory guid- allowance for loan and lease losses (ALLL) in
ance. An ALLL methodology should be system- accordance with the institutions’ stated policies
atic, consistently applied, and auditable. The and procedures, generally accepted accounting
methodology should be validated periodically principles (GAAP), and ALLL supervisory
and modified to incorporate new events or find- guidance.3 To fulfill this responsibility, boards
ings, as needed. The guidance specifies that of directors instruct management to develop and
management, under the direction of the board of maintain an appropriate, systematic, and consis-
directors, should implement appropriate proce- tently applied process to determine the amounts
dures and controls to ensure compliance with of the ALLL and provisions for loan losses.
the institution’s ALLL policies and procedures. Management should create and implement suit-
Institution management should (1) segment the able policies and procedures to communicate
portfolio to evaluate credit risks; (2) select loss the ALLL process internally to all applicable
rates that best reflect the probable loss; and personnel. Regardless of who develops and
(3) be responsive to changes in the organization, implements these policies, procedures, and
the economy, or the lending environment by underlying controls, the board of directors
changing the methodology, when appropriate.
Furthermore, supporting information should be 3. [The actual policy statement includes a bibliography]
included on summary schedules, whenever fea- that lists applicable ALLL GAAP guidance, interagency state-
sible. Under this policy, institutions with less- 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
applying GAAP to determine the ALLL.
1. See 66 Fed. Reg. 35,629–35,639 (July 6, 2001).
2. The guidance was developed in consultation with Secu-
rities and Exchange Commission staff, who are issuing paral- BHC Supervision Manual July 2007
lel guidance in the form of Staff Accounting Bulletin No. 102. Page 1
ALLL Methodologies and Documentation 2065.4
should assure themselves that the policies spe- standards that are appropriate for an institution’s
cifically address the institution’s unique goals, size and the nature and scope of its activities.
systems, risk profile, personnel, and other For financial-reporting purposes, including
resources before approving them. Additionally, regulatory reporting, the provision for loan and
by creating an environment that encourages per- lease losses and the ALLL must be determined
sonnel to follow these policies and procedures, in accordance with GAAP. GAAP requires that
management improves procedural discipline and allowances be well documented, with clear
compliance. explanations of the supporting analyses and
The determination of the amounts of the rationale.8 This [2001] policy statement
ALLL and provisions for loan and lease losses describes but does not increase the documenta-
should be based on management’s current judg- tion requirements already existing within
ments about the credit quality of the loan portfo- GAAP. Failure to maintain, analyze, or support
lio, and should consider all known relevant an adequate ALLL in accordance with GAAP
internal and external factors that affect loan and supervisory guidance is generally an unsafe
collectibility as of the reporting date. The and unsound banking practice.9
amounts reported each period for the provision This guidance [the 2001 policy statement]
for loan and lease losses and the ALLL should applies equally to all institutions, regardless of
be reviewed and approved by the board of direc- the size. However, institutions with less-
tors. To ensure the methodology remains appro- complex lending activities and products may
priate for the institution, the board of directors find it more efficient to combine a number of
should have the methodology periodically vali- procedures (for example, information gathering,
dated and, if appropriate, revised. Further, the documentation, and internal-approval processes)
audit committee4 should oversee and monitor while continuing to ensure the institution has a
the internal controls over the ALLL- consistent and appropriate methodology. Thus,
determination process.5 much of the supporting documentation required
The [Federal Reserve and other] banking for an institution with more-complex products
agencies6 have long-standing examination poli- or portfolios may be combined into fewer sup-
cies that call for examiners to review an institu- porting documents in an institution with less-
tion’s lending and loan-review functions and complex products or portfolios. For example,
recommend improvements, if needed. Addition- simplified documentation can include spread-
ally, in 1995 and 1996, the banking agencies sheets, checklists, and other summary docu-
adopted interagency guidelines establishing ments that many institutions currently use. Illus-
standards for safety and soundness, pursuant to trations A and C provide specific examples of
section 39 of the Federal Deposit Insurance Act how less-complex institutions may determine
(FDI Act).7 The interagency asset-quality guide- and document portions of their loan-loss
lines and [this guidance will assist] an institu- allowance.
tion in estimating and establishing a sufficient
ALLL supported by adequate documentation, as
required under the FDI Act. Additionally, the 2065.4.1.1 Documentation Standards
guidelines require operational and managerial
Appropriate written supporting documentation
for the loan-loss provision and allowance facili-
4. All institutions are encouraged to establish audit com-
mittees; however, at small institutions without audit commit-
8. The documentation guidance within this [2001] policy
tees, the board of directors retains this responsibility.
statement is predominantly based upon the GAAP guidance
5. Institutions and their auditors should refer to Statement
from Financial Accounting Standards Board (FASB) State-
on Auditing Standards No. 61, ‘‘Communication with Audit
ment No. 5 and No. 114 (FAS 5 and FAS 114, respectively);
Committees’’ (as amended by Statement on Auditing Stan-
Emerging Issues Task Force Topic No. D-80 (EITF Topic
dards No. 90, ‘‘Audit Committee Communications’’), which
D-80 and attachments), ‘‘Application of FASB Statements No.
requires certain discussions between the auditor and the audit
5 and No. 114 to a Loan Portfolio’’ (which includes the
committee. These discussions should include items, such as
Viewpoints article—an article issued in 1999 by FASB staff
accounting policies and estimates, judgments, and uncertain-
providing guidance on certain issues regarding the ALLL,
ties that have a significant impact on the accounting informa-
particularly on the application of FAS 5 and FAS 114 and how
tion included in the financial statements.
these statements interrelate); Chapter 7, ‘‘Credit Losses,’’ the
6. The [other] banking agencies are the Federal Deposit
American Institute of Certified Public Accountants’ (AICPA)
Insurance Corporation, the Office of the Comptroller of the
Audit and Accounting Guide, Banks and Savings Institutions,
Currency, and the Office of Thrift Supervision.
2000 edition (AICPA Audit Guide); and the Securities and
7. Institutions should refer to the guidelines *** for state
Exchange Commission’s (SEC) Financial Reporting Release
member banks, appendix D to part 208***.
No. 28 (FRR 28).
9. Failure to maintain adequate supporting documentation
BHC Supervision Manual July 2007 does not relieve an institution of its obligation to record an
Page 2 appropriate ALLL.
tates review of the ALLL process and reported • the description of the institution’s systematic
amounts, builds discipline and consistency into methodology, which should be consistent with
the ALLL-determination process, and improves the institution’s 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 institution’s 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 institution’s ALLL methodol- priate reports, details of reviews per-
ogy to be effective, the institution’s 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 institution’s credit-
administration function, financial-
• the roles and responsibilities of the institu- reporting group, management, board of
tion’s 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 institution’s 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 SEC’s 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 period’s 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 management’s 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 institution’s ALLL methodology is influ-
individually impaired, should be grouped
enced by institution-specific factors, such as an
with other loans that share common char-
institution’s 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 institution’s written policies and procedures — descriptions of qualitative factors (e.g.,
should describe the primary elements of the industry, geographical, economic, and
institution’s ALLL methodology, including political factors) that may affect loss rates
portfolio segmentation and impairment mea- or other loss measurements.
surement. In order for an institution’s ALLL
methodology to be effective, the institution’s The supporting documents for the ALLL may
written policies and procedures should describe be integrated in an institution’s 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 institution’s 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 loan’s 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- A’s 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 A’s 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 loan’s 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 appraiser’s 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 loan’s 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 loan’s collateral,
less costs to sell, which it estimated to be
$8 million. This documentation should include
Example 2: ALLL Under FAS 114— (1) the institution’s 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 loan’s 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 FFIEC’s Federal Register
Example 3: ALLL Under FAS 114—Fully 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 institution’s 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 C’s collat- • The documentation in Institution C’s 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 loan’s
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 C’s credit-administration function documents, and (3) Institution C’s 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- C’s 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 institution’s or third party’s
therefore does not maintain any ALLL balance inspection of the collateral
for these loans. — historical losses on similar loans
— confidence in the institution’s 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 tution’s 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 model’s 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 rower’s primary industry. Example 5 describes
• trends in volume and terms of loans one institution’s 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 D’s 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 year’s 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 institution’s
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 Y’s 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 D’s management has identi- requirements. In contrast, recent information
fied particular segments of its commercial and indicates Company Z’s 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 institution’s loan-
the manufacturing businesses. Institution D’s 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 Y’s loan and Segment 2 for Company Z’s
sis that resulted in the adjustments to the loss loan). Management’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 F’s 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-
Estimates—Documenting 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 institution’s directors should establish
An institution’s 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 institution’s 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 institution’s 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 loan’s 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. loan’s 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 Appendix—Application 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 institution’s 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
Liabilities—a 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 loan’s 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 tion’s 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 institution’s
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 Council’s 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
institution’s 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- BHC’s 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 BHC’s 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 BHC’s 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 BHC’s 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 BHC’s 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
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
tion’s 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 organization’s 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 organization’s 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.
organization’s 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 employee’s 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 employee’s 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 employee’s salary).
consistent with the Principles for Sound Compensation Prac-
tices issued by the Financial Stability Board (FSB) in April
2009, and with the FSB’s 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 organization’s 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
organization’s 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 industry’s 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
Reserve’s 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-
Comptroller’s 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 bank’s profitability, even if the
Page 2 plan covers all or most of the organization’s employees.
tion’s 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,
zation’s overall supervisory rating. pose a threat to the organization’s safety and
The Federal Reserve (or the organization’s 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 organization’s 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 organization’s overall risk tol-
cies are found to exist in the organization’s 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 organization’s 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 organization’s 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 FBO’s group-wide policies developed in accordance
and update this guidance as appropriate to incor- with the rules of the FBO’s home country supervisor. The
porate best practices that emerge from these policies of the FBO’s U.S. operations should also be consis-
efforts. tent with the FBO’s 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 Reserve’s 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 Commission’s 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 OTS’s 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-
tion’s 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 employee’s 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 organization’s 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 employee’s activities and the
management and internal control functions of impact of those activities on the organization’s
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 organization’s 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 employee’s 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 employee’s 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 employee’s incentive for safety-and-soundness reasons given the
compensation payments are determined based threat they pose to the organization’s solvency
on performance measures that are only distantly and the federal safety net.
linked to the employee’s 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 organization’s 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
ee’s 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 employee’s award is
as the risks to the organization from the employ- extended (for example, from one year to two
ee’s 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 employee’s 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- employees—including 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 employees—as 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 employee’s 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-
ee’s 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- tion’s 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
organization’s 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 organization’s 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 organization’s 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 employee’s departure—in
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 employee’s 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 employee’s 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 employee’s previous
Page 8 employment.
(subject to any clawback or malus17), these 2068.0.2.2 Principle 2: Compatibility

changes could reduce the employee’s incentive with Effective Controls and
to remain at the organization and, thus, weaken Risk-Management
an organization’s ability to retain qualified tal-
ent, which is an important goal of compensa- A banking organization’s 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 organization’s
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 organization’s 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 employee’s 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 employee’s pay sensi-
tions. tive to risk.
Such actions may significantly weaken the
• Banking organizations should effectively com- effectiveness of an organization’s 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
tion’s employees need to understand that the purposes. In such cases, the employee’s 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 zation’s 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
organization’s 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- organization’s risk-management processes and
tion’s 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 organization’s 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 organization’s 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 organization’s overall • Compensation for employees in risk-
framework for compliance monitoring. An management and control functions should be
LCBO’s 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.
zation’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s
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 firm’s U.S. operations, consistent with the FBO’s 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 targets—is 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 organization’s 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 organization’s 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 organization’s incentive compensation awards and payments relative to
compensation arrangements are consistent with risk outcomes on a backward-looking basis to
the organization’s safety and soundness. These determine whether the organization’s 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 organization’s 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 organization’s
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 organization’s 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 organization’s 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.
committee—reporting to the full board—that Thus, an LCBO should use a systematic
has primary responsibility for overseeing the approach—supported by robust and formalized
organization’s incentive compensation systems. policies, procedures, and systems—to 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 organization’s disclosure prac- responsible for oversight of the organiza-
tices should support safe and sound incentive tion’s firm-wide activities or material
compensation arrangements. business lines;
b. individual employees, including non-
If a banking organization’s 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 organization’s 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
A holding company and its depository institu- Regarding Intercorporate Income Tax Account-
tion subsidiaries may generally file a consoli- ing Transactions of Bank Holding Companies
dated group income tax return. For bank regula- and State-Chartered Banks That Are Members
tory purposes, however, each depository of the Federal Reserve System. The statement
institution is viewed as, and reports as, a sepa- was revised and replaced by the December 1998
rate legal and accounting entity. Each holding Policy Statement on Income Tax Allocation in a
company subsidiary that participates in filing a Holding Company Structure, which does not
consolidated tax return should record its tax materially change any of the guidance previ-
expenses or tax benefits as though it had filed a ously issued.
tax return as a separate entity. The amount and The tax structure of bank holding companies
timing of any intercompany payments or becomes more complicated when deferred taxes
refunds to the subsidiary that result from its are considered in the intercorporate tax settle-
being a part of the consolidated return group ments.1 Deferred taxes occur when taxable
should be no more favorable than if the subsidi- income, for financial reporting purposes, differs
ary was a separate taxpayer. A consolidated from taxable income as reported to the taxing
return permits the parent’s and other subsidi- authorities. This difference is due to timing dif-
aries’ taxable losses to be offset against other ferences between financial-statement income
subsidiaries’ taxable income, with the parent and tax income for loan-loss provisions and
most often providing the principal loss. This can other items, such as foreign tax credits. In addi-
be illustrated with the following example: tion, differences result from the use of the cash
basis of accounting for tax purposes, as opposed
Parent Non- Non- Consoli- to the accrual basis of accounting used in finan-
Only Bank bank A bank B dated cial reporting. The different bases are chosen by
management.
Contribution to
consolidated net
An example of deferred income taxes fol-
taxable income lows, using an estimated tax rate of 40 percent.
(loss): $(100) $2,000 $500 $(50) $2,350
Assumed tax Financial Tax
rate 40% 40% 40% 40% 40% Reporting Return
Tax payment/ Pre-tax income $200 $150

(benefit) $(40) $ 800 $200 $(20) $ 940
Currently payable 60 60
Deferred portion 20 —
In this example, the parent, as the representa-
tive of the consolidated group to the Internal TOTAL 80 60
Revenue Service, would collect $800 from the Net income $120 $90
bank subsidiary and $200 from Nonbank Sub-
sidiary A, and pay $20 to Nonbank Subsidiary
B. In return, the parent would remit to the tax The deferred portion represents the tax effect of
authorities $940, resulting in a net cash reten- delaying the recognition of income or taking
tion of $40 by the parent. more of a deduction for tax-return purposes
Bank holding companies employ numerous (40% x $50). This is a temporary difference
methods to determine the amount of estimated since over the ‘‘life’’ of the bank holding com-
payments to be received from their subsidiaries. pany, income and deductions should theoreti-
Although the tax-accounting methods to be used cally equalize for both book and tax purposes.
by bank holding companies are not prescribed Financial Accounting Standards Board State-
by the Federal Reserve System, the method
employed must afford subsidiaries equitable 1. The issue becomes more complex because of GAAP-
treatment compared with filing separate returns. based tax expenses versus actual taxes paid under relevant tax
In general terms, tax transactions between any laws (the difference between the two expenses is either a
subsidiary and its parent should be conducted as deferred tax liability or asset on the balance sheet). If the
sharing agreement is based on the tax expense on the state-
though the subsidiary was dealing directly with ment of income, more funds may be transferred to the paying
state or federal taxing authorities. agent than are required to settle the actual taxes owed.
In 1978 the Board of Governors addressed
the issue of intercorporate income tax settle- BHC Supervision Manual June 1999
ments by issuing a formal Policy Statement Page 1
Taxes (Consolidated Tax Filing) 2070.0
ment No. 109 (FASB 109), ‘‘Accounting for include, under certain circumstances, the
Income Taxes,’’ provides guidance on many Board’s cease-and-desist powers.
aspects of accounting for income taxes, includ- On occasion, bank holding companies have
ing the accounting for deferred tax liabilities used deferred tax assets as a vehicle to transfer
and assets. FASB 109 describes how a bank cash or other earning assets of subsidiaries, prin-
holding company should record (1) taxes pay- cipally from the bank, into the parent company.
able or refundable for the current year and The Board’s opinion is that each deferred tax
(2) deferred tax liabilities and assets for the asset or liability must remain on the books of
future tax consequences of events that have the subsidiary. If deferred tax assets have been
been recognized in the banking organization’s transferred to the parent, regardless of when the
financial statements or tax returns. transfer may have occurred, immediate arrange-
Generally, all bank holding companies must ments must be made to return the asset to the
file annual income tax returns. The bank hold- appropriate subsidiary. Instances of transferring
ing company can pay the entire amount of tax deferred tax assets to the parent are worthy of
(that is, the amount still due after estimated tax inclusion in the Examiner’s Comments and Mat-
payments) on or before the due date for filing, ters Requiring Special Board Attention, page
or it can elect to pay by the extension deadline if one of the inspection report.
one is granted. Bank holding companies may
receive extensions from taxing authorities to file
their returns later. For the federal tax return, a 2070.0.1 INTERAGENCY POLICY
six-month extension may be granted. STATEMENT ON INCOME TAX
Bank holding companies generally pay esti- ALLOCATION IN A HOLDING
mated taxes throughout the year. The most com- COMPANY STRUCTURE
mon payment dates will be as follows (assum-
The federal bank and savings association’s regu-
ing calendar period):
latory agencies (the agencies) issued the follow-
ing policy statement to provide guidance to
April 15 — first estimate (25%)
banking organizations and savings associations
June 15 — second estimate (25%)
regarding the allocation and payment of taxes
September 15 — third estimate (25%)
among a holding company and its subsidiaries.
December 15 — fourth estimate (25%)
A holding company and its subsidiaries will
March 15 — Due date for income tax
often file a consolidated group income tax
return for U.S. corporations
return. However, for bank regulatory purposes,
or foreign corporations with
each depository institution of the consolidated
offices in the United States.
group is viewed as, and reports as, a separate
Last day for filing for the auto-
legal and accounting entity. Accordingly, each
matic six-month extension.
depository institution’s applicable income taxes,
September 15 — Due date of return if six-month
reflecting either an expense or benefit, should be
extensions were granted.
recorded as if the institution had filed as a
separate tax-paying entity.2 The amount and tim-
The bank holding company will calculate the ing of payments or refunds should be no less
amount of the estimated payments to the Inter- favorable to a subsidiary than if it was a sepa-
nal Revenue Service by using one of two meth- rate taxpayer. Any practice that is not consistent
ods: (1) prior year’s tax liability (most com- with this policy statement may be viewed as
monly used) or (2) 90 percent of the estimated an unsafe and unsound practice prompting
tax based on the current year’s estimated tax- either informal or formal corrective action. See
able income. SR-98-38.
Bank holding companies have engaged in
intercorporate income tax settlements that have
the effect of transferring assets and income from 2070.0.1.1 Tax-Sharing Agreements
a bank subsidiary to the parent company in
excess of those settlements that would be con- A holding company and its subsidiary institu-
sistent with the Board’s 1978 policy statement. tions are encouraged to enter into a written,
The Board will apply appropriate supervisory
remedies to situations that are considered ineq- 2. Throughout the policy statement, the terms ‘‘separate
entity’’ and ‘‘separate taxpayer’’ are used synonymously.
uitable or improper. These remedies may When a depository institution has subsidiaries of its own, the
institution’s applicable income taxes on a separate-entity basis
BHC Supervision Manual June 1999 include the taxes of the subsidiaries of the institution that are
Page 2 included with the institution in the consolidated group return.
comprehensive tax-allocation agreement tai- 2070.0.1.3 Tax Payments to the Parent

lored to their specific circumstances. The agree- Company
ment should be approved by the respective
boards of directors. Although each agreement Tax payments from a subsidiary institution to
will be different, tax-allocation agreements usu- the parent company should not exceed the
ally address certain issues common to consoli- amount the institution has properly recorded as
dated groups. its current tax expense on a separate-entity basis.
Therefore, such an agreement should— Furthermore, such payments, including esti-
mated tax payments, generally should not be
1. require a subsidiary depository institution to made before the institution would have been
compute its income taxes (both current and obligated to pay the taxing authority had it filed
deferred) on a separate-entity basis; as a separate entity. Payments made in advance
may be considered extensions of credit from the
2. discuss the amount and timing of the institu-
subsidiary to the parent and may be subject to
tion’s payments for current tax expense,
affiliate transaction rules, i.e., sections 23A and
including estimated tax payments;
23B of the Federal Reserve Act.
3. discuss reimbursements to an institution A subsidiary institution should not pay its
when it has a loss for tax purposes; and deferred tax liabilities or the deferred portion of
4. prohibit the payment or other transfer of its applicable income taxes to the parent. The
deferred taxes by the institution to another deferred tax account is not a tax liability
member of the consolidated group. required to be paid in the current reporting
period. As a result, the payment of deferred
income taxes by an institution to its holding
company is considered a dividend subject to
2070.0.1.2 Measurement of Current and dividend restrictions,3 not the extinguishment of
Deferred Income Taxes a liability. Furthermore, such payments may
constitute an unsafe and unsound banking
Generally accepted accounting principles, practice.
instructions for the preparation of both the Thrift
Financial Report and the federally supervised
bank Reports of Condition and Income, and 2070.0.1.4 Tax Refunds from the Parent
other guidance issued by the agencies require Company
depository institutions to account for their cur-
rent and deferred tax liability or benefit. An institution incurring a loss for tax purposes
When the depository-institution members of a should record a current income tax benefit and
consolidated group prepare separate bank regu- receive a refund from its parent in an amount no
latory reports, each subsidiary institution should less than the amount the institution would have
record current and deferred taxes as if it files its been entitled to receive as a separate entity. The
tax returns on a separate-entity basis, regardless refund should be made to the institution within a
of the consolidated group’s tax-paying or reasonable period following the date the institu-
-refund status. Certain adjustments for statutory tion would have filed its own return, regardless
tax considerations that arise in a consolidated of whether the consolidated group is receiving a
return, e.g., application of graduated tax rates, refund. If a refund is not made to the institution
may be made to the separate-entity calculation within this period, the institution’s primary fed-
as long as they are made on a consistent and eral regulator may consider the receivable as
equitable basis among the holding company either an extension of credit or a dividend from
affiliates. the subsidiary to the parent. A parent company
In addition, when an organization’s consoli- may reimburse an institution more than the
dated income tax obligation arising from the
alternative minimum tax (AMT) exceeds its 3. These restrictions include the prompt-corrective-action
regular tax on a consolidated basis, the excess provisions of section 38(d)(1) of the Federal Deposit Insur-
should be consistently and equitably allocated ance Act (12 U.S.C. 1831o(d)(1)) and its implementing regu-
among the members of the consolidated group. lations: for insured state nonmember banks, 12 CFR 325,
subpart B; for national banks, 12 CFR section 6.6; for savings
The allocation method should be based upon the associations, 12 CFR 565; and for state member banks,
portion of tax preferences, adjustments, and 12 CFR 208.45.
other items generated by each group member
which causes the AMT to be applicable at the BHC Supervision Manual June 1999
consolidated level. Page 3
refund amount it is due on a separate-entity tax liability. Transactions in which a parent

basis. Provided the institution will not later be ‘‘forgives’’ any portion of a subsidiary institu-
required to repay this excess amount to the tion’s deferred tax liability should not be
parent, the additional funds received should be reflected in the institution’s regulatory reports.
reported as a capital contribution. These transactions lack economic substance
If the institution, as a separate entity, would because each member of the consolidated group
not be entitled to a current refund because it has is jointly and severally liable for the group’s
no carry-back benefits available on a separate- potential future obligation to the taxing authori-
entity basis, its holding company may still be ties. Although the subsidiaries have no direct
able to utilize the institution’s tax loss to reduce obligation to remit tax payments to the taxing
the consolidated group’s current tax liability. In authorities, these authorities can collect some or
this situation, the holding company may reim- all of a group liability from any of the group
burse the institution for the use of the tax loss. If members if tax payments are not made when
the reimbursement will be made on a timely due.
basis, the institution should reflect the tax bene-
fit of the loss in the current portion of its appli-
cable income taxes in the period the loss is 2070.0.2 QUALIFYING
incurred. Otherwise, the institution should not SUBCHAPTER S CORPORATIONS
recognize the tax benefit in the current portion
of its applicable income taxes in the loss year. The Small Business Job Protection Act of 1996
Rather, the tax loss represents a loss carry- made changes to the Internal Revenue Code (the
forward, the benefit of which is recognized as a code). On October 29, 1996, the FFIEC issued a
deferred tax asset, net of any valuation bulletin notifying all federally insured banks
allowance. and thrifts of the impact of these changes. Thrift
Regardless of the treatment of an institution’s organizations may qualify for Subchapter S cor-
tax loss for regulatory reporting and supervisory poration status under the code’s revisions and
purposes, a parent company that receives a tax could generally receive pass-through tax treat-
refund from a taxing authority obtains these ment for federal income tax purposes if certain
funds as agent for the consolidated group on criteria are met.
behalf of the group members.4 Accordingly, an The bulletin states that no formal application
organization’s tax-allocation agreement or other is required to be filed with the federal bank and
corporate policies should not purport to charac- thrift regulatory agencies merely as a result of
terize refunds attributable to a subsidiary deposi- an election by a bank, thrift, or parent holding
tory institution that the parent receives from a company to become a Subchapter S corporation.
taxing authority as the property of the parent. However, if an institution takes certain steps to
meet the criteria to qualify for this tax status,
2070.0.1.5 Income-Tax-Forgiveness particularly the code’s limitations on the num-
Transactions ber and types of shareholders, applications or
notices to the agencies may be required.
A parent company may require a subsidiary The FFIEC bulletin also states that any distri-
institution to pay it less than the full amount of butions made by the Subchapter S banking orga-
the current income tax liability that the institu- nization to its shareholders, including distribu-
tion calculated on a separate-entity basis. Pro- tions intended to cover shareholders’ personal
vided the parent will not later require the institu- tax liabilities for their shares of the income of
tion to pay the remainder of the current tax the institution, will continue to be regarded as
liability, the amount of this unremitted liability dividends and subject to any limitations under
should be accounted for as having been paid relevant banking law. See SR-96-26.
with a simultaneous capital contribution by the
parent to the subsidiary.
In contrast, a parent cannot make a capital 2070.0.3 INSPECTION OBJECTIVES
contribution to a subsidiary institution by ‘‘for-
giving’’ some or all of the subsidiary’s deferred 1. To determine whether the supervisory and
accounting guidance set forth in FASB 109,
4. See 26 CFR 1.1502-77(a). other tax-accounting standards, and the 1998
interagency policy statement on income tax
BHC Supervision Manual June 1999 allocation has been appropriately, equitably,
Page 4 and consistently applied.
2. To verify that the parent’s intercorporate tax sharing agreements, the following inspection
policy contains a provision requiring the sub- procedures should be followed:
sidiaries to receive an appropriate refund a. Determine whether each subsidiary is
from the parent when they incur a loss, and required to compute its income taxes
that such a refund would have been receiv- (current and deferred) on a separate-
able from the tax authorities if the subsidiary entity basis.
was filing a separate return. b. Ascertain if the amount and timing of
3. To ascertain that tax payments and tax payments for current tax expense,
refunds between financial institution subsidi- including estimated tax payments, are
aries and the parent company have been lim- discussed.
ited to no more than what the institution c. Determine if reimbursements are dis-
might have paid to or received from the tax cussed when an institution has a loss for
authorities, if it had filed its tax returns on a tax purposes.
timely, separate-entity basis.5 d. Determine if there is a prohibition on the
4. To determine that no deferred tax liability, payment or other transfer of deferred
corresponding asset, or the deferred portion taxes by an institution to another mem-
of its applicable income taxes has been trans- ber of the consolidated group.
ferred from a bank subsidiary to the parent 2. Review briefly the parent’s intercompany
company. transaction report; general ledger income
5. To verify that there has been proper account- tax accounts; cash receipts and disburse-
ability for tax-forgiveness transactions ments; and, if necessary, tax-return work-
between the parent company and its financial papers and other pertinent corporate
institution subsidiaries. documents.
6. To substantiate that corporate practices are a. Ascertain that the taxes collected by the
consistent with corporate policies. parent company from each depository
institution subsidiary do not exceed the
amount that would have been paid if a
2070.0.4 INSPECTION PROCEDURES separate return had been filed.
b. When depository institution subsidiaries
1. Obtain and discuss with the bank holding are making their tax payments directly to
company’s management its intercorporate the taxing authorities, determine whether
income tax policies and tax-sharing agree- other subsidiaries are paying their pro-
ments. Obtain and retain a copy of the inter- portionate share.
corporate tax policies and agreements in the 3. Review the separate regulatory reports for
workpaper files. Review the written inter- depository institution members of the hold-
corporate tax-settlement policy and ascer- ing company that are included in the filing
tain that it includes the following: of a consolidated tax return.
a. a description of the method(s) used in a. Verify that each subsidiary institution is
determining the amount of estimated recording current and deferred taxes as if
taxes paid by each subsidiary to the it was filing its own tax returns on a
parent separate-entity basis.
b. an indication of when payments are to be b. Ascertain that any adjustments for statu-
made tory tax considerations, arising from fil-
c. a statement that deferred taxes are main- ing a consolidated return, are also made
tained on the affiliate’s general ledger to the separate-entity calculations consis-
d. procedures for handling tax claims and tently and equitably among the holding
refunds company affiliates.
Bank holding companies should also have writ- 4. Determine if any excess amounts (tax bene-
ten tax-sharing agreements with their subsidi- fits), resulting from the filing of a consoli-
aries that specify intercorporate tax-settlement dated return, are consistently and equitably
policies. The Board encourages bank holding allocated among the members of the con-
companies to develop such agreements. For tax- solidated group.
5. Review the tax payments that are made
from the bank and the nonbank subsidiaries
5. The term ‘‘separate-entity basis’’ recognizes that certain
adjustments, in particular tax elections in a consolidated
to the parent company.
return, may, in certain periods, result in higher payments
by the bank than would have been made if the bank was BHC Supervision Manual June 1999
unaffiliated. Page 5
a. Determine that payments, including esti- later than the date the institutions would
mated payments, that are being requested have filed their own returns and that the
do not significantly precede the time that refund is not characterized as the parent
a consolidated or estimated current tax company’s property.
liability would be due and payable by b. If the parent company does not require a
the parent to the tax authorities. subsidiary to pay its full amount of cur-
b. Verify with management that the tax rent tax liability, ascertain that the
payments to the parent company were amount of the tax liability is recorded as
not in excess of the amounts recorded by having been paid and that the corre-
its depository institution subsidiaries as sponding credit is recorded as a capital
current tax expense on a separate-entity contribution from the parent company to
basis. the subsidiary.
c. Determine that subsidiary institutions are 7. Determine that the deferred tax accounts of
not paying their deferred tax liabilities each bank subsidiary are maintained on its
on the deferred portions of their applica- books and that they are not transferred to
ble income taxes to the parent company. the parent organization.
d. Ascertain that the parent company is not 8. Determine if the Internal Revenue Service
deriving tax monies from depository or other tax authorities have assessed any
institution subsidiaries that are used for additional tax payments on the consolidated
other operating needs. group, and whether the holding company
6. When a subsidiary incurs a loss, review the has provided an additional reserve to cover
tax system to determine that bank and non- the assessment.
bank subsidiaries are receiving an appropri- 9. Complete the Other Supervisory Issues
ate refund from the parent company, that is, page of the Report of Bank Holding Com-
an amount that is no less than what would pany Inspection (FR 1225 and FR 1241).
have been received if the tax return had 10. Verify the accuracy of the FR Y-8, Report
been filed on a separate-entity basis. of Intercompany Transactions, pertaining to
a. Verify that the refund(s) are received no the information on tax settlements.
FFIEC Policy Statement 4-870 1999 FRB 111

on Income Tax Allocation
in a Holding Company
Structure

Page 6
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
WHAT’S 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 organization’s viability.
For this reason, BHCs, in managing their fund-
A key principle underlying the Federal ing positions, should control liquidity risk by
Reserve’s 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
Reserve’s 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 organization’s 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 BHC’s 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- company’s 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 BHC’s 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
borrower’s financial condition.
In developing and carrying out funding pro- 2080.05.3 EXAMINER’S
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 ratings—composite (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 organization’s 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 company’s 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 investor’s 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 # 33–4412, September 20, garded as ‘‘investment quality’’ (ratings of less
1961), that are deemed necessary to qualify than medium grade—refer 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 issuer’s 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 spouse’s 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 company’s
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 90–19 and SR–620)
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-
tests—a 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. bank’s 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 Board’s 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 bank’s 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 Board’s 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 company’s 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 Glass–Steagall 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 company’s 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 company’s access to bank credit is almost 3. To determine compliance with the Federal
universal, and most small to medium-sized com- Reserve System’s 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 90–19 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 bank’s 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 company’s pro-
short- term bank notes are usually pegged to the cedures for authorizing the issuance of commer-
creditor’s 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 company’s 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
company’s 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 company’s (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 company’s 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 bank’s 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 ‘‘Examiner’s
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 Reserve’s
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 90–19, 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-
company’s 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 debt’s 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
er’s debt structure when offering financing. If income statement for debt and interest expense
the borrower’s 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
doesn’t 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 BHC’s 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 parent’s 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 company’s 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 company’s 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 more consistent with generally accepted ac-
source of capital formation and growth. Earn- counting principles. Two different calculations
ings retained after dividend payout can often be are performed to measure the amount of divi-
sufficient to keep pace with asset growth, dends that may be paid, a Net Profits Test and
thereby preserving the balance or relationship an Undivided Profits Test.
between equity capital and total assets. Often
referred to as ‘‘internal funding,’’ earnings reten-
tion should be carefully reviewed to assure that 2080.4.1.1 Net Profits Test
the BHC’s capital base is keeping pace with
asset growth. The approval of the Federal Reserve is required
Bank earnings retention should be reviewed for dividends declared by a member bank that in
carefully due to the dividend requirements often any calendar year exceeds the net profits of the
imposed on banks by their parent companies. current year, combined with retained net profits
Although a bank’s board of directors must ap- for the two proceeding years (the ‘‘Net Profits
prove the declaration and payment of any bank Test’’). Under the regulation, net profits of a
dividend, often the bank’s board is actually rati- year will equal net income. A member bank is
fying a decision determined at the parent level. required to use these rules in calculating net
The need for bank retention of earnings is par- profits beginning in 1991 and thereafter.
ticularly pronounced either during periods of
expansion or periods of declining earnings or
losses. 2080.4.1.2 Undivided Profits Test
Parent company management may be under
pressure from shareholders or ‘‘the market’’ to The parent company’s bank subsidiaries must
increase dividends or to maintain dividends at receive prior approval of the Federal Reserve
historic levels despite reversals in consolidated before paying dividends in amounts greater than
earnings trends. Examiners should be careful to undivided profits then on hand, after deducting
point out to management that dividend pres- any bad debts in excess of the allowance for
sures often serve to the detriment of the bank loan and lease losses. Under the regulations
subsidiary(ies) which is often asked to supply effective January 25, 1991, undivided profits
the proceeds via a dividend to the parent com- then on hand include undivided profits plus the
pany. As a regulator of banks (and bank holding amount of ‘‘surplus surplus’’ that meets certain
companies), the Federal Reserve System is con- conditions. ‘‘Surplus surplus’’ is defined as the
cerned with the preservation and maintenance of amount of capital surplus in excess of the
a sound banking system and in particular, amount required under applicable state law, and
soundly capitalized banks. Earnings retention the regulations provide that a bank may include
contributes to capital growth and should be en- surplus surplus in undivided profits then on hand
couraged. For additional information on earn- only if the bank can demonstrate that surplus
ings retention and dividends see sections surplus is from earnings of prior periods
2020.5.1, 4010.1, and 4020.1. (‘‘earned surplus surplus’’). Transfers from sur-
plus surplus to undivided profits must receive
prior approval of the Federal Reserve. Bad debts
2080.4.1 PAYMENT OF DIVIDENDS in excess of the allowance for loan and lease
BY BANK SUBSIDIARIES losses must be subtracted from undivided profits
then on hand in calculating the amount available
Bank dividends can be determined to be exces- for dividends. Bad debts are defined as debts
sive if they exceed the limitations imposed by due and unpaid for a period of six months unless
either section 5199(b) or 5204 (also referred to well secured and in the process of collection.1
as sections 56 and 60(b)) of the Revised Statutes
and accordingly, should be reviewed with re-
gard to those limitations. The Federal Reserve
Board amended Regulation H on December 20, 1. Because for most banks bad debts are less than the
1990, regarding the payment of dividends by allowance for loan and lease losses, this subtraction will not
state member banks [12 C.F.R. 208.19(a) and apply to most banks.
208.19(b)]. These new regulations make the ele-
ments that are taken into account in determining BHC Supervision Manual December 1992
a state member bank’s dividend paying capacity 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 ESOP’s 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
ny’s 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 85–21 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-
ployer’s pre-tax income. Contributions are held
2080.5.1 STOCK OPTION PROGRAMS in trust, and benefits when paid out upon an
employee’s retirement, death, or termination of
Employee stock option programs generate a service, must be paid in company stock. The
nominal percentage of a holding company’s 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
company’s 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) 72–3 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
76–3. 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 81–697 (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 employer’s 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 ESOP’S 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 ERISA’s 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 2550.407d–6). 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 BHC’s management. Section
BHC Supervision Manual December 1992 225.41 of Regulation Y specifies transactions—
Page 2 acquisitions—that 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- Board’s 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
serve’s 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-
ny’s 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 90–31 to any bank holding company en-
mine public confidence in an organization’s 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
bank’s 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
WHAT’S 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 Board’s 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 Board’s 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 Board’s 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;
Board’s 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 company’s 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 holder’s 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 parent’s 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
company’s subsidiary (or the subsidiary’s 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 company’s ‘‘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 Board’s 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-
Board’s attention or from a company’s seeking pany which
to obtain the Board’s 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 Board’s 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 company’s stock records and the
company’s 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 4–191.1) (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
WHAT’S 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 Act’s 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- Board’s 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 Board’s 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 Board’s 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 Board’s public web site at www.
2090.1.1 COMMITMENTS AND federalreserve.gov/generalinfo/applications/afi/.
CONDITIONS FOR APPROVAL In particular, review the System’s 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 Board’s 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 institution’s shares may be 2090.1.4.2 Rebuttable Presumption of
required to file notice under the Board’s 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 individual’s 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 person’s 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 Act’s 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 Board’s 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 INSTITUTION’S 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
Reserve’s 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 party’s 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
person’s overall financial strength and the insti- 2090.1.12 CORRECTIVE ACTION
tution’s 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 institution’s 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 BHC’s 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
WHAT’S NEW IN THIS REVISED operating/capital losses of one corporation
SECTION against the profits/capital gains of another.
Once a company becomes a bank holding
Effective July 2006, this revised section incorpo- company, either by the formation of a one-bank
rates the Board’s February 16, 2006, revision of or multibank holding company, section 3(a)(3)
Regulation Y (effective March 30, 2006). The of the act prohibits the direct or indirect acquisi-
revised rule increased the asset-size threshold tion of over 5 percent of any additional bank’s
from $150 million to $500 million in consoli- or bank holding company’s shares without prior
dated assets and amended the related eligibility Board approval. In addition to the above, sec-
criteria for determining whether a bank holding tion 3(a)(3) serves to prevent an existing bank
company (BHC) may qualify for the Board’s holding company from increasing, without prior
Small Bank Holding Company Policy Statement Board approval, its ownership in an existing
(the policy statement) and the capital guide- subsidiary bank unless greater than 50 percent
lines. The revised rule includes an exemption of the shares are already owned (section
from the capital guidelines; modified the quali- 3(a)(B)). A bank holding company which owns
tative criteria used in determining if a BHC, more than 50 percent of a bank’s shares may
that is under the asset-size threshold, would not buy and sell those shares freely without Board
qualify for the policy statement or the exemption approval, provided the ownership never drops to
from the capital guidelines; and clarified the 50 percent or less. If a bank holding company
treatment under the policy statement of subordi- owns 50 percent or less of a bank’s shares, prior
nated debt associated with trust preferred Board approval is required before each addi-
securities. tional acquisition of shares takes place until the
ownership reaches more than 50 percent.
2090.2.1 FORMATION OF A BANK

HOLDING COMPANY AND 2090.2.2 HISTORY OF APPLYING
CHANGES IN OWNERSHIP THE CAPITAL ADEQUACY
GUIDELINES TO THE POLICY
The formation of a bank holding company and STATEMENT ON THE FORMATION
certain changes in the ownership of banks OF SMALL BANK HOLDING
owned by a bank holding company come under COMPANIES
the provisions of section 3 of the BHC Act.
Section 3(a)(1) prohibits the formation of a bank On March 28, 1980, the Board issued a policy
holding company without prior Board approval. statement with regard to the formation of small
A company may receive approval pursuant to one-bank holding companies. The policy state-
section 3(a)(1) to become either a one-bank ment was included with the revision of Regula-
holding company or a multibank holding tion Y (12 C.F.R. 225, appendix C) on January
company. 5, 1984. Subsequent to this policy statement,
A primary reason for the formation of a one- capital adequacy standards were adopted for
bank holding company is to obtain income tax large multibank holding companies (on a con-
benefits.1 These benefits include offsetting solidated basis2) in December 1981 (amended in
June 1983, April 1985, and November 1986)
that set minimum capital levels and capital
1. A corporation is entitled to a special deduction from zones relating to primary and total capital.3
gross income for dividends received from a taxable domestic These were replaced in January 1989 (amended
corporation. There is (1) a 70 percent deduction for dividends in October 1991) by the current minimum capi-
received from a corporation that is less than 20 percent
owned; (2) an 80 percent deduction for dividends received
from a corporation that is 20 to less than 80 percent owned; 2. Capital adequacy is evaluated on a bank-only basis for
(3) a 100 percent deduction for dividends received from small bank holding companies.
members of the same affiliated group (i.e., a corporation that 3. Primary capital included common stockholders’ equity,
is 80 percent or more commonly owned); and (4) a 100 per- contingency and other capital reserves, the allowances for
cent deduction for dividends received from small business loan and lease losses, and the minority interest in the equity
investment corporations. There is also an overall limitation on accounts of consolidated subsidiaries. It also included limited
dividends received. The recipient’s aggregate amount is lim- amounts of perpetual preferred stock, mandatory convertible
ited to 70 percent (80 percent for those corporations that are securities, and perpetual debt.
20 to less than 80 percent owned) of taxable income. The
manner in which the deduction is computed is also subject to BHC Supervision Manual July 2006
further limitation. Page 1
Control and Ownership (BHC Formations) 2090.2
tal adequacy standards that use the risk-based On February 16, 2006, the Board approved a
capital and leverage capital measures. revision to Regulation Y (effective March 30,
Typically, a small bank holding company’s 2006) that increased the asset-size threshold
capital position has not been evaluated on a from $150 million to less than $500 million in
consolidated basis. The capital adequacy evalu- pro forma consolidated assets for determining if
ation of applications for the formation of small (1) a BHC may qualify under the Board’s Small
bank holding companies initially followed an Bank Holding Company Policy Statement (the
8 percent gross capital to total assets standard.4 policy statement) and (2) the BHC qualifies for
Subsequently, the 1981 guidelines established an exemption from the Board’s risk-based and
minimum 5.5 percent primary and 6.0 percent leverage capital guidelines for BHCs. The Board
total capital ratios and the concept of capital also established eligibility qualitative criteria for
zones above the minimum capital ratios. When determining if a BHC that otherwise meets the
analyzing bank capital for small bank holding asset threshold should not qualify for the policy
company formations, December 1981’s 7 per- statement and the exemption from the capital
cent (zone 1) total capital to assets leverage guidelines. The qualitative criteria emphasize
ratio (after adjusting for the addition of the that a BHC should not: (1) be engaged in signifi-
allowance for loan and lease losses to the ratio’s cant nonbanking activities through a nonbank
numerator and denominator) became the finan- subsidiary, (2) conduct significant off-balance-
cial equivalent of 1980’s 8 percent gross capital sheet activities through a nonbank subsidiary, or
standard. For the bank, the change resulted in (3) have a material amount of SEC-registered
evaluating applications for capital adequacy debt or equity securities outstanding.
based on a 7 percent total capital to total assets
ratio. Since most small banks did not have quali-
fying secondary capital, the practical effect of
the change was that both the zone 1 primary and 2090.2.3 SMALL BANK HOLDING
total capital ratios were at least 7 percent. In COMPANY POLICY STATEMENT
September 1990, a minimum tier 1 leverage
ratio became effective. A tier 1 to total assets In acting on applications filed under the act, the
leverage ratio of 6 percent was applied as the Board follows the principle that bank holding
financial equivalent of the former 7 percent total companies should serve as a source of strength
capital ratio. for their subsidiary banks. When bank holding
Even though the components of the various companies incur debt and rely on the earnings
capital ratios have changed over time, the capi- of their subsidiary banks as the means of repay-
tal standards used to evaluate capital positions ing such debt, a question arises as to the prob-
of banks for small bank holding formations have able effect on the financial condition of the
not. The fundamental policy is still the same. In holding company and its subsidiary bank or
both instances, approximately the same percent- banks.
age of small banks meets both ratios. It also The Board believes that a high level of debt at
should be noted that, if at any time, state or the parent holding company level impairs the
federal banking authorities or loan agreements ability of a bank holding company to provide
require the banks of small bank holding com- financial assistance to its subsidiary bank or
pany formations to satisfy higher capital stan- banks, and, in some cases, the servicing require-
dards, those standards will be used when evalu- ments on such debt may be a significant drain
ating capital adequacy. on the bank’s resources. For these reasons, the
Effective April 21, 1997, revisions to Regula- Board has not favored the use of acquisition
tion Y included revisions to the Board’s one- debt in the formation of bank holding compa-
bank holding company policy statement. The nies or in the acquisition of additional banks.
policy statement was revised to generalize its Nevertheless, the Board has recognized that the
applicability beyond the formation of a bank transfer of ownership of small banks often
holding company to include acquisitions by requires the use of acquisition debt. The Board
qualifying small bank holding companies. therefore has permitted the formation and
expansion of small bank holding companies
with debt levels that are higher than what would
4. The allowance for loan and lease losses was not added
back to total assets. In other words, the ‘‘total assets’’ were net
be permitted for larger bank holding companies.
of the allowance for loan and lease losses, a contra asset. Approval of these applications has been given
on the condition that the small bank holding
BHC Supervision Manual July 2006 companies demonstrate the ability to service the
Page 2 acquisition debt without straining the capital of
their subsidiary banks and, further, that such 2090.2.3.2.1 Reduction in Parent
companies restore their ability to serve as a Company Leverage
source of strength for their subsidiary bank
within a relatively short period of time. Small BHCs are to reduce their parent company
In the interest of facilitating the transfer of debt consistent with the requirement that all
ownership in banks without compromising bank debt be retired within 25 years of being incurred.
safety and soundness, the Board has adopted the The Board expects these BHCs to reach a debt-
procedures and standards for the formation and to-equity ratio of .30 to 1 or less within 12 years
expansion of small bank holding companies after incurrence of the debt. The bank holding
subject to the small bank holding company pol- company must also comply with debt-servicing
icy statement. and other requirements imposed by its creditors.
The policy statement focuses on the relation- The term debt as used in the ratio of debt to
ship between debt and equity at the parent hold- equity, means any borrowed funds (exclusive of
ing company. The holding company has the short-term borrowings that arise out of current
option of improving the relationship of debt-to- transactions, the proceeds of which are used for
equity by repaying the principal amount of its current transactions) and any securities issued
debt or through the retention of earnings, or by, or obligations of, the holding company that
both. Under these procedures, newly organized are the functional equivalent of borrowed funds.
small one-bank holding companies are expected Subordinated debt associated with trust pre-
to reduce the relationship of their debt-to-equity ferred securities generally would be treated as
over a reasonable period of time to a level that is debt for purposes of this policy statement. See
comparable to that maintained by many large paragraphs 2.C., 3.A., 4.A.i, and 4.B.i of the
and multibank holding companies. policy statement. A BHC, however, may
exclude from debt an amount of subordinated
debt associated with trust preferred securities
that is up to 25 percent of the bank holding
2090.2.3.1 Applicability of Policy company’s equity (as defined below) less good-
Statement will5 on the parent company’s balance sheet, in
determining compliance with the requirements
The policy statement applies only to BHCs with of such paragraphs of the policy statement. In
pro forma consolidated assets of less than $500 addition, a BHC subject to this policy statement
million that (1) are not engaged in significant that has not issued subordinated debt associated
nonbanking activities either directly or through with a new issuance of trust preferred securities
a nonbank subsidiary, (2) do not conduct signifi- after December 31, 2005, may exclude from
cant off-balance-sheet activities (including secu- debt any subordinated debt associated with trust
ritization and asset management or administra- preferred securities until December 31, 2010.
tion) either directly or through a nonbank BHCs subject to this policy statement may also
subsidiary, and (3) do not have a material exclude from debt until December 31, 2010, any
amount of SEC-registered debt or equity securi- subordinated debt associated with refinanced
ties outstanding (other than trust preferred secu- issuances of trust preferred securities originally
rities). The Board may, in its discretion, exclude issued on or prior to December 31, 2005, pro-
any BHC, regardless of asset size, from the vided that the refinancing does not increase the
policy statement if such action is warranted for BHC’s outstanding amount of subordinated
supervisory purposes. Although the policy state- debt. Subordinated debt associated with trust
ment primarily applies to the formation of small preferred securities will not be included as debt
BHCs, it also applies to existing BHCs that wish in determining compliance with any other
to acquire an additional bank or company and to requirements of this policy statement.
transactions involving changes in control, stock The term equity as used in the ratio of debt to
redemptions, or other shareholder transactions. equity, means total stockholders’ equity of the
The criteria are described below. BHC, as defined in accordance with generally
5. Goodwill is defined as the excess of purchase price of

any acquired company or asset over the sum of the fair market
2090.2.3.2 Ongoing Requirements values assigned to identifiable assets or asset acquired, less
the fair market values of the liabilities assumed, accounted for
in accordance with generally accepted accounting principles.
All organizations operating under the policy
statement must meet the requirements set forth BHC Supervision Manual July 2006
below on an ongoing basis. Page 3
accepted accounting principles. In determining the holding company is (1) not reducing its debt
the total amount of stockholders’ equity, the consistent with the requirement that the debt-to-
BHC should account for its investments in the equity ratio be reduced to 30 percent within 12
common stock of subsidiaries by the equity years of consummation of the proposal or
method of accounting. (2) not meeting the requirements of its loan
Ordinarily, the Board does not view redeem- agreement(s).
able preferred stock as a substitute for common
stock in a small BHC. Nevertheless, to a limited
degree and under certain circumstances, the 2090.2.3.3 Core Requirements for All
Board will consider redeemable preferred stock Applicants
as equity in the capital accounts of the holding
company if the following conditions are met: When an organization subject to the policy
(1) the preferred stock is redeemable only at the statement (1) files an application or notice pur-
option of the issuer and (2) the debt-to-equity suant to the BHC Act, as amended, and
ratio of the holding company would be at or (2) intends to incur debt to finance the acquisi-
remain below .30:1 following the redemption or tion of a small bank or company, the Board will
retirement of any preferred stock. Preferred assess the application or notice and take into
stock that is convertible into common stock of account a full range of financial and other infor-
the holding company may be treated as equity. mation. The Board will consider the recent trend
and stability of the bank’s or company’s earn-
ings, prospective growth of the bank or com-
2090.2.3.2.2 Capital Adequacy pany to be acquired, asset quality, the ability of
the applicant to meet debt-servicing require-
Each insured depository subsidiary of a small ments without placing an undue strain on the
BHC is expected to be well capitalized. Any resources of the bank(s), and the record and
institution that is not well capitalized is expected competency of management. In addition, the
to become well capitalized within a brief period Board will require applicants to meet the mini-
of time. mum requirements set forth below. As a general
rule, failure to meet any of these requirements
will result in denial of an application; however,
2090.2.3.2.3 Dividend Restrictions the Board reserves the right to make exceptions
if the circumstances warrant.
A small BHC whose debt-to-equity ratio is
greater than 1:1 is not expected to pay any
corporate dividends on common stock until it 2090.2.3.3.1 Minimum Down Payment
reduces its debt-to-equity ratio to 1:1 or less and
otherwise meets the requirements in sections The amount of acquisition debt should not
225.14(c)(1)(ii), 225.14(c)(2), and 225.14(c)(7) exceed 75 percent of the purchase price of the
of Regulation Y. Dividends may be paid by bank(s) or company to be acquired. When the
small BHCs with debt-to-equity of at or below owner(s) of the holding company incurs debt to
1:1, provided all of the following conditions are finance the purchase of the bank(s) or company,
met: the dividends are (1) reasonable in amount, such debt will be considered acquisition debt
(2) do not adversely affect the ability of the even though it does not represent an obligation
BHC to service its debt in an orderly manner, of the BHC, unless the owner(s) can demon-
and (3) do not adversely affect the ability of the strate that such debt can be serviced without
subsidiary banks to be well capitalized.6 Also, it reliance on the resources of the bank(s) or BHC.
is expected that dividends will be eliminated if
6. For BHCs with consolidated assets under $500 million, 2090.2.3.3.2 Ability to Reduce Parent
well-capitalized means that the BHC meets the requirements
for expedited/waived processing of the policy statement and
Company Leverage
that, on a consolidated basis, the BHC (1) maintains a total
risk-based capital ratio (as defined in appendix A of Regula- The BHC must clearly be able to reduce its
tion Y) of 10.0 percent or greater; (2) maintains a tier 1 debt-to-equity ratio and comply with its loan
risk-based capital ratio of 6.0 percent or greater; and (3) is not agreement(s) as stated within the ongoing
subject to any written agreement, order, capital directive, or
prompt-corrective-action directive issued by the Board to requirements discussed previously. Failure to
BHC Supervision Manual July 2006 meet and maintain a specific capital level for any capital
Page 4 measure.
meet the criteria would normally result in denial lation Y) discussed previously in this section. A
of an application. bank holding company application that seeks to
expand a small bank holding company with or
without creating or expanding a chain control-
2090.2.3.4 Additional Application ling assets of less than $500 million would be
Requirements for Expedited Processing evaluated on the basis of the policy statement in
the same manner as if the proposed bank hold-
2090.2.3.4.1 Expedited Notices ing company was not part of a chain.
The above application would be evaluated on
A small BHC proposal will be eligible for the the basis of the financial and managerial condi-
expedited processing procedures set forth in section of the entire organization. Although the
tions 225.14 and 225.23 of Regulation Y if policy statement would generally be applied,
(1) the BHC is in compliance with the ongoing the focus of the analysis would be as much on
requirements of the policy statement, (2) the the organization as an operating entity as on the
BHC meets the previously discussed core instant proposal. For example, it would be
requirements for all applicants, and (3) the fol- expected that the condition of the applicant
lowing requirements are met: organization and that of its subsidiaries would
be consistent with expansion, one aspect of
1. The parent BHC has a pro forma debt-to- which is that each banking subsidiary generally
equity ratio of 1:1 or less. would be expected to maintain capital well
2. The BHC meets all the criteria for expedited above the minimum levels. The policy state-
action of sections 225.14 and 225.23 of ment would generally govern the payment of
Regulation Y. dividends by the applicant organization and any
prospective use of preferred stock. The bank to
be acquired would be expected to maintain
2090.2.3.4.2 Waiver of Stock-Redemption above-minimum capital ratios consistent with
Filing those contemplated by the Board’s capital
adequacy guidelines.
A small BHC will be eligible for the stock- An acquisition debt retirement period would
redemption filing exemption for well-capitalized apply with respect to each proposal and the
BHCs that is found in sections 225.14(c)(2) and acquisition debt/purchase price ratio limitation
225.14(c)(6) if the following requirements are of 75 percent would generally apply to the
met: instant application. A specific parent-only debt/
equity limit would not be applied. However, it
1. The parent BHC has a pro forma debt-to- would be expected that the ratio would decline
equity ratio of 1:1 or less. over time.
2. The BHC is in compliance with the ongoing
In addition, the financial and managerial con-
requirements of the policy statement and
dition of the members of any chain thereby
meets the requirements of sections
formed or expanded (including compliance con-
225.14(c)(1)(ii), 225.14(c)(2), and
siderations and general consistency with the
225.14(c)(7) of Regulation Y.
capital adequacy guidelines, giving consider-
ation to the need to maintain capital positions
well above the minimum ratios) would be evalu-
2090.2.4 CAPITAL CONSIDERATIONS ated. The chain would not have to meet a spe-
IN SMALL MULTIBANK AND CHAIN cific, combined parent-only debt/equity stan-
BANK HOLDING COMPANY dard. However, there would be a general
APPLICATIONS presumption that the debt/equity level of the
chain would tend to decline after the initial
Multibank holding companies and chain bank- leveraged approval. Although individual bank
ing organizations (whether or not the chain holding companies might be leveraged up to
members are banks or bank holding companies) .30:1, over time the combined leverage of the
with less than $500 million in combined assets chain would tend to be less than this level
that meet certain conditions will not be consoli- through increases in the equity or reductions in
dated or combined for capital adequacy pur- the debt of the organization. Proposals by bank-
poses. Rather, such organizations will be ana- ing organizations whose combined banking
lyzed in the context of the standards described
in the Board’s policy statement on small bank BHC Supervision Manual July 2006
holding companies (appendix C of Regu- Page 5
assets exceed $500 million would be evaluated 2. Determine if the BHC is in compliance with
for capital adequacy on the basis of an analysis the Small Bank Holding Company Policy
of the consolidated organization. (The term con- Statement (Regulation Y, appendix C) by—
solidated as used with the analysis of large a. verifying that the board of directors and
chains would involve actually consolidating senior management have established and
each parent bank holding company with its sub- regularly maintain a plan to
sidiary (or subsidiaries), and then combining • retire the BHC’s debt within 25 years of
each such consolidated entity as well as any incurring the debt and
other bank in the chain). An analysis of the • reach a debt-to-equity ratio of .30:1 or
capital adequacy of each constituent entity in a less within 12 years of incurring the
large banking organization would also continue debt.
to be assessed to determine whether the holding 3. Ascertain if the BHC uses a regular periodic
company would serve as a source of strength to monitoring process to ensure the full retire-
its subsidiary banks. ment of the holding company’s debt within
the above-stated required or expected
periods.
2090.2.5 INSPECTION OBJECTIVES 4. Determine whether the BHC is well capital-
ized or, if not, whether it will be well capital-
1. To determine compliance with all commit- ized within a brief period of time.
ments made in the application/notification 5. Determine if the payment of corporate divi-
process. dends has been restricted until the BHC’s
2. To determine if the BHC is in compliance debt-to-equity ratio is 1:1 or less and until
with the Small Bank Holding Company Pol- the BHC otherwise meets the criteria
icy Statement (Regulation Y, appendix C), set forth in sections 225.14(c)(1)(ii),
including whether the BHC’s debt is being 225.14(c)(2), and 225.14(c)(7) of Regulation
reduced within the required or expected time Y.
periods.

1. Review all commitments made by the com-
pany and its shareholders to determine com-
pliance therewith.

Page 6
Capital adequacy guidelines 225 4–797

Regulation Y, appendixes A and D 4–798
4–855
Small BHC Policy Statement 225 4–856

Regulation Y, appendix C
1. 12 U.S.C., unless specifically stated otherwise.
3. Federal Reserve Regulatory Service reference.

Page 7
(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 ‘‘person’s’’ 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 shareholder’s 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 firm’s 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
company’s 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 BHC’s 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 organization’s 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 shareholder’s 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 shareholder’s holdings have risen to
requirements of the Board’s 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
Board’s 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 organization’s 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
WHAT’S 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 Board’s 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 Board’s 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-
Board’s 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 organization’s management or policies that
updates the guidance found in the Board’s 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 organization—an
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 Board’s 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 company’s
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 organization’s decision-making The 1982 Policy Statement sets out the
process, thus protecting taxpayers from Board’s 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 BOARD’S 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 Board’s
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 Board’s
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 Board’s 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 Board’s
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 investor’s 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-
investor’s 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 management’s 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 acquiree’s 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 investor’s 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 lender’s influence by prepaying the loan.
A measure to avoid problems of control aris- 2090.4.2.4 Review by the Board
ing through the investor’s 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 Board’s 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 Board’s 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 Board’s 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 acquiree’s 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 acquiree’s 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 acquiree’s 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 acquiree’s 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-
acquiree’s 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 investor’s 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
organization’s 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-
nization’s 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 Board’s 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 BOARD’S 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 investor’s 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 Board’s 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
Board’s views on specific approaches to avoid meetings of the board.
7. An investor’s total interest is equal to the greater of the
control.5 investor’s 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 investor’s 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 investor’s 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 organization’s 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 organization’s 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 organization’s 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 investor’s 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 investor’s 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 organization’s 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 organization’s 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 organization’s board of directors, advocate
considered voting shares at all times for pur- for changes in the banking organization’s 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 organization’s 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 tion’s 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 bank’s
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 organization’s 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- organization’s 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
zation’s management and policies—especially (6) acquiring significant assets or control of
when coupled with a sizeable voting stock another firm.13
investment—by 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
investment—provide 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 investor’s 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 investor’s 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 organization’s 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
organization’s liquidity or unduly restrict management’s flex-
ibility to run the organization, particularly in times of finan-
cial difficulty, or that could limit the regulator’s 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 investor’s 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 Ownership—General (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 Board’s 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 Y–6, 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
WHAT’S 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
company’s 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
WHAT’S 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 affiliate’s transactions to the nonbank bank’s or industrial
bank’s 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 BHC’s 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 Board’s 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 Board’s 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 law’s 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 FDIC’s 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
International Banking Activities
Section 2100.0
WHAT’S NEW IN THIS REVISED ing organizations to obtain financial and operat-
SECTION ing information and, in some instances, to
evaluate the organization’s efforts to implement
Effective July 2010 this section was revised to corrective measures or to test their adherence to
discuss the Federal Reserve’s 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 Reserve’s 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
2110.0.1 STATUTORY TOOLS FOR business in the United States, their nonbank
FORMAL SUPERVISORY ACTION subsidiaries, Edge Act and agreement corpora-
tions, and institution-affiliated parties of those
Statutory tools are available to the Federal entities.
Reserve’s Board of Governors if formal supervi-
sory action is warranted against a bank holding
company or its bank or nonbank subsidiaries, or
against certain individuals associated with either 2110.0.2.1 Cease-and-Desist Orders
of them. The objective of formal actions is to
correct practices that the regulators believe to be When Board staff, in conjunction with the
unlawful, unsafe, or unsound. The initial consid- appropriate Federal Reserve Bank, determine
eration and determination of whether formal that a cease-and-desist action is necessary, the
action is required usually results from the Board may issue a notice of charges and of
inspection process. This section dicusses the hearing to the offending institution or person.
following topics: The notice of charges will contain a statement
describing the facts constituting the alleged vio-
1. Board jurisdiction under the law lations or unsafe or unsound practices. The issu-
2. actions or practices that may trigger the ance of the notice of charges and of hearing
statutory remedies starts a formal process that may include the
3. Board staff procedures convening of an administrative hearing to be
4. the elements of a corrective order conducted before an administrative law judge,
5. temporary orders who makes a recommended decision to the
6. written agreements Board. At the conclusion of the hearing process
7. suspensions and removals and after consideration of the proceeding by the
8. enforcement of orders Board, the Board may issue a final cease-and-
9. civil money penalties desist order. Institutions and individuals who are
10. termination of certain nonbank subsidiary subject to cease-and-desist orders that were
activities or ownership issued as a result of contested proceedings can
appeal the Board’s issuance of the order to
federal courts of appeal.
2110.0.2 TYPES OF CORRECTIVE To abbreviate the period of litigation, the
ACTIONS offending party or institution is permitted an
opportunity to consent to the issuance of a
Generally, under 12 U.S.C. 1818(b), the Board cease-and-desist order without the need for the
may use its cease-and-desist authority and other notice and an administrative hearing. Board staff
enforcement tools against (1) a bank holding has the option of first drafting a proposed cease-
company, (2) a nonbank subsidiary of a bank and-desist order and presenting the matter to the
holding company, and (3) any institution- offenders for their consent before submission of
affiliated party. Institution-affiliated party the case to the Board. Banks (and bank holding
includes any director, officer, employee, control- companies) or individuals are advised that they
ling shareholder (other than a bank holding may have legal counsel present at all meetings
company), agent, person who has filed or is with Board or Reserve Bank staff concerning
required to file a change in control notice, con- formal corrective actions. If the parties voluntar-
sultant, joint venture partner, or other person ily agree to settle the case by the issuance
who participates in the conduct of the affairs of of a consent cease-and-desist order, the terms of
a bank holding company or nonbank subsidiary, the settlement will be presented to the Board for
and any independent contractor (including any its ratification and formal issuance of the order,
attorney, appraiser, or accountant) who know- at which time the order will be final and
ingly or recklessly participates in any violation binding.
of law or regulation, any breach of fiduciary Once it is issued by the Board, a cease-and-
duty, or any unsafe or unsound practice that desist order may require the persons or entity
causes or is likely to cause more than a minimal subject to the order to (1) cease and desist from
financial loss to, or a significant adverse effect the practices or violations or (2) take affirmative
on, the institution. The Board’s enforcement
authority also extends to foreign financial insti- BHC Supervision Manual December 2002
tutions and their branches and agencies doing Page 1
Formal Corrective Actions 2110.0
action to correct the violations or practices. 2110.0.2.3 Written Agreements

Affirmative actions might include returning the
holding company to its original condition (as it When circumstances warrant a less severe form
was before the practice or violation), having an of formal supervisory action, a formal written
individual reimburse the company for unautho- agreement may be used. A written agreement
rized or improper payments received, or both. may be with either the Board or with the
Affirmative actions may also include (1) restitu- Reserve Bank under delegated authority (12
tion, reimbursement, indemnification, or guaran- C.F.R. 265.11(a)(15)). All written agreements
tee against loss if the person or entity was must be approved by the Board’s staff director
unjustly enriched by the violation or practice, or of the Division of Banking Supervision and
if the violation or practice involved a reckless Regulation and by the general counsel. The
disregard for the law, applicable regulations, or provisions of a written agreement may relate to
a prior order; (2) restrictions on growth; (3) dis- any of the problems found at the institution or
position of any loan or asset; (4) rescission of involving institution-affiliated parties.
agreements or contracts; (5) employment of
qualified officers or employees; and (6) any
other action the Board determines to be appro- 2110.0.2.4 Removal Authority
priate. Under 12 U.S.C. 1818(b)(3), it is clear
that the cease-and-desist authority in section In addition to its cease-and-desist authority, the
8(b) of the Federal Deposit Insurance Act also Board is authorized by 12 U.S.C. 1818(e) to
applies to BHCs and Edge and agreement corpo- suspend and remove current or former
rations, as well as to all institution-affiliated institution-affiliated parties of bank holding
parties associated with them. companies and their nonbank subsidiaries for
certain violations and activities. The Board may
also prohibit permanently their future involve-
ment with insured depository institutions,
2110.0.2.2 Temporary Cease-and-Desist BHCs, and nonbank subsidiaries. The Board is
Orders authorized to issue a written notice of its inten-
tion to remove from office or prohibit from
The Board may issue a temporary (emergency) further participation (or, under certain condi-
cease-and-desist order for a violation of law, tions, to suspend immediately) any institution-
rule, or regulation, or for the undertaking of an affiliated party of a BHC whenever it deter-
unsafe or unsound practice that is likely to cause mines the following:
the insolvency of a subsidiary bank or company,
cause the significant dissipation of a subsidiary 1. The institution-affiliated party has directly or
bank’s or BHC’s assets or earnings, weaken the indirectly—
condition of the subsidiary bank or company, or a. violated any law, regulation, cease-and-
otherwise seriously prejudice the interests of desist order, condition imposed in writing,
depositors. The Board may also issue a tempo- or any written agreement;
rary order if it determines that an institution’s b. engaged in any unsafe or unsound prac-
books and records are so incomplete or inaccu- tice; or
rate that the institution’s financial condition or c. breached a fiduciary duty; and
the details or purpose of any transaction cannot 2. because of the violation, practice, or
be determined through the normal supervisory breach—
process. The temporary order may require the a. the institution has suffered or will suffer
same corrections as an order issued either on financial loss or other damage;
consent or after the full administrative process. b. the interests of depositors have been or
The advantage of the temporary order is that it could be prejudiced; or
is effective immediately upon service on the c. the institution-affiliated party has received
entity or individual. The temporary order financial gain or other benefit from the
remains in effect pending the completion of the violation or practice; and
administrative process, unless set aside or modi- 3. such violation, practice, or breach—
fied by a court. Within 10 days of the service of a. involves personal dishonesty; or
the temporary order, the subject may appeal to a b. demonstrates a willful or continuing disre-
U.S. district court for relief from the order. gard for the safety or soundness of the
institution.
Page 2 If an institution-affiliated party’s actions war-
rant immediate attention, the Board is autho- the holding company, and if the activity, owner-
rized to temporarily suspend the person pending ship, or control is inconsistent with sound bank-
the outcome of the complete administrative pro- ing principles or inconsistent with the purposes
cess. An institution-affiliated party currently of the Bank Holding Company Act or the Finan-
associated with a BHC may also be suspended cial Institutions Supervisory Act of 1966, the
or removed for cause based on actions taken Board may order the bank holding company to
while formerly associated with a different terminate the activity or sell control of the non-
insured depository institution, BHC, or other bank subsidiary.
business institution. ‘‘Other business institu-
tion’’ is not specifically defined in the statute so
that it may be interpreted to include any other 2110.0.2.6 Violations of Final Orders and
business interests of the institution-affiliated Written Agreements
party.
Under 12 U.S.C. 1818(g), the appropriate fed- When any of the various types of formal
eral banking agency is authorized to suspend enforcement orders discussed above has been
from office or prohibit from further participation violated, including a temporary cease-and-desist
any institution-affiliated party charged or order, the Board may apply to a U.S. district
indicted for the commission of a crime involv- court for enforcement of the action, and the
ing personal dishonesty or breach of trust that is court may order and require compliance. Viola-
punishable by imprisonment for a term exceed- tions of final orders and written agreements may
ing one year under state or federal law, if the also give rise to the assessment of civil money
continued participation might threaten either the penalties against the offending institution or its
interests of depositors or public confidence in institution-affiliated parties, as the circum-
the bank. The suspension can remain in effect stances warrant. The amount of the civil money
until the criminal action is disposed of or until penalty is the same as that described in the civil
the suspension is terminated by the agency. money penalty section below. Any institution-
The statute also authorizes the Board to ini- affiliated party who violates a suspension or
tiate removal or prohibition actions against removal order is subject to a criminal fine of up
(1) any institution-affiliated party who has com- to $1 million, imprisonment for up to five years,
mitted a violation of any provision of the Bank or both, as well as a civil money penalty assess-
Secrecy Act that was not inadvertent or uninten- ment or federal court action.
tional, (2) any officer or director of a bank who
has knowledge that an institution-affiliated party
has violated the money-laundering statutes and 2110.0.2.7 Civil Money Penalties
did not take appropriate action to stop or pre-
vent the recurrence of such a violation, or The Board may assess civil money penalties
(3) any officer or director of a bank who violates against any institution or institution-affiliated
the prohibitions on management interlocks. party for (1) any violation of law or regulation,
These removal or prohibition actions do not (2) any violation of a final cease-and-desist,
require a finding of gain to the individual, loss temporary cease-and-desist, suspension,
to the institution, personal dishonesty, or willful removal, or prohibition order, or with respect to
or continuing disregard for the safety or sound- federally insured depository institutions, any
ness of the institution. failure to comply with a prompt-corrective-
action directive,1 (3) any violation of a condi-
2110.0.2.5 Termination of Nonbank

Activity 1. Prompt-corrective-action directives may be enforced in
the federal courts, and they may cause any bank, company, or
The Board is authorized by 12 U.S.C. 1844(e) to institution-affiliated party that violates the directive to be
subject to civil money penalties. The failure of a bank to
order a bank holding company to terminate cer- implement a capital-restoration plan, or the failure of a com-
tain activities of its nonbank subsidiary (other pany having control of a state member bank to fulfill a
than a nonbank subsidiary of a bank) or to sell guarantee that the company has given in connection with a
its shares of the nonbank subsidiary. When the capital plan accepted by the Federal Reserve, could subject
the bank or company or any of its institution-affiliated parties
Board has reasonable cause to believe that the to a civil money penalty assessment. See section 4133.1 of the
bank holding company’s continuation of any Federal Reserve’s Commercial Bank Examination Manual.
activity or ownership or control of any of its
nonbank subsidiaries constitutes a serious risk BHC Supervision Manual December 2002
to the financial safety, soundness, or stability of Page 3
tion imposed in writing by the Board in connec- 2110.0.2.8 Publication

tion with the granting of an application or other
request, and (4) any violation of a written Under 12 U.S.C. 1818(u), the Board is required
agreement. to publish and make publicly available any final
The Board can assess a fine of up to $5,000 order issued with respect to an administrative
per day for any of these violations. A fine of up enforcement proceeding it has initiated. If the
to $25,000 per day can be assessed for any of Board determines that publication would seri-
these violations if the offender recklessly ously threaten the safety and soundness of the
engages in an unsafe or unsound practice in institution, it may delay publication for a reason-
conducting the affairs of the institution, or if an able time. The Board is also required to publish
individual breaches his or her fiduciary duty, any written agreement or other written state-
when such violation, practice, or breach is part ment, a violation of which may be enforced by
of a pattern of misconduct, causes or is likely to the Board, as well as publish any modifications
cause more than a minimal loss, or results in to or terminations of orders or agreements.
pecuniary gain or other benefit for the offender.
A civil money penalty of up to $1 million per
day can be assessed for any of these violations if 2110.0.2.9 Public Hearings
the offender knowingly committed the violation,
knowingly engaged in the unsafe or unsound All hearings on the record, including contested
practice, or knowingly breached his or her fidu- cease-and-desist, removal, and civil money pen-
ciary duty and, in so doing, knowingly or reck- alty proceedings, are open to the public. Tran-
lessly caused a substantial loss to the financial scripts of all testimony and copies of all docu-
institution or received substantial pecuniary gain ments, which could include examination and
or other benefit. Civil money penalties may also inspection reports and supporting documents
be assessed for any violation of the Change in (except those filed under seal), are made avail-
Bank Control Act and for violations of the anti- able to the public. These documents could
tying provisions of federal banking law, among include examiner’s workpapers, file memoran-
other provisions (12 U.S.C. 1972). dums, reports of examination and inspection,
The Board may also assess civil money penal- and correspondence between a problem institu-
ties for the submission of any late, false, or tion or wrongdoer and the Federal Reserve
misleading reports required by the Bank Hold- Bank. Appropriate actions should always be
ing Company Act and Regulation Y of the taken to ensure that all written material prepared
Board of Governors. If a financial institution in connection with any supervisory matter be
maintains procedures that are reasonably accurate and free of insupportable conclusions
adapted to avoid inadvertent errors and uninten- or opinions.
tionally fails to publish any report, submits any
false or misleading report or information, or is
minimally late with the report, it can be assessed 2110.0.2.10 Subpoena Power
a fine of up to $2,000 per day. The financial
institution has the burden of proving that the Under 12 U.S.C. 1818(n), which is made appli-
error was inadvertent under these circumstances. cable to BHCs by 12 U.S.C. 1818(b)(3) and
If the error was not inadvertent, a penalty of up 1844(f), the Board has the authority to issue
to $20,000 per day can be assessed for all false subpoenas directly or through its delegated rep-
or misleading reports or information submitted resentatives, and it has the authority to adminis-
to the Board. If the submission was done in a ter oaths or take depositions in connection with
knowing manner or with reckless disregard for an examination or inspection. An examiner may
the law, a fine of up to $1 million or 1 percent of find it necessary to apply some of these enforce-
the institution’s assets can be assessed for each ment powers to collect certain information from
day of the violation. Notwithstanding the above, unwilling sources.
violations of the Bank Holding Company Act
(with the exception of late, false, or inaccurate
report violations as described above) may be 2110.0.2.11 Interagency Notification
addressed by the assessment of civil money
penalties of not more than $25,000 per day. Any federal banking regulatory agency that pro-
poses to take formal enforcement action (such
as a cease-and-desist order, civil money penalty,
BHC Supervision Manual December 2002 or removal) must notify the other federal finan-
Page 4 cial institution regulatory agencies (including
the Office of Thrift Supervision) that such action ever, some of the restrictions on these payments
is being taken. The Board must take similar are the same or similar. The FDIC’s regulations
steps in connection with actions against bank generally prohibit insured depository institu-
holding companies, their nonbank subsidiaries, tions and their holding companies from making
and all institution-affiliated parties. In the case golden parachute payments except in certain
of an informal enforcement action, such as circumstances.2
memorandums of understanding, notification The FDIC’s regulations define a golden para-
must be made when there is an affiliation or chute payment to mean any payment in the
inter-institution relationship. Notifications are to nature of compensation (or agreement to make
be made to a designated contact person speci- such a payment) for the benefit of any current or
fied by each agency. former institution-affiliated party of an insured
With respect to federal–state agency coordi- depository institution or its holding company
nation, the Federal Reserve provides the appro- that meets four criteria. First, the payment or
priate state supervisory authority with notice of agreement must be contingent on the termina-
its intent to institute a formal corrective action tion of the institution-affiliated party’s employ-
against a bank holding company. Pursuant to ment or association. Second, the payment or
12 U.S.C. 1818(m), the federal regulatory agen- agreement is received on or after, or made in
cies are required to provide the appropriate state contemplation of, among other things, a deter-
supervisory authority with notice of their intent mination that the institution or holding company
to institute a formal corrective action against a is in a troubled condition under the regulations
state-chartered bank. This requirement is made of the applicable banking agency.3 Third, the
applicable to bank holding companies, their payment or agreement must be payable to an
nonbank subsidiaries, and all institution- institution-affiliated party when an insured
affiliated parties by 12 U.S.C. 1818(b)(3). (See depository institution has been assigned a
SR-97-5.) CAMELS composite rating of 4 or 5 under the
Uniform Financial Institutions Rating System or
when its holding company is assigned a com-
2110.0.3 GOLDEN PARACHUTE posite rating of 4 or 5 or unsatisfactory under
PAYMENTS AND INDEMNIFICATION the Federal Reserve Bank Holding Company
PAYMENTS Rating System. Fourth, the payment or agree-
ment is payable to an institution-affiliated party
The Crime Control Act authorizes the Federal when the insured depository institution is sub-
Deposit Insurance Corporation (FDIC) to project to a proceeding to terminate or suspend its
hibit or limit, by order or regulation, any golden deposit insurance by the FDIC. Several other
parachute payment or indemnification payment factors are also considered in determining
an insured depository institution or bank hold- whether a payment is a golden parachute.
ing company makes to any institution-affiliated The definition of a golden parachute payment
party of an insured depository institution. In also covers a payment made by a bank holding
general, an indemnification payment reimburses company that is not in a troubled condition to an
an insider for a specified liability or cost that the institution-affiliated party of an insured deposi-
person incurred (for example, a bank might tory institution subsidiary that is in a troubled
indemnify a director for the cost of legal fees or condition, if the other criteria in the definition
even, theoretically, penalties in connection with are met. This circumstance may arise when a
a Federal Reserve investigation or enforcement bank holding company, as part of an agreement
action). Golden parachute payments are sever- to acquire a troubled bank or savings associa-
ance payments or agreements to make severance
payments that are paid or entered into at a time 2. See the FDIC’s golden parachute regulations in 12
when the bank or holding company is in a C.F.R. 359.
troubled condition. These payments require the 3. See section 225.71 of Regulation Y (12 C.F.R. 225.71),
which defines a ‘‘troubled condition’’ for a state member bank
prior written approval of the institution’s pri- or bank holding company as an institution that (1) has a
mary regulator and the FDIC. A golden para- composite rating of 4 or 5; (2) is subject to a cease-and-desist
chute payment includes a glorified severance order or formal written agreement that requires action to
payment to a former insider that is paid under improve the institution’s financial condition, unless otherwise
informed in writing by the Federal Reserve; or (3) is informed
specified circumstances. Although both types of in writing by the Federal Reserve that it is in a troubled
payments fall under the same statute, section condition.
18(k) of the Federal Deposit Insurance Act (the
FDI Act) (12 U.S.C. 1828(k)), the two types of BHC Supervision Manual December 2003
payments are quite different and distinct. How- Page 5
tion, proposes to make payments to the troubled troubled condition; and (3) that the individual
institution’s institution-affiliated parties that has violated specified banking or criminal laws.
are conditioned on their termination of If a state member bank or bank holding com-
employment.4 pany makes or enters into an agreement to make
A state member bank or bank holding com- a golden parachute payment without prior regu-
pany may make or enter into an agreement to latory approval when such approval is required,
make a golden parachute payment only (1) if the appropriate follow-up supervisory action should
Federal Reserve, with the written concurrence be taken. The follow-up could include an en-
of the FDIC, determines that the payment or forcement action requiring the offending
agreement is permissible; (2) as part of an agree- institution-affiliated party to reimburse the insti-
ment to hire competent management in certain tution for the amount of the prohibited payment.
conditions, with the consent of the Federal The appropriate Reserve Bank supervisory staff,
Reserve and the FDIC as to the amount and and also the appropriate staff of the Board’s
terms of the proposed payment; or (3) pursuant Division of Banking Supervision and Regula-
to an agreement to provide a reasonable sever- tion, should be notified and consulted on the
ance not to exceed 12 months’ salary in the golden parachute–related issues. (See SR-03-
event of an unassisted change in control of the 06.)
depository institution, with the consent of the Bank holding companies or banks (including
Federal Reserve. In determining the permissibil- state member banks) may seek to indemnify
ity of the payment, the Federal Reserve may their officers, directors, and employees from any
consider a variety of factors, including the indi- judgments, fines, claims, or settlements, whether
vidual’s degree of managerial responsibilities civil, criminal, or administrative. The bylaws of
and length of service, the reasonableness of the some bank holding companies or banks may
payment, and any other factors or circumstances have broadly worded indemnification provi-
that would indicate that the proposed payment sions, or they may have entered into separate
would be contrary to the purposes of the statute indemnification agreements that cover the ongo-
or regulations. ing activities of their own institution-affiliated
A state member bank or bank holding com- parties. Such indemnification provisions may be
pany requesting approval to make a golden para- inconsistent with federal banking law and
chute payment or enter into an agreement to regulations, as well as safe and sound banking
make such a payment should submit its request practices.
simultaneously to the appropriate FDIC regional Supervisory and examiner staff should be
office and Reserve Bank. The request must alert to the limitations and prohibitions on
detail the proposed payments and demonstrate indemnification imposed by section 18(k) of the
that the state member bank or bank holding FDI Act5 and the regulations issued thereunder
company does not possess and is not aware of by the FDIC. The purpose of the law and regula-
any evidence that there is reasonable basis to tions is to safeguard the assets of financial insti-
believe, at the time the payment is proposed to tutions and to preserve the deterrent effects of
be made, (1) that the institution-affiliated party administrative enforcement actions by ensuring
receiving such a payment has committed any that individuals subject to final enforcement
fraud, breach of fiduciary duty, or insider abuse actions bear the costs of any judgments, fines,
or has materially violated any applicable bank- and associated legal expenses.
ing law or regulation that had or is likely to have A ‘‘prohibited indemnification payment’’
a material adverse effect on the bank or com- includes any payment (or agreement to make a
pany; (2) that the individual is substantially payment) by a bank holding company or feder-
responsible for the institution’s insolvency or ally insured bank to an institution-affiliated
party to pay or reimburse such person for any
4. The FDIC’s regulations exclude from the definition of a liability or legal expense in any federal banking
golden parachute payment several types of payments, such as agency administrative proceeding that results in
payments made pursuant to a qualified pension or retirement a final order or settlement in which the
plan; a benefit plan or bona fide deferred compensation plan
(which are further defined in the FDIC’s regulations); or a institution-affiliated party is assessed a civil
severance plan that provides benefits to all eligible employ- money penalty, is removed or prohibited from
ees, does not exceed the base compensation paid over the banking, or is required to cease an action or take
preceding 12 months, and otherwise meets the regulatory any affirmative action, including making restitu-
definition of nondiscriminatory and other conditions in the
FDIC’s regulations. tion, with respect to the bank holding company
or bank.6 In cases in which the institution-
Page 6 5. See 12 U.S.C. 1828(k).
6. See 12 C.F.R. 359.
affiliated party prevails, the institution can make disciplinary actions against independent public
a payment if the board of directors determines accountants and accounting firms that perform
that the payment is in the best interest of the audit services covered by the act’s provisions.
institution and it does not have a material Section 36, as implemented by part 363 of the
adverse effect on the institution’s safety and FDIC’s rules (12 C.F.R. 363), requires that each
soundness. federally insured depository institution with
The law and the FDIC’s regulations reinforce total assets of $500 million or more obtain an
the Federal Reserve’s long-standing policy that audit of its financial statements and an attesta-
an institution-affiliated party who engages in tion on management’s assertions concerning
misconduct should not be insulated from the internal controls over financial reporting per-
consequences of his or her misconduct. From a formed by an independent public accountant
safety-and-soundness perspective, a federally (the accountant). The insured depository institu-
insured bank should not divert its assets to pay a tion must include the accountant’s audit and
fine or other final judgment issued against an attestation reports in its annual report.
institution-affiliated party for misconduct that The agencies jointly published amended rules
presumably violates the bank’s policy of com- pursuant to section 36 that set forth the practices
pliance with applicable law, especially when the and procedures to implement their authority to
individual’s misconduct has already harmed the remove, suspend, or debar, for good cause,8 an
bank. accountant or firm from performing audit and
The senior management of bank holding com- attestation services for an insured state member
panies and federally insured banks should over- bank, or from performing these services for a
see the review of the banking organization’s bank holding company that obtains audit ser-
bylaws, as well as any outstanding indemnifica- vices to satisfy statutory or regulatory require-
tion agreements and insurance policies, to ments imposed by section 36 or part 363 on an
ensure that they conform with the requirements insured subsidiary bank of that holding com-
of federal law and regulations. If a bank holding pany. Immediate suspensions are permitted in
company or state member bank fails to take limited circumstances. Also, an accountant or
appropriate action to bring its indemnification accounting firm is prohibited from performing
provisions into compliance with federal laws audit services for the covered institution if an
and regulations, appropriate follow-up supervi- authorized agency has taken such a disciplinary
sory action may be taken. As part of the supervi- action against the accountant or firm, or if the
sory process, which will include merger and U.S. Securities and Exchange Commission or
acquisition applications, the Federal Reserve’s the Public Company Accounting Oversight
supervisory and examiner staff will review iden- Board (PCAOB) has taken certain disciplinary
tified agreements having indemnification-related action against the accountant or firm.
issues for compliance with federal law and regu- The amended rules reflect the agencies’
lations. (See SR-02-17.) increasing concern about the quality of audits
The Crime Control Act does not specifically and internal controls for financial reporting. The
authorize the Board to prohibit these payments. rules emphasize the importance of maintaining
Whenever the Board becomes aware of such high quality in the audits of the financial posi-
payments by a bank holding company or a state tion and in the attestations of management
member bank, however, it will refer these mat- assessments at federally insured depository
ters to the FDIC for action. Also, the Board may institutions and bank holding companies.
use its general cease-and-desist authority to pro-
hibit such payments if they are deemed to be an
unsafe or unsound practice.
the Office of the Comptroller of the Currency, the Federal
Deposit Insurance Corporation, and the Office of Thrift Super-
2110.0.4 DISCIPLINARY ACTIONS vision. The Board approved its rules on August 6, 2003 (see
press release of August 8, 2003). The rules, which became
AGAINST ACCOUNTANTS AND effective October 1, 2003, are found in part 263, section
ACCOUNTING FIRMS PERFORMING 263.94, and subpart J, sections 263.400–263.405 (12 C.F.R.
CERTAIN AUDIT SERVICES 263.94 and 12 C.F.R. 263.400–263.405).
8. The rules provide that certain violations of law, negli-
Section 36 of the Federal Deposit Insurance Act gent conduct, reckless violations of professional standards, or
lack of qualifications to perform auditing services may be
(the FDI Act) authorizes the federal bank and considered good cause.
thrift regulatory agencies (the agencies)7 to take
7. The Board of Governors of the Federal Reserve System, Page 7
2110.0.5 APPOINTMENT OF current senior executive officer who is propos-

DIRECTORS AND SENIOR ing to assume a different senior officer position.
EXECUTIVE OFFICERS Subpart H of Regulation Y details the proce-
dures for filing and the content of the notice.
Under section 32 of the Federal Deposit Insur- The Board may disapprove a notice if it finds
ance Act (12 U.S.C. 1831i) and subpart H of that the competence, experience, character, or
Regulation Y (12 C.F.R. 225.71 et seq.), any integrity of the proposed individual indicates
state member bank or bank holding company that his or her service would not be in the best
that is in a troubled condition or does not meet interest of the institution’s depositors or the
minimum capital standards must provide 30 public. A disapproved individual or the institu-
days’ written notice to the Board of Governors tion that filed the notice may appeal the Federal
before appointing any new director or senior Reserve’s notice of disapproval under the proce-
executive officer.9 This requirement also applies dures detailed in Regulation Y. The individual
to any change in the responsibilities of any may not serve as a director or senior executive
officer while the appeal is pending. If a state
member bank or bank holding company that is
9. Under extraordinary circumstances, the Board or in a troubled condition appoints a director or
Reserve Bank may permit an individual to serve as a director senior officer without the required 30 days’ prior
or senior executive officer before a notice is provided; how-
ever, this permission does not affect the Federal Reserve’s written notice, appropriate follow-up supervi-
authority to disapprove a notice within 30 days of its filing. sory action should be taken.

Page 8
Foreign Corrupt Practices Act and
Federal Election Campaign Act Section 2120.0
2120.0.1 INTRODUCTION 2120.0.3 BANKS AND THE FECA
On January 17, 1978, the three federal bank National banks and other federally chartered
supervisory agencies issued a joint policy state- corporations are specifically prohibited from
ment to address their concern with regard to the making contributions or expenditures in connec-
potential for improper payments by banks and tion with any election; other corporations, in-
bank holding companies in violation of the For- cluding banks and bank holding companies, may
eign Corrupt Practices Act and the Federal Elec- not make contributions or expenditures in con-
tion Campaign Act. nection with federal elections. However, corpo-
While not widespread, the federal bank super- rations may establish and solicit contributions
visory agencies were concerned that such prac- to ‘‘separate segregated funds’’ to be used for
tices could reflect adversely on the banking sys- political purposes; these are discussed in greater
tem and constitute unsafe and unsound banking detail below.
practices in addition to their possible illegality. State member banks and bank holding com-
The potential devices for making political panies may make contributions or expenditures
payments in violation of the law could include that are consistent with state and local law in
compensatory bonuses to employees, designated connection with state or local elections. Because
expense accounts, fees or salaries paid to offi- many states have laws that prohibit or limit
cers, and preferential interest rate loans. In addi- political contributions or expenditures by banks,
tion, political contributions could be made by familiarization with applicable state and local
providing equipment and services without laws is a necessity. According to the joint policy
charge to candidates for office. Refer to F.R.R.S. statement of the three banking agencies, a polit-
at 3–447.1 and 4–875. ical contribution must meet not only the require-
ment of legality but also the standards of safety
and soundness. Thus, a contribution or expendi-
2120.0.2 SUMMARY OF THE ture, among other things, must be recorded
FEDERAL ELECTION CAMPAIGN properly on the bank’s books, may not be exces-
ACT sive relative to the bank’s size and condition,
and may not involve self-dealing.
The Federal Election Campaign Act (FECA), Banks may make loans to political candidates
enacted in 1971, was designed to curb potential provided the loans satisfy the requirements set
abuses in the area of federal election financing. out below.
In general, FECA regulates the making of cam-
paign contributions and expenditures in connec-
tion with primary and general elections to fed- 2120.0.4 CONTRIBUTIONS AND
eral offices. Since 1907, federal law has EXPENDITURES
prohibited national banks from making contribu-
tions in connection with political elections. The words ‘‘contribution’’ and ‘‘expenditure’’
FECA does not specifically address the making are defined broadly by FECA and the Commis-
of contributions and expenditures by banks or sion’s regulations to include any loan, advance,
other corporations to advocate positions on deposit, purchase, payment, distribution, sub-
issues that are the subjects of public referenda. scription or gift of money or anything of value
As originally enacted, FECA required disclo- which is made for the purpose of influencing the
sure of contributions received or expenditures nomination or election of any person to federal
made; however, amendments to the law in 1974 office. The payment by a third party of compen-
and 1976 imposed additional limitations on con- sation for personal services rendered without
tributions and expenditures as well. The 1974 charge to a candidate or political committee is
amendments also established the Federal Elec- also treated as a contribution by FECA, al-
tion Commission (Commission) to administer though the term does not include the value of
FECA’s provisions. The Commission is respon- personal services provided by an individual
sible for adopting rules to carry out FECA, for without compensation on a volunteer basis.
rendering advisory opinions, and for enforcing Although loans are included in the definitions
the Act. The Commission was reorganized as a of contribution and expenditure under FECA, a
result of the FECA Amendments of 1976, and it
has issued regulations interpreting the statute BHC Supervision Manual December 1992
(11 C.F.R.). Page 1
Foreign Corrupt Practices Act and Federal Election Campaign Act 2120.0
specific exemption is provided for bank loans In practice, most corporate segregated funds
made in the ordinary course of business and in are administered by a group of corporate person-
accordance with applicable banking laws and nel, which, if the fund receives any contribu-
regulations. The Commission’s regulations pro- tions or makes any expenditures during a calen-
vide, further, that in order for extensions of dar year, constitutes a ‘‘political committee,’’ as
credit to a candidate, political committee or defined by FECA. As such, it is required to file a
other person in connection with a federal elec- statement of organization with the Commission,
tion to be treated as a loan and not a contribu- to keep detailed records of contributions and
tion, they must be on terms substantially similar expenditures, and to file with the Commission
to those made to non-political debtors and be reports identifying contributions in excess of
similar in risk and amount. The regulations also $200 and candidates who are recipients of con-
provide that a debt may be forgiven only if the tributions from the fund.
creditor has treated it in a commercially reason- Solicitation of contributions to corporate seg-
able manner, including making efforts to collect regated funds by political committees must be
the debt which are similar to the efforts it would accomplished within the precise limits estab-
make with a non-political debtor. In considering lished by FECA. All solicitations directed to
whether a particular transaction is a contribution corporate employees must satisfy the following
or a loan, it is expected that a factor would be requirements: (1) the contribution must be en-
the extent to which the creditor may have de- tirely voluntary; (2) the employee must be in-
parted from its customary credit risk analysis. formed of the political purposes of the fund at
FECA and the implementing regulation per- the time of the solicitation; and (3) the em-
mit certain limited payments to candidates or ployee must be informed of his right to refuse to
their political committees. For example, pay- contribute without reprisal. Beyond those basic
ment of compensation to a regular employee requirements, FECA distinguishes between ‘‘ex-
who is providing a candidate or political com- ecutive and administrative’’ personnel and other
mittee with legal or accounting services which employees. The former and their families may
are solely for the purpose of compliance with be solicited any number of times, while the
the provisions of the FECA is exempt from the latter and their families may only be solicited
definitions of contribution and expenditure. The through a maximum of two written solicitations
Commission’s regulations also permit occa- per year, and these solicitations must be ad-
sional use of a corporation’s facilities by its dressed to the employees at their homes. Solici-
shareholders and employees for volunteer polit- tations may also be directed to corporate stock-
ical activity; however, reimbursement to the cor- holders and their families in the same manner as
poration is required for the normal rental charge to executive and administrative personnel.
for anything more than occasional or incidental Although a corporation, or a corporation and
use. its subsidiaries, may form several political com-
mittees, for purposes of determining the statu-
tory limitations on contributions and expendi-
2120.0.5 SEPARATE SEGREGATED tures, all committees established by a
FUNDS AND POLITICAL corporation and its subsidiaries are treated as
COMMITTEES one. Thus, the total amount which all political
committees of a corporation and its subsidiaries
FECA allows the establishment and administra- may make to a single candidate is $5,000 in any
tion by corporations of ‘‘separate segregated federal election (provided that the committees
funds’’ to be utilized for political purposes. are qualified multicandidate committees under
While corporate monies may not be used to FECA).
make political contributions or expenditures,
corporations may bear the costs of establishing
and administering these separate segregated 2120.0.6 INSPECTION OBJECTIVES
funds, including payment of rent for office
space, utilities, supplies and salaries. These 1. To determine if the company has made
costs need not be disclosed under FECA. Com- improper or illegal payments in violation of
mission regulations also permit a corporation to either of these statutes, and regardless of legal-
exercise control over its separate segregated ity, and whether they constitute an unsafe and
fund. unsound banking practice.
2. To determine if controls have been estab-
BHC Supervision Manual December 1992 lished to prevent unproper payments in viola-
Page 2 tion of these statutes.
2120.0.7 INSPECTION PROCEDURES course of business in accordance with applica-

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

Page 4
Internal Credit-Risk Ratings at Large Banking
Organizations Section 2122.0
Techniques, practices, and tools for credit-risk vide information as to the institution’s overall
management are evolving rapidly, as are the appetite for risk, giving due consideration to the
challenges that banking organizations face in uncertainties faced by lenders and the long-term
their business-lending activities. For larger insti- viability of the institution. Accordingly, large
tutions, the number and geographic dispersion banking organizations should have strong risk-
of their borrowers make it increasingly difficult rating systems which should take proper account
for such institutions to manage their loan port- of gradations in risk. They should also consider
folios simply by remaining closely attuned to (1) the overall composition of portfolios in
the performance of each borrower. As a result, originating new loans, (2) assessing overall port-
one increasingly important component of the folio risks and concentrations, and (3) reporting
systems for controlling credit risk at larger insti- on risk profiles to directors and management.
tutions is the identification of gradations in Moreover, such rating systems should also play
credit risk among their business loans, and the an important role in (1) establishing an appropri-
assignment of internal credit-risk ratings to ate level for the allowance for loan and lease
loans that correspond to these gradations.1 The losses, (2) conducting internal analyses of loan
use of such an internal rating process is appro- and relationship profitability, (3) assessing capi-
priate and necessary for sound risk management tal adequacy, and possibly (4) administering
at large institutions. See SR-98-25. performance-based compensation.
Certain elements of internal rating systems Examiners should evaluate the adequacy of
are necessary to support sophisticated credit- internal credit-risk-rating systems, including
risk management. Supervisors and examiners, ongoing development efforts, when assessing
both in their on-site inspections and other con- both asset quality and the overall strength of
tacts with banking organizations, need to risk management at large institutions. Recogniz-
emphasize the importance of development and ing that a strong risk-rating system is an impor-
implementation of effective internal credit- tant element of sound credit-risk management
rating systems and the critical role such systems for such institutions, examiners should specifi-
should play in the credit-risk-management pro- cally evaluate the adequacy of internal risk-
cess at sound large institutions. See SR-98-18 rating systems at large institutions as one factor
with regard to lending standards for commercial in determining the strength of credit-risk man-
loans. agement. In doing so, examiners should be cog-
Internal rating systems are currently being nizant that an internal risk-identification and
used at large institutions for a range of purposes. -monitoring system should be consistent with
At one end of this range, they are primarily used the nature, size, and complexity of the banking
to determine approval requirements and identify organization’s activities.
problem loans. At the other end, they are an
integral element of credit-portfolio monitoring
and management, capital allocation, the pricing
of credit, profitability analysis, and the detailed 2122.0.1 APPLICATION TO LARGE
analysis to support loan-loss reserving. Internal BANK HOLDING COMPANIES
rating systems being used for these latter pur-
poses should be significantly richer and more The guidance provided in this section should be
robust than systems used for the purposes such applied to all ‘‘large’’ bank holding companies.
as approval requirements and identifying prob- For this purpose, examiners should treat an insti-
lem loans. tution as being ‘‘large’’ if its lending activities
As with all material financial institutional are sufficient in scope and diversity such that
activities, a sound risk-management process informal processes that rely on keeping track of
should adequately illuminate the risks being the condition of individual borrowers are inad-
taken. It should also cause management to ini- equate to manage its loan portfolio. In this con-
tiate and apply appropriate controls that will text, those institutions with significant involve-
allow the institution to balance risks against ment in relevant secondary-market credit
returns. Furthermore, the process should pro- activities, such as securitization of business
loans or credit derivatives, should have more
elaborate and formal approaches for managing
1. For information on current practices in risk rating among
large banking organizations, see ‘‘Credit Risk Rating at Large
U.S. Banks,’’ Federal Reserve Bulletin, November 1998, BHC Supervision Manual December 1998
pp. 897–921. Page 1
Internal Credit-Risk Ratings at Large Banking Organizations 2122.0
the risks associated with these activities.2 system itself. Although assigning such risk
Whether or not they are active in such ratings—as with ratings issued by public rating
secondary-market credit activities, however, agencies—necessarily involves subjective judg-
larger and complex institutions typically would ment and experience, a properly designed rating
require a more structured and sophisticated set system will allow this judgment to be applied in
of arrangements for managing credit risk than a structured, more or less formal manner.
smaller regional or community institutions. In Credit-risk ratings are designed to reflect the
performing their evaluation, examiners should quality of a loan or other credit exposure, and
also consider whether other elements of the thus, explicitly or implicitly, the loss characteris-
risk-management process might compensate for tics of that loan or exposure. Increasingly, large
any specific weaknesses attributable to an inad- institutions link definitions to one or more mea-
equate rating system. surable outcomes such as the probability of a
In addition, examiners should review internal borrower’s default or expected loss (which
management information system reports to couples the probability of default with some
determine whether the portion of loans in lower- estimate of the amount of loss to be incurred in
quality pass grades has grown significantly over the event a default occurs). In addition, credit-
time, and whether any such change might have risk ratings may reflect not only the likelihood
negative implications for the adequacy of risk or severity of loss but also the variability of loss
management or capital at the institution. Exam- over time, particularly as this relates to the
iners should also consider whether a significant effect of the business cycle. Linkage to these
shift toward higher-risk pass grades, or an over- measurable outcomes gives greater clarity to
all large proportion of loans in a higher-risk risk-rating analysis and allows for more consis-
pass grade, should have negative implications tent evaluation of performance against relevant
for the institution’s asset-quality rating, includ- benchmarks. The degree of linkage varies
ing the adequacy of the loan-loss reserve. To among institutions, however.
some extent, such reviews are already an infor- Although the degree of formality may vary,
mal part of the current inspection process. most institutions distinguish the risks associated
Examiners should also continue the long- with the borrowing entity (essentially default
standing practice of evaluating trends in catego- risk) from the risks stemming from a particular
ries associated with problem assets. transaction or structure (more oriented to loss in
Examiners should discuss these issues, event of default). In documenting their credit-
including plans to enhance existing credit-rating administration procedures, institutions should
systems, with bank management and directors. clearly identify whether risk ratings reflect the
Inspection comments on the adequacy of risk- risk of the borrower or the risk of the specific
rating systems and the credit quality of the pass transaction. In this regard, many large institu-
portfolio should be incorporated within the tions currently assign both a borrower and facil-
inspection report, noting deficiencies where ity rating, requiring explicit analysis of both the
appropriate. loan’s obligor and how the structure and terms
of the particular loan being evaluated (that is,
collateral or guarantees) might strengthen or
2122.0.2 SOUND PRACTICES IN weaken the quality of the loan.
FUNCTION AND DESIGN OF The rating scale chosen should meaningfully
INTERNAL RATING SYSTEMS distinguish gradations of risk within the institu-
tion’s portfolio so that there is clear linkage to
A consistent and meaningful internal risk-rating loan quality (and/or loss characteristics), rather
system is a useful means of differentiating the than just to levels of administrative attention.3
degree of credit risk in loans and other sources
of credit exposure. This consistency and mean-
ing is rooted in the design of the risk-grading 3. See the December 1993 Interagency Policy Statement
on the Allowance for Loan and Lease Losses in section
2010.7. The policy does not apply to bank holding companies
2. Secondary-market credit activities generally include
directly. As they supervise their respective FDIC-insured
loan syndications, loan sales and participations, credit deriva-
financial institution subsidiaries, bank holding companies are
tives, and asset securitizations, as well as the provision of
advised to apply this supervisory guidance. Internal risk-
credit enhancements and liquidity facilities to such transac-
rating systems and/or supporting documentation should be
tions. Such activities are described further in section 2129.05
sufficient to enable examiners to reconcile the totals for the
and in SR-97-21.
various internal risk ratings under the institution’s system
to the federal banking agencies’ categories for those loans
BHC Supervision Manual December 1998 graded below ‘‘pass’’ (that is, loans classified as special
Page 2 mention, substandard, doubtful, or loss).
To do so, the rating system should be designed allow for consistent assignment of risk grades to
to address the range of risks typically encoun- similarly risky transactions. Such criteria should
tered in the underlying businesses involving the include guidance both on the factors that should
institution’s loan portfolio. One reflection of be considered in assigning a grade and how
this degree of meaning is that there should be a these factors should be weighed in arriving at a
fairly wide distribution of portfolio outstandings final grade.
or exposure across grades, unless the portfolio is Such criteria can promote consistency in
genuinely homogeneous. Many current rating assessing the financial condition of the borrower
systems include grades intended solely to cap- and other objective indicators of the risk of the
ture credits needing heightened administrative transaction. One vehicle for enhancing the
attention, such as so-called ‘‘watch’’ grades. degree of consistency and accuracy is the use of
Prompt and systematic tracking of credits in ‘‘guidance’’ or ‘‘target’’ financial ratios or other
need of such attention is an essential element of objective indicators of the borrower’s financial
managing credit risk. However, to the extent performance as a point of comparison when
that loans in need of attention vary in the risk assigning grades. Banking organizations may
they pose, isolating them in a single grade may also provide explicit linkages between internal
detract from that system’s ability to indicate grades and credit ratings issued by external par-
risk. One alternative is the use of separate or ties as a reference point, for example, senior
auxiliary indicators for those loans needing such public debt ratings issued by one or more major
administrative attention. ratings agencies. The use of default probability
Institutions whose risk-rating systems are models, bankruptcy scoring, or other analytical
least effective in distinguishing risk use them tools can also be useful as supporting analysis.
primarily to identify loans that are classified for However, the use of such techniques requires
supervisory purposes or that bank management institutions to identify the probability of default
otherwise believes should be given increased that is ‘‘typical’’ of each grade. The borrower’s
attention (that is, ‘‘watch’’ loans). Such systems primary industry may also be considered, both
contribute little or nothing to evaluating the in terms of establishing the broad characteristics
bulk of loans in the portfolio—that is, loans for of borrowers in an industry (for example, degree
which no specific difficulties are present or fore- of vulnerability to economic cycles or long-term
seen. In some cases these institutions might also favorable or unfavorable trends in the industry)
establish one or two risk grades for loans having and of a borrower’s position within the industry.
very little perceived risk, such as those collater- In addition to quantitative indications and
alized by cash or liquid securities or those to tools, credit policies and ratings definitions
‘‘blue-chip’’ private firms. Although the forego- should also cite qualitative considerations that
ing gradations are well-defined in terms of the should affect ratings. These might include fac-
relative credit risk they represent, the conse- tors such as (1) the strength and experience of
quence for these least effective systems is that the borrower’s management, (2) the quality of
the bulk of the loan portfolio falls into one or financial information provided, and (3) the
two remaining broad risk grades—representing access of the borrower to alternative sources of
‘‘pass’’ loans that are neither extremely low risk funding. Addressing qualitative considerations
nor current or emerging problem credits—even in a structured and consistent manner when
though such grades may encompass many dif- assigning a risk rating can be difficult. It requires
ferent levels of underlying credit risk. experience and business judgment. Nonetheless,
adequate consideration of these factors is impor-
tant to assessing the risk of a transaction appro-
2122.0.3 SOUND PRACTICES IN priately. In this regard, institutions may choose
ASSIGNING AND VALIDATING to cite significant and specific points of compari-
INTERNAL RISK RATINGS son for qualitative factors in describing how
such considerations can affect the rating (for
Experience and judgment, as well as more example, whether a borrower’s financial state-
objective elements, are critical both in making ments have been audited or merely compiled by
the credit decision and in assigning internal risk its accountants, or whether collateral has been
grades. Institutions should provide clear and independently valued).
explicit criteria for each risk grade in their credit Although the rating process requires the exer-
policies, as well as other guidance to promote cise of good business judgment and does not
consistency in assigning and reviewing grades.
Criteria should be specified, even when address- BHC Supervision Manual December 1998
ing subjective or qualitative considerations, that Page 3
lend itself to formulaic solutions, some formal- risk makeup, of the portfolio. Such consistency
ization of the process can be helpful in promot- further permits risk grades to become a reliable
ing accuracy and consistency. For example, the input into portfolio credit-risk models.5
use of a ‘‘risk-ratings analysis form’’ can be
important (1) in providing a clear structure for
identifying and addressing the relevant qualita- 2122.0.4 APPLICATION OF
tive and quantitative elements to be considered INTERNAL RISK RATINGS TO
in determining internal risk grades, and (2) for INTERNAL MANAGEMENT AND
documenting how those grades were set by ANALYSIS
requiring analysis or discussion of key quantita-
tive and qualitative elements of a transaction. As noted earlier, robust internal credit-rating
Risk ratings should be reviewed, if not systems are an important element in several key
assigned, by independent credit-risk manage- areas of the risk-management process. Although
ment or loan-review personnel both at the incep- nearly all large institutions currently use risk
tion of a transaction and periodically over the ratings, many of the institutions need to further
life of the loan.4 Such independent reviewers develop these systems so that they provide accu-
should reflect a level of experience and business rate and consistent indications of risk and suffi-
judgment that is comparable to that of the line cient granularity—finer distinctions among
staff responsible for assigning and reviewing risks, especially for riskier assets. Described
initial risk grades. Among the elements of such below are approaches to risk management and
independent review should be whether risk- analysis that are based on robust internal risk-
rating changes (and particularly downgrades) rating systems and that are currently being used
have been timely and appropriate. Such inde- at some banking organizations. These tech-
pendent reviews of individual ratings support niques appear to be emerging as sound practices
the discipline of the rating assignments by in the use of risk ratings.
allowing management to evaluate the perfor-
mance of those individuals assigning and
reviewing risk ratings. If an institution relies on 2122.0.4.1 Limits and Approval
outside consultants, auditors, or other third par- Requirements
ties to perform all or part of this review role,
such individuals should have a clear understand- Many large institutions have different approval
ing of the institution’s ‘‘credit culture’’ and its requirements and thresholds for different inter-
risk-rating process, in addition to commensurate nal grades, allowing less scrutiny and greater
experience and competence in making credit latitude in decision making for loans with lesser
judgments. risk.6 While this appears reasonable, institutions
Finally, institutions should track performance should also consider whether the degree of
of grades over time to gauge migration, consis- eased approval requirements (or the degree to
tency, and default/loss characteristics to allow which limits are higher) is supported by the
for evaluation of how well risk grades are being degree of reduced risk and uncertainty associ-
assigned. Such tracking also allows for ex post ated with these lower-risk loans. If not, lesser
analysis of the loss characteristics of loans in requirements may provide incentives to rate
each risk grade. loans too favorably, particularly in the current
Because ratings are typically applied to differ- benign economic environment, with resulting
ent types of loans—for example, to both com- underassessment of transaction risks.
mercial real estate and commercial loans—it is
important that each grade retains the same
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 institution’s portfolio, management
risk and to manage them accordingly. It also
allows management and supervisors to monitor
the overall degree of risk, and changes in the 5. For a discussion of these models and the role played by
internal credit-risk ratings, see the May 1998 Federal Reserve
System report, ‘‘Credit Risk Models at Major U.S. Banking
4. See section 2010.10 regarding internal loan review. Institutions: Current State of the Art and Implications for
Assessments of Capital Adequacy,’’ prepared by the Federal
BHC Supervision Manual December 1998 Reserve System Task Force on Internal Credit-Risk Models.
6. See section 2160.0 for more general guidance involving
Page 4 risk evaluation and control.
and directors should receive information on the meaningful assessment of the risks inherent in
profile of actual outstanding balances, expo- each transaction and in the portfolio as a whole,
sures, or both by internal risk grade.7 Such can be important tools in avoiding competitive
information can thus be one consideration future excessive practices.
among others, such as concentrations in particu-
lar industries or borrower types, in evaluating an
institution’s appetite for originating various 2122.0.4.5 Internal Allocation of Capital
types of new loans. Portfolio analysis may range
from simple tallies of aggregates by risk grade Those institutions that choose to allocate capital
to a formal model of portfolio behavior that may use their internal risk grades as important
incorporates diversification and other elements inputs in identifying appropriate internal capital
of the interaction among individual loan types. allocations. Use of appropriately allocated capi-
In this more complex analysis, gradations of tal in evaluating profitability offers many advan-
risk reflect only one among many dimensions of tages, including the incentive to consider both
portfolio risk, along with potential industry con- risk and return in making lending decisions
centrations, exposure to an unfavorable turn in rather than merely rewarding loan volume and
the business cycle, geographical concentrations, short-term fee revenue. Under appropriate
and other factors. circumstances—that is, where internal capital
allocations are sufficiently consistent, rigorous,
and well-documented—such allocations may
2122.0.4.3 Allowance for Loan and also be considered as a source of input for
Lease Losses supervisory evaluations of capital adequacy.9
The makeup of the loan portfolio and the loss
characteristics of each grade—including indi- 2122.0.5 INSPECTION OBJECTIVES
vidual pass grades—should be considered, along
with other factors, in determining the adequacy 1. To evaluate whether the internal risk-
of an institution’s allowance for loan and lease identification and -monitoring systems are
losses.8 consistent with—
a. sound practices in the function and design
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 institution’s asset-
loans well below the level indicated by the quality ratings and valuations, and the
long-term risk of the transaction. Given that examiner’s evaluation of the adequacy of
bank lending, particularly pricing, can be highly the allowance for loan and lease losses.
competitive, the application of appropriate disci- 3. To determine whether improvements are
plines to pricing, in conjunction with a clear and needed in the credit-risk-management pro-
cess and to discuss them with the board of
directors and senior management.
7. See section 2010.2 regarding a bank holding company’s 4. To document the extent to which the institu-
supervision of its subsidiaries and loan administration. See tion has adopted current and emerging sound
also the more general financial analysis sections 4020.2 and
4060.1 with regard to evaluating the asset quality of subsidi-
ary financial institutions and evaluating the asset quality of
9. See sections 4060.3 and 4060.4 regarding the evaluation
the holding company on a consolidated basis.
of capital adequacy of bank holding companies.
8. See footnote 3. Section 2010.7 emphasizes the bank
holding company’s responsibility as it supervises its subsidi-
aries with respect to each entity maintaining an adequate BHC Supervision Manual December 1998
allowance for loan and lease losses. Page 5
practices in the use of internal ratings infor- with respect to—

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

Page 7
Risk-Focused Safety-and-Soundness Inspections
Section 2124.0
WHAT’S NEW IN THIS REVISED determine whether the banking and nonbank
SECTION subsidiaries are following their internal policies
and procedures and those of the bank holding
Effective July 2006, footnote 3 was revised to company, and to evaluate the adequacy of inter-
include a reference to SR-00-14, ‘‘Enhance- nal control systems.
ments to the Interagency Program for Supervis- Transaction testing remains a reliable and
ing the U.S. Operations of Foreign Banking essential inspection technique for assessing a
Organizations.’’ banking organization’s 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 organization’s
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 organization’s
holding company and its subsidiaries are risk-management processes or internal controls
exposed, evaluating the organization’s 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 organization’s exposure to those risks. ing sufficient to fully assess the degree of risk
Given the Federal Reserve’s 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 organization’s 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 organizations supervised by the Federal
assessment of the accuracy of regulatory report- Reserve. However, as the largest banking orga-
ing often has involved extensive review of rec- nizations have undergone considerable geo-
onciliations of a bank holding company’s gen- graphic expansion and the range of their prod-
eral ledger to the FR Y-9C report and other FR ucts has become more diversified, coordinating
Y-series reports. Other similar procedures typi-
cally have been completed to ascertain compli- BHC Supervision Manual July 2006
ance with applicable laws and regulations, to Page 1
Risk-Focused Safety-and-Soundness Inspections 2124.0
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 com- significant to the organization’s risk profile or
pany’s operations. This approach to conducting that have inadequate risk-management processes
full-scope inspections provides more-continuous or rudimentary internal controls represent the
supervisory contact with the largest bank hold- highest risks and should undergo the most rigor-
ing companies and facilitates improved coordi- ous scrutiny and testing.
nation of inspection efforts with other federal Identifying the significant activities of a bank
banking agencies. It also provides more flexibil- holding company, including those activities con-
ity in the allocation of examiner resources, ducted off-balance-sheet, should be the first step
which has been especially important as the com- in the risk-assessment process. These activities
plexity of banking markets and products has may be identified through the review of prior
increased and led to the development of cadres bank examination and bank holding company
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
and provides a foundation from which to deter- a primary source of credit and liquidity risks.
mine the procedures to be conducted during an They may also present considerable market risk
inspection. Risk assessments identify the finan- (if the bank holding company or its subsidiaries
cial activities in which a banking organization are originating mortgage loans for later resale),
has chosen to engage, determine the types and interest-rate risk (if fixed-rate loans are being
granted), or legal risk (if loans are poorly docu-
Page 2 1. Appendix A defines these primary risk types.
mented). Similarly, the asset-liability manage-

ment function has traditionally been associated
with exposures to interest-rate and liquidity
risks. Operational risks are also associated with
many of the transactions undertaken by this
function, and market risks are associated with
the investments and hedging instruments com-
monly used by the asset-liability management
function. The quantity of risks associated with a

Page 2.1
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 section 4070.1
sure is not readily quantified may also represent and SR-95-51.)
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 organization’s 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 company’s 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 2124.0.2.2 Preparation of a Scope
asset-liability management practices, can Memorandum
include a review of the historical performance
of net interest margins, as well as the results of Once the inspection planning and risk-
internal projections of future earnings perfor- assessment processes are completed, a scope
mance or net economic value under a variety of memorandum should be prepared. A scope
plausible interest-rate scenarios. The measure- memorandum provides a detailed summary of
ment of the quantity of market risk arising from the supervisory strategy for a bank holding com-
trading in cash and derivative instruments may pany and assigns specific responsibilities to
take into account the historic volatility of trad- inspection team members. A scope memoran-
ing revenues, the results of internal models cal- dum should be tailored to the size and complex-
culating the level of capital and earnings at risk ity of the bank holding company that is subject
under various market scenarios, and the market to review, define the objectives of each inspec-
value of contracts relative to their notional tion, and generally include—
amounts.
Once the types and quantities of risk in each 1. a summary of the results of the prior
activity have been identified, a preliminary inspection;
assessment of the banking organization’s pro- 2. a summary of the strategy and significant
cess to identify, measure, monitor, and control activities of the banking organization, includ-
these risks should be completed. This evaluation ing its new products and activities;
should be based on findings from previous 3. a description of the bank holding company’s
examination and inspection activities conducted organization and management structure;
by the Reserve Bank or other banking agencies, 4. a summary of performance since the prior
supplemented by the review of internal policies inspection;
and procedures, management reports, and other 5. a statement of the objectives of the current
documents that provide information on the inspection;
extent and reliability of internal risk- 6. an overview of the activities and risks to be
management systems. Sound risk-management addressed by the inspection; and
processes vary from one banking organization 7. a description of the procedures that are to be
to another, but generally include four basic ele- performed at the inspection.
ments for each individual financial activity or
function and for the organization in aggregate. BHC Supervision Manual July 2005
These elements are (1) active board and senior Page 3
For large complex organizations operating in administration practices are considered satisfac-
a number of states or internationally, the plan- tory, fewer loans may need be reviewed to
ning and risk-assessment processes are necessar- verify that this is the case (that is, fewer loans
ily more complicated. The traditional scope than would be reviewed if deficiencies in credit-
memorandum may have to be broadened into a administration practices were suspected). This
more extensive set of planning documents to review may be achieved through a valid statisti-
reflect the unique requirements of complex bank cal sampling technique, when appropriate. It
holding companies. Examples of these planning should be noted that if credit-administration
documents include annual consolidated analy- practices are initially considered sound, but if
ses, periodic risk assessments, and supervisory loans reviewed to verify this raise doubts about
plans. the accuracy of internal assessments or the com-
pliance with internal policies and procedures,
the number and volume of loans subject to
2124.0.2.3 On-Site Procedures review should generally be expanded. Examin-
ers should thus review a sufficient number of
The amount of review and transaction testing loans in order to ensure that the level of risk is
necessary to evaluate particular functions or clearly understood, an accurate determination of
activities of a bank holding company generally the adequacy of the ALLL can be made, and the
depends on the quality of the process the com- deficiencies in the credit risk-management pro-
pany uses to identify, measure, monitor, and cess can be comprehensively detailed.
control the risks of an activity. When the risk-
management process is considered sound, fur-
ther procedures are limited to a relatively small
number of tests of the integrity of the manage-
ment system. Once the integrity of the manage-
2124.0.2.4 Evaluation of Audit Function
ment system is verified through limited testing,
as Part of Assessment of Internal Control
conclusions on the extent of risks within the
Structure
function or activity are drawn based on internal
A bank holding company’s internal control
management assessments of those risks rather
structure is critical to its safe and sound func-
than on the results of more-extensive transaction
tioning in general and to its risk-management
testing by examiners. On the other hand, if
system in particular. When properly structured,
initial inquiries into the risk-management
internal controls promote effective operations
system—or efforts to verify the integrity of the
and reliable financial and regulatory reporting;
system—raise material doubts as to the system’s
safeguard assets; and help to ensure compliance
effectiveness, no significant reliance should be
with laws, regulations, and internal policies and
placed on the system. A more extensive series
procedures. In many banking organizations,
of tests should be undertaken to ensure that the
internal controls are tested by an independent
banking organization’s exposure to risk from a
internal auditor who reports directly to the board
given function or activity can be accurately
of directors or its audit committee. However, in
gauged and evaluated. More-extensive transac-
some smaller banking organizations whose size
tion testing is also generally completed for
and complexity of operations do not warrant an
activities that are much more significant to a
internal audit department, reviews of internal
bank holding company than is completed for
controls may be conducted by other personnel
other areas, although the actual level of testing
independent of the area subject to review.
for these significant activities may be reduced
Because the audit function is an integral part
commensurate with the quality of internal risk-
of a bank holding company’s assessment of its
management processes.
internal control system, examiners must include
Consider, as an example, the risk exposure
a review of the organization’s control-
associated with commercial lending activities.
assessment activities in every inspection. Such
Traditionally, examiners have reviewed a rela-
reviews help identify significant risks and facili-
tively high number and dollar volume of real
tate a comprehensive evaluation of the organiza-
estate–associated loans.2 If, however, credit-
tion’s internal control structure and also provide
information to determine the inspection proce-
2. Guidance on the selection of loans for review is pro-
vided in SR-94-13, ‘‘Loan Review Requirements for On-Site
dures that should be completed in assessing
Examinations.’’ internal controls for particular functions and
activities and for the bank holding company
BHC Supervision Manual July 2005 overall. When conducting this review, examin-
Page 4 ers should evaluate the independence and com-
petence of the personnel conducting control hand, at larger bank holding companies that are
assessments and the effectiveness of the assess- typically engaged in more-complex and widely
ment program in covering the bank holding diversified activities, effective risk-management
company’s significant activities and risks. In systems must evaluate various functional man-
addition, examiners should meet with the inter- agement processes in combination so that aggre-
nal auditors or other personnel responsible for gate risk exposures can be identified and moni-
evaluating internal controls. Examiners should tored by senior management. Management
review internal control risk assessments, work information reports should typically be gener-
plans, reports, workpapers, and related commu- ated for the overall organization, as well as for
nications with the audit committee or board of individual functional areas. Some aggregate or
directors. specific company-wide limits may also be
Depending on the size and complexity of the needed for the principal types of risks that are
activities conducted by a bank holding com- relevant to the company’s activities.
pany, the examiner should also consider con- A critical aspect of ensuring that a bank hold-
ducting a similar review of the work performed ing company’s risk-management and control
by the company’s external auditors. Such a procedures remain adequate is the ongoing test-
review often provides added insight into key ing of the strength and integrity of these proce-
risk areas by detailing the nature and extent of dures and the extent to which the procedures are
the external auditors’ testing of those areas. understood and followed throughout the organi-
zation. When assigning a risk-management rat-
ing, examiners should assess the adequacy of
2124.0.2.5 Evaluation of Overall the company’s efforts to ensure that its proce-
Risk-Management Process dures are being followed. The company’s vali-
dation efforts must be conducted by individuals
To highlight the importance of a banking organi- who have proper levels of organizational inde-
zation’s risk-management process, bank holding pendence and expertise, such as internal or
companies are assigned a risk-management rat- external auditors, internal risk-management
ing on a five-point scale as a significant part of units, or managers or other professionals of the
the evaluation of the management components bank holding company who have no direct con-
of the bank holding company RFI/C(D) rating nection to the activities for which procedures
system. (See section 4070.0.) In addition, U.S. are being assessed.
branches and agencies of foreign banking orga-
nizations are assigned a similar rating under the
ROCA rating system.3 These risk-management 2124.0.2.6 Evaluation of Compliance
ratings encompass evaluations of the quality of with Laws and Regulations
risk-management processes for all significant
activities and all types of risks. As such, they Compliance with relevant laws and regula-
should largely summarize conclusions on the tions should be assessed at every inspection.
adequacy of risk-management processes for The steps taken to complete these assessments,
each individual function or activity evaluated. however, will vary depending on the circum-
In assigning risk-management ratings, it is stances of the bank holding company being
important that examiners consider the quality of reviewed. When an organization has a history of
the risk-management process for the bank hold- satisfactory compliance with relevant laws and
ing company overall, as well as for each indi- regulations or an effective compliance function,
vidual function. At smaller bank holding compa- only a relatively limited degree of transaction
nies engaged in traditional banking and testing need be conducted to assess compliance.
nonbanking activities, relatively basic risk- For example, when evaluating compliance with
management processes established for each sig- the appraisal requirements of Regulation Y at a
nificant activity, such as lending or asset- bank holding company with a formal compli-
liability management, may be adequate to allow ance function, compliance may be ascertained
senior management to effectively manage the by reviewing the scope and findings of internal
organization’s overall risk profile. On the other and external audit activities, evaluating the
internal appraisal-ordering and -review pro-
3. U.S. branches and agencies of foreign banking organiza- cesses, and sampling a selection of appraisals
tions are assigned separate ROCA ratings for risk manage-
ment, operational controls, compliance, and asset quality,
for compliance, as part of the supervisory loan-
under guidance included in SR-00-14, ‘‘Enhancements to the
Interagency Program for Supervising the U.S. Operations of BHC Supervision Manual July 2006
Foreign Banking Organizations.’’ Page 5
review process. On the other hand, at bank ties and arrangements, including its internal
holding companies that have a less satisfactory control structure, and the qualifications of
compliance record or that lack a compliance internal and external auditors and other inde-
function, more appraisals would naturally need pendent personnel involved in the program.
to be tested to assess the overall compliance 5. To emphasize the preparation of a risk-
with the appraisal requirements of Regulation Y. focused scope memorandum that is tailored
to the size and complexity of the bank hold-
ing company under inspection.
2124.0.2.7 Documentation of Supervisory 6. To evaluate compliance with laws and
Findings regulations.
7. To adequately document and communicate
The examiners’ workpaper documentation of inspection supervisory findings, recommen-
supervisory findings is necessary for Reserve dations, and conclusions.
Bank management to objectively verify the
inspection work performed. Such documenta-
tion also provides a source of information on the
condition and prospects of a bank holding com- 2124.0.4 INSPECTION PROCEDURES
pany that is invaluable for planning future
1. Identify the significant on- and off-balance-
reviews. Most important, examiners’ workpaper
sheet activities of the bank holding
documentation provides support for the conclu-
company.
sions and recommendations detailed in the
a. Review prior inspection reports and
inspection report.
workpapers, surveillance and monitoring
reports generated by the Board and
2124.0.2.8 Communication of Reserve Bank staff, Uniform Bank Per-
Supervisory Findings formance Reports and Bank Holding
Company Performance Reports, regula-
Effective and open communication between tory reports (for example, bank Call
bank supervisory agencies and the board of Reports and FR Y-series and other
directors and management of bank holding com- FFIEC reports), and other relevant super-
panies is essential to ensuring that the results of visory materials.
inspections are fully understood; the director- b. Review strategic plans and budgets;
ship and management are aware of any identi- internal management reports; board of
fied deficiencies; and, when necessary, they take directors information packages; corre-
appropriate corrective actions. spondence and minutes, including min-
utes of meetings held between the bank
holding company and the Reserve Bank;
2124.0.3 INSPECTION OBJECTIVES annual reports and quarterly SEC filings;
press releases and published news
1. To ensure that the bank holding company has stories; and stock analysts’ reports.
in place the processes necessary to identify, 2. Hold periodic discussions with manage-
measure, monitor, and control its risk expo- ment to gain insight into recently adopted
sures for each of its activities or functions. strategies or plans to change activities or
2. To improve inspection efficiencies by stress- management processes.
ing increased in-office planning of inspec- 3. Once the significant activities have been
tions, using a risk-focused emphasis. identified, determine and analyze the types
3. To identify and assess significant on- and (for example, credit, market, liquidity,
off-balance-sheet activities and the greatest operational, legal, and reputational) and
types and quantities of risk exposures and quantities of risks to which those activities
vulnerabilities to the bank holding company, expose the bank holding company, placing
tailoring the extent of transaction testing to greater inspection emphasis on the high-
the results of this review and other inspec- risk areas.
tions’ findings. 4. Develop an assessment of the processes that
4. To review and assess the effectiveness and are used to identify, measure, monitor, and
adequacy of documentation of the bank hold- control the risks. Focus on the extent of
ing company’s control and assessment activi- board and senior management oversight;
the adequacy of policies, procedures, limits,
BHC Supervision Manual July 2006 risk-measurement, risk-monitoring, and
Page 6 management information systems; and the
existence of adequately documented inter- on the condition and prospects of the bank
nal audits and controls. holding company and its significant subsid-
5. Prepare a scope memorandum tailored to iaries, as well as the inspection’s conclu-
the size and complexity of the bank holding sions and recommendations.
company under inspection.
6. Conduct limited tests of the integrity of the
risk-management system. Conduct more- 2124.0.5 APPENDIX A—DEFINITIONS
extensive transaction testing for those areas OF RISK TYPES EVALUATED AT
of a bank holding company that are very INSPECTIONS
significant compared with other areas, ad-
justing the level of transaction testing to the 1. Credit risk arises from the potential that a
quality of internal risk-management pro- borrower or counterparty will fail to perform
cesses. If initial inquiries or efforts to verify on an obligation.
the system raise material doubts as to its 2. Market risk is the risk to a bank holding
effectiveness, place no reliance on the integ- company’s condition resulting from adverse
rity of the bank holding company’s risk- movements in market rates or prices, such as
management system and conduct more- interest rates, foreign-exchange rates, or
extensive transaction testing. equity prices.
7. Review the bank holding company’s risk- 3. Liquidity risk is the potential that a bank
assessment control activities, including an holding company will be unable to meet its
assessment of internal controls for particu- obligations as they come due because of an
lar functions and activities and for the bank inability to liquidate assets or obtain
holding company overall. adequate funding (referred to as ‘‘funding
a. Evaluate the independence and compe- liquidity risk’’) or that it cannot easily
tence of the personnel conducting con- unwind or offset specific exposures without
trol assessments and the effectiveness of significantly lowering market prices because
the assessment program in covering the of inadequate market depth or market disrup-
bank holding company’s significant tions (‘‘market liquidity risk’’).
activities and risks. 4. Operational risk arises from the potential
b. Meet the independent external and inter- that inadequate information systems, opera-
nal auditors and other personnel respon- tional problems, breaches in internal con-
sible for evaluating internal controls and trols, fraud, or unforeseen catastrophes will
review the internal control risk assess- result in unexpected losses.
ments, work plans, reports, workpapers, 5. Legal risk arises from the potential that unen-
and related communications with the forceable contracts, lawsuits, or adverse
audit committee or the board of judgments can disrupt or otherwise nega-
directors. tively affect the operations or condition of a
8. Assess the adequacy of efforts to ensure bank holding company.
that the current risk-management and con- 6. Reputational risk is the potential that nega-
trol procedures are being followed. tive publicity on a bank holding company’s
9. Assess compliance with laws and regula- business practices, whether true or not, will
tions, adjusting the extent of transaction cause a decline in the customer base, costly
testing with the organization’s history of litigation, or revenue reductions.
satisfactory compliance.
10. Document all work performed and the
supervisory findings. Include information

Page 7
Risk-Focused Supervision Framework for Large
Complex Banking Organizations Section 2124.01
WHAT’S NEW IN THIS REVISED sors. Seamless supervision, which reduces

SECTION regulatory burden and duplication, is pro-
moted. The supervisory process uses exam-
Effective January 2009, this section has been iner resources effectively by using the institu-
revised to include additional risk-focused SR tion’s internal and external risk-assessment
letter topics and manual references in appen- and risk-monitoring systems; making appro-
dix A. priate use of joint and alternating examina-
tions and inspections; and tailoring supervi-
sory activities to an institution’s condition,
2124.01.1 INSPECTION APPROACH risk profile, and unique characteristics.
FOR RISK-FOCUSED SUPERVISION 3. To promote safety and soundness. The
supervisory process effectively evaluates the
The inspection approach for large complex safety and soundness of banking organiza-
banking organizations (LCBOs) is a risk- tions, including the assessment of risk-
focused process that relies on (1) an understand- management systems, financial condition,
ing of the banking organization1 (the institu- and compliance with laws and regulations.
tion), (2) the performance of risk assessments, 4. To provide a comprehensive assessment of
(3) the development of a supervisory plan, and the institution. The supervisory process inte-
(4) inspection procedures that are tailored to the grates specialty areas (for example, informa-
risk profile. The process for a complex institution technology systems, trust, capital
tion relies more heavily on a central point of markets, and consumer compliance (see
contact (CPC), detailed risk assessments, and a SR-03-22/CA-03-15)) and functional risk
supervisory plan before the on-site inspection. assessments and reviews, in cooperation with
The risk-focused inspection also incorporates interested supervisors, into a comprehensive
the U.S. operations of foreign banking organiza- assessment of the institution.
tions (FBOs), for which the Federal Reserve has
overall supervisory authority. See SR-97-24,
SR-99-15, and section 2124.04. 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
2. To foster consistency, coordination, and com- assigned a dedicated supervisory team and
munication among the appropriate supervi- staff with specialized skills, knowledge, and
experience tailored to the unique profile of a
1. For this section, the term banking organization refers to particular institution.
bank holding companies (BHCs) and their domestic and for- 2. Review of functional activities. Large institu-
eign banking and nonbank subsidiaries. It is used synono- tions are generally structured along business
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 2009
member banks). See section 2124.01.1.3.1. Page 1
Risk-Focused Supervision Framework for Large Complex Banking Organizations 2124.01
lines or functions, and some activities are supplement existing supervisory processes.
managed on a centralized basis. As a result, a Banking organizations are also encouraged
single type of risk may cross several legal to continually review and enhance their
entities. Therefore, the supervisory program public disclosures in order to promote
incorporates assessments along functional transparency and to foster and support
lines to evaluate risk exposure and its impact supervisory processes and effective market
on safety and soundness. These functional discipline.
reviews will be integrated into the risk 6. Emphasis on ongoing supervision. Large
assessments for specific legal entities and institutions face a rapidly changing environ-
used to support the supervisory ratings for ment. The supervisory program thus empha-
individual legal entities.2 sizes ongoing supervision, monitoring, and
3. Focus on risk-management processes. Large assessment through increased planning; a no-
institutions generally have highly developed less-than-quarterly reassessment of the orga-
risk-management systems, such as internal nization’s profile; and continuous off-site
audit, loan review, and compliance. The monitoring. Ongoing supervision allows for
supervisory program emphasizes each insti- timely adjustments to the supervisory strat-
tution’s responsibility to be the principal egy as conditions change within the institu-
source for detecting and deterring abusive tion, enhanced information sharing System-
and unsound practices through adequate wide and on an interagency basis, and the
internal controls and operating procedures. use of information technology platforms that
The program incorporates an approach that foster more-effective collaboration and
focuses on and evaluates the institution’s communication.
risk-management systems, processes, and 7. Effective communication with management.
core proficiencies for identifying, measur- An effective program of regular and mean-
ing, monitoring, and controlling key risks, ingful contacts with management is neces-
including credit, market, and operational sary to maintain a current understanding of
risks. Yet, the program retains transaction the institution’s risk profile and risk-
testing and supervisory rating systems, such management processes without imposing
as CAMELS, RFI/C(D), and ROCA. This undue burden, interfering with legitimate
diagnostic perspective provides insight into management prerogatives, or compromising
how effectively an institution is managing the objectivity of the supervisory process.
its operations and how well it is positioned
to meet future business challenges. The pro-
gram places less emphasis on traditional
‘‘point-in-time’’ balance-sheet assessments. 2124.01.1.3 Banking Organizations
4. Tailoring of supervisory activities. Large Covered by the Framework
institutions are unique, but all possess the
ability to quickly change their risk profiles. For purposes of the risk-focused supervision
To deliver effective supervision, the pro- framework, LCBOs generally have a functional-
gram incorporates an approach that tailors management structure, a broad array of prod-
supervisory activities to the risk profile of ucts, operations that span multiple supervisory
an institution. By concentrating on an insti- jurisdictions, and consolidated assets of $1 bil-
tution’s major risk areas, examiners can lion or more.3 These institutions may be state
achieve a more relevant and penetrating un- member banks, BHCs (including their nonbank
derstanding of the institution’s condition. and foreign subsidiaries), and branches and
5. Review of internally and externally gener- agencies of FBOs. The complex-institution pro-
ated management information. A review of cess may also be appropriate for some organiza-
internal management and board reports, tions with consolidated assets less than
internal and external audit reports, and $1 billion.
publicly available information will further
LCBOs are larger institutions that have par-
ticularly complex operations and dynamic risk
2. When functions are located entirely in legal entities that
are not primarily supervised by the Federal Reserve, the
profiles. To be effective, a supervisory program
results of supervisory activities conducted by the primary
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 2009 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 tion’s 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 organization’s
(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 organization’s 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 Board’s 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 institution’s 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 institution’s 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-
institution’s 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 institution’s 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 institution’s internal Bank’s 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 institution’s 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 institution’s financial condition. For state
relevant area’s 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 institution’s 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 1—Steps 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
Reserve’s supervisory role in relation to an insti-
1. Understanding 1. Institutional overview tution and its affiliates. For example, the Federal
the institution Reserve’s role pertaining to an FBO will vary
2. Assessing the 2. Risk matrix depending on whether the Federal Reserve is
institution’s 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 institution’s 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 Reserve’s handbook ‘‘Framework communicate the contact’s 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 institution’s 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 institution’s risk-management the institution’s 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 institution’s 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 OCC’s Supervisory Monitoring System charter conversion since the prior review
(SMS) and the FDIC’s Bank Information Track- 2. a summary of the organization’s business
ing System (BITS). strategies, key business lines, product mix,
Using information generated by the institu- marketing emphasis, growth areas, acquisi-
tion’s 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
institution’s 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 organization’s 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 institution’s 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 institution’s condition. period under review
This information may be particularly valuable in 8. a summary of supervisory activity performed
assessing an organization’s 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 January 2007
executive summary that communicates, in one Page 9
examinations; supervisory actions and the 6. reputational risk, which is the potential that
institution’s degree of compliance; and appli- negative publicity regarding an institution’s
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 institution’s preference litigation, or revenue reductions
for the coordination of specialty inspections
or examinations and combined inspection An institution’s 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 institution’s overall risk environment, the
reliability of its internal risk management, the
2124.01.6 ASSESSING THE adequacy of its information technology systems,
INSTITUTION’S 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 institution’s 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 section 4070.1 and SR-95-51 for additional
both the strengths and vulnerabilities of an insti- guidance on the evaluation of an institution’s
tution and provides a foundation for determin- 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 institution’s risk toler-
perform on an obligation ance and of management’s perception of the
2. market risk, which is the risk to an institu- organization’s strengths and weaknesses. Such
tion’s 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 institution’s 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 institution’s 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 institution’s internal risk management. That range of a banking organization’s activities to
includes an assessment of the adequacy of the determine the level and trend of consumer com-
institution’s internal audit, loan-review, and pliance risk. To address the risks identified in an
compliance functions. External audits also pro- organization’s 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 organization’s 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 System’s 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 management’s 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 institution’s 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
organization’s overall risk profile. To address information and the assessment of consumer
this need, the Federal Reserve enhanced its bank compliance risk into the LCBO’s or LBO’s
holding company supervision program to ensure overall risk assessment.
that examiners are focusing appropriately on The consumer compliance examiner and the
consumer compliance risk–related matters CPC will determine, on a case-by-case basis,
across the broad range of a BHC’s activities. whether and what type of supervisory activities
(See SR-03-22.) should be included in the organization’s 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 organization’s 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 organization’s management. This coor-
dination should help to ensure a seamless pro-
cess in which consistent messages are delivered
10b. The Board’s 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 institution’s internal audit function
organization’s 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 institution’s
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 decisions—moving 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 2—Types 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 institution’s 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
tion’s 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.
institution’s 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 institution’s 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 BHC’s
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
tion’s 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 institution’s overall financial zation’s 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.
institution’s risk-management systems. There are few noted exceptions to the institu-
tion’s 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 institution’s 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 institution’s 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 institution’s 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 BHC’s 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 institution’s
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 institution’s 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 weakness—fair, 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 institution’s 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
ment’s 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 3—Composite 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 organization’s overall of the institution. The risk assessment delineates
condition—in 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 institution’s
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 institution’s 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 institution’s risk profile. inspection or examination are being or will be
addressed. To the extent that the institution’s
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-
institution’s 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 institution’s 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 entity’s 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 Reserve’s scheduling conferences. review of the organization’s 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 tution’s 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
institution’s 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 informed—this may well be the first inspection
complex institutions.15 The letters are designed or examination finding. As specific items are
to reduce the institution’s 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
institution’s 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 management’s 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 institution’s 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
ment’s ability to accurately identify problem
and potential problem transactions and to mea- After performing the inspection or examination
sure, monitor, and control the institution’s 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 examiner’s 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 FBO’s 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 institution’s 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) parent’s inspection report in lieu of separate
4. audit and internal control review reports, unless the institution’s 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 organization’s
10. payments system risk (wire transfers,
supervisory plan.
reserves, settlement)
The contents of the report should clearly and
concisely communicate to the institution’s 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 agement’s ability to identify, measure, monitor,
include appropriate comments regarding defi- and control risks.17 The rating assigned should
ciencies noted in the institution’s risk- reflect the adequacy of the institution’s 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 A—RISK-FOCUSED SUPERVISORY LETTERS AND BHC

SUPERVISION MANUAL SECTION NUMBERS
BHCSM
SR-letter SR-letter title
section no.
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-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-02-1 Revisions to Bank Holding Company Supervision Procedures for 5000.0.4.3
Organizations with Total Consolidated Assets of $5 Billion or Less
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-99-23 Recent Trends in Bank Lending Standards for Commercial Loans 2010.2.2
2010.10
SR-99-18 Assessing Capital Adequacy in Relation to Risk at Large Banking 4060.7
Organizations and Others with Complex Risk Profiles
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

Page 19
BHCSM
SR-letter SR-letter title
section no.
SR-99-15 Risk-Focused Supervision of Large Complex Banking 2124.04

Organizations
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 (CAMELS—adding 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
SR-96-26 Provisions of Individual Components of the Rating System 5010.4
SR-96-17 Supervisory Guidance for Credit Derivatives 2129.0
SR-96-14 Risk-Focused Safety and Soundness Examinations and Inspections 2124.0
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 Internal Controls 4070.1
at State Member Banks and Bank Holding Companies
SR-93-69 Examining Risk Management and Internal Controls for Trading 2125.0
Activities of Banking Organizations
SR-93-19 Supplemental Guidance for Inspection of Nonbank Subsidiaries 5000.0.4.4
of Bank Holding Companies

Page 20
2124.01.12 APPENDIX B—NONBANK 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 subsidiary’s total assets 10 percent or more of BHC consolidated tier 1 capital?
Yes No
2. Is the subsidiary’s 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 BHC’s 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 20.1
Risk-Focused Supervision Framework for Large, Complex Banking Organizations 2124.01
2124.01.13 APPENDIX C—FEDERAL 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 Examiner’s 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 company’s 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 company’s 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 corporation’s 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 person’s 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 director’s or executive officer’s 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 company’s 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 corporation’s 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 bank’s 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 corporation’s 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 organization’s liability

Page 27
Ongoing Risk-Focused Supervision Program for Large
Complex Banking Organizations Section 2124.04
The Federal Reserve’s ongoing large complex 2124.04.1 CONTINUED

banking organization (LCBO) supervisory pro- UNDERSTANDING OF AN LCBO
gram is designed to recognize dramatic changes AND ITS MAJOR RISKS
in the financial, technological, legal, and regula-
tory environment that necessitate a flexible
supervisory framework. This includes the ongo- The process of maintaining a current under-
ing review and assessment of LCBO risk pro- standing of an LCBO and its major risks relies
files and the continual adjustment of supervi- heavily on gathering information from a wide
sory plans and programs for individual banking variety of public and confidential sources,
organizations (BOs). Environmental factors that including supervisory reviews and evaluations
have a significant impact on the nature of LCBO and discussions with management and other
operations and the financial system include the supervisors. One of the primary objectives of
following: this enhanced supervisory method is to generate
a flow of meaningful information that continu-
ously promotes a comprehensive understanding
1. Financial innovation and deregulation. The
of the LCBO. This understanding should include
range, volume, and complexity of traditional
the LCBO’s major business lines and strategies,
banking businesses have increased, and BOs
the risks inherent in its business activities, and
have moved into nontraditional and poten-
the quality and effectiveness of its risk-
tially more-complex financial activities and
management systems. Maintaining an up-to-
services, such as securitizations, securities
date understanding of an LCBO’s risk profile
underwriting and dealing, trading, deriva-
reduces the time-consuming and burdensome
tives, and other capital-markets activities.1
discovery process associated with conducting
2. Increasing competitive pressures. The dis-
on-site examinations. Similarly, this understand-
tinctions between financial products have
ing can also facilitate the timely and efficient
blurred, and the competition in national and
processing of major regulatory applications,
global markets between BOs, nonbank finan-
including acquisitions and mergers, and other
cial firms, and diversified financial services
requests from BOs. Publicly available informa-
conglomerates has intensified.
tion, internal management reports, discussions
3. Geographic expansion and globalization. with management, regulatory reports, informa-
The continued expansion of BOs, both tion from internal and external auditors, and
nationally and globally, and the integration information from other supervisors are examples
of financial markets have increased the chal- of the sources that are used to develop and
lenges associated with assessing and super- maintain a current understanding of the organi-
vising the worldwide activities of U.S. BOs zation. It may be less burdensome for the BO if
and the U.S. operations of foreign banking supervisors can access management reports
organizations. electronically, so electronic access should be
4. Revolution in information technology. The employed when and where feasible and
dramatic changes in information and tele- appropriate.
communications technology have increased
the speed, complexity, geographic scope, and It is important that the principal risk-focused
volume of financial transactions, and have supervisory tools and documents, including the
made possible new techniques for BOs to overview, risk matrix, and risk assessment for
take on and manage risks. the LCBO, remain current. Accordingly, the
central point of contact (CPC) should regularly
These environmental factors have the potential distill and incorporate significant new informa-
for swift and dramatic changes in the risk pro- tion into these documents at least quarterly.
files of LCBOs and can provide avenues for the Factors such as emerging risks; new products;
more rapid transmission of financial shocks. and significant changes in business strategy,
Such developments in turn require supervisors management, condition, or ownership may war-
to employ more-continuous and risk-focused rant more-frequent updates. In general, the more
supervision processes. See SR-99-15, SR-97- dynamic the LCBO’s operations and risks, the
24, and section 2124.01. more frequently the CPC should update the risk
assessment, strategies, and plans.
1. The term ‘‘banking organizations’’ refers to bank hold- BHC Supervision Manual July 2005
ing companies and their bank and nonbank subsidiaries. Page 1
Ongoing Risk-Focused Supervision Program for Large Complex Banking Organizations 2124.04
2124.04.2 DESIGN AND EXECUTION tatives of the principal regulators of major affili-
OF A CURRENT SUPERVISORY PLAN ates to reconfirm agreement on the overall plan
and to coordinate its implementation, when
Effective risk-focused supervision requires the warranted.
development and maintenance of a supervisory
plan that is current and relevant to the organiza-
tion’s changing risk profile. In addition to
addressing all key supervisory objectives, the 2124.04.3 COMMUNICATION
supervisory plan should be individually tailored AND COORDINATION AMONG
for each BO to reflect its particular organiza- SUPERVISORS TO DEVELOP AND
tional and operational structure and, where ADMINISTER A SUPERVISORY PLAN
appropriate, the activities of other principal or
functional supervisors. The supervisory plan and The communication process as described herein
attendant supervisory activities, including can serve as the basis for executing a compre-
on-site examinations, inspections, and supervi- hensive supervisory approach that capitalizes on
sory reviews, should be sufficiently robust to the mandates and resources of the various super-
maintain an up-to-date and thorough under- visory authorities (for example, banking, securi-
standing of the BO’s operations and risks, as ties, and insurance authorities), while minimiz-
well as to maintain the quality of its risk- ing possible duplication and burden on the BO.
management systems. The objective is for supervisors to work coop-
Ongoing assessments of the LCBO’s major eratively in developing supervisory plans and
risks (for example, credit, market, liquidity, scope documents and, when possible and appro-
operational, legal, and reputational risks) should priate, to carry out important supervisory activi-
be used to formulate, revise, and update the ties on a joint or coordinated basis. Coordina-
supervisory plan. The Federal Reserve’s super- tion and communication among supervisors can
visory plan should endeavor to take into account reduce the burden on BOs and result in a more
(1) the nature and scope of major activities efficient deployment of supervisory resources.
conducted by other regulators involved in the An important element of the LCBO program
LCBO and (2) any actions necessary to address is effective communication between the Federal
existing or emerging supervisory concerns, Reserve and the BO’s management throughout
including follow-up on past supervisory issues. the supervision cycle. Communication with the
For BOs supervised by the Federal Reserve, a LCBO can take various forms, including formal
combination of full- and limited-scope examina- and informal meetings with management and
tions, inspections, targeted reviews, meetings the board of directors, as well as the issuance of
with management, and analyses of public and periodic and annual supervisory reports, includ-
supervisory information should be used to main- ing examination or inspection reports, to the
tain an up-to-date risk assessment and to reduce organization’s management and board. The
unnecessary regulatory burden. The necessary objective of these reports is to identify signifi-
level of transaction testing and the degree of cant risks and summarize the Federal Reserve’s
reliance on sampling should be fully explained view of the financial condition and effectiveness
in the scope documents of the supervisory plan of the LCBO’s risk-management processes.
and should adequately address the types and As part of the LCBO program, the manage-
level of risks in the organization’s business ment of the BO should be encouraged to con-
lines. Instances in which efficiencies can be tinue and, if warranted, strengthen communica-
gained by relying on the work of other regulations with Reserve Bank management, CPCs,
tors, internal and external auditors, and the inter- and the supervisory teams, particularly with
nal risk-management function should, where respect to providing information to supervisors
appropriate, be specified in the plan and incor- on a timely basis regarding material financial or
porated into the supervisory program. operational issues or problems. BOs should also
The CPC should review and revise the super- be encouraged to continuously review and
visory plan whenever necessary (but in no case enhance their public disclosures in order to pro-
less frequently than quarterly) to reflect any mote transparency and foster effective market
significant new information or emerging trends discipline. Also, if BOs promptly notify supervi-
or risks. The supervisory plan and any revisions sors of emerging problems, they often can be
should be periodically discussed with represen- resolved in a way that minimizes disruptions.
Strong two-way communications and informa-
BHC Supervision Manual July 2005 tion flows between supervisors and the LCBO’s
Page 2 senior management, including key business-line
and risk managers, are essential to the success affiliates are critical elements of the LCBO pro-
of the LCBO program. In carrying out this program and are essential to successful supervision
gram, the Federal Reserve will continue to of LCBOs. Most LCBOs, regardless of their
assign its highest priority to information secu- business lines and functional management struc-
rity and to protecting the integrity of sensitive, ture, operate through a variety of legal entities
confidential supervisory information and exami- that may be under the jurisdiction of different
nation or inspection information. licensing and supervisory authorities in the
The LCBO supervisory framework also United States and abroad.
requires that results and findings of supervisory To maximize efficiency and reduce regulatory
activities conducted throughout the supervisory burden, the risk-assessment and supervisory-
cycle be continually evaluated and reflected in planning processes should use and leverage off,
the Federal Reserve’s current understanding and or benefit from, the efforts of other principal
assessment of the organization’s risk profile. supervisors to the extent possible, consistent
Reports of examination or inspection or letters with achieving the Federal Reserve’s key super-
to the LCBO’s management and board of direc- visory objectives. The Reserve Bank respon-
tors should routinely be prepared when exami- sible for the supervision of the LCBO should
nations, inspections, and targeted reviews are have regular contacts with supervisors of impor-
completed. If necessary, the organization’s tant affiliates of the organization to discuss and
supervisory ratings should be revised in a timely coordinate matters of common interest; to
manner, based on those findings.2 Risk- develop supervisory plans; and, when and where
management and composite supervisory ratings appropriate, to coordinate the scheduling and
should be adjusted appropriately if material conduct of examinations, inspections, and tar-
weaknesses in risk-management systems or con- geted reviews. Consistent with the supervisory
trols exist, even if these weaknesses have not needs and responsibilities of the Federal Reserve
yet affected the organization’s reported financial and the other supervisors, information may be
results. exchanged as permitted by law and in accor-
At least annually, a comprehensive summary dance with applicable rules and policies of the
supervisory report should be prepared that sup- Board. In addition, meetings should be held at
ports the organization’s assigned ratings and reasonable intervals with internal and external
encompasses the results of the entire supervi- auditors to review audit plans, evaluate signifi-
sory cycle. This report should convey the Fed- cant audit findings and other control assess-
eral Reserve’s view of the condition of the ments, and foster opportunities to leverage off
LCBO and its key risk-management processes, the auditors’ work. Building on the work of
communicate the composite supervisory rat- auditors, when and where appropriate, can
ing(s), discuss each of the major business risks, enhance supervisory efficiency and reduce the
summarize the supervisory activities conducted regulatory burden on the LCBO.
during the supervisory cycle and the resulting
findings, and assess the effectiveness of any
corrective actions taken by the LCBO. This 2124.04.3.2 Enhanced Use of Information
report will satisfy supervisory and legal require- Technology
ments for a full-scope examination or inspec-
tion. Reserve Bank management, as well as The Federal Reserve’s supervisory approach for
Board officials, when warranted, will meet with LCBOs continues to use enhanced information
the LCBO’s board of directors to present and technology. Timely and user-friendly access to a
discuss the contents of the report and the Fed- full range of internal and third-party informa-
eral Reserve’s assessment of the condition of tion, as well as mechanisms to foster collabora-
the BO. tion among Federal Reserve staff and other
supervisors, is essential to effective risk-focused
2124.04.3.1 Information Sharing and supervision for LCBOs. Effective and timely
Coordination with Supervisory Authorities information flows, facilitated by the use of en-
and External and Internal Auditors hanced information technology, can provide a
way for supervisors to ‘‘harvest’’ and share the
Information sharing and coordination within the core knowledge and experience gained through
Federal Reserve and with supervisors of major the conduct of supervisory activities and
through ongoing contacts with BOs. Ready
2. The supervisory ratings include the RFI/C(D) and
CAMELS ratings, and an FBO’s combined U.S. operations BHC Supervision Manual July 2005
rating. Page 3
access to the collective knowledge, insights, and participate in examinations and targeted
current assessments of fellow supervisors, bank reviews.
management, financial markets, and other rel- In addition to designing and executing the
evant third parties can enhance the ability of supervisory strategy for an LCBO, the CPC has
supervisors to identify problems in a timely responsibility for managing the supervisory
manner and formulate effective supervisory team. Important objectives in managing the
responses. To this end, the Federal Reserve Sys- supervision resources for a particular LCBO are
tem’s information-sharing and information tech- to maximize institutional knowledge and mini-
nology strategies will continue to be aimed at mize burden to the BO, while maintaining an
broadening and strengthening the role of the objective, ongoing understanding of the BO’s
CPCs, supervisory teams, and other System staff risk profile. The CPC serves as the Federal
who are responsible for conducting and oversee- Reserve’s primary day-to-day contact for a par-
ing its supervisory programs, including the ticular LCBO and has, together with other mem-
LCBO program. bers of the Reserve Bank management team,
primary responsibility for communicating with
senior officials of the LCBO.
2124.04.4 ORGANIZATION OF The supervisory team’s major responsibilities
FEDERAL RESERVE SUPERVISORY are to maintain a high level of knowledge on the
TEAMS BO and to ensure that supervisory strategies and
priorities are consistent with the identified risks
A principal component of the supervisory and the LCBO’s profile. The team should
framework is the assignment of a dedicated include supervisors with broad-based knowl-
supervisory team to each LCBO. The teams are edge and experience in banking, as well as
made up of individuals with specialized skills, specialists whose technical skills and market
which are based on the organization’s particular knowledge bring depth and perspective to
business lines and risk profile. This full-time, highly focused reviews of selected LCBO
dedicated cadre will be supplemented, as neces- activities.
sary, by other specialized System staff, who will

Page 4
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 Reserve’s 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 Reserve’s 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 organization’s 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 organization’s
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 organization’s 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 organization’s 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 organization’s 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 organization’s
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 organization’s 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 organization’s U.S. operations. The pro-
gram should be reasonably designed to ensure
that the organization’s 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 Reserve’s views on compliance risk-management
capital. Nevertheless, it is important that an organization’s
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,
tion’s 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 organization’s 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 organization’s
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 agement’s 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 organization’s business activities in
a manner that is consistent with the board’s 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- nization’s 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 organization’s 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 Commission’s 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 organization’s 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 organization’s 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 organization’s management and is now used to automate all levels of a banking
board of directors to effectively manage the organization’s 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 organization’s 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 organization’s
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 organization’s 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 Reserve’s 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
organization’s 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 organization’s 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-
zation’s 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
zation’s or activity’s 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 hardware’s 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 organization’s 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 organization’s mission and busi- zation’s 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
organization’s 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 zation’s 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 organization’s
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 organization’s 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 zation’s 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 organization’s 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 institution’s information 7. Review, on a sample basis, the reliability,
technology. Did the review establish whether accuracy, and completeness of processed
the organization’s 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 hardware’s 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 A—Examples 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 bank’s 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
bank’s 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.
Information Security Standards
Section 2124.4
WHAT’S NEW IN THIS REVISED Board of Governors of the Federal Reserve Sys-
SECTION tem approved amendments to the standards on
December 16, 2004 (effective July 1, 2005). The
Effective July 2006, footnote 12 was revised to amended information security standards imple-
include a reference to SR-00-14, ‘‘Enhance- ment sections of 501 and 505 of the Gramm-
ments to the Interagency Program for Supervis- Leach-Bliley Act (15 U.S.C. 6801 and 6805)
ing the U.S. Operations of Foreign Banking and section 216 of the Fair and Accurate Credit
Organizations.’’ Transactions Act of 2003 (15 U.S.C. 1681w).
Effective January 2006, this section, previ- The Gramm-Leach-Bliley Act requires the agen-
ously titled ‘‘Standards for Safeguarding Cus- cies to establish information standards consist-
tomer Information,’’ has been retitled ‘‘Informa- ing of administrative, technical, and physical
tion Security Standards’’ to conform with an safeguards for customer records and informa-
interagency final rule that implements section tion. (See SR-01-15.) Bank holding companies
216 of the Fair and Accurate Credit Transac- and financial holding companies must comply
tions Act of 2003. The Interagency Guidelines with the information security standards (see
Establishing Information Security Standards, as appendix F for Regulation Y).2 The information
amended December 16, 2004, generally require security standards apply to customer informa-
each bank holding company to develop, imple- tion maintained by or on behalf of state member
ment, and maintain, as part of its existing infor- banks, bank holding companies, and the non-
mation security program, appropriate measures bank subsidiaries or affiliates of each.3 (The
to properly dispose of consumer information information security standards include standards
derived from consumer reports in order to for the proper disposal of consumer and cus-
address the risks associated with identity theft. tomer information and guidance on response
(See 12 C.F.R. 225, appendix F.) The amend- programs for unauthorized access to customer
ments to the information security standards were information. (See SR-05-23/CA-05-10.) See
effective July 1, 2005. sections 2124.4.1.1 and 2124.4.2.
The section has also been revised to incorpo- Under the information security standards,
rate the Interagency Guidance on Response each bank holding company falling within the
Programs for Unauthorized Access to Customer scope of the standards must implement a com-
Information and Customer Notice (the guid- prehensive, written information security pro-
ance), which was jointly issued on March 23, gram.4 A bank holding company’s board of
2005 (effective March 29, 2005), by the adopt- directors, or an appropriate committee of the
ing agencies. The guidance describes the board, must oversee the company’s develop-
response programs, including customer notifica- ment, implementation, and maintenance of the
tion procedures, that a bank holding company
should develop and implement to address unau- 2004); and Regulation H, 12 CFR 208, appendix D-2; Regula-
thorized access to or use of customer information K, 12 CFR 211.9 and 211.24; and Regulation Y, 12 CFR
tion that could result in substantial harm or 225, appendix F.
inconvenience to a customer. (See SR-05-23/CA- 2. The discussion in this section applies equally to finan-
cial holding companies and bank holding companies.
05-10.) 3. The information security standards do not apply to bro-
kers, dealers, investment companies, and investment advisers,
or to persons providing insurance under the applicable state
insurance authority of the state in which the person is domi-
2124.4.1 INTERAGENCY GUIDELINES ciled. The appropriate federal agency or state insurance
ESTABLISHING INFORMATION authority regulates these insurance entities under sections 501
SECURITY STANDARDS and 505 of the Gramm-Leach-Bliley Act.
4. The information security standards apply to customer
The federal banking agencies jointly issued information; as a result, a bank holding company that does not
maintain any customer information is not subject to the infor-
interagency guidelines establishing information mation security standards. In addition, when customer infor-
security standards (the information security mation is maintained only in the banking subsidiaries or
standards), which became effective July 1, functionally regulated nonbank subsidiaries of the holding
2001.1 (See appendix A, section 2124.4.5.) The company, examiners generally may rely on the primary super-
visor’s assessment of the subsidiaries’ information security
programs, if applicable, to determine the holding company’s
compliance with the information security standards.
1. The 2001 information security standards were titled
Interagency Guidelines Establishing Standards for Safeguard-
ing Customer Information. See 66 Fed. Reg. 8,616–8,641 BHC Supervision Manual July 2006
(February 1, 2001); 69 Fed. Reg. 7,610–7,621 (December 28, Page 1
Information Security Standards 2124.4
information security program—this board over- (2) sufficiency of policies, procedures, customer
sight includes assigning specific responsibility information systems, and other arrangements
for the program’s implementation and review- that are in place to control risks.
ing reports received from management. The Appropriate policies, procedures, training,
information security program should include and testing must be implemented to manage and
administrative, technical, and physical safe- control identified risks. Management must also
guards appropriate to the size and complexity of report at least annually to the board of directors
the bank holding company and the nature and or an appropriate committee of the board. Man-
scope of its activities. agement’s reports should describe the overall
While all parts of a bank holding company status of the information security program and
are not required to implement a uniform infor- the bank holding company’s compliance with
mation security program and set of policies, all the information security standards. The reports
elements of the information security program should discuss material matters related to the
must be coordinated. A bank holding company BHC’s information security program, address-
must ensure that each of its subsidiaries is sub- ing issues such as risk assessment, risk-
ject to a comprehensive information security management and -control decisions, service-
program. It may fulfill this requirement either provider arrangements, results of testing,
1) by including a subsidiary within the scope of security breaches or violations and manage-
the bank’s holding company’s comprehensive ment’s responses to them, and recommenda-
information security program or (2) by having tions for changes in the information security
the subsidiary implement a separate comprehen- program.
sive information security program in accordance The information security standards outline
with the information security standards and pro- specific information security measures that bank
cedures of appendix F, Regulation Y. holding companies must consider in implement-
A bank holding company’s information secu- ing an information security program. A bank
rity program must be designed to (1) ensure the holding company should adopt appropriate mea-
security and confidentiality of customer infor- sures to manage and control identified risks,
mation,5 (2) protect against anticipated threats commensurate with the sensitivity of the infor-
or hazards to the security or integrity of such mation as well as the complexity and scope of
information, (3) protect against unauthorized its activities. The measures that a bank holding
access to or use of customer information that company must consider and may adopt include
could result in substantial harm or inconve- access controls, access restrictions, encryption
nience to any customer, and (4) ensure the of electronic customer information, dual control
proper disposal of customer information and procedures, segregation of duties, and employee
consumer information.6 Each bank holding com- background checks for employees who have
pany must identify reasonably foreseeable inter- responsibilities for or access to customer infor-
nal and external threats that could result in mation. In addition, a bank holding company
unauthorized disclosure, misuse, alteration, or must have monitoring systems and response
destruction of customer information or customer programs and measures to protect against
information systems. An assessment must be destruction, loss, or damage of customer infor-
made of the (1) likelihood and potential damage mation due to potential environmental hazards,
of these threats, taking into consideration the such as fire and water damage or technological
sensitivity of the customer information, and failures. Training and testing, are critical com-
ponents to implement an effective information
5. Customer information is defined to include any record, security program. Each bank holding company
whether in paper, electronic, or other form, containing non-
public personal information, as defined in Regulation P, about
must regularly test the key controls, systems,
a financial institution’s customer that is maintained by or on and procedures. Tests should be conducted or
behalf of the bank holding company. reviewed by independent third parties or by staff
6. A customer is defined in the same manner in Regulation who are independent of the individuals who
P—a consumer who has established a continuing relationship
with a bank holding company, under which the bank holding
develop or maintain the security program.
company provides one or more financial products or services The Federal Reserve recognizes that banking
to the consumer to be used primarily for personal, family, or organizations are highly sensitive to the impor-
household purposes. The definition of customer does not tance of safeguarding customer information and
include a business, nor does it include a consumer who has
not established an ongoing relationship with the bank holding
the need to maintain effective information secu-
company. rity programs. Existing examination and inspec-
tion procedures and supervisory processes
BHC Supervision Manual July 2006 already address information security. As a result,
Page 2 most banking organizations may not need to
implement any new controls and procedures.

Examiners should assess compliance with the
information security standards during each
safety-and-soundness inspection, which may
include targeted reviews of information technol-

Page 2.1
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 provider’s 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 company’s 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-
ny’s 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 company’s 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 tion’s 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 institution’s response program should
to be included in a bank holding company’s 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, institution’s 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- tution’s 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 Board’s 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 to expeditiously implement its response
relationship with the institution.12 program.
2124.4.2.1.1 Components of a Response

2124.4.2.1 Response Programs Program
Financial institutions should take preventive At a minimum, an institution’s response pro-
measures to safeguard customer information gram should contain procedures for the
against attempts to gain unauthorized access to following:
the information. For example, financial institu-
tions should place access controls on customer 1. assessing the nature and scope of an incident,
information systems and conduct background and identifying what customer information
checks on employees who are authorized to systems and types of customer information
access customer information.13 However, every have been accessed or misused
financial institution should also develop and 2. notifying its primary federal regulator as
implement a risk-based response program to soon as possible when the institution
address incidents of unauthorized access to cus- becomes aware of an incident involving
tomer information in customer information sys- unauthorized access to or use of sensitive
tems14 that occur nonetheless. A response pro- customer information, as defined below
gram should be a key part of an institution’s 3. consistent with the Suspicious Activity
information security program.15 The program Report (SAR) regulations,17 notifying appro-
should be appropriate to the size and complexity priate law enforcement authorities, in addi-
of the institution and the nature and scope of its tion to filing a timely SAR in situations
activities. involving federal criminal violations requir-
In addition, each institution should be able to ing immediate attention, such as when a
address incidents of unauthorized access to cus- reportable violation is ongoing
tomer information in customer information sys- 4. taking appropriate steps to contain and con-
tems maintained by its domestic and foreign trol the incident to prevent further unautho-
service providers. Therefore, consistent with the rized access to or use of customer informa-
obligations in the information security standards tion, for example, by monitoring, freezing, or
that relate to these arrangements and with exist- closing affected accounts, while preserving
ing guidance on this topic issued by the agen- records and other evidence
cies,16 an institution’s contract with its service 5. notifying customers when warranted
provider should require the service provider to
take appropriate actions to address incidents of As noted above for the second component, a
unauthorized access to the financial institution’s financial institution and a bank holding com-
customer information. These actions include pany are to notify its primary federal regulator
notifying the institution as soon as possible of of a security breach involving sensitive cus-
any such incident, which enables the institution tomer information, whether or not it notifies its
customers. The banking organization experienc-
ing such a breach should promptly notify its
12. See the information security standards, 12 C.F.R. 225, supervisory central point of contact at its
appendix F, at section I.C.2.b. and the Board’s Privacy Rule Reserve Bank and provide information on the
(Regulation P), section 216.3(h) (12 C.F.R. 216.3(h)).
13. Institutions should also conduct background checks on nature of the incident and on whether law
employees to ensure that they do not violate 12 U.S.C. 1829, enforcement authorities were notified or a Sus-
which prohibits an institution from hiring an individual con- picious Activity Report (SAR) was or will be
victed of certain criminal offenses or who is subject to a
prohibition order under 12 U.S.C. 1818(e)(6).
17. An institution’s obligation to file a SAR is set out in
14. Under the information security standards, an institu-
the SAR regulations and supervisory guidance. See 12 C.F.R.
tion’s customer information systems consist of all the methods
208.62 (state member banks); 12 C.F.R. 211.5(k) (Edge and
used to access, collect, store, use, transmit, protect, or dispose
agreement corporations); 12 C.F.R. 211.24(f) (uninsured state
of customer information, including the systems maintained by
branches and agencies of foreign banks); and 12 C.F.R.
its service providers. See the information security standards,
225.4(f) (bank holding companies and their nonbank subsidi-
12 C.F.R. 225, appendix F, section I.C.2.d.
aries). See also SR-03-12, ‘‘Revisions to the Suspicious Activ-
15. See SR-97-32, ‘‘Sound Practices Guidance for Infor-
ity Report Form,’’ and SR-01-11, ‘‘Identity Theft and Pretext
mation Security for Networks,’’ for additional guidance on
Calling.’’
preventing, detecting, and responding to intrusions into finan-
cial institution computer systems.
16. See SR-00-04, ‘‘Outsourcing of Information and Trans- BHC Supervision Manual July 2006
action Processing.’’ Page 5
filed. When reporting security breaches involv- sible, it should notify the affected customer as
ing sensitive customer information, the institu- soon as possible.
tion should provide the central point of contact Customer notice may be delayed if an appro-
with information on the steps taken to contain priate law enforcement agency determines that
and control the incident, the number of custom- notification will interfere with a criminal inves-
ers potentially affected, whether customer notifi- tigation and provides the institution with a writ-
cation is warranted, and whether a service pro- ten request for the delay. However, the institu-
vider was involved. A banking organization tion should notify its customers as soon as
should not delay providing prompt initial notifi- notification will no longer interfere with the
cation to its central point of contact. (See SR-05- investigation.
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 institution’s 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
institution’s 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 customer’s 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 customer’s Social Security number,
a key part of that duty. driver’s license number, account number, credit
Timely notification of customers is important or debit card number, or with a personal identifi-
to managing an institution’s reputation risk. cation number or password that would permit
Effective notice also may reduce an institution’s access to the customer’s account. Sensitive cus-
legal risk, assist in maintaining good customer tomer information also includes any combina-
relations, and enable the institution’s 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 customer’s 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
that misuse of the information is reasonably
BHC Supervision Manual July 2006 possible, it should notify all customers in the
Page 6 group.
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.18 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 pany’s compliance with the Interagency
customer’s 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 BHC’s 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 FTC’s 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 System’s Commercial Bank Examination
dents of identity theft.)19 Manual, assess the BHC’s compliance with
the Interagency Guidelines Establishing
Information Security Standards including its
standards for safeguarding customer
information.
18. 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 BHC’s overall information
requests for assistance. security program and its compliance with the
19. The FTC web site for the ID theft brochure and the information security standards.
FTC hotline phone number are www.consumer.gov/idtheft/
and 1-877-IDTHEFT. The institution may also refer custom-
ers to any materials developed pursuant to section 151(b) of
the FACT Act (educational materials developed by the FTC to BHC Supervision Manual January 2006
teach the public how to prevent identity theft). Page 7
2124.4.5 APPENDIX A— B. Objectives

INTERAGENCY GUIDELINES
ESTABLISHING INFORMATION A bank holding company’s 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 company’s written
information security program; and
A. Information Security Program
2. oversee the development, implementation,
and maintenance of the bank holding compa-
Each bank holding company is to implement a
ny’s information security program, including
comprehensive, written information security
assigning specific responsibility for its imple-
program that includes administrative, technical,
mentation and reviewing reports from man-
and physical safeguards appropriate to the size
agement.
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 unautho-
within the scope of the bank holding company’s rized 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 January 2006 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
company’s 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 company’s 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- ny’s 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
pany’s 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 company’s
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
company’s 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 management’s responses; and recommenda-
overall status of the information security pro- tions for changes in the information security
gram and the bank holding company’s 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 FTC’s 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 entity’s 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 FTC’s 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
(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 Program’s Red
‘‘The Program,’’ discusses a Program’s 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 institution’s customers lines, each financial institution or creditor’s 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 institution’s 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 institution’s
(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 institution’s 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 Program’s implementation,
secured account; (4) reopening a covered • reviewing reports prepared by staff regard-
account with a new account number; (5) not ing the institution’s 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 creditor’s Pro-
Program’s 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 institution’s 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 institution’s a. identify and detect relevant Red Flags for
oversight of its Program, periodic reports the BHC’s covered accounts and whether
from service providers are to be issued on the it incorporated those Red Flags into its
Program’s 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 Commission’s rules on Fair Credit the Program’s continued administration,
Reporting, section 681, Subpart A—Identity 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 rule’s 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 A—Identity
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 organization’s 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 management’s application line the organization’s risk management guid-
of this guidance to the holding company and ance for trading and derivative activities. At a
to a banking organization’s 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 organization’s 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 organization’s 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
organization’s 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 organization’s 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
tion’s 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 Management’s 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 organization’s 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 organization’s 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 organization’s 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 organization’s
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 levels—from individual risk-taking against predetermined tolerances, as
traders to the board of directors—and 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 organization’s 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. ment’s 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 organization’s 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 examiner’s assessment of limits are appropriate in view of the banking
the quality of the management information sys- organization’s 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 annually—and more often as
may occur less frequently, but examiners should market conditions dictate—to 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
nization’s 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 organization’s 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 organization’s 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 firm’s 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 organization’s 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 organization’s potential future expo- exceptions were resolved according to the bank-
sure from the instrument as a result of market ing organization’s adopted policies and proce-
changes. Replacement cost should be deter- dures. Examiners should also evaluate whether
mined using current market prices or generally the organization’s 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
tion’s 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 party’s 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 organization’s credit Market risk is the risk to a banking organiza-
exposures should reflect these risk-reducing fea- tion’s 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 organization’s 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 portfolio’s 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, organization’s 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
organization’s risk management process. markets, either because of concerns about the
Examiners should also ensure that the organi- banking organization’s 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 tion’s liquidity plan should reflect the organiza-
and board of directors. These limits should be tion’s 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- dealer’s market-making activities. In such situa-
tion’s 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 organization’s
Page 6 liquidity plan and in the broader context of the
banking organization’s liquidity management through policies developed by the organiza-

process. In their reviews, examiners should con- tion’s 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. zation’s 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 organization’s 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 Reserve’s 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 organization’s 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 examiner’s 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; nization’s 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 organization’s 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 line’s 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 organization’s 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 organization’s
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 organization’s audit programs,
cessing, examiners should evaluate written poli- the nature of the audit findings, and manage-
cies and procedures for recording trades, assess ment’s response to those findings will influence
the trading area’s 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 organization’s 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
Investment Securities and End-User Derivatives
Activities Section 2126.1
WHAT’S NEW IN THIS REVISED merits of developing internal policies that
SECTION specify the type of pre-acquisition analysis
(stress testing) that is consistent with the scope,
Effective January 2007, this section was revised sophistication, and complexity of their invest-
to delete a reference to SR-95-17 that was super- ment securities and end-user derivative hold-
seded by SR-98-12, or the former section ings. Such analyses should be conducted for
2126.0. A reference to the previous 1992 Super- certain types of instruments, including those
visory Policy Statement on Securities Activities that have complex or potentially volatile risk
is also deleted. 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 2126.1.1 SUPERVISORY POLICY
statement was adopted by the Board of STATEMENT ON INVESTMENT
Governors and provides guidance on sound SECURITIES AND END-USER
practices for managing the risks of investment DERIVATIVES ACTIVITIES
activities. The guidance focuses on risk-
management practices of state member banks 2126.1.1.1 Purpose
and Edge corporations. The basic principles also
This policy statement (statement) provides
apply to bank holding companies, which should
guidance to financial institutions (institutions) on
manage and control risk exposures on a
sound practices for managing the risks of
consolidated basis, recognizing the legal distinc-
investment securities and end-user derivatives
tions and potential obstacles to cash movements
activities.2 The FFIEC agencies—the Board of
among subsidiaries. The statement’s risk-
Governors of the Federal Reserve System, the
management principles should also be
Federal Deposit Insurance Corporation, the
incorporated into the policies of U.S. branches
Office of the Comptroller of the Currency, the
and agencies of foreign banks.1
Office of Thrift Supervision, and the National
The statement’s principles set forth sound
Credit Union Administration—believe that
risk-management practices that are relevant to
effective management of the risks associated
most portfolio-management endeavors. The
with securities and derivative instruments
statement places greater emphasis on a risk-
represents an essential component of safe and
focused approach to supervision. Instruments
sound practices. This guidance describes the
held for end-user reasons are considered, taking
practices that a prudent manager normally would
into consideration a variety of factors such as
follow and is not intended to be a checklist.
management’s ability to manage and measure
Management should establish practices and
risk within the institution’s holdings and the
maintain documentation appropriate to the
impact of those holdings on aggregate portfolio
institution’s individual circumstances, consistent
risk.
with this statement.
The statement focuses on managing the mar-
ket, credit, liquidity, operational, and legal risks
of investment and end-user activities. When 2126.1.1.2 Scope
managing the interest-rate-risk component of
market risk, institutions are informed of the This guidance applies to all securities in held-to-
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 2007
home-country supervisory authority. Page 1
Investment Securities and End-User Derivatives Activities 2126.1
maturity and available-for-sale accounts as To properly discharge its oversight responsibili-

defined in the Statement of Financial Account- ties, the board should review portfolio activity
ing Standards No.115 (FAS 115), certificates of and risk levels, and require management to
deposit held for investment purposes, and end- demonstrate compliance with approved risk
user derivative contracts not held in trading limits. Boards should have an adequate
accounts. This guidance covers all securities understanding of investment activities. Boards
used for investment purposes, including money that do not should obtain professional advice to
market instruments, fixed-rate and floating-rate enhance its understanding of investment-activity
notes and bonds, structured notes, mortgage oversight, so as to enable it to meet its
pass-through and other asset-backed securities, responsibilities under this statement.
and mortgage-derivative products. Similarly, Senior management is responsible for the
this guidance covers all end-user derivative daily management of an institution’s invest-
instruments used for nontrading purposes, such ments. Management should establish and
as swaps, futures, and options.3 This statement enforce policies and procedures for conducting
applies to all federally insured commercial investment activities. Senior management
banks, savings banks, savings associations, and should have an understanding of the nature and
federally chartered credit unions. level of various risks involved in the institu-
As a matter of sound practice, institutions tion’s investments and how such risks fit within
should have programs to manage the market, the institution’s 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 institution’s
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 those initiating risk-taking positions.
controlling 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
oversight is an integral part of an effective
risk-management program. The board of direc- Investment policies, procedures, and limits pro-
tors is responsible for approving major policies vide the structure to effectively manage invest-
for conducting investment activities, including ment activities. Policies should be consistent
the establishment of risk limits. The board should with the organization’s broader business strate-
ensure that management has the requisite skills to gies, capital adequacy, technical expertise, and
manage the risks associated with such activities. risk tolerance. Policies should identify relevant
investment objectives, constraints, and guide-
lines for the acquisition and ongoing manage-
3. Natural-person federal credit unions are not permitted to ment of securities and derivative instruments.
purchase nonresidential mortgage asset-backed securities and
may participate in derivative programs only if authorized by the
Potential investment objectives include generat-
National Credit Union Administration. ing earnings, providing liquidity, hedging risk
exposures, taking risk positions, modifying and
BHC Supervision Manual January 2007 managing risk profiles, managing tax liabilities,
Page 2 and meeting pledging requirements, if applica-
ble. Policies should also identify the risk charac- requirements, including any exceptions to estab-
teristics of permissible investments and should lished policies, procedures, and limits. Reports
delineate clear lines of responsibility and author- to management should generally reflect more
ity for investment activities. detail than reports to the board of the institution.
An institution’s management should under- Reporting should be frequent enough to provide
stand the risks and cash-flow characteristics of timely and adequate information to judge the
its investments. This is particularly important changing nature of the institution’s risk profile
for products that have unusual, leveraged, or and to evaluate compliance with stated policy
highly variable cash flows. An institution should objectives and constraints.
not acquire a material position in an instrument
until senior management and all relevant per-
sonnel understand and can manage the risks
associated with the product. An institution’s internal control structure is criti-
An institution’s investment activities should cal to the safe and sound functioning of the
be fully integrated into any institution-wide risk organization generally and the management of
limits. In so doing, some institutions rely only investment activities in particular. A system of
on the institution-wide limits, while others may internal controls promotes efficient operations;
apply limits at the investment portfolio, sub- reliable financial and regulatory reporting; and
portfolio, or individual instrument level. compliance with relevant laws, regulations, and
The board and senior management should institutional policies. An effective system of
review, at least annually, the appropriateness of internal controls includes enforcing official lines
its investment strategies, policies, procedures, of authority, maintaining appropriate separation
and limits. of duties, and conducting independent reviews
of investment activities.
For institutions with significant investment
2126.1.1.4.2 Risk Identification, activities, internal and external audits are inte-
Measurement, and Reporting gral to the implementation of a risk-
management process to control risks in invest-
Institutions should ensure that they identify and
ment activities. An institution should conduct
measure the risks associated with individual
periodic independent reviews of its risk-
transactions prior to acquisition and periodically
management program to ensure its integrity,
after purchase. This can be done at the institu-
accuracy, and reasonableness. Items that should
tional, portfolio, or individual-instrument level.
be reviewed include—
Prudent management of investment activities
entails examination of the risk profile of a par- 1. compliance with and the appropriateness of
ticular investment in light of its impact on the investment policies, procedures, and limits;
risk profile of the institution. To the extent prac- 2. the appropriateness of the institution’s risk-
ticable, institutions should measure exposures to measurement system given the nature, scope,
each type of risk, and these measurements and complexity of its activities; and
should be aggregated and integrated with simi- 3. the timeliness, integrity, and usefulness of
lar exposures arising from other business activi- reports to the board of directors and senior
ties to obtain the institution’s overall risk profile. management.
In measuring risks, institutions should con-
duct their own in-house pre-acquisition analy- The review should note exceptions to poli-
ses, or to the extent possible, make use of spe- cies, procedures, and limits and suggest correc-
cific third-party analyses that are independent of tive actions. The findings of such reviews should
the seller or counterparty. Irrespective of any be reported to the board and corrective actions
responsibility, legal or otherwise, assumed by a taken on a timely basis.
dealer, counterparty, or financial advisor regard- The accounting systems and procedures used
ing a transaction, the acquiring institution is for public and regulatory reporting purposes are
ultimately responsible for the appropriate per- critically important to the evaluation of an orga-
sonnel understanding and managing the risks of nization’s risk profile and the assessment of its
the transaction. financial condition and capital adequacy.
Reports to the board of directors and senior Accordingly, an institution’s policies should
management should summarize the risks related provide clear guidelines regarding the reporting
to the institution’s investment activities and
should address compliance with the investment BHC Supervision Manual January 2007
policy’s objectives, constraints, and legal Page 3
treatment for all securities and derivatives hold- on an ongoing basis. Accordingly, institutions
ings. This treatment should be consistent with should have appropriate policies to ensure such
the organization’s business objectives, generally understanding. In particular, institutions should
accepted accounting principles (GAAP), and have policies that specify the types of market-
regulatory reporting standards. risk analyses that should be conducted for vari-
ous types or classes of instruments, including
that conducted prior to their acquisition (pre-
2126.1.1.5 Risks of Investment Activities purchase analysis) and on an ongoing basis.
Policies should also specify any required docu-
The following discussion identifies particular mentation needed to verify the analysis.
sound practices for managing the specific risks It is expected that the substance and form of
involved in investment activities. In addition to such analyses will vary with the type of instru-
these sound practices, institutions should follow ment. Not all investment instruments may need
any specific guidance or requirements from their to be subjected to a pre-purchase analysis. Rela-
primary supervisor related to these activities. tively simple or standardized instruments, the
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 institution’s 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-
tion’s 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 institution’s 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
institution’s investment portfolio (changes in the the risk profile of the institution, it is a sound
investment portfolio’s 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 institution’s market
that appropriately account for these activities risk requires timely information about the cur-
and the strength of the institution’s 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- rate with the size and nature of these invest-
sensitivity limits on their investment portfolio ments. Institutions with significant holdings of
or on individual securities. These sub-institution highly complex instruments should ensure that
limits, if established, should also be consistent they have the means to value their positions.
with agency guidance. Institutions employing internal models should
It is a sound practice for an institution’s man- have adequate procedures to validate the models
agement to fully understand the market risks and to periodically review all elements of the
associated with investment securities and modeling process, including its assumptions and
derivative instruments prior to acquisition and
4. Federal credit unions must comply with the investment-
BHC Supervision Manual January 2007 monitoring requirements of 12 C.F.R. 703.90. See 62 Fed.
Page 4 Reg. 32,989 (June 18, 1997).
risk-measurement techniques. Managements terparty will fail to honor its obligation at or

relying on third parties for market-risk- before the time of settlement. The selection of
measurement systems and analyses should dealers, investment bankers, and brokers is par-
ensure that they fully understand the assump- ticularly important in effectively managing these
tions and techniques used. risks. The approval process should include a
Institutions should provide reports to their review of each firm’s financial statements and
boards on the market-risk exposures of their an evaluation of its ability to honor its commit-
investments on a regular basis. To do so, the ments. An inquiry into the general reputation of
institution may report the market-risk exposure the dealer is also appropriate. This includes
of the whole institution. Alternatively, reports review of information from state or federal secu-
should contain evaluations that assess trends in rities regulators and industry self-regulatory
aggregate market-risk exposure and the perfor- organizations such as the National Association
mance of portfolios in terms of established of Securities Dealers concerning any formal
objectives and risk constraints. They also should enforcement actions against the dealer, its affili-
identify compliance with board-approved limits ates, or associated personnel.
and identify any exceptions to established stan- The board of directors is responsible for
dards. Institutions should have mechanisms to supervision and oversight of investment port-
detect and adequately address exceptions to lim- folio and end-user derivatives activities, includ-
its and guidelines. Management reports on mar- ing the approval and periodic review of policies
ket risk should appropriately address potential that govern relationships with securities dealers.
exposures to yield curve changes and other fac- Sound credit-risk management requires that
tors pertinent to the institution’s holdings. credit limits be developed by personnel who are
as independent as practicable of the acquisition
function. In authorizing issuer and counterparty
2126.1.1.5.2 Credit Risk credit lines, these personnel should use stan-
dards that are consistent with those used for
Broadly defined, credit risk is the risk that an other activities conducted within the institution
issuer or counterparty will fail to perform on an and with the organization’s overall policies and
obligation to the institution. For many financial consolidated exposures.
institutions, credit risk in the investment port-
folio may be low relative to other areas, such as
lending. However, this risk, as with any other 2126.1.1.5.3 Liquidity Risk
risk, should be effectively identified, measured,
monitored, and controlled. Liquidity risk is the risk that an institution can-
An institution should not acquire investments not easily sell, unwind, or offset a particular
or enter into derivative contracts without assess- position at a fair price because of inadequate
ing the creditworthiness of the issuer or counter- market depth. In specifying permissible instru-
party. The credit risk arising from these posi- ments for accomplishing established objectives,
tions should be incorporated into the overall institutions should ensure that they take into
credit-risk profile of the institution as compre- account the liquidity of the market for those
hensively as practicable. Institutions are legally instruments and the effect that such characteris-
required to meet certain quality standards (i.e., tics have on achieving their objectives. The
investment grade) for security purchases. Many liquidity of certain types of instruments may
institutions maintain and update ratings reports make them inappropriate for certain objectives.
from one of the major 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 of different types of instruments under various
legal requirements and that the institution fully scenarios. Accordingly, institutions should
understands the risk involved. Institutions articulate clearly the liquidity characteristics of
should establish limits on individual counter- instruments to be used in accomplishing institu-
party exposures. Policies should also provide tional objectives.
credit-risk and concentration limits. Such limits Complex and illiquid instruments can often
may define concentrations relating to a single or involve greater risk than actively traded, more
related issuer or counterparty, a geographical liquid securities. Oftentimes, this higher poten-
area, or obligations with similar characteristics. tial risk arising from illiquidity is not captured
In managing credit risk, institutions should
consider settlement and presettlement credit BHC Supervision Manual December 1998
risk. These risks are the possibility that a coun- Page 5
by standardized financial modeling techniques. dealer providing the instrument), the institu-
Such risk is particularly acute for instruments tion should review and understand the
that are highly leveraged or that are designed to assumptions used to price the instrument.
benefit from specific, narrowly defined market 2. Personnel. The increasingly complex nature
shifts. If market prices or rates do not move as of securities available in the marketplace
expected, the demand for such instruments can makes it important that operational personnel
evaporate, decreasing the market value of the have strong technical skills. This will enable
instrument below the modeled value. them to better understand the complex finan-
cial structures of some investment
instruments.
2126.1.1.5.4 Operational (Transaction) 3. Documentation. Institutions should clearly
Risk define documentation requirements for secu-
rities transactions, saving and safeguarding
Operational (transaction) risk is the risk that important documents, as well as maintaining
deficiencies in information systems or internal possession and control of instruments
controls will result in unexpected loss. Sources purchased.
of operating risk include inadequate procedures,
human error, system failure, or fraud. Inaccu- An institution’s policies should also provide
rately assessing or controlling operating risks is guidelines for conflicts of interest for employees
one of the more likely sources of problems who are directly involved in purchasing and
facing institutions involved in investment selling securities for the institution from securi-
activities. ties dealers. These guidelines should ensure that
all directors, officers, and employees act in the
Effective internal controls are the first line of best interest of the institution. The board may
defense in controlling the operating risks wish to adopt policies prohibiting these employ-
involved in an institution’s investment activi- ees from engaging in personal securities transac-
ties. Of particular importance are internal con- tions with these same securities firms without
trols that ensure the separation of duties and specific prior board approval. The board may
supervision of persons executing transactions also wish to adopt a policy applicable to direc-
from those responsible for processing contracts, tors, officers, and employees restricting or pro-
confirming transactions, controlling various hibiting the receipt of gifts, gratuities, or travel
clearing accounts, preparing or posting the expenses from approved securities dealer firms
accounting entries, approving the accounting and their representatives.
methodology or entries, and performing
revaluations.
Consistent with the operational support of 2126.1.1.5.5 Legal Risk
other activities within the financial institution,
securities operations should be as independent Legal risk is the risk that contracts are not
as practicable from business units. Adequate legally enforceable or documented correctly.
resources should be devoted, such that systems Institutions should adequately evaluate the
and capacity are commensurate with the size enforceability of its agreements before indi-
and complexity of the institution’s investment vidual transactions are consummated. Institu-
activities. Effective risk management should tions should also ensure that the counterparty
also include, at least, the following: has authority to enter into the transaction and
that the terms of the agreement are legally
1. Valuation. Procedures should ensure inde- enforceable. Institutions should further ascertain
pendent portfolio pricing. For thinly traded that netting agreements are adequately docu-
or illiquid securities, completely independent mented, executed properly, and are enforceable
pricing may be difficult to obtain. In such in all relevant jurisdictions. Institutions should
cases, operational units may need to use have knowledge of relevant tax laws and
prices provided by the portfolio manager. interpretations governing the use of these
For unique instruments where the pricing instruments.
isbeing provided by a single source (e.g., the

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 organization’s (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 BO’s 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 counterparty’s 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 counterparty’s 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 profiles—especially
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 organization’s 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 counterparties—as 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 BO’s 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 party’s ability to manage the risks of its
of individual counterparties or types of business.
counterparties—a counterparty’s 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 BO’s internal con-
important when a counterparty’s 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 counterparty’s 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 BO’s 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 weeks—their 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-
contract’s 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 organization’s 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 management’s 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 organization’s 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 contract—a period exposure-measurement systems accordingly.
which is typically much shorter than the con- Supervisors should also be cognizant of the
tract’s 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 BO’s 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 treatment—as
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 counterparty’s 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 increases—well 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 organization’s 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 organization’s
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
counterparty’s 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 organization’s 2. Focus special attention on areas where a
internal audit and independent risk- BO’s practices may not conform to its stated
management functions adequately focus on policies.
growth, profitability, and risk criteria when a. Determine if the banking organization’s
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 organization’s 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 organization’s 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 exposures—that are used to
that exhibit significant growth or above- measure, monitor, and control derivatives
normal profitability. counterparty credit exposures—could 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
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 organization’s 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 bank’s or bank holding company’s (BHC’s) 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 organization’s ment at commercial banks and Edge Act corpo-
safety and soundness. rations, the basic principles presented in the
Evaluating a BHC’s 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 organization’s 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 BHC’s 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 BHC’s 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 organization’s 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
WHAT’S 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 organization’s 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 management’s
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 institution’s risk exposures. Risk to zation’s risk-management process and assess
principal is typically small. Accordingly, when management’s 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 institution’s 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 institution’s 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 organization’s 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 organization’s 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
protection—albeit at lower yields—than 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 Reserve’s 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 organization’s 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 organization’s 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 statement’s 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. agement’s ability to manage and measure risk
within the institution’s 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 organization’s 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 Reserve’s Regulation D
Reserve Regulatory Service at 3–1562.
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
organization’s 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 agency’s or a
the position will reduce the institution’s overall government-sponsored agency’s 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. government–sponsored
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,
government–sponsored 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 company’s
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 company’s 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 company’s 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 company’s 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 Reserve’s 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- pany’s 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 company’s 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 company’s 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 company’s 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 company’s
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 organization’s 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 company’s 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 organization’s 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 zation’s 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 organization’s 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 organization’s 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 organization’s 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
WHAT’S NEW IN THIS REVISED commercial paper programs. These securitiza-

SECTION tion programs enable banks to help arrange
short-term financing support for their customers
Effective January 2007, this section has been without having to extend credit directly. This
revised to incorporate the August 4, 2005, Inter- arrangement provides borrowers with an alter-
agency Guidance on the Eligibility of Asset- native source of funding and allows banks to
Backed Commercial Paper (ABCP) Liquidity earn fee income for managing the programs.
Facilities and the Resulting Risk-Based Capital Fees are earned for providing credit and liquid-
Treatment. The guidance clarifies the applica- ity enhancements to these programs.
tion of the asset-quality test for determining the Involvement in credit-enhanced and asset-
eligibility or ineligibility of an ABCP liquidity backed commercial paper programs, however,
facility and the resulting risk-based capital can have potentially significant implications for
treatment of such a facility for banks. The guid- organizations’ credit- and liquidity-risk expo-
ance also re-emphasizes that the primary func- sure. Therefore, examiners need to be fully
tion of an eligible ABCP liquidity facility should informed on the fundamentals of these pro-
be to provide liquidity—not credit enhance- grams, on the risks associated with these pro-
ment. (See 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 over the last few years.
FUNDING SOURCE These programs use a special-purpose entity
(SPE) to acquire receivables generally origi-
The issuance of commercial paper provides an nated either by corporations or sometimes by
alternative to bank borrowing for large corpora- the advising bank itself.3 The SPEs, which are
tions (nonfinancial and financial) and munici- owned by third parties,4 fund their acquisitions
palities. Generally, commercial paper issuers are of receivables by issuing commercial paper that
those with high credit ratings. In recent years, is to be repaid from the cash flow of the
however, some corporations with lower credit receivables.
ratings have been able to issue commercial Bank involvement in an asset-backed com-
paper by obtaining credit enhancements1 (credit mercial paper program can range from advising
support from a firm with a high credit rating) or the program to advising and providing all of
other high-quality asset collateral (asset-backed the required credit and liquidity enhancements
commercial paper) to allow them to enter the in support of the SPE’s commercial paper.
market as issuers. An example of credit- Typically, the advising bank or an affiliate per-
supported commercial paper is one supported by forms a review to determine if the receivables
a letter of credit (LOC), the terms of which of potential program participants (that is, cor-
specify that the bank issuing the LOC guaran- porate sellers) are eligible for purchase by the
tees that the bank will pay off the commercial SPE. The scope of the review is similar to that
paper if the issuer fails to pay off the commer- used in structuring securitizations collateralized
cial paper upon maturity.2 A credit enhancement by credit card receivables or automobile-
could also consist of a surety bond from an secured loans.
insurance company. Once the bank (or its affiliate) determines that
2128.03.2 COMMERCIAL BANK 3. To date, the type of receivables that have been included
INVOLVEMENT IN CREDIT- in the programs are trade receivables, installment sales con-
ENHANCED AND ASSET-BACKED tracts, financing leases, and noncancelable portions of operat-
ing leases and credit card receivables.
COMMERCIAL PAPER 4. Employees of an investment banking firm or some other
third party generally own the equity of the SPE. The advising
A number of commercial banks have become bank can specifically avoid owning the stock if it does not
involved in credit-enhanced and asset-backed 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 January 2007
2. This arrangement is usually referred to as LOC paper. Page 1
Credit-Supported and Asset-Backed Commercial Paper 2128.03
a receivables portfolio has an acceptable credit- est credit rating. These enhancements are gener-
risk profile, it approves the purchase of the ally structured in one of two ways. In the first, a
portfolio at a discounted price by the SPE. The commercial bank enters into a single agreement
bank or its affiliate may also act as the operating under which it is unconditionally obligated to
agent for the SPE, which entails structuring the provide funding for all or any portion of matur-
sale of receivable pools to the SPE and then ing commercial paper that an SPE cannot pay
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 SPE’s
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- EXCLUSION OF ASSET-BACKED
chaser from potential loss. As noted above, the COMMERCIAL PAPER PROGRAM
first level of loss protection is provided by the ASSETS AND RELATED MINORITY
difference between the face value of the receiv- INTERESTS
ables purchased and the discounted price paid
for them, known as ‘‘holdback’’ or ‘‘overcollat- An asset-backed commercial paper (ABCP) pro-
eralization.’’ In some cases, the terms of the sale gram typically is a program through which a
also give the SPE recourse back to the seller if banking organization provides funding to its
there are defaults on the receivables. The corporate customers by sponsoring and adminis-
amount of overcollateralization and recourse tering a bankruptcy-remote special-purpose
varies from pool to pool and depends, in part, on entity that purchases asset pools from, or
the quality of the receivables in the pool and the extends loans to, those customers.5 The asset
desired credit rating for the paper to be issued. pools in an ABCP program might include, for
Usually, the level of credit protection provided example, trade receivables, consumer loans, or
by overcollateralization is specified in terms of asset-backed securities. The ABCP program
some multiple of historical loss experience for raises cash to provide funding to the banking
similar assets. organization’s customers through the issuance
In addition to overcollateralization and of externally rated commercial paper into the
recourse, secondary credit enhancements are market. Typically, the sponsoring banking orga-
also customarily provided. Secondary credit nization provides liquidity and credit enhance-
enhancements include letters of credit, surety ments to the ABCP program. These enhance-
bonds, or other backup facilities that obligate a ments aid the program in obtaining high credit
third party to purchase pools of receivables from ratings that facilitate the issuance of the com-
the SPE at a specified price. In addition to credit mercial paper.6
enhancements, the programs generally have
liquidity enhancements to ensure that the SPE 5. The definition of ABCP program generally includes
can meet maturing-paper obligations. structured investment vehicles (entities that earn a spread by
issuing commercial paper and medium-term notes and using
The rating agencies typically require an the proceeds to purchase highly rated debt securities) and
SPE’s commercial paper to have secondary securities arbitrage programs.
enhancements aggregating 100 percent of the 6. A bank is considered the ‘‘sponsor of an ABCP pro-
gram’’ if it establishes the program; approves the sellers
amount outstanding in order to receive the high- permitted to participate in the program; approves the asset
pools to be purchased by the program; or administers the
BHC Supervision Manual January 2007 program by monitoring the assets, arranging for debt place-
Page 2 ment, compiling monthly reports, or ensuring compliance
In January 2003, the Financial Accounting capital charge against any exposures of the
Standards Board (FASB) issued FASB Interpre- banking organization arising in connection with
tation No. 46, ‘‘Consolidation of Variable Inter- such ABCP programs, including direct-credit
est Entities’’ (FIN 46), which was effective the substitutes, recourse obligations, residual inter-
first annual reporting period after June 15, 2003. ests, liquidity facilities, and loans, in accordance
FIN 46 required, for the first time, the consolida- with sections III.B.5., III.C. and III.D. (12
tion of variable interest entities (VIEs) onto the C.F.R. 225, appendix A) of the risk-based capi-
balance sheets of companies deemed to be the tal rule. When calculating the banking organiza-
primary beneficiaries of those entities. FASB tion’s tier 1 and total capital, any associated
revised FIN 46 in December 2003 as FIN 46-R minority interests must also be excluded from
(effective for publicly owned banking organiza- tier 1 capital. As a result of FIN 46-R, banking
tions by March 31, 2004). FIN 46-R requires the organizations are to include all assets of consoli-
consolidation of many ABCP programs onto the dated ABCP programs as part of their
balance sheets of banking organizations. Bank- on-balance-sheet assets.
ing organizations that are required to consoli- A banking organization is able to exclude
date ABCP program assets must include all of ABCP program assets from its risk-weighted
the program assets (mostly receivables and asset base only with respect to those programs
securities) and liabilities (mainly commercial for which it is the sponsor and that meet the
paper) on their balance sheets for purposes of rule’s definition of an ABCP program. An
the Consolidated Financial Statements for Bank ABCP program is defined as a program that
Holding Companies (FR Y-9C Report) or the primarily issues (that is, more than 50 percent)
bank Reports of Condition and Income (Call externally rated commercial paper backed by
Reports). assets or other exposures held in a bankruptcy-
Sponsoring banking organizations generally remote, special-purpose entity. Thus, a banking
face limited risk exposure to ABCP programs. organization sponsoring a program issuing
This risk is usually confined to the credit ABCP that does not meet the rule’s definition of
enhancements and liquidity-facility arrange- an ABCP program must continue to include the
ments that sponsoring banking organizations program’s assets in the institution’s risk-
provide to these programs. In addition, opera- weighted asset base.
tional controls and structural provisions, along
with overcollateralization or other credit
enhancements provided by the companies that 2128.03.3.1 Liquidity Facilities
sell assets into ABCP programs, mitigate the Supporting ABCP
risks to which sponsoring banking organizations
are exposed. Because of the limited risks, the Liquidity facilities supporting ABCP often take
agencies7 adopted a July 17, 2004 (effective the form of commitments to lend to, or to pur-
September 30, 2004) revised rule that permits chase assets from, the ABCP programs in the
sponsoring banking organizations to exclude event that funds are needed to repay maturing
from risk-weighted assets (for purposes of cal- commercial paper. Typically, this need for
culating the risk-based capital ratios) ABCP liquidity is due to a timing mismatch between
program assets that require consolidation under cash collections on the underlying assets in the
FIN 46-R, subject to certain requirements. program and scheduled repayments of the com-
Under the Board’s risk-based capital rule, a mercial paper issued by the program.
banking organization that must consolidate an A banking organization that provides liquid-
ABCP program that is defined as a variable ity facilities to ABCP is exposed to credit risk
interest entity under GAAP may exclude the regardless of the term of the liquidity facilities.
consolidated ABCP program assets from risk- For example, an ABCP program may require a
weighted assets provided that the banking orga- liquidity facility to purchase assets from the
nization is the sponsor of the ABCP program. If program at the first sign of deterioration in the
a banking organization excludes such consoli- credit quality of an asset pool, thereby removing
dated ABCP program assets, the banking orga- such assets from the program. In such an event,
nization must assess the appropriate risk-based a draw on the liquidity facility exposes the
banking organization to credit risk.
with the program documents and with the program’s credit Short-term commitments with an original
and investment policy.
7. The Board of Governors of the Federal Reserve System,
maturity of one year or less expose banking
the Federal Deposit Insurance Corporation, the Office of the
Comptroller of the Currency, and the Office of Thrift BHC Supervision Manual January 2007
Supervision. Page 3
organizations to a lower degree of credit risk ings, if applicable. For example, if an eligible
than longer-term commitments. This difference short-term liquidity facility providing liquidity
in the degree of credit risk is reflected in the support to ABCP covered an asset-backed secu-
risk-based capital requirement for the different rity (ABS) externally rated AAA, then the
types of exposures through liquidity facilities. notional amount of the liquidity facility would
The Board’s risk-based capital guidelines be converted at 10 percent to an on-balance-
impose a 10 percent credit-conversion factor on sheet credit-equivalent amount and assigned to
unused portions of eligible short-term liquidity the 20 percent risk-weight category appropriate
facilities supporting ABCP. A 50 percent credit- for AAA-rated ABS.8
conversion factor applies to eligible ABCP
liquidity facilities having a maturity of greater
than one year. To be an eligible ABCP liquidity
2128.03.3.2 Overlapping Exposures to an
facility and qualify for the 10 or 50 percent
ABCP Program
credit-conversion factor, the facility must be A banking organization may have multiple over-
subject to an asset-quality test at the time of lapping exposures to a single ABCP program
inception that does not permit funding against (for example, both a program-wide credit
(1) assets that are 90 days or more past due, enhancement and multiple pool-specific liquid-
(2) assets that are in default, and (3) assets or ity facilities to an ABCP program that is not
exposures that are externally rated below invest- consolidated for risk-based capital purposes). A
ment grade at the time of funding if the assets or banking organization must hold risk-based capi-
exposures were externally rated at the inception tal only once against the assets covered by the
of the facility. However, a liquidity facility may overlapping exposures. Where the overlapping
also be an eligible liquidity facility if it funds exposures are subject to different risk-based
against assets that are guaranteed—either condi- capital requirements, the banking organization
tionally or unconditionally—by the U.S. govern- must apply the risk-based capital treatment that
ment, U.S. government agencies, or by an results in the highest capital charge to the over-
OECD central government, regardless of lapping portion of the exposures.
whether the assets are 90 days past due, in For example, assume a banking organization
default, or externally rated investment grade. provides a program-wide credit enhancement
The 10 or 50 percent credit-conversion factor that would absorb 10 percent of the losses in all
applies regardless of whether the structure issu- of the underlying asset pools in an ABCP pro-
ing the ABCP meets the rule’s definition of an gram and also provides pool-specific liquidity
ABCP program. For example, a capital charge facilities that cover 100 percent of each of the
would apply to an eligible short-term liquidity underlying asset pools. The banking organiza-
facility that provides liquidity support to ABCP tion would be required to hold capital against 10
when the ABCP constitutes less than 50 percent percent of the underlying asset pools because it
of the securities issued by the program, thus is providing the program-wide credit enhance-
causing the issuing structure not to meet the ment. The banking organization would also be
rule’s definition of an ABCP program. How- required to hold capital against 90 percent of the
ever, if a banking organization (1) does not meet liquidity facilities it is providing to each of the
this definition and must include the program’s underlying asset pools. For risk-based capital
assets in its risk-weighted asset base or (2) oth- purposes, the banking organization would not
erwise chooses to include the program’s assets be required to hold capital against any credit
in risk-weighted assets, then no risk-based capi- enhancements or liquidity facilities that compro-
tal requirement will be assessed against any mise the same program assets.
liquidity facilities provided by the banking orga- If different banking organizations have over-
nization that supports the program’s ABCP. lapping exposures to an ABCP program, how-
Ineligible liquidity facilities will be treated as ever, each organization must hold capital against
recourse obligations or direct-credit substitutes the entire maximum amount of its exposure. As
for the purposes of the Board’s risk-based capi- a result, while duplication of capital charges
tal guidelines. will not occur for individual banking organiza-
The resulting credit-equivalent amount would tions, some systemic duplication may occur
then be risk-weighted according to the under- where multiple banking organizations have
lying assets or the obligor, after considering any overlapping exposures to the same ABCP
collateral or guarantees, or external credit rat- program.
BHC Supervision Manual January 2007 8. See section III.B.3.c. of the guidelines (12 C.F.R. 225,
Page 4 appendix A).
2128.03.3.3 Asset-Quality Test below investment grade rather than the banking
organization providing liquidity.10
In order for a liquidity facility, either short- or The following forms of credit enhancements
long-term, that supports ABCP not to be consid- are generally acceptable for purposes of satisfy-
ered a recourse obligation or a direct-credit sub- ing the asset quality test:
stitute, it must meet the rule’s risk-based capital
definition of an eligible ABCP liquidity facility. • ‘‘funded’’ credit enhancements that the bank-
An eligible ABCP liquidity facility must meet a ing organization may access to cover delin-
reasonable asset-quality test that, among other quent, defaulted, or below-investment-grade
things, precludes funding assets that are 90 days assets, such as overcollateralization, cash
or more past due or in default. When assets are reserves, subordinated securities, and funded
90 days or more past due, they typically have spread accounts;
deteriorated to the point where there is an • surety bonds and letters of credit issued by a
extremely high probability of default. Assets third party with a nationally recognized statis-
that are 90 days past due, for example, often tical rating organization rating of single A or
must be placed on nonaccrual status in accor- higher that the banking organization may
dance with the agencies’ Uniform Retail Credit access to cover delinquent, defaulted, or
Classification and Account Management Pol- below-investment-grade assets, provided that
icy.9 Further, they generally must also be classi- the surety bond or letter of credit is irrevo-
fied Substandard under that policy. cable and legally enforceable; and
In addition to the above, if the assets covered • one month’s worth of excess spread that the
by the liquidity facility are initially externally banking organization may access to cover
rated (at the time the facility is provided) the delinquent, defaulted, or below-investment-
facility can be used to fund only those assets grade assets if the following conditions are
that are externally rated investment grade at the met: (1) excess spread is contractually
time of funding. The practice of purchasing required to be trapped when it falls below
assets that are externally rated below investment 4.5 percent (measured on an annualized basis)
grade out of an ABCP program is considered to and (2) there is no material adverse change in
be the equivalent of providing credit protection the banking organization’s ABCP underwrit-
to the commercial paper investors. Thus, liquid- ing standards. The amount of available excess
ity facilities permitting purchases of below- spread may be calculated as the average of the
investment-grade securities will be considered current month’s and the two previous months’
either recourse obligations or direct-credit excess spread.
substitutes.
However, neither the ‘‘90-days-past-due’’ Recourse directly to the seller, other than the
limitation nor the ‘‘investment grade’’ limitation funded credit enhancements enumerated above,
apply to the asset-quality test with respect to regardless of the seller’s external credit rating,
assets that are conditionally or unconditionally is not an acceptable form of credit enhancement
guaranteed by the U.S. government or its agen- for purposes of satisfying the asset quality test.
cies or by another OECD central government. Seller recourse—for example, a seller’s agree-
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 securities—may 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’’
for purposes of the risk-based capital rule 10. See SR-05-13 and its attachment, Interagency Guid-
because the provider of the credit enhancement ance on the Eligibility of Asset-Backed Commercial Paper
Liquidity Facilities and the Resulting Risk-Based Capital
generally bears the credit risk of the assets that Treatment.
are 90 days or more past due, in default, or
9. See 65 Fed. Reg. 36,904 (June 12, 2000). Page 5
vider may be obligated to fund against, the 2128.03.4 BOARD-OF-DIRECTORS

liquidity facility should be treated as recourse or POLICIES PERTAINING TO CREDIT-
a direct credit substitute. The full amount of ENHANCED OR ASSET-BACKED
assets supported by the liquidity facility would COMMERCIAL PAPER
be subject to a 100 percent credit conversion
factor.11 The Federal Reserve Board reserves A banking organization (that is, a bank or a
the right to deem an otherwise eligible liquidity bank holding company) participating in an
facility to be, in substance, a direct credit substi- asset-backed commercial paper program should
tute if a banking organization uses the liquidity ensure that such participation is clearly and logi-
facility to provide credit support. cally integrated into its overall strategic objec-
The banking organization is responsible for tives. Furthermore, management should ensure
demonstrating to the Federal Reserve Board that the risks associated with the various roles
whether acceptable credit enhancements cover that the institution may play in such programs
the 90 days or more past due, defaulted, or are fully understood and that safeguards are in
below-investment-grade assets that the organi- place to manage the risks properly.
zation may be obligated to fund against in each Appropriate policies, procedures, and con-
seller’s asset pool. If the banking organization trols should be established by a banking organi-
cannot adequately demonstrate satisfaction of zation before it participates in asset-backed
the conditions in the above-referenced inter- commercial paper programs. Significant poli-
agency guidance, the Federal Reserve Board cies and procedures should be approved and
further reserves the right to determine that a reviewed periodically by the organization’s
credit enhancement is unacceptable for purposes board of directors. These policies and proce-
of the requirement for an asset quality test and, dures should ensure that the organization fol-
therefore, it may deem the liquidity facility to be lows prudent standards of credit assessment and
ineligible. approval regardless of the role an institution
plays in an asset-backed commercial paper pro-
gram. Such policies and procedures would be
2128.03.3.4 Market Risk Capital applicable to all pools of receivables to be pur-
Requirements for ABCP Programs chased by the SPE as well as to the extension of
any credit enhancements and liquidity facilities.
Procedures should include an initial, thorough
Any facility held in the trading book whose credit assessment of each pool for which the
primary function, in form or in substance, is to banking organization had assumed credit risk,
provide liquidity to ABCP—even if the facility followed by periodic credit reviews to monitor
does not qualify as an eligible ABCP liquidity performance throughout the life of the exposure.
facility under the rule—will be subject to the Furthermore, the policies and procedures should
banking-book risk-based capital requirements. outline the credit-approval process and establish
Specifically, banking organizations are required in-house exposure limits, on a consolidated
to convert the notional amount of all trading- basis, with respect to particular industries or
book positions that provide liquidity to ABCP organizations, that is, companies from which the
to credit-equivalent amounts by applying the SPE purchased the receivables as well as the
appropriate banking-book credit-conversion fac- receivable obligors themselves. Controls should
tors. For example, the full amount of all eligible include well-developed management informa-
ABCP liquidity facilities with an original matu- tion systems and monitoring procedures.
rity of one year or less will be subject to a 10
Institutions should analyze the receivables
percent conversion factor, regardless of whether
pools underlying the commercial paper as well
the facility is carried in the trading account or
as the structure of the arrangement. This analy-
the banking book.
sis should include a review of—
1. the characteristics, credit quality, and

expected performance of the underlying
receivables;
2. the banking organization’s ability to meet its
11. See 12 CFR 208, appendix A, section III.B.3.b.i.
obligations under the securitization arrange-
ment; and
BHC Supervision Manual January 2007 3. the ability of the other participants in the
Page 6 arrangement to meet their obligations.
Banking organizations providing credit retained interests, and variable interest enti-
enhancements and liquidity facilities should ties (VIEs) (for example, asset-backed com-
conduct a careful analysis of their funding capa- mercial paper [ABCP] programs, those that
bilities to ensure that they will be able to meet are defined as VIEs under generally accepted
their obligations under all foreseeable circum- accounting principles) are properly
stances. The analysis should include a determi- accounted for on the banking organization’s
nation of the impact that fulfillment of these books and are correctly reported on its regu-
obligations would have on their interest-rate risk latory reports.
exposure, asset quality, liquidity position, and 7. To determine that capital is commensurate
capital adequacy. with, and that there are accurate determina-
Examiners should carefully review the asset- tions of the risk weights for, the risk expo-
backed commercial paper facilities provided by sures arising from recourse obligations,
banking organizations to ensure that they are direct-credit substitutes, asset- and mortgage-
applying, for risk-based capital purposes, the backed securities, ABCP programs and
proper conversion factors to their obligations ABCP liquidity facilities, and other asset-
supporting asset-backed commercial paper pro- securitization transactions.
grams. In addition, examiners should determine
whether the previously discussed policies are
operative and that institutions are adequately 2128.03.6 INSPECTION PROCEDURES
managing their risk exposure. If not appropriate
for the open section, a discussion of the size, 1. Review the minutes of board-of-directors or
effectiveness, and risks associated with asset- executive committee meetings. Establish
backed commercial paper programs should be whether the significant policies and proce-
included in the confidential section of the dures for credit-enhanced or asset-backed
examination or inspection report. See SR-92-11. commercial paper have been approved and
reviewed periodically by the organization’s
board of directors.
2128.03.5 INSPECTION OBJECTIVES a. Determine whether the policies are
operative and whether institutions are ade-
1. To determine whether the banking organi- quately managing their risk exposure.
zation (that is, a bank or a bank holding b. Determine whether the policies and proce-
company) participating in an asset-backed dures are applicable to all pools of receiv-
commercial paper program has included ables to be purchased by the SPE as well
this participation in its overall strategic as to the extension of any credit
objectives. enhancements and liquidity facilities.
2. To determine whether management fully 2. Determine if the organization follows pru-
understands the risks associated with the dent standards of credit assessment and
banking organization’s involvement in approval.
credit-enhancement and asset-backed com- a. Ascertain whether the procedures include
mercial paper programs and whether appro- an initial, thorough credit assessment of
priate safeguards are in place to properly each pool for which the organization had
manage those risks. assumed credit risk. The initial review
3. To ascertain that the appropriate policies, should be followed by periodic credit
procedures, and controls have been estab- reviews to monitor performance through-
lished by the banking organization before out the life of the exposure.
participating in asset-backed commercial b. Determine if the policies and procedures
paper programs. outline the credit-approval process and
4. To verify whether existing managerial and establish in-house exposure limits, on a
internal controls include well-developed consolidated basis, with respect to particu-
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.
6. To ensure that all asset-backed securities BHC Supervision Manual January 2007
owned, any assets sold with recourse, Page 7
the commercial paper as well as analyzes any associated minority interest were
the structure of the arrangement. Does the excluded from the banking organization’s
analysis include a review of— calculation of its risk-based capital ratios.
• the characteristics, credit quality, and c. Ascertain whether the liquidity facilities
expected performance of the underlying the banking organization extends to the
receivables; ABCP program satisfy the risk-based
• the ability of the banking organization capital requirements, including the appro-
to meet its obligations under the securi- priate asset-quality test, of an eligible
tization arrangement; and ABCP program liquidity facility. (See
• the ability of the other participants 12 C.F.R. 225, appendix A, section
in the arrangement to meet their III.B.3.a.iv.)
obligations? d. Determine whether the banking organiza-
3. Review the organization’s funding obligation applied the correct credit-conversion
tions and commitments, and determine factor to the eligible ABCP liquidity
whether there is sufficient liquidity to satisfy facilities when it determined the amount
those funding requirements. Include a deter- of risk-weighted assets for its risk-based
mination of the impact that fulfillment of capital ratios. (See 12 C.F.R. 225, appen-
these obligations would have on their dix A, section III.D.)
interest-rate risk exposure, asset quality, e. Determine if all ineligible ABCP liquidity
liquidity position, and capital adequacy. facilities were treated as either direct-
4. Review carefully the risk-based capital cal- credit substitutes or as recourse obliga-
culations for ABCP facilities to ensure that tions, as required by the risk-based capital
they are applying, for risk-based capital pur- guidelines.
poses, the proper conversion factors to their f. If the banking organization had multiple
obligations supporting the asset-backed com- overlapping exposures, determine if the
mercial paper programs. banking organization applied the risk-
5. Determine if the banking organization con- based capital treatment that resulted in the
solidates, in accordance with GAAP highest capital charge. (See 12 CFR 225,
(FASB’s FIN 46-R, ‘‘Consolidation of Vari- appendix A, section III.B.6.c.)
able Interest Entities’’), the assets of any 6. Include in the inspection report a discussion
ABCP program or other such program that it of the size, effectiveness, and risks associ-
sponsors. ated with ABCP programs (include the dis-
a. Determine if the banking organization’s cussion in the confidential section of the
ABCP program met the definition of a inspection report if not appropriate for the
sponsored ABCP program under the risk- open section).
based capital guidelines.
b. Verify that the assets of the banking orga-
nization’s eligible ABCP program and

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 company’s 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
company’s 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 company’s 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-
company’s 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 company’s 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 company’s 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 arm’s
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 company’s 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 company’s earnings and capital business purpose other than to systematically
may be exposed to as a result of its actions. improve the quality of the trust’s assets. The
legitimate business purpose is evidenced by
Account Removal: Example 1a the bank holding company’s prearranged,
arm’s-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 company’s 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 company’s 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 trust’s 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
ny’s 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 trust’s
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 company’s
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 trust’s 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 company’s 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 company’s 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 company’s criteria that were more conservative than
balance sheet closely track the performance of industry standards, the applicable Federal
the trust’s 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 Reserve’s
its books. If a bank holding company engages in standards, and the FFIEC’s policy.
this practice, examiners should consider its 3. Charged-off receivables held by the trust are
effect on the bank holding company’s capital sold to a third party. The funds generated by
adequacy. this sale, effectively accelerating the recov-
ery on these receivables, improve the trust’s
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- company’s earnings or capital to the risk of loss.
ity than the receivables retained on the bank Because of the margin compression, the bank
holding company’s 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- ny’s 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 company’s 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 company’s earnings or capital.
1. Affinity accounts are added to the pool of 2. The trust’s 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 Reserve’s
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 company’s earnings or capital will result not affect the bank holding company’s 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 company’s
bank holding company’s 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 Enhancer’s
the bank holding company’s 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 company’s 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 company’s 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.
Servicer’s Payment of Deficiency Analysis. The bank holding company’s subse-

Balances: Example 4 quent reimbursement of the credit-enhancement
provider’s losses constitutes implicit recourse
Facts. A wholly owned subsidiary of a bank because the bank holding company’s 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 loan’s outstanding principal.
Analysis. The subsidiary’s 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
ny’s 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 company’s 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 company’s 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 company’s 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 organization’s man-
safety and soundness. When examiners review a agement and board of directors should ensure
bank holding company’s 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 organization’s 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 institution’s 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 company’s 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
organization’s 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 organization’s 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 company’s 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 organization’s 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
ny’s 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
WHAT’S NEW IN THIS REVISED ests, for regulatory reporting purposes, should
SECTION not be carried as assets on a BO’s 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 BO’s
activities, including interest-only strips receiv- securitization-related retained interest must be
able, arise when a banking organization (BO) supported by documentation of the interest’s
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 BO’s 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 BO’s
first mortgages, commercial loans, home equity capital, the BO’s 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 BO’s 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 management’s 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 BO’s 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-
ness of collections activities, ability of the 3. Vintage analysis for each pool using monthly
default-management staff to resolve severely data. Vintage analysis will help management
delinquent loans in a timely and efficient man- understand historical performance trends and
ner, and the appropriateness of loss-recognition their implications for future default rates,
practices. Because the securitization of assets prepayments, and delinquencies, and there-
can result in the current recognition of antici- fore retained interest values. Management
pated income, the risk-management function can use these reports to compare historical
should pay particular attention to the types, vol- performance trends with underwriting stan-
umes, and risks of assets being originated, trans- dards, including the use of a validated credit-
ferred, and serviced. Senior management and scoring model, to ensure loan pricing is con-
the risk-management staff must be alert to any sistent with risk levels. Vintage analysis also
pressures on line managers to originate abnor- helps in the comparison of deal performance
mally large volumes or higher-risk assets to at periodic intervals and validates retained-
sustain ongoing income needs. Such pressures interest valuation assumptions.
can lead to a compromise of credit-underwriting 4. Static-pool cash-collection analysis. A static-
standards. This may accelerate credit losses in pool cash-collection analysis involves
future periods, impair the value of retained inter- reviewing monthly cash receipts relative to
ests, and potentially lead to funding problems. the principal balance of the pool to determine
The risk-management function should also the cash yield on the portfolio, comparing
ensure that appropriate management informa- the cash yield to the accrual yield, and track-
tion systems (MIS) exist to monitor securitiza- ing monthly changes. Management should
tion activities. Reporting and documentation compare monthly the timing and amount of
methods must support the initial valuation of cash flows received from the trust with those
retained interests and ongoing impairment projected as part of the FAS 157 retained-
analyses of these assets. Pool-performance interest valuation analysis. Some master-trust
information will help well-managed BOs
ensure, on a qualitative basis, that a sufficient BHC Supervision Manual July 2008
amount of economic capital is being held to Page 3
structures allow excess cash flow to be monthly. Performance triggers include early
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- 2128.06.3 VALUATION AND
folio in terms of default and prepayment MODELING PROCESSES
rates. If cash receipts are less than those
assumed in the original valuation of the The method and key assumptions used to value
retained interest, this analysis will provide the retained interests and servicing assets or
management and the board with an early liabilities must be reasonable and fully
warning of possible problems with collec- documented. The key assumptions in all valua-
tions or extension practices, and impairment tion analyses include prepayment or payment
of the retained interest. rates, default rates, loss-severity factors, and
5. Sensitivity analysis. A sensitivity analysis discount rates. BOs are expected to take a logi-
measures the effect of changes in default cal appropriate approach when developing
rates, prepayment or payment rates, and dis- securitization assumptions and capitalizing
count rates to assist management in establish- future income flows. It is important that
ing and validating the carrying value of the management quantifies the assumptions at least
retained interest. Stress tests should be per- quarterly on a pool-by-pool basis and maintains
formed at least quarterly. Analyses should supporting documentation for all changes to the
consider potential adverse trends and deter- assumptions as part of the valuation. Policies
mine ‘‘best,’’ ‘‘probable,’’ and ‘‘worst case’’ should define the acceptable reasons for chang-
scenarios for each event. Other factors that ing assumptions and require appropriate
need to be considered are the impact of management approval.
increased defaults on collections staffing, the An exception to this pool-by-pool valuation
timing of cash flows, spread-account capture analysis may be applied to revolving-asset trusts
triggers, overcollateralization triggers, and if the master-trust structure allows excess cash
early-amortization triggers. An increase in flows to be shared between series. In a master
defaults can result in higher-than-expected trust, each certificate of each series represents
costs and a delay in cash flows, thus decreas- an undivided interest in all of the receivables in
ing the value of the retained interests. Man- the trust. Therefore, valuations are appropriate
agement should periodically quantify and at the master-trust level.
document the potential impact to both earn- To determine the value of the retained interest
ings and capital, and report the results to the at inception, and make appropriate adjustments
board of directors. Management should going forward, the BO must implement a rea-
incorporate this analysis into their overall sonable modeling process to comply with FAS
interest-rate risk measurement system.7 157. Management is expected to employ appro-
Examiners will review the BO-conducted priate valuation assumptions and projections,
analysis and the volatility associated with and to maintain verifiable objective documenta-
retained interests when assessing the Sensi- tion of the fair value of the retained interest.
tivity to Market Risk component rating (the Senior management is responsible for ensuring
‘‘S’’ in the CAMELS rating system for banks that the valuation model accurately reflects the
or the ‘‘M’’ for the BHC rating system8). cash flows according to the terms of the securiti-
6. Statement of covenant compliance. Ongoing zation’s structure. For example, the model
compliance with deal-performance triggers should account for any cash collateral or over-
as defined by the pooling and servicing collateralization triggers, trust fees, and
agreements should be affirmed at least insurance payments if appropriate. The board
and management are accountable for the model
7. The Joint Agency Policy Statement on Interest-Rate builders’ possessing the necessary expertise and
Risk (see SR-96-13 and section 2127.0) advises institutions technical proficiency to perform the modeling
with a high level of exposure to interest-rate risk relative to process. Senior management should ensure that
capital that they will be directed to take corrective action. See
also SR-99-18 and Section 4060.7
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 July 2008 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 BO’s 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 BO’s board of directors is responsible for
mechanisms are both appropriate for the BO’s 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 BO’s 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 BO’s 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 BO’s 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—
BO’s 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
BO’s 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 management’s 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 BO’s 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- BO’s earnings and capital at risk. These
dards in risk management. Timely and adequate enhancements should generally be aggregated
information on the BO’s asset securitization to determine the extent of a BO’s 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 BO’s 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 BO’s 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 BO’s 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 BO’s 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 BO’s
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 BO’s 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 organization’s 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 statement’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s portfolio (for example, by origi-
purchased loans or in the portfolio’s 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 institution’s 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
program’s 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 borrower’s
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 estate–related 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 institution’s 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 institution’s 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 institution’s 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 company’s 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 examiner’s 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 institution’s 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 institution’s 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-
tion’s (or industry’s) portfolio. 2128.08.1.4 Classification Guidelines for
Subprime Lending
2128.08.1.3.2 Pools of Subprime Well-managed subprime lenders should recog-

Loans—Not 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 institution’s 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

institution’s 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
tion’s income is not overstated. Page 7
reflect the borrower’s 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 customer’s 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 customer’s
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 borrower’s 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 borrower’s
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 customer’s 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 institution’s overall capital adequacy will be
lender forecloses or otherwise takes possession evaluated on a case-by-case basis through
of the borrower’s property (generally the bor- on-site examinations and off-site monitoring
rower’s home or automobile). In other cases, the procedures, considering, among other factors,
lender may use the threat of foreclosure or the institution’s 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
borrower’s 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 institution’s 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 Reserve’s 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 institution’s 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 institution’s risk-management program. Page 9
should depend on the factors analyzed above, and easily understood by the institution’s
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 institution’s 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 Reserve’s capital
An institution’s 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 portfolio’s 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 management’s 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- ment’s 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 institution’s 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 institution’s
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 Appendix—Questions 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 institution’s 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 institution’s 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 620–679.12
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 620–660 range
listed, as well as for the type and quality of as an indication that the ‘‘borrower’s 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 borrower’s 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.’’ Fitch’s 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 & Poor’s 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 institution’s 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 & Poor’s 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 & Poor’s has classified nonprime B the guidance. Any determination made by an
auto securitization pools as having occa- examiner that an institution’s 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 & Poor’s, ‘‘Auto Loan Criteria and Market
11. Standard & Poor’s, ‘‘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.
tion’s management and with each agency’s ing company’s 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 company’s subprime-lending
quality and is applied only to the subprime programs.
portfolio, not the institution’s entire asset struc- 4. Determine whether the bank holding com-
ture. This is consistent with the financial market- pany’s contingency plans (including those
place’s 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 loan–backed 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 company’s 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 company’s 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 company’s 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 management’s 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 company’s bank holding company’s 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 customer’s 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 customer’s 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 customer’s 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 customer’s 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 customer’s
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
institution’s 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 institutions—it 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 institution’s
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 institution’s 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 client’s disclosure obligations;6
market practices. An institution’s 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
parent’s subsidiary) is an integral and important part of the
bank’s group-wide policies developed in accordance with the
parent’s operations.
rules of the foreign bank’s home country supervisor and
should be consistent with the foreign bank’s overall corporate
and management structure as well as its framework for risk BHC Supervision Manual July 2007
management and internal controls. Page 3
tion’s 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
tomer’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 institution’s 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 management’s 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 customer’s 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 institution’s

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 institution’s 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 institution’s 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 institution’s 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 institution’s policies and procedures
vidual employees are complying with the finan-
should provide for the appropriate levels of
cial institution’s 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 institution’s 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 institution’s 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.
institution’s 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 customer’s 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 asset’s
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 organization’s 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 organization’s 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 asset—if 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 organization’s 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 agement’s 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 organization’s 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.
organization’s 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 bond’s 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 note’s 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 organization’s 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 asset’s 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 tion’s 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 obligor’s
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 client’s financial borrowers;
records since the borrowing entity’s 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 organization’s 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 borrower’s 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 asset’s post-default prices until the organization stems from these concentrations,
swap’s 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 beneficiary’s 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-
organization’s 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 examiner’s presumption
of repayment, as well as on the potential effect may be against a diminution of the severity of
of the assets on the bank’s safety and sound- the underlying asset’s 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 borrower’s 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 loan’s 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 obligor’s
‘‘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 ment’s 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- organization’s 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. organization’s 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 borrower’s 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-
er’s 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 organization’s 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 obligor’s
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 Management—Secondary-Market Credit Activities
WHAT’S 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 organization’s 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 organization’s 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 organization’s 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 organization’s 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 from—or providing credit pro-
cially, appear to have isolated the banking orga- tection to—third 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 institution’s 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 assets—because
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 institution’s 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 trust’s 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 trust’s 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 facility—such 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 pool—credit risk can be shifted
from the program’s 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
program’s commercial paper without increasing institutions may expose them to significant repu-
the program’s credit-enhancement levels. tational risks. Loan-syndication underwriting
7. Dilution essentially occurs when the receivables in the

underlying asset pool—before collection—are 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 trust’s 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 loan’s 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 institution’s 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 institution’s balance sheet. An early amorti-
banking organizations sponsoring the issuance zation of a banking organization’s asset-backed
of asset-backed securities act as servicer, admin- securities could impede its ability to fund
istrator, or liquidity provider in the securitiza- itself—either through reissuance or other
tion transaction. It is imperative that these insti- borrowings—since the institution’s 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
institution’s 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 institution’s 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 institution’s senior management and board to
sponsoring or issuing organization’s 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
institution’s 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 institution’s 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 institution’s 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 institution’s efforts to quantify its
surate with the level of the organization’s 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- tion’s 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 institution’s 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 institution’s 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 management’s 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 institution’s 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 institution’s balance
a banking organization’s 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-
nization’s 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 supervisor’s judgment, an institu-
delinquencies and defaults, as well as the conse- tion’s 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 institution’s capital reflected in the banking organization’s
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 institution’s 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 organization’s 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.
Reserve’s 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 institution’s 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 institution’s 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 institution’s liquidity, dards for allowances or liabilities for
earnings, and capital adequacy. losses, capital, and contingency funding.
4. To review the substance of the institution’s 2. Assess whether the institution’s 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 institution’s 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 company’s management
system of internal controls—focused on lines has performed adequate credit investiga-
of authority and the separation of duties—to 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 BHC’s 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 institution’s 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. tion’s 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 Corporation—A 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 Board’s 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 company’s 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 Member—A 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 Board’s 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 Activities—This 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.
Convergence—The process by which the fu-
Basis—Basis 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 Option—A 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 Options—This 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 Hedging—The 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 Check—A 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 Contracts—Standardized
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 Contract—This 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 Contract—This 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 Exchange—Under the Commodities
forward contracts. Exchange Act (CEA), a ‘‘board of trade’’ desig-
Forward Contracts—Over-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 MAE—Either 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. Hedge—The process of entering transactions
Futures Contracts—Standardized 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 organization’s overall level
of risk.
BHC Supervision Manual December 1992 Initial Futures Margin—In 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.
pant’s performance of contractual obligations. Naked Call Option—Refers to the issuance or
Interest Rate Cap—A 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 Interest—Refers 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 Collar—the 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 Contracts—Option 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 Floor—is 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 Contract—A 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 Hedge—The 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 Margin—Maintenance 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 Clause—A 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 customer’s 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 Cap—This 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 Delivery—See ‘‘Firm Forward high so that the securities would trade at or
Contract.’’ below par when computed based on the agreed
Mark-to-market—The process by which the to yield.
carrying value (market value or fair value) of a Put Option—An 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 Contract—This 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 Turn—Commissions 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 asset–liability 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 Contract—A 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 Hedge—The 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 Contract—Optional 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.
party’s option. See the fuller discussion of
Standby Contracts under 2130.0.3.1.2)
TBA (To Be Announced) Trading—TBA 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 Margin—is 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 Hedge—a 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 con- for 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 broker—possibly a member of a clearing house
types of participants: customers—the buyers or of an exchange—will 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-
exchange’s 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 exchange’s 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
ers—to 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
day’s 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 day’s 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 day’s 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 day’s 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 customer’s (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 1—Closing 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 customer’s 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 constraints—daily price CONTRACTS
movement limits—upon 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
exchange’s 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 Board’s 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 option—not 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 = 5–10/64 − 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 option’s 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 seller’s 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 corporation’s 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 option’s
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 contract’s 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
buyer’s 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 buyer’s 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 CFTC’s 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 buyer’s ability to profit from
2130.0.10 EXAMPLES OF CONTRACT
declines in market rates below the specified
STRATEGIES
floor. Clearly, one’s 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 person’s
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 hedger’s 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 Board’s 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.
131⁄2% 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 dealer’s 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 96-8⁄32
(based on current GNMA 8’s cash price) at for $962,500 to yield
98-28⁄32 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 95-20⁄32, 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 dealer’s
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 87-10⁄32: expiring Mar. 1999 at 86-21⁄32:
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 79-1⁄32
Principal = 3,950,000 Contract value = 3,951,563
Cash loss = ($415,625) Futures gain = $381,250
Although the hedge did not prevent the dealer’s 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 organization’s 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 81⁄4%
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 81⁄4% 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 (81⁄4%) $ 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
*Computation—Purchase 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 loss—incorporating banking organization’s 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 borrower’s 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 borrower’s 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 bills—assuming A cap agreement is typically specified by
no basis risk—plus 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 mismatch—for 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 practitioner’s 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 Board’s 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 Board’s 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 organization’s 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 Board’s 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 Board’s policy statement on engaging in futures,
Page 20 forwards, and option contracts.
managers, determine whether management 7. Ascertain whether the banking organization’s

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 organization’s 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
contracts—for example, bond or bill finan- instruments.
cial contracts—to 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 organization’s 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
organization’s 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 organization’s 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 organization’s 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 examiner’s attention on a bank holding com-
default in all instances. pany’s 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 4–830). 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 organization’s 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 BHC’s 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 organization’s 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 3–1562). 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 organization’s 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 management’s responsibility to minimize
the contract’s 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 organization’s 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 company’s financial-contract activities tion’s board of directors and written proce-
should be noted on the ‘‘Examiner’s 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 organization’s 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 organization’s 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 4–830

holding companies engaging in
futures, forward, and options
contracts on U.S. government and
agency securities and money market
instruments
Policy Statement on Financial 3–1535

Contracts
Supervisory Policy Statement on 3–1562

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 agent’s 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 Reserve’s 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 lender’s overall compli-
2140.0.3 GUIDELINES ance with established policies and the firm’s
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 borrower’s
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 lender’s 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 lender’s 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 lender’s
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 3–1579.5

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 firm’s 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 subsidiary’s 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 counterparty’s 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 counterparty’s 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 York’s 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 dealer’s 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- counterparty’s general reputation and whether
sion’s 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 York’s 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 firm’s certified values or delays in receiving collateral.
public accountant stating that it found no mate-
rial weaknesses in the dealer’s 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 firm’s interest in the securities as superior to
to establish and protect the firm’s 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 firm’s 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 firm’s 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 firm’s 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 firm’s 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 management’s 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 3–1579

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 organization’s 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 light—whether 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 1970’s 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 organization’s 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. Management’s 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 management’s policies, proce-
of ‘‘new’’ sources of risk concentration to eval- dures, and practices in recognizing exposure-
uate the company’s 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 company’s exposure-
1. To review the risk evaluation and control risk figures, or constraints placed on types of
process. transactions.
2. To determine if management’s 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 management’s 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 company’s exposure-risk figures.
5. To assess the effect on the holding compa-
ny’s 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 organization’s 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 institution’s 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 bank’s 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), aff’d, 890 F.2d 1275 (2d Cir. 1989), cert. denied,
[1985–1987 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 [1989–1990] 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- ity’s 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 bank’s 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 product’s accumulated value. The penalty lead the bank’s 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 bank’s 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 A–G) 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 591⁄2 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 individual’s
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:
tion’s directors. The policies should also include (a) the depository institution has
a program to evaluate the underwriter’s 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 bank’s 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 organization’s investment advisory ser- should be designed to ensure that the bank will
vices can pose material risks to the bank’s 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 bank’s 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 bank’s 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 bank’s audit commit-
Federal Reserve Act and the Board’s 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 organization’s 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
(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—
tion’s 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 BHC’s 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 BHC’s or subsidiary’s 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 BHC’s policies, procedures, and prac- investment fund.
tices (includes those involving the parent 4. Find out if the BHC’s internal audit function
company’s oversight and investment adviser monitors any financial support given to bank
subsidiaries). The BHC’s 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 BHC’s 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 customer’s 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 customer’s 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 5–795 (1946).) When used in
discussing a bank’s 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 er’s 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 Board’s securities credit regulations, on of Regulation T. A similar aiding and abetting
settlement date, the customer’s 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 organization’s 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 customer’s 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 customer’s 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 organization’s custom- securities.
ers’ accounts. As long as a financial institution
uses its funds to complete a customer’s 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 company’s 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 company’s 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 institution’s 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 Bank’s 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 Board’s 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,
er’s 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 Board’s 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 company’s board
The SEC, in exercising its broad authority to of directors’ policies for its banking institu-
enforce the Board’s 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- customer’s 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 company’s 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 company’s
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
pany’s 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— 5–942.15,

delivery-versus- 5–942.18,
payment transactions 5–942.2,
5–942.21,
5–942.22
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 writer’s 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/borrower’s 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 borrower’s 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 issuer’s 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 agent’s 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
WHAT’S NEW IN THIS REVISED ber 27, 1994, followed by an interagency state-
SECTION ment on October 27, 2003. (See SR-94-35,
SR-94-55, SR-95-16, SR-95-27, SR-99-26, and
Effective January 2007, this section incorpo- SR-03-18.) The October 27, 1994, Interagency
rates the June 22, 2006, interagency statement, Appraisal and Evaluation Guidelines can be
The 2006 Revisions to Uniform Standards of found in appendix A (see section 2231.0.16).
Professional Appraisal Practice, which was The October 27, 2003, interagency statement on
effective on July 1, 2006. Under the appraisal Independent Appraisal and Evaluation Func-
regulations, banking organizations must ensure tions can be found in appendix B (see section
that their appraisals supporting federally 2231.0.17). The interagency statement further
related transactions adhere to Uniform Stan- clarifies and should be reviewed in conjunction
dards of Professional Appraisal Practice with the agencies’ appraisal and real estate lend-
(USPAP). The interagency statement provides ing regulations and the Interagency Appraisal
an overview of the 2006 USPAP revisions and and Evaluation Guidelines.
the ramifications of those revisions to regulated The intent of the statute and subpart G of the
banking organizations. (See SR-06-9.) Board’s Regulation Y (12 C.F.R. 225) is to
The following paragraphs (through section protect federal financial and public policy inter-
2231.0.1) provide an overview of the Board’s ests in real estate–related financial transactions
appraisal regulation and also the interagency that require the services of an appraiser in con-
guidelines for real estate appraisal and evalua- nection with federally related transactions. The
tion policies and review procedures. statute requires that real estate appraisals be
prepared in writing, in accordance with uniform
The Board’s long-standing policy on real estate standards, by individuals who have demon-
appraisals emphasizes the importance of sound strated competency and whose professional con-
appraisal policies and procedures in a banking duct is subject to effective supervision.
organization’s real estate lending activity. In The statute permitted each state to establish a
December 1987, the Board and the other bank program for certifying and licensing real estate
regulatory agencies jointly adopted guidelines appraisers who are qualified to perform apprais-
for real estate appraisal policies and review pro- als in connection with federally related trans-
cedures. With the passage of the Federal Finan- actions.2 Additionally, title XI designated the
cial Institutions Reform, Recovery, and Enforce- Appraisal Qualifications Board and the
ment Act of 1989 (FIRREA), the Board and the Appraisal Standards Board of the Appraisal
other federal financial institutions regulatory Foundation, a nonprofit appraisal industry
agencies adopted regulations in August 1990 to group, as the authority for establishing
implement the statute’s title XI (the statute) qualifications criteria for appraiser certification
(12 U.S.C. 3331) provisions (12 U.S.C. 3310, and standards for the performance of an
3331–3351, and 1844(b)) relating to the perfor- appraisal. The states were authorized by the
mance and use of appraisals by federally regu- statute to establish qualification standards for
lated financial institutions. On June 7, 1994, the licensing. The statute established the Appraisal
Board and the federal financial institutions regu- Subcommittee of the Federal Financial Institu-
latory agencies adopted several amendments to tions Examination Council to monitor the
their appraisal regulations to clarify the agen- requirements established to meet the intent of
cies’ appraisal requirements.1 Additionally, the
Board revised its guidelines for real estate 2. A federally related transaction refers to any real estate–
appraisal and evaluation programs in Septem- related financial transaction entered into on or after August 9,
ber 1992. The guidelines were reissued on Octo- 1990, that (1) the Board or any regulated institution engages
in or contracts for and (2) requires the services of an appraiser.
A real estate–related financial transaction is any transaction
1. The appraisal standards for federally related transactions involving (1) the sale, lease, purchase, investment in, or
are found in sections 225.61 to 225.67 of subpart G of exchange of real property, including interests in property,
Regulation Y. Section 225.63 was amended, effective Decem- or the financing thereof; (2) the refinancing of real property or
ber 28, 1998, to exclude from the Board’s appraisal require- interests in real property; or (3) the use of real property or
ments transactions that involve underwriting or dealing in interests in property as security for a loan or investment,
mortgage-backed securities. The amendment permits bank including mortgage-backed securities. (See 12 U.S.C. 3350
holding company subsidiaries engaged in underwriting and (4)–(5).)
dealing in securities to underwrite and deal in mortgage-
backed securities without demonstrating that the loans under-
lying the securities are supported by appraisals that meet the BHC Supervision Manual July 2009
Board’s appraisal requirements. (See 1999 FRB 50.) Page 1
Real Estate Appraisals and Evaluations 2231.0
the statute. (See www.asc.gov.) If the Appraisal 2231.0.1.1 Appraisal and Evaluation
Subcommittee issues a finding that the poli- Programs
cies, practices, or procedures of a state are
inconsistent with title XI, the services of The appraisal and evaluation programs should
licensed or certified appraisers from that state be tailored to the lender’s size, its location, and
may not be used in connection with federally the nature of its real estate market and attendant
related transactions. real estate–related activity. These programs
The Board’s appraisal regulation (Regulation should establish prudent standards and proce-
Y, subpart G (12 C.F.R. 225, subpart G)) dures to ensure that written appraisals or evalua-
requires appraisals performed in connection tions are obtained and analyzed for real estate–
with federally related transactions entered into related financial transactions before a final credit
after August 9, 1990, to comply with the regula- decision is made.
tion. Real estate–related financial transactions Appraisal and evaluation programs should
entered into before August 9, 1990, would have also establish the manner in which the institu-
had to comply with the Board’s supervisory tion selects, evaluates, and monitors individuals
guidelines, issued in 1987, as well as with safe who perform real estate appraisals or evalua-
and sound banking practices. Transactions are tions. Key elements of the programs should
deemed to have been entered into and a loan is ensure that individuals are fairly considered for
deemed to have been originated if there was a the assignment, possess the requisite expertise
binding commitment to perform before the to satisfactorily complete the assignment, hold
effective date. The requirement to use a state- the proper state certification or license if appli-
certified or -licensed appraiser was effective cable, and are capable of rendering a high-
December 31, 1992.3 quality appraisal or evaluation in writing.
2231.0.1.2 Real Estate Appraisal

2231.0.1 APPRAISAL AND Compliance Procedures
EVALUATION POLICY
To ensure compliance with the Board’s real
A banking organization’s board of directors is estate appraisal regulation and supervisory
responsible for adopting policies and procedures guidelines, the banking organization should
that establish effective real estate appraisal and have established regulatory compliance proce-
evaluation programs. Analyzing real estate col- dures for all appraisals and evaluations. The
lateral at a loan’s inception and over its life compliance review may be part of a loan offi-
requires a sufficient understanding of appraisals cer’s overall credit analysis and may take the
and evaluations in order to fully assess credit form of a narrative or checklist. The individual
risk. While the appraisal plays an important role who prepared the appraisal or evaluation should
in the loan-approval process, undue reliance take corrective action for noted deficiencies.
should not be placed on the value of collateral in Unreliable appraisals or evaluations should be
lieu of an adequate assessment of the borrow- replaced before the final credit decision. Formal
er’s repayment ability. However, when a credit documentation or evidence of the review should
becomes troubled, the primary source of repay- be maintained.
ment often shifts from the borrower’s capacity Additionally, a banking organization should
to repay to the value of the collateral. For these have comprehensive analytical procedures that
reasons, it is important to have sound appraisal focus on certain types of loans, such as large-
policies and procedures. dollar credits, loans secured by complex or spe-
cialized properties, nonresidential construction
loans, or out-of-area real estate loans. The bank-
3. States had the flexibility to adopt an earlier implementa-
ing organization should establish criteria for
tion date for state requirements that an appraiser be certified identifying which appraisals should be consid-
or licensed to perform an appraisal within his or her state. ered for more comprehensive analytical proce-
Financial institutions doing business in a state that had an dures. These comprehensive analytical proce-
earlier effective date for mandatory use of a certified or
licensed appraiser than the federally mandated effective date
dures should be designed to verify the
would have had to abide by any state laws. appropriateness of the methods and approaches
used in the appraisal and assess the reasonable-
BHC Supervision Manual July 2009 ness of the appraiser’s analysis, opinions, and
Page 2 conclusions.
Formal documentation to support the compre- rial change in market conditions that threatens
hensive analytical procedures should be main- the banking organization’s real estate collateral
tained. An individual performing this analysis, protection.
either an employee of the banking organization For loan workouts, a reappraisal or reevalua-
or an outside consultant, should have real tion may be prudent, even if it is obtained after
estate–related training or experience and be the modification. If there is an expected delay in
independent of the transaction. The individual obtaining the appraisal or evaluation, the bank-
may not change the appraisal’s or evaluation’s ing organization should first protect its interest
estimate of value as a result of the review— to facilitate the orderly collection of the loan or
unless that person is appropriately licensed or to reduce the risk of loss. In a troubled-loan
certified and performs the review according to situation, a reappraisal would not be required
procedures in Standard 3 of the Uniform Stan- when a banking organization advances funds to
dards of Professional Appraisal Practice. protect its interest in a property, such as to
repair damaged property, because these funds
are being used to restore the damaged property
2231.0.1.3 Reappraisals and to its original condition.
Re-evaluations Real estate posted as collateral that has been
acquired by a banking organization through
A program should be developed for obtaining foreclosure or deed in lieu of qualifies for the
reappraisals or re-evaluations as part of a pro- appraisal exemption for subsequent transactions.
gram of prudent portfolio review and monitor- Therefore, the banking organization is only
ing techniques—even when additional financing required to have an evaluation but may first
is not being contemplated. Examples include initiate the foreclosure proceedings to protect its
obtaining appraisals and revaluations for loans collateral interests before obtaining the evalua-
comprising large credit exposures and out-of- tion. Because the sale or disposal and the financ-
area loans. The decision to reappraise or ing of the sale of other real estate owned
re-evaluate the real estate collateral for a subse- (OREO) do not arise from an existing extension
quent transaction should be guided by the of credit, these OREO transactions do not
appraisal exemption for renewals, refinancings, qualify for the appraisal exemption. Thus, a
and other subsequent transactions. Loan work- banking organization is required to have a valid
outs, debt restructurings, loan assumptions, and appraisal to support the sale of OREO unless the
similar transactions involving the addition or transaction qualifies for another appraisal
substitution of borrowers may qualify for the exemption. If the banking organization already
exemption for renewals, refinancings, and other has a valid appraisal (or an evaluation) of the
subsequent transactions. Use of this exemption, real estate, it need not obtain a new appraisal.
however, depends on the condition and quality
of the loan, the soundness of the underlying
collateral, and the validity of the existing 2231.0.2 TRANSACTIONS NOT
appraisal or evaluation. REQUIRING THE SERVICES OF A
A loan may be renewed or refinanced on the LICENSED OR CERTIFIED
basis of a valid appraisal or evaluation if the APPRAISER
planned future use of the property is consistent
with the use identified in the appraisal or evalu- The Board has determined that certain catego-
ation. However, if the property has reportedly ries of real estate–related financial transactions
appreciated because of a planned change in use, do not require the services of a certified or
such as a rezoning, an appraisal would be licensed appraiser and, as such, are not consid-
required for a federally related transaction— ered federally related transactions.
unless another exemption applied (for example, Transactions not requiring the services of a
if the amount financed is below the appraisal certified or licensed appraiser include transac-
threshold). tions in which—
While the Board’s appraisal regulation gener-
ally allows appropriate evaluations of real estate 1. the transaction value4 is $250,000 or less;
collateral in lieu of an appraisal for loan renew-
als and refinancings, in certain situations an 4. Transaction value is defined as the amount of the loan or
appraisal is required. If new funds in excess of extension of credit under consideration. For a pool of loans or
reasonable closing costs are advanced, a new
appraisal for the renewal of an existing trans- BHC Supervision Manual January 2007
action should be obtained when there is a mate- Page 3
2. a lien on real property has been taken as an appraisal under any other law;
collateral in an abundance of caution; 12. the transaction involves underwriting or
3. the transaction is not secured by real estate; dealing in mortgage-backed securities;5 or
4. a lien on real estate has been taken for 13. the Board determines that the services of an
purposes other than the real estate’s value; appraiser are not necessary to protect fed-
5. the transaction is a business loan that has a eral financial and public policy interests in
transaction value of $1 million or less and is real estate–related financial transactions or
not dependent on the sale of, or rental to protect the safety and soundness of the
income derived from, real estate as the pri- institution.
mary source of repayment;
6. a lease of real estate is entered into, unless For transactions below the appraisal thresh-
the lease is the economic equivalent of a old, qualifying for the $1 million or less
purchase or sale of the leased real estate; business-loan exemption, or qualifying for the
7. the transaction involves an existing exten- existing extension-of-credit exemption, the
sion of credit at the lending institution, pro- Board still requires an appropriate evaluation of
vided that there has been no obvious and the real property collateral that is consistent
material change in market conditions or with safe and sound banking practices.
physical aspects of the property that threat- The Board reserves the right to require an
ens the adequacy of the institution’s real appraisal on an exempt transaction whenever it
estate collateral protection after the transac- is necessary to address safety-and-soundness
tion, even with the advancement of new concerns. Whether a banking organization will
monies, or there is no advancement of new be required to obtain an appraisal for a particu-
monies, other than funds necessary to cover lar transaction or an entire group of credits will
reasonable closing costs; depend on its condition. For example, if a bank-
8. the transaction involves the purchase, sale, ing organization is in troubled condition that is
investment in, exchange of, or extension of attributable to underwriting problems in its real
credit secured by a loan or interest in a loan, estate loan portfolio, the Board may require the
pooled loans, or interests in real property, banking organization to obtain an appraisal for
including mortgage-backed securities, and all new transactions below the threshold. How-
each loan or interest in a loan, pooled loan, ever, regardless of a banking organization’s con-
or real property interest met the Board’s dition, an examiner may require an appraisal for
regulatory requirements for appraisals at the a particular real estate–related transaction to
time of origination; address safety-and-soundness concerns.
9. the transaction is wholly or partially insured
or guaranteed by a U.S. government agency
or U.S. government–sponsored agency; 2231.0.3 OBTAINING AN APPRAISAL
10. the transaction either qualifies for sale to
a U.S. government agency or U.S. The banking organization or its agent is respon-
government–sponsored agency, or involves sible for engaging the appraiser and must have
a residential real estate transaction in which sufficient time to analyze the appraisal as part of
the appraisal conforms to the Federal its decision process to enter into the transaction.
National Mortgage Association or Federal (See the discussion below on the selection of an
Home Loan Mortgage Corporation appraiser.) A banking organization may not
appraisal standards applicable to that cate- accept an appraisal prepared for a potential bor-
gory of real estate; rower as the appraisal for a federally related
11. the regulated institution is acting in a fidu- transaction. An appraisal obtained by a financial
ciary capacity and is not required to obtain services institution may be used by a federally
regulated institution so long as procedures have
been established for reviewing appraisals, the
a mortgage-backed security, the transaction value is the review indicates that the appraisal meets the
amount of each individual loan. In determining transaction
value, the senior and junior debt are considered separate regulation’s requirements, and the review is
transactions under the appraisal rule. However, a series of documented in writing.
related transactions will be considered one transaction if it For a multiphased development or construc-
appears that an institution is attempting to avoid the appraisal tion loan, the appraisal of an earlier phase can-
requirement by structuring the transactions below the
appraisal threshold. not be used for a new phase due to the change in
BHC Supervision Manual January 2007 5. This Regulation Y exemption from the Board’s appraisal
Page 4 standards was effective on December 28, 1998.
risk. However, if the original appraisal was pre- obtaining an appraisal that is appropriate for the
pared for all phases of the project, the project particular federally related transaction. The
appraisal may be used if the appraisal’s value appraisal must consider the risk and complexity
for the new phase is still valid at the time of the transaction. The level of detail should be
additional credit is extended. sufficient to understand the appraiser’s analysis
and opinion of the property’s market value. In
accordance with USPAP, appraisers are respon-
2231.0.4 USEFUL LIFE OF AN sible for establishing the scope of work to per-
APPRAISAL form in rendering an opinion of the property’s
market value and have available three different
Since a banking organization may wish to use reporting options. The appraiser’s scope of work
an existing appraisal or evaluation for a subse- should be consistent with the valuation method-
quent loan or investment, its appraisal and ology employed for similar property types, mar-
evaluation program should include criteria to ket conditions, and transactions.
determine the validity of an existing appraisal or
evaluation. The useful life of an appraisal will
vary, depending on the circumstances surround- 2231.0.5.1 Interagency Statement on the
ing the property and the marketplace. When 2006 USPAP
deciding if an appraisal or evaluation may be
used for a subsequent transaction, a banking The federal banking and thrift agencies6 issued
organization should determine if any material an interagency statement, The 2006 Revisions
changes to the underlying assumptions have to Uniform Standards of Professional Appraisal
occurred that would affect the original estimate Practice, on June 22, 2006. (See SR-06-9.) The
of value. statement provides an overview of the USPAP
Examples of factors that could cause material revisions and the ramifications of the revisions
changes to reported values include the passage to regulated institutions’ compliance with the
of time; the volatility of the local market; the agencies’ appraisal regulations.
availability of financing; the inventory of com- The ASB revised the USPAP in 2006, effec-
peting properties; new improvements to, or lack tive July 1, 2006, and incorporated certain
of maintenance of, the subject or competing, prominent revisions,7 including a new Scope of
surrounding properties; a change in zoning; or Work Rule. It also deleted the Departure Rule
environmental contamination. The banking and its associated terminology (such as ‘‘bind-
organization should document its information ing’’ and ‘‘specific’’ requirements and ‘‘com-
sources and analyses used to determine if an plete’’ and ‘‘limited’’ appraisals). The Scope of
existing appraisal or evaluation remains valid. It Work Rule clarifies the standards for the type
should also document whether the banking orga- and extent of research and analysis performed
nization will be using that appraisal or evalua- by the appraiser in an appraisal assignment. The
tion in a subsequent transaction. ASB noted that the appraisal process was not
changed and that there is a greater emphasis on
the appraiser’s process of problem identification
2231.0.5 APPRAISAL and the development of an appropriate scope of
REQUIREMENTS work.
Under the USPAP’s Scope of Work Rule, an
The objective of an appraisal is to communicate appraiser must determine an appropriate scope
the appraiser’s reasoning and conclusions logi- of work that should be performed to produce
cally so that the reader is led to the appraiser’s ‘‘credible assignment results.’’ According to the
opinion of market value. The contents of USPAP Advisory Opinion 29, credible assign-
appraisals should conform to the standards of
the Board’s appraisal regulation and to those
established in the current USPAP as promul- the Office of the Comptroller of the Currency, the Federal
gated by the Appraisal Standards Board (ASB) Deposit Insurance Corporation, the Office of Thrift Supervi-
of the Appraisal Foundation. The actual form, sion, and the National Credit Union Administration.
length, and content of appraisal reports may 7. The 2006 USPAP and other ASB documents are avail-
able on the Appraisal Foundation web site at
vary, depending on the type of property being www.appraisalfoundation.org/s_appraisal/
appraised and the nature of the assignment. sec.asp?CID=3&DID=3.
Standard forms completed in compliance with
the regulation and USPAP are also acceptable. BHC Supervision Manual January 2007
A banking organization is responsible for Page 5
ment results depend on the scope of work meet- fails to comply with supplemental standards, the
ing or exceeding both (1) the expectations of appraiser is in violation of the USPAP Ethics
parties who are regularly intended users for Rule. When ordering appraisals, a banking orga-
similar assignments and (2) what an appraiser’s nization should convey to an appraiser that these
peers’ actions would be in performing the same supplemental standards remain applicable.
or a similar assignment. Further, the appraisal The Board’s appraisal regulation permitted
report must contain sufficient disclosure to allow banking organizations to use appraisals pre-
intended users to understand the scope of work pared according to the former USPAP Departure
performed. (Appraisers may continue to label Provision, which permits limited exceptions to
appraisal reports as self-contained, summary, or ‘‘specific guidelines’’ in USPAP. Under the
restricted use.) former Departure Provision, the appraisal
A banking organization may use an engage- amendment would be considered a complete or
ment letter in ordering an appraisal to facilitate limited appraisal. In a complete appraisal
communications with the appraiser and to docu- assignment, an appraiser must meet all USPAP
ment the expectations of each party to the standards and guidelines in estimating market
appraisal assignment. To determine an apprais- value. In a limited appraisal assignment, the
al’s acceptability, a banking organization should appraiser elects to depart from certain specific
review the report to assess the adequacy of the guidelines by invoking the Departure Provision.
appraiser’s scope of work given the intended
use of the appraisal. In accordance with the
Board’s appraisal regulation, a banking organi-
zation must determine that the appraisal report 2231.0.5.3 Appraisal Reports
contains sufficient information and analysis to
support the credit decision. The appraisal report usually includes a disclo-
sure of sales history and an opinion as to the
highest value and best use of the property. After
2231.0.5.2 Appraisal Standards preparing a report, appraisers must certify that—
The minimum standards for appraisals per- 1. statements of fact are true and correct,
formed in connection with federally related 2. limiting conditions have been disclosed,
transactions are those set forth in USPAP, as 3. they have no interest (present or future) in
well as any other standards that the Board deems the transaction or property,
necessary. In summary, an appraisal must— 4. compensation is not contingent on rendering
a specified value,
1. conform to the generally accepted appraisal 5. they have complied with USPAP,
standards as evidenced by USPAP, unless 6. an inspection of the property was or was not
principles of safe and sound banking require performed, and
compliance with stricter standards; 7. assistance was or was not received in the
2. be written and contain sufficient information preparation of the appraisal.
and analysis to support the banking organiza-
tion’s decision to engage in the transaction; Three different report formats can be used to
3. analyze and report appropriate deductions report the results of the appraisal assignment: a
and discounts for proposed construction or self-contained report, a summary report, and a
renovation, partially leased buildings, non- restricted report. Since USPAP requires all
market lease terms, and tract developments appraisal reports to encompass all aspects of the
with unsold units; assignment, reports will differ based on the
4. be based on the definition of market value as degree of detail presented. The self-contained
set forth in the regulation; and appraisal report provides the most detail; the
5. be performed by state-licensed or -certified summary appraisal report condenses the infor-
appraisers in accordance with the require- mation; and the restricted appraisal report pre-
ments in the regulation. sents minimal information, with supporting
details maintained in the appraiser’s work files.
From the appraiser’s perspective, these regu- The restricted report is not appropriate for a
latory appraisal requirements are ‘‘supplemental significant number of federally related transac-
standards’’ to USPAP. If an appraiser knowingly tions because the minimal amount of informa-
tion limits the usefulness of the document for
BHC Supervision Manual January 2007 underwriting, compliance, and other decision-
Page 6 making purposes. However, a restricted report
might be used when providing ongoing collat- 2. comparable-sales approach

eral monitoring of a banking organization’s real 3. capitalization-of-income approach
estate transactions and under other circum-
stances when a banking organization’s program All three approaches have particular merits
requires an evaluation. depending on the type of real estate being
appraised. For single-family residential prop-
erty, the cost and comparable-sales approaches
2231.0.5.4 Appraisal Content are most frequently used since the common use
of the property is the personal residence of the
The appraisal must reflect a market value of the owner. However, if a single-family residential
real estate. The regulation defines market value property is intended to be used as a rental prop-
as the most probable price that a property should erty, the appraiser would have to consider the
bring in a competitive and open market under income approach as well as the cost and
all conditions requisite to a fair sale, the buyer comparable-sales approaches. For special-use
and seller each acting prudently and knowledge- commercial properties, the appraiser may have
ably, and assuming the price is not affected by difficulty obtaining sales data on comparable
undue stimulus. Implicit in this definition is the properties and may have to base the value esti-
consummation of a sale as of a specified date mate on the cost and capitalization of income
and the passing of title from the seller to the approach. If an approach is not used in the
buyer under conditions whereby— appraisal, the appraiser should disclose the rea-
son the approach was not used and whether this
1. the buyer and seller are typically motivated, had an impact on the value estimate.
2. both parties are well informed or well
advised and acting in what they consider
their own best interests, 2231.0.6.1 Value Correlation
3. a reasonable time is allowed for exposure in
the open market, The three value estimates—cost, market, and
4. payment is made in terms of cash in U.S. income—must be evaluated by the appraiser
dollars or in terms of financial arrangements and correlated into a final value estimate based
comparable thereto, and on the appraiser’s judgment. Correlation does
5. the price represents the normal consideration not imply averaging the value estimates
for the property sold, unaffected by special obtained by using the three different approaches.
or creative financing or sales concessions When these value estimates are relatively close
granted by anyone associated with the sale. together, correlating them and setting the final
market-value estimate presents no special
To properly underwrite a construction loan, a problem. However, if widely divergent values
banking organization may need to know the are obtained by using the three appraisal
prospective value of a property and its market approaches, the appraiser must exercise judg-
value as of the appraisal date. Prospective value ment in analyzing the results and determining
is based on events yet to occur, such as comple- the estimate of market value.
tion of construction or renovation, reaching sta-
bilized occupancy, or some other event yet to be
determined. Thus, more than one value may be 2231.0.6.1.1 Cost Approach
reported in an appraisal as long as all values are
clearly described and reflect the projected dates In the cost approach to value estimation, the
when future events could occur. Assumptions appraiser obtains a preliminary indication of
and projections used to develop prospective value by adding the estimated depreciated repro-
value estimates must be fully supported and duction cost of the improvements to the esti-
reasonable in light of current market conditions. mated land value. This approach is based on
the assumption that the reproduction cost is
the upper limit of value and that a newly con-
2231.0.6 APPRAISAL VALUATION structed building would have functional and
APPROACHES mechanical advantages over an existing build-
ing. The appraiser would evaluate any depre-
The appraiser typically uses three market-value ciation, that is, disadvantages or deficiencies, of
approaches to analyze the value of property:
1. cost approach Page 7
the existing building in relation to a new and in selecting the appropriate capitalization
structure. rate and method. The following data are
The cost approach consists of four basic assembled and analyzed to determine potential
steps: (1) estimate the value of the land as net income and value:
though vacant, (2) estimate the current cost of
reproducing the existing improvements, (3) esti- 1. Rent schedules and the percentage of
mate depreciation and deduct from the occupancy for the subject property and for
reproduction-cost estimate, and (4) add the esti- comparable properties for the current year
mate of land value and the depreciated repro- and several preceding years. This informa-
duction cost of improvements to determine the tion provides gross rental data and the trend
value estimate. of rentals and occupancy, which are then
analyzed by the appraiser to estimate the
gross income the property should produce.
2231.0.6.1.2 Comparable-Sales Approach 2. Expense data such as taxes, insurance, and
operating costs being paid from revenues
The focus of this approach is to determine the derived from the subject property and com-
recent sales price of similar properties. Through parable properties. Historical trends in these
an appropriate adjustment for differences in the expense items are also determined.
subject property and the selected comparable 3. The timeframe for achieving ‘‘stabilized’’ or
properties, the appraiser estimates the market normal occupancy and rent levels (also
value of the subject property based on the sales referred to as the ‘‘holding period’’).
price of the comparable properties. To deter- 4. An appropriate capitalization rate and valua-
mine the extent of comparability of two or more tion technique, selected and applied to net
properties, the appraiser must judge their simi- income to establish a value estimate.
larity with respect to age, location, condition,
construction, layout, and equipment. The sales Basically, the income approach converts all
or list price of those properties that the appraiser expected future net operating income into a
determines to be most comparable will tend to value estimate. When market conditions are
set the range for the value of the subject stable and no unusual patterns of future rents
property. and occupancy rates are expected, the direct-
capitalization method is used to value income
properties. This method calculates the value of a
2231.0.6.1.3 Income Approach property by dividing an estimate of its stabilized
annual income by a factor called a ‘‘cap’’ rate.
The income approach estimates the project’s Stabilized income generally is defined as the
expected income over time converted to an esti- yearly net operating income produced by the
mate of its present value. The income approach property at normal occupancy and rental rates; it
typically is used to determine the market value may be adjusted upward or downward from
of income-producing properties such as office today’s actual market conditions. The cap rate—
buildings, apartment complexes, hotels, and usually defined for each property type in a mar-
shopping centers. In the income approach, the ket area—is viewed by some analysts as the
appraiser can use several different capitalization required rate of return stated in terms of current
or discounted-cash-flow techniques to arrive at a income.
market value. These techniques include the The use of this technique assumes that either
band-of-investments method, mortgage-equity the stabilized income or the cap rate, used accu-
method, annuity method, and land-residual tech- rately, captures all relevant characteristics of the
nique. The use of a particular technique will property relating to its risk and income poten-
depend on whether there is project financing, tial. If the same risk factors, required rate of
there are long-term leases with fixed-level pay- return, financing arrangements, and income pro-
ments, and the value is being rendered for a jections are used, explicit discounting and direct
component of the project such as land or capitalization will yield the same results.
buildings. For special-use properties, new projects, or
The accuracy of the income approach troubled properties, the discounted-cash-flow
depends on the appraiser’s skill in estimating (net present value) method is the more typical
the anticipated future net income of the property approach to analyzing a property’s value. In this
method, a timeframe for achieving a stabilized
BHC Supervision Manual January 2007 or normal occupancy and rent level is projected.
Page 8 Each year’s net operating income during that
period is discounted to arrive at the present Thus, investment value can be significantly
value of expected future cash flows. The proper- higher than market value in certain circum-
ty’s anticipated sales value at the end of the stances and should not be used in credit-
stabilization period (its terminal or reversion analysis decisions.
value) is then estimated. The reversion value 3. Liquidation value assumes that there is little
represents the capitalization of all future income or no current demand for the property and
streams of the property after the projected occu- that the property needs to be disposed of
pancy level is achieved. The terminal or rever- quickly. In this situation, the owner may
sion value is then discounted to its present value have to sacrifice property appreciation for an
and added to the discounted income stream to immediate sale.
arrive at the total present market value of the 4. Going-concern value is based on the value of
property. the business entity, rather than the value of
Most importantly, the analysis should be the real estate. The valuation is based on the
based on the ability of the project to generate existing operations of a business that has a
income over time based on reasonable and proven operating record, with the assumption
supportable assumptions. Additionally, the dis- that the business will continue to operate.
count rate should reflect reasonable expectations 5. Assessed value represents the value on which
about the rate of return that investors require a taxing authority bases its assessment. The
under normal, orderly, and sustainable market assessed value and market value may differ
conditions. considerably due to tax assessment laws, tim-
ing of reassessments, and tax exemptions
allowed on properties or portions of a
2231.0.7 OTHER DEFINITIONS OF property.
VALUE 6. Net realizable value (NRV) is recognized
under generally accepted accounting prin-
The Board’s appraisal regulation requires that ciples9 as ‘‘the estimated selling price in the
the appraisal contain a market value of the real ordinary course of business less estimated
estate collateral. Some other definitions of value costs of completion (to the stage of comple-
that are encountered when appraising and evalu- tion assumed in determining the selling
ating real estate transactions are described price), holding, and disposal.’’ The NRV is
below. generally used to evaluate the carrying
amount of assets being held for disposition
1. Fair value is an accounting term that is gen- and properties representing collateral. While
erally defined as the amount in cash or cash- the market value or future selling price is
equivalent value or other consideration that a generally used as the basis for the NRV
real estate parcel would yield in a current calculation, the NRV also reflects the current
sale between a willing buyer and a willing owner’s costs to complete the project and to
seller (selling price), other than a forced or hold and dispose of the property. For this
liquidation sale.8 According to accounting reason, the NRV will generally be less than
literature, fair value is generally used in the market value.
valuing assets in nonmonetary trans-
actions, troubled-debt restructuring, quasi- The appraiser should state the definition of
reorganizations, and business combinations value reported in the appraisal, and, for feder-
accounted for by the purchase method. An ally related transactions, the value must meet
accountant generally defines fair value as the definition of market value in the regulation.
market value; however, depending on the This is the most probable price that a property
circumstances, these values may not be the should bring in a competitive and open market
same for a particular property. under all conditions requisite to a fair sale,
2. Investment value is based on the data and assuming the buyer and seller are both acting
assumptions that meet a particular investor’s prudently and knowledgeably, and the price is
criteria and objectives for a specific property not affected by undue stimulus. Other presenta-
or project. The investor’s criteria and objec-
tives are often substantially different than
those of participants in a broader market. 9. FASB Statement No. 67, ‘‘Accounting for Costs and
Initial Rental Operations of Real Estate Projects,’’ appen-
dix A—Glossary.
8. FASB Statement No. 67, ‘‘Accounting for Costs and
Initial Rental Operations of Real Estate Projects,’’ appen- BHC Supervision Manual January 2007
dix A—Glossary. Page 9
tions of value, in addition to market value, are 2231.0.8.1 Form and Content of
allowed and may be included in the appraisal at Evaluations
the request of the banking organization.
The documentation for evaluations should fully
support the estimate of value and include suffi-
cient information to understand the evaluator’s
2231.0.8 EVALUATION analysis, assumptions, and conclusions. The
REQUIREMENTS evaluator is not required to use a particular form
or valuation approach, but the analysis should
apply to the type of property and fully explain
The Board’s appraisal regulation requires an
the value rendered.
evaluation for certain real estate–related finan-
An individual who conducts an evaluation
cial transactions that are exempt from the title
should have real estate–related training or expe-
XI appraisal requirement. These transactions
rience relevant to the type of property. However,
include—
the individual does not have to be a state-
licensed or -certified appraiser. Prudent prac-
1. transactions below the $250,000 threshold; tices require that a more detailed evaluation be
2. transactions qualifying for the exemption for performed as the banking organization engages
business loans of $1 million or less, when in more complex real estate–related financial
rental income or sales proceeds from real transactions or as its overall exposure in a real
estate is not the primary source of repay- estate–related financial transaction increases.
ment; and An evaluation for a transaction that needs a
3. subsequent transactions resulting from an more detailed analysis should describe the prop-
existing extension of credit (for example, erty; give its location; and discuss its use, espe-
renewals and refinancings). cially for nonresidential property. An evaluation
for a transaction that requires a less detailed
An evaluation should provide a general esti- analysis may be based on information such as
mate of the value of the real estate and need not comparable property sales information from
meet the detailed requirements of a title XI sales-data services (for example, the multiple-
appraisal.10 An evaluation must provide appro- listing service or current tax-assessed value in
priate information to enable the banking organi- appropriate situations).11 Further, an evaluation
zation to make a prudent decision regarding the may be based on the banking organization’s
transaction. Moreover, a banking organization own real estate loan portfolio experience and on
is not precluded from obtaining an appraisal that value estimates prepared for recent loans on
conforms to the regulation for any exempt comparable properties, when appraisals meeting
transaction. At a minimum, an evaluation the regulatory requirements were obtained.
should— Regardless of the method, the banking organiza-
tion must document its analysis and findings in
1. be written; the loan file.
2. include the preparer’s name, address, and
signature, and the effective date of the
evaluation; 2231.0.9 SELECTION AND
3. describe the real estate collateral, its condi- QUALIFICATIONS CRITERIA FOR
tion, and its current and projected use; APPRAISERS AND EVALUATORS
4. describe the sources of information used in
the analysis; The accuracy of an appraisal or evaluation
depends on the competence and integrity of the
5. describe the analysis and supporting informa-
individual performing the appraisal or evalua-
tion; and
tion, as well as on that person’s expertise at
6. provide an estimate of the real estate’s mar- developing and interpreting pertinent data for
ket value, with any limiting conditions. the subject property. Appraisers and evaluators
should have adequate training, experience, and
10. An appraisal is the kind of specialized opinion on the
11. Assessed values for tax purposes may be a specified
value of real estate that contains certain formal elements
fraction of market value, as determined by the tax assessor.
recognized by appraisal industry practices and standards.
Therefore, tax-assessed values should be adjusted to a market-
value equivalent. In cases where the assessed value does not
BHC Supervision Manual January 2007 have a reliable correlation to current value, the use of assessed
Page 10 value would be inappropriate as the basis for an evaluation.
knowledge of the local real estate market to appropriate experience and educational back-
make sound judgments concerning the value of ground to complete the assignment. Financial
a particular property. Their level of training, institutions may not exclude a qualified
experience, and knowledge should be commen- appraiser from consideration for an appraisal
surate with the type and complexity of the prop- assignment solely because the appraiser lacks
erty to be valued. Additionally, appraisers and membership in a particular appraisal organiza-
evaluators should be independent of the credit tion or does not hold a particular designation
decision, have no interest in the property being from an appraisal association, organization, or
appraised, and have no affiliations or associa- society.
tions with the potential borrower. Absent abso- In that regard, banking organizations are
lute lines of independence, a banking organiza- expected to treat all appraisers fairly and equi-
tion must be able to demonstrate that it has tably in determining whether to use the services
prudent safeguards in place to isolate its of a particular appraiser. Generally, banking
collateral-evaluation process from influence or organizations have established procedures for
interference from the loan-production process. selecting appraisers and maintaining an
approved appraiser list. The practice of pre-
approving appraisers for ongoing appraisal work
2231.0.9.1 Appraiser Qualifications and maintaining an approved appraiser list is
acceptable so long as all appraisers are required
Title XI of FIRREA identified two classifica- to follow the same approval process. However,
tions of appraisers to be used in federally related a banking organization that requires appraisers
transactions: state-certified appraisers and who are not members of a particular appraisal
state-licensed appraisers. For a state-certified organization to formally apply, pay an applica-
appraiser, the statute anticipated that the states tion fee, and submit samples of previous
would adopt similar standards for certification appraisal reports for review—but does not have
based on the qualification criteria of the identical requirements for appraisers who are
Appraiser Qualifications Board of the Appraisal members of other appraisal organizations—
Foundation. The Appraisal Foundation stan- would be viewed as having a discriminatory
dards set forth minimum educational, testing, selection process.
experience, and continuing-education require-
ments. For a licensed appraiser, the states have
some latitude to establish qualification stan- 2231.0.9.3 Appraisals Performed by
dards, provided criteria are adequate to protect Certified or Licensed Appraisers
federal financial and public policy interest.
The Appraisal Subcommittee of the FFIEC is In summary, a banking organization is required
responsible for monitoring state compliance to use a certified appraiser for (1) all federally
with the statute. The Board also has the author- related transactions over $1 million, (2) nonresi-
ity to impose additional certification and licens- dential federally related transactions of more
ing requirements on those adopted by a given than $250,000, and (3) complex residential fed-
state. erally related transactions of more than
$250,000.12 A banking organization may use
either a state-certified or a state-licensed
2231.0.9.2 Selection of an Appraiser appraiser for noncomplex residential federally
related transactions that are under $1 million.
An independent appraisal is one in which the
appraiser is not participating in the admini-
stration of the credit or in the approval of the 2231.0.9.4 Other Appraiser Designations
transaction and has no interest, financial or oth-
erwise, in the property. In certain instances Some states have adopted other appraiser desig-
involving small banking organizations, officers nations that may cause confusion about whether
and directors who perform appraisals must a particular appraiser holds the appropriate des-
take appropriate steps to ensure that they are
independent from the transaction under 12. A complex one- to four-family residential property
appraisal is one in which (1) the property to be appraised is
consideration. atypical, (2) the form of ownership is atypical, or (3) the
When selecting an appraiser for an appraisal market conditions are atypical.
assignment, a banking organization is expected
to consider whether the individual holds the BHC Supervision Manual January 2007
proper state certification or license and has the Page 11
ignation for a given appraisal assignment. Addi- activities, including, but not limited to, apprais-
tionally, some states use designations such as als, real estate lending, real estate consulting,
‘‘certified residential’’ appraiser and ‘‘certified and real estate sales. A banking organization
general’’ appraiser, which leads to further con- may also augment in-house expertise by hiring
fusion. Other states have no specified license an outside consultant familiar with a certain
designation but have used the term ‘‘certified market or a particular type of real estate. The
residential’’ based on the standards for licens- evaluation procedures should have established
ing. For this reason, a banking organization standards for selecting qualified individuals to
needs to understand the qualification criteria set perform evaluations and for confirming their
forth by the state appraiser regulatory body and qualifications and independence to evaluate a
whether these standards are equivalent to the particular transaction. An individual performing
federal designations accepted by the Appraisal an evaluation need not be licensed or certified.
Subcommittee. However, if a banking organization desires, it
The Appraisal Subcommittee has recognized may use state-licensed or -certified appraisers to
two other appraiser designations: certified resi- prepare evaluations.
dential appraiser and transitional licensed
appraiser. For the certified residential appraiser,
the minimum qualification standards are those 2231.0.10 EXAMINER REVIEW OF
established by the Appraiser Qualifications APPRAISAL AND EVALUATION
Board for ‘‘certified residential real estate POLICIES
appraiser.’’ Under the Board’s regulation, a cer-
tified residential appraiser would be permitted to A banking organization’s appraisal and eval-
appraise real estate in connection with a feder- uation policies and procedures will be reviewed
ally related transaction designated for a ‘‘certi- as part of the inspection of the organization’s
fied’’ appraiser, provided the individual is com- overall activities. This review will include the
petent for the particular appraisal assignment. organization’s procedures for selecting an
The Appraisal Subcommittee and the Board appraiser for a particular appraisal or evaluation
are also willing to recognize a transitional assignment and for confirming that the appraiser
license that would allow a state to issue a license is qualified, independent, and, if applicable,
to an appraiser, provided the individual has licensed or certified to undertake the assign-
passed an examination and has satisfied either ment. If an institution maintains a listing of
the education or experience requirement. A tran- qualified real estate appraisers who are accept-
sitionally licensed appraiser is permitted to able for the banking organization’s use, the
appraise real estate collateral in connection with examiner should ascertain whether the board of
a federally related transaction as if licensed. The directors or senior management has reviewed
transitionally licensed appraiser is expected to and approved the list.
complete his or her education or experience If a banking organization is in troubled condi-
requirement within a set time frame, or the tion that is attributable to underwriting prob-
license expires. Recognition of a transitional lems in its real estate loan portfolio, the Board
license was believed to be necessary to ease the may require the banking organization to obtain
initial problems and inefficiencies resulting from appraisals for all new real estate–related finan-
a new regulatory program. The Appraisal Sub- cial transactions below the threshold that are not
committee has advised the states that the use of subject to another exemption. The Reserve Bank
the transitional licenses should be phased out will determine if a particular banking organiza-
once the appraiser regulatory program is fully tion will have to obtain appraisals below the
established. As a result, use of the transitional threshold.
license and the applicable time frame will vary When analyzing individual credits, examiners
from state to state. will analyze appraisals or evaluations to deter-
mine that the methods, assumptions, findings,
and conclusions are reasonable and comply with
2231.0.9.5 Qualifications of Individuals the Board’s rule, policies, and supervisory
Who Can Perform Evaluations guidelines. Examiners should not challenge
underlying assumptions, including the discount
Evaluations can be performed by a competent and capitalization rates used in appraisals, that
person who has experience in real estate–related slightly differ from norms that would generally
be associated with the property under review.
BHC Supervision Manual January 2007 Furthermore, an examiner is not bound to accept
Page 12 the appraisal or evaluation results, regardless of
whether a new appraisal or evaluation was tions. The topics include—

requested during the examination. An examiner
who concludes that an appraisal or evaluation is 1. selecting an appraiser,
deficient for any reason will take that fact into 2. ordering an appraisal,
account when judging the quality of the credit. 3. accepting a transferred appraisal,
When the examiner can establish that the 4. reviewing appraisals, and
underlying facts or assumptions are inappropri- 5. evaluation and other appraisal topics.
ate and can support alternative assumptions, he
or she may adjust the estimated value of the The interpretive responses address common
property for credit-analysis purposes. It is impor- questions on the requirements of the appraisal
tant to emphasize that an examiner’s overall regulations and the October 2003 interagency
analysis and classification of a credit may be statement Independent Appraisal and Evalua-
based on other credit or underwriting standards, tion Functions (the interagency statement).13
even if the loan is secured by real property (See SR-05-5 and its attachment.)
whose value is supported by an appraisal or On September 8, 2005, the Federal Reserve
evaluation. and the other federal financial institutions regu-
Significant failures to meet standards and pro- latory agencies jointly issued additional inter-
cedures as outlined above will be criticized and pretive responses (also in a question-and-answer
corrective action will be required. Furthermore, format) to assist regulated institutions in com-
banking organizations that fail to maintain a plying with the agencies’ appraisal regulations
sound appraisal or evaluation program or that and real estate lending requirements when
fail to comply with the agencies’ appraisal regu- financing residential construction in a tract
lations and policies or the Board’s supervisory development.14 (See SR-05-14 and its
guidelines will be cited in inspection reports and attachment.)
may be criticized for unsafe and unsound bank- The topics include the—
ing practices. Deficiencies will require correc-
tive action. 1. definition of residential tract development,
The appraisal regulation and guidelines including clarification of a residential unit
require that banking organizations use the ser- and pre-sold unit;
vices of qualified, independent, and certified 2. appraisal requirements for residential tract
or licensed appraisers to perform appraisals. development, raw land, residential lots, and
Furthermore, a banking organization that know- condominium buildings;
ingly uses the services of an individual who is 3. clarification of loan amount and collateral
not properly certified or licensed to perform an value for purposes of calculating the loan-to-
appraisal in connection with a federally related value ratio for residential-tract-development
transaction is violating the Board’s Regula- loans;
tion Y or applicable law. Any action of a state- 4. acceptable use of an appraisal of a model
certified or -licensed appraiser that is contrary to home;
the Board’s appraisal regulation or applicable 5. underwriting characteristics of a revolving
law should be reported to the Federal Reserve line of credit in which a borrowing base sets
Bank for referral to the appropriate state the availability of funds to the borrower; and
appraiser regulatory agency for investigation. 6. appraisal requirements for transactions
financing the construction of single-family
homes in a residential tract development.
2231.0.11 INTERAGENCY
RESPONSES TO QUESTIONS ON THE Refer to these interpretive documents when
AGENCIES’ APPRAISAL questions arise about the appraisal regulations,
REGULATIONS AND ON THE the interagency statement, and appraisals
INTERAGENCY STATEMENT ON involving residential tract lending.
INDEPENDENT APPRAISAL AND
EVALUATION FUNCTIONS 13. See also the Board’s appraisal regulations (12 C.F.R.
208, subpart E, and 12 C.F.R. 225, subpart G) and related
On March 22, 2005, the Federal Reserve and the guidance, including SR-94-55 and SR-03-18.
14. See the Interagency Appraisal and Evaluation Guide-
other federal financial institutions regulatory lines (SR-94-55) and the real estate lending standards regula-
agencies issued interpretive responses (in a tion and guidelines, 12 C.F.R. 208, subpart E and appendix C.
question-and-answer format) to questions raised
by federally regulated financial institutions BHC Supervision Manual January 2007
about the agencies’ real estate appraisal regula- Page 13
2231.0.12 INSPECTION OBJECTIVES ises, DPC assets, or OREO transactions.

Review the appraisals and evaluations for
1. To determine whether policies, practices, compliance with the Board’s appraisal
procedures, and internal controls regarding regulation and appraisal guidelines and
real estate appraisals and evaluations for real for compliance with the banking organiza-
estate–related financial transactions are tion’s appraisal and evaluation programs.
adequate. c. When real estate–related transactions are
2. To determine whether the banking organiza- examined on a portfolio basis, review the
tion’s officers and employees are conforming appraisal and evaluation processes. Deter-
with the appraisal policies of the board of mine whether the processes ensure that
directors. appraisals and evaluations comply with
3. To determine whether appraisals performed the Federal Reserve Board’s appraisal
in connection with federally related transac- regulation, the interagency appraisal
tions comply with the minimum standards of guidelines, and the banking organization’s
the Board’s appraisal regulation and the Uni- appraisal and evaluation programs.
form Standards of Professional Appraisal 2. When performing the above steps, determine
Practice. whether the following procedures are in
4. To determine if appraisers used in connec- place:
tion with federally related transactions are a. The board of directors approves and peri-
certified or licensed as appropriate. odically reviews the appraisal policies and
5. To determine whether appraisers are procedures that establish the appraisal and
competent to render appraisals in federally evaluation programs for real estate lend-
related transactions and whether they are ing, as required by the Board’s real estate
independent of the transaction or other lending regulation.
lending, investment, or collection functions b. Policies and procedures establish and
as appropriate. maintain an effective, independent
6. To initiate corrective action when policies, appraisal and evaluation program for all
practices, procedures, or internal controls are of the banking organization’s lending
deficient, or when violations of laws or regu- functions; policies and procedures are suf-
lations or noncompliance with provisions of ficiently comprehensive; and policies and
supervisory guidelines has been noted. procedures are applied uniformly to all
units engaged in federally related
transactions.
2231.0.13 INSPECTION PROCEDURES c. The appraisal and evaluation programs
include comprehensive appraisal and
1. Test real estate–related financial transactions evaluation critique procedures and inter-
for compliance with approved real estate nal loan-review procedures.
appraisal and evaluation policies and estab- d. The banking organization engages compe-
lished practices, procedures, and internal tent individuals who are independent of
controls. Also obtain a listing of any defi- the transaction to perform appraisals and
ciencies noted in the latest review performed evaluations, and the banking organiza-
by internal or external auditors, and deter- tion’s appraisal and evaluation programs
mine if appropriate corrections have been establish how it selects, evaluates, and
made. On the basis of these results, deter- monitors those individuals.
mine the scope of the inspection for e. The appraisal and evaluation programs
appraisals. establish the selective criteria the banking
a. Provide copies of the banking organiza- organization uses to select, evaluate,
tion’s appraisal and evaluation policies monitor, and ensure the independence of
and procedures to examiners assigned to the individuals who perform or critique
functional areas in which real estate– real estate appraisals and evaluations.
related transactions may require the ser- f. The appraisal program (1) considers the
vices of an appraiser or evaluator. independent appraiser’s qualifications,
b. Review appraisals and evaluations of indi- experience, and educational background;
vidual real estate–related transactions dur- (2) ensures that appraisals are not used
ing the inspection of loans, BHC prem- that were prepared by an individual who
is recommended or selected by the bor-
BHC Supervision Manual January 2007 rower (including those individuals listed
Page 14 by the banking organization as approved
appraisers); and (3) conforms to the ensure that appraisals or evaluations for
Board’s appraisal regulation. certain types of transactions, such as
g. The evaluation program ensures that eval- large-dollar credits, loans secured by com-
uations conform to the Board’s guidance plex or specialized properties, nonresiden-
on evaluations (SR-94-55, SR-94-50, and tial real estate construction loans, or out-
SR-03-18). of-area real estate, provide adequate
h. The appraisal and evaluation programs support for the particular transaction.
appropriately reflect the banking organiza- e. The banking organization ensures that
tion’s size, its location, and the nature individuals who perform reviews of
and complexity of its real estate lending appraisals and evaluations have appropri-
and other real estate–related lending ate training and experience and are
activities. independent of the transaction.
i. Policies and procedures require indepen- f. There is adequate documentation to dem-
dent appraisals and evaluations to be onstrate that the review has occurred.
written. While a checklist may serve this purpose
j. Criteria have been established for deter- for many transactions, a more comprehen-
mining when to obtain reappraisals or sive review would require a more detailed
re-evaluations as part of a program of written analysis.
prudent portfolio review and monitoring. g. Appropriate procedures exist for resolv-
k. The banking organization has appropriate ing any deficiencies noted in the review.
procedures to assess the validity of Procedures should require that (1) the
appraisals and evaluations for certain sub- individual who prepared the appraisal or
sequent transactions exempt from the evaluation correct the deficiencies or (2) a
Board’s appraisal requirements, or to new appraisal or evaluation be obtained
determine whether new appraisals or before making the final credit extension or
evaluations were obtained. other decision.
3. Review and assess the banking organiza-
tion’s compliance procedures to ensure that h. The program ensures that changes of
the appraisal and evaluation programs are an appraisal’s estimate of value were
effective and in compliance with regulatory made in accordance with Standard 3 of
requirements and that the appropriateness of the Uniform Standards of Professional
appraisals and evaluations is reviewed before Appraisal Practice (USPAP), and the pro-
final credit decisions. Determine if the fol- gram ensures that the changes were made
lowing procedures are in place: by an appropriately qualified licensed or
a. The monitoring procedures demonstrate certified appraiser.
that appraisals and evaluations comply i. Appropriate procedures exist for referring
with the Board’s appraisal regulation and potential cases of misconduct by licensed
the Board’s appraisal and evaluation and certified appraisers to the appropriate
guidelines. state appraiser regulatory authority.
b. The program provides that appraisals and 4. Assess the procedures for determining
evaluations are obtained before the final whether a real estate–related transaction
credit or other decision. However, for requires an appraisal or evaluation or is oth-
transactions involving loan workouts or erwise exempt from the Board’s appraisal
restructurings to facilitate the orderly col- regulation.
lection of the credit or to reduce the risk a. For appraisals required under the appraisal
of loss, appraisals or evaluations were program, determine whether the banking
obtained in a reasonable time after the organization has performed the following
transaction occurred. procedures:
c. The programs have review procedures to • The banking organization engaged the
verify that the methods, assumptions, and appraiser or, if the appraiser was
conclusions in the appraisals or evalua- engaged directly by another financial
tions are reasonable and appropriate for services entity, the banking organiza-
the transaction and the property. tion determined that the appraisal com-
d. Criteria are established to identify which plies with its own program and the
transactions should have their appraisal or Board’s appraisal regulation. (The
evaluation considered for more compre-
hensive analytical critique procedures. For BHC Supervision Manual January 2007
example, the banking organization should Page 15
banking organization may not accept an • The appraisal clearly identifies each
appraisal prepared for the borrower.) value estimate and, for the prospective
• The appraisal was obtained in sufficient value, gives the projected dates when
time to be analyzed before the final future events are expected to occur,
credit or other decision. when more than one estimate of value is
• The appraisal conforms to the generally reported.
accepted appraisal standards as evi- • The individual who performed the
denced by USPAP, for example— appraisal was independent of the trans-
— the appraiser uses the three action and appropriately licensed and
market-value approaches—cost, certified for the assignment:
comparable-sales, and income—and — A certified appraiser must perform
correlates the results into a final the appraisal for a transaction of
value estimate; $1 million or more, a nonresidential
transaction of $250,000 or more, or
— if the above-mentioned approaches
a complex residential transaction of
were not used, the appraiser dis-
$250,000 or more.
closes the reason and whether this
— A licensed or certified appraiser
affected the value estimate;
must perform the appraisal for any
— the appropriate type of appraisal other type of federally related
was obtained (complete or limited), transaction.
and the appropriate report format • The individual who performed the
(self-contained, summary, or appraisal had appropriate training, expe-
restricted) was used for the particu- rience demonstrating his or her exper-
lar transaction; and tise in appraising similar types of prop-
— if a limited appraisal was used (that erties, and knowledge of the property’s
is, the appraiser invoked the former market.
Departure Provision), the appraisal • The Reserve Bank documents incidents
fully discloses the limiting of possible appraiser misconduct for
conditions. possible referral to the state appraiser
• The appraisal is written and contains regulatory agency.
sufficient information and analysis to b. For exempt transactions requiring an
support the banking organization’s deci- evaluation, such as transactions below the
sion to enter into the transaction. $250,000 threshold, business loans of less
• If the appraisal is for proposed construc- than $1 million, and subsequent transac-
tion or renovation, partially leased tions such as renewals and refinancings,
buildings, nonmarket lease terms, or determine whether the following proce-
tract developments with unsold units, dures are in place:
the appraisal includes an appropriate • The evaluation, at a minimum—
analysis and disclosure of deductions — is written;
and discounts for holding costs, market- — includes the preparer’s name,
ing costs, leasing commissions, rent address, and signature and the effec-
losses, tenant improvements, and entre- tive date;
preneurial profits. — describes the real estate collateral,
• The appraisal contains an estimate of its condition, and its current and
the current market value of the property projected use;
in its actual physical condition and cur- — describes the source of information
rent zoning, as defined by the Board’s used in the analysis;
appraisal regulation. — describes the analysis and support-
• The appraisal contains an estimate of ing information; and
the property’s prospective market value — gives an estimate of the real estate’s
based on the completion of improve- value with limiting conditions.
ments or stabilized occupancy, if the • The evaluation provides sufficient detail
appraisal is for a property where to support the estimate of collateral
improvements or renovations are to be value in more-complex real estate–
made. related transactions or when the overall
exposure is high.
BHC Supervision Manual January 2007 • The individual who performed the
Page 16 evaluation had the appropriate real
estate training and sufficient experience appraisal when the approach is appro-
and knowledge of the market to prepare priate for the type of property;
the evaluation. • use of dissimilar comparables in the
• The individual who performed the comparable-sales approach to valuation
evaluation, regardless of whether the (for example, the age, size, quality, or
banking organization’s staff performed location of the comparable is signifi-
the evaluation, was independent of the cantly different from the subject prop-
transaction, credit decision, or function. erty, making reconciliation of value
5. Assess management’s compliance with its difficult);
policies and procedures and with the Board’s • underestimation of factors such as the
appraisal regulation and guidance by review- construction cost, the construction or
ing appraisals and evaluations. lease-up period, and rent concessions;
6. If the review of appraisals or evaluations on • use of best-case assumptions for the
one- to four-family residential loans or multi- income approach to valuation without
family loans indicates that the appraisals or performing a sensitivity analysis on the
evaluations do not meet the Board’s require- factors that would identify the lender’s
ments or that the loan-to-value ratio at origi- downside risk;
nation was higher than 80 percent for fixed- • overly optimistic assumptions, such as a
rate loans or 75 percent for floating-rate high absorption rate in an overbuilt mar-
loans, these loans may not be eligible for the ket; and
50 percent risk weight permitted under the • the nonreconcilement of demographic
Board’s risk-based capital rule. factors (such as existing housing inven-
7. Evaluate the banking organization’s indepen- tory, projected completions, and
dent appraisal and evaluation programs, and expected market share to the value ren-
determine the following: dered) and the discussion of demo-
a. the adequacy of written, independent graphic factors as background
appraisals and evaluations information.
b. the methods the banking organization’s 8. Report any instances of questionable conduct
officers use to conform with established by appraisers, along with supporting docu-
policy mentation, to the Reserve Bank for possible
c. internal control deficiencies or exceptions referral to the appropriate state appraisal
d. the integrity of the appraisal and evalua- authorities.
tion process, including appraisal and 9. Update workpapers with any information that
evaluation compliance procedures will facilitate future inspections.
e. the integrity of individual appraisals and
evaluations—their adequacy and reason-
ableness, the appropriateness of the meth- 2231.0.14 INTERNAL CONTROL
ods, assumptions, and techniques used; QUESTIONNAIRE
and their compliance with the Board’s
appraisal regulation and real estate Review the internal controls, policies, practices,
appraisal and evaluation guidelines and procedures for real estate appraisals and
f. recommended corrective action when evaluations. The appraisal and evaluation sys-
policies, practices, or procedures are tem should be documented completely and con-
found to be deficient cisely and should include, where appropriate,
g. the degree of any violations of the Board’s narrative descriptions, flow charts, copies of
appraisal regulation, and the extent of forms used, and other pertinent information. The
noncompliance with interagency appraisal items marked with an asterisk (*) require sub-
guidelines, if noted stantiation by observation or testing.
h. the existence of other matters of signifi-
cance, for example—
• misrepresentation of data, such as the 2231.0.14.1 Appraisal and Evaluation
omission of information on favorable Policies
financing, seller concessions, sales his-
tory, feasibility, zoning, easements, or 1. Has the board of directors, consistent with its
deed restrictions; duties and responsibilities, adopted written
• inadequate techniques of analysis, that
is, failure to use the cost, comparable- BHC Supervision Manual January 2007
sales, or income approach in the Page 17
appraisal and evaluation policies that approaches into a final value estimate
define— based on the appraiser’s judgment?
a. management’s responsibility for select- c. explain why an approach is inappropri-
ing, evaluating, monitoring, and ensuring ate and not used in the appraisal?
the independence of the individual who is d. fully support the assumptions and
performing the appraisal or evaluation? the value rendered through adequate
b. the basis for selecting staff appraisers and documentation?
engaging fee appraisers for a particular *5. Are appraisals received before the bank
appraisal assignment? (Is the individual holding company makes its final credit or
independent of the transaction, and does other decision? (For example, is the date
he or she possess the requisite qualifica- of the loan commitment letter later than
tions, expertise, and educational back- the date of the appraisal—unless the loan
ground and hold the proper state certifica- commitment letter is conditioned on
tion or license, if applicable?) receipt of the appraisal?)
c. the procedures as to when appraisals and *6. If the bank holding company is depending
evaluations should be obtained? on an appraisal obtained for another finan-
d. the procedures for when to obtain an inde- cial services institution as support for its
pendent reappraisal or re-evaluation, transaction, does the bank holding com-
including its frequency and scope? pany have appraisal review procedures to
e. appraisal and evaluation compliance and ensure that the appraisal meets the stan-
review procedures? Do those procedures dards of the appraisal regulation? These
ensure that the bank holding company’s types of transactions would include loan
appraisals and evaluations are reviewed participations and mortgage-backed
by qualified and adequately trained indi- securities.
viduals who are not involved in the loan- *7. If an appraisal for one transaction is used
production process, and ensure that the for a subsequent transaction, are the deter-
appraisals are consistent with USPAP and minations that the appraiser is indepen-
the Board’s regulations, policies, and dent, the appraisal complies with the
guidelines? Board’s appraisal regulation, and the
f. internal controls that prevent officers, loan appraisals are still valid sufficiently
officers, and directors that order a review, documented?
appraisal, or an evaluation from having
sole authority for approving the requested
loans? 2231.0.14.3 Appraisers
2. Does the board of directors periodically
review its appraisal, evaluation, and review 8. Are appraisers fairly considered for
policies and procedures to ensure that they assignments regardless of their membership
meet the needs of the bank holding compa- or lack of membership in a particular
ny’s real estate lending activity? appraisal organization?
9. Before taking the assignment, do appraisers
have the requisite knowledge, education,
2231.0.14.2 Appraisals qualifications, and experience to complete
the appraisal?
*3. Are appraisals in writing, dated, and 10. For large, complex, or detached commer-
signed? cial real estate properties—
*4. Does the appraisal meet the minimum a. are written engagement letters used when
standards of the Board’s regulation and ordering appraisals, and are copies of the
USPAP, including the appraisal’s purpose, letters retained?
market value, effective date, and market- b. are more in-depth review procedures
ing period, and the sales history of the used for appraisals ordered by agents of
subject property? Does the appraisal— the banking organization?
a. reflect a valuation using the 11. Are appraisers independent of the
cost, income, and comparable-sales transaction?
approaches? a. Are staff appraisers independent of the
b. evaluate and correlate the three lending, investment, and collection func-
tions and not involved, except as an
BHC Supervision Manual January 2007 appraiser, in the federally related transac-
Page 18 tion? Has a determination been made
that they have no direct or indirect inter *18. Are evaluations required to be in writing,
est, financial or otherwise, in the dated, and signed?
property? *19. Does the bank holding company require
b. Are fee appraisers engaged directly by sufficient information and documentation
the banking organization or its agents? to support the estimate of value and the
c. Are written assurances obtained that evaluator’s analysis?
those appraisers have no direct or indi- *20. If an evaluation obtained for one transac-
rect interest, financial or otherwise, in tion is used for a subsequent transaction, is
the property or transaction? the determination that the evaluation is
d. Are any appraisers recommended or still valid sufficiently documented?
selected by the borrower (applicant)? *21. Are evaluations received before making
12. If staff appraisers are used, does the bank the final credit decision?
holding company periodically have inde- *22. If the bank holding company is depending
pendent appraisers perform test appraisals on an evaluation obtained for another
to check the organization’s knowledge of financial services institution as support for
trends, values, and markets? its transaction, does the holding company
13. If fee appraisers are used, are investigations have evaluation review procedures to
performed to determine their knowledge, ensure that the evaluation meets the
education, experience, qualifications, and Board’s regulation and guidance?
reputation?
14. Is the status of an appraiser’s state certifica-
tion or license verified with the state 2231.0.14.5 Evaluators
appraiser regulatory authority to ensure that
the appraiser is in good standing? 23. Are individuals who perform evaluations
15. Are fee appraisers paid the same fee competent to complete the assignment?
whether or not the loan is granted? 24. Are evaluations prepared by individuals
16. If the transaction is outside the local geo- who are independent of the transaction?
graphic market, does the bank holding com-
pany engage appraisers or consultants who
have knowledge of the market where the 2231.0.14.6 Reappraisals and
real estate collateral is located? Re-evaluations
25. Is a formal reappraisal and re-evaluation
2231.0.14.4 Evaluations program followed?
26. Does the bank holding company sufficiently
17. Are individuals performing evaluations document and follow its criteria for
independent of the transaction? obtaining reappraisals or re-evaluations?

Page 19
Appraisal standards for federally 3310, Subpart G, 4-053–

related transactions 3331, 225.61–67 4-054.4
3351
Interagency Appraisal and Evalu- 3-1577

tation Guidelines, October 27,
1994 (previously September 1992)
Independent Appraisal and Evalu- 3-1577.1

ation Functions, October 27, 2003
(interagency statement)
The 2006 Revisions to Uniform

Standards of Professional
Appraisal Practice, June 22, 2006
(interagency statement, effective
on July 1, 2006)


Page 20
2231.0.16 APPENDIX A—INTERAGENCY APPRAISAL AND EVALUATION

GUIDELINES, OCTOBER 27, 1994
Purpose Supervisory Policy

The Office of the Comptroller of the Currency An institution’s real estate appraisal and evalua-
(OCC), the Board of Governors of the Federal tion policies and procedures will be reviewed as
Reserve System (FRB), the Federal Deposit part of the examination of the institution’s over-
Insurance Corporation (FDIC), and the Office of all real estate–related activities. An institution’s
Thrift Supervision (OTS) (the agencies) are policies and procedures should be incorporated
jointly issuing these guidelines, which super- into an effective appraisal and evaluation pro-
sede each of the agencies’ appraisal and evalua- gram. Examiners will consider the institution’s
tion guidelines issued in 1992.1 These guide- size and the nature of its real estate–related
lines address supervisory matters relating to real activities when assessing the appropriateness of
estate appraisals and evaluations used to support its program.
real estate–related financial transactions and When analyzing individual transactions,
provide guidance to examining personnel and examiners will review an appraisal or evaluation
federally regulated institutions about prudent to determine whether the methods, assumptions,
appraisal and evaluation policies, procedures, and findings are reasonable and in compliance
practices, and standards. with the agencies’ appraisal regulations, poli-
cies,4 supervisory guidelines, and the institu-
tion’s policies. Examiners also will review the
Background steps taken by an institution to ensure that the
individuals who perform its appraisals and
Title XI of the Financial Institutions Reform, evaluations are qualified and are not subject to
Recovery, and Enforcement Act of 1989 conflicts of interest. Institutions that fail to
(FIRREA) requires the agencies to adopt regula- maintain a sound appraisal or evaluation pro-
tions on the preparation and use of appraisals by gram or to comply with the agencies’ appraisal
federally regulated financial institutions.2 Such regulations, policies, or these supervisory guide-
real estate appraisals are to be in writing and lines will be cited in examination reports and
performed in accordance with uniform stan- may be criticized for unsafe and unsound bank-
dards by an individual whose competency has ing practices. Deficiencies will require correc-
been demonstrated and whose professional con- tive action.
duct is subject to effective state supervision.
Common agency regulations3 issued pursuant
to section 304 of the Federal Deposit Insurance
Corporation Improvement Act of 1991
Appraisal and Evaluation Program
(FDICIA) also require each regulated institution An institution’s board of directors is responsible
to adopt and maintain written real estate lending for reviewing and adopting policies and proce-
policies that are consistent with safe and sound dures that establish an effective real estate
banking practices and that reflect consideration appraisal and evaluation program. The program
of the real estate lending guidelines attached to should—
the regulation. The real estate lending guide-
lines state that a real estate lending program • establish selection criteria and procedures to
should include an appropriate real estate evaluate and monitor the ongoing perfor-
appraisal and evaluation program. mance of individuals who perform appraisals
1. FRB: ‘‘Guidelines for Real Estate Appraisal and Evalu-
or evaluations,
ation Programs,’’ September 28, 1992; OCC: BC-225, ‘‘Real • provide for the independence of the person
Estate Appraisal and Evaluation Guidelines,’’ September 28, performing appraisals or evaluations,
1992; FDIC: FIL-69-92, ‘‘Guidelines for Real Estate
Appraisal and Evaluation Programs,’’ September 30, 1992;
OTS: Thrift Bulletin 55, ‘‘Real Estate Appraisal and Evalua-
4. The appraisal guidance contained in the Interagency
tion Guidelines,’’ October 13, 1992.
Policy Statement on the Review and Classification of Com-
2. OCC: 12 C.F.R. 34, subpart C; FRB: 12 C.F.R. 208.18
mercial Real Estate Loans, November 7, 1991, generally
and 12 C.F.R. 225, subpart G; FDIC: 12 C.F.R. 323; and OTS:
applies to all transactions.
12 C.F.R. 564.
3. OCC: 12 C.F.R. 34, subpart D; FRB: 12 C.F.R. 208,
subpart C; FDIC: 12 C.F.R. 365; and OTS: 12 C.F.R. 545 and BHC Supervision Manual January 2007
563. Page 21
• identify the appropriate appraisal for various the institution’s loan-production process. An
lending transactions, appraiser and an individual providing evaluation
• establish criteria for contents of an evaluation, services should be independent of the loan and
• provide for the receipt of the appraisal or collection functions of the institution and have
evaluation report in a timely manner to facili- no interest, financial or otherwise, in the prop-
tate the underwriting decision, erty or the transaction. If absolute lines of inde-
• assess the validity of existing appraisals pendence cannot be achieved, an institution
or evaluations to support subsequent must be able to clearly demonstrate that it has
transactions, prudent safeguards to isolate its collateral-
• establish criteria for obtaining appraisals or evaluation process from influence or interfer-
evaluations for transactions that are otherwise ence from the loan-production process.
exempt from the agencies’ appraisal regula- The agencies recognize, however, that it is
tions, and not always possible or practical to separate the
• establish internal controls that promote com- loan and collection functions from the appraisal
pliance with these program standards. or evaluation process. In some cases, such as in
a small or rural institution or branch, the only
individual qualified to analyze the real estate
Selection of Individuals Who May collateral may also be a loan officer, other offi-
Perform Appraisals and Evaluations cer, or director of the institution. To ensure their
independence, such lending officials, officers, or
An institution’s program should establish crite- directors should abstain from any vote or
ria to select, evaluate, and monitor the perfor- approval involving loans on which they per-
mance of the individuals who perform a real formed an appraisal or evaluation.
estate appraisal or evaluation. The criteria
should ensure that—
Transactions That Require Appraisals
• the institution’s selection process is nonpref-
erential and unbiased; Although the agencies’ appraisal regulations
• the individual selected possesses the requisite exempt certain categories of real estate–related
education, expertise, and competence to com- financial transactions from the appraisal require-
plete the assignment; ments, most real estate transactions over
• the individual selected is capable of rendering $250,000 are considered federally related
an unbiased opinion; and transactions and thus require appraisals.5 A fed-
• the individual selected is independent and erally related transaction means any real estate–
has no direct or indirect interest, financial or related financial transaction in which the agen-
otherwise, in the property or the transaction. cies engage, contract for, or regulate, and that
requires the services of an appraiser. An agency
Under the agencies’ appraisal regulations, the also may impose more stringent appraisal
appraiser must be selected and engaged directly requirements than the appraisal regulations
by the institution or its agent. The appraiser’s require, such as when an institution’s troubled
client is the institution, not the borrower. An condition is attributable to real estate loan
institution may use an appraisal that was pre- underwriting problems.6
pared by an appraiser engaged directly by
another financial services institution, as long as
the institution determines that the appraisal con- Minimum Appraisal Standards
forms to the agencies’ appraisal regulations and
is otherwise acceptable. The agencies’ appraisal regulations include five
minimum standards for the preparation of an
appraisal. The appraisal must—
Independence of the Appraisal and
5. To facilitate recovery in designated major disaster areas,
Evaluation Function subject to safety-and-soundness considerations, section 2 of
the Depository Institutions Disaster Relief Act of 1992 autho-
Because the appraisal and evaluation process is rized the agencies to waive certain appraisal requirements for
an integral component of the credit-underwriting up to three years after a presidential declaration of a natural
disaster.
process, it should be isolated from influence by 6. As a matter of policy, OTS requires problem associa-
tions and associations in troubled condition to obtain apprais-
BHC Supervision Manual January 2007 als for all real estate–related transactions over $100,000
Page 22 (unless the transaction is otherwise exempt).
• conform to generally accepted appraisal stan- appropriate deductions and discounts for
dards as evidenced by the Uniform Standards items such as leasing commission, rent
of Professional Appraisal Practice (USPAP) losses, and tenant improvements from an
promulgated by the Appraisal Standards estimate based on stabilized occupancy.
Board (ASB) of the Appraisal Foundation
unless principles of safe and sound banking • be based upon the definition of market value
require compliance with stricter standards; set forth in the regulation; and
Although allowed by USPAP, the agencies’ Each appraisal must contain an estimate of
appraisal regulations do not permit an market value, as defined by the agencies’
appraiser to appraise any property in which appraisal regulations.
the appraiser has an interest, direct or indi-
rect, financial or otherwise. • be performed by state-licensed or -certified
appraisers in accordance with requirements
• be written and contain sufficient information set forth in the regulation.
and analysis to support the institution’s deci-
sion to engage in the transaction;
Appraisal Options
As discussed below, appraisers have avail-
able various appraisal development and An appraiser typically uses three market-value
report options; however, not all options approaches to analyze the value of a property—
may be appropriate for all transactions. A cost, income, and comparable-sales—and recon-
report option is acceptable under the agen- ciles the results of each to estimate market
cies’ appraisal regulations only if the value. An appraisal will discuss the property’s
appraisal report contains sufficient informa- recent sales history and contain an opinion as to
tion and analysis to support an institution’s the highest and best use of the property. An
decision to engage in the transaction. appraiser must certify that he or she has com-
plied with the current USPAP and is indepen-
• analyze and report appropriate deductions and dent. Also, the appraiser must disclose whether
discounts for proposed construction or reno- the subject property was inspected and whether
vation, partially leased buildings, nonmarket anyone provided significant assistance to the
lease terms, and tract developments with person signing the appraisal report.
unsold units; The agencies do not prohibit the use of a
Limited Appraisal for a federally related trans-
This standard is designed to avoid having action, but the agencies believe that institutions
appraisals prepared using unrealistic should be cautious in their use of a Limited
assumptions and inappropriate methods. Appraisal because it will be less thorough than a
For federally related transactions, an Complete Appraisal.
appraisal is to include the current market Complete and Limited Appraisal assignments
value of the property in its actual physical may be reported in three different report for-
condition and subject to the zoning in effect mats: a Self-Contained Report, a Summary
as of the date of the appraisal. For proper- Report, or a Restricted Report. The major differ-
ties where improvements are to be con- ence among these three reports relates to the
structed or rehabilitated, the regulated degree of detail presented in the report by the
institution may also request a prospective appraiser. The Self-Contained Appraisal Report
market value based on stabilized occupancy provides the most detail, while the Summary
or a value based on the sum of retail sales. Appraisal Report presents the information in a
However, the sum of retail sales for a pro- condensed manner. The Restricted Report pro-
posed development is not the market value vides a capsulized report with the supporting
of the development for the purpose of the details maintained in the appraiser’s files.
agencies’ appraisal regulations. For pro- The agencies believe that the Restricted
posed developments that involve the sale of Report format will not be appropriate to under-
individual houses, units, or lots, the write a significant number of federally related
appraiser must analyze and report appropri- transactions due to the lack of sufficient support-
ate deductions and discounts for holding ing information and analysis in the appraisal
costs, marketing costs, and entrepreneurial
profit. For proposed and rehabilitated rental BHC Supervision Manual January 2007
developments, the appraiser must make Page 23
report. However, it might be appropriate to use otherwise exempt from the agencies’ appraisal
this type of appraisal report for ongoing collat- regulations.
eral monitoring of an institution’s real estate
transactions and under other circumstances
when an institution’s program requires an Evaluation Content
evaluation.
Moreover, since the institution is responsible An institution should establish prudent stan-
for selecting the appropriate appraisal report to dards for the preparation of evaluations. At a
support its underwriting decisions, its program minimum, an evaluation should—
should identify the type of appraisal report that
will be appropriate for various lending transac- • be written;
tions. The institution’s program should consider • include the preparer’s name, address, and
the risk, size, and complexity of the individual signature, and the effective date of the
loan and the supporting collateral when deter- evaluation;
mining the level of appraisal development and • describe the real estate collateral, its condi-
the type of report format that will be ordered. tion, its current and projected use;
When ordering an appraisal report, institutions • describe the source(s) of information used in
may want to consider the benefits of a written the analysis;
engagement letter that outlines the institution’s • describe the analysis and supporting informa-
expectations and delineates each party’s respon- tion; and
sibilities, especially for large, complex, or out- • provide an estimate of the real estate’s market
of-area properties. value, with any limiting conditions.
An evaluation report should include calcula-

Transactions That Require Evaluations tions, supporting assumptions, and, if utilized, a
discussion of comparable sales. Documentation
A formal opinion of market value prepared by should be sufficient to allow an institution to
a state-licensed or -certified appraiser is not understand the analysis, assumptions, and con-
always necessary. Instead, less-formal evalua- clusions. An institution’s own real estate loan
tions of the real estate may suffice for trans- portfolio experience and value estimates pre-
actions that are exempt from the agencies’ pared for recent loans on comparable properties
appraisal requirements. The agencies’ appraisal might provide a basis for evaluations.
regulations allow an institution to use an appro- An evaluation should provide an estimate of
priate evaluation of the real estate rather than an value to assist the institution in assessing the
appraisal when the transaction— soundness of the transaction. Prudent practices
also require that as an institution engages in
• has a value of $250,000 or less; more-complex real estate–related financial
• is a business loan of $1,000,000 or less, and transactions, or as its overall exposure increases,
the transaction is not dependent on the sale of, a more detailed evaluation should be performed.
or rental income derived from, real estate as For example, an evaluation for a home equity
the primary source of repayment; or loan might be based primarily on information
• involves an existing extension of credit at the derived from a sales data services organization
lending institution, provided that (i) there has or current tax assessment information, while an
been no obvious and material change in the evaluation for an income-producing real estate
market conditions or physical aspects of the property should fully describe the current and
property that threatens the adequacy of the expected use of the property and include an
institution’s real estate collateral protection analysis of the property’s rental income and
after the transaction, even with the advance- expenses.
ment of new monies, or (ii) there is no
advancement of new monies other than funds
necessary to cover reasonable closing costs. Qualifications of Individuals Who
Perform Evaluations
Institutions should also establish criteria for
obtaining appraisals or evaluations for safety- Individuals who prepare evaluations should
and-soundness reasons for transactions that are have real estate–related training or experience
and knowledge of the market relevant to the
BHC Supervision Manual January 2007 subject property. Based upon their experience
Page 24 and training, professionals from several fields
may be qualified to prepare evaluations of cer- the renewal of an existing transaction when
tain types of real estate collateral. Examples there is a material change in market conditions
include individuals with appraisal experience, or the physical aspects of the property that
real estate lenders, consultants or salespersons, threatens the institution’s real estate collateral
agricultural extension agents, or foresters. Insti- protection.
tutions should document the qualifications and The decision to reappraise or re-evaluate the
experience level of individuals whom the insti- real estate collateral should be guided by the
tution deems acceptable to perform evaluations. exemption for renewals, refinancings, and other
An institution might also augment its in-house subsequent transactions. Loan workouts, debt
expertise and hire an outside party familiar restructurings, loan assumptions, and similar
with a certain market or a particular type of transactions involving the addition or substitu-
property. Although not required, an institution tion of borrowers may qualify for the exemption
may use state-licensed or -certified appraisers to for renewals, refinancings, and other subsequent
prepare evaluations. As such, Limited Apprais- transactions. Use of this exemption depends on
als reported in a Summary or Restricted format the condition and quality of the loan, the sound-
may be appropriate for evaluations of real ness of the underlying collateral, and the valid-
estate–related financial transactions exempt ity of the existing appraisal or evaluation.
from the agencies’ appraisal requirements. A reappraisal would not be required when an
institution advances funds to protect its interest
in a property, such as to repair damaged prop-
Valid Appraisals and Evaluations erty, because these funds should be used to
restore the damaged property to its original con-
The agencies allow an institution to use an dition. If a loan workout involves modification
existing appraisal or evaluation to support a of the terms and conditions of an existing credit,
subsequent transaction, if the institution docu- including acceptance of new or additional real
ments that the existing estimate of value remains estate collateral, which facilitates the orderly
valid. Therefore, a prudent appraisal and evalua- collection of the credit or reduces the institu-
tion program should include criteria to deter- tion’s risk of loss, a reappraisal or re-evaluation
mine whether an existing appraisal or evaluation may be prudent, even if it is obtained after the
remains valid to support a subsequent transac- modification occurs.
tion. Criteria for determining whether an exist- An institution may engage in a subsequent
ing appraisal or evaluation remains valid will transaction based on documented equity from a
vary depending upon the condition of the prop- valid appraisal or evaluation, if the planned
erty and the marketplace, and the nature of any future use of the property is consistent with the
subsequent transaction. Factors that could cause use identified in the appraisal or evaluation. If a
changes to originally reported values include the property, however, has reportedly appreciated
passage of time; the volatility of the local mar- because of a planned change in use of the prop-
ket; the availability of financing; the inventory erty, such as rezoning, an appraisal would be
of competing properties; improvements to, or required for a federally related transaction,
lack of maintenance of, the subject property or unless another exemption applied.
competing surrounding properties; changes in
zoning; or environmental contamination. The
institution must document the information Program Compliance
sources and analyses used to conclude that an
existing appraisal or evaluation remains valid An institution’s appraisal and evaluation pro-
for subsequent transactions. gram should establish effective internal controls
that promote compliance with the program’s
standards. An individual familiar with the
Renewals, Refinancings, and Other appropriate agency’s appraisal regulation should
Subsequent Transactions ensure that the institution’s appraisals and evalu-
ations comply with the agencies’ appraisal regu-
While the agencies’ appraisal regulations gener- lations, these guidelines, and the institution’s
ally allow appropriate evaluations of real estate program. Loan-administration files should docu-
collateral in lieu of an appraisal for loan renew- ment this compliance review, although a
als and refinancings, in certain situations an detailed analysis or comprehensive analytical
appraisal is required. If new funds are advanced
over reasonable closing costs, an institution BHC Supervision Manual January 2007
would be expected to obtain a new appraisal for Page 24.1
procedures are not required for every appraisal as a result of a review conducted by an appropri-
or evaluation. For some loans, the compliance ately qualified state-licensed or -certified
review may be part of the loan officer’s overall appraiser in accordance with Standard III of
credit analysis and may take the form of either a USPAP.
narrative or a checklist. Corrective action should
be undertaken for noted deficiencies by the indi-
vidual who prepared the appraisal or evaluation. Portfolio Monitoring
An institution’s appraisal and evaluation pro-
gram should also have comprehensive analytical The institution should also develop criteria for
procedures that focus on certain types of loans, obtaining reappraisals or re-evaluations as part
such as large-dollar credits, loans secured by of a program of prudent portfolio review and
complex or specialized properties, nonresiden- monitoring techniques—even when additional
tial real estate construction loans, or out-of-area financing is not being contemplated. Examples
real estate. These comprehensive analytical proof such types of situations include large credit
cedures should be designed to verify that the exposures and out-of-area loans.
methods, assumptions, and conclusions are rea-
sonable and appropriate for the transaction and
the property. These procedures should provide Referrals
for a more detailed review of selected appraisals
and evaluations prior to the final credit decision. Financial institutions are encouraged to make
The individual(s) performing these reviews referrals directly to state appraiser regulatory
should have the appropriate training or experi- authorities when a state-licensed or -certified
ence, and be independent of the transaction. appraiser violates USPAP or applicable state
Appraisers and persons performing evalua- law, or engages in other unethical or unprofes-
tions should be responsible for any deficiencies sional conduct. Examiners finding evidence of
in their reports. Deficient reports should be unethical or unprofessional conduct by apprais-
returned to them for correction. Unreliable ers will forward their findings and recommenda-
appraisals or evaluations should be replaced tions to their supervisory office for appropriate
prior to the final credit decision. Changes to an disposition and referral to the state, as necessary.
appraisal’s estimate of value are permitted only

Page 24.2
2231.0.17 APPENDIX B—INTERAGENCY STATEMENT ON INDEPENDENT

APPRAISAL AND EVALUATION FUNCTIONS
On October 27, 2003, the federal bank and thrift the selection criteria must provide for the inde-
agencies1 (the agencies) jointly issued this state- pendence of the individual performing the
ment on Independent Appraisal and Evaluation appraisal or evaluation. That is, the individual
Functions. The statement addresses concerns has neither a direct nor indirect interest, finan-
about the independence of the collateral- cial or otherwise, in the property or transaction.
valuation process that were identified during Institutions also need to ensure that the indi-
examinations. This statement applies to all real vidual selected is competent to perform the
estate–related financial transactions originated assignment. Consideration should be given to
or purchased by a regulated institution for its the individual’s qualifications, experience, and
own portfolio or as assets held for sale. It clari- educational background. Selection occurs when,
fies and should be reviewed in conjunction with based on an oral or written agreement, the indi-
the agencies’ appraisal and real estate lending vidual accepts the assignment to appraise or
regulations2 and the Interagency Appraisal and evaluate a particular property. Moreover,
Evaluation Guidelines (the guidelines).3 appraisal or evaluation preparatory work should
An institution’s board of directors is respon- not commence until the institution finalizes the
sible for reviewing and adopting policies and selection process.
procedures that establish and maintain an effec- The agencies’ appraisal regulations address
tive, independent real estate appraisal and evalu- appraiser independence and require that an insti-
ation program (the program) for all of its lend- tution, or its agent, directly engage the appraiser.
ing functions. The real estate lending functions The only exception to this requirement is that an
include commercial real estate mortgage depart- institution may use an appraisal prepared for
ments, capital-market groups, and asset- another financial services institution, provided
securitization and -sales units. Concerns about that the institution determines that the appraisal
the independence of real estate appraisals and conforms to the agencies’ appraisal regulations
evaluations include the risk that appraisals and is otherwise acceptable. Independence is
prepared by biased or compromised appraisers compromised when an institution uses an
may undermine the integrity of credit- appraiser who is recommended by the borrower
underwriting processes. More broadly, an insti- or allows the borrower to select the appraiser
tution’s lending functions should not have from the institution’s list of approved appraisers.
undue influence that might compromise the pro- Institutions may not use an appraisal prepared
gram’s independence. by an individual who was selected or engaged
by a borrower. An institution’s use of a
borrower-ordered appraisal violates the agen-
Selecting Individuals to Perform cies’ appraisal regulations. Likewise, institu-
Appraisals or Evaluations tions may not use ‘‘readdressed appraisals’’—
appraisal reports that are altered by the appraiser
The guidelines establish minimum standards for to replace any references to the original client
an effective program, including standards for with the institution’s name. Altering an
selecting individuals who may perform apprais- appraisal report in a manner that conceals the
als or evaluations. Among other considerations, original client or intended users of the appraisal
is misleading and violates the agencies’
1. The Board of Governors of the Federal Reserve System appraisal regulations and the Uniform Standards
(FRB), the Office of the Comptroller of the Currency (OCC), of Professional Appraisal Practice (USPAP).
the Federal Deposit Insurance Corporation (FDIC), the Office
of Thrift Supervision (OTS), and the National Credit Union It is also important to ensure that the program
Administration (NCUA). is safeguarded from internal influence and inter-
2. FRB: 12 C.F.R. 208, subpart E and appendix C, and 12 ference from an institution’s loan-production
C.F.R. 225, subpart G; OCC: 12 C.F.R. 34, subparts C and D;
FDIC: 12 C.F.R. 323 and 12 C.F.R. 365; OTS: 12 C.F.R. 564, staff. Individuals independent of the loan-
12 C.F.R. 560.100, and 12 C.F.R. 560.101; and NCUA: 12 production area should oversee the selection of
C.F.R. 722.5. appraisers and individuals providing evaluation
3. The interagency guidelines may be found in SR-letter services. The agencies recognize that it may not
94-55 for the FRB; the Comptroller’s Handbook for Commer-
cial Real Estate and Construction Lending for the OCC; be possible or practical for small institutions to
FIL-74-94 for the FDIC; and Thrift Bulletin 55a for the OTS.
NCUA was not a party to the guidelines; however, the NCUA BHC Supervision Manual January 2006
applies the content to credit unions, when applicable. Page 25
separate the collateral-valuation and loan- financial services institution.

production processes. To ensure independence, Even in small institutions when absolute lines
loan officials, officers, or directors with the of independence cannot be achieved, effective
responsibility for ordering appraisals and evalu- internal controls should be implemented to
ations should not have sole approval authority ensure that no single person has sole authority
for granting the loan request. to render credit decisions involving loans on
When selecting and engaging appraisers, an which they ordered or reviewed the appraisal or
institution needs to identify the assignment and evaluation. Further, lending officials, officers, or
order the appropriate appraisal or evaluation, as directors should abstain from any vote or
discussed in the guidelines. To foster control approval involving loans for which they per-
and accountability, institutions are encouraged formed the appraisal or evaluation.
to use written engagement letters when ordering
appraisals, especially for large, complex, or out-
of-area commercial real estate properties. An Supervisory Approach
institution should include a copy of the written
engagement letter in the permanent loan file. An Examiners will review an institution’s standards
appraiser may also incorporate an engagement of independence, taking into consideration the
letter in the appraisal report. The engagement size of the institution and the nature and com-
letter confirms that the assignment was made in plexity of its real estate–related activities.
a manner that complies with the institution’s Examiners will consider whether policies and
procedures and the agencies’ regulations and procedures are comprehensive and applied uni-
guidelines. formly to all units engaging in federally related
transactions.
If an institution suspects that a licensed or
Appraisal and Evaluation Compliance certified appraiser is violating applicable laws or
Reviews USPAP, or is otherwise engaging in other
unethical or unprofessional conduct, the institu-
An institution’s appraisal and evaluation pro-
tion should refer the matter directly to the appro-
gram must maintain effective internal controls
priate state appraiser regulatory authorities.
that promote compliance with program stan-
Examiners finding evidence of unethical or
dards and the agencies’ appraisal regulations
unprofessional conduct, including improperly
and guidelines. Internal controls should, among
prepared appraisals or evaluations and read-
other criteria, confirm that appraisals and evalu-
dressed appraisals, should forward their findings
ations are reviewed by qualified and adequately
and their recommendations to their supervisory
trained individuals who are not involved in the
office for appropriate disposition and referral to
loan-production processes. The institution’s
the state appraiser regulatory authority, as neces-
standards for and the depth of such reviews
sary. Institutions and institution-affiliated par-
should reflect the risk of the transaction and the
ties, including lenders, staff, and fee appraisers,
process through which the appraisal or evalua-
are reminded that they could be subject to
tion is obtained. An institution should establish
enforcement actions, which include removal/
more in-depth review procedures for appraisals
prohibition orders, cease-and-desist orders, and
of large, complex, or out-of-area commercial
civil money penalties, for violations of the agen-
real estate credits and for those appraisals and
cies’ appraisal and real estate lending
evaluations that are ordered by agents of the
regulations.
institution, such as loan brokers or another

Page 26
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 examiner’s 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 project’s 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 for—and the
value of—new 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 institution’s 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 institution’s management of the lending
• Construction delays or other unplanned
function.
adverse events resulting in cost overruns that
The policies governing an institution’s 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 institution’s 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 institution’s activities, and
ity and increasing sales cancellations that may
should be consistent with prudent banking prac-
reduce the project’s 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-
tution’s 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 collateral’s 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 appraisal’s 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 collateral’s value
ment from reliable sources. as determined by the institution’s 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 examiner’s 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 examiner’s 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 borrower’s 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 borrower’s 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. 90–16); 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. R–0685);
ers consider a number of factors, including the Federal Deposit Insurance Corporation, 12 CFR 323 (RIN
character, overall financial condition and 3064–AB05); Department of the Treasury; Office of Thrift
Supervision, 12 CFR Part 564 (Docket No. 90–1495).
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 today’s 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 today’s 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 borrower’s 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 loan’s 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 examiner’s 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 guarantor’s financial condi-
whose terms have been restructured should tion, income, liquidity, cash flow, contingent
be identified in the institution’s internal credit liabilities, and other relevant factors (including
review system, and closely monitored by credit ratings, when available) to demonstrate
management. the guarantor’s 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 borrower’s intent and ability to fulfill the
2240.0.3.2 Considerations Relating to a
obligation without reliance on third party guar-
Guarantor’s 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, guarantor’s 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;
Guarantor’s 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 guarantor’s 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 guarantor’s finan- completion of those phases.
cial capacity and willingness to perform, it is Examiners also consider the institution’s
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 BHC’s 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 Board’s 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 non–real 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 portfolio’s 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 Reserve’s 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
institution’s 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 institution’s 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 institution’s
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.
Board’s 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 company’s 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 Board’s 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 individual’s 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 company’s historical record
the law, a fine of up to $1 million or 1 percent of concerning the timely submission of reports
the institution’s 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
institution’s 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- er’s 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 management’s 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
agement’s 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. SBIC’s and has grown and the stock has appreciated in
MESBIC’s 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 SBIC’s and MESBIC’s 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 MESBIC’s 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. SBIC’s 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 company’s 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 company’s
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. SBIC’s 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. SBIC’s and MESBIC’s 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 MESBIC’s, the SBA allows them to incur
Page 2 higher leverage. MESBIC’s 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. MESBIC’s 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 SBIC’s 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 SBIC’s
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 SBIC’s 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 SBIC’s 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-
ny’s 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 company’s 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 director’s 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 management’s 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 director’s 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 SBIC’s and MESBIC’s 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 director’s 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 company’s 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; company’s 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 company’s general ledger with

least 70 percent coverage of the portfolio; statements prepared for the latest FR Y–6;
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 customer’s 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 4–173

bank holding company 1843(c)(5) 4–175
4–174
Limitations of an SBIC’s 13 C.F.R. 107.901(a)

control over business
enterprises
Criteria for various types of 13 C.F.R. 121.3–10

business investments of an 13 C.F.R. 121.3–11
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 4–175.1

acquired DPC

Page 6
2260.0.9 APPENDIX 1—VENTURE 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 payable—affiliates XXXX

Notes payable—others XXXX
Accrued taxes payable XXXX
Deferred tax credits XXXX
Other liabilities XXXX
Total liabilities XXXX
STOCKHOLDER’S EQUITY
Common stock (par value XXX) XXXX

Surplus XXXX
Retained earnings XXXX
Net unrealized appreciation (depreciation) of equity interests XXXX
Total stockholder’s equity XXXX
Total liabilities and stockholder’s equity XXXX

Page 7
2260.0.10 APPENDIX 2—VENTURE CAPITAL COMPANY—SAMPLE 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
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 1—Activities 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 2—Activities Considered ‘‘Closely Related
to Banking’’ Under Section 4(c)(8) of the Bank
Holding Company Act
3000.0.4 Appendix 3—Activities 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 Act—Savings Bank

Subsidiaries of BHCs Engaging in Nonbanking
Activities
3005.0 Section 2(c)(2)(F) of the BHC Act—Credit 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 Act—Exemptions

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 Act—Investment 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 Act—Acquisition

of DPC Shares or Assets, Including Real Estate
3030.0.1 Exemption to Section 4(c)(2) Disposition

Requirements of DPC Shares
3040.0 Section 4(c)(4) of the BHC Act—Interests 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 Act—Investments 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 Act—Ownership

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
3060.0.1.2 Acquisition of Nonbank Interests—Royalties
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 Section 4(c)(8) of the BHC Act—Mortgage Banking
3070.0.1 Board Oversight and Management

3070.0.1.1 Board Oversight

Page 2
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
3070.0.1.6 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
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

Page 3
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
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 A—First Day Letter
3070.0.12 Appendix B—Accounting Literature
3070.0.13 Appendix C—Regulatory Guidance

Page 4
3070.3 Nontraditional Mortgages—Associated 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)
3071.0 Section 4(c)(8) of the BHC Act—Mortgage Banking—
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
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

Page 5
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 ABC’s 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 Act—Servicing 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 Act—Receivables
3090.1 Factoring
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

Page 6

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 Act—Consumer 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 Company’s Condition
3104.0 Acquiring Debt in Default
3104.0.1 Acquisition of Defaulted Debt—Board Order
3105.0 Credit Card Authorization and Lost/Stolen Credit Card

Reporting Services
3107.0 Stand-Alone Inventory-Inspection Services
3110.0 Section 4(c)(8) of the BHC Act—Industrial Banking
3110.0.1 Nonbanking Acquisitions Not Requiring Prior Board

Approval
3111.0 Section 4(c)(8) of the BHC Act—Acquisition of

Savings Associations
3111.0.1 Acquisition of a Savings Association

Page 6.1
3120.0 Section 4(c)(8) of the BHC Act—Trust Services
3120.0.1 On-Site Inspections
3130.0 Section 4(c)(8) of the BHC Act—General 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 Act—Leasing 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
3140.0.3 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 Act—Community Welfare

Projects
3150.0.1 Investments in Corporations or Projects to Promote

Community Welfare—Board 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 Act—EDP Servicing

Company
3160.0.1 Introduction—Provision 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
3160.0.12.2 On-Site
3160.1 Section 4(c)(8) of the BHC Act—EDP 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 Traveler’s

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 Services—Printing and Selling MICR-

Encoded Items
3170.0 Section 4(c)(8) of the BHC Act—Insurance 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 Board’s
Regulation Y
3170.0.3.2 Section 225.28(b)(11)(ii) of Regulation Y—Sale 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 Y—Insurance
in Small Towns
3170.0.3.4 Section 225.28(b)(11)(iv) of Regulation Y—Insurance
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 Y—Bank
Holding Company’s Insurance Coverage for
Internal Operations
3170.0.3.6 Section 225.28(b)(11)(vi) of Regulation Y—Small Bank
Holding Companies
3170.0.3.7 Section 225.28(b)(11)(vii) of Regulation Y—Insurance
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 Act—Insurance

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 Board’s Regulation Y—Credit 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 Act—Courier Services


Page 10
3200.0 Section 4(c)(8) of the BHC Act—Management

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 Counseling—Initial Board Order
3210.0 Section 4(c)(8) of the BHC Act—Money 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 Act—Arranging

Commercial Real Estate Equity Financing
3230.0 Section 4(c)(8) of the BHC Act—Agency

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 Act—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-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 Board’s 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 Act—Underwriting 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 Act—Agency 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
3250.0.7.6 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 FCM—Executing and Clearing, and Clearing Without
Executing, Futures and Options on Futures on
Nonfinancial Commodities
3251.0.5.1 BHC’s Execution and Clearance of Futures and Options
on Futures on Nonfinancial Commodities
3251.0.5.2 FCM’s 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
Banker’s 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 A—Previous 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 Board’s 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 Services—Other 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 Act—Investment 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 Company’s 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 BHC’s Own Position
in Foreign Currency
3260.0.4.6 Derivative Transactions as Principal
3270.0 Section 4(c)(8) of the BHC Act—Real Estate and

Personal Property Appraising
3270.0.1 Scope of Inspection

3270.0.2 Appraisal Standards for Federally Related
Transactions
3270.0.3 Appraiser’s 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 Act—Check-Guaranty

and Check-Verification Services

3330.0 Section 4(c)(8) of the BHC Act—Operating a

Collection Agency

3340.0 Section 4(c)(8) of the BHC Act—Operating 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 Discount—Members 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 BHC’s Subsidiary Banks Issuing Securities-Based
Credit Can Require Borrowers to Keep the Securities
Collateral in an Account at the BHC’s 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 Act—Grandfather

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

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

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

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 Act—Export 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 Board’s 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 Act—Financial 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 FHC’s 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
3950.0.4.1.4 Compliance
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 A—Joint 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 B—Glossary
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 Internal Control Questionnaire
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

Page 25
Introduction to BHC Nonbanking and FHC Activities
Section 3000.0
The Bank Holding Company Act of 1956 (BHC tion 225.28(b) of the Board’s Regulation Y
Act) was enacted to limit the expansion of bank- lists permissible nonbanking activities that the
ing institutions into nonbanking activities. A Board has deemed to meet these criteria. (See
bank holding company was defined in the BHC appendix 1.) The list of permissible nonbank-
Act as an entity that owned or controlled 25 per- ing activities has been expanded at various
cent or more of the voting shares of two or times.
more banks; companies owning only one bank The Board also has permitted by order, on an
were exempted from regulation under the BHC individual basis, certain activities that it has
Act. considered to be closely related to banking
During the 1960s, the number of commercial under section 4(c)(8) of the BHC Act. In doing
enterprises that purchased one bank, engaged in so, the Board did not expand the list of permis-
nonbanking activities, and remained exempt from sible activities under section 225.28(b) of Regu-
regulation grew dramatically. As a result of this lation Y. (For a list of such activities, see appen-
change in the structure of bank ownership, Con- dix 2.)
gress enacted the Bank Holding Company Act In determining whether the performance of a
Amendments of 1970. Of these amendments, nonbank activity by a bank holding company or
the most significant is the extension of the act to the acquisition of a nonbank firm by a bank
grant to the Federal Reserve Board the authority holding company was a proper incident to bank-
to regulate the activities of one-bank holding ing, the Board applied a ‘‘public interest test.’’
companies. The Board determined whether the proposed
In 1978, Congress passed the International new activity or proposed acquisition ‘‘[could]
Banking Act (IBA). Section 8 of the IBA expanded reasonably be expected to produce benefits to
the nonbanking prohibitions of the BHC Act to the public, such as greater convenience, increased
foreign banks that engage in the business of competition, or gains in efficiency, that out-
banking in the United States directly through a weigh possible adverse effects, such as undue
branch or agency or indirectly through a subsid- concentration of resources, decreased or unfair
iary commercial lending company. This expanded competition, conflicts of interest, or unsound
the nonbanking restrictions beyond simply cov- banking practices.’’
ering foreign banks that own or control U.S. An interpretation of Regulation Y (12 C.F.R.
banks or bank holding companies. However, 225.126) dated April 28, 1972, and amended
section 2(h) of the BHC Act provides foreign September 20, 1972, listed activities that the
organizations that are principally engaged in the Board determined do not satisfy the ‘‘so closely
business of banking outside the United States related’’ test under section 4(c)(8). The Board
with exemptions from the nonbanking prohibi- subsequently determined that a number of other
tions of the BHC Act. Further exemptions have activities do not satisfy the closely related test.
been granted by the Board’s discretionary author- (For a complete list of these impermissible
ity under section 4(c)(9) when such exemptions activities, see appendix 3, and, for a brief
were in the public interest and were consistent description of a selected number of the activities
with the purposes of the BHC Act. denied by the Board, see section 3700.0 et seq.)
Under section 4(c) of the BHC Act, Congress As the primary regulator for bank holding
exempted a limited number of investments from companies and their directly held nonbank sub-
the general prohibition against owning or con- sidiaries, the Federal Reserve System conducts
trolling shares of nonbank concerns. Section inspections of their operations, financial condi-
4(c)(8) permitted investment in ‘‘shares of any tion, and compliance with appropriate banking
company the activities of which the Board and other related statutes and regulations. Inspec-
after due notice and opportunity for hearing tion personnel are called upon to evaluate the
has determined by regulation to be so closely current condition of the organizations, as well as
related to banking or managing or controlling their future prospects.
banks as to be a proper incident thereto.’’ The On August 10, 1987, the Competitive Equal-
act also provided that any bank holding com- ity Banking Act of 1987 was signed into law.
pany might apply to the Board for permission This act redefined the definition of ‘‘bank’’ in
to engage in an activity that had not yet been section 2 of the BHC Act so that an FDIC-
determined to be permissible if the applicant insured institution is deemed a bank.
was of the opinion that the activity in its
particular circumstances was closely related to BHC Supervision Manual December 2001
banking or managing or controlling banks. Sec- Page 1
Introduction to BHC Nonbanking and FHC Activities 3000.0
State-Authorized Activities of Savings activities of Edge Act or agreement corpora-

Banks tions. An Edge Act or agreement corporation is
an international banking vehicle that may only
A special rule was established for qualified engage in listed or approved activities that are
savings banks (state-chartered, FDIC-insured incidental to international or foreign business.
institutions organized before March 5, 1987) (See 12 C.F.R. 211.6) The restriction generally
that are subject to the BHC Act. (See section permits an Edge Act or agreement corporation
2090.7.) In accordance with section 3 of the to engage only in international banking or finan-
BHC Act, a qualified savings bank may engage cial activities. (See 12 C.F.R. 211.8.) A separate
in any nonbanking activity, except insurance manual, Guidelines and Instructions for Exami-
activities, either directly or through a subsidiary, nation of Edge Corporations, sets forth the rules
that it is permitted to conduct directly as a and procedures for examining Edge Act or agree-
state-chartered savings bank, even if those ment corporations and for determining whether
activities are not otherwise permissible for bank their activities are permissible.
holding companies. To engage in those activi-
ties, however, a qualified savings bank must
remain a savings bank and a subsidiary of a Companies that own only an Edge Act or agree-
savings bank holding company (a company that ment corporation. Any company, other than a
controls one or more qualified savings bank, that acquired an Edge Act or agreement
banks whose total aggregate assets, upon forma- corporation after March 5, 1987, must conform
tion and at all times thereafter, constitute at its activities to section 4 of the BHC Act.
least 70 percent of the assets of the holding
company). With respect to insurance activities,
qualified savings banks may engage in under- Underwriting and Dealing in Debt and
writing and selling savings bank life insurance Equity Securities
if the savings bank is located in Connecticut,
Massachusetts, or New York, and if certain other
conditions are met. 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-
BHCs Engaging in Nonbanking Activities
ment companies), subject to the prohibition on
in Foreign Countries
affiliation with an organization dealing in securi-
A bank holding company has greater leeway to ties under section 20 of the Glass-Steagall Act.
perform nonbanking activities abroad than in (See 1989 FRB 192.) The Board delayed com-
the United States in that it may engage in non- mencement of the activity by each applicant
banking activities abroad that would not be per- until it determined that the applicant had estab-
missible in the United States. However, activi- lished the necessary managerial and operational
ties abroad are subject to limitations. Section infrastructure to commence the expanded under-
211.8 of Regulation K requires a bank holding writing and dealing activity and to comply with
company to limit its direct and indirect activities the Board order. The applicant’s capital plan
abroad to those usual in connection with bank- had to be determined to be adequate along with
ing and financial activities and to necessary the necessary policies and procedures needed to
related activities. Section 211.10 also lists par- comply with the Board’s order. The Board’s
ticular activities that are permissible abroad and order requires that loans to and capital invest-
provides rules regarding when a bank holding ments in the underwriting subsidiary be deducted
company must submit an application to engage from the bank holding company’s capital, as
in such activities directly or through investments. provided for in the Board’s capital adequacy
guidelines. The Board further confirmed that the
activities could not be conducted in any other
subsidiary other than the Board-approved sec-
Edge Act or Agreement Corporations tion 20 subsidiary. (See section 3600.21.4.)
A bank holding company may own an Edge Act As for underwriting and dealing in equity
or agreement corporation. The Federal Reserve securities, the Board stated in the order that it
Act and Regulation K govern the permissible would review within a year whether applicants
could commence the activity. The first Board
Page 2
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 Board’s 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
iary’s 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 Activities—the ‘‘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-
company’s 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 Reserve’s 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 1—Activities 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 company’s 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 traveler’s 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 BHC’s certain proposed flood zone–determination 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- Garn–St 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 company’s
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 2—Activities 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 receivable–related
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 Garn–St 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 3—Activities 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 Board’s 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 45160–45161 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 Board’s 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 law—including 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 Board’s 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 Board’s 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 Applicant’s 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
WHAT’S 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 Bank’s
(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 customers—services
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 Bank’s outstanding credit card
that the depositor may withdraw by check or balance in the event of the borrower’s 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 bank’s (MB Bank’s) 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 Bank’s parent, business of issuing and processing credit cards for individuals
MB BHC—a bank holding company for the and in transactions that are necessary and incident to that
purposes of the BHC Act—in 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 Bank’s 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 customer’s 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 Bank’s 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 staff’s February 18, 2005, interpreta-
Bank was issuing debit cards and holding related tion and in letters to the Board’s Legal Division,
deposits that were not permissible for a deposi- the Board’s Legal Division informed MB Bank’s
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 bank’s name to the current holders cease to be a bank, the Board also determined
of MB Bank’s 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
card–related 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 organization’s 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 Board’s
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 Board’s 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 company’s 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 Board’s 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 bank’s 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 bank’s 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 Board’s 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 section—activities 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 bank’s 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 company’s 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 subsidiary’s 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 4–192

subsidiary banks as furnishing of
services
Furnishing insurance not ‘‘services’’ 225.109 4–193
Services for banks that are not 225.113 4–194

subsidiaries
Computer services for customers of 225.118 4–195

subsidiary banks
Applicability of Bank Service Corp. 225.115 4–174.1

Act in certain BHC situations
Mortgage company services 225.122 4–196
Insurance and sale of short-term debt 250.221, 4–867

obligations by BHCs 225.130
Operations subsidiaries of a BHC 225.141
Shares held by a subsidiary bank in a 225.101(g) 4–185

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 BHC’s 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 Board’s 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 Board’s 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 Board’s delegated authority, the BHC Supervision Manual June 1997
Reserve Banks may approve a BHC’s 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 arm’s-length trans- Real property is often shown on an entity’s
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- mechanic’s liens. Property acquired DPC may
tive subsidiary. The Board does not have author- be recorded on the company’s 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 company’s 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 company’s
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 BHC’s 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 Officer’s 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 company’s 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
entity’s 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 management’s 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) 4–020 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 4–187

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)(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 company’s 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 bank’s 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 Board’s
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 Act’s
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 bank’s 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 Board’s 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 inquirer’s 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 inquirer’s
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 Board’s 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 staff’s
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 company’s internal report-
Interests in nonbanking organiza- 1843 225.12(a) 3–744.13

tions 1843(c)(4) 225.22(d)(3)
A qualifying foreign banking 211.23(f)(4) 4–305.2

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 bank’s capital and surplus.
ness) and carrying out functions the bank is Under section 4(c)(5), a holding company’s
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.
BHC’S 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 4–185

premise corporation
Investment in bank service 1861–65 250.301 1–329

corporation
Investment in small 15 USC 682b 225.107 4–173

business investment 225.111 4–175
corporation (SBIC) 225.112 4–174
Operating subsidiaries/ 250.141 3–415.4

loan production offices
Section 23A 371c 250.240 3–1133

Section 23B 371c 1–206.1
Mortgage company 225.122 4–196

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 Interests—Royalties 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 subsidiary’s 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 company’s 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 company’s 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 company’s general ledgers with
cordingly, most holding companies conduct these statements prepared for the latest FR Y–6.
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 4–187
acquired D.P.C.
Aggregating shares owned 225.101 4–187

by subsidiaries
Five percent limit on ‘‘any 225.137 4–189

class of voting securities’’
Control with less than 225.137 4–189

5 percent
4(c)(7)
Indirect ownership of 225.102 4–188
shares of investment
company

Page 3
Section 4(c)(8) of the BHC Act (Mortgage Banking)
Section 3070.0
WHAT’S NEW IN THIS REVISED record. Mortgage loans can also be acquired
SECTION through a network of correspondent companies.
Most mortgage banking companies use a com-
Effective January 2007, this section was revised bination of origination and acquisition strate-
to delete a reference to SR-95-31, which was gies. The decision about whether to originate
superseded by SR-99-26, Interagency Guidance or purchase loans also varies over time due
on High LTV Residential Real Estate Lending. 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 management’s 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- that were retained in permanent loan portfolio
sponsored programs. Such loans are either sold or those that were sold to another permanent
directly or are converted into securities that are investor. Fees paid for services rendered in
collateralized by the underlying mortgages administering the mortgage portfolios of inves-
(mortgage-backed securities). The pools of col- tors are a principal source of revenue for most
lateralized mortgage loans backing mortgage- mortgage bankers. In general, the company re-
backed securities provide a form of risk diversi- ceives a fee that is usually based on a percent of
fication for the investor. the unpaid balance of the administered mort-
Originations, secondary market sales, and gages. In return for the fee, the servicer is
servicing constitute the primary functional busi- responsible for collecting and remitting pay-
ness lines within a typical mortgage company. ments, managing the tax and insurance escrow
As an originator of mortgages, the company is accounts, inspecting the properties when required,
responsible for the initial phase of the mortgage, pursuing delinquent borrowers, foreclosing on
from original contacts with the borrowers to the
closing of the loans. At closing, the company BHC Supervision Manual January 2007
disburses its funds and becomes the lender of Page 1
Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0
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 lender’s 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
ing subsidiaries located elsewhere within the holding companies, they may also serve as exam-
bank holding company’s organizational structure. ination guidance and procedures for mortgage
The mortgage banker, as a lender, has the banking subsidiaries of state member banks.
flexibility to fund any and all phases of a project The way in which these procedures are used
including land acquisition, development, and should be determined on a case-by-case basis
construction. Land acquisition credit may be depending on the size of a particular company
extended for the acquisition of more than one and its business activities. The information in
parcel of land, which may not necessarily be ‘‘Board Oversight and Management,’’ ‘‘Finan-
identified with a specific project. More fre- cial Analysis,’’ and ‘‘Intercompany Transac-
quently, acquisition credit is tied into a specific tions’’ presented in this section is applicable to
project for which the lender expects to fund all mortgage banking reviews. The subsection
more than one phase. In development-phase ‘‘Mortgage-Servicing Rights’’ is recommended
lending, funds are advanced to ‘‘improve’’ the for use in companies that have significant risk
exposure. The examiner should also target func-
BHC Supervision Manual January 2007 tional areas such as production, marketing, and
Page 2 servicing/loan administration.
3070.0.1 BOARD OVERSIGHT AND

MANAGEMENT
The examiner should assess the quality and
effectiveness of a mortgage banking company’s
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 company’s
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 company’s busi-
to the institution’s 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 community’s 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 management’s 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 company’s activi-
to operate the mortgage banking company’s 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 company’s 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-
section 4070.1 and SR-95-51). ity and capital needs, and relevant industry and
peer-group performance statistics for each
operational area. Directors should also receive
3070.0.1.1 Board Oversight information regarding exceptions to established
policies and operating procedures, volume-
The mortgage banking company’s board pro- related processing backlogs, and the effective-
vides oversight, governance, and guidance to ness of the internal control programs. Informa-
the executive management team. The board may tion on hedging products and strategies should
include executives of the mortgage banking be routinely provided to the board and to hold-
company, executives of the bank holding coming company management. In connection with
pany and other affiliated companies, and outside this portion of the review, examiners should
directors. also request and review information regarding
The examiner should determine whether a all loans to insiders and their related interests to
separate board exists, as well as the identity and ensure that no preferential transactions have
qualifications of the members. Minutes of board been extended to these parties.
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 Control—Integrated
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 entity’s 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 June 1996
compliance with applicable laws and regulations. Page 3
loan administration. Management formulates management’s 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 management’s 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 management’s 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 company’s 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 management’s 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 company’s
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 Management’s attitude toward risk is communi-
respond to changing circumstances. Because cated to employees through the company’s 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. Management’s failure to communicate
The strategic plan should identify the com- acceptable standards of behavior may encourage
pany’s 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 June 1996 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 company’s 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 auditor’s
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 management’s 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 company’s 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 company’s internal control structure. Examiners
recording of transactions and a proper safe- should also review management’s 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 June 1997
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
the mortgage banking company sample at least Examiners should also determine whether
10 percent of all closed loans each month and procedures exist to detect and investigate sus-
conduct a quality control review to determine pected fraud, either internal or external. In many
the extent of accuracy, completeness, and adher- instances, the legal department coordinates fraud
ence to agency underwriting standards. Random training and investigations, as well as the sub-
samples should include loans originated through mission of criminal referral or suspicious activi-
the company’s own production network, pur- ties reports and the initiation of legal action. If a
chased loans, loans for which work was per- separate fraud division or unit does not exist,
formed by a third party (outsourced), and loans examiners should determine whether procedures
with various product characteristics, such as a governing the detection, investigation, and refer-
high loan-to-value or a convertible feature. ral of potentially fraudulent situations exist
Quality control personnel reverify loan docu- and function effectively. Examiners should also
mentation, including the appraisal, down pay- determine whether management reports ade-
ment, employment, and income information. quately detail and track potential exposure.
After each review, the department should issue
a comprehensive report detailing specific qual-
ity control findings and recommendations. Qual- 3070.0.1.6 Inspection Objectives—Board
ity control reviews must be completed within Management and Oversight
90 days of closing. Exceptions to company pol-
icy or investor underwriting standards should be
1. To assess the composition, qualifications,
documented and communicated to executive
and degree of oversight provided by the mort-
management. Corrective measures should be
gage company’s board and executive manage-
initiated promptly.
ment team.
The quality control function should serve as
an early warning system that alerts management 2. To determine whether the organizational
to situations that may jeopardize the financial structure is appropriate given the nature and
strength, image, or origination and sale capacity scope of the mortgage banking company’s
of the company. To function as an effective operations.
management control, the quality control depart- 3. To evaluate the reasonableness of the oper-
ating budget, long-term business planning, per-
BHC Supervision Manual June 1997 formance measurement systems, and MIS and
Page 6 related management and board reports.
4. To determine the nature of the company’s 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 Procedures—Board 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 department’s 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.
management’s 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 department’s
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
auditor’s scope, responsibilities, and extent of sourcing meets the company’s 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 company’s 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, management’s 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 company’s 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 department’s 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 FannieMae’s and/or
for the top 5 to 20 percent of the loan principal FHLMC’s 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 company’s 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 buyer’s own ments, an executive officer’s compensation based
name using its own funds, closed in the seller’s on volume, an emphasis on high-risk product
name using the buyer’s 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 company’s own specifi- ing, (3) underwriting, (4) closing and funding,
cations. Historically, the company’s 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 applicant’s 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 company’s 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 System’s 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 company’s 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 company’s 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 correspondent’s 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-
pany’s 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 management’s 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 department’s 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 banker’s 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
pany’s loan production for maximum profit. If establish methods for evaluating and monitoring
the company’s 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 lender’s 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 company’s 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 management’s 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-
mittee’s 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 company’s 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 management’s 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 company’s 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 company’s 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,
company’s 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 management’s philosophy and
strategy to determine the amount of interest-rate
risk they are willing to accept. How successful Counterparty Risk
has the company’s marketing strategy been over
the past few years and how is it changing? What
are management’s primary sources of market 1. Review the marketing committee’s 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 management’s 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 Association’s 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 loan’s 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. Management’s 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 company’s
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- servicer’s 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 servicer’s 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-
er’s 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 FannieMae’s regular tance cycles vary by investor.
option, the servicer retains all risk of loss from The examiner should discuss with servicing
mortgage default. With FannieMae’s 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 pany’s 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 department’s operation should be
guaranteed loan, the VA makes a calculation assessed. A servicing department’s management
that will guide its decision to accept or reject faces a variety of risks that it should identify
conveyance of the property. The VA’s 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 VA’s guaranteed
tute adequate and effective internal controls to
percentage of the indebtedness. The mortgage
match a servicing portfolio’s growth and the
servicer, at its option, could pay down the out-
department’s 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 servicer’s 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 mortgagor’s 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 servicer’s 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 servicer’s 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 personnel’s 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 company’s 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-
ment’s 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 servicer’s 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.
ment’s 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 management’s 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 company’s 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 ny’s 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 servicer’s 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 company’s risk should be brought to management’s atten-
balance sheet and income statement. The finan- tion and discussed in the Examiner’s 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 management’s of cash, reverse repurchase agreements, market-
attention and documented in page one, Examin- able securities, receivables and advances, mort-
er’s 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
ny’s 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 company’s 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 company’s 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 management’s 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 borrower’s financial flex-
further protect its security interest, the ware- ibility if the company’s 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 company’s 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. Management’s
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 management’s 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 Board’s 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
ny’s 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 ment’s 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 borrower’s
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, agement’s 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 Board’s
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 company’s
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 Examiner’s
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 company’s balance 3070.0.5.4.2 Presentation of
sheet for potential classifications. ORE may usu- Classifications
ally warrant a substandard classification due to
an investment’s 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 subsidiary’s 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 subsidiary’s
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. 225.61–67), 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 company’s external auditors regarding the
• the examiner’s 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 company’s
to the classification. Historical information and business orientation and management’s 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 tion’s 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 ny’s use of financial leverage. Finally, the exam-
adequate contra asset allowances and other con- iner should consider the company’s 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 Management’s ability to satisfy the company’s
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 examiner’s 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
ment’s 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 company’s 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 company’s financial flexibility. lead to significant earnings volatility in the event
Financial flexibility is the ability to obtain the that interest rates change rapidly. Management’s
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 company’s 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 company’s 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 company’s 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 Reserve’s 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 company’s 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 company’s busi- based on the volume of projected foreclo-
ness orientation, and management’s 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 company’s
business orientation and management’s 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, 31–90 days, 91–180 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 company’s 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-
ny’s 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 company’s 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 transferor’s 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 3—Excess 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-
transferor’s 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 agreement’s
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 company’s 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 period’s 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 company’s 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 organization’s 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 company’s 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 System’s 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 company’s
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 instrument’s 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 company’s 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 management’s 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 seller’s
Page 42 risk parameters and individual portfolio.
An IAR servicing hedge is an off-balance- 3070.0.6.11 Inspection Procedures

sheet, interest rate–driven 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 servicer’s 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 company’s 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 management’s 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 company’s 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 company’s 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: model’s 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 23A—quantitative
ment for hedges, related gains and losses, and restrictions and collateral requirements—are dis-
the overall effectiveness of the company’s hedge cussed next.
program. If hedge accounting treatment is being
used, management and/or the company’s 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 bank’s 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 bank’s capital and surplus for transactions
board of directors (if applicable), and the parent with all of its affiliates.20 Covered transactions
company’s 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 company’s • 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 bank’s
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 officer’s 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 affiliate’s 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 bank’s 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. bank’s 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 bank’s 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 credit’’22 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 bank’s 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 affiliate’s 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 government–guaranteed obligations, instru-
based on the bank’s independent credit evalu- ments that are acceptable at the Federal Reserve’s
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 3–1164.3), 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, 3–1133.
22. Under section 23A, as amended by the Garn–St Germain
inherent volatility, making it difficult to accu-
Act in 1982, a member bank’s 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 bank’s 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 company’s • 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 bank’s 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 Owner’s 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 System’s 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 banks—restrictions
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
company’s 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 Board’s 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 customer’s 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 way—it does not extend 1. Review management’s 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 Board’s 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 customer’s 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 company’s 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 auditor’s 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 subsidiary’s 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 company’s 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 company’s 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-
seller’s 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 zone–determination 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 borrower’s behalf
zone–determination 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 corporation’s condition,
gage lenders and to provide mortgage lenders asset quality as indicated by nonaccrual and
with ongoing flood zone–tracking services with delinquency reports, the level of risk exposure
respect to their mortgage loans. The company’s 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 zone–determination 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 zone–determination 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 zone–determination 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 affiliate’s notes 3–1131

from a third party
Activities not closely 225.126 4–184

related to banking
Acquisition of assets 225.132 4–175.1
Purchase by member bank 250.250 3–1133

of loans originated by a
mortgage banking firm
Mortgage companies 225.122 4–196

acquired under sections
4(c)(1) or 4(c)(8) of the act
Activities closely related 225.131 4–176

to banking
Investments in community 225.127 4–178

welfare projects
Staff opinion on engaging in 225.28(b)(2) 4–318.4

certain proposed flood
zone–determination activities

Page 52.1
3070.0.11 APPENDIX A—FIRST 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 organization’s
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 company’s board of directors that includes each
individual’s 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 management’s 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 company’s 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 management’s 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 banking–related 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 bank’s 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 management’s 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 company’s 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 company’s 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 company’s board of directors
77. Provide a copy of the bank holding company’s 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 company’s 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 B—ACCOUNTING 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. 65—When 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 C—REGULATORY 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
2125.0 Trading Activities of Banking Organizations
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
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 borrower’s
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-
While some institutions have offered nontra- mensurate with the risk, and an allowance for
ditional mortgages for many years with appro- loan and lease losses (ALLL) that reflects the
priate risk management and sound portfolio per- collectibility of the portfolio.
formance, the market for these products and the
number of institutions offering them has expanded The Federal Reserve expects institutions to
rapidly. Nontraditional mortgage loan products effectively assess and manage the risks associ-
are now offered by more lenders to a wider ated with nontraditional mortgage loan products.5
spectrum of borrowers; these borrowers may not Institutions should use the guidance to ensure
otherwise qualify for more traditional mortgage that risk-management practices adequately
loans and may not fully understand the risks address these risks. Risk-management pro-
associated with nontraditional mortgage loans. cesses, policies, and procedures in this area will
Many of these nontraditional mortgage loans be carefully scrutinized. Institutions that do not
are underwritten with less stringent income and adequately manage these risks will be asked to
take remedial action.
This guidance focuses on the higher risk ele-
the Office of the Comptroller of the Currency, the Federal
ments of certain nontraditional mortgage prod-
Deposit Insurance Corporation, the Office of Thrift Supervi- ucts, not the product type itself. Institutions with
sion, and the National Credit Union Administration. sound underwriting, adequate risk management,
2. The term institution(s), as used in this interagency guid- and acceptable portfolio performance will not
ance, applies to Federal Reserve-supervised state member
banks and their subsidiaries, bank holding companies, and the
be subject to criticism merely for offering such
nonbank subsidiaries of bank holding companies. It also refers products.
to all other federally supervised banks and their subsidiaries,
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 January 2007
residential mortgage loan products. Page 1
Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3
3070.3.1 NONTRADITIONAL LOAN For all nontraditional mortgage loan prod-

TERMS AND UNDERWRITING ucts, an institution’s analysis of a borrower’s
STANDARDS repayment capacity should include an evalua-
tion of the borrower’s 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 borrower’s 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 Reserve’s balance increase that may accrue from the nega-
real estate lending standards and appraisal regu- tive amortization provision.9
lations and associated guidelines.6 Furthermore, the analysis of repayment
Central to prudent lending is the internal dis- capacity should avoid overreliance on credit
cipline to maintain sound loan terms and under- scores as a substitute for income verification in
writing standards despite competitive pressures. the underwriting process. The higher a loan’s
Institutions are strongly cautioned against ced- credit risk, either from loan features or borrower
ing underwriting standards to third parties that characteristics, the more important it is to verify
have different business objectives, risk toler- the borrower’s income, assets, and outstanding
ances, and core competencies. Loan terms should liabilities.
be based on a disciplined analysis of potential
exposures and compensating factors to ensure
that risk levels remain manageable. 3070.3.1.2 Collateral-Dependent Loans
Institutions should avoid the use of loan terms
3070.3.1.1 Qualifying Borrowers for and underwriting practices that may heighten
Nontraditional Loans
7. The fully indexed rate equals the index rate prevailing at
Payments on nontraditional loans can increase origination plus the margin that will apply after the expiration
significantly when the loans begin to amortize. of an introductory interest rate. The index rate is a published
Commonly referred to as payment shock, this interest rate to which the interest rate on an ARM is tied.
increase is of particular concern for payment- Some commonly used indices include the 1-Year Constant
Maturity Treasury Rate (CMT), the 6-Month London Inter-
option ARMs where the borrower makes mini- bank Offered Rate (LIBOR), the 11th District Cost of Funds
mum payments that may result in negative (COFI), and the Moving Treasury Average (MTA), a 12-
amortization. Some institutions manage the month moving average of the monthly average yields of U.S.
potential for excessive negative amortization Treasury securities adjusted to a constant maturity of one
year. The margin is the number of percentage points a lender
and payment shock by structuring the initial adds to the index value to calculate the ARM interest rate at
terms to limit the spread between the introduc- each adjustment period. In different interest-rate scenarios, the
tory interest rate and the fully indexed rate. fully indexed rate for an ARM loan based on a lagging index
Nevertheless, an institution’s qualifying stan- (for example, the MTA rate) may be significantly different
from the rate on a comparable 30-year fixed-rate product. In
dards should recognize the potential impact of these cases, a credible market rate should be used to qualify
payment shock, especially for borrowers with the borrower and determine repayment capacity.
high loan-to-value (LTV) ratios, high debt-to- 8. The fully amortizing payment schedule should be based
income (DTI) ratios, and low credit scores. Rec- 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
ognizing that an institution’s underwriting crite- term would be calculated based on a 30-year amortization
ria are based on multiple factors, an institution schedule. For balloon mortgages that contain a borrower
should consider these factors jointly in the quali- option for an extended amortization period, the fully amortiz-
fication process and potentially develop a range ing payment schedule can be based on the full term the
borrower may choose.
of reasonable tolerances for each factor. How- 9. The balance that may accrue from the negative amortiza-
ever, the criteria should be based upon prudent tion provision does not necessarily equate to the full negative
and appropriate underwriting standards, consid- amortization cap for a particular loan. The spread between the
ering both the borrower’s characteristics and the introductory or ‘‘teaser’’ rate and the accrual rate will deter-
mine whether a loan balance has the potential to reach the
product’s attributes. 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 January 2007 payments are made. The borrower could be qualified based on
Page 2 this lower maximum loan balance.
the need for a borrower to rely on the sale or 3070.3.1.5 Simultaneous Second-Lien
refinancing of the property once amortization Loans
begins. Loans to individuals who do not
demonstrate the capacity to repay, as structured, Simultaneous second-lien loans reduce owner
from sources other than the collateral pledged equity and increase credit risk. Historically, as
are generally considered unsafe and unsound.10 combined loan-to-value ratios rise, so do defaults.
Institutions that originate collateral-dependent A delinquent borrower with minimal or no equity
mortgage loans may be subject to criticism, cor- in a property may have little incentive to work
rective action, and higher capital requirements. with a lender to bring the loan current and avoid
foreclosure. In addition, second-lien HELOCs
typically increase borrower exposure to increas-
ing interest rates and monthly payment burdens.
3070.3.1.3 Risk Layering Loans with minimal or no owner equity gener-
ally should not have a payment structure that
Institutions that originate or purchase mortgage allows for delayed or negative amortization
loans that combine nontraditional features, such without other significant risk-mitigating factors.
as interest-only loans with reduced documenta-
tion or a simultaneous second-lien loan, face
increased risk. When features are layered, an 3070.3.1.6 Introductory Interest Rates
institution should demonstrate that mitigating
factors support the underwriting decision and As a marketing tool for payment-option ARM
the borrower’s repayment capacity. Mitigating products, many institutions offer introductory
factors could include higher credit scores, lower interest rates set well below the fully indexed
LTV and DTI ratios, significant liquid assets, rate. When developing nontraditional mortgage
mortgage insurance, and other credit enhance- product terms, an institution should consider the
ments. While higher pricing is often used to spread between the introductory rate and the
address elevated risk levels, it does not replace fully indexed rate. Since initial and subsequent
the need for sound underwriting. monthly payments are based on these low intro-
ductory rates, a wide initial spread means that
borrowers are more likely to experience nega-
tive amortization, severe payment shock, and an
3070.3.1.4 Reduced Documentation earlier-than-scheduled recasting of monthly pay-
ments. Institutions should minimize the likeli-
Institutions increasingly rely on reduced docu- hood of disruptive early recastings and extraor-
mentation, particularly unverified income, to dinary payment shock when setting introductory
qualify borrowers for nontraditional mortgage rates.
loans. Because these practices essentially substi-
tute assumptions and unverified information for
analysis of a borrower’s repayment capacity and 3070.3.1.7 Lending to Subprime
general creditworthiness, they should be used Borrowers
with caution. As the level of credit risk increases,
the Federal Reserve expects an institution to Mortgage programs that target subprime bor-
more diligently verify and document a borrow- rowers through tailored marketing, underwriting
er’s income and debt-reduction capacity. standards, and risk selection should follow the
Clear policies should govern the use of reduced applicable interagency guidance on subprime
documentation. For example, stated income lending.11 Among other things, the subprime
should be accepted only if there are mitigating guidance discusses circumstances under which
factors that clearly minimize the need for direct subprime lending can become predatory or abu-
verification of repayment capacity. For many sive. Institutions designing nontraditional mort-
borrowers, institutions generally should be able gage loans for subprime borrowers should pay
to readily document income using recent W-2
statements, pay stubs, or tax returns. 11. See SR-99-6, Subprime Lending and its attachment,
Interagency Guidance on Subprime Lending, March 1, 1999,
and SR-01-4, Subprime Lending and its attachment, inter-
agency Expanded Guidance for Subprime Lending Programs,
January 31, 2001.
10. A loan will not be determined to be ‘‘collateral- BHC Supervision Manual January 2007
dependent’’ solely through the use of reduced documentation. Page 3
particular attention to this guidance. They should risk characteristics of their nontraditional mort-
also recognize that risk-layering features in loans gage loan portfolios.
to subprime borrowers may significantly increase
risks for the institution and the borrower.
3070.3.2.1 Policies
3070.3.1.8 Non-Owner-Occupied Investor An institution’s policies for nontraditional mort-

Loans gage lending activity should set acceptable lev-
els of risk through its operating practices, account-
Borrowers financing non-owner-occupied investing procedures, and policy exception tolerances.
ment properties should qualify for loans based Policies should reflect appropriate limits on risk
on their ability to service the debt over the life layering and should include risk-management
of the loan. Loan terms should reflect an appro- tools for risk-mitigation purposes. Further, an
priate combined LTV ratio that considers the institution should set growth and volume limits
potential for negative amortization and main- by loan type, with special attention for products
tains sufficient borrower equity over the life of and product combinations in need of heightened
the loan. Further, underwriting standards should attention due to easing terms or rapid growth.
require evidence that the borrower has sufficient
cash reserves to service the loan, considering
the possibility of extended periods of property 3070.3.2.2 Concentrations
vacancy and the variability of debt service
requirements associated with nontraditional mort- Institutions with concentrations in nontraditional
gage loan products. mortgage products should have well-developed
monitoring systems and risk-management prac-
tices. Monitoring systems should keep track of
3070.3.2 PORTFOLIO AND concentrations in key portfolio segments such as
RISK-MANAGEMENT PRACTICES loan types, third-party originations, geographic
area, and property occupancy status. Concentra-
Institutions should ensure that risk-management tions also should be monitored by key portfolio
practices keep pace with the growth and chang- characteristics such as non-owner-occupied
ing risk profile of their nontraditional mortgage investor loans and loans with (1) high combined
loan portfolios and changes in the market. Active LTV ratios, (2) high DTI ratios, (3) the potential
portfolio management is especially important for negative amortization, (4) credit scores of
for institutions that project or have already expe- borrowers that are below established thresholds,
rienced significant growth or concentration lev- and (5) risk-layered features. Further, institu-
els. Institutions that originate or invest in nontra- tions should consider the effect of employee
ditional mortgage loans should adopt more robust incentive programs that could produce higher
risk-management practices and manage these concentrations of nontraditional mortgage loans.
exposures in a thoughtful, systematic manner. Concentrations that are not effectively managed
To meet these expectations, institutions should— will be subject to elevated supervisory attention
and potential examiner criticism to ensure timely
• develop written policies that specify accept- remedial action.
able product attributes, production and port-
folio limits, sales and securitization practices,
and risk-management expectations; 3070.3.2.3 Controls
• design enhanced performance measures and
management reporting that provide early warn- An institution’s quality control, compliance, and
ing for increasing risk; audit procedures should focus on mortgage lend-
• establish appropriate ALLL levels that con- ing activities posing high risk. Controls to moni-
sider the credit quality of the portfolio and tor compliance with underwriting standards and
conditions that affect collectibility; and exceptions to those standards are especially im-
• maintain capital at levels that reflect portfolio portant for nontraditional loan products. The
characteristics and the effect of stressed eco- quality control function should regularly review
nomic conditions on collectibility. Institutions a sample of nontraditional mortgage loans from
should hold capital commensurate with the all origination channels and a representative
sample of underwriters to confirm that policies
BHC Supervision Manual January 2007 are being followed. When control systems or
Page 4 operating practices are found deficient, business-
line managers should be held accountable for tion will respond to reduced demand in the
correcting deficiencies in a timely manner. secondary market.
Since many nontraditional mortgage loans While third-party loan sales can transfer a
permit a borrower to defer principal and, in portion of the credit risk, an institution remains
some cases, interest payments for extended exposed to reputation risk when credit losses on
periods, institutions should have strong controls sold mortgage loans or securitization transac-
over accruals, customer service, and collections. tions exceed expectations. As a result, an institu-
Policy exceptions made by servicing and collection may determine that it is necessary to repur-
tions personnel should be carefully monitored to chase defaulted mortgages to protect its reputation
confirm that practices such as re-aging, payment and maintain access to the markets. In the Fed-
deferrals, and loan modifications are not inad- eral Reserve’s view, the repurchase of mortgage
vertently increasing risk. Customer service and loans beyond the selling institution’s contractual
collections personnel should receive product- obligation is implicit recourse. Under the risk-
specific training on the features and potential based capital rules, a repurchasing institution
customer issues with these products. would be required to maintain risk-based capital
against the entire pool or securitization.13 Insti-
tutions should familiarize themselves with these
3070.3.2.4 Third-Party Originations guidelines before deciding to support mortgage
loan pools or buying back loans in default.
Institutions often use third parties, such as mort-
gage brokers or correspondents, to originate
nontraditional mortgage loans. Institutions should 3070.3.2.6 Management Information and
have strong systems and controls in place for Reporting
establishing and maintaining relationships with
third parties, including procedures for perform- Reporting systems should allow management to
ing due diligence. Oversight of third parties detect changes in the risk profile of its nontradi-
should involve monitoring the quality of origi- tional mortgage loan portfolio. The structure
nations so that they reflect the institution’s lend- and content should allow the isolation of key
ing standards and compliance with applicable loan products, risk-layering loan features, and
laws and regulations. borrower characteristics. Reporting should also
Monitoring procedures should track the qual- allow management to recognize deteriorating
ity of loans by both origination source and key performance in any of these areas before it has
borrower characteristics. This will help institu- progressed too far. At a minimum, information
tions identify problems such as early payment should be available by (1) loan type (for exam-
defaults, incomplete documentation, and fraud. ple, interest-only mortgage loans and payment-
If problems involving appraisals, loan documen- option ARMs); (2) risk-layering features (for
tation, credit problems, or consumer complaints example, payment-option ARMs with stated
are discovered, the institution should take imme- income and interest-only mortgage loans with
diate action. Remedial action could include more simultaneous second-lien mortgages); (3) under-
thorough application reviews, more frequent writing characteristics (for example, LTV, DTI,
re-underwriting, and even termination of the and credit score); and (4) borrower performance
third-party relationship. (for example, payment patterns, delinquencies,
interest accruals, and negative amortization).
Portfolio volume and performance should be
3070.3.2.5 Secondary-Market Activity tracked against expectations, internal lending
standards, and policy limits. Volume and perfor-
The sophistication of an institution’s secondary- mance expectations should be established at the
market risk-management practices should be subportfolio and aggregate portfolio levels. Vari-
commensurate with the nature and volume of ance analyses should be performed regularly to
activity. Institutions with significant secondary- identify exceptions to policies and prescribed
market activities should have comprehensive, thresholds. Qualitative analysis should occur
formal strategies for managing risks.12 Contin- when actual performance deviates from estab-
gency planning should include how the institu- lished policies and thresholds. Variance analysis
13. Refer to 12 C.F.R. 208 and 225, appendix A, III.B.3.

12. Refer to SR-02-16, dated May 23, 2002, Interagency
Questions and Answers on Capital Treatment of Recourse,
Direct Credit Substitutes, and Residual Interests in Asset BHC Supervision Manual January 2007
Securitizations and its attachment. Page 5
is critical to the monitoring of a portfolio’s risk fying attributes. Segments could also differenti-
characteristics and should be an integral part of ate loans by payment and portfolio characteris-
establishing and adjusting risk-tolerance levels. tics, such as loans on which borrowers usually
make only minimum payments, mortgages with
existing balances above original balances, and
3070.3.2.7 Stress Testing mortgages subject to sizable payment shock.
The objective is to identify credit quality indica-
Based on the size and complexity of their lend- tors that affect collectibility for ALLL measure-
ing operations, institutions should perform sen- ment purposes. In addition, understanding char-
sitivity analysis on key portfolio segments to acteristics that influence expected performance
identify and quantify events that may increase also provides meaningful information about future
risks in a segment or the entire portfolio. The loss exposure that would aid in determining
scope of the analysis should generally include adequate capital levels.
stress tests on key performance drivers such as Institutions with material mortgage banking
interest rates, employment levels, economic activities and mortgage servicing assets should
growth, housing value fluctuations, and other apply sound practices in valuing the mortgage
factors beyond the institution’s immediate con- servicing rights for nontraditional mortgages.
trol. Stress tests typically assume rapid deterio- The valuation process should follow generally
ration in one or more factors and attempt to accepted accounting principles and use reason-
estimate the potential influence on default rates able and supportable assumptions.14
and loss severity. Stress testing should aid an
institution in identifying, monitoring, and man-
aging risk, as well as developing appropriate 3070.3.3 CONSUMER PROTECTION
and cost-effective loss-mitigation strategies. The ISSUES
stress testing results should provide direct feed-
back in determining underwriting standards, prod- While nontraditional mortgage loans provide
uct terms, portfolio concentration limits, and flexibility for consumers, the Federal Reserve is
capital levels. concerned that consumers may enter into these
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 manner—before disclosures may be required
products, particularly in a stressed environment, under the Truth in Lending Act or other laws—to
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 January 2007 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 institution’s 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 property—even 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. sumer’s outstanding loan balance. Payment state-
19. Institutions may not be able to incorporate all of the ments also could provide the consumer’s current
practices recommended in this guidance when advertising
nontraditional mortgages through certain forms of media, loan balance, what portion of the consumer’s
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 borrower’s 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 tion’s 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 borrower’s 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 borrower’s income and assets. has borrower qualification criteria that
include an evaluation of a borrower’s 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 amortization—by 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 organization’s 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-
tion’s nontraditional mortgage loan terms tices, including consideration of each
are supported by a disciplined analysis of borrower’s 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 Reserve’s 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 organization’s
BHC Supervision Manual January 2007 underwriting standards—
Page 10 a. address the effect of a substantial pay-
ment increase in the borrower’s capacity of disruptive early recastings and extraor-
to repay when loan amortization begins, dinary payment shock when setting
b. comply with the Federal Reserve’s 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. er’s ability to service the debt over the
2. Verify that the banking organization’s 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 borrower’s Portfolio and Risk-Management Practices
repayment capacity include—
a. an evaluation of the borrower’s 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 borrower’s 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
er’s financial capacity (for example, nonbanking organization’s nontraditional
verification of reported income when the mortgage loan portfolios.
borrower’s 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 owner’s 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 zation’s 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-
tion’s lending standards and in compli- ing organization’s immediate control.
ance with applicable laws and regulations. 9. Find out if the stress testing results provide
5. Determine if the banking organization’s 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 Banking—Derivative
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 institution’s 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 SEC’s 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 Banking—Derivative 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 institution’s 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 institution’s
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
institution’s 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 20–21, 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 correspondent’s 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 Corrections—A 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
lender’s 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 lender’s 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 ABC’s 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 1—Notional 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 60–61.
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 1—continued 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 ABC’s 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 ABC’s 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. ABC’s pol-
3071.0.1.6.1.2 Discussion of ABC’s 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 2—ABC’s 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 ABC’s
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 ABC’s
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, ABC’s 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, ABC’s 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 3—Regulatory Reporting Implications for Derivative Loan Commitments and

Forward Loan-Sales Commitments
Amount Reference
Derivative loan commitments
Notional amount of ‘‘over-the-counter written options’’28 $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 company’s management to follow
erly reported on the balance sheet as an (1) the bank holding company’s 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 BHC’s needed—based on the examination’s 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 purchaser’s 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 BHC’s 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
tomer’s 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 customer’s 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 staff’s February 9, 2006,
subsidiary. legal interpretation.
The 1031 exchange subsidiary (1) would not
participate in negotiating the terms of the real
2. The BHC’s 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 bank’s standard OCC Interpretive Letter No. 880 (December 16, 1999) and
underwriting terms and conditions. OCC Corporate Decision No. 2001–30 (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 Board’s 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 company’s nonbank subsidiary
based on the volume of loans being serviced was the nation’s 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 authority’s 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 subsidiary’s 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 company’s 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 servicer’s 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 servicer’s 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 firm’s own
in the inspection report. account.
The servicing arrangement is of a fiduciary 3. To determine if the firm’s 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 firm’s 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 Board’s 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 Board’s 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 Board’s 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. management services. The applicants further
The commitments and conditions of this order committed that they would not provide real
required that (1) the asset-management activi- property management or real estate brokerage
ties would be provided to the banks and savings services as part of the proposed activities.
associations, (2) the applicant would obtain the The Board previously determined that, within
Board’s approval before providing asset- certain parameters, providing asset-management
management services for pools of assets that services for assets originated by financial institu-
were not originated or held by financial institutions (banks, savings associations, and credit
tions and their affiliates, (3) the applicant would unions) and their bank holding company affili-
cause its asset-management subsidiary to estab- ates is an activity closely related to banking (see
lish procedures to preserve the confidentiality of 1991 FRB 331, 334 and section 3600.15.3). The
information obtained in the course of providing applicants proposed to conduct all asset-
asset-management services, and (4) neither the management activities subject to the same con-
applicant nor its management subsidiary would ditions as in the Board orders previously cited.
take title to the assets managed by the asset- The applicants proposed to engage in asset-
management subsidiary. management activities for assets originated by
The applications of these holding companies nonfinancial institutions as well as by financial
were approved by a Board order on Decem- institutions. These assets include real estate,
ber 24, 1990 (1991 FRB 124). Two additional consumer, and other loans; equipment leases;
and extensions of credit. Assets of nonfinancial
institutions include pension funds, leasing com-
1. Asset-management services include acting as agent in
the liquidation or sale of loans and collateral for loans, includ-
ing real estate and other assets acquired through foreclosure BHC Supervision Manual June 1999
or in satisfaction of debts previously contracted. Page 1
Section 4(c)(8)—(Asset-Management, Asset-Servicing, and Collection Activities) 3084.0
panies, finance companies, and investment com- regardless of the originating entity. The Board
panies formed to engage in asset-management also determined that the proposal was consistent
activities. The managed assets would be limited with the asset-management proposals approved
to the types of assets that financial institutions in its prior orders. The Board concluded that the
have the authority to originate. The Board con- applicants’ proposed activities are closely related
cluded that the applicants would have the exper- to banking and approved the order on December
tise to engage in managing these types of assets, 21, 1992. (1993 FRB 131)

Page 2
(Receivables) Section 3090.0
Two nonbanking activities authorized under credit facility secured by an assignment of
section 4(c)(8) of the BHC Act, per Regulation accounts receivable (accounts receivable financ-
Y in section 225.28(b)(1), are the discount pur- ing). These activities date back to Board orders
chasing of a client’s accounts receivables (fac- issued in 1951. See sections 3090.1 and 3090.2.
toring) and the establishment of a revolving

Page 1
(Factoring) Section 3090.1
3090.1.1 INTRODUCTION forthcoming, and if bankruptcy threatens the
seller, buyers may hold back their future
Factoring is the discount purchasing of the cli- purchases.
ent’s accounts receivable invoices for goods that
have been manufactured and shipped. Factoring
differs from accounts receivable financing in 3090.1.2 FUNDING
that the factor assumes the credit risk of collect-
ing payment from the recipient of the goods. Since factors traditionally provide financing to
The principal advantage of factoring is that the industries with seasonal borrowing require-
client is assured of the collection of the pro- ments, such as textiles, shoes, clothing, and
ceeds of its sales, regardless of whether the other consumer goods, their own funding pro-
factor is paid. grams will usually reflect this volatility. It may
A factor generally offers four basic services: be expected that factors generally will have
(1) credit investigation and approval; (2) buying greater access to short-term unsecured credit
the client’s accounts receivable at a discount facilities than would be expected for other non-
(generally between .75 and 1.5 percent) after bank activities. This would hold true for factors
shipment of the goods to which there is no funded solely from internal sources as well as
subsequent claim, just a claim against the external sources.
invoices; (3) bookkeeping in the form of posting Because of a factor’s inherent funding volatil-
accounts; and (4) advancing funds in the form ity, a major portion of a factor’s liabilities will
of an ‘‘open account’’ when there could be be short-term debt. For the internally funded
30 days between shipment and payment. The company, this source will be predominantly
later allows the client to replenish inventory commercial paper proceeds from the parent
loans for working capital or expansion. company, with perhaps some bank line proceeds
Maturity factoring and advance factoring are intermixed. The externally funded company will
the basic techniques of the industry. In maturity probably rely on bank lines for its short-term
factoring, an average maturity due date is com- needs, usually with the parent company’s guar-
puted for the receivables purchased during a anty of the debt.
period and the client receives payment on that Longer term funding may be provided through
date. Advance factoring uses the same computa- bank term loans and subordinated debt, although
tions, however, the client has the option of tak- the volume of this type of debt appears to be
ing advance payments equal to a percentage of low relative to other financing industries. The
the balance due at any time prior to the com- terms and covenants of long-term debt appear to
puted average maturity due date. The unad- allow for relatively more flexibility in opera-
vanced balance, sometimes called the ‘‘client’s tions and more highly leveraged positions than
equity,’’ is payable on demand at the due date. similar debt for other financing industries in
The factor’s balance sheet reflects the pur- recognition of the volatility of factoring opera-
chases as ‘‘factored receivables’’ and the liabili- tions and the liquidity of factoring assets.
ties as ‘‘due to clients.’’ Usually the due to The principal suppliers of senior and subordi-
clients balance will be significantly less than the nated funds to factors and accounts receivable
factored receivables balance because of pay- financers appear to be limited to a few insurance
ments and advances to the clients. The income companies that specialize in this field, although
statement will show factoring commissions, a few banks also provide senior term funding.
which represent the discount on the receivables These lenders have incorporated their percep-
purchased. Interest income for advances on the tions of acceptable balance sheet ratios and
due to client balances may or may not be a earnings performance into their debt agreements
separate line item. as restrictive covenants. Since comparative
The factor is a pivoting point between the industry data is limited, these restrictive cove-
buyer and the seller. The buyer must pay or all nants may be the examiner’s primary means of
parties lose. Also the seller must have a reputa- evaluating leverage, loss reserves, and capital
tion for delivering quality merchandise. The fac- adequacy. The ‘‘due to clients’’ account is another
tor must know the business well enough to significant measure of a factor’s liabilities. As
account for sudden increases in returns for out- noted before, the account represents the
of-specification merchandise or for merchandise
of low quality. If the seller does not perform BHC Supervision Manual December 1992
adequately, payment for the goods may not be Page 1
Section 4(c)(8) of the BHC Act (Factoring) 3090.1
accumulation of the amounts payable to the typical practices and considerations in this form
clients upon the maturity of their factored of financing.
receivables. This liability is, to a large extent, During the preliminary phase, the following
self-liquidating through the collection of those information should be reviewed:
receivables. 1. System approvals for offices and activities,
An analysis of the changes in the relative including stipulated public benefits;
proportions of the ‘‘due to clients’’ account 2. Financial statements, both interim and fis-
should provide valuable input into the analysis cal, for a sufficient period to determine trends
of a factor’s earnings. Since factoring is a highly and operating patterns;
competitive industry, price cutting has reduced 3. All management reports which should
factoring commissions to a point where they indicate problem loans, loan volume, new
provide minimal support to earnings; therefore, accounts and other reports regarding loan port-
the interest margins on factoring advances have folio and company status;
a significant impact on net income. The implica- 4. External debt instruments to determine
tion of the analysis of proportional changes is material restrictive covenants;
that as more clients take advances (reducing 5. Internal audit reports and workpapers;
‘‘due to clients’’), profit margins should widen, 6. Minutes of the board of directors, execu-
and conversely, as the ‘‘due to clients’’ propor- tive committee and loan committee, if available
tion of total liabilities rises, profit margins may at the parent company;
be expected to narrow. 7. The results of a parent company loan review,
if any.
8. To be requested:
3090.1.3 INSPECTION OBJECTIVES a. Schedules of past due loans, intercom-
pany participations, and large loans;
1. To determine whether the company is op- b. Schedules of problem accounts, liqui-
erating within the scope of its approved activi- dating accounts, and repossessed assets;
ties and within the provisions of the Act and c. General ledger trial balance;
Regulation Y. d. Loan trial balance, including over-
2. To determine whether transactions with advances;
affiliates, including banks, are in accordance e. Statements of company lending, accrual,
with applicable statutes and regulations. and other policies;
3. To determine the quality of the asset port- f. Reconcilement of the loan loss reserve
folios, and whether lending, monitoring and col- for the period between inspections;
lection policies are adequate to maintain sound g. Listing of common borrowers between
asset conditions. affiliates.
4. To determine the adequacy of the reserve
for loan losses and whether the asset charge-off
policy is appropriate.
5. To determine the viability of the company 3090.1.4.1 On-Site Procedures
as a going-concern, and whether its affiliate
status represents a potential or actual adverse After reviewing the material available at the
influence upon the condition of the consolidated parent company, including the audit review, a
corporation. decision whether to go on-site is in order. Some
of the determinants of this decision are relative
size, current earnings performance, overall con-
3090.1.4 INSPECTION PROCEDURES tribution to the corporation’s condition, asset
quality as indicated by internal loan review
The inspection procedures for a factor have reports and problem loan reports, and the condi-
been divided into two phases, preliminary and tion of the company when last inspected. From
on-site, when considered necessary. the information provided, it might be deter-
The preliminary phase entails the gathering mined that the company is operating properly
and analysis of information at the parent com- and is in apparently sound condition. In such a
pany in order to determine the scope of the field case, an on-site inspection may not be war-
work to be performed on-site. The on-site seg- ranted. Conversely, a deteriorating condition
ment of the procedures expresses some of the might be detected which would require a visit,
even though a satisfactory condition had been
BHC Supervision Manual December 1992 determined during the previous inspection. Sub-
Page 2 sidiaries in unsatisfactory condition should be
inspected each time the parent company is may allow the factor to obtain comparison and
inspected. monitoring data on the client. If a monitoring
The following comments provide a general system is in place, the data provided will be
outline of the factor’s basic operation. This out- valuable in the asset analysis process.
line will provide a background for the com- The evaluation of a factor includes a review
ments in the inspection procedures. of its systems and controls as well as an analysis
While the typical factoring agreement stipu- of the quality of its assets, both of which may be
lates that all accounts receivable of a client are accomplished by a two segment analytical
assigned to the factor, not all are purchased approach. A major portion of a factor’s assets
without recourse. The agreement between the will be factored receivables, for which the credit
factor and the client will usually state that department has the responsibility for credit qual-
receivables subject to shipping disputes and ity and collection. The other major portion of
errors, returns, and adjustments are chargeable the assets will be the client loans and credit
to the client because they do not represent bona accommodations, for which the account officers
fide sales. In addition, sales made without the are responsible. The procedures for each area
factor’s approval are considered client risk will be dealt with separately.
receivables, with full recourse to the client if the
customer fails to pay.
The usual approval process requires the client 3090.1.4.2 Credit Department
to contact the factor’s credit department before
filling a sales order on credit terms. The credit Because of its integral function in the credit and
department will research its files, determine the collection process, the credit department is the
credit worthiness of the customer, and approve heart of a factor. The department maintains
or reject the sale. As stated before, if the credit credit files, which are continually updated as
department rejects the sale, the client may com- purchases are made and paid for by the custom-
plete the sale, but at its own risk. The most ers. These files will include financial statements,
common reasons for rejection are sales to affili- credit bureau reports, and details of purchasing
ates, sales to known bad risks, sales to custom- volume and paying habits. Usually, each cus-
ers whose credit cannot be verified, and sales to tomer will have an assigned credit line, which is
customers whose outstanding payables exceed the credit department’s estimate of the custom-
the factor’s credit line. er’s credit capacity.
Once a sale has been made and the receivable The evaluation of this department should take
assigned to the factor, approved or not, the the form of a review of a sample of the customer
client’s account will be credited for the net files. The sample may be drawn from lists of
invoice amount of the sale. That is, any trade or large volume customers and closely monitored
volume discounts, early payment terms, and customers, or it may be a random sample. The
other adjustments are deducted from the invoice examiner should have either a copy of depart-
amount. The receivable then becomes part of mental policies and procedures or a verbal
the client’s ‘‘availability’’ to be paid in advance understanding of them prior to the review. It
or at the computed due date, depending upon the should be kept in mind that the objective of the
basis of the factoring arrangement. review is to critique the credit and collection
Each month the client will receive an ‘‘ac- process and to verify departmental effective-
counts current’’ statement from the factor which ness, and not to obtain classifications.
details the transactions on a daily basis. This
statement will reflect the daily assignments of 3090.1.4.3 Asset Evaluation
receivables, remittances made, deductions for
term loans, and interest charges and factoring Prior to the review of asset quality, the examiner
commissions. Credit memos, client risk, charge should receive the lists of problem clients, client
backs, and other adjustments will also be shown. over-advances, term loans, and credit accommo-
Client risk charge backs are the amounts deducted dations; as well as the aging schedule of fac-
from the balance due to the client upon the tored receivables including client risk receiv-
failure of customers to pay receivables factored ables. These will be used as the basis for selecting
at client risk. the clients to be reviewed. It is recommended
The accounts current statement and the avail- that the selection be made from the list of clients
ability sheets will be necessary for the asset with term loans, largest first, in addition to the
analysis process. Considering the volume of
transactions, the accounting system that devel- BHC Supervision Manual December 1992
ops this data will probably be automated, which Page 3
acknowledged problems. Clients with high dilu- receivables’’ is the only portion of factored vol-
tion rates and those with client risk receivables ume that is appropriate for use in the amount
equal to 20 percent or more of factored volume classified. Because of the recourse aspect the
may also be included. balance is considered as an indirect obligation
It should be noted that a factor usually col- rather than a direct obligation.
lects principal and interest payments directly As a further step in the evaluation of the
from the client’s availability, which means that lending area and its controls, the evaluation of
the expected delinquency rate is minimal. Past the steps taken and the results of at least one
due factored volume is not an effective measure recent client liquidation should be made. By
of client quality. reviewing the chronology of events along with
A maturity client’s availability is the sum of the loan and collateral balances, the effective-
all factored receivables, less trade and other ness of systems and controls under extended
discounts, factoring commissions, credit memos, circumstances may be assessed. The type of
and client risk charge-backs. There may also be liquidation will have a bearing on the losses
other deductions for letters of credit and other taken. Losses tend to be higher when client
credit accommodations. An advance client’s fraud is involved.
availability would be further reduced by ad- In the process of evaluating a factor’s condi-
vances on the factored receivables, interest tion, the adequacy of systems and controls and
charges, and the reciprocal of the contractually the capability of management are considered
agreed upon ‘‘advance’’ percentage. This recip- significant measures. Asset quality, as measured
rocal, 20 percent in the case of an 80 percent by classifications, may be influenced by sea-
advance client, is sometimes referred to as the sonal aspects and should be carefully analyzed
client’s ‘‘equity’’ in the factored receivables. to allow for such influences. Because of a lack
Availability may be increased by liens on addi- of regular and consistent comparative data for
tional collateral such as inventory, machinery the industry, earnings and capital adequacy
and equipment, real estate, and other marketable are evaluated in terms of the company’s own
assets. performance.
The review and analysis of asset quality will The review of the company’s internal systems
be procedurally similar to that used in accounts and controls should be continuous during the
receivable financing. However, certain aspects inspection. Considering the large volume of
of the financial statements may need elabora- daily transactions that flows through a factor,
tion. The client’s balance sheet will have a ‘‘due any internal control that can be easily negated
from factor’’ account instead of accounts receiv- represents a potential problem and should be
able. The account balance may be somewhat brought to management’s attention. In the broad
lower than a normal receivables balance, which context, this review would include the credit
would affect turnover ratios and other short- controls for both clients and customers. Since
term ratios. The difference relates to the client’s credit problems can develop rapidly in factor-
ability to convert sales to cash faster with a ing, credit controls and systems must be respon-
factor than if the receivables were to be col- sive to the identification of these problems.
lected normally. In addition, the analysis of the Deficiencies noted should be discussed with
statements should incorporate an assessment of management and, if significant, cited in the
the client’s ability to absorb normal dilution and report. The company’s earnings trends may be
the potential losses associated with client risk evaluated by using a comparative yield on assets
receivables, particularly when these factors are approach. By analyzing yields on asset cate-
higher than usual for the portfolio. gories from period to period the examiner will
As a factor’s systems and controls for client be able to make a judgment as to the efficiency
loans are somewhat similar to those for accounts of the systems. Factors are subject to the same
receivable financing, the evaluation of asset price competition in the commercial finance
quality must consider these factors before the market as accounts receivable financers. Declin-
classification of a client is made. While the ing portfolio yields may reflect the inroads made
typical client may have less than satisfactory by competition and may indicate a decline in
financial statements, the factor’s working knowl- future profitability.
edge of the client’s operations and industry The subject of capital adequacy is influenced
tends to mitigate the risk factors present. by the aforementioned seasonal characteristics.
For classification purposes, ‘‘client risk Over the period of a year, the comparisons of
equity to assets and equity to liabilities will vary
BHC Supervision Manual December 1992 significantly. It is suggested that an average
Page 4 balance sheet be used to stabilize the variations.
In addition to balance-sheet ratio analysis, the comparisons between fiscal periods may reflect
effects of dividends and fees paid to the parent a declining trend. Such a trend should be dis-
company on the capital accounts may be ana- cussed with parent company management.
lyzed to determine the rate of internal capital The report comments should summarize these
generation. If the company is in a growth pro- considerations in a clear, concise presentation.
file, or attempting to gain market share, the
Loans to affiliates 23A FRA

371c
Purchase of affiliate’s notes from 23A FRA 3–1131 1951 FRB 960
a third party 371c
Activities not closely related 4(c)(8) BHC Act 225.126 4–184

to banking 1843(c)(8)
Acquisition of assets 4(c)(8) BHC Act 225.132 4–175.1 1974 FRB 725
1843(c)(8) 1984 FRB 370
Real estate mortgages as eligible 23A FRA 1933 FRB 566

collateral under section 23A 371c
Indebtedness of affiliate on assets 23A FRA 3–1125 1936 FRB 324

acquired from member bank 371c
Marketability of collateral under 23A FRA 3–1121 1935 FRB 395

section 23A 371c
Activities closely related 4(c)(8) BHC Act 225.123 4–176 1971 FRB 514
to banking 1843(c)(8) 225.28(b)(1) 1975 FRB 245
1984 FRB 50
1984 FRB 370
1984 FRB 376
1984 FRB 452
1984 FRB 736
1986 FRB 143
1988 FRB 177
1988 FRB 330
1989 FRB 79
1992 FRB 74
Community development 4(c)(8) BHC Act 225.127 4–178 1972 FRB 572
activities 1843(c)(8) 225.28(b)(12)

Page 5
(Accounts Receivable Financing) Section 3090.2
3090.2.1 INTRODUCTION seasonal businesses, a large portion of the
financer’s liabilities will be short-term debt. For
Accounts receivable financing is a revolving internally funded financers, this debt will be
credit facility secured by an assignment of predominantly commercial paper proceeds from
accounts receivable. As a financing technique, it the parent company, with perhaps some bank
allows the client (the financed company) to lines intermixed. The externally funded com-
obtain working capital without waiting for cus- pany will probably rely on bank lines for its
tomer payments. This form of financing is fre- short-term needs, usually with the parent com-
quently used by companies with working-capital pany’s guaranty of the debt.
shortages, companies in seasonal industries, and Longer term funding may be provided through
companies with weak financial conditions. Typi- bank term loans and subordinated debt, although
cally, the funding requirements of these compa- the volume of this type of debt appears to be
nies are in excess of any amounts that would be low relative to other financing industries, another
available through unsecured bank financing. parallel to factoring. The terms and covenants of
The financing process begins with a bona fide long-term debt appear to allow for more flexibil-
credit sale by the client and the assignment of ity in operations and somewhat more highly
the resulting receivable to the financer. Upon leveraged positions than similar debt for other
assignment, the financer advances a specific per- financing industries. This practice is apparently
centage of the receivable to the client. The loan in recognition of the volatility of this form of
is repaid by customers’ direct payments or, in financing and the liquidity of the assets support-
the case of a lockbox, by the remittance of the ing the financer’s loans.
customer’s payment to the financer, who returns The principal suppliers of senior and subordi-
the amount in excess of the loan to the client. nated funds to collateral lenders (factors and
While a simple concept for a single transac- accounts receivable financers) appear to be lim-
tion, the operations of an accounts receivable ited to a few insurance companies that special-
financer become a complex process when many ize in this field, although a few banks also
clients and perhaps thousands of receivables are provide senior term funding. These lenders have
involved. incorporated their perceptions of acceptable
Companies engaged in accounts receivable balance-sheet ratios and earnings performance
financing usually incorporate the full range of into their debt agreements as restrictive cov-
commercial financing activities into their opera- enants. Since comparative industry data are
tion. These activities would include inventory limited, these restrictive covenants may be the
financing, loans secured by machinery and equip- examiner’s primary means of evaluating lever-
ment, some forms of real estate loans, and loans age, loss reserves, and capital adequacy.
secured by other assets. As a general statement,
these companies will provide working-capital 3090.2.3 INSPECTION OBJECTIVES
financing using almost any form of viable collat-
eral to secure the loans. These additional activi- 1. To determine whether the company is op-
ties are facilitated by the financer’s in-depth erating within the scope of its approved activi-
knowledge of the borrowers’ financial condi- ties and within the provisions of the act and
tions and cash flows. This knowledge comes Regulation Y.
from the controls placed on the borrowers, such 2. To determine whether transactions with
as periodic field audits, the flow of the borrow- affiliates, including banks, are in accordance
er’s cash through the company, and an internal with applicable statutes and regulations.
staff that specializes in the financed industries. 3. To determine the quality of the asset port-
folios and whether lending, monitoring, and col-
3090.2.2 FUNDING lection policies are adequate to maintain sound
asset conditions.
Accounts receivable financing companies, like 4. To determine the adequacy of the reserve
factors, traditionally provide working-capital for loan losses and whether the asset charge-off
financing to seasonal industries. Consequently, policy is appropriate.
the funding programs of these financing com- 5. To determine the viability of the company
panies will reflect these variations in their as a going concern, and whether its affiliate
increased use of short-term funds relative to
other nonbanking activities. BHC Supervision Manual June 1996
Since many accounts receivable clients have Page 1
Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2
status represents a potential or actual adverse 3090.2.4.1 On-Site Procedures

influence upon the condition of the consolidated
corporation. After reviewing the material available at the
parent company level, including the audit review,
a decision whether to go on-site is in order.
3090.2.4 INSPECTION PROCEDURES Some of the determinants of this decision would
The inspection procedures for an accounts include relative size, current earnings perfor-
receivable company have been divided into two mance, overall contribution to the corporation’s
phases, preliminary and on-site. condition, asset quality as indicated by internal
The preliminary phase entails the gathering loan review reports and problem loan reports,
and analysis of information at the parent com- and the condition of the company when last
pany in order to determine the scope of the field inspected. From the information provided, it
work to be performed on-site, if required. The might be determined that the company is operat-
on-site segment of the procedures expresses ing properly and is in apparently sound condi-
some of the typical practices and considerations tion. In such a case, an on-site inspection may
in this form of financing. not be warranted. Conversely, a deteriorating
During the preliminary phase, the following condition might be detected which would re-
information should be reviewed: quire a visit, even though a satisfactory condi-
1. system approvals for offices and activities, tion had been determined during the previous
including stipulated public benefits inspection. Subsidiaries in unsatisfactory condi-
2. financial statements, both interim and fis- tion should be inspected each time the parent
cal, for a sufficient period to determine trends company is inspected.
and operating patterns The on-site inspection procedure will be simi-
3. all management reports which should lar to that used in a commercial department of a
indicate problem loans, loan volume, new bank. Selection and evaluation of the assets,
accounts and other reports regarding loan port- review of internal controls, identification of
folio and company status lending policies, and credit review procedures
4. external debt instruments to determine mate- are all familiar areas to the examiner and do not
rial restrictive covenants need further explanation. However, the account-
5. internal audit reports and workpapers— ing and reporting systems are somewhat differ-
a. internal control exception report to ent and will require the examiner to become
determine weaknesses and corrective actions, familiar with systems and policies before pro-
b. flow charts in the workpapers which ceeding with the asset evaluation process.
will enable the examiner to become familiar
with company systems, and
c. additional internal reports may be iden- 3090.2.4.2 Accounting and Controls
tified which may assist the inspection on-site
6. minutes of the board of directors, execu- There are two basic systems within the account-
tive committee and loan committee, if available ing and control environment of an accounts
at the parent company receivable company. The first system provides
7. the results of a parent company loan review, accounting and control for client loans and col-
if completed lateral balances and is frequently automated to
8. To be requested: handle the large flows of data generated in the
a. schedules of past-due loans, inter- operation. It is also common to find lockbox
company participations, and large loans arrangements with banks that tie into the client
b. schedules of problem accounts, liquidat- system for the receipt of customer remittances.
ing accounts, and repossessed assets Such lockbox arrangements provide a greater
c. general ledger trial balance degree of control over remittances.
d. loan trial balance The mechanics of the client system will be
e. statements of company lending, accrual, detailed in the internal audit file, which should
and other policies also indicate the adequacy and efficiency of the
f. reconcilement of the loan-loss reserve system’s controls. The audit file may also indi-
for the period between inspections cate the accounting techniques used and the
g. listing of common borrowers between client-monitoring reports that are generated by
affiliates the system, such as dilution rates and trends,
and year-to-year volume and operating compari-
BHC Supervision Manual June 1996 sons. The client system provides the basic data
Page 2 for the company’s accounting and control sys-
tem. While the basic accounting considerations the quantity shipped was less than that ordered).
are outlined in the AICPA Industry Audit Guide: It is the client’s responsibility to provide this
Audits of Finance Companies, there are certain information to the financer on a daily basis. If
accounting aspects which deserve additional there is sufficient availability, the requested
treatment. In some cases where a group of amount is usually advanced. On occasion, the
related companies are clients, the financing availability computation will show the client to
arrangements may include cross-guarantees and be ‘‘over-advanced,’’ that is the loan balance
cross-collateralization agreements. In these cases, exceeds the agreed percentage advance against
the financer might utilize excess availability for collateral. This situation may have occurred be-
some of the related entities to offset the over- cause some receivables have become past due,
advance of another entity. Another treatment or the financer may have authorized additional
that may be applied is the use of a ‘‘reserve for funds to meet some valid client requirement. As
liquidating accounts,’’ which in some instances a rule, over- advance positions are usually sub-
is a specific reserve for a problem account that ject to a quick paydown to reduce the loan
reverses at least current period earnings for the balance to the original contractual terms.
account. This reserve is in addition to the allow- At times, the availability computation will
ance for bad debts and may not be an explicit reflect additional collateral value in the form of
balance sheet account, but an offset to gross inventories, machinery and equipment, and other
loans outstanding. assets, shown net of an advance percentage.
These categories usually indicate term loans,
secured by liens against the respective assets,
3090.2.4.3 Definitions which expand the collateral base and provide
additional support to the client’s working capital
While many of the following comments define requirements. These term loans should not be
certain routine accounting and control consider- confused with loans for the acquisition of such
ations for accounts receivable financing, certain assets which might appear only in the client’s
of the concepts are necessary for proper evalua- monthly statement.
tion of client quality (i.e., availability, dilution, The accounts receivable financer charges in-
over-advances, and advances on other collat- terest on the daily cash borrowings of the client
eral). These definitions are general in nature as and accumulates these charges on the client’s
is the terminology, however, the processes will monthly statement. The total interest charge for
be similar in almost every company. advances on receivables and other loans is
Loans to the client are based upon a contrac- deducted directly from remittances received by
tual percentage of the client’s eligible receiv- the financer. Accordingly, the expected delin-
ables against which the financer has agreed to quency rate for an accounts receivable operation
advance funds. Eligible receivables include all is low except for the rare loan which is paid
assigned receivables, less trade discounts, early directly by the client and other assets which
payment discounts, contra-accounts (reciprocal formerly belonged to a defunct client.
sales between the client and customers), receiv-
ables past due beyond the eligibility period
specified in the contract, and other adjustments. 3090.2.4.4 Over-Advances and Other
The advance percentage is determined by a Loans
number of factors which include the expected
average dilution rate (disputed invoices, mis- It was indicated earlier that an over-advance
shipped goods, returns and allowances, etc.) and represented funds advanced in excess of avail-
the client’s expected gross profit margin. As a able loanable funds and that there are two basic
general rule, lenders in this field try to finance causes for over-advances. Some over-advances
only the cost of sales and not the client’s profits. occur because a portion of eligible receivables
Because this form of financing involves rap- becomes past due and ineligible for advances.
idly changing collateral balances, a high volume This condition is usually corrected by the
of customer payments, and frequent loan re- assignment of additional receivables or receipt
quests, the financer has to determine the client’s of customer payments, and therefore may exist
‘‘availability’’ (loanable funds) before advanc- only for a few days.
ing the loan. Availability is the total of eligible The other basic over-advance occurs when a
receivables times the advance percentage less client requires additional funds for valid busi-
credit memos and the current loan balance.
Credit memos are adjustments to the customer’s BHC Supervision Manual December 1995
account for errors in the client’s shipments (i.e., Page 3
ness purposes, such as an inventory buildup at group to be considered is the acknowledged

the beginning of a season. In such cases, the problem accounts. The next sample should be
over-advance is set up as a very short-term loan drawn from accounts with high dilution rates,
and paid down rapidly out of the client’s avail- those with frequent or large over-advances, and
ability. While the policy for over-advances varies those which constantly take down all of their
between financers, when they are permitted they availability. Participations, purchased or sold,
are usually carefully analyzed by the internal between affiliates should also be included in the
credit committee and closely monitored until examiner’s sample. While this approach may
paid off. exclude some of the larger accounts, it is intended
If a client is involved only in receivables to include those accounts which are potential
financing and has made an over-advance request, problems in the primary review group. Should
the financer generally will prefer to take a lien the company have a monitoring system for
against inventory rather than make an unsecured potential problem accounts, the system should
over-advance. Regardless of the purpose of the be used for drawing the review sample.
inventory loan, the financer will advance only a The principal tools for the review process
small percentage of the inventory value (40 to should include: the credit file, the field audit file,
50 percent) to allow for shrinkage, spoilage and the monthly statement for the inspection date,
obsolescence of the collateral. While inventory the availability sheet for the inspection date, and
liens are in effect, the field audit staff will par- updated information for the interim period end-
tially verify the inventory during each audit. ing with the on-site inspection date. Within the
While machinery and equipment may be credit file, the copies of the financing agree-
pledged as additional collateral to support work- ments will indicate the specific terms of the
ing capital loans during the business period, borrowing relationship: the pledged collateral;
most client companies will also finance equip- advance percentage; interest rate; guarantees;
ment purchases on a secured basis. In either appraisals; and the required communications,
case, the financer usually advances a percentage such as monthly receivables agings, inventory
of the quick sale or auction value of the equip- and machinery and equipment certification,
ment as determined by an appraisal. During etc. The usual file information will also in-
field audits, the presence of the equipment and clude management’s analysis of the client’s
appropriate lien tagging are verified by the field operations.
auditors. The field audit file will contain the audit
On occasion, a lien on real estate is part of the reports originated by the financer’s field audit
pledged collateral. The real estate may be oper- staff. These reports are usually quite comprehen-
ating premises, land, or the property of the sive, with a primary focus upon critical financial
principal of the client. Such liens may occur areas. As a minimum, the auditors will analyze
when the client is acquiring new, or expand- trade payables, State and federal taxes, cash
ing old, operating facilities and is using the flows, inventories, and receivables. Particular
financing relationship to fund the project. How- attention is paid to the client’s sales and ship-
ever, in many cases the lien was taken to pro- ping procedures in order to ascertain that valid
vide additional collateral for working capital invoices are being assigned to the financer. The
loans. In either case, appropriate documentation client’s accounting procedures are also analyzed
and appraisals should be on file. to determine their effectiveness and accuracy.
It should be noted that loans on real estate These reports represent a primary source of
collateral are limited to those providing support information regarding the general financial con-
to the primary business of the client. Loans to dition of the client.
finance speculative real estate acquisitions, and The client’s monthly statement and availabil-
unrelated commercial property are not consid- ity sheets represent spot information on the cli-
ered to be the usual practice of this industry, and ent’s activity. Many clients operate in seasonal
would be considered as not complying with the industries such as clothing and textiles. In such
general activities of a commercial finance com- industries, a client will tend to use all of its
pany, unless specifically approved. availability, as well as seasonal over-advances,
during its inventory buildup period, and will pay
off the over-advances and may have excess
3090.2.4.5 Asset Evaluation availability during the sales and collection period.
In selecting the loans to be reviewed, the first The examiner will have to analyze the client’s
current position with regard to its particular
BHC Supervision Manual December 1995 operating cycle. Over-advances granted to a cli-
Page 4 ent for valid reasons do not necessarily repre-
sent undue exposure or a substandard asset for It is common practice in the accounts receiv-
the financer. able and factoring industry for the lender to
The financial statements of a client quite fre- require a pledge of client company stock by the
quently reflect a ‘‘relatively unsatisfactory or principals, particularly in overextended situa-
weak’’ financial condition, with minimal work- tions. Additional pledges of securities owned by
ing capital, high leverage, and uncertain earn- the principals may also provide added collateral.
ings as prime ingredients. There have been cases While such pledges are not precluded by Regu-
where both deficit working capital and deficit lation Y and the act, once they become com-
net worth were in evidence, however, the financ- pany assets they should be reviewed for control
ing relationship has continued to function prop- and retention purposes.
erly. The financer can continue these relation-
ships if the short-term factors (sales volume,
receivables and inventory turnover, and current 3090.2.4.7 Financial Condition
liabilities) are appropriate and the character of
the principals warrants the exposure. Analysis Secured lending relies upon the four C’s of
of a financed client should emphasize the short- credit: the traditional Capital, Character, Capac-
term analytical factors and the related trends in ity, and Collateral. Pragmatically, these lenders
the evaluation of asset quality. practice a fifth C, Control. In this context, con-
Such factors as the success of the selling trol implies the continuous monitoring of the
season, availability of materials, and fad mer- client’s financial condition, continued evalua-
chandising will have direct impact on the cli- tion of the collateral, constant contact with the
ent’s financial condition. While the loan may be client, and the adjusting of the credit accommo-
adequately protected by pledged collateral, the dation to conform to the client’s current situa-
ability of the client to continue operations may tion. This control is the reason that the secured
be affected by these short-term factors. lender can maintain a proper and mutually prof-
For classification purposes, the financer’s con- itable financing arrangement with the client.
trols will have to be considered in addition to It is to be expected that the typical portfolio
weighing the degree and quality of collateral may include clients with less than satisfactory
protection, short-term factors, and the client’s financial conditions. Considering the controls
ability to withstand any financial reverses that imposed upon the borrowing relationships, the
are evident. Clients with deficit net worth, past- secured lender has compensated for some of the
due trade obligations, and delinquent taxes should additional risk in the loans. The combination of
be considered to be problems and appropriately field audits, collateral controls, and account
classified. The ability of the financer to control officer contact can be expected to reduce the
the risk exposure in the portfolio will be an exposure to unsatisfactory clients to a mini-
important consideration in determining whether mum. However, clients do fail and losses may
to classify a specific loan. be taken in liquidating the account. The inci-
dence rate of liquidations and the extent of
3090.2.4.6 DPC Assets losses taken may be an indicator of the effective-
ness of company controls.
In some companies, assets acquired from de- The earnings of an accounts receivable com-
funct clients remain in the loan account instead pany are based upon loans carrying interest rates
of being reclassified to another balance-sheet above prime, which means that loan volume is a
category. Usually, these assets are uncollected major determinant of revenues. Because this
accounts receivable, inventory, and machinery industry is very competitive, loan pricing is
and equipment which have not been liquidated. frequently used to obtain new clients from other
However, these assets may include securities, as lenders in order to promote growth in loan vol-
well as business and personal real estate, which ume. Increases in loan volume combined with
had been pledged as collateral. By retaining declining interest margins may be an indicator
these assets in the loan category, effective liqui- of price competition that is yielding negative
dation of the respective assets may be delayed results. Analysis of client turnover may verify
because they usually represent small dollar this possibility.
amounts. Apart from this consideration, classifi- In summary, management’s ability to control
cation as loans may disguise the fact that certain risk and achieve profitability is essential to the
of the assets may be subject to provisions of soundness of an accounts receivable operation.
Regulation Y and the act, such as control and
retention considerations. Separate control of BHC Supervision Manual December 1997
these assets is recommended. Page 5
The effectiveness of company policies, the agement’s ability to obtain satisfactory client
expertise of the lending staff and field audit quality and terms in a price-competitive envi-
staff, and the adequacy of systems and controls ronment. The examiner will have to balance
are the expressions of this ability to control risk. these factors in assessing the condition of the
Company profitability is a measure of man- company.
Loans to affiliates 23A FR Act

371c
Purchase of affiliate’s notes

from a third party 3–1131 1951 FRB 960
Acquisition of assets 225.132 4–175.1 1974 FRB 725

1984 FRB 370
Activities closely related 225.123 4–176 1971 FRB 514

to banking 1975 FRB 245
Investments in community 225.127 4–178 1972 FRB 572

welfare projects

Page 6
(Consumer Finance) Section 3100.0
3100.0.1 INTRODUCTION er’s operations. In a sense, this approach to
funding represents regulation and control by
The basic activity of a consumer finance com- market forces rather than by governmental
pany is making installment loans to individuals intervention.
and is permissible pursuant to section 225.28(b)(1) In other holding companies, management has
of Regulation Y and section 4(c)(8) of the BHC elected to support these operations using hold-
Act (the act). In most areas, a company may ing company funding sources such as commer-
make these loans under one or more of the cial paper and lines of credit. In using this
following licenses: consumer discount, small approach, operating management is generally
loan, sales finance, or second mortgage. Most of free from market restrictions on operations.
a company’s activity will probably be direct It is likely that most affiliated consumer finance
cash lending, in which the borrower and the companies will have a funding plan that falls
lender come into direct contact with one another somewhere between these two extremes. Since
in the credit-extension process. However, a sig- commercial paper generally carries a lower total
nificant volume of lending is done through third- cost than bank lines of credit, the examiner may
party contact. This is sales finance lending in find that the senior short-term debt component
which the company purchases, or discounts, the is almost completely supplied by the parent
loans originated by a durable goods dealer in company. On the other hand, long-term debt
daily retail sales activity. Second mortgage lend- may have been obtained directly, or with the
ing may be originated from either direct contact parent company’s guaranty, or it may have been
or through home-improvement contractors. borrowed from the parent company’s sources—
Most consumer finance companies offer credit- that is, the parent borrows from a third party and
related insurance as part of their services, and re-lends the proceeds to the subsidiary.
may have a captive insurance subsidiary if they Since a large volume of consumer installment
are large enough. Inspection considerations and paper carries maturities of three years or more,
procedures for reviewing credit-related insur- the use of commercial paper proceeds with
ance activities are covered in section 3170.0. maximum maturities of 270 days warrants some
comment. Securities Act Release No. 401 spe-
cifically recognizes this use of commercial paper
3100.0.2 FUNDING as appropriate. Further information may be found
in the Code of Federal Regulations, 17 C.F.R.
In some holding companies, management has 231.4412. Also see sections 2080.1 and 5010.16
elected to use a conventional industry funding for information on commercial paper.
pattern to support its consumer finance com-
pany operations. This pattern makes use of long-
term subordinated debt in a specific proportion 3100.0.3 INSPECTION OBJECTIVES
to equity capital. The further addition of senior
long-term and short-term debt is then limited by 1. To determine whether the company is operating
restrictive covenants incorporated into the sub- within the scope of its approved activities
ordinated debt agreements. These covenants also and within the provisions of the act and
provide operating limits for management in such Regulation Y.
areas as the proportions of specific classes of 2. To determine whether transactions with
assets, minimum levels of net worth to be main- affiliates, including banks, are in accordance
tained, and the maximum dividend payout with applicable statutes and regulations.
allowable. Since the wording and limits of 3. To determine the quality of the asset port-
these covenants are negotiated between the bor- folio, and whether lending, monitoring, and
rower and the subordinated debt holder, gener- collection policies are adequate to maintain
alizations regarding the usual terms are not sound asset conditions.
practicable. 4. To determine the adequacy of the reserve for
It appears that certain life insurance compa- loan losses and whether the asset charge-off
nies supply most of this subordinated debt to the policy is appropriate.
consumer finance industry. Along with their 5. To determine the viability of the company as
general knowledge of the industry, these insur- a going concern, and whether its affiliate
ance companies police their loans by requiring
periodic reports from the borrower and by send- BHC Supervision Manual December 1997
ing teams of their people to review the borrow- Page 1
Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0
status represents a potential or actual adverse 4. external debt instruments to determine mate-
influence on the condition of the consoli- rial restrictive covenants
dated corporation or the subsidiary bank(s). 5. internal audit reports and workpapers:
a. internal control exception reports to
determine weaknesses and corrective
actions
3100.0.4 INSPECTION PROCEDURES b. flow charts in the workpapers to become
familiar with company systems
After reviewing the material available at the c. additional internal reports may be identi-
parent company level, including the audit review, fied which may assist the inspection on-site
a decision whether or not to go on-site is in 6. examination reports of any state regulatory
order. Some of the determinants of this decision agencies having jurisdiction over the compa-
would include relative size, current earnings ny’s offices
performance, overall contribution to the corpo-
ration’s condition, asset quality as indicated by 7. minutes of the board of directors, executive
delinquency reports and industry comparisons committee, and any other such committee, if
(detailed later in this section), and the condition available at the parent company
of the company when last inspected. From the 8. the results of a parent company loan review
information provided, it might be determined or operations review, if conducted and
that the company is operating properly and is in available
apparently sound condition. In such a case, an 9. the following items to be requested from
on-site inspection may not be warranted, provid- management:
ing that a fairly recent on-site inspection had a. detailed past-due schedules and inter-
been conducted. Conversely, a deteriorating con- company participations
dition might be detected which would require a b. schedule of problem accounts, liquidating
visit, even though a satisfactory condition had accounts, and repossessed assets
been determined during the previous inspection.
c. general-ledger trial balance
Subsidiaries in unsatisfactory condition should
be inspected each time the parent company is d. loan trial balance
inspected. e. policy statements on lending, accrual, and
The inspection procedures for a consumer charge-offs
finance company have been divided into two f. reconcilement of the loan-loss reserve for
phases: preliminary and on-site. The prelimi- the period between inspections
nary phase entails the gathering and analysis of g. organization chart
information at the parent company to determine h. listing of company offices with addresses
the scope of the field work to be performed and operating licenses
on-site. The on-site phase establishes a mini-
mum scope of the inspection at the main office,
and includes considerations to be incorporated
into a visit to field offices if the inspection scope 3100.0.4.1 On-Site Phase
is expanded to that degree.
During the preliminary phase, the following The procedures of the on-site inspection are
information should be reviewed: intended to evaluate management and its super-
1. system approvals for offices and activities, visory efforts, to determine the soundness and
including stipulated public benefits compliance with the company’s operating poli-
2. financial statements, both interim and fiscal, cies, and to analyze the impact of these policies
for a sufficient period to determine trends on the company’s financial condition using ratio
and operating patterns analysis. A thorough understanding of the poli-
3. all management reports which should indicate cies and systems of the company is necessary
problem loans, loan volume, delinquencies, for the examiner to accurately determine the
and other reports regarding loan portfolio company’s condition.
and company status including the Robert During the initial period on-site, the examiner
Morris Associates’ Direct Cash Lending Ques- may obtain an overview of the company’s sys-
tionnaire and similar reports tems by interviewing the key staff officers. These
individuals can provide the examiner with the
BHC Supervision Manual December 1997 detailed reports, policy manuals, and other infor-
Page 2 mation necessary for the inspection.
3100.0.4.2 Policy Evaluation should be selected. Concentration on poor offices

will result in a biased assessment of the supervi-
Because of its large volume of transactions and sory effort and may result in an invalid evalua-
the number of offices involved, the typical con- tion of company policies. The selection of the
sumer company will maintain an extensive set offices may be made by using the number of
of policy and procedure manuals which are policy exceptions cited, poor performance
intended to guide company personnel in their records, or local economic conditions as criteria.
daily activities. During the review of these manu-
als, the examiner should bear in mind that lib-
eral policies and procedures may allow the com-
pany to mask portfolio problems and reflect 3100.0.4.4 Detailed Procedures for an
other than an accurate condition in its financial Office Visit
statements.
The principal policies to be considered cover The following steps outline a general procedure
such areas as: for determining field compliance with company
1. extensions of credit; policies and assessing the effectiveness of the
2. treatment of delinquent accounts and partial supervisory effort. The examiner may modify,
payments; eliminate, or expand any of these steps or may
3. loan renewals; devise any procedure deemed appropriate under
4. loan charge-offs; the circumstances present.
5. provisions for loan losses; The review of loans on-site should be ori-
6. bulk purchases of loans, for both credit and ented toward confirming the implementation of
account purposes; and company policies for delinquency, balance
7. treatment of deferred income. renewals, charge-offs, extensions, partial pay-
After assessing the soundness of company poli- ments, collection, and loan approvals. This review
cies, the next step is to test their implementation is intended to be a test of compliance and not
through a review of the company’s supervisory a review of specific assets for classification
structure. purposes.
1. Review the detailed delinquency report for
the selected office for a short period before
3100.0.4.3 Evaluation of the Supervisory the inspection date, generally two or three
Structure months. Trace the well overdue loans through
to resolution, pay-off, charge-off, or rein-
The effectiveness of the supervisory structure is statement. Check these loans against the loan
a key element in the condition of a consumer register to determine whether new loans have
finance operation. This system serves two func- been granted to these customers and if so,
tions: it communicates the policies to the field determine if they are in accordance with
personnel, and it enforces those policies. Assum- company policy.
ing that management’s policies are valid, the 2. Review the controls for charging off loans
effectiveness of this system will be partially and determine the effectiveness of the collec-
reflected in the ratio analysis of the company. tion and recovery effort.
However, it may take close analysis to deter- 3. Review the loans to present borrowers. While
mine whether any poor ratios are due to inad- renewals are usually granted to the better
equate policies or ineffective enforcement. customers, the examiner will find a volume
In order to evaluate the supervisory effort, the of renewals (‘‘under 10 percent new money
examiner may review a sample of the various advanced’’ loans). In some companies, these
supervisor’s reports which are prepared after ‘‘under 10 percent new money’’ loans repre-
visits to the loan offices. The sample should sent efforts to rehabilitate borrowers with
represent a cross-section of the offices and super- poor payment records due to ill health, unem-
visors in order to obtain a balanced view of the ployment, etc. However, the examiner may
company. find that management is using this approach
A further evaluative step may be undertaken to adjust and control delinquency and loss
if there are sufficient resources available to the rates. There should be sufficient internal con-
examiner. The on-site visits to selected loan trols present to prevent the continuous renewal
offices may provide considerable input to the of such loans to poor borrowers.
examiner in assessing supervisory effort. In
selecting the offices to be visited, well- BHC Supervision Manual December 1997
performing as well as poor-performing offices Page 3
The examiner may find that some office return these accounts to current status. The
personnel are circumventing these controls, manager’s collection efforts must begin early
for example, by advancing 11 percent new in the delinquency pattern if the loans are to
money to the borrower. If found, such cir- be salvaged from charge-off. Consistent, per-
cumvention raises serious questions regard- sistent, frequent effort is expected.
ing portfolio quality, the adequacy of internal The foregoing steps should provide the examiner
controls, and the effectiveness of the supervi- opportunity to evaluate the company’s policies,
sory effort. A high volume of ‘‘under 10 per- procedures, and supervisory systems.
cent’’ loans or evidence of circumvention of
controls may warrant separate treatment in
the report. 3100.0.4.5 Additional Procedures
4. Review partial-payment, interest-only, and
extension accounts. Significant numbers of While field visits are a desirable aspect of the
these accounts may indicate potential prob- inspection procedure, the examiner may have to
lems for the loan portfolio and the office. rely on other procedures to be satisfied with
5. Review credit-extension and loan documen- certain aspects of company operations, particu-
tation procedures, especially if the office’s larly when the company reports past-due receiv-
portfolio has a high level of losses or fre- ables on a recency rather than a contractual
quent litigation. Proper credit controls and basis. The additional procedures may be neces-
documentation are essential for sound opera- sary when the examiner has other reasons to
tions. If the office extends second mortgage question portfolio quality or the adequacy of
financing, appraisals and lien searches should internal controls.
be included with the documentation. The examiner may perform an extensive review
6. Test the office’s delinquency reporting. There of the most recent audit of the company, includ-
are two methods for computing delinquen- ing the workpapers and programs of the internal
cies, a contractual basis and the recency and independent auditors, when available. In
basis. On a contractual basis, principal reduc- this review, the examiner should be able to
tions are applied to the most overdue pay- determine whether internal controls are adequate,
ment under the contract and the loan is con- and portfolio characteristics are properly reported.
sidered past due from the date of the oldest
unsatisfied payment. On a recency basis,
delinquency is computed from the date of 3100.0.4.6 Compliance
last payment regardless of contract terms.
As an example, assume a loan was granted Certain aspects of the company are subject to
with payments beginning the first of March. review for compliance with the requirements of
The borrower makes the first payment on the act and Regulation Y. These include public
time and the second payment on the first of benefits, office activities and locations, and bulk
June. On the first of April, the loan is a purchases of assets.
30-day recency account and current contrac- 1. Public benefits stipulated in approval orders
tually. On the first of May, the loan is a frequently require continuing reduced inter-
60-day recency account and a 30-day con- est rates or insurance charges as part of the
tractual account. Upon receipt of payment in approval to operate. It is expected that these
June, the loan is current on a recency basis relative public benefits continue in effect
and a 60-day (two-payment) contractual despite changes in state-mandated rates.
account. Notice the difference in computa- 2. Office locations and activities are subject to
tions between the banking industry and the approval by the Board before opening for
consumer finance industry. business. The operating licenses and activi-
The consumer finance industry has begun ties of the offices should also be reviewed for
to institute contractual delinquency reporting compliance with the respective approvals.
standards. As these standards are developed 3. On occasion, a consumer finance company
and refined, changes in the computation of may make a bulk purchase of loans or other
delinquent accounts may be expected. assets of another finance company. Under
7. Review the collection effort. The past-due certain circumstances, these purchases require
accounts will be under the control of the the prior approval of the Board (12 C.F.R.
collection manager, whose objective is to 225.132). These bulk purchases should not
be confused with the bulk purchase of sales
BHC Supervision Manual December 1997 finance contracts from a retailer recently
Page 4 signed to a dealer agreement.
4. While most consumer finance activity relates renewal of loans to avoid charge-off. Adequate
to consumer installment loans, some compa- controls might include special coding of such
nies also extend credit under the ‘‘large loan’’ loans, with supervisory review of the renewals.
provisions of the consumer lending statutes Inadequate controls over these assets represent
of certain states. While the limitations vary poor management practices deserving special
from state to state, these provisions allow comment.
loans of many times the size of normal con- Most subordinated debt agreements provide
sumer loans. A review of these large loans for an adjustment (reduction) to net worth when
may indicate that there are extensions of calculating compliance with leverage limits for
credit to local businesses which may consti- any loans past due 60 days on a recency basis
tute commercial installment lending. Unless that exceed loss reserves. As there are some
specifically approved by the System, this seasonal characteristics to the loan portfolio, it
activity may not be permissible for the com- may be of benefit to compare the delinquency
pany being inspected. Review for compli- statistics on inspection date to the company’s
ance with various consumer regulations is seasonal pattern as revealed in both the subordi-
the responsibility of the Federal Trade Com- nated debt calculations and monthly past-due
mission. reports. It is possible that a currently adverse
portfolio condition may be due to local eco-
nomic conditions which correct themselves over
3100.0.4.7 Asset Classification Policy a period of time. Such conditions may relate to a
tourist economy, an agricultural community, or
As previously discussed, companies use one of a strike at a major local employer’s plant. Con-
two different methods of delinquency computa- sumer finance companies are very sensitive to
tion. In general, classifications should be based these local factors; therefore, these factors may
on the contractual reporting basis whenever temper the examiner’s evaluation of the loss
possible. Since much of the industry utilizes reserves.
recency reporting, which tends to reduce classi-
fications comparatively, the classification
approach enumerated above may unduly penal- 3100.0.4.8 Ratio Analysis
ize an affiliated company using the contractual
basis. This is particularly true when such impor- In order to assess the condition of a company
tant measures of portfolio quality as the liquida- using ratio analysis, the examiner will have to
tion ratios are in line with industry averages. be familiar with the company’s accounting poli-
Therefore, formula classification may result in cies and systems. It will become obvious from
more severe classifications for companies using the data used in the ratios that, under certain
the contractual method than those reporting on a accounting treatments, the data can be misinter-
recency basis. Examiners should indicate the preted. The following analysis has been struc-
reporting method used when calculating tured around the Direct Cash Lending Question-
classifications. naire, published by the Robert Morris Associ-
Classification information is used to evaluate ates and endorsed by the National Consumer
the adequacy of the loss reserve. In assessing Finance Association, in an effort to provide both
the adequacy of the loss reserves, the examiner a format for developing the information and a
should take into consideration the charge-off means of minimizing the possibility of misinter-
frequency, the period of delinquency which pretation. While some consumer companies do
would require charge-off under company policy, not prepare the questionnaire, much of the infor-
and the controls regarding renewal of severely mation is required for management purposes
past-due accounts. A shorter charge-off cycle and should be available from company systems.
prevents the accumulation of poor-quality assets; The analytical factors presented have been
in this respect, monthly charge-offs are prefer- derived from two principal sources: A Lender’s
able to annual charge-offs. An unlimited ‘‘when Approach to a Realistic Analysis of Consumer
deemed uncollectible’’ charge-off policy is con- Finance Companies by Richard E. Edwards
sidered lax and inadequate. The delinquency (Philadelphia: The Philadelphia National Bank,
period to required charge-offs refers to the period 1970) and the Industry Audit Guide: Audits of
of time a loan is past due before it is charged to Finance Companies by the Committee on Finance
the reserve; a six-month period is understand- Companies (New York: American Institute of
ably preferred to a nine-month or one-year
period. Management should have sufficient con- BHC Supervision Manual December 1997
trols in place to prevent the continued Page 5
Certified Public Accountants, 1988). These will tend to show a higher principal collec-
sources provide basic information on certain tion percentage and, accordingly, a higher
accounting and management policies and are liquidity. This ratio can be used to estimate
recommended as references for the examiner. near term collections as compared to current
While the Federal Reserve System stipulates no outstandings.
specific accounting policies, the examiner may Monthly cash collections should not include
choose to criticize those policies which result in loan renewals or rebates during the period.
a misleading presentation of the company’s On an industry-wide basis, there appears to
financial condition. be a pattern of increased loan renewals dur-
Each year the Annual Statement Studies, pub- ing November and December, which would
lished by Robert Morris Associates, includes be reflected in a seasonal decrease in princi-
sets of consumer finance company operating pal cash collections. Lower than expected
ratios. This information will provide a back- collections may be indications of changes in
ground against which the performance of the local economic patterns or of increased mar-
company under inspection can be measured. ket effort by a competitor which has resulted
Such compiled ratios should be used only as in loan payoff. In any event, adverse change
background as they represent the ‘‘average com- in the collection pattern should be reviewed
pany’’ in the respective sample. Attention should for the underlying causes.
be directed toward the company’s trends as they 2. The ratio of unsubordinated liabilities less
compare to the industry’s trends and the changes cash and near cash to estimated monthly
in the company that are indicated by those principal collections results in the number of
trends. months it would take to pay senior debt.
3. The ratio of senior debt to gross receivables
reflects the proportion of gross receivables
3100.0.4.9 Delinquency which would have to be liquidated to repay
senior debt. The higher the percentage, the
As shown in the Annual Statement Studies, the more senior lenders are relying on the assets
delinquency rates are on a recency-of-payment for protection.
basis. While past-due statistics based on con-
tractual payments are preferred, companies con-
tinue to report on a recency basis. It is important 3100.0.4.11 Loss Reserves
to have full knowledge of the company’s report-
ing, lending, and renewal policies in order to Analysis of the loss reserve for a specific entity
fully understand the implications of this data. has to include company policy regarding loan
The trends for ‘‘interest-only’’ accounts and charge-offs, delinquencies, payments, and charge-
‘‘partial-payment’’ accounts will provide some off frequency. In addition, if charge-offs are
measure of the adherence of the operating per- made gross of deferred income, the reserve
sonnel to company policy regarding these loan account may be slightly larger than if charge-
categories. offs were net of deferred income. Ratios used to
evaluate loss reserves include—
1. Reserve for loan losses to total receivables,
3100.0.4.10 Liquidation net of deferred income,
2. Loans charged off less recoveries to average
Liquidation ratios provide two types of informa- outstandings (net or gross of deferred income,
tion. First, they indicate the amount of principal depending on policy).
cash flowing back to the company for liquidity Unless the company’s charge-off and
purposes. Secondly, they indicate the amount delinquency policies are realistic, this ratio
required to pay senior debt and the period of will not depict true losses over the periods,
time required to do so. Several ratios follow: and
1. Average monthly cash principal collection to 3. Recoveries to loans charged off tends to be
average net monthly outstanding. higher in companies with conservative charge-
The higher this percentage, the more liq- off policies than those with liberal policies.
uid the portfolio. A company following con- This ratio is indicative of the effectiveness of
servative policies such as requiring full pay- a company’s collection and follow-up policy.
ments and a contractual aging of receivables
BHC Supervision Manual December 1997 3100.0.4.12 Volume

Page 6
Analyzing aspects of a company’s loan volume
can provide the examiner with some informa- In comparing classifications from one inspec-
tion regarding the company’s renewal and credit tion to another, there might be a difference in
policies. the loss classifications which may be interpreted
Lengthening of loan maturities during the as an apparent improvement or decline in asset
current period will be reflected in the future quality should the inspections bracket the charge-
average monthly principal collections and in the off date. Similar misinterpretations can occur
company’s liquidity. While loans of longer from a change in charge-off frequency, a change
maturity are not necessarily indicative of an to an automatic charge-off policy, or a shorten-
adverse trend, the reasons behind a longer matu- ing in the past-due period required for charge-
rity portfolio should be analyzed. Ratios used to off.
evaluate loan volume include: Certain accounting and reporting techniques
1. New money advanced to present borrowers may also be misleading in ratio analysis. For
to total loan volume. example, an artificial improvement in earnings
would be reported when a company changes
This ratio is somewhat indicative of whether from a collection basis to an accrual basis of
the company’s renewal policy is conserva- income recognition, if the collection and
tive or liberal. A high percentage may indi- follow-up policy had been poor or deteriorating.
cate that a volume of new money is being Only a thorough review of the accounting poli-
advanced along with the renewal of the pre- cies and an understanding of their interplay with
vious balance. operating policies will prevent this type of mis-
2. Loans to present borrowers with less than 10 interpretation. In some cases, the company’s
percent new money advanced to loan volume. accounting system may yield results that inad-
A high ratio can indicate the possibility of vertently distort the ratios. A company recogniz-
disguised delinquencies and potential charge- ing income on a straight-line basis would, dur-
offs. The examiner may take a random sample ing a period of low loan volume, reflect improving
of loans in the new money advanced to gross interest income as a percentage of loans
present borrowers category and review them outstanding. While the importance of realistic
to determine whether or not the company’s accounting policies cannot be overstated, nei-
‘‘balance renewal’’ policy is being followed. ther can the proper interpretation of reported
The preceding ratios were presented because results be overstressed.
they represent a means of measuring the effect One of the key elements in the evaluation of
of certain company policies. The analysis of the company’s performance is reflected in the
company operations may be expanded to include ratios, but not quantified by the analysis. The
other ratios such as return on equity, return on company’s internal controls and management
assets, interest margins, and other conventional information systems are the primary means of
measurements. The particular format utilized controlling asset quality and communicating
will, of course, vary to some degree between management’s policies. The supervisory effort
companies, however, the analysis should be is not only reflected by the ratios, but also in
broad enough in scope to determine the compa- such areas as personnel turnover, citations in
ny’s trends and the causes of those trends. state supervisory reports, audit exceptions, and
litigation. The systems relied on by manage-
ment should be responsive not only to the chang-
ing needs of the company, but also to the chang-
3100.0.4.13 Evaluation of the Company’s ing climate of consumer regulations.
Condition In the inspection report commentary, the
examiner should maintain an objective view of
Ratio analysis of a consumer finance company the company under inspection. Management’s
is a feasible technique for evaluating its condi- corrective actions for exceptions and plans to
tion because of the ‘‘portfolio effect’’ of its reverse adverse trends are a necessary ingredi-
assets. However, the examiner must look beyond ent in the commentary. Report comments should
the ratios and analyze the effects of company give the reader an accurate picture of the condi-
policies on the elements of the ratios. As an tion of the company and its relationship with,
example, if a company only charges off loans and impact on, the financial condition of the
once a year, the losses determined by a formula consolidated corporation and the subsidiary
classification would be less just after the charge- bank(s).
off date than just before.
Page 7
Activities not closely 225.126 4–184

related to banking
Marketability of collateral 3–1121 1935 FRB 395

under section 23A
Activities closely related to 225.123 4–176 1971 FRB 514

banking 1975 FRB 245
Expansion of activities 225.28(b)(1) 1984 FRB 371

of a trust company, or 1985 FRB 51
acquisition of a de novo 1985 FRB 55
bank, to include consumer 1985 FRB 61
lending 1985 FRB 253

Page 8
Section 4 (c)(8) of the BHC Act
(Acquiring Debt in Default) Section 3104.0
The Board amended Regulation Y, effective company in managing certain assets as the cor-
April 21, 1997, to include the acquiring of debt porate general partner in two limited partner-
in default as an authorized nonbanking activity ships (the partnerships).1 The applicant commit-
for bank holding companies (see Regulation Y, ted to conduct the activities, which the Board
section 225.28(b)(2)(vii)). A bank holding may previously determined to be permissible, through
acquire debt that is in default at the time of the partnerships, subject to the limitations previ-
acquisition if the company— ously established by the Board.2
One nonbanking activity proposed by the
1. divests shares or assets securing debt in partnerships, acquisition of defaulted debt, was
default that are not permissible investments an activity that the Board had not previously
for bank holding companies, within the time approved. The partnerships are engaged prima-
period required for divestiture of property rily in making, servicing, and investing in dis-
acquired in satisfaction of a debt previously counted bank loans and other debt securities.3
contracted under section 225.12(b) of Regu- The partnerships acquire debt that has been or is
lation Y; in the process of being restructured, including
2. stands only in the position of a creditor and secured and unsecured debt in the form of bank
does not purchase equity of obligors of debt loans, privately placed and publicly traded debt
in default (other than equity that may be instruments, bonds, notes, debentures, and dis-
collateral for such debt); and counted receivables.4 The applicant stated that
3. does not acquire debt in default secured by the partnerships will take an active role in the
shares of a bank or bank holding company. restructuring of the defaulted debt they acquire,
including participating on creditors’ commit-
The Board held that these restrictions were tees. The applicant indicates that such dis-
necessary to define the scope of the activity and counted debt would be acquired for the purpose
to ensure that the activity remains the acquisi- of restructuring the debt to achieve a higher
tion of debt instead of an impermissible non- yield and greater collateral protection.
banking activity involving the acquisition of Some of the debt the partnerships would
securities or other assets. As for calculating the acquire may be in default at the time of acquisi-
time period for disposing of the underlying tion and may be secured by voting shares or
shares or assets, the time period is the same as
that applied under the BHC Act to disposing of
shares or assets acquired in satisfaction of a debt
previously contracted. During this period, a 1. The first partnership group (in which the company
bank holding company can divest the property owned more than a 50 percent interest) was to terminate by
December 31, 1995. The company owned less than 50 percent
or, in the case of any debt that has been previ- of the second partnership group, which would terminate by
ously contracted, restructure the debt. December 31, 1999.
The initial Board order that was issued to 2. See 1994 FRB 736. The partnerships, together with the
permit the acquisition of defaulted debt is sum- applicant and its affiliates, would hold not more than 5 percent
of any class of voting securities of any issuer and not more
marized here as a historical example of the than 25 percent of the total equity, including subordinated
nonbanking activity. Provisions or commitments debt, of any issuer. In addition, the applicant committed that
made in the Board order should not be relied no directors, officers, or employees of the applicant or its
upon. The current requirements are found in affiliates will serve as directors, officers, or employees of any
issuer of which the applicant and its affiliates hold more than
section 225.28(b)(2)(vii) of Regulation Y. 10 percent of the total equity. The applicant also committed
that future limited partnerships would be structured in the
same manner as the current partnerships.
3104.0.1 ACQUISITION OF 3. The partnerships are not leveraged, and the applicant
stated that the partnerships will not be leveraged. The appli-
DEFAULTED DEBT—BOARD ORDER cant has committed that neither the applicant nor any of
its subsidiaries would be permitted to make loans to the
A bank holding company (the applicant) within partnerships.
the meaning of the BHC Act gave notice under 4. The debt investments may include investments in com-
panies that may be contemplating, be involved in, or recently
section 4(c)(8) of the BHC Act (12 U.S.C. have completed a negotiated restructuring of their outstanding
1843(c)(8)) and the Board’s Regulation Y that it debt or a reorganization under chapter 11 of the Federal
proposed to acquire a company (the company) Bankruptcy Code.
and engage nationwide in asset-based commer-
cial lending and management of assets. BHC Supervision Manual June 1999
The applicant proposed to engage through the Page 1
Section 4 (c)(8) of the BHC Act (Acquiring Debt in Default) 3104.0
other assets that would be impermissible for a The Board stated that the acquisition of
bank holding company to hold without Board defaulted debt under the circumstances and con-
approval.5 Because the partnerships would have ditions proposed by the applicant is an activity
the right in some cases to take title immediately that is closely related to banking. The applicant
to shares or assets securing defaulted debt that stated that it will only purchase debt, not equity,
they acquire, the applicant committed that the and will stand in the position of a creditor.
partnerships would treat this collateral, as well Based on all the facts of record, the Board
as any other assets acquired in renegotiating this concluded that the proposed activities are closely
debt, as assets acquired in satisfaction of a debt related to banking. The Board approved the
previously contracted (DPC). Under the BHC notice on October 17, 1995 (see 1995 FRB
Act, a bank holding company must divest any 1128). Approval was specifically conditioned
shares or assets acquired as DPC within two on the applicant’s compliance with the commit-
years from the date the asset is acquired. For ments made in connection with the notice.
this purpose, the applicant has committed that it
will consider shares or assets acquired in satis-
faction of defaulted debt to have been acquired
on the date the defaulted debt is acquired.6
5. The applicant has committed that the partnerships will

not acquire debt in default that is secured by shares of banks
or bank holding companies.
6. The applicant could apply for up to a three-year exten-
sion. See 12 C.F.R. 225.22(d)(1). The Board notes that the
divestiture requirement would be satisfied if, during the dives-
titure period, the partnerships renegotiate the debt into a
performing obligation and release the collateral to the bor-
rower as part of the renegotiation. To the extent that defaulted
debt acquired by the partnerships is secured by assets or
shares that would be permissible investments for a bank
holding company, this divestiture commitment would not
apply.

Page 2
Section 4(c)(8) of the BHC Act (Credit Card Authorization
and Lost/Stolen Credit Card Reporting Services) Section 3105.0
A bank holding company applied for the Board’s credit card authorization services, banks have a
approval, pursuant to section 4(c)(8) of the BHC financial interest in the security of the credit
Act, to engage de novo, through its existing cards and the availability of credit. Based on the
nonbank subsidiary, in credit card authorization foregoing, the Board believed that banks gener-
services and lost/stolen credit card reporting ally have, in fact, provided the services pro-
services. The credit card authorization activity posed by the applicant and are particularly well
would consist of providing, for a fee, a service suited to provide the proposed services. On that
to issuers of credit cards that would enable basis, the Board concluded that the proposed
merchants to determine the validity and credit services were closely related to banking.
limits of cards tendered to them. In addition, the Since the proposed credit card reporting ser-
applicant was to provide, for a fee, a reporting vice would create more competition and provide
service to credit card holders, that would enable greater conveniences by allowing an individual
them to report the loss or theft of any of their who loses more than one card to report all lost
credit cards via a single toll-free telephone call cards at once to one source rather than having to
to the nonbank subsidiary. make separate notifications to each card issuer,
A number of banks indirectly offer the ser- and there was no evidence of adverse effects as
vice of reporting lost cards that are issued by a result of the proposal, the application was
other institutions by arranging with independent approved by the Board on January 5, 1985
companies to provide the service under a trade (1985 FRB 648). See Regulation Y, sec-
name associated with the bank. With respect to tion 225.28(b)(2).

Page 1
(Stand-Alone Inventory-Inspection Services) Section 3107.0
A domestic bank holding company (the appli- BHC (applicant) or a third pary. The service
cant) applied for the Board’s permission under would be provided throughout the United States,
section 4(c)(8) of the BHC Act and section but only in connection with inventory pledged
225.23(a)(3) of the Board’s Regulation Y to as collateral for a loan.
engage de novo, through a wholly owned sub- Bank holding companies currently inspect
sidiary, in the following services to customers and survey collateral for loans made or services
who make loans secured by inventory: provided by them. Banks inspect collateral for
loans originated in direct lending activities. The
1. identifying inventory and deciding its gen- applicant suggested that its proposed collateral-
eral condition, level of protection, and amount inspection services to third-party lenders are
of use, as appropriate identical to the collateral-inspection services
2. identifying inventory subject to a purchase- performed for its own extensions of credit.
money security interest under the Uniform In accordance with section 225.28(b)(1) of
Commercial Code Regulation Y, the Board authorized bank hold-
3. identifying missing inventory and any credit ing companies to make, acquire, and service
exposure that could result loans for the company’s own account or for the
4. supporting the proper allocation of loan pay- account of others. The Board believes that these
ments that are related to the aging or sale of activities include collateral-inspection services
inventory1 provided to third parties in connection with
third-party extensions of credit. The Board also
The applicant would provide the above believes that bank holding companies have the
inventory-inspection services only in connec- necessary expertise to provide this service for
tion with an extension of credit either by the other lenders (on a stand-alone basis).
The Board found that public benefits would
result from a potential increase in the availabil-
ity of inventory financing. It noted that there
was no evidence suggesting that the proposal
1. For example, a loan may be secured by a pool of
inventory collateral, but there may be an agreement to apply
would result in significant adverse effects. The
loan proceeds to specific items of collateral in a specified financial and managerial resources of the appli-
order. Equipment used beyond a stated number of hours might cant were believed to be consistent with previ-
be of limited value, and the lender might agree to release its ous approvals. The Board, based on the facts of
security interest in such items. The inspection of inventory
collateral would verify the equipment’s proceeds to pay off
record, and the commitments and conditions
the oldest (or the youngest) items of collateral first (or last), made by the applicant, approved the request on
rather than applying the proceeds pro rata to all items. September 13, 1993 (1993 FRB 1053).

Page 1
(Industrial Banking) Section 3110.0
A bank holding company may acquire or retain risk-weighted assets (on a consolidated basis)
an industrial bank to the extent authorized by of the acquiring lending company or indus-
state law, under section 225.28(b)(4) of Regula- trial bank, or more than $100 million, which-
tion Y only if the industrial bank acquired by ever amount is less;
the holding company is not a ‘‘bank’’ within the • the assets acquired do not represent more than
meaning of the Bank Holding Company Act. 50 percent of the selling company’s consoli-
Industrial loan companies, industrial banks, and dated assets that are devoted to lending activities
Morris Plan banks are state-chartered financial or industrial banking business;
institutions which engage primarily in the busi- • the acquiring company notifies the Reserve
ness of furnishing consumer loans and small- Bank of the acquisition within 30 days after
business loans. The distinction between these the acquisition; and
institutional forms and consumer finance com- • the acquiring company, after giving effect to
panies lies in the ability to generate funds through the transaction, meets the Board’s capital
the acceptance of deposits or issuance of certifi- adequacy guidelines and the Board has not
cates of indebtedness (thrift notes). Although previously notified the acquiring company
some of these institutions have the same char- that it may not acquire the assets under the
ters as banks (in some states), they traditionally exemption.
have not been considered to be banks for pur-
poses of the Bank Holding Company Act as
they cannot both make commercial loans and 3110.0.2 INSPECTION OBJECTIVES
accept demand deposits, although in some states
they have been empowered to offer NOW 1. To determine the quality of the loan portfolio
accounts. Under a decision of the Supreme and the overall condition of the company.
Court, NOW accounts are not demand deposits 2. To determine what exposure the subsidiary
for the purposes of defining what a bank is. presents to the holding company and subsidi-
Thus, industrial loan companies and similar ary bank(s).
institutions may offer NOW accounts and make 3. To determine compliance with applicable
commercial loans without being treated as banks laws and regulations.
for purposes of the Bank Holding Company
Act. These institutions may be insured by the
Federal Deposit Insurance Corporation and are 3110.0.3 INSPECTION PROCEDURES
eligible for membership in the Federal Reserve
System. Many of the companies are ‘‘self- 1. Contact the applicable state regulatory agency
insured’’ (by a consortium of similar institutions to determine the legal parameters within
in the form of a guaranty corporation) or are which the company operates and to assess
uninsured. the degree to which the company is super-
vised. Each of the institutional structures
under this exemption is state chartered, and
3110.0.1 NONBANKING the laws and regulations vary widely from
ACQUISITIONS NOT REQUIRING state to state. The company may be directly
PRIOR BOARD APPROVAL supervised by its state department of bank-
ing or may be subject to virtually no super-
In accordance with 12 C.F.R. 225.22(d)(8) of vision or regulation. If the company is
Regulation Y, the Board’s prior approval is not insured by the Federal Deposit Insurance
required for certain asset acquisitions by a lend- Corporation or is a member of the Federal
ing company or industrial bank. This refers to Reserve System, the company is primarily
the assets of an office(s) of a company of which subject to the primary supervision and regu-
all, or substantially all, the assets relate to mak- lation of that agency. In cases in which the
ing, acquiring, or servicing loans for personal, company is supervised by a banking agency,
family, or household purposes, if— that agency’s report of examination will
generally suffice. However, when the com-
• the acquiring company has previously received pany is not supervised or examined, or
Board approval to engage in lending or indus- when the Reserve Bank finds the supervis-
trial banking activities under Regulation Y;
• the assets acquired during any 12-month period BHC Supervision Manual December 1997
do not represent more than 50 percent of the Page 1
Section 4(c)(8) of the BHC Act (Industrial Banking) 3110.0
ing agency’s report inadequate, an on-site dent of any government agency or munici-
inspection is necessary. pality and therefore are limited in the amount
2. Focus on an evaluation of the loan portfolio of protection which can be offered depositors.
and securities account, a determination of 6. Review back-up lines of credit available to
the volatility of the deposits, an appraisal of ensure secondary liquidity to the company.
the adequacy of the audit program, and a 7. Review the deposit accounts of the com-
review of the company’s internal policies. pany. The deposits are evidenced by certifi-
3. Review the receivables representing lend- cates of indebtedness, or thrift notes. Infor-
ing activities. The company should provide mation regarding the number of deposits,
a schedule of the aging of the consumer the size of accounts, and maturity distribu-
receivables. It is preferable that the aging tion should be obtained to assess the stabil-
be done on a contractual method. Classifi- ity of the funding base.
cation of the consumer paper may be done
on a formula basis. The larger credits must 8. Determine that the institution makes proper
be given a complete evaluation. disclosure to the public as to the type of
4. Review the adequacy of the allowance for instrument the certificate represents. Some
loan and lease losses in conjunction with states require that a disclosure statement, or
the asset evaluation. a prospectus, be filed with the public yearly,
5. Price the securities portfolio, with particular which sets forth the uses to which the funds
emphasis placed upon determining its are being put and states that the funds are
liquidity. Since the deposits of these institu- not insured. This prospectus should be
tions are not always insured, they are more reviewed for proper disclosure of the required
susceptible to a deposit run off; therefore, information to ensure against possible suits.
the requirement of adequate liquidity is of 9. Check the company’s policy concerning
paramount importance. withdrawals, giving recognition to state law
The deposits may be insured by a guar- requirements, to ascertain whether funds are
anty corporation up to a certain limit in generally not allowed to be withdrawn with-
some states. These guaranty corporations out prior notice.
have provided some stability to the indus- 10. Review the scope of the internal or external
try. The guaranty corporations are indepen- audits.
Subject Laws 1 Regulations 2 Interpretations Orders
Reference for authorized 225.28(b)(4) 1982 FRB 253

nonbanking activity— 1983 FRB 921
activity closely related to 1984 FRB 231
banking 1984 FRB 234
1984 FRB 371
1984 FRB 469
1984 FRB 741
1985 FRB 476
Nonbanking acquisition not 225.22 (d)(8)

requiring Board approval
(conditions specified)

Page 2
(Acquisition of Savings Associations) Section 3111.0
WHAT’S NEW IN THIS REVISED The Board may not impose these restrictions on
SECTION such transactions in the future, except for those
restrictions required by sections 23A and 23B of
Effective January 2006, this section has been the Federal Reserve Act.
revised to clarify that bank holding companies With respect to previous Board approvals of
may acquire, and thereby engage in operating, a the acquisition of problem thrifts by BHCs,
savings association. Bank holding companies, FIRREA required the Board to modify those
however, must conform the acquired associa- approvals by limiting any restrictions on trans-
tions’ nonbanking activities to those permissible actions between the savings association and
under section 4 of the Bank Holding Company its holding company affiliates to those required
Act (the BHC Act). The section also discusses or under sections 23A and 23B of the Federal
lists additional Board orders that have autho- Reserve Act. In 1989, the Board removed the
rized the acquisition of savings associations. tandem restrictions imposed on the operations
of savings association subsidiaries of a bank
holding company. (See 1989 FRB 71b.)
3111.0.1 ACQUISITION OF A The Board amended Regulation Y pursuant
SAVINGS ASSOCIATION to FIRREA, effective October 10, 1989 (12
C.F.R. 225.28(b)(4)(ii)). The regulation allows
Prior to 1989, the Board had determined that bank holding companies to acquire healthy and
the operation of a savings association was closely failed or failing savings and loan associations in
related to banking but concluded, as a general accordance with FIRREA. The regulation per-
rule, that the operation of a savings and loan mits bank holding companies to acquire savings
association was not a proper incident to banking and loan associations in any state, regardless of
because the potential adverse effects, of allow- whether the holding company may operate a
ing the affiliations of banks and thrift institu- bank in that state. It does not impose any opera-
tions outweighed the potential public benefits tional or branching conditions on the operation
(1977 FRB 280). Upon consideration of some of savings and loan associations. The regulation
individual cases, the Board found that the adverse authorizes, as a permissible activity under sec-
effects of the affiliation would be outweighed by tion 4(c)(8) of the BHC Act, the owning, con-
the public benefits of preserving the failing thrift trolling, or operating of a savings association if
institution as a competitor in its market and of the savings association engages only in deposit
ensuring public confidence. (See 1985 FRB taking, lending, and other activities that are per-
462.) The 1982 Garn–St Germain Act recog- missible for BHCs.1 The Board has permitted a
nized the Board’s authority under section 4(c)(8) short divestiture period for impermissible invest-
of the BHC Act to approve such acquisitions ments and other activities. (See 1992 FRB 707.)
by authorizing the Board to dispense with the
necessary notice and hearing requirements of The Board requires that when a bank holding
this section under appropriate emergency company acquires a savings association, the
circumstances. BHC must conform the acquired institution’s
The Financial Institutions Reform, Recovery, direct and indirect activities to those permissible
and Enforcement Act of 1989 (FIRREA) for bank holding companies under section 4 of
amended section 4 of the Bank Holding Com- the BHC Act. In 2002, a foreign banking organi-
pany Act to authorize, effective August 9, 1989, zation subject to the provisions of the BHC Act,
bank holding companies to acquire any savings and its wholly owned subsidiary, requested the
association. The legislation lifted the previously
existing ‘‘tandem operations’’ restrictions as
1. Section 225.2(m) of Regulation Y defines a savings
they applied to savings associations owned by association as (1) any federal savings association or federal
bank holding companies. (See 1989 FRB 716, savings bank; (2) any building and loan association, savings
appendix I.) These restrictions (1) provided that and loan association, homestead association, or cooperative
savings associations acquired by a bank holding bank if such association or cooperative bank is a member of
the Savings Association Insurance Fund; and (3) any savings
company could not be operated in tandem with bank or cooperative deemed by the director of the Office of
any other subsidiary of the bank holding com- Thrift Supervision to be a savings association under section
pany and (2) required approval by the appropri- 10(l) of the Home Owners’ Loan Act.
ate Federal Reserve Bank before the savings
association engaged in any transactions with the BHC Supervision Manual January 2006
bank holding company or its other subsidiaries. Page 1
Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0
Board’s approval under section 4(c)(8) and sec- sidiary of the same holding company. This pro-
tion 4(j) of the BHC Act to acquire a savings vision, known as the Oakar amendment,2 autho-
association and thereby engage in operating a rized bank holding companies to (1) merge
savings association, and to conduct certain non- troubled savings associations into bank subsidi-
banking activities as a result of that acquisition. aries during the moratorium and (2) avoid
The foreign banking organization committed the payment of exit and entrance fees to the
that it would conform all the activities of the deposit insurance funds required under FIRREA
acquired savings association to those permis- for other savings association conversion
sible under section 4(c)(8) of the BHC Act and transactions.
Regulation Y. (See section 225.28(b)(4)(ii). See A FIRREA provision (12 U.S.C. 1815(e))
also 2002 FRB 385, 2002 FRB 485, 2003 FRB addressing the liability of commonly controlled
439, 2004 FRB 503, and 2005 FRB 91.) The institutions has a significant bearing on BHCs.
foreign banking organization was also treated as Any insured depository institution is liable for
a financial holding company. Any other activi- any loss incurred by the FDIC in connection
ties of the acquired savings association were, with a commonly controlled insured depository
therefore, required to conform to those permis- institution in default or in danger of default.
sible for a financial holding company under (See section 2090.8 for a discussion of this
section 4(k) of the BHC Act. provision and section 2021.1 for a discussion on
FIRREA previously established a five-year the sister-bank exemption from sections 23A
moratorium on any acquisition that involved the and 23B of the Federal Reserve Act.)
transfer of deposits from one federally insured
deposit fund to another, with limited exceptions.
As a general rule, the moratorium prevented an
institution whose deposits were insured by the 2. The Federal Deposit Insurance Corporation Act of 1991
amended the Oakar provision (commonly referred to as the
Savings Association Insurance Fund (SAIF) from ‘‘Oakar II amendment’’) to authorize a bank that is not a
converting to an institution whose deposits were subsidiary of a bank holding company to merge directly with
insured by the Bank Insurance Fund (BIF). A a thrift. The Riegle Community Development and Regulatory
provision of FIRREA provided that this morato- Improvement Act further amended the Oakar provisions to
eliminate the requirement for prior Federal Reserve Board
rium did not apply to the merger of a SAIF- approval of Oakar transactions when the bank involved (in an
insured savings association owned by a bank acquisition of a thrift) is a Bank Insurance Fund member
holding company into a BIF-insured bank sub- subsidiary bank of a bank holding company.
3111.0.2 LAWS, REGULATIONS, INTERPRETATIONS, ORDERS
Activity approval 1843(4)(i) 225.28(b)(4)(ii) 1997 FRB 275
Determination that the 1989 FRB 86

operation of a thrift 1986 FRB 724
institution is closely related 1986 FRB 342
to banking 1985 FRB 340
1983 FRB 812
1982 FRB 660
1982 FRB 316
1977 FRB 280
1974 FRB 868

Page 2
Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0
Bank holding companies 225.28(b)(4)(ii) 2005 FRB 91

acquiring savings associations 2004 FRB 503
must conform their direct and 2003 FRB 439
indirect nonbank activities to 2002 FRB 485
those permissible for bank hold- 2002 FRB 385
ing companies
Acquisition of stock savings 1985 FRB 462

and loan associations
Removal of tandem restrictions 1989 FRB 716
Establishing branches on an 1993 FRB 890

interstate basis after
acquisition
Minority investment (interest) 1995 FRB 509

in a savings bank


Page 3
(Trust Services) Section 3120.0
The performance of trust services by a trust administration and may not be offered or mar-
company subsidiary that is neither a ‘‘bank’’ nor keted as a separate service.
a nonbank bank encompasses virtually any kind The board of directors and senior manage-
of fiduciary, agency, or custodial service comment of financial holding companies (FHCs)
monly performed by a trust company so long as and bank holding companies (BHCs) are
the subsidiary does not accept demand deposits responsible for overseeing the operations of
or make loans, except as expressly permitted by their fiduciary activities in a safe and sound
section 225.28(b)(5) of Regulation Y. Generally, manner. Such oversight (particularly for those
under Regulation Y, a trust company may only BHCs and FHCs engaged in a broad range of
accept deposits arising out of trust funds not financial activities) at the consolidated level is
currently invested; perform escrow services, important because the risks associated with finan-
such as receiving, holding, and disbursing down- cial activities as well as fiduciary activities can
payments and other funds deposited by purchas- cut across legal entities and business lines. Fed-
ers in real estate transactions; and act as an eral Reserve examiners review and assess the
agent for an issuer of, or broker or dealer in, internal policies, reports, and procedures and
securities in a capacity of a paying agent, effectiveness of the BHC/FHC consolidated risk-
dividend-disbursing agent, or securities clearing management process.
agent, so long as the funds are not used by the The appropriate regulator of trust activities
customer as a general-purpose checking account (including activities of a fiduciary, agency, or
and do not bear interest. The subsidiary’s lend- custodial nature) has the primary responsibility
ing activities are restricted to making call loans for evaluating risks, hedging, and risk manage-
to securities dealers and to purchasing money ment at the legal-entity level for any subsidiary
market instruments; however, such loans may or subsidiaries that the regulator supervises.
not be used to provide funding for nonbank Federal Reserve examiners should seek to use
subsidiaries of the holding company. the examination findings of the appropriate regu-
Trust companies may be either state chartered lators. (See SR-00-13.)
or nationally chartered. Some nationally char- To determine the complete scope of fiduciary
tered trust companies have national bank char- assets within an FHC/BHC, examiners should
ters but have agreed through limitations in their reference the Uniform Bank Performance Report
bylaws to engage only in those activities permit- (UBPR), which reflects the information gath-
ted for trust departments of national banks. To ered on Schedule RC-T. To further understand
prevent the use of a trust company as a vehicle the scope of fiduciary assets within an FHC/
for evasion of section 3(d) of the Bank Holding BHC, an examiner should also look at informa-
Company Act, the Board has conditioned its tion reported on Schedules Y-11 and Y-9C with
approval of certain interstate acquisitions by respect to income derived from trust, fiduciary,
requiring that (1) the trust company’s demand and asset-management activities. (See also page
deposit–taking activities not be operated in tan- 4 of the Bank Holding Company Performance
dem with any other subsidiary, (2) demand Report (BHCPR) for the amount and percent-
deposit and commercial lending services of ages of income from fiduciary activities to
affiliates will not be linked in any way, and adjusted operating income (tax-equivalent),
(3) the trust company will not engage in any including the BHC’s corresponding peer-group
transactions with affiliates, other than the pay- ratios.)
ment of dividends or the infusion of capital, Peer analysis is also available at the bank
without the Board’s approval (for example, see level. Examiners should refer to pages Trust 1
U.S. Trust Corporation, 1984 FRB 371). The and Trust 1A of the UBPR. General comparison
scope of these conditions may be reviewed by information is also available on a lagged basis
the Board in connection with nonbank bank in the FFIEC’s electronic report ‘‘Trust Assets
applications. of Financial Institutions’’ (www2.fdic.gov/
As part of normal administration of its trust structur/trust/index.asp). Aggregate data are listed
accounts, a trust company will from time to time by year back to 1996.
engage in an activity, such as property manage-
ment or land development, that has been
determined to be not closely related to banking
by the Board. Any such service may only be BHC Supervision Manual December 2003
performed incidentally to fiduciary-account Page 1
Section 4(c)(8) of the BHC Act (Trust Services) 3120.0
3120.0.1 ON-SITE INSPECTIONS regular examination by another federal banking

agency (i.e., if it is an uninsured, state-chartered
Trust companies are normally engaged in activi- nonmember trust company), the Reserve Bank
ties such as management of funds for individu- should perform regular on-site inspections to
als. These activities are significant to the integ- include, at a minimum, full-scope reviews of the
rity of the banking system and involve significant trust activity. The inspections would use proce-
potential liability to the bank holding company dures such as those used in the examinations of
if not properly conducted. Therefore, periodic trust activities of state member banks. This por-
on-site inspections should be performed. If the tion of the inspection should be performed by
trust company is examined by a state banking examiners specially trained in trust examina-
department, then alternate-year examination pro- tions. Holding company inspectors should spe-
cedures may apply. If nationally chartered, a cifically review trust activities for compliance
review of the periodic on-site examinations of with any conditions imposed by the Board in
the Comptroller of the Currency will generally connection with the approval of an application.
suffice. If the trust company is not subject to a

Page 2
(General Financial and Investment Advisory Activities) Section 3130.0
The main sections that follow (sections 3130.1 registered under that act, including sponsor-
through 3130.9) address all financial and investing, organizing, and managing a closed-end
ment advisory activities under section 4(c)(8) of investment company;
the BHC Act and section 225.28(b)(6) of Regu- 2. furnishing general economic information and
lation Y that have been authorized by the Board. advice, general economical statistical fore-
This section provides general inspection objec- casting services, and industry studies;
tives and procedures that relate to such financial 3. providing advice in connection with mergers,
and investment advisory activities. These objec- acquisitions, divestitures, investments, joint
tives and procedures can be applied to the BHC ventures, leveraged buyouts, recapitaliza-
inspection of every advisory activity when advi- tions, capital structurings, financing transac-
sory activities are not listed separately in any of tions and similar instruments, and conduct-
this manual’s individual advisory sections. ing financial-feasibility studies;
Any commitments that were made by the 4. providing information, statistical forecasting,
bank holding company or its nonbank subsidi- and advice with respect to any transaction in
aries to the Federal Reserve System pertaining foreign exchange, swaps, and similar transac-
to its financial and investment advisory non- tions, commodities, and any forward con-
banking activities should be reviewed by the tract, option, future, option on a future, and
examiner for compliance and applicability, in similar instrument;
accordance with the current statutory and regu- 5. providing educational courses and instruc-
latory provisions. Any existing commitments or tional materials to consumers on individual
conditions that relate to the financial resources financial-management matters; and
of a bank holding company or its subsidiaries or 6. providing tax-planning and tax-preparation
to commitments or conditions that relate to the services to any person.
risk-management policies of the organization
should remain intact and should be reviewed Sections 3130.1 through 3130.9 include many
by an examiner for compliance during each historical examples of various financial and
inspection. investment advisory activities that have been
The Board’s Regulation Y, effective April approved by the Board. These examples are to
1997, resulted in a structural reorganization of be viewed as historical references. They should
financial and investment advisory nonbanking be considered as to their applicability to current
activities. The provision of discretionary invest- statutory and regulatory provisions. Some
ment advice is no longer limited to institutional examples include, but are not limited to, provid-
customers. Bank holding companies and their ing financial advice in rendering fairness opin-
subsidiaries may engage in financial and invest- ions and providing valuation services in connec-
ment advisory activities without restriction. Bank tion with mergers, acquisitions, divestitures,
holding companies can manage retail customer investments, joint ventures, leveraged buyouts,
accounts outside of the trust department of an recapitalizations, and capital structurings. Other
affiliated bank (to the extent permitted by law). examples include providing advice on financing
Further, bank holding companies may engage in and similar transactions with respect to private
any combination of permissible nonbanking and public financings and loan syndications;
activities listed in Regulation Y. Accordingly, conducting financial-feasibility studies; and pro-
bank holding companies may provide financial viding financial advice to state and local govern-
and investment advice jointly with permissible ments with respect to the issuance of their
agency transactional service, investment or trad- securities.
ing transactions as principal, or any other listed
nonbanking activity.
The rules in Regulation Y provide examples
of financial and investment advisory activities 3130.0.1 INSPECTION OBJECTIVES
that are illustrative rather than exclusive. With
regard to the examples, a bank holding company 1. To review the adviser’s organizational struc-
may act as an investment or financial adviser ture and the qualifications of its management
without restriction to any person, including to conduct business, and to determine whether
they are satisfactory.
1. serving as an investment adviser (as defined
in section 2(a)(20) of the Investment Com- BHC Supervision Manual June 1998
pany Act of 1940) to an investment company Page 1
Section 4(c)(8) of the BHC Act (General Financial and Investment Advisory Activities) 3130.0
2. To determine the status of the adviser’s c. avoids executing customer transactions

financial condition and the adequacy of when acting in an advisory capacity.
internal controls, general accounting poli- 2. Prepare financial statements for the last two
cies, and reporting procedures, and to deter- fiscal years, plus interim if appropriate.
mine if they reflect the guidelines estab- Analyze for adverse trends and evaluate for
lished by management. negative effects on affiliates.
3. To determine whether fee income is accu- 3. Evaluate asset quality when warranted, docu-
rately computed and reported on a consis- menting the scope and detailing asset review.
tent basis. Compile classification data, write up classi-
4. To determine what financial effect the activ- fications if appropriate, and evaluate reserve
ity has on the parent holding company and adequacy.
the bank subsidiaries. 4. Obtain documentation for all indebtedness.
5. To review and evaluate investment prac- Evaluate funding sources for maturity mis-
tices considering the adviser’s investment match, dependence on affiliates’ concentra-
responsibilities for the selection and allocations, and dependability. Review borrow-
tion of investments for various types of ings from affiliate banks for compliance
accounts to determine whether they are with section 23A of the Federal Reserve
appropriate. Act.
6. To evaluate funding sources, including 5. Review income and expense accounts and
indebtedness, and their management with transactions with affiliates for compliance
respect to maturities and interest rates. with section 23B of the Federal Reserve
7. To determine the adequacy of internal and Act.
external audits. 6. Review the company’s revenue sources to
8. To determine whether the adviser company determine that it has not taken positions and
has adequate policies and procedures to pre- does not, itself, execute transactions when
vent self-dealing and similar improper acting in an advisory capacity.
conflicts. 7. Evaluate contracts and service agreements
9. To determine whether operating practices with affiliates. Identify whether the com-
provide for adequate legal documents and pany receives or provides services or prod-
agreements such that the account activities, ucts. Determine that the services or prod-
in general, are consistent with the contrac- ucts are needed and received or provided,
tual responsibilities and authorities. and that the contract or agreement terms
10. To determine if any litigation is pending represent market rates.
against the company and the possible impact 8. Review the company’s fee schedule for pro-
of an unfavorable court decision. viding advice and the fees charged by affili-
11. To evaluate compliance with applicable bank ated banks to conduct transactions for the
holding company laws, regulations, and company’s customers. Determine whether
interpretations, including compliance with the bank is being adequately compensated
the standards of care and conduct applica- for executing trades, or whether these prof-
ble to fiduciaries as required by Regula- its are accruing largely to the benefit of the
tion Y. company.
9. Review checking-account statements for all
3130.0.2 INSPECTION PROCEDURES accounts at affiliate banks for overdrafts
since the previous inspection.
1. Review System approval and activities for 10. Evaluate whether the nonbank activities are
conformance with any limitations. Deter- being performed by affiliate bank personnel
mine if the activity is conducted through a or are using bank assets. If so, is the bank
separately incorporated subsidiary of the adequately compensated?
bank holding company that— 11. Identify off-balance-sheet activities and con-
a. refrains from taking positions for its own tingent liabilities, and assess the risk to the
account; company and any affiliate.
b. observes the standards of care and con- 12. Obtain a listing of litigation against the
duct applicable to fiduciaries with respect company or any individuals who represent
to its advisory and transactional services; the company from the company’s legal coun-
and sel, and evaluate potential effects on the
financial condition.
BHC Supervision Manual June 1998 13. Obtain and review internal and external
Page 2 audit reports and workpapers.
Section 4(c)(8) of the BHC Act (General Financial and Investment Advisory Activities) 3130.0
14. Obtain and review internal and external 18. Evaluate insurance for adequacy.
asset-review reports. 19. Obtain or verify that workpapers contain
15. Obtain and review copies of the board of the following permanent documentation:
directors’ and senior management’s poli- a. System approval letters
cies and procedures. b. date of incorporation or date acquired
16. Review a sample of recommendations to c. date activity commenced
determine that a reasonable basis exists for d. articles of incorporation and by-laws
the company’s recommendations. e. commitments
f. supervisory actions
17. Review the advisory contracts to determine g. other pertinent correspondence
if there are any conflicts of interests involv- 20. Obtain and review a listing of shareholders
ing the parent company or affiliates, as well for each class of stock outstanding, and a
as the officers, directors, or principal share- schedule of officers, directors, and their re-
holders and their related interests of the lated interests.
holding company and its affiliates.

Page 3
(Investment or Financial Advisers) Section 3130.1
A bank holding company or its nonbank subsid- same name as the name of the bank
iary that engages in investment or financial holding company or any of its subsidiary
adviser activities is subject to section 225.28(b)(6) banks, or that has a name that contains the
of Regulation Y. The purpose of an inspection word ‘‘bank.’’
of a company providing investment or financial 5. Since investment adviser activities may cre-
advice is to determine that it is operating accord- ate potential conflicts of interest, the Board
ing to applicable laws, regulations, and interpre- determined that a bank holding company
tations, and to determine that the company is and its subsidiaries should not purchase in
subject to an adequate audit program. Regula- their sole discretion, in a fiduciary capacity
tion Y allows a bank holding company to serve (including as managing agent), securities of
as an investment adviser as defined in section any investment company for which the bank
2(a)(20) of the Investment Company Act of holding company acts as investment adviser,
1940 (15 U.S.C. 80a-2(a)(20)), which defines an unless the purchase is specifically autho-
‘‘investment adviser’’ of an investment com- rized by (1) the terms of the instrument
pany as ‘‘...any person who pursuant to contract creating the fiduciary relationship, (2) court
with such company regularly furnishes advice order, or (3) the law of the jurisdiction
to such company with respect to the desirability under which the trust is administered.
of investing in, purchasing or selling securities 6. A bank holding company may not engage,
or other property, or is empowered to determine directly or indirectly, in the underwriting,
what securities or other property shall be pur- public sale, or distribution of securities of
chased or sold by such company...’’ any investment company for which it or any
The Board has issued an interpretive rule nonbank subsidiary acts as investment
regarding the investment adviser activities of adviser, except in compliance with section
bank holding companies under Regulation Y 20 of the Glass-Steagall Act. The Board has
(12 C.F.R. 225.125). The following is a list of determined, however, that the conduct of
some of its provisions: securities brokerage activities by a bank
holding company or its nonbank subsidi-
1. Bank holding companies, including their aries, when conducted individually or in
bank and nonbank subsidiaries, may act as combination with investment advisory
investment advisers to various types of invest- activities, is not deemed to be the under-
ment companies such as mutual funds and writing, public sale, or distribution of secu-
closed-end investment companies. Mutual rities prohibited by the Glass-Steagall Act.
funds and closed-end investment compa- 7. A bank holding company or any of its non-
nies are described in the interpretation. bank subsidiaries that have been authorized
2. Bank holding company investment adviser by the Board under the Bank Holding Com-
activities are limited by the Glass-Steagall pany Act to conduct securities brokerage
Act (Banking Act of 1933 (12 U.S.C. 24, activities (either separately or in combina-
78, 377, 378)). This act generally prohibits tion with investment advisory activities)
member banks from engaging in the pur- may act as agent, upon the order and for the
chase or sale of equity securities other than account of customers of the holding com-
in an agency capacity. pany or its nonbank subsidiary, to purchase
3. A bank holding company may not sponsor, or sell shares of an investment company for
organize, or control a mutual fund. This which the bank holding company or its
does not apply to closed-end investment subsidiaries act as an investment adviser.
companies so long as they are not primarily 8. A bank holding company or any of its non-
or frequently engaged in the issuance, sale, bank subsidiaries that have been authorized
or distribution of securities. by the Board under the Bank Holding Com-
4. A bank holding company should not act as pany Act to provide investment advice to
investment adviser to an investment com- third parties generally (either separately or
pany which has a name similar to the bank in combination with securities brokerage
holding company or any of its subsidiary services) may provide investment advice to
banks, unless the prospectus of the invest- customers with respect to the purchase or
ment company contains certain required sale of shares of an investment company for
disclosures. In no case should a bank hold-
ing company act as investment adviser to an BHC Supervision Manual June 1998
investment company that has either the Page 1
Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1
which the holding company or any of its had traditionally existed between banks and
subsidiaries acts as an investment adviser. state and local governments, and the net public
9. A bank holding company or its subsidiary benefits that would result from provision of
bank, at the time a service is provided, must advice to such governments by bank holding
caution customers to read the prospectus of companies, the Board indicated that it would be
the investment company before investing. more flexible in determining what particular
Customers must be advised in writing that services constitute ‘‘providing financial advice’’
the investment company’s shares are not rather than ‘‘management consulting’’ when the
insured by the Federal Deposit Insurance services are solely for state and local govern-
Corporation and are not deposits, obliga- ments rather than other nonbank organizations.
tions, or endorsed or guaranteed in any way With the Board’s April 1997 revision of Regula-
by any bank (unless that is the case). The tion Y, investment and financial advisory activi-
role of the company or affiliate as adviser to ties were grouped together and a bank holding
the investment company must be disclosed company could act as an investment or financial
in writing. Such disclosures may be done adviser without restriction.
orally, but the cusotomer must be given The Board also allowed the provision of
such disclosures in writing immediately management consulting services regarding any
thereafter. financial, economic, accounting, or audit matter
10. Because of potential conflicts of interest, a to any company. These financial activities are
bank holding company which acts both as directly related to the activities and expertise of
custodian (pursuant to section 225.25(b)(3) bank holding companies. Management consult-
of Regulation Y) and investment adviser for ing services are subject to a revenue limitation,
an investment company should exercise care however. They may be provided to any cus-
to maintain at a minimum level demand tomer on any matter, provided that the total
deposit accounts of the investment com- annual revenue derived from the management
pany which are placed with a bank affiliate, consulting services does not exceed 30 percent
and should not invest cash funds of the of the company’s total annual revenue derived
investment company in time deposit accounts from management consulting activities. Thus,
(including certificates of deposit) of any any services provided to state and local govern-
bank affiliate. ments that are deemed management consulting
services are subject to this revenue limitation.
3130.1.1 REAL ESTATE

DEVELOPMENT ADVISERS FOR
STATE AND LOCAL GOVERNMENTS 3130.1.2 INSPECTION OBJECTIVES
Advising state and local governments about 1. To review the adviser’s organizational struc-
methods available to finance real estate develop- ture and the qualifications of management
ment projects, and evaluating projected income to conduct business, and to determine whether
to determine if debt resulting from proposed they are satisfactory.
development projects can be adequately ser- 2. To determine the status of the adviser’s
viced is permissible if the activities are autho- financial condition and the adequacy of
rized under section 225.28(b)(6) of Regula- internal controls, general accounting poli-
tion Y. cies, and reporting procedures, and to deter-
Before this activity was incorporated into mine if they reflect the guidelines estab-
Regulation Y, in 1980, the Board had received lished by management.
certain comments noting that certain aspects of 3. To determine whether fee income is accu-
these advisory services may be within the scope rately computed and reported on a consis-
of the activity of ‘‘management consulting.’’ tent basis.
The Board had found that it was not permissible 4. To determine what financial effect the activ-
for bank holding companies to offer manage- ity has on the parent holding company and
ment consulting services to nonaffiliated compa- the bank subsidiaries.
nies. Certain management consulting advice could 5. To review and evaluate investment prac-
be provided to unaffiliated depository institu- tices considering the adviser’s investment
tions, however. In view of the relationship that responsibilities for the selection and alloca-
tion of investments for various types of
BHC Supervision Manual June 1998 accounts, and to determine whether they are
Page 2 appropriate.
6. To evaluate funding sources, including with section 23A of the Federal Reserve
indebtedness, and their management based Act.
on maturities and interest rates. 8. Review checking-account statements for all
7. To determine the adequacy of internal and accounts at affiliate banks, checking for
external audits. overdrafts since the previous inspection.
8. To determine whether the adviser company 9. Complete the inspection checklist (see the
has adequate policies and procedures to pre- sections beginning at 3130.1.3.2) based on
vent self-dealing and similar improper con- the guidance provided in section 3130.1.3.1.
flicts. 10. Identify off-balance-sheet activities and con-
9. To determine whether operating practices tingent liabilities, and assess the risk to the
provide for adequate legal documents and company and any affiliate.
agreements such that the account activities, 11. Obtain a listing of litigation against the
in general, are consistent with the contrac- company or any individuals who represent
tual responsibilities and authorities. the company from the company’s legal coun-
10. To determine if any litigation is pending sel, and summarize the matters in litigation
against the company and the possible impact (or in threatened litigation) and any com-
of an unfavorable court decision. promise actions. Evaluate the potential effects
11. To evaluate compliance with applicable bank on the company’s financial condition.
holding company laws, regulations, and 12. Evaluate contracts and service agreements
interpretations, including compliance with with affiliates. Identify whether the com-
the standards of care and conduct applica- pany receives or provides services or prod-
ble to fiduciaries as required by Regula- ucts. Determine that the services or prod-
tion Y. ucts are needed and received or provided,
and that the contract or agreement terms
represent market rates.
13. Review income and expense accounts and
3130.1.3 INSPECTION PROCEDURES transactions with affiliates for compliance
with section 23B of the Federal Reserve
1. Obtain the company’s policy and procedure Act.
manuals, and distribute relevant portions to 14. Evaluate whether the nonbank activities are
the examiners for review and compliance being performed by affiliate bank personnel
evaluation. or whether bank assets are being used. If so,
2. Review the minutes of meetings of the is the bank adequately compensated?
board of directors, audit committees, and 15. Review FR System approvals, and check
any officer-level committees. Ensure that conformance with any specified limitations
examiners performing other portions of the or commitments.
inspection review relevant minutes or sum- 16. Review a sample of recommendations to
maries thereof. determine that a reasonable basis exists for
3. Obtain, review, and evaluate the adequacy the company’s recommendations.
of internal and external audit procedures, 17. Review the advisory contracts to determine
reports, and workpapers. if there are any conflicts of interests involv-
4. Prepare financial statements for the last two ing the parent company or affiliates, as well
fiscal years, plus the interim period, if as the officers, directors, or principal share-
appropriate. Analyze and evaluate the infor- holders and their related interests of the
mation for adverse trends and for negative holding company and its affiliates.
effects on affiliates. 18. Evaluate insurance, including bond cover-
5. Obtain, review, and evaluate internal and age, for adequacy. Determine the extent of
external asset-review reports. current liability insurance relating to the
6. Evaluate asset quality where warranted, docu- adviser function, and evaluate the adequacy
menting the scope and detailing asset review. of such coverage—particularly the extent to
Compile classification data, write up classi- which possible significant surcharges would
fications if appropriate, and evaluate the be covered by such insurance.
adequacy of contra asset allowances. 19. Obtain a listing of shareholders for each
7. Obtain documentation for all indebtedness. class of stock outstanding and a schedule of
Evaluate funding sources for maturity mis- officers, directors, and their related interests.
match, dependence on affiliates, concentra-
tions, and dependability. Review borrow- BHC Supervision Manual June 1998
ings from affiliate banks for compliance Page 3
20. Obtain or update biographical and experi- interests in the financial services which it offers.
ence information for key management per- As indicated in SR-88-11 (April 28, 1988),
sonnel, together with overall staffing and examiners should use their discretion to sched-
salary levels as appropriate for full evaluation. ule inspections based on the size and complex-
21. Determine whether operating practices pro- ity of the adviser’s operations. Most section
vide for adequate legal documents and agree- 4(c)(8) BHC subsidiaries will be subject to SEC
ments such that the account activities, in registration requirements. (See SR-91-4 (SA).)
general, are consistent with contractual Appropriate checklist questions should be com-
responsibilities. pleted for registered investment advisers which
22. Ascertain if senior management is aware, or provide investment advice to affiliated banks or
has adopted the procedures necessary to trust companies and for investment advisers
become aware, of its current and potential which engage in activities which could have a
responsibilities in connection with any significant impact on the bank holding compa-
regulatory-reporting and/or regulatory- ny’s financial safety and soundness. The check-
compliance requirements. list should also be completed for all advisers
23. Obtain or verify that workpapers contain that manage investment portfolios for their cus-
the following permanent documentation: tomers. The checklist is only a guideline and
a. System approval letters some of the sections in the checklist may not be
b. date of incorporation or date acquired applicable. Conversely, the scope of such
c. date activity commenced examinations is not limited to the items included
d. articles of incorporation and by-laws in this checklist.
e. commitments
f. supervisory actions
g. other pertinent correspondence 3130.1.3.2 Inspection Checklist
The questions in this checklist will assist the
3130.1.3.1 Scope of Inspection examiner in evaluating various areas of supervi-
sory concerns.
It is expected that inspections of investment
adviser subsidiaries will generally be conducted
as part of regularly scheduled bank holding 3130.1.3.2.1 Review of Fundamental
company inspections. If, however, the invest- Policies and Procedures
ment adviser subsidiary provides portfolio man-
agement services for a significant portion of The investment adviser’s policies and proce-
trust assets held by a state member bank, the dures should be reviewed using the following
Reserve Bank should inspect the investment checklist to ensure that fundamental policies
adviser subsidiary at the same time it examines and procedures have been established and
the trust operations of the bank subsidiary. The implemented.
scope of the inspection should be based on a
review of the nature and complexity of the 1. Are adequate minutes of the board and board
financial services provided to customers. An committee meetings prepared?
adviser which merely provides investment advice 2. Is the adviser properly chartered and
and does not provide any additional financial registered?
services, such as portfolio management, safe- 3. Does the adviser have sufficient blanket bond
keeping, recordkeeping, or trading services, may or other fidelity or liability coverage in place?
not require an inspection. However, an adviser 4. Is corporate and regulatory reporting per-
which provides portfolio management, safekeep- formed on a timely basis?
ing, or other services will require an inspection. 5. Does the above reporting fairly present the
To determine the scope of the inspection, it is accounting and supplemental data reflected
essential to identify what types of services are by the corporate records?
being offered to customers and to assess the 6. Are internal accounting controls, provided
risks associated with those services. by a segregation of duties or a need for
The examiner needs to understand the advis- administrative approvals, adequate?
er’s operations, including how it represents itself 7. Are duties properly segregated in the receiv-
to clients and whether the adviser has any vested ing, disbursing, and recording of cash and
cash transactions?
BHC Supervision Manual June 1998 8. Are fee calculations and billing procedures
Page 4 adequate to ensure accuracy and propriety?
9. Are all security transactions authorized or activities. The examiner should determine
approved by the appropriate management whether the board of directors has developed
level, and is there documented evidence of adequate objectives and policies.
the authorization or approval?
3130.1.3.2.2.1 Supervision and Organization

3130.1.3.2.2 Supervision and Checklist
Organization
1. If the board of directors does not directly
Supervision refers to the conduct of an adviser’s supervise investment adviser activities—
board of directors and senior management in a. has a responsible board committee(s)
establishing, communicating, and enforcing a been named to exercise this function?
system of policies, procedures, and practices b. are any delegations consistent with by-
suitable to its business objectives and legal law provisions and other appropriate
requirements. Organization may be character- principles?
ized as the framework of committees and the c. do the board’s minutes nevertheless reflect
assigned responsibilities through which supervi- periodic but timely review of the con-
sion functions. The examiner should (1) review duct and operating results of the function?
the structure of the organization for adequacy of 2. Do minutes of the board, or its commit-
management information systems and (2) the tee(s), reflect that members—
organization framework as both relate to meet- a. attend meetings with reasonable
ing the entity’s stated responsibilities as well as frequency?
generally accepted standards of conduct. The b. require and approve, where necessary,
examiner should review the supervisory func- appropriate written policies, strategic
tion by first identifying the duties and plans, and management reports relating
responsibilities of the board of directors. The thereto?
directors owe the duty of reasonable supervi- c. review audit and regulatory reports (and
sion, including appropriate attention to areas in management proposals and corrective
which the adviser is assuming sensitive and measures in response thereto), litigation
complex fiduciary responsibilities. The next level developments, earnings and expense
of review is the committee and officer positions reports, and changes to fee schedules?
to which certain authority has been delegated. In 3. Through adoption of formal policies and
reviewing this level of supervision, the exam- provisions for auditing, does the board
iner should keep in mind that certain functions adequately seek to ensure the integrity of
cannot be delegated; for example, approval of the organization’s records and operational
significant new services or lines of business, systems?
approval of formal policies designed to ensure 4. Are policies and procedures adequately com-
that the adviser operates in basic compliance municated to officers and staff?
with laws and regulations, and the selection and 5. Does the board or a board committee con-
supervision of senior management cannot ordi- sider, periodically review, and provide for
narily be delegated. Informal delegations and insurance protection?
operating practices represent the last level of 6. Does the bank holding company maintain
review. In reviewing both formal and informal access to competent legal counsel and, where
delegations, consideration should be given to appropriate, obtain written opinions on sig-
the institution’s size and complexity. A final nificant legal questions such as—
determination of the adequacy of supervision a. pending or threatened litigation?
and organization must be based on findings of b. account agreements whose terms are
the entire inspection of the bank holding com- unclear or ambiguous or raise compli-
pany or its nonbank subsidiaries. While topics cated points of law?
that have direct or indirect impact on the ade- c. proposed actions or policies involving
quacy of director supervision and management matters such as conflicts of interest,
competence are of particular sensitivity, examin- restricted securities, ERISA, and other
ers nevertheless have a responsibility to care- matters involving possible legal exposure?
fully address and comment upon such issues. 7. If an account’s securities are registered in a
During the course of the inspection, the exam- nominee name(s)—
iner should review the supervisory and organi-
zational structure of the bank holding company, BHC Supervision Manual June 1998
with particular reference to investment-related Page 5
a. is the nominee agreement current? ment advice, particularly to retail clients, an

b. is the nominee registered with the Ameri- investment adviser should observe the standards
can Society of Corporate Secretaries (to of care and conduct applicable to fiduciaries.1
guard against duplication of the nominee
name) and state authorities (where
required by local law)? 3130.1.3.2.3.1 Investment Standards and
8. Is staffing adequate, in terms of both num- Research
bers and qualifications, to handle the cur-
rent volume of business? 1. Are the general investment standards and
9. Is there adequate provision for management review and selection responsibilities defined
succession, or for continuing operations in and approved by the board of directors?
case of the loss of key personnel? 2. Does management or senior investment per-
10. Is senior management aware of its responsi- sonnel review overall investment policy and
bilities in connection with, and has it estab- potential investment problems at least
lished written policies and procedures to annually?
ensure compliance with, any applicable 3. Is portfolio management policy adequately
regulatory-reporting requirements? communicated to appropriate personnel (for
11. Are significant functions of the investment example, by including it in committee min-
adviser subject to either internal or external utes, directives, or memoranda circulated to
audit? If not, ascertain whether an audit such personnel)?
program should either be developed or 4. Does the institution, where appropriate,
expanded. diversify investments according to—
12. When appropriate in light of the size and a. types of assets, such as common stocks,
complexity of the adviser’s operations, has fixed-income securities, and real estate?
management had an audit of financial state- b. types of securities by characteristics such
ments performed by certified public as income, growth, and size of company?
accountants? c. types of securities by industry and specific
13. Have all significant exceptions and recom- companies within industries?
mendations in audits or examinations or d. maturities of debt securities?
inspection reports been corrected, imple- e. geographic location of companies of issue,
mented, or otherwise satisfactorily resolved? such as utilities?
f. tax-exempt income?
5. If the institution has a list of securities approved
3130.1.3.2.3 Portfolio Management for purchase, retention, and/or sale—
a. are recommendations for additions to or
Investment selection is the process whereby the deletions from such list(s) approved by a
adviser evaluates, selects, and reevaluates those committee or group with appropriate
securities or other financial assets it will buy or authority and expertise?
sell for its clients, or for which it will make b. are periodic reviews made of the lists of
recommendations. It includes the process of securities approved for purchase, reten-
researching and selecting recommended indi- tion, or sale to assess the current appropri-
vidual stocks and bonds, and setting objectives ateness of the investments listed?
or strategies for diversifications by types and 6. If the institution uses any research or analy-
classes of securities into general or specialized sis in its general investment-review and
portfolios, as well as the process of communi- -selection process—
cating and executing overall strategies for par- a. are appropriate factors taken into account?
ticular accounts. b. is appropriate documentation obtained and
When an adviser holds itself out as a profes- filed to reflect consideration of such factors?
sional, the adviser will be held to a high stan- 7. If the size and character of the entity’s discre-
dard of prudence and expertise in the investment- tionary investment responsibilities are such
selection and -review process. Therefore, advisers that the type of detailed research consider-
must carefully consider policies and procedures
1. The term ‘‘portfolio investment’’ is intended to refer
in this area in accordance with the size and generally to the investment of funds in a ‘‘security’’ as defined
character of the investment-selection responsi- in section 2(1) of the Securities Act of 1933 (15 U.S.C. 77b)
bilities undertaken. In furnishing portfolio invest- or in real property interests, except when the real property is
to be used in the trade or business of the person being advised.
BHC Supervision Manual June 1998 In furnishing portfolio investment advice, bank holding com-
panies and their subsidiaries shall observe the standards of
Page 6
care and conduct applicable to fiduciaries.
ations and files envisioned in the previous 5. As appropriate to the size and character of
question are not relied on, does it use ratings business, are account synopses and histori-
by acceptable financial-rating agencies, such cal data used in the review of account
as Moody’s or Standard and Poor’s, together assets?
with evaluation of basic relevant factors per- 6. Does the investment-review information
taining to the type of security under include—
consideration? a. amount and description of investment?
8. Where appropriate, does the organization dif- b. categories of investment, such as bonds
ferentiate its investment-selection process as and stocks?
to the type of account in question, such as c. types of investments within each cate-
those for which the need for growth or income gory, such as industry groups for stocks?
is paramount, or for taxable versus tax-free d. cost?
trusts or retail versus institutional accounts? e. market or appraised value at review date?
9. Do personnel possess sufficient expertise f. annual income?
and experience to properly implement the g. yield at market?
firm’s investment-selection systems and h. rating of recognized financial service?
responsibilities? 7. For accounts in which the adviser makes
investments at the direction of the client,
does the adviser—
3130.1.3.2.3.2 Account Administration a. review the account to detect illegal, non-
conforming, substandard, or otherwise
Special consideration has to be given to accounts unsuitable investments?
subject to the Employee Retirement Income b. advise the power holder of any improper
Security Act of 1974 (ERISA), which imposes investments?
fiduciary responsibilities upon any person who c. inform parties at interest in the account
has any power of control, management, or dis- if any improper investment is not dis-
position over the funds or other property of any posed of, and seek legal relief, if
employee benefit fund. When an adviser exer- necessary?
cises investment discretion over such plans, the d. resign from the account if corrective
extensive fiduciary responsibility and prohibited action is not taken concerning improper
transaction rules of ERISA will apply. investments?
8. Have proxy voting policies and procedures
1. Does the adviser have portfolio manage- as listed below been established for ERISA
ment procedures which provide for— accounts that are suitable in relation to
a. consideration of the needs and objectives assumed responsibilities?
of particular types of accounts, such as a. voting of routine proxies?
the need for income versus growth or b. identification and handling of proxy or
taxable versus tax-free income? tender determinations when sensitive
b. conformity with investment provisions social issues, conflicts of interest, signifi-
of governing instruments? cant increases in management power or
c. consideration of the liquidity needs of perquisites, or merger or buy-out propos-
the account for anticipated distributions? als are involved?
d. appropriate diversification, including NOTE: For requirements relating to
avoidance or elimination of concentra- proxy processing and the Shareholder
tions in individual securities and by type Communications Act of 1985, see
and subclass of securities? Operations and Internal Controls in the
2. When assets in discretionary accounts are Trust Examination Manual. For ques-
considered unsuitable, is a program of pru- tions relating to the voting of affiliate
dent and timely sale of such assets followed stock, see Conflicts of Interest in the
unless retention is required? Trust Examination Manual.
3. In order to determine the advisability of When an adviser invests accounts in
retaining or changing assets, does the adviser options and/or futures, the following check-
have procedures for periodic reviews? list questions (numbers 9 through 13) should
4. Do minute books or other records— be completed. For additional information as
a. identify reviewed accounts? to appropriate uses of options and futures
b. report written conclusions on the advis-
ability of retaining or disposing of assets BHC Supervision Manual June 1998
in the accounts? Page 7
contracts, see SR-83-2(SA) and SR-83- ment adviser subsidiary was organized for the
39(SA). purpose of providing investment advice and ser-
9. When an adviser uses options and/or futures, vices for the trust accounts held at one or more
has the board of directors or a directors’- of its affiliates. These subsidiaries often employ
level committee approved a policy and strat- the same individuals who worked in the banks
egy for their use? Does the policy address— or trust company which they advise.
a. the investment objectives to be accom- Conflict-of-interest problems may arise when
plished by the use of these contracts? the adviser exercises any ‘‘discretion’’ when
b. the specific types of contracts to be used? there are mutually opposing interests. The most
c. the types of accounts authorized to use serious conflict of interest is self-dealing, which
these contracts? could include transactions such as an investment
d. restrictions and/or conditions upon use in affiliated banks or the purchase of securities
of contracts, such as selection of broker- from or through an affiliate. To resolve conflicts
age houses, position limits, time frames, of interest, such transactions and the fees associ-
leveraging, etc.? ated with them must be fully disclosed and
10. Was adequate disclosure made and adequate authorized by the appropriate parties.
authorization obtained to execute contract Potential conflict-of-interest situations are not
transactions for various types of participat- limited to transactions between affiliates, but
ing accounts? can be between the adviser and any of its direc-
11. Are adequate systems and controls in effect tors, officers, or employees individually. Due to
to ensure— the complexity, sensitivity, and exposure involved
a. proper tax treatment? in conflicts of interest, it is particularly impor-
b. proper segregation of securities and/or tant that an adviser develop the awareness and
monies? policies and procedures to identify and deal
c. conformance with account objectives? with conflicts situations. Therefore, it is consid-
d. adherence to adopted strategy, position ered highly desirable, even when not specifi-
limits, and related program parameters? cally required by regulation, that written poli-
e. periodic management evaluation and cies be adopted and periodically revised as
reporting systems with respect to— necessary.
• results of contract activities upon over-
all investment performance?
• market developments, including cur-
rent liquidity of relevant futures and 3130.1.3.2.4.1 Self-Dealing
options contracts in which positions
are taken? 1. Has the adviser—
• financial condition, fee competitive- a. acquired any assets from itself or its
ness, and performance of involved affiliates?
broker-dealers? b. acquired any assets from directors, offi-
12. Does the accounting system accurately reflect cers, or employees of the organization or
contract activities with respect to— its affiliates, or from any other individu-
a. transaction details? als with whom a connection exists that
b. current gains or losses on open contract might affect their best judgment?
positions? 2. Has the adviser sold or transferred any
c. necessary tax information? account assets, by loan or otherwise, to—
13. Do operating personnel appear sufficiently a. any affiliates?
knowledgeable relative to the level of b. directors, officers, or employees of any
contract-transactions activity? affiliates?
c. other individuals or corporations with
whom such a connection exists or other
3130.1.3.2.4 Conflicts of Interests organizations in which such an interest
exists that might affect the exercise of its
The inspection of an investment adviser subsid- best judgment?
iary which provides services to an affiliated trust 3. Has the company purchased any securities
company or bank with a trust department requires for a customer account from any member of
expanded inspection procedures. Often the invest- an undivided syndicate for which the adviser
or any of its affiliates are participating, or
BHC Supervision Manual June 1998 from a private placement which the adviser
Page 8 assisted?
4. Does the company have satisfactory poli- and specific authorization of the customer?
cies and procedures, in terms of its size and 10. Does the company act as investment adviser
character of business, to address the preced- to an open-end or closed-end investment
ing situations? company that is registered under the Invest-
5. If the company directs extra fee-producing ment Company Act of 1940? If so, do its
business to itself or an affiliate (for exam- activities conform with the Board’s inter-
ple, brokerage services or options-trading pretation at 12 C.F.R. 225.125, which defines
services), or if it charges separate fees to the scope of permissible activities?
accounts for securities transactions or other
services commonly provided as part of gen-
eral account administration (for example, 3130.1.3.2.4.2 Broker Selection
fees for cash management or investments in
mutual funds when management or admin- 1. When volume of activity warrants, is alloca-
istration fees are received by the company tion of brokerage business controlled through
or an affiliate)— an approved list which is periodically reviewed
a. has it identified those accounts which and approved by the company’s board or a
may properly participate in such services senior-officer-level committee?
in accordance with adopted policy, legal 2. Does management attempt to obtain the best
opinion, a Department of Labor ruling, service for customers, including periodic
and/or other necessary determinations? evaluations of broker qualifications such as—
b. has it made appropriate prior disclosures a. financial condition?
and obtained adequate specific authoriza- b. past record of good and timely delivery
tions for those accounts identified as and payment on trades?
entitled to the services? c. quality of execution and ability to handle
6. Have any assets held by the company in one specialized transactions?
account been sold to another account? d. quality of research received, if applicable?
NOTE: The transaction may be permissible 3. Are there procedures to monitor or periodi-
if appropriate disclosure is made, authoriza- cally survey available negotiated commis-
tion is received, and the law or the govern- sion prices in order to ascertain reasonable
ing instrument do not prohibit it. However, costs for the execution requirements of its
an interaccount transaction for ERISA accounts?
accounts may be a prohibited transaction. In 4. If commissions higher than the ‘‘lowest’’
addition, difficult problems can arise in available negotiated commissions are being
establishing or documenting a ‘‘fair’’ price paid for executions in order to receive goods
for the transaction, particularly if the asset and/or services—
is a thinly traded security or is a unique a. have such goods and/or services been
asset. determined to reasonably qualify as ‘‘bro-
7. Does the company have appropriate poli- kerage and research services’’ as defined
cies and procedures to ensure— in section 28(e)(3) of the Securities
a. its discretionary accounts are not left in Exchange Act of 1934?
uninvested cash positions beyond a mini- b. does an appropriate committee periodi-
mum period of time? cally (at least annually) review and deter-
b. its accounts are invested in affiliate mine that the value of the goods and ser-
interest-bearing deposits only for appro- vices justifies the payment of the higher
priate temporary or other purposes? brokerage commissions?
NOTE: To the extent the company has 5. Does the entity periodically review and main-
long-term affiliate deposits or significant tain records of all goods and/or services
aggregate holdings, a special review received from brokers or third parties in
should be made of the company’s docu- return for brokerage and/or dealer business
mentation evidencing the suitability of allocated to particular firms?
such investments in view of available 6. Do policies and procedures preclude—
alternate vehicles. a. selection of broker-dealers on the basis of
8. Are securities of affiliates only purchased deposit balances?
upon proper direction or specific authoriza- b. agreements or understandings for alloca-
tion in account instruments? tion of specific amounts of business to a
9. When the adviser purchases securities which
are underwritten by an affiliate, does the BHC Supervision Manual June 1998
adviser do so only upon proper direction Page 9
broker-dealer such that the adviser com- average basis to the participating accounts?
pany would not be able to cease allocating b. are allocable shares similarly pro-rated to
business to the firm if it were no longer participating accounts when a combined
providing acceptable execution? trade is not executed at once, but in a
7. Are auditing and other monitoring controls number of transactions over a period of
and reporting procedures in effect to verify time?
the compliance of traders with policies 7. Does the adviser maintain policies ‘‘reason-
regarding broker selection and payment of ably designed to prevent the misuse of mate-
commissions? NOTE: Under section 28(e) rial non-public information?’’
of the Securities Exchange Act of 1934, the
adviser may also legitimately pay more than
the lowest-available commission for reasons 3130.1.3.2.5 Recordkeeping
of execution, financial soundness, and effi-
ciency of delivery and payment. Registered investment advisers are subject to
8. In addition to advisory services, are broker- extensive recordkeeping requirements. SEC Rule
age services provided for customers pursuant 204-2 imposes recordkeeping standards and
to section 225.28(b)(7)(i) of Regulation Y? If requires that registered investment advisers keep
so, the examiner should refer to the discount accurate records. In addition to this recordkeep-
brokerage examination procedures in SR- ing, the adviser is subject to the ‘‘brochure rule’’
85-29 (FIS), which contains guidelines and (Rule 204-3). This rule requires an investment
checklist questions for the inspection of bro- adviser to deliver a specified disclosure state-
kerage activities. ment with respect to its background and busi-
ness practices to every client or prospective
client. In addition to an initial disclosure, the
3130.1.3.2.4.3 Trading Policies and Practices adviser must offer annually to deliver a current
disclosure statement upon request. Those advis-
1. When trading specialists are employed, are ers which have custody or possession of securi-
there adequate written or unwritten standards ties of any client must maintain certain addi-
of competence, education, and training for tional records, including separate ledger accounts
such individuals? for each client, copies of confirmations, and a
2. When specialists are not employed, are the position record showing the interest of each
individuals responsible for trading reason- client and the location of the securities.
ably trained and informed in relation to the
volume and character of trading activity they 1. Does the investment adviser make and keep
are required to perform? current appropriate books and records
3. When transactions are permitted to be crossed including—
between accounts, are procedures adequate a. journals or summary journals?
to ensure fair pricing of the transactions? If it b. a memorandum of each order given by the
is not clear the transactions are permitted, firm or instructions received, showing terms
has the company determined through counsel and conditions of the orders?
that crossing is permissible under applicable c. all checkbooks, bank statements, canceled
law? checks, and cash reconciliations?
4. When specialists are employed and volume d. all bills or statements, paid or unpaid?
of activity permits, are block trades consid- e. trial balances, financial statements, and
ered in order to obtain more favorable trade internal audit papers?
prices and execution prices for accounts?
f. written communications received or sent
5. If applicable, do procedures, including estab-
by the firm?
lishment of time frames in advance of such
g. list of discretionary accounts?
trading, require special authorization and
attention for large or block trades which are h. powers of attorney and discretionary
to be executed in a number of transactions? powers?
6. If procedures permit the combining of pur- i. written agreements?
chase or sale orders of the same security— j. copies of each notice, circular, advertise-
a. are resulting benefits in price and/or ment, newspaper article, investment letter,
execution costs applied on a pro rata or bulletin, or other communication recom-
mending the purchase or sale of a security?
BHC Supervision Manual June 1998 2. Does the adviser maintain a record of every
Page 10 transaction in which the adviser or any
‘‘advisory representative’’ has a direct or 2. Does the adviser gain effective access to
indirect beneficial interest? client assets through practices, arrange-
3. Are partnership articles, articles of incorpora- ments, or relationships with clients, such as
tion, charter, minute books, and stock certifi- trustee, executor, or account signator?
cate books maintained at the adviser’s princi- 3. When the adviser has custody of client
pal office? funds or securities, does the adviser main-
4. If required books and records are photocop- tain the following records:
ied or microfilmed, or if they are produced or a. a record reflecting all purchases, sales,
reproduced on computer storage media— receipts, and deliveries of securities, and
a. are such media indexed and arranged to all debits and credits to such accounts?
permit immediate location of any particu- b. a separate ledger account for each client,
lar record? showing purchases, sales receipts, and
b. were any copies or printouts of such records deliveries of securities?
promptly provided on request? c. copies of confirmations of all transac-
c. is at least one copy of the original records tions for such clients?
that are now on such media stored in a d. a record for each security in which any
separate location from the original for the client has a position, reflecting the name
time required? of the client, amount of interest, and
d. does the adviser maintain procedures for location of security?
the maintenance and preservation of, and 4. When the adviser renders investment-
access to, records so as to reasonably safe- management services, are the following
guard them from loss, alteration, or records maintained:
destruction? a. for each client, a record of securities
e. does the adviser have facilities for the purchased and sold, containing the date,
immediate, easily readable projection of amount, and price of each transaction?
microfilmed records and for producing b. a record for each security in which any
easily readable facsimile enlargements? client has a current position, showing the
5. Do the entries in the general ledger and jour- name of each client and current interest
nals properly reflect payments or receipts of or number of shares owned by each
monies or other goods or services? client?
6. Do the financial statements, canceled checks, 5. Are client assets physically segregated from
deposit slips, and check register properly the adviser’s own assets?
reflect payments or receipts of monies or 6. For the vault and other related security-
other goods or services? processing areas, are adequate controls/
7. When the adviser’s financial records indicate safeguards in effect which include the
that it is capitalized with client funds (through following:
either loans or equity), have adequate disclo- a. Are assets maintained under a system of
sures been made to clients about the risks joint custody or dual control?
and conflicts of interest involved? b. Is access to these areas restricted to
designated/authorized personnel?
c. As appropriate, are other controls/
3130.1.3.2.6 Security Storage and safeguards systems in place (for exam-
Processing ple, rotation of assignments, key/lock
combinations, or vault or area entrance
Investment advisers generally do not take pos- log(s))?
session and control of client funds and securi- d. Is a security-ticket system used as a vault
ties. However, in those cases in which such and asset-movement control system?
responsibilities are assumed, the inspection must 7. If a security-ticket system is used, are
evaluate those internal controls which are in adequate controls/safeguards in effect which
place for the safeguarding of client funds and include the following:
securities. Controls and related processing pro- a. Are security tickets prenumbered?
cedures must be appropriately designed and b. Does each copy of the security ticket
implemented by the adviser to efficiently and clearly indicate its destination to ensure
safely facilitate such operations. prompt and accurate delivery?
1. Does the adviser have custody of client BHC Supervision Manual June 1998
funds or securities? Page 11
c. Does the security ticket provide the nec- e. If securities received are not properly
essary information to ensure proper pro- registered in the company’s nominee
cessing and recording of the transaction? name, are procedures in place to ensure
d. Does the security ticket contain suffi- prompt re-registration, control, and
cient copies to ensure that sound internal follow-up until re-registration?
control is maintained over the physical 10. For the delivery of assets, are adequate
security-movement process by providing control/safeguards in place which include
the following with a copy (or copies): the following:
• portfolio managers who initiated the a. Are appropriate receipts obtained and on
transactions? file for securities delivered?
• appropriate vault/operations personnel? b. Are procedures in place to ensure that
• the audit/asset control function? bearer securities are not mailed in amounts
e. Are unissued security tickets properly in excess of the company’s insurance
safeguarded and subject to adequate limits?
numeric controls?
11. Do vault custodians—
8. Does the control of security ticket/
transaction cancellation and replacement a. compare securities received/withdrawn
include— to the security ticket?
a. restricting the ability to initiate such b. for withdrawals, verify that the security
action to supervisory personnel? ticket is signed (initialed) by authorized
b. reporting such activity to the audit/asset personnel?
control function and other function(s) c. for securities temporarily withdrawn from
affected by such action? the vault (for example, for transfer,
c. procedures to ensure that securities are re-registration, or account/portfolio man-
returned to the vault or that funds charged ager review), is a copy of the security
from an account are redeposited, or that ticket retained by vault personnel pend-
the securities or funds are immediately ing the return of the security to the vault?
placed under the control of a new secu- 12. For pending security transactions, are
rity ticket/transaction? adequate controls in effect which include
d. identifying a replacement security ticket the following:
by recording such information on the a. Are pending items periodically reviewed
replacement ticket? by operations personnel?
e. requiring all copies of the replaced secu- b. Do procedures provide for prompt
rity ticket to be forwarded to the audit/ follow-up on items which have not been
asset control function? completed within established time
9. For assets received, are adequate controls/ periods?
safeguards in effect which include the c. Are exceptions promptly reported and
following: resolved by appropriate personnel (for
a. Are all assets received promptly placed example, management, supervisors,
under joint custody or control? and/or the audit/asset control function)?
b. Is appropriate documentation required
d. Are current pending security items
and on file for all assets received, and is
in compliance with established proce-
it compared to actual assets received and
dures for reporting exceptions, and are
posted to control ledgers?
those transactions which have not
c. As applicable, are procedures in place
been completed within established time
for controlling and properly handling
periods been followed up satisfactorily?
assets received by other means, includ-
NOTE: Examiner judgment should be
ing delivery by mail or messenger?
used in determining the scope of this
d. If assets are not to be physically held
review. However, at a minimum, the
or issued (for example, mutual fund
review should include procedures for
shares), is a receipt, statement, or acknow-
handling security transactions pending
ledgment obtained from the issuer or
30 days or more.
holder and processed by receipt ticket
or other means to ensure proper 13. Does the security-processing system—
accountability? a. contain a sufficient number of controls/
safeguards to properly reflect the current
BHC Supervision Manual June 1998 status of and limit an individual’s con-
Page 12 trol over a security transaction?
b. contain sufficient information to identify, 3130.1.4 INSPECTION FINDINGS

locate, and trace the movement of each
asset? A written summary of the subsidiary’s activities
c. provide for adequate segregation of duties should be presented to the examiner in charge of
and responsibilities? the bank holding company inspection and should
14. Has individual accountability or responsi- be included in the inspection report or its sup-
bility been properly assigned for the physi- porting workpapers. Material exceptions should
cal protection of the securities and related be noted with management’s responses under an
cash flow, if applicable, throughout the appropriate caption in the open section of the
security-processing system? report. Any comments in the report regarding
the scope of the investment advisory inspections
15. Do procedures require that orders for trades should note that such inspections are primarily
originate with account or portfolio manag- focused on safety-and-soundness considerations
ers, with the signature or initials of the and not on compliance with securities laws.
authorizing party shown on the order form In those cases in which a separate Report of
or purchase/sale ticket? Bank Holding Company Inspection on Invest-
16. Are transactions made on a first-in, first-out ment Advisory Activities is prepared, examiners
basis (that is, executed in order of receipt), may use the Uniform Interagency Trust Rating
except when combined in blocks for execu- System (see SR-98-37 FRB, revised October
tion pursuant to appropriate written 13, 1998, and effective January 1, 1999), which
procedures? provides a basis for the evaluation of critical
17. Do operations personnel perform indepen- areas of supervisory concern. The rating system
dently of account or portfolio managers is generally used by federal supervisory agen-
to— cies to assess the condition of trust companies.
a. reconcile trade tickets to brokers’ However, the system can be adopted to report
confirmations? on advisory operations as well. When the
b. monitor and promptly follow up on any inspection uncovers significant deficiencies which
outstanding transactions, such as confir- require corrective action, and the inspection was
mations not received within specified not done in conjunction with a concurrent bank
time periods or purchases/sales which holding company inspection, a separate report
have not settled on settlement date? should be prepared and delivered to the inspected
nonbank adviser. Send a copy of the summary
c. promptly post payments for purchases/ and any report comments to the Trust Activities
sales to the recordkeeping system and Program, Washington, DC 20551.
promptly record/remove assets?
3130.1.5 ON-SITE INSPECTION BY

TRUST EXAMINERS
3130.1.3.2.7 Other Matters
An investment advisory subsidiary of a bank
1. Is the adviser or any of its principals involved holding company will normally be registered as
in litigation or arbitration which will have an an investment adviser under the federal securi-
impact on its ability to fulfill its contract with ties laws, and will be subject to examinations of
clients? its advisory activities by the Securities and
2. Were any matters of a material nature found Exchange Commission (SEC). Nevertheless,
in the adviser’s correspondence, such as sig- because investment responsibility is involved in
nificant client complaints? any investment adviser’s activities, and since
3. Did a review of customer-complaint files the SEC’s routine examinations may be infre-
reveal any possible areas for special inspec- quent, periodic on-site inspections should be
tion focus? conducted as an integral part of BHC inspections.
Consideration should be given to using trust
4. Did a review of the adviser’s current finan- examiners to conduct, or at least participate in,
cial condition raise concerns as to the advis- on-site inspections of financial and investment
er’s solvency or its ability to otherwise con- advisory nonbank subsidiaries, especially when
tinue to provide advisory services? the subsidiary provides services to an affiliate
5. Are there any other aspects of the adviser’s
operations, or the operations of an affiliate, BHC Supervision Manual June 1999
which raise concerns? Page 13
bank trust department examined by the Board of The companies being advised on a contrac-
Governors of the Federal Reserve System. If the tual basis and which were sponsored by the
bank holding company has to ‘‘spin off’’ the holding company or any affiliate are also defined
investment research and selection process of its as affiliates in sections 23A and 23B of the
banks’ trust departments into an investment Federal Reserve Act. The examiner should there-
advisory subsidiary, there may be a need to fore be alert to any intercompany transactions
review the activities of the trust departments between a bank subsidiary and the advised com-
together with those of the advisory subsidiary pany. A review of financial statements of such
through an on-site inspection. companies is warranted.
Limitations and 15 U.S.C. 225.28(b)(6) 4–177 1997 FRB 275

activity approval 80; section 225.125 1971 FRB 512
23A FRA 1972 FRB 149,
371c 571
Activity approval— 225.28(b)(6) 1997 FRB 275

real estate development 1980 FRB 962
advisers for state and 984
and local governments

Page 14
4(c)(8)—Advice on Mergers and Similar Corporate Structurings,
Capital Structurings, and Financing Transactions Section 3130.3
This section renders inspection guidance on relationship between trusts and their advisers
financial and investment advisory activities that has gone beyond the parameters of advice and
are provided in connection with mergers, acqui- resulted in legal entanglements, conflicts of
sitions, divestitures, investments, joint ventures, interest, and financial exposure for the bank
leveraged buyouts, recapitalizations, capital struc- holding company. Because of the potential risk
turings, and financing transactions and similar exposures which may result when a bank hold-
transactions, and on conducting financial- ing company or its subsidiary engages in this
feasibility studies.1 This section also provides activity, the overall relationship must be subject
historical examples of financial and investment to particular scrutiny during an inspection.
advice previously approved by Board order. The REITs were established by the U.S. Congress
examples consist of various kinds of advice in 1960, effective January 1, 1961. A REIT is a
with regard to mergers and similar corporate hybrid form of an investment vehicle which is
transactions under the current Regulation Y, sec- essentially a financial intermediary specializing
tion 225.28(b)(6)(iii). Some of the examples of in real estate lending and investment. A REIT
advisory nonbank activities were approved for obtains funds by borrowing from financial insti-
inclusion into Regulation Y long before the tutions or other lenders or by issuing shares
revision of Regulation Y that was effective April (equity capital). It invests the funds in real
21, 1997. The reader of these examples must estate, either as a lender or equity owner. REITs
only take into consideration the current provi- are usually owned by passive owners, not opera-
sions of Regulation Y. There should be no reli- tors. REITs are designed to take advantage of
ance on Board order commitments, old regula- benefits within the federal Internal Revenue
tory provisions, supervisory policies, and Code.
interpretations made before April 21, 1997, unless There are generally four types of REITs:
they were not revised. Certain former provisions equity, mortgage, hybrid, and ‘‘finite-life.’’ An
or commitments may no longer be applicable. equity REIT acquires income-producing proper-
The historical examples discussed in this section ties, deriving its earnings mostly from rents. A
have been revised according to the new regula- mortgage REIT provides financing to real estate
tory provisions. projects that are owned by others, deriving its
If inspection objectives and procedures are earnings from interest charged on the loans. A
stated in a specific section, the examiner should hybrid REIT combines the equity REIT and the
use this specialized guidance. In addition, the mortgage REIT. The finite-life REIT is struc-
examiner should use the generalized inspection tured to self-liquidate within an established time
objectives and procedures in section 3130.0, frame.
which are generally applicable to all advisory By meeting certain prescribed requirements
activities. during a taxable year, a REIT may function as a
conduit with respect to income distributed to its
beneficiaries. If at least 95 percent of the trust’s
3130.3.1 ADVISER TO A MORTGAGE income is distributed to the beneficiaries (exclud-
OR REAL ESTATE INVESTMENT ing capital gains), the trust pays no taxes on the
TRUST distributed income, thus avoiding the double
taxation associated with corporations. There-
An adviser to a mortgage or real estate invest- fore, this investment vehicle has the tax advan-
ment trust (REIT) furnishes expertise in the tage of a partnership but offers the limited liabil-
areas of funds acquisition, lending, investing, ity and perpetuity of a corporation.
and servicing that is similar to the role of adviser A REIT must be a corporation (other than an
to a mutual fund. The contracted service is insurance company or bank), an association, or
performed on a fee basis that is generally based a trust, or it must be managed by at least one
on a percentage of the trust’s total assets. The trustee, with transferable shares of beneficial
intention of the exemption, found in section interest as form and evidence of ownership.
225.28(b)(iii) of Regulation Y, is to allow the There must be at least 100 beneficial owners,
relationship to be advisory in nature as opposed and the trust must elect to be treated as a REIT
to controlling. However, in some instances, the for tax purposes. A REIT must meet the follow-
ing threefold gross income test. At least 95 per-
1. Feasibility studies do not include assisting management
with the planning or marketing for a given product or provid- BHC Supervision Manual June 1998
ing general operational or management advice. Page 1
Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions 3130.3
cent of the trust’s income must come from real amount of any cash or earning assets that will be
property rentals, dividends, abatements and given to the trust.
refunds of real property taxes, interest on loans, A holding company and a trust have separate
or gains from the sale of securities or real estate, and distinct shareholders but common manage-
with the further stipulation that no less than ment. The potential exposure in such cases may
75 percent of the trust’s income must be directly be pronounced. Such relationships should be
related to real property. Also, less than 30 per- reviewed for conflicts of interest. Loans may be
cent of the trust’s income can be derived from booked by the holding company or its subsidi-
the sale of any securities held for less than six ary and subsequently sold to the trust. The credit
months and from foreclosure property and real decision may have been made by the subsidiary,
property held for less than four years that is not and the REIT’s purchase of the loans may have
involuntarily converted. been approved by the affiliated adviser. The
In addition to the threefold gross income test, benefits to the holding company may include
there is a twofold investment test which must be receiving the origination fee and selling the loan
met. First, at least 75 percent of the value of the to the trust, thereby increasing the REIT’s assets,
trust’s total assets must be real estate assets, upon which the holding company’s advisory fee
government securities, and cash. Second, 25 per- is based. Following receipt of the sale’s pro-
cent of the trust’s total assets may be securities, ceeds, the process may be repeated. If the hold-
but the trust cannot hold securities from one ing company has participated in this type of
issuer which amount to greater than 5 percent of process, there is potential for a conflict of inter-
the trust’s total assets and more than 10 percent est. The holding company or its subsidiary may
of the outstanding voting securities of the issuer. have to repurchase the credit.
Theatened or pending litigation may result
from loans that were originated by the holding
company or its subsidiaries or that were recom-
3130.3.1.1 Evaluating Advisory Activities mended by the adviser. The number of such
for a REIT loans together with the current payment status
of the credit should be determined. If there are
A bank holding company may have an insignifi- numerous loans on a nonaccrual status, the hold-
cant amount of capital invested in the advisory ing company may have accumulated a signifi-
company. However, if the bank holding com- cant loss. Finally, any suit involving the adviser
pany or its subsidiaries have extensions of credit which pertains to services it performed should
or unfunded commitments outstanding, an evalu- be explored as to its validity and potential finan-
ation of the credit may be needed using normal cial exposure.
classification criteria as to their collectibility,
particularly if there is substantial risk exposure.
Examination/inspection reports of subsidiaries 3130.3.2 INSPECTION OBJECTIVES
should be reviewed to determine the consoli-
dated exposure. The holding company or its 1. To determine the level of risk involved when
banking subsidiaries may be participating in the bank holding company or its subsidiaries
exchanges or swaps with the advised REIT, have extensions of credit and unfunded com-
whereby trust assets are exchanged for forgive- mitments outstanding to the advised trust.
ness of bank debt. Such pending asset swaps 2. To review for conflicts of interests in cases
should be considered in conjunction with the when a holding company and a trust have
credit evaluations. The swaps may be for the separate and distinct shareholders but com-
purpose of reducing the REIT’s liabilities, which mon management.
can involve an exchange of assets with the 3. To review all threatened or pending litigation
lender. The lender’s balance sheet reflects an involving loans originated by the holding
exchange of one asset for another together with, company or its subsidiaries that were recom-
possibly, a lump-sum payment of cash to the mended by the adviser.
trust. If a swap is pending, review the criteria 4. To review all covered transactions between a
that the holding company used to (1) determine bank holding company’s subsidiary bank and
the benefit of the swap to the company and a REIT, if the REIT is sponsored and advised
(2) select which of the REIT’s assets would be on a contractual basis by the bank or any
considered for the swap. Also, determine the subsidiary or affiliate of the bank, to ensure
that transactions are permitted pursuant to
BHC Supervision Manual June 1998 sections 23A and 23B of the Federal Reserve
Page 2 Act.
5. To determine whether the REIT has been ary, and if the REIT’s purchase of the
advised to sell real estate in the ordinary loans was approved by the affiliated adviser.
course of business and, if so, whether the b. If significant conflicts of interest exist,
appropriate liability account for corporate determine whether the holding company
federal and state taxes has been established or its subsidiary must repurchase any
by the advised subsidiary. associated credit.
6. To determine whether the REIT adviser is 3. Review all threatened or pending litigation
providing the appropriate advice to the REIT involving loans originated by the holding
to generate nonspeculative high yields; company or its subsidiaries that were recom-
adequate liquidity; portfolio diversification; mended by the adviser.
sufficient cash flow to pay dividends; con- a. Determine the number and amount of
tinuous repricing; and adequate public dis- such loans together with the current pay-
closure, including the extent of risk involved. ment status of the credit and whether any
7. To determine the adequacy and quality of loans are on a nonaccrual status.
professional management and the level of b. Evaluate any suit involving the adviser
management’s equity stake in the REIT. that pertains to services it performed as to
8. To determine the effect on net earnings from the suit’s validity and potential financial
floating interest rates on asset yields that may exposure.
have been caused by prepayment risk. 4. Evaluate the effect on net earnings and divi-
dends that declining rates (floating-rate assets)
have on the prices of floating-rate mortgage
3130.3.3 INSPECTION PROCEDURES assets. Determine the results and the nature
of any hedging strategies that are used to
1. Determine if there are any significant exten- offset a decline in net earnings.
sions of credit or unfunded commitments
outstanding. If so— See also the inspection procedures in sections
a. evaluate the credit using normal classifi- 3130.0 and 3130.1.
cation criteria as to collectibility;
b. review examination or inspection reports
of the holding company’s subsidiaries and
determine the consolidated exposure; and
3130.3.4 FINANCIAL ADVICE ON
c. review any pending asset swaps in con-
ISSUING SECURITIES OF FOREIGN
junction with the credit evaluations, if the
GOVERNMENTS IN THE UNITED
holding company or its banking subsidi-
STATES
aries are participating in exchanges or 3130.3.4.1 Financial Advice to the
swaps with the advised REIT whereby Canadian Federal, Provincial, and
trust assets are exchanged for forgiveness Municipal Governments
of bank debt.
• Review the lender’s balance sheet to An example of providing financial and invest-
make certain that it reflects an exchange ment advisory activities is a Board order that
of one asset for another, as well as any was previously approved (now authorized under
lump-sum payment of cash to the trust. section 225.28(b)(6)(iii) of Regulation Y). The
• Review the criteria the holding com- order specifically authorized the providing of
pany used to (1) determine the benefit financial advice to the Canadian federal and
of the swap to the company and (2) select provincial governments for issuing their securi-
which of the REIT’s assets would be ties in the United States. Also, the Board’s
considered for the swap. Regulation K authorizes the provision of such
• Determine the amount of any cash or investment, financial, or economic advisory ser-
earning assets that will be given to the vices to foreign governmental entities (see sec-
trust. tion 211.10(a)(8)). The Board approved the pro-
2. Determine and evaluate any significant con- posed activity on February 12, 1988 (1988 FRB
flicts of interests in cases when a holding 249).
company and a trust have separate and dis- Another Board order authorized a foreign
tinct shareholders but common management. bank, subject to the BHC Act, to acquire a
a. Determine if there are any loans booked securities firm to engage in this activity, but to
by the holding company or its subsidiary
and subsequently sold to the trust, if the BHC Supervision Manual June 2002
credit decision was made by the subsidi- Page 3
expand the activity to include the providing of nies and of large blocks of utility stock for a
such advice to the Canadian municipal govern- variety of purposes, and (3) expert-witness testi-
ments in addition to the federal and provincial mony on behalf of utility companies in rate
governments. The Board concluded that the cases.
slight modification would not alter the activity In providing financial-feasibility studies, all
to render it less closely related to banking. The financial aspects of the particular project were
Board approved the order on March 28, 1988 evaluated, including economic conditions, sales
(1988 FRB 334). Other approved Board orders and earnings statements, balance sheets, and
for this activity are 1988 FRB 500 and 1988 cash-flow data. Each engagement involved ana-
FRB 571. lyzing and projecting the income to be gener-
ated by a particular project. The Board believed
that this activity was functionally similar to the
3130.3.4.2 Providing Financial Advice to financial advice traditionally offered by banks to
the Japanese National and Municipal their commercial lending customers. The appli-
Governments and Their Agencies cant provided evidence revealing that certain
major banks perform similar financial-feasibility
Another example of providing advice to foreign analysis services for their customers. The Board
governments is a bank holding company that thus approved the provision of such financial-
applied for the Board’s approval to engage, feasibility studies for corporations. Certain com-
through its wholly owned securities subsidiary, mitments were made to guard against any pos-
in certain securities-related, foreign-exchange, sible conflicts of interests and related adverse
and investment and financial advisory activities. effects between the applicant’s credit-extending
The activity, which consisted of providing finan- subsidiaries and the company, acting as an adviser
cial advice to the Japanese national and munici- regarding the financial-feasibility studies.
pal governments, had not previously been autho- Included was the condition that the company’s
rized for bank holding companies. When making financial advisory activities would not encom-
its decision, the Board referred to similar orders pass the performance of routine tasks or opera-
as well as to the facts provided. It approved tions for a customer on a daily or continuous
these advisory services by order on June 4, basis.
1990. (See 1990 FRB 654.) Upon consideration of the above, the Board
The Board, effective September 10, 1992, also determined the activity of providing valua-
added the providing of financial advice to for- tions of companies, as well as the expert-witness
eign governments, such as advice with respect testimony incidental to such valuations, to be
to the issuance of their securities, to the activi- permissible. The commercial lending and trust
ties permissible by Regulation Y, currently autho- departments of banks commonly make valua-
rized by section 225.28(b)(iii). tions of a broad range of tangible and intangible
property, including the securities of closely held
companies. The applicant provided evidence
3130.3.5 PROVIDING that numerous banks compete directly with the
FINANCIAL-FEASIBILITY STUDIES company in offering corporate valuations for a
AND VALUATION SERVICES fee.
The Board, effective September 10, 1992,
The following provides an example of a bank added the providing of financial-feasibility stud-
holding company that was authorized to provide ies to the list of nonbanking activities permitted
financial-feasibility studies and valuation ser- by Regulation Y (see section 225.28(b)(6)(iii)).
vices, including expert-witness testimony in con- With the Regulation Y revisions, effective April
nection with the valuation services. A bank 1997, the Board specifically determined that
holding company (the applicant) had requested feasibility studies do not include assisting man-
the Board’s approval to acquire 100 percent of agement with the planning or marketing for a
the voting shares of a company (the company) given project or providing general operational
that engaged in investment advisory, investment or management advice. The 1992 amendment to
management, and financial advisory services. this regulation permitted bank holding compa-
The company engaged in providing (1) finan- nies to conduct feasibility studies for high net
cial-feasibility studies for specific projects of worth individuals, as well as corporations, and
private corporations, (2) valuations of compa- financial and nonfinancial institutions. With the
April 1997 amendment, such services could be
Page 4
provided to any person.
3130.3.5.1 Valuation Services provide education-financing advisory services.2

The company would enable state governments
The valuation services included the following to assist parents in financing the higher educa-
activities: tion of their children.
The company will (1) develop and manage an
1. the valuation of a company for purposes of educational savings and lending program on
acquisitions, mergers, and divestitures behalf of the state, (2) design and provide neces-
2. tender-offer evaluations sary computer software for the program, (3) pro-
3. advice for management or for a bankruptcy vide marketing and program materials, and
court on the viability and capital adequacy of (4) train state personnel to implement the pro-
financially troubled companies and on the gram. The notificants would eventually provide
fairness of bankruptcy reorganizations the services to various state governments
4. valuation opinions on transactions in pub- nationwide.
licly held securities As part of developing the education savings
5. valuations on the fair market value of employee and lending program, the company would assist
stock ownership trusts in formulating and defining its overall scope;
6. periodic valuation of stock of privately owned provide the research necessary to begin opera-
companies held in pension or profit-sharing tions; design the program’s operations; and
plans, charitable trusts, or venture-capital organize the program in cooperation with all
funds interested parties, including coordinating partici-
7. the valuation of a privately owned company pation among the state authorities. The com-
or of a large block of publicly owned securi- pany would also coordinate key functions of a
ties for estate-tax purposes college-funding program, such as marketing,
8. for estate-tax purposes, valuations of a public relations, training, investment, lending,
company’s common stock and other securi- legal documentation, financial recordkeeping,
ties for recapitalization of a privately held and ongoing program evaluation. In addition,
company the company would design, install, and maintain
the computer software necessary to implement
the program’s services. The company’s compen-
3130.3.5.2 Utility-Rate Testimony in sation would be based on application fees received
Support of Utility-Company Valuations by a state educational assistance authority and
the amount of investment and loan balances
The company frequently provided expert wit- held by the program.
ness testimony on behalf of utility firms in rate
cases. The company’s personnel were retained All of the intended services are integrally
to give expert testimony on financial matters related to advising and administering student-
such as the cost of capital, economic conditions, loan and college-savings programs. Banks offer-
and the rate of return expected by investors in ing their own student-loan and college-savings
utility securities. The Board believed that to a programs engage in many of the planned activi-
large degree the activity may be considered ties and are uniquely suited to advise and assist
incidental to the company’s general provision of other potential providers, including state gov-
economic information and advice which is per- ernments, in structuring and implementing
missible under section 225.28(b)(6)(ii) of Regu- student-loan and college-savings programs.3 The
lation Y. Also, banks routinely calculate the cost Board previously concluded that bank holding
of capital for customers to advise them regard- companies may provide similar advisory and
ing financial alternatives. support services to state authorities that are
engaged in making student loans.4 Accordingly,
3130.3.6 EDUCATION-FINANCING
2. The notificants would have varying ownership interests
ADVISORY SERVICES in excess of 5 percent. Other individual ownership interests of
less than 5 percent would be held by various banks and
Four bank holding companies (collectively, the savings institutions located in one state. Each notificant com-
notificants) gave notice pursuant to section 4(c)(8) mitted that the company would be treated as a subsidiary
within the meaning of the BHC Act (12 U.S.C. 1841(d)).
of the Bank Holding Company Act (BHC Act) 3. See 12 C.F.R. 225.28(b)(1) and (6).
(12 U.S.C. 1843(c)(8)) and section 225.23 of the 4. See 1985 FRB 725.
Board’s Regulation Y (12 C.F.R. 225.23) of
their intention to each acquire more than 5 per- BHC Supervision Manual December 1998
cent of a company (the company) that would Page 5
based on all the facts of record, the Board September 25, 1995 (1995 FRB 1042). Approval
concluded that the proposed activities are closely of this proposal is specifically conditioned on
related to banking under section 4(c)(8) of the the notificants’ compliance with the commit-
BHC Act. The Board approved the notice on ments made in connection with this notice.

Page 6
Providing financial-feasibility stud- 225.28(b)(6)(iii) 1985 FRB 118,

ies, valuation services, utility-rate 120
testimony, but not ‘‘public’’ credit
ratings
Financial-feasibility studies for 1987 FRB 59

issues of tax-exempt revenue bonds
and private corporations
Advice in connection with merger, 225.28(b)(6)(iii) 1987 FRB 59

acquisition/ divestiture, and financ-
ing transactions and advice regard-
ing loan syndications, interest-rate
swaps, and interest-rate-cap
transactions
Providing financial advice to the 225.28(b)(6)(iii) 1988 FRB 249

Canadian federal, municipal, and 1988 FRB 334
provincial governments, such as
with respect to the issuance of their
securities in the United States
Financial advice to the Japan- 225.28(b)(6)(iii) 1990 FRB 654

ese national and municipal
governments
Financial advice to state and local 225.28(b)(6)(iii) 1973 FRB 701

governments
Financial advice vs. management 1972 FRB 674,

consulting 676
Investment advice pertaining to 1983 FRB 564

income-producing real property
Investment advisory activities and 225.28(b)(6)(iii) 1994 FRB 638

joint ventures with securities firms
Education-Financing Advisory 1995 FRB 1042

Services
Regulation Y revision 62 Federal 1997 FRB 275

Register
9290 to 9307
(February 28,
1997)

Page 7
4(c)(8)—Informational, Statistical Forecasting, Advisory Services for Transactions in
Foreign Exchange and Swaps, Commodities, and Derivative Instruments Section 3130.4
3130.4.1 INFORMATIONAL, As a condition for approval, the applicants were
STATISTICAL FORECASTING, AND required to seek the Board’s authorization if
ADVICE ON SUCH TRANSACTIONS they engaged in any additional activities within
AS FOREIGN EXCHANGE, SWAPS, the United States. (See 1983 FRB 221.)
COMMODITIES, AND DERIVATIVES Effective February 6, 1984, the Board amended
Regulation Y to allow bank holding companies
Providing financial and investment advisory to offer foreign-exchange advisory and transac-
activities may consist of a bank holding compa- tional services that include providing general
ny’s providing information, statistical forecast- information and statistical forecasting with respect
ing, and advice with respect to any transaction to foreign-exchange markets. The activity
in foreign exchange, swaps, caps, and similar included arranging for ‘‘swaps’’ among custom-
transactions, commodities, and any forward con- ers with complementary foreign-exchange expo-
tract, option, future, option on a future, and sures and the execution of foreign-exchange
similar instruments.1 The Board has found finan- transactions, provided the activity would be con-
cial advice regarding interest-rate swap and cap ducted through a separately incorporated subsid-
transactions to be permissible. The Board has iary of the bank holding company that will
also found that providing advice in connection observe the standards of care and conduct appli-
with currency swaps is permissible,2 as well as cable to fiduciaries with respect to its foreign-
providing advice regarding loan syndications.3 exchange advisory and transactional services.
This section provides an example of a February
16, 1983, Board order permitting a bank holding
company to establish a de novo subsidiary to 3130.4.1.1 Inspection Objectives
offer certain informational, advisory, and trans-
actional services including the provision of the 1. To determine the financial effect of the activ-
following: ity on the parent BHC and its bank subsidi-
ary (or subsidiaries).
1. General economic information and statistical 2. To determine that the specific activities pro-
forecasting with respect to foreign exchange vided by the company are permissible.
and money markets through time-sharing 3. To determine that the company is not expos-
networks. The services included the analysis ing itself to conflicts of interest between its
of foreign-exchange and money market trends own role of recommending foreign-exchange
in the context of economic and political positions to its customers and any role its
developments and the provision of informa- affiliates may have in executing foreign-
tion with respect to foreign exchange. exchange transactions.
2. Advisory services designed to assist custom-
ers in monitoring, evaluating, and managing
their foreign-exchange exposure, including
making recommendations regarding policies 3130.4.1.2 Inspection Procedures
and procedures to enhance a customer’s abil-
1. Review the company’s financial statements
ity to identify, measure, and manage finan-
for accuracy, and determine if there are any
cial risks in a multicurrency environment.
factors or trends that could have an adverse
The newly formed subsidiary would also pro-
impact on the parent holding company or the
vide advice on the timing of purchases and
bank subsidiary (or subsidiaries).
sales of foreign exchange in both spot and
2. Review the company’s policies and proce-
forward markets.
dures to determine that the following are
3. Transactional services with respect to foreign- present:
exchange exposures. The subsidiary would a. adequate minutes of the board and board
arrange foreign-exchange transactions by anaf- committee meetings
filiated bank holding company and other b. adequate blanket bond coverage
commercial banks. 3. Review a sample of recommendations to
determine that a reasonable basis exists for
the company’s recommendations.
1. See 62 Federal Register 9,290 (February 28, 1997) (12
C.F.R. 225.28 (b)(6)) or 1997 FRB 275.
2. See 1989 FRB 308. BHC Supervision Manual June 1998
3. See 1987 FRB 220. Page 1
4(c)(8)—Informational, Statistical Forecasting, and Advisory Services 3130.4
4. Review the company’s fee schedule for pro- calculated on an assumed principal amount for a
viding advice and the fees charged by affili- deferred time period. The caps and swaps are
ated banks to conduct foreign-exchange trans- typically used to manage or hedge outstanding
actions for the company’s customers. positions in the financial markets.
Determine whether bank subsidiaries are being The Board’s authorization included the fol-
adequately compensated for executing trades, lowing conditions:
or whether these profits are accruing largely
to the benefit of the bank holding company 1. The advice rendered by the company on an
or its nonbank subsidiaries. explicit fee basis will be rendered without
5. Review the company’s revenue sources to regard to correspondent balances maintained
determine that it has not taken foreign- by the customers of the company at any
exchange positions and does not execute depository institution subsidiary of the BHC.
foreign-exchange transactions. 2. Company’s financial advisory activities shall
not encompass the performance of routine
tasks or operations for a customer on a daily
or continuous basis. The Board, on Novem-
ber 28, 1986, approved the activity by order
3130.4.2 FINANCIAL ADVICE AS TO
(1987 FRB 59). (See 1990 FRB 756.) The
THE STRUCTURING OF AND
Board subsequently, effective September 10,
ARRANGING FOR LOAN
1992, added this nonbanking activity to the
SYNDICATIONS, INTEREST-RATE
list of activities permitted by Regulation Y.
SWAPS, CAPS, AND SIMILAR
(See section 225.28(b)(6)(iii) for loan syndi-
TRANSACTIONS
cations and 225.28(b)(6)(iv) for interest-rate
swaps and caps.)
A bank holding company may provide informa-
tion, statistical forecasting, and advice with Reference can also be made to another Board
respect to any transaction in swaps, caps, and order (1991 FRB 184) relating to providing
similar transactions; commodities; and any for- advice on joint ventures, leveraged buyouts,
ward contract, option, future, option on a future, restructurings, recapitalizations, and other cor-
and similar instruments.4 The Board has found porate transactions (see 225.28 (b)(6)(iii) of
financial advice regarding interest-rate swap and Regulation Y), as well as to providing advice
cap transactions to be permissible.5 The Board regarding the structuring and arranging of swaps,
has also found the provision of advice regarding caps, and similar transactions relating to interest
loan syndications to be permissible.6 rates, currency and exchange rates and prices,
An example of a Board order regarding pro- and economic and financial indexes (see
viding financial advice is one in which a bank 225.28(b)(6)(iv) of Regulation Y).
holding company (BHC) applied for the Board’s
approval to establish its company de novo as a
financial advisory firm. The Board had not pre- 3130.4.3 ADVICE RELATING TO THE
viously approved the structuring of and arrang- STRUCTURING OF AND
ing for loan syndications (see section ARRANGING FOR CURRENCY
225.25(b)(6)(ii) of Regulation Y) or arranging SWAPS
for interest-rate ‘‘swaps’’ and interest-rate caps,
and similar transactions (see section 225.28 A foreign bank subject to the BHC Act applied
(b)(6)(iv) of Regulation Y). Interest-rate caps for the Board’s approval to acquire a company
are contractual agreements wherein the seller of engaged in certain securities, foreign-exchange,
a cap agrees to make payment to the purchaser and financial advisory activities. The Board pre-
of a cap if a particular interest-rate index (prime) viously determined the activities proposed by
exceeds a predetermined level, with payments the BHC, except for providing advice relating to
the structuring of and arranging for currency
swaps, to be closely related to banking. As for
advice on currency swaps, it was noted that
4. See 62 Federal Register 9,290 (February 28, 1997) (12 most banks that provide advice relating to interest-
C.F.R. 225.28 (b)(6)) or 1997 FRB 275.
5. See 1989 FRB 308.
rate swaps also provide advice relating to cur-
6. See 1987 FRB 220. rency swaps. Providing advice as to currency
swaps was deemed to be functionally and opera-
BHC Supervision Manual June 1998 tionally similar to providing advice relating to
Page 2 the structuring of and arranging for interest-
rate swaps. Both transactions have the common approval to provide de novo investment advice
objectives of securing low-cost funds and con- concerning futures and options on futures con-
verting one type of risk to another, and both tracts on foreign exchange, government securi-
transactions require similar documentation. The ties, and bullion and money market instruments.
Board approved the activity by order on Febru- In addition, the company would provide port-
ary 13, 1989 (1989 FRB 308). The Board, effec- folio investment advice, for which applicant had
tive September 10, 1992, added providing advice previously received authorization pursuant to
as to currency swaps to the nonbanking activi- Regulation Y (the authorization is currently
ties permitted by regulation. See section included in section 225.28(b)(6)(iv)).
225.28(b)(iv) of Regulation Y. Previously, the Board had approved the
provision of investment advice as a futures com-
mission merchant (FCM) (section 225.28(b)(7)
3130.4.4 ADVICE WITH RESPECT TO (iv)(A)) or as a commodity trading adviser (CTA)
FUTURES CONTRACTS registered with the Commodity Futures Trading
Commission (CFTC). The provision by an FCM
3130.4.4.1 Limited Advisory Services or CTA of such advice could include providing
with Respect to Futures Contracts on counsel, publications, written analyses, and
Stock Indexes and Options on Such reports relating to the purchase and sale of
Futures Contracts futures contracts and options on futures con-
tracts that bank holding company futures com-
The following is an example of a bank holding mission merchant subsidiaries are permitted to
company that applied to the Board to engage de execute and clear. Such advisory services could
novo, through a wholly owned subsidiary, in the also consist of providing written or oral presen-
provision of advisory services with respect to tations on the historical relationship between the
futures contracts on stock indexes and options cash and futures markets or the functions of
thereon. The advisory services to be provided futures as hedging devices, demonstrating
consisted of general research and advice on examples of financial futures uses for hedging,
market conditions and hedging strategies, client- and assisting in structuring a hedging strategy
account information and reconciliation of trades, for a cash position. FCMs and CTAs are subject
and communication linkage between clients and to registration with and regulation by the Com-
exchange floors in connection with the subsid- modity Futures Trading Commission pursuant
iary’s futures commission merchant activities. to the Commodity Exchange Act, as amended.
The services offered to customers were pro- (7 U.S.C. 1).
vided either as part of an integrated package of Before incorporation of the advisory activity
services or for a separate fee. into Regulation Y (see 1986 FRB 369), the
The futures advisory services were essentially Board had determined by order that the provi-
identical to the advisory services previously sion of futures and options advice by FCMs is
approved by the Board by regulation and order permissible and closely related to banking (see
with respect to other financially related futures 1985 FRB 168 and 111, 1984 FRB 780, and
contracts. The Board concluded the applicant’s 1984 FRB 369). A CTA could provide such
provision of advisory services for futures con- advice even though it is not acting as an FCM.
tracts on stock indexes and for options thereon The issue presented by this latter proposal
to be permissible (1987 FRB 220 and section was whether the conduct of this activity by
225.28(b)(6)(iv) of Regulation Y). company would be a proper incident to banking
Previously, the Board had approved the if company, serving as an adviser, did not meet
execution and clearance of futures contracts on the former Regulation Y requirement of regis-
stock indexes and options thereon (1985 FRB tering with the CFTC as a CTA or FCM. The
251). At that time, however, the Board had not applicant expected to qualify for a statutory
approved a proposal to provide investment advi- exemption (7 U.S.C.6m) from the registration
sory services in connection with the execution under section 4m of the Commodity Exchange
and clearance of such instruments. Act. This exemption provides that any person
who, during the previous 12 months, has not
furnished commodity advisory services to more
3130.4.4.2 Advice on Certain Futures and than 15 persons and has not represented himself
Options on Futures or herself to the public as a CTA is exempt from
This section is a historical example of a bank BHC Supervision Manual December 1999
holding company that requested the Board’s Page 3
the registration requirements for CTAs under vices.7 The Board previously determined that
the act. The applicant’s proposal permitted com- the proposed activities, with the exception of
pany to provide commodity trading advice with- providing discretionary portfolio management
out those safeguards. The Board held that it services with respect to futures and options on
expects the adviser to disclose to its customers futures on nonfinancial commodities, are closely
substantially the same information required for related to banking.
registered CTAs, including the CTA’s perfor- The Board had permitted bank holding com-
mance record, conflicts of interest, possible trad- panies to provide investment advice with respect
ing risks, and civil and criminal actions against to futures and options on futures on both finan-
the CTA. cial and nonfinancial commodities. (See section
The Board concluded that the possible adverse 225.28(b)(6)(iv) of Regulation Y.) The Board
effects would be further minimized by the fol- also previously approved providing discretion-
lowing conditions: ary portfolio management services with respect
to futures and options on futures on financial
1. Company will remain subject to the antifraud commodities. (See 1995 FRB 386.) In addition,
provisions of the Commodity Exchange Act the Office of the Comptroller of the Currency
as well as other restrictions in the act. permits national banks to engage in discretion-
2. The adviser will not trade for its own account ary funds management with respect to futures
(except to hedge), will limit its advice to and options on futures on nonfinancial com-
instruments that banks deal in extensively modities. (See OCC Interpretive Letter No. 494
(foreign exchange, bullion, government secu- (December 20, 1989).)
rities, and money market instruments), and In this regard, applicants committed that com-
will only serve customers that are financially pany would provide the proposed discretionary
sophisticated and have significant dealings or portfolio management services only at the request
holdings in the underlying commodities or of the customer. Applicants also committed that
instruments. The Board approved the appli- company would comply with applicable law,
cation by order on October 18, 1988 (1988 including fiduciary principles. In addition,
FRB 820). applicants proposed that company exercise its
discretionary portfolio management authority
only in purchasing and selling exchange-traded
futures and options on futures contracts previ-
3130.4.5 PROVIDING ously approved by the Board. (See SR-93-27.)
DISCRETIONARY PORTFOLIO The Board gave its approval on June 30, 1995
MANAGEMENT SERVICES ON (1995 FRB 803).
FUTURES AND OPTIONS ON
FUTURES ON NONFINANCIAL
COMMODITIES 3130.4.6 COMBINATION OF
PROVIDING ADVICE WITH OTHER
With respect to the Regulation Y provisions NONBANKING ACTIVITIES
effective April 21, 1997, discretionary portfolio
management advice is not separately listed in
section 225.28(b)(6)(iv). Discretionary invest- 3130.4.6.1 Providing Nonfinancial
ment advice is discussed, however, within the Futures Advice and the Combining of
preamble to the final rule. The preamble empha- Foreign-Exchange, Government Securities
sizes that such advice may be provided to any Advisory, and Execution Services
person (such advice is no longer limited to
institutional investors) regarding contracts relat- A BHC applicant requested the Board’s permis-
ing to financial and nonfinancial assets. sion to engage in trading options on foreign
Foreign banking organizations (applicants) exchange and offering investment advice on
subject to the BHC Act provided notice to financial and nonfinancial options and futures
engage through their subsidiary (company) in contracts, securities, and interest-rate and cur-
providing investment advisory services with rency swaps. The applicant applied to provide
respect to futures and options on futures on these advisory services through a partnership, of
financial and nonfinancial commodities, includ- which it would own 80 percent of its equity.
ing discretionary portfolio management ser-
7. Company does not trade futures or options on futures for
BHC Supervision Manual December 1999 its own account or provide futures commission merchant
Page 4 execution or clearance services.
This partnership would provide these advisory ship would not provide advice to third parties
services only to the applicant, its affiliates, and without Federal Reserve approval. The Board
the applicant’s partner, a commodity trading thus approved the providing of investment advice
organization. The partnership would provide on nonfinancial futures, options, and options on
execution services only to the applicant and its futures.
affiliates, not to the applicant’s partner. The applicant also proposed that the partner-
The Board had not previously approved the ship provide execution services to the appli-
provision of nonfinancial futures advice for bank cant’s wholly owned subsidiary and to the appli-
holding companies. The Board noted that the cant’s U.S. branches with respect to—
Office of the Comptroller of the Currency (OCC),
by OCC Interpretive Letter 494 (December 20, 1. over-the-counter options on foreign exchange,
1989), determined that a national bank could U.S. government securities, and other money
provide execution, clearing, and advisory ser- market instruments, and indexes on such
vices for customer transactions in standardized, securities and instruments;
exchange-traded ‘‘nonfinancial’’ futures con- 2. exchange-traded transactions in futures,
tracts and options, such as futures on oil and options, and options on futures on foreign
agricultural products. The OCC determined that exchange, U.S. government securities, and
the contracts are financial products and that the other money market instruments, and indexes
provision of investment advice was essentially on such securities and instruments; and
the same as the advice given with respect to 3. spot and forward transactions in foreign
financial futures contracts. The OCC contends exchange.
that investment advice is incidental to the bank’s
authority to purchase and sell the instruments on The Board previously approved the combina-
behalf of its customers. tion of advice and execution for—
The Board has permitted bank holding com-
panies to provide advice with respect to futures 1. foreign-exchange transactions (1990 FRB
and options on futures relating to bank-eligible 649),
securities, bullion, and foreign exchange (12 2. transactions on derivative instruments based
C.F.R. 225.28(b)(6)(iv)). The Board also has on U.S. government securities and other money
permitted bank holding companies to provide market instruments (1990 FRB 664), and
investment advice with respect to options and 3. securities brokerage (1989 FRB 396).
futures contracts based on broad-based indexes
of stock and bonds (1990 FRB 770). The Board The Board approved by order the providing of
thus determined that the provision of investment the combination of foreign-exchange and gov-
advice with respect to investing in options and ernment securities advisory and execution ser-
futures, based on nonfinancial instruments, to be vices on December 21, 1990 (1991 FRB 126).
the functional equivalent of providing advice on For these reasons, the Board approved the
options and futures based on financial instru- providing of discretionary portfolio manage-
ments. In each case, the bank holding company ment services with respect to futures and options
subsidiary is furnishing advice with respect to on futures on nonfinancial commodities on June
trading of a financial instrument. The partner- 30, 1995. (See 1995 FRB 803).

Page 5
Provide information and advice on 1983 FRB 221

foreign operations and arrange
foreign-exchange transactions
Foreign-exchange and advisory and 225.28(b)(6)(iv)

transactional services added to
Regulation Y
Financial advice as to the structur- 225.28(b)(6)(iii) 1987 FRB 59

ing of, and arranging for loan syn- and (iv) 1990 FRB 756
dications, interest-rate swap, caps,
and similar transactions
Advisory services with respect to 225.28(b)(6)(iv) 1987 FRB 220

futures contracts on stock indexes
and options on such futures
contracts
Providing discretionary portfolio 225.28(b)(6)(iv) 1995 FRB 803

management services on futures
and options on futures on nonfi-
nancial commodities
Providing nonfinancial futures 225.28(b)(6)(iv) 1995 FRB 803

advice and the combining of
foreign-exchange, government
securities advisory, and execution
services
Advice in connection with cur- 225.28(b)(6)(iv) 1989 FRB 309

rency swaps

Page 6
4(c)(8)—Providing Educational Courses and Instructional Materials
for Consumers on Individual Financial Management Section 3130.5
The financial and investment advisory nonbank- with currency swaps is permissible,2 as well as
ing activity of consumer financial counseling providing advice regarding loan syndications.3
may consist of providing advice, educational The revised Regulation Y, effective April 1997,
courses, and instructional materials to individu- deleted restrictions on consumer-counseling ser-
als on consumer-oriented financial-management vices that prohibited bank holding companies
matters, including debt consolidation, applying from promoting specific products and services,
for a mortgage, bankruptcy, budget manage- and from obtaining or disclosing confidential
ment, real estate tax shelters, tax planning, customer information without the customer’s
retirement and estate planning, insurance, and consent. These restrictions do not apply to banks
general investment management. The authority that engage in the above activities.
for this advisory activity is currently derived Prudent management should take into consid-
from section 225.28(b)(6)(v) of Regulation Y. eration certain actions to prevent potential con-
This nonbanking activity was added to the flicts from arising. When considering these orders,
Regulation Y ‘‘laundry list’’ in 1986. Previ- the Board was concerned that the provision of
ously, the Board authorized the provision of consumer financial counseling activities could
consumer financial counseling services by order. potentially result in unfair competition, conflicts
(See 1979 FRB 65, 1979 FRB 265, 1985 FRB of interest, and other adverse effects. (See 1979
253, and 1985 FRB 662. These references are FRB 267.) Examiners should be alert to prob-
only historical examples.) A bank holding com- lems that may arise from such conflicts as they
pany may provide information, statistical fore- review this nonbanking activity. Further, the
casting, and advice with respect to any transac- examiner should determine whether counselors,
tion in foreign exchange, swaps, caps, and similar as a general practice, are advising each cus-
transactions, commodities, and any forward con- tomer that they are not required to purchase any
tract, option, future, option on a future, and services from affiliates, and determine whether
similar instruments.1 The Board has found finan- customers have the option to exclude them-
cial advice regarding interest-rate swap and cap selves from service and product offerings pro-
transactions to be permissible. The Board has vided by affiliates.
also found that providing advice in connection
1. See 62 Federal Register 9,290 (February 28, 1997) (12 2. See 1989 FRB 308.
C.F.R. 225.28 (b)(6)) or 1997 FRB 275. 3. See 1987 FRB 220.
Providing financial-management 1979 FRB 265

courses, counseling, and related
instructional materials
Engaging, through an acquired 1985 FRB 253

bank, in consumer financial
counseling
Providing consumer financial coun- 225.28(b)(6)(v) 1986 FRB 833

seling services as a permissible 1985 FRB 662
nonbanking activity

Page 1
4(c)(8)—Tax-Planning and Tax-Preparation Services
Section 3130.6
Financial and investment advisory services 3. To determine whether the company has for-
include tax-planning and tax-preparation ser- mal written policies and procedures to ensure
vices. Tax planning involves providing advice accurate, timely, and confidential preparation
and strategies designed to minimize tax liabili- and maintenance of customers’ tax returns.
ties. For individuals, this includes analysis of 4. To determine whether the tax-return prepar-
the tax implications of retirement plans, estate ers are appropriately qualified to provide
planning, and family trusts; for corporations, it such tax services, and to determine the extent
includes analysis of the tax implications of of management’s involvement in the activity.
mergers and acquisitions, the portfolio mix, spe- 6. To identify the potential and extent of off-
cific investments, previous tax payments, and balance-sheet risk associated with the activity.
year-end tax planning. Tax preparation involves
the preparation of tax forms and advice concern-
ing liability based on records and receipts sup- 3130.6.2 INSPECTION PROCEDURES
plied by the client. This nonbanking activity
was included in the Regulation Y ‘‘laundry list’’ 1. Review the company’s financial statements
in 1986. (See section 225.28(b)(6)(vi).) Such for accuracy, and determine if there are any
services may be provided to any person. Effec- factors or trends that could have an adverse
tive April 21, 1997, certain restrictions were impact on the parent company or the bank
removed. These Regulation Y revisions deleted subsidiaries.
restrictions in the area of tax-planning and tax- 2. Determine whether bonding and other insur-
preparation services that prohibited bank hold- ance coverage is adequate in relation to the
ing companies from promoting specific products risks associated with the activity.
or services and from obtaining or disclosing 3. Review pertinent contracts, client lists, pub-
confidential customer information without the lic advertising and information, correspon-
customer’s consent. These restrictions do not dence, and other documentation representing
apply to banks. This fact needs to be considered the services provided, and determine if charges
when referring to the historical examples that for the tax-preparation service are on an
follow. explicit fee basis that is not dependent on the
The Board had previously approved, by order amount of tax savings achieved.
(1985 FRB 168), the activity of tax-preparation 4. Determine if the client has a written legal
services for individuals. Since tax-preparation opinion on file certifying that the activity is
services for corporations is functionally or not considered the practice of law.
operationally similar to the tax-preparation ser- 5. Review pertinent correspondence and the
vices that banks already provide to individuals minutes of board of directors and board com-
as well as to their affiliates and other financial mittee meetings, and determine if any signifi-
institutions, the Board approved the providing cant law suits, Internal Revenue Service
of corporate tax-preparation services. When the adverse actions, or other potential or contin-
nonbanking activity was incorporated into Regu- gency losses are pending and probable because
lation Y in 1986, tax-planning and tax- of inaccurate tax-return preparation. Analyze
preparation services were authorized, not only their probable effect in relation to the finan-
for individuals and corporations, but for noncor- cial condition of the company.
porate businesses, such as partnerships and sole 6. Review the company’s formal written poli-
proprietorships and tax-exempt nonprofit orga- cies and procedures for assurance of profes-
nizations. Tax-planning and tax-preparation ser- sional competence in providing sound tax-
vices must be conducted in accordance with planning advice and the accurate, timely, and
applicable jurisdictional law. confidential preparation and maintenance of
customer’s tax returns. The policies and pro-
cedures should require that tax-planning
3130.6.1 INSPECTION OBJECTIVES advice be clearly communicated by persons
who are adequately supervised and who pos-
1. To ascertain whether the customer has the sess the necessary professional technical train-
option to be excluded from promotions of ing and experience needed to provide tax-
other specific products and services. planning advice.
2. To determine what financial effect the activ-
ity has on the parent company and its BHC Supervision Manual June 1998
subsidiaries. Page 1
4(c)(8)—Tax-Planning and Tax-Preparation Services 3130.6
Preparation of tax returns in a non- 1985 FRB 168

fiduciary capacity is closely related
to banking
Permissible nonbanking activity 225.28(b)(6)(vi) 1986 FRB 833

Page 2
(Leasing Personal or Real Property) Section 3140.0
3140.0.1 LEASING AUTHORIZATIONS leasing transactions meeting the following crite-
WITHIN REGULATION Y ria are considered permissible:
Leasing is a form of financing that provides a 1. The lease must be on a nonoperating basis.
lessee (the customer) the right to use land or 2. The initial lease term must be at least 90 days.
depreciable assets without tying up working 3. For leasing involving real property—
capital. As a result of the tax benefits that can a. at the inception of the initial lease, the
arise from the ownership of equipment, real effect of the transaction must yield a return
property, or tangible personal property, leasing that will compensate the bank holding
provides the lessor (the owner of the property) company, as lessor, for its full investment
with a generally higher rate of return than what in the property plus the estimated total
could be achieved through lending. In 1971, cost of financing the property over the
‘‘leasing personal property or acting as agent, term of the lease (this includes rental pay-
broker, or adviser in leasing such property’’ was ments, estimated tax benefits, and the esti-
added to the Regulation Y list of permissible mated residual value of the property at the
nonbanking activities for bank holding compa- expiration of the initial lease); and
nies. In 1974, the authority to engage in this b. the estimated residual value (yield) of the
activity was expanded to include the leasing of property at the expiration of the initial
real property. term of the lease may not exceed 25 per-
In 1997, restrictions on leasing activities were cent of the acquisition cost of the property
removed to permit greater flexibility to acquire to the bank holding company (lessor).
leaseable property in quantity and to sell or
re-lease property upon the lease’s expiration. With respect to leasing personal or real property
The removed restrictions consisted of the maxi- on a nonoperating basis, the bank holding com-
mum lease term, maximum holding period for pany or its subsidiary may not engage in operat-
leased property, limit on acquisitions of prop- ing, servicing, maintaining, or repairing leased
erty to specific leasing transactions, restriction property during the lease term. A bank holding
on leases to those that served as the functional company, however, can arrange for a third party
equivalent of extensions of credit, and 100 per- to provide the services or products. (See Regula-
cent limit on the amount of reliance that could tion Y, section 225.28(b)(3).)
be placed on the value of leased property. The As for automobiles, a bank holding company
added clarifications consisted of more details on may not (1) provide servicing, repair, or mainte-
the requirements for a nonoperating lease, par- nance of the leased vehicle during the lease
ticularly those for automobile rentals. term; (2) purchase parts and accessories either
in bulk or for an individual vehicle after its
delivery to the lessee; (3) provide the loan of an
automobile during the vehicle’s servicing; (4) pur-
3140.0.2 PERMISSIBLE LEASING chase insurance for the lessee; or (5) provide for
ACTIVITIES the renewal of the vehicle’s license (registra-
tion) without authorization from the lessor.
Two types of leasing activities are permissible
for bank holding companies: full-payout leasing
and high-residual-value leasing. A full-payout 3140.0.2.1 Automobile Fleet Leasing and
lease is the functional equivalent of an exten- Fleet-Management Services
sion of credit that relies primarily on rental
payments and tax benefits to recover the cost of A foreign banking organization (FBO) that is
the leased property and related financing costs. treated as a bank holding company requested an
High-residual-value leasing may involve sig- opinion from the Board’s staff regarding leasing
nificant reliance on the expected residual value activities that the Board has determined to be
of the leased property—on average, under 50 per- permissible under section 225.28(b)(3) of Regu-
cent. However, this value can extend up to the lation Y. (See 12 C.F.R. 225.28(b)(3).) In con-
full original cost of the property (that is, to nection with its automobile-leasing activities,
recover the full acquisition cost of the leased the FBO provides, through a wholly owned
property plus related financing costs).
When leasing personal or real property, or BHC Supervision Manual December 2004
acting as agent, broker, or adviser, only those Page 1
Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0
automobile fleet leasing subsidiary (AFLS), fleet- ability to perform fleet servicing for owned
management services to its automobile fleet vehicles is necessary to retain customers in con-
leasing customers. In connection with making nection with AFLS’s fleet-leasing activities.
automobile and equipment leases that conform Board staff determined, in view of all the facts
with the requirements of Regulation Y, AFLS of record, including this necessity, the minimal
engages in the business of commercial lending amount of revenue earned from servicing owned
and financial leasing of motor vehicle fleets and vehicles,3 and the fact that the activity is prima-
equipment located throughout the United States, rily an agency activity, that the FBO could pro-
and providing fleet-management services to com- vide fleet-management services to owned vehi-
panies that lease corporate automobile fleets. cles as an activity incidental to the FBO’s
AFLS and other participants in the business authorized leasing activities. In a December 19,
market and deliver the three services as a bundled 2003, opinion, Board staff stated that the provi-
service to clients.1 sion of fleet-management services on owned
To better provide fleet-management services vehicles is subject to the same restrictions set
to its automobile-leasing customers (in connec- forth in Regulation Y for leased vehicles.4
tion with leases that conform with Regulation
Y), AFLS acquired another fleet-management-
services subsidiary company (FMSS) that 3140.0.3 ACCOUNTING FOR LEASES
(1) arranges for third parties to provide vehicle
maintenance, accident-management services, and Leasing has become a prominent financing vehi-
safety-management services and (2) directly cle. Lessors have employed a number of differ-
provides client-support services in connection ent methods in structuring and accounting for
with the services arranged by AFLS. FMSS, in leases. The Financial Accounting Standards Board
addition to permissible leasing activities, con- (FASB) Statement No. 13, ‘‘Accounting for
ducts some fleet-management services for auto- Leases,’’ has become the uniform standard in
mobiles that are owned by the client and that are accounting for leases.5
not, therefore, subject to a lease. Accounting for leases must be viewed from
As represented, approximately 90 percent of the perspective of the parties involved in the
the vehicles serviced by FMSS are leased and leasing transaction, the lessee and the lessor.
10 percent are client-owned. Revenues earned Negotiations and closing costs incurred with
from fleet-management services that are pro- respect to the lease should be written off over
vided for client-owned vehicles are less than the life of the lease. In applying FASB 13,
2 percent of the AFLS’s total revenues. The certain terminology is used. Basic terms that
FBO asked whether it would be permissible for should be considered are described below.
it to provide fleet-management services with Inception of a lease. The inception of a lease
regard to automobile fleets if the customer owns refers to the date the lease contract was signed
rather than leases the vehicles. or to the date that the construction was com-
In an opinion issued on December 19, 2003, pleted, or, if earlier, to the date of the written
Board staff noted that Regulation Y, as a general commitment stating the significant terms.
matter, permits a bank holding company to Term of the lease. The lease term consists of
engage in any incidental activities that are nec- the noncancelable term and the period compris-
essary to carry on an activity permitted by the ing the bargain renewal option.
regulation.2 Board staff stated also that, in light Fair value of lease property. The fair value of
of the nature of the practices in the fleet- a lease consists of the price that the property
management industry and the difficulty in con- could be sold in an arm’s-length transaction.
tinually monitoring the migration between leased Economic life of the leased property. The
and owned vehicles in the same fleet, some economic life of the leased property represents
1. The Board previously found providing fleet-

3. AFLS has stated that it will limit its fleet-management
management services to be permissible if the fleet involves
services involving vehicles not subject to a Regulation Y
vehicles that are under a lease that conforms to Regulation Y.
permissible lease to no more than 15 percent of the fleet-
(See 12 C.F.R. 225.28(b)(3), footnote 5.) Permissible leases
management revenues and to 5 percent of the total leasing
are considered to be the financial equivalent of a loan.
revenues of AFLS.
2. See 12 C.F.R. 225.21(a)(2). Staff also noted that the
4. See footnote 5 of section 225.28(b)(3) of the Board’s
courts have recognized the authority of bank holding compa-
Regulation Y (12 C.F.R. 225.28(b)(3), n. 5).
nies to engage in incidental activities that are reasonably
5. Other FASB releases dealing with leasing are FASB
necessary to the conduct of closely related activities.
Statements 22, 23, 27, 28, 29, 76, 77, 92, 94, 98, and 109;
FASB Interpretations 19, 21, 23, 24, 26, and 27; and FASB
BHC Supervision Manual December 2004 Technical Bulletins 79-10, 79-12, 79-13, 79-14, 79-15, 79-16,
Page 2 85-3, 86-2, and 88-1.
the period over which the property is expected 3140.0.3.1 Accounting for Leases by a
to be economically beneficial to one or more Lessee
users for its intended purpose.
Estimated residual value of the leased prop- The two methods for accounting for leasing
erty (ERV). The residual value is the estimated transactions by a lessee are the operating method
fair value of the leased property at the expira- and the capitalized-lease method.
tion of the lease term.
Interest rate implicit in the lease. The implicit
interest rate is the discount rate that causes 3140.0.3.1.1 Operating Method of
the sum of the minimum lease payments and the Accounting for Leases
unguaranteed residual value at the end of the
lease term to be equal to the fair value of the The operating accounting method merely records
property at the beginning of the lease term. the cost of the rental payments as an expense
Lessee’s incremental borrowing rate. The when it is required to be paid in accordance with
incremental borrowing rate is the interest rate at the terms of the lease agreement.
which the lessee could borrow the funds to
purchase the leased property.
Example: Assume that equipment is leased for $100,000 per year for three years. Under this
method, the annual cost would be recorded as a rental expense on the income statement:
Dr. Rent $100,000

Cr. Cash $100,000
To record an annual payment of rent based on an operating-lease agreement.
3140.0.3.1.2 Capitalized-Lease Method of

Accounting for Leases
3140.0.3.1.2.1 When a Lessee Is to Use the
Capitalized-Lease Method
If any one of the following conditions exist, the

lessee must capitalize the lease:
1. The asset is owned by the lessee at the end
of the lease term.
*2. The lease term is equal to or more than
75 percent of the estimated economic life of
the asset.
3. The lessee can purchase the asset below its
fair market value before or at the end of the
lease term (bargain purchase option).
*4. The present value of the minimum lease
payments at the beginning of the least term
is equal to or more than 90 percent of the
fair market value of the property.
* If the lease begins in the remaining 25 percent of
the asset’s estimated economic life, these items do not
apply; such leases are considered operating leases.
Using this method, the lease is recorded as an

asset at the lesser of the present value of the
rental and other minimum lease payments or the
fair value of the leased property as though the
lease obligation was being purchased on credit. BHC Supervision Manual December 2004
Page 3
The payment made is treated as a payment made

on an installment debt. At the same time, the
asset is being amortized over the lease term. The
lease obligation is treated as a long-term debt.
The discount rate that is used to capitalize the
lease is the lessee’s incremental borrowing rate
or the interest rate implicit in the lease agreement.
Example #1: This example illustrates the capitalized-lease method using the same example as
above with the added fact that the lease agreement contains an interest rate of 10 percent. Assume
that the interest rate of the lease agreement is the same as the lessee’s marginal borrowing rate.
Dr. Capitalized Lease $248,685

Cr. Lease Obligation $248,685
To record an equipment lease obligation under a capitalized-lease agreement.

(Present value of $100,000 per year for three years at a 10 percent interest rate)
1st Year
Interest Expense $ 24,869
Lease Obligation 75,131
Cash $100,000
To record the first year’s payment on an equipment lease obligation.

($248,685 2 .10 = $24,869)
Dr. Equipment Lease Amortization $ 82,895

Cr. Capitalized Lease $ 82,895
To record the annual amortization of a capitalized equipment lease.

($248,685/3 years)
2nd Year
Dr. Interest Expense $ 17,355
Dr. Lease Obligation 82,645
Cr. Cash $100,000
To record the second annual lease payment under a three-year capitalized-lease agreement.
(Interest = $248,685 + 24,869 − $100,000 = $173,554 2 .10 = $17,355)
Dr. Lease Amortization $ 82,895

Cr. Capitalized Lease $ 82,895
To record the second year’s lease amortization under a three-year capitalized lease.
3rd Year
Dr. Interest Expense $ 9,091
Dr. Lease Obligation 90,909
Cr. Cash $100,000

Page 4
To record the third year’s lease payment under a three-year capitalized-lease obligation.
(Interest = $173,554 + $17,355 = $190,909 − $100,000 = $90,909 2 .10 = $9,091)
The financial statements are to include foot-

notes that disclose the present value of noncan-
celable lease commitments where the lessor
either recovers more than 75 percent of the
economic life of the asset leased or recovers the
investment plus a reasonable return.
3140.0.3.2 Accounting for Leases by a

Lessor
3140.0.3.2.1 Operating Lease (Lessor)

A lessor would have the following accounting
entries for an operating lease:
Dr. Cash $xxx,xxx

Cr. Rent Income on Leased Assets6 $xxx,xxx
Dr. Depreciation Expense $xxx,xxx

Cr. Accumulated Depreciation—Leased Assets $xxx,xxx
In order for the lessor to be able to capitalize

a direct-financing lease, any one of the same
four criteria for a lessee must apply along with
two additional criteria:
6. Any rent received in advance would be initially credited BHC Supervision Manual December 2004
to ‘‘unearned rent revenue.’’ Page 4.1
1. Collectibility of the minimum lease pay- to be recognized over the life of the lease. In the
ments must be reasonably predictable. example below, the cost of the property is tem-
2. No important uncertainties exist as the amount porarily charged to a fixed asset account, then
of unreimbursable costs incurred. transferred to lease payments receivable.
Throughout the lease term, the rentals receiv-
In accounting for the lessor’s capitalized lease able account is periodically reduced by the full
transactions, there are some common accounts amount of each rental payment received.
that are used. These are described below.
Unearned income from lease financing
receivables. Unearned income represents the 3140.0.3.2.2 Direct Financing
unearned interest liability account that is netted Capitalized Lease
against the total of lease payments receivable
which includes the estimated residual value for In this situation, a finance company purchases
balance-sheet presentation. It represents the equipment from a manufacturer (recorded as
‘‘interest’’ income equal to the excess of rentals equipment [asset] when purchased). The finance
receivable over the fair value of the property at company (lease financing nonbanking subsidi-
the inception of the lease. ary) then leases that equipment and records it as
Lease financing receivables. This asset account a normal financing lease. There is no dealer
is established in the amount of total lease pay- profit from the sale of the asset. Unearned inter-
ments to be received from the lessee. The amount est income is recognized over the life of the
by which the rentals receivable exceeds the cost lease using the effective interest method. Since
of the property is the functional equivalent of the lessor has ‘‘sold’’ the asset, no depreciation
interest and represents a portion of the income is recorded.
Example #1: Lease with No Guaranteed Residual Value by the Lessee

Assume that the finance company purchases equipment costing $100,000. It then leases the
equipment to a lessee under a five-year lease agreement that requires annual payments of $25,000
per year. At the end of the lease term, the lessee will own the equipment. The implied interest rate is
7.931 percent (comparison of the present value of the equipment of $100,000 against the $25,000
annual payment for five years).
Dr. Equipment $100,000

Cr. Cash $100,000
To record the purchase of equipment to be leased
Dr. Lease Financing Receivables $125,000

Cr. Equipment $100,000
Cr. Unearned Income from Lease Financing Receivables 25,000
To record the initial lease
Year 1
Dr. Cash $ 25,000
Cr. Lease Financing Receivables $ 25,000
Dr. Unearned Income from Lease Financing Receivables $ 7,931

Cr. Income from Lease Financing Receivables 7,931
To record the receipt of the first equipment lease payment.
Lease Payments Receivable $125,000

Unearned Interest Revenue −25,000
$100,000 2 .07931 = $7,931

Page 5
Year 2
Dr. Cash $ 25,000

Cr. Income from Lease Financing Receivables $ 6,577
To record the receipt of the second equipment lease payment.

Lease Payments Receivable $100,000
Unearned Interest −17,069 ($25,000 − 7,931)
(Present Value of Remaining Receivable $ 82,931) 2 .07931 = $6,577
Year 3
Dr. Cash $ 25,000

To record the receipt of the third equipment lease payment.

Lease Payments Receivable $ 75,000
Unearned Interest −10,492 ($17,069 − $6,577)
Year 4
Dr. Cash $ 25,000
Cr. Lease Financing Receivables $25,000

To record the receipt of the fourth equipment lease payment.

Year 5
Dr. Cash $ 25,000
Cr. Leases Financing Receivables $ 25,000

To record the receipt of the fifth equipment lease payment.


Page 6
Example #2: Lease with a Residual Value (Guaranteed by the Lessee)

A lessor acquires property to be leased for $14,000 (its fair value at the inception of the lease).
The estimated economic life of the property is five years. The lease has a noncancelable lease term
of four years with a rental payment due of $3,649 at the end of each year. The lessee guarantees the
residual value at the end of the four-year lease term in the amount of $4,000. The lessor’s implied
rate of interest in the lease is 10.8695 percent. The present value of the minimum lease payments at
this interest rate and monthly payments exceeds 90 percent of the fair value of the property at the
inception of the lease (.90 2 $14,000 = $12,600).
Year 1
January 1, 19x1
Dr. Equipment $ 14,000

Cash $ 14,000
To record purchase of equipment for the purpose of a financing lease.

Dr. Lease Financing Receivables $ 18,596
Cr. Equipment $ 14,000
Cr. Unearned Income from Lease Financing Receivables 4,596
To record investment in direct-financing lease
December 31, 19x1

To recognize the portion of unearned income that is earned at the end of the first year of investment.
(Fair value of property at inception of the lease of $14,000 2 10.8695% = $1,521)
Dr. Cash $ 3,649

To record receipt of the first year’s rental
Year 2
Cr. Interest Income from Lease Financing Receivables $ 1,290
To recognize the portion of unearned income that is earned at the end of the second year of
investment
($14,000 + 1,521 − 3,649 = $11,872 2 10.8695% = $1,290)
Dr. Cash $ 3,649

To record the receipt of the second year’s rental
Year 3

($11,872 + 1,290 − 3,649 = $9,513 2 10.8695% = $1,034)

Page 7
To recognize the portion of unearned income that is earned at the end of the third year of investment
Dr. Cash $ 3,649

To record the receipt of the third year’s rental.
Year 4
Dr. Unearned Income from Lease Financing Receivables $ 751
Cr. Income Lease Financing Receivables $ 751
To recognize the portion of unearned income that is earned at the end of the fourth year of
investment.
($9,513 + 1,034 − $3,649 = $6,898 2 10.8695% = $751)
Dr. Cash $ 3,649

Cr. Lease Financing Receivable $ 3,649
To record the receipt of the fourth year’s rental.
Dr. Cash $4,000

To record the receipt of the lessor’s guaranteed residual value (guaranteed by the lessee) at the end
of the lease term.
($6,898 + 751 − $3,649 = $4,000)
3140.0.3.2.3 Balance-Sheet Presentation interest rate method, and that the lease is now
considered a loss. Further assume that the third
The lease payments receivable would be reported payment should have been received eight months
on the balance sheet as a single amount ‘‘net ago. It is determined during the inspection that
investment’’ (Lease Financing Receivables less the lease should be classified as doubtful of
the balance of the Unearned Income from Lease collection. The balance to be classified is the net
Financing Receivables). If the lessor has estab- investment of $7,728. This consists of the bal-
lished an allowance for possible lease losses, ance of Lease Financings Receivable of $9,513
this amount is shown separately as a deduction (includes the $4,000 estimated guaranteed resi-
from the net investment. The net investment dual value) less the balance of Unearned Income
in the direct financing lease is $18,000 for from Lease Financings Receivable of $1,785
example #2 above. It consists of the gross ($1,034 + $751 = amount due on regular pay-
investment of $18,596 ($3,649 2 4 annual ment intervals) or a net investment of $7,728.
rental payments) plus the $4,000 residual value
less the unearned income of $4,596.
3140.0.3.2.5 Delinquency
3140.0.3.2.4 Classification
It is considered appropriate to state in the
If it is deemed appropriate to classify a lease, inspection report the percentage of delinquency
the amount to be classified (in example #2 in the lease portfolio. The percentage is calcu-
above) would be the net investment. For illustra- lated by deviding the aggregate rentals receiv-
tion, assume that two of the four payments had able on delinquent leases (less unearned income
been received on the lease, that income has been on the delinquent leases) by the total of rentals
recognized monthly according to the effective receivable on all leases (less their unearned
income). Estimated realizable values would not
BHC Supervision Manual December 1997 be included in the delinquent amounts unless
Page 8 they were guaranteed by the lessee.
3140.0.4 LEVERAGED LEASES inspection may not be necessary. The inspection

frequency requirements, found in section
The lessor can ‘‘leverage’’ a lease transaction by 5000.0.4, should be reviewed in making such a
borrowing a substantial portion of the acquisi- determination.
tion cost from a long-term lender, with the rent- 1. The following information should be avail-
als and the property pledged as collateral for the able at the start of the inspection:
loan. The lessor borrows in order to finance a a. trial balance of all leases and outstanding
leasing transaction with a small, or perhaps, a credits,
negative equity in the property to be leased. b. listing of accounts on which payments
The initial step in accounting for this type of are delinquent 30 days or more, or on
lease involves calculating the cash flows over which payments are otherwise not being
the term of the lease. The cash flows include made according to schedule,
the income tax effects of tax deductions to the c. comparative interim and fiscal financial
lessor, the lessor’s initial investment in the prop- statements of the leasing company,
erty, the rental receipts net of debt service, and d. listing of unbooked assets and contin-
the proceeds expected to be received from the gent liabilities,
sale of any residual. The next step in accounting e. cash-flow projections for the current fis-
for a leverage lease involves determining the cal year and the next fiscal year,
applied interest rate that, when applied to the net f. listing of available lines of credit,
investment in the years that the net investment g. copies of the most recent internal and
will be positive, would precisely allocate the net external audit reports, and
income to the positive years. See appendix E of h. minutes of board and executive commit-
SFAS 13 for an example as to how to account tee meetings since the date of the previ-
for a leveraged lease. ous inspection.
2. Establish a ‘‘credit line’’ above which all
leases will be reviewed. The line can be set
3140.0.5 INSPECTION OBJECTIVES at an amount that will cause a certain per-
centage of the dollar volume of the lease
1. To determine the effect of the investment in portfolio to be reviewed (e.g., between 70 per-
the leasing subsidiary upon consolidated cent and 80 percent), or at an amount that
operations, and indirectly upon the bank sub- will cause the review of each lease exceed-
sidiaries’ safety and soundness. ing a certain percentage of gross capital.
2. To determine if the company is operating in Leases on which payments are delinquent
compliance with applicable laws and regula- are to be reviewed regardless of amount.
tions, and to ensure that corrective action is 3. Analyze the creditworthiness of the lessees.
initiated if warranted. Consideration is given to the figures derived
3. To determine if policies, procedures, and from the lessee’s financial statements, as
controls are adequate to protect the company well as cash flow, trends and projections of
from mismanagement, unnecessary risk, and growth in sales and income, and the qualifi-
loss. cations of management.
4. To assess the management’s ability to oper- Delinquency on a lease obligation is
ate the company in a safe and sound manner. potentially more serious than delinquency
5. To determine that accounting practices do on a conventional loan. If the property
not overstate income. under lease is necessary for the lessee’s
continued production of income, as is fre-
quently the case, the lessee’s financial con-
3140.0.6 INSPECTION PROCEDURES dition will be seriously deteriorated before
the lessee is willing to risk losing the prop-
The decision whether the operations of a leasing erty by default.
subsidiary will be inspected ‘‘on-site’’ is based 4. For those leases which might result in loss
on the availability and adequacy of leasing com- to the lessor, or for which financial informa-
pany data at the offices of the parent company. tion was not adequate to make such a deter-
Item 1 below provides a listing of information mination, transcribe the following informa-
necessary to the inspection process. If this and tion to line sheets:
any other information necessary to assess the a. name and line of business of lessee
overall condition of the subsidiary is available
at the parent’s office or can be obtained through BHC Supervision Manual December 1997
a written request to the subsidiary, an on-site Page 9
b. name of guarantor(s) continually renewed until the cost is fully

c. original date of the lease contract recovered.
d. original amount of the rentals receivable 8. Ascertain whether title to the property rests
e. ERV of the property with the lessor, and that the lessor has taken
g. book value of the investment in the lease steps to protect its ownership rights. Evi-
as of the inspection date dence of filing under the Uniform Commer-
h. cost of the property cial Code, where appropriate, should be
i. description and location of the property found in the documentation file. Aircraft
j. amount and frequency of rental payments should be registered with the FAA, inter-
k. original amount, term, rate, and schedule state vehicles with the ICC, and ships with
of amortization of any nonrecourse debt the Coast Guard.
associated with the lease 9. Check for cancellation or other provisions
l. lessor’s percentage of equity participa- in the contract which could jeopardize the
tion in the lease obligation, if applicable full-payout status of the lease. There is no
m. summary financial data indicating the need to take exception to a cancellation
creditworthiness of the lessee, and guar- provision which provides for payment by
antors, if applicable the lessee of an amount which allows the
5. Before the conclusion of the inspection, dis- lessor to recover fully its investment in the
cuss with management all classified leases. property.
Inadequate or negative cash flow and unfa- 10. Check that insurance coverage is effective
vorable trends reflected in financial state- on leased property and is provided by the
ments of the lessee are usually indicative of lessee in compliance with all insurance pro-
a substandard lease. Leases classified doubt- visions of the contract in an amount suffi-
ful typically include those on which pay- cient to protect against loss from property
ments are delinquent for an extended period damage. Public liability insurance should
and those on which the lessor’s recovery of also be provided to protect against loss from
investment is dependent upon an event of lawsuits which could arise from situations
unknown probability, such as a pending such as the crash of leased aircraft.
lawsuit or insurance claim. 11. Review the lessee’s duties under the con-
A loss classification results from the les- tract with respect to repairs and taxes. Deter-
see’s inability or refusal to continue making mine whether the lessor has instituted pro-
payments. cedures to check that the lessee’s required
6. Prepare a write-up to support the classifica- duties are being performed.
tions. The write-up should include the les- 12. Review the status of all property acquired
see’s type of business, present financial sta- for lease purposes but which is not now
tus, circumstances which led to the under lease. Determine the reason for the
classification, the probability that the terms ‘‘off-lease’’ status of the property, ascertain
of the lease can be met, and the amount of the realizable value of the property, and
protection afforded by sale or re-lease of the investigate whether the off-lease property
underlying property. will be sold or re-leased within the required
7. Review a sample of the lessor’s computa- two-year period.
tions of lease yields to determine whether 13. Investigate the lessor’s procedures for
the lessor will recover not less than the full periodic review of the reasonableness of the
investment in the property plus the esti- estimated residual value. The estimate should
mated total cost of financing the property be reviewed at least annually and reduced
over the term of the lease. This includes in amount on the books if the value has
rental payments, estimated tax benefits, and declined on a presumably permanent basis.
the estimated residual value of the property 14. Review past operations of the lease company
at the expiration of the initial lease. to determine if projections of income and
With respect to the full-payout lease, ERV have been realistic in light of actual
governmental entities may be prohibited experience.
from entering into leases for periods exceed- 15. Review the minutes of the meetings of the
ing one year. In that case, the bank holding board and executive committees to deter-
company or its subsidiary (as lessor) should mine whether purchases of property and
demonstrate that the lease is expected to be delinquent leases are reported to the board.
16. Determine if the company has entered into
BHC Supervision Manual December 1997 leases with companies owned or controlled
Page 10 by any director, officer, or 10 percent share-
holder of the leasing company or holding 23. Check for action taken on matters criticized
company. Compare the rates and terms on in the most recent audit reports and the
such leases to the rates and terms offered on previous inspection report. Determine if
leases to companies of similar credit standing. leases classified ‘‘loss’’ were removed from
17. Check for lease concentrations to any one the books.
lessee or industry and prepare a comment 24. Investigate whether any affiliated banks main-
for the inspection report if any concentra- tain compensating balances for lines of credit
tion is considered unwarranted. of the leasing company, and if so, whether
18. Determine whether the company has the leasing company compensates the bank
established limits for the maximum amount for maintenance of the balances. If ‘‘loss’’
of ‘‘credit’’ to be extended to a single les- leases have not been removed from the
see. If such limits have been established, books, discuss with management the rea-
investigate whether the company adheres to sons why the charge-offs were not made.
them. If they have not been established, Determine whether the financial statements
inquire as to the company’s policy on this and reports submitted to the Board of Gov-
matter. ernors were misstated as a result of the ‘‘no
19. Provide the examiner-in-charge with charge-off’’ decision.
information to be included in the inspection 25. For higher residual value leasing, determine
report, including: that—
a. scope of the inspection (on- or off- a. the residual values have been estimated
premises) accurately;
b. comments concerning any policies or b. residual values are reviewed and adjusted
conditions having an adverse effect on annually;
the leasing company or parent company c. the initial terms of the lease are at least
c. brief history of the company and a 90 days;
description of its activities d. the lessor relies on a residual value of
d. summary analysis of financial factors of the leased property that will recoup the
the company, including trends in the acquisition cost of the property and any
volume and classification of receivables, related financing or other associated
adequacy of capital and reserves, return costs;
on assets, and contribution to consoli- e. the aggregate book value of all tangible
dated income and consolidated assets personal property held for such a lease,
e. statutory authority under which the com- having an estimated residual value in
pany operates excess of 25 percent of the acquisition
f. details of all borrowings of the company cost of the property, does not exceed
from within the holding company sys- 10 percent of the BHC’s consolidated
tem and from external sources domestic and foreign assets;
g. details of any litigation in which the f. the BHC maintains separately identifi-
company is a defendant able records of the leasing transactions
h. scope and frequency of audit of the and activities; and
company by both internal and external g. each company maintains capitalization
auditors fully adequate to meet its obligations
20. Compare current earnings performance and and support its activities, and that its
balance-sheet ratios of the company with capital levels are commensurate with
past performance and industry composites. industry standards for companies engaged
21. Determine whether cash flows of the com- in comparable leasing activities.
pany are adequate to service all debts.
22. Assess the adequacy of internal controls
over the company’s operations.

Page 11
Automobile leasing 1976 FRB 930
Consumer leasing 15 U.S.C. 1667
Higher residual value 1991 FRB 490,187

leasing 1990 FRB 462, 960
Personal or real property 225.28(b)(3)

leasing activities of bank
holding companies
Special-purpose leasing 3–712

corporation

Page 12
(Community Welfare Projects) Section 3150.0
The Board considers the making of equity and activity is primarily designed to promote the
debt investments in corporations or projects community welfare. Factors that the Board might
designed ‘‘primarily to promote’’ community consider include whether the activity benefits
welfare as an activity closely related to banking. low- and moderate-income individuals in areas
The Board includes such investments in the list such as housing and employment and the need
of permissible nonbanking activities in Regula- for specialized community development activi-
tion Y; however, bank holding companies must ties in different localities. The Board will con-
obtain prior approval to engage in these activi- sider a range of different activities, but will
ties. The Board, effective April 21, 1997, included probably not approve a proposal that does not in
the provision of advisory and related services some way either benefit low- or moderate-
for programs designed primarily to promote income individuals or benefit the specialized
community welfare into Regulation Y. Such needs of local communities.
advisory activities had previously been permit- Once a bank holding company has obtained
ted only by Board order. For examples of advi- Board approval to engage in community devel-
sory services approved for community develop- opment activities pursuant to Regulation Y, the
ment projects, see 1990 FRB 671, 1989 FRB holding company may, without further System
576, and 1988 FRB 140. approval, engage either directly or through a
subsidiary in certain community development
activities, so long as such activities do not
3150.0.1 INVESTMENTS IN exceed 5 percent of the bank holding company’s
CORPORATIONS OR PROJECTS TO total consolidated capital stock and surplus.
PROMOTE COMMUNITY A bank holding company may invest and
WELFARE—BOARD provide financing—
INTERPRETATION
1. to a corporation or project or class of corpo-
The Board also provides guidance with regard rations or projects that the Board previously
to investments in community welfare projects has determined is a public welfare project
through its interpretation (see section 225.127 pursuant to paragraph 23 of section 9 of the
of Regulation Y (12 C.F.R. 225.127)). This Federal Reserve Act (12 U.S.C. 338a);
interpretation describes projects that the Board
has considered as promoting community wel- 2. to a corporation or project that the Office of
fare as their primary intent. These include but the Comptroller of the Currency previously
are not limited to— has determined, by order or regulation, is a
public welfare investment pursuant to sec-
1. projects to construct or rehabilitate housing tion 5136 of the Revised Statutes (12 U.S.C.
for low- or moderate-income persons, 24 (Eleventh));
2. projects for construction or rehabilitation of 3. to a community development financial insti-
ancillary local commercial facilities neces- tution (other than a bank or bank holding
sary to provide goods or services principally company) pursuant to section 103(5) of the
to persons residing in low- or moderate- Community Development Banking and Finan-
income housing, and cial Institutions Act of 1994 (12 U.S.C.
3. projects designed explicitly to create improved 4702(5));
job opportunities for low- or moderate- 4. for the development, rehabilitation, manage-
income groups. ment, sale, and rental of residential property
if a majority of the units will be occupied by
Because the Board believes that bank holding low- and moderate-income persons or if the
companies should take an active role in the property is a ‘‘qualified low-income build-
quest for solutions to the nation’s social prob- ing’’ as defined in section 42(c)(2) of the
lems, it has not defined other types of invest- Internal Revenue Code (26 U.S.C. 42(c)(2));
ments designed primarily to promote the com- 5. for the development, rehabilitation, manage-
munity welfare in order to give bank holding ment, sale, and rental of nonresidential real
companies greater flexibility in developing new property or other assets located in a low- or
and creative approaches to resolving community moderate-income area provided the property
problems. Accordingly, the Board has main-
tained the flexibility to determine whether an BHC Supervision Manual December 1997
Page 1
Section 4(c)(8) of the BHC Act (Community Welfare Projects) 3150.0
is used primarily for low- and moderate- within a major city, located adjacent to a
income persons; public housing project. Commitments included
6. to one or more small businesses located in a providing training to welfare recipients resid-
low- or moderate-income area to stimulate ing in public housing projects and employing
economic development; low- and moderate-income individuals at the
7. for the development of, and to otherwise hotel complex, and donating a portion of the
assist with, job training or placement facili- profits to a nonprofit corporation designated
ties or to foster programs designed primarily to provide low-cost housing, employment,
for low- and moderate-income persons; and business opportunities for disadvantaged
8. to an entity located in a low- or moderate- residents. (See 1996 FRB 679.)
income area if that entity creates long-term
employment opportunities, a majority of which
(based on full-time equivalent positions) will 3150.0.3 EXAMPLES OF
be held by low- and moderate-income per- INVESTMENTS VIEWED AS NOT
sons; and PROMOTING COMMUNITY
9. for providing technical assistance, credit coun- WELFARE
seling, research, and program development
assistance to low- and moderate-income per- The Board has indicated that some investments
sons, small businesses, or nonprofit corpora- are not designed primarily to promote commu-
tions to help achieve community development. nity welfare unless there is substantial evidence
to the contrary, even though the investment may
3150.0.2 EXAMPLES OF benefit the community to some extent. Examples
BOARD-APPROVED ACTIVITIES include investments to build or rehabilitate high-
DESIGNED TO PROMOTE income housing or commercial, office, or indus-
COMMUNITY WELFARE trial facilities which are not designed explicitly
to create job opportunities for low-income per-
With its primary thrust to promote community sons, even though the investment may benefit
welfare rather than creating a focus on a collat- the community to some extent. This latter point
eral effect, economic rehabilitation and develop- was made in an order (see 1996 FRB 679)
ment should focus on providing housing, ser- whereby the Board denied an application by a
vices, or jobs for low- or moderate-income bank holding company to acquire an investment
residents or groups. Examples of projects previ- in an industrial development corporation
ously approved by the Board include an invest- involved in the construction of a shopping and
ment in— office complex in an urban renewal area. The
Board identified the critical issue as whether the
1. an agricultural test farm (testing crops, equip- project was devised primarily to promote the
ment, alternative farming methods and chemi- community welfare or primarily designed as a
cals, and providing student agricultural profit-making venture in which the benefits to
research opportunities and financial planning the community were merely a collateral effect.
workshops for farmers (see 1990 FRB 671); In another case, the Board denied a proposal
2. an entity that provides education to young intended to acquire a company that indirectly
persons (see 1991 FRB 70) through a non- acted as a managing general partner of a private
profit, tax-exempt bank holding company development venture. The venture was a large-
(educational programs consisted of the Ameri- scale, urban redevelopment initiative, jointly
can economic system, how to start a busi- sponsored by government and private entities,
ness, college financial planning, and career that was intended to revitalize a geographic area
opportunities in banking); that was largely abandoned within a working
3. the acquisition and redevelopment of a sole middle-class community. (See 1990 FRB 672.)
medical clinic in a small rural town without
public transportation that was located 30
miles from another facility and was needed 3150.0.4 INSPECTION OBJECTIVES
to attract new physicians to replace those
retiring (see 1991 FRB 63); and 1. To determine that new investments and financ-
4. a limited partnership to develop a nearly ing in community development and other
vacant office building into a hotel complex corporations and projects are designed pri-
marily to promote community welfare.
BHC Supervision Manual December 1997 2. To determine that previous investments and
Page 2 financings continue to meet the standards
imposed by section 225.28(b)(12) of Regula- encompasses a wide variety of programs, proce-

tion Y. dures will have to be developed on an ad hoc
3. To determine that the activity remains within basis. When federal or state approval of the
the scope of regulatory approval when such program is required, the examiner may wish to
approval involves specific rather than gen- review applications and other materials submit-
eral investments. ted to such authorities. The terms or conditions
4. To determine that advisory and related ser- imposed by such bodies as well as the subsid-
vices for programs designed primarily to pro- iary’s continued eligibility may also be of
mote community welfare are being con- importance. Contact with responsible federal or
ducted within the scope of their regulatory state officials may be deemed appropriate in
approval. certain cases. Such contacts, however, should be
initiated only in accordance with respective
Reserve Bank procedures. When a community
3150.0.5 INSPECTION PROCEDURES welfare project or financing does not include the
involvement of another governmental body, the
As is standard practice in the examination of examiner will need to verify directly whether
other subsidiaries engaged in nonbanking activi- goals essential to the nature of the activity, such
ties, a thorough review of pertinent books, records, as providing housing for the elderly or jobs for
contracts, and financial statements should be low- or moderate-income people, are being met.
undertaken by the examiner. To fulfill the In this regard, the burden should be on the
inspection objectives concerning this activity, holding company to provide such data. In some
the examiner may have to go beyond routine instances, an on-site visit to the project may be
investigative practices. Since this activity appropriate.

Page 3
Permissible investments 1701 225.28(b)(12) 4–178 1972 FRB 495

described 225.127 1978 FRB 45
1984 FRB 452
Provision of community 1988 FRB 140
development advice on a 1989 FRB 576
fee-for-service basis
Purchase of land 1990 FRB 672
for agricultural
testing activities
Nonprofit, tax- 1991 FRB 70
exempt BHC—educational
programs in economics,
starting businesses,
financial planning,
career opportunities in
banking
Projects to create 1992 FRB 619
improved job opportunities
for low- or moderate-
income groups
Approval of community 1996 FRB 679
development converting an
office building into a
hotel complex, located
next to a public
housing project
designated as
‘‘difficult to develop’’
Denial of a bank 1976 FRB 639
holding company
formation by a
community development
corporation
Denial of a venture 1994 FRB 733
that would revitalize
an abandoned area
in a middle-class
community

Page 4
(EDP Servicing Company) Section 3160.0
3160.0.1 PROVISION OF DATA request of a customer if the service is not
PROCESSING AND TRANSMISSION otherwise reasonably available in the rel-
SERVICES evant market area.
Under section 4(c)(8) of the BHC Act, the per-

missibility of bank holding company data pro- 3160.0.3 SECTION 4(c)(8) vs.
cessing activities is generally predicated upon SECTION 4(c)(1)
the type of data processed or transmitted. Sub-
sidiaries formed under this section may engage Section 4(c)(1) data processing subsidiaries,
in business directly with outside customers, which do not require prior approval, are limited
unlike section 4(c)(1) subsidiaries, which can as follows:
act only as servicers for affiliates1 and cannot
deal directly with outside customers. 1. They can furnish computer services only for
The intent of section 4(c)(8) is to permit bank the internal operations of the bank holding
holding companies and their nonbank subsidi- company and its bank affiliates. 1
aries to directly provide to customers financially 2. Direct computer services to nonaffiliated cus-
or economically oriented services (or services tomers are not permitted. Any contract to
that are similar to these services) that banks furnish services to nonaffiliated customers
have traditionally used in their own internal must be between the affiliate bank and its
operations and provided to their customers. Such customer, with the data processing subsidiary
services (with prior approval) are unrestricted as acting as a servicer for its affiliate bank. In
to location and may be provided from out-of- addition, the kinds of services furnished are
state locations. limited to those that a bank can normally
provide.
3160.0.2 INCIDENTAL ACTIVITIES
Section 4(c)(8) data processing subsidiaries
The Board regards the following as incidental may deal directly with the customer. In accor-
activities necessary to carrying on permissible dance with section 4(c)(8) of the BHC Act and
data processing activities: section 225.28(b)(14) of Regulation Y, the kinds
of services nonbank subsidiaries of bank hold-
1. Making excess computer time available to ing companies may provide to others are—
anyone as long as the only involvement by
the bank holding company system is furnish- 1. data processing and transmission services,
ing the facility and the necessary operating facilities (including hardware, software, docu-
personnel. This stipulation applies when— mentation, or operating personnel), data-
a. the equipment is not purchased solely for bases, advice, and access to such services,
the purpose of creating excess capacity to facilities, or databases by any technological
sell; means, if—
b. hardware is not offered in conjunction a. the data to be processed or furnished are
with excess capacity; and financial, banking, or economic data and
c. the facilities for the use of the excess b. the hardware provided in connection with
capacity do not include providing any the data processing and transmission ser-
software other than systems software vices is offered only in conjunction with
(including language), network communi- software designed and marketed for the
cations support, and the operating person- processing and transmission of financial,
nel and documentation necessary for main- banking, or economic data, and the general-
taining and using these facilities. purpose hardware does not constitute more
2. Selling byproducts of permissible data pro- than 30 percent of the cost of any pack-
cessing and data transmission activities when aged offering.
they are not designed, or appreciably enhanced, 2. data processing, data storage, and data trans-
for the purpose of marketability. mission services for a third party that are not
3. Furnishing any data processing service upon financial, banking, or economic related if the
subsidiary’s total annual revenue derived from
1. In this context, ‘‘affiliates’’ is limited to other organiza-
tions that have subsidiaries of the same parent bank holding BHC Supervision Manual June 2004
company as the servicer. Page 1
Section 4(c)(8) of the BHC Act (EDP Servicing Company) 3160.0
those activities does not exceed 30 percent of ises of the customer is closely related to banking
its total annual revenues derived from data if conducted within the limits of Regulation Y.
processing, data storage, and data transmis-
sion activities. On November 26, 2003, the
Board approved an increase of this limit to
49 percent, effective January 8, 2004. See 3160.0.7 EXCESS CAPACITY
1993 FRB 1158, 2004 FRB 55, and section
3160.2. The Board currently recognizes that, The sale of excess computer time is currently
in certain situations, a bank holding com- treated in a Board interpretation as a permissible
pany may have bona fide operational reasons incidental activity. The interpretation (12 C.F.R.
for conducting its financial and related nonfi- 225.123(e)(1)) currently permits a bank holding
nancial data processing activities through company to make excess computer time avail-
separately incorporated subsidiaries. In these able to anyone so long as the only involvement
cases, bank holding companies may request of the holding company is furnishing the facility
permission to administer the 49 percent rev- and the necessary operating personnel. Data
enue test on a business-line or multiple- processors that process time-sensitive data must
entity basis. See section 225.28(b)(14) of maintain sufficient capacity to meet peak
Regulation Y (12 C.F.R. 225.28(b)(14)). demand and provide backup in case of equip-
ment failure. Excess capacity necessarily results
from such needs; thus the sale of excess capac-
3160.0.4 MINICOMPUTER ity is necessary to reduce costs and to remain
ACTIVITIES competitive. Bank holding companies are lim-
ited in the sale of excess capacity as follows:
Some data processing subsidiaries are actively
engaged in placing minicomputers with some of 1. A bank holding company may not purchase
their customers. However, if the subsidiary acts data processing equipment solely for the pur-
as sales agent for the manufacturer and receives pose of creating excess capacity.
a commission, it is in violation of section 2. A bank holding company may not sell hard-
225.28(b)(14) of Regulation Y and should be ware in conjunction with excess capacity.
advised to cease the practice. 3. A bank holding company may provide only
limited types of software in connection with
its sale of excess capacity. This includes sys-
3160.0.5 HARDWARE AND tems software (that is, software designed
SOFTWARE AS AN INTEGRATED only to control and operate the hardware and
PACKAGE not to perform substantive operations), net-
work communications support, and the oper-
Customers of data processing services require ating personnel and documentation neces-
that suppliers provide them with hardware and sary for maintaining and using these facilities.
software as an integrated package. Providing
general-purpose hardware is permissible only if
the cost of the hardware does not exceed 30 per-
cent of the cost of the packaged offering, and 3160.0.8 BYPRODUCTS
only in conjuction with permissible software.
When hardware is provided in a specialized The sale of byproducts for the development of a
form (such as ATMs), its provision meets the program for a permissible data processing activ-
National Courier test and is closely related to ity is treated in a Board interpretation (12 C.F.R.
banking and therefore not subject to the 30 per- 225.123(e)) as a permissible incidental activity.
cent limitation. Byproducts may be data, software, or data pro-
cessing techniques or information developed by
the bank holding company. Byproducts may not
3160.0.6 PACKAGED FINANCIAL be designed or appreciably enhanced for the
SYSTEMS purpose of marketability.
The Board found that providing packaged finan-

cial systems, including data processing hard- 3160.0.9 REQUIREMENT OF
ware and software, to be installed on the prem- SEPARATE RECORDKEEPING
BHC Supervision Manual June 2004 The Board’s data processing interpretation is
Page 2 designed to minimize any possibility of unfair
competition. A bank holding company subsidi- permissibility of services performed, the rev-
ary or related entity that provides permissible enue limitations of section 225.28(b)(14) of
data processing and data transmission activities Regulation Y, the types of customers serviced,
(services, facilities, byproducts, or excess and transactions between affiliates. The inspec-
capacity) must keep separate books and records tion should also provide an overall financial
and provide the documents to any new or renewal evaluation.
customer upon request.

3160.0.10 SUMMARY
Holding company EDP proposals are evaluated
from the standpoint of whether the proposed 1. Where available, review the EDP examina-
data processing activities involve banking, finan- tion report in conjunction with the lead bank
cial, or related economic data within the mean- examination for details of the subsidiary’s
ing of the Board’s Regulation Y. Processing, operations and management.
storing, and transmitting data for third parties, 2. Review correspondence files and the
when the data are not financial, banking, or application memo for the history of the
economic, is permissible if the revenues derived subsidiary.
from those activities do not exceed 49 percent
of the subsidiary’s total annual revenues derived
from data processing, data storage, and data 3160.0.12.2 On-Site
transmission activities. For examples of previ-
ous Board authorizations for data processing 3. Have a brief meeting with the chief execu-
and transmission services in accordance with tive officer of the subsidiary to establish
Regulation Y, see sections 3160.1 through 3160.5. contact and present a brief indication of the
The data processing that is permissible under scope of the inspection.
Regulation Y encompasses various data pro- 4. Ask the controller of the company for the
cessing services, including sales analysis, inven- schedules and other information requested
tory analysis, freight payment, municipal tax in the entry letter.
billing, credit union accounting, and savings 5. Request the following information and sched-
and mortgage company bookkeeping and pay- ules in addition to what was requested in
roll processing. the entry letter:
a. complete list of the computer applica-
tions the subsidiary performs
3160.0.11 INSPECTION OBJECTIVES b. list of customers
c. policy and procedures manual, if any
1. To determine that the full range of EDP d. copy of the latest internal and external
services performed are permissible finan- financial and operational audits and
cially oriented activities in compliance with internal control reviews
applicable laws and regulations. e. copy of the types of management
2. To review the relationship between the data reports the subsidiary submits to the par-
processing subsidiary and its affiliates and ent company and directors
the effect of those relationships on the affairs f. internal management organization chart
and soundness of the bank affiliate. g. copy of the agreement executed with the
3. To determine if operating policies are adequate affiliates concerning the services pro-
and if management is operating in conform- vided and the fees collected
ance with the established policies. 6. Review minutes of meetings of the board of
4. To initiate corrective action when policies, directors and of the executive committee to
practices, procedures, or internal controls are determine the broad types of the company’s
deficient or when violations of law or regula- operations.
tion have been noted. 7. Determine the scope of the inspection, based
NOTE: All bank-related EDP servicers receive on evaluations of—
EDP examinations conducted by the primary a. corporate minutes,
bank regulator; these examinations cover detailed b. schedules,
operations, audit, proper backup, and overall
computer operations. The bank holding company– BHC Supervision Manual June 2004
related inspection should focus on the types and Page 3
c. accounting records, two years may be prepared if the informa-

d. internal controls, and tion is available and meaningful.
e. the scope of the work performed by the 14. Prepare a statement of income using the
internal auditor. same procedures outlined above.
8. Review the trial balances and compare them 15. Review all significant internal policies. Deter-
with the respective general ledger control mine if the policies were developed inter-
accounts. nally or by the parent company.
9. Where necessary, interview pertinent divi- 16. Review the subsidiary’s management reports
sion heads. to the parent company. Is the reporting com-
10. Determine if management information sys- plete and frequent (at least quarterly)? Is the
tems are adequate and if regular periodic parent company fully aware of the subsid-
reports are made available. Determine if the iary’s operations or problems?
reports provide sufficient segregated details
on the annual revenues earned from (1) finan- 17. Review the adequacy of internal and exter-
cial-, banking-, or economic-related data nal financial and operational audits and
processing and data transmission services internal control reviews. Interview the EDP
and (2) third-party nonfinancial data pro- auditor and review the audit reports and
cessing and data transmission services. CPA management letters (for the period of
Ascertain whether the information will allow the inspection). Also conduct interviews
verification of compliance with the revenue with the auditors, including the EDP audi-
limitations found in section 225.28(b)(14) tor (if one was engaged).
of the Board’s Regulation Y. 18. Review the condition of the company’s
11. Verify that the subsidiary of the bank hold- records, that is, their availability, complete-
ing company is complying with the revenue ness, and accuracy. Deficiencies should be
limitations found in section 225.28(b)(14) discussed in detail with recommendations
of Regulation Y. for improvement.
12. Review the data processing, data storage, 19. Review all intercompany transactions. Be
and data transmission services provided to consistently alert for any transactions with
customers for violations of the Board’s regu- affiliate bank(s) that would be a violation of
lations and interpretations. Obtain sufficient Federal Reserve Act sections 23A and 23B
documentation for the workpapers. and Regulation W.
13. Prepare a statement of condition with a 20. Review significant litigation and other con-
minimum two-year comparison. More than tingent liabilities.
EDP auditing 225.28(b)(14)
Types of activities—incidental 225.123 and 4–176 1975 FRB 215

activities 225.123(a)
Data processing as an activity 225.123(e) 1974 FRB 58

closely related to banking
Section 4(c)(1) type of EDP services 225.118 4–195

Page 4
Retention of data subsidiary 1972 FRB 318
Order authorizing a bank holding 1982 FRB 505

company to engage in expanded
data processing and data transmis-
sion activities
Amendment of Regulation Y for 225.28(b)(14) 1982 FRB 552

expanded activities 1997 FRB 275
Order authorizing a BHC to offer 225.28(b)(14) 1986 FRB 497

financial-office service and the ser-
vice of designing and assembling
data processing hardware. Receipt
of hotel information and the ability
to make airline and hotel reserva-
tions is not related to the provision
of banking, financial, and eco-
nomic data.
Order authorizing engaging in elec- 1993 FRB 1158

tronic benefit services, stored-
value-card services, and electronic
data interchange services
Order authorizing the provision of 1994 FRB 139

a network for the processing and
transmission of medical payment
data
Order authorizing the provision of 1994 FRB 1107

traveler’s checks and postage
stamps via an ATM card and
terminal
Order allowing a BHC to process 1995 FRB 295

certain nonfinancial data—
personnel information for financial
institutions for use in their internal
operations
Order authorizing optical scanning 1995 FRB 1049

and database preparation
Order authorizing engaging in the 1996 FRB 363

development, production, and pro-
vision of customer home banking—
personal financial management
using personal computers

Page 5
Order allowing a 1996 FRB 674

BHC to engage in—
(1) providing data processing and
data transmission services to non-
affiliated financial institutions and
(2) assisting the institutions in 1996 FRB 680
offering their customers banking
and financial services over the
Internet
Order approving limited nonfinan- 1996 FRB 348

cial data processing and transmis-
sion services, including customer
identification, account, and infor-
mation or verification files for
detecting fraudulent use.
Order approving the development 1997 FRB 135

and provision of a data processing
and data transmission system
(‘‘gateway’’) to depository institu-
tions and their affiliates. The sys-
tem would make home banking
and other financial services avail-
able to the institutions’ and affili-
ates’ customers. The gateway would
provide customers with an elec-
tronic link to an Internet provider.
Order approving the development 1997 FRB 335

and sale of computer software to
broker-dealers and financial insti-
tutions that would allow customers
to purchase and sell securities over
the Internet using personal
computers.
Amendment of Regulation Y to 2004 FRB 55

expand the ability of BHCs, includ-
ing FHCs, to process, store, and
transmit nonfinancial data in con-
nection with data processing, stor-
age, and transmission activities.

Page 6
Section 4(c)(8) of the BHC Act (EDP Servicing—Network for the
Processing and Transmission of Medical Payment Data) Section 3160.1
A bank holding company applied for the Board’s Adjudication software. The Board also autho-
approval to acquire all the shares of a nonbank rized the bank holding company’s nonbank sub-
data processing company to engage in the pro- sidiary to furnish claims-adjudication software
cessing and transmission of certain medical- to payers. The software is designed for the pro-
payment data. The nonbank subsidiary plans to cessing of routine claims and would include
engage in activities that specialize in a range of the basic rules of a payer’s coverage contract.
medical-payment electronic funds transfer ser- Claims-adjudication processing would involve
vices, including the development of software the interaction of financial and banking data and
products related to the processing of medical- medical and coverage data as a necessary pre-
claims payments. lude to electronic funds transfer. The Board
Basic network services. The Board deter- found that the processing of medical and cover-
mined by order that a nonbank subsidiary of a age data involved in claims adjudication is an
bank holding company may provide a network integral and necessary part of the processing of
for the processing and transmission of medical- related financial and banking information, and
payment data between health-care providers the nonbank subsidiary’s processing of under-
(such as physicians, hospitals, and pharmacies) lying payment transactions. The Board con-
and entities responsible for paying medical cluded that the nonbank subsidiary’s provision
benefits (such as health insurers, health main- of claims-adjudication software is permissible
tenance organizations, and preferred provider as an activity incidental to its provision of soft-
organizations). These nonbanking activities are ware for the processing of banking and financial
permissible under the Bank Holding Company data and to its operation of a medical-payments
Act and the Board’s Regulation Y (12 C.F.R. network.
225.28(b)(14)). The information on the patient’s Electronic data interchange. The bank hold-
medical-benefits card (made available by paying ing company’s nonbank subsidiary also plans to
organizations) would be used to access the sys- provide medical–payments system participants
tem (similar to a debit or credit card). In gen- with statistical and other data derived from the
eral, health-care providers would enter claims information in its database. Each participant
information into the network with a request for would have on-line access to all of the data it
payment, and the payers would authorize elec- places into the system, and third parties desig-
tronic fund transfers for full or partial payment nated by a payer or provider could also receive
of the claims. access to the data owned by that customer. The
The bank holding company’s nonbank sub- Board has previously stated that bank holding
sidiary would also process and transmit medical- companies may provide byproducts of permis-
treatment data necessary for the processing of sible data processing and data transmission
claims, and would furnish providers with access activities as long as the byproducts are not
to a coverage-information database. The data- designed, or appreciably enhanced, for the pur-
base would transmit information about the terms pose of marketability (12 C.F.R. 225.123(e)(2)).
of a particular payer’s medical coverage con- The Board has also indicated that byproducts
tract, such as the extent to which specific medi- include data, software, or data processing tech-
cal treatments are covered by the patient’s insur- niques that may be applicable to the data pro-
ance policy. While such medical and coverage cessing requirements of other industries.
data are not financial data, the processing and The nonbank subsidiary may perform limited
transmission of these data are essential to the selection, combination, and similar functions on
transmission and processing of the medical pay- raw data so that the data can be transmitted to
ments and financial information in the network. the customer in a reorganized and more usable
Also, these data processing services allow the form. It may also design software that would
electronic transfer of funds. The Board found enable customers to perform similar reorganiza-
that the processing and transmission of the tion functions on raw data. The Board con-
medical and coverage data, in connection with cluded that the proposed electronic data
the nonbank subsidiary’s operation of a pay- interchange services would constitute permis-
ments network, are permissible as incidental sible byproducts of the nonbank subsidiary’s
activities. The Board further determined that the primary data processing activities, and are there-
nonbank subsidiary’s operation of a medical- fore permissible as an incidental activity.
payments network would constitute permissible
data processing and data transmission activities BHC Supervision Manual December 1997
under the BHC Act. Page 1
4(c)(8) (EDP Servicing—Network for the Processing and Transmission of Medical Payment Data) 3160.1
The Board’s approval of the application on representations that were made by the applicant
December 22, 1993, is based on the facts of and the conditions referred to in the order. (See
record and is subject to the commitments and 1994 FRB 139.)

Page 2
Electronic Benefit Transfer, Stored-Value-Card,
and Electronic Data Interchange Services Section 3160.2
Four bank holding companies (the applicants) cards in which authorized funds can be trans-
applied for the Board’s approval under section ferred and credited using magnetic stripe or
4(c)(8) of the Bank Holding Company Act to computer chip technology. The services would
engage de novo, through their joint venture cor- be provided in connection with both ‘‘closed’’
poration (the company), in nonbanking activi- and ‘‘open’’ stored-value-card systems. Closed
ties consisting of engaging in electronic benefit systems include both single-vendor stored-value-
transfer services, stored-value-card services, and card systems and systems designed for single-
electronic data interchange services. The appli- use sites. An open system, by contrast, refers to
cants proposed to engage in the activities through- multiple-vendor, multiple-site stored-value-card
out the United States. The applicants provide systems.
data processing and transmission services through
the company to retail merchants using point-of-
sale (POS) terminals and to banks who are 3160.2.2.1 Stored-Value-Card Closed
members of the company’s automated teller Systems
machine (ATM) network.
In most current closed systems, cash must
be deposited in a particular vendor’s card-
3160.2.1 ELECTRONIC BENEFIT dispensing terminal, and the card received from
TRANSFER SERVICES the terminal may be used only for purchases
from that specific vendor. The card itself is
The electronic benefit transfer services would disposable, and the only account reconciliation
involve data processing and transmission ser- that may be required would involve the ven-
vices required to permit the delivery of govern- dor’s own cash receipts, the amount of funds
mental program benefits (such as welfare pay- debited from the cards at turnstiles or other
ments and food stamps) through the ATM and points of sale, and the amount of the vendor’s
POS terminals of participating merchants and liabilities stored on outstanding cards. The com-
banks. Under a benefits-services system, a bene- pany intended to play a role in the operation of
fit recipient would be issued a magnetically this basic type of closed system, as well as to
encoded card similar to an ATM card, which help develop and operate more complex closed
could be used to obtain access to a government systems. These systems would use a plastic card
benefit account maintained on behalf of the containing electronic technology, such as a com-
recipient. The Board concluded that such activi- puter chip or magnetic stripe, to which funds
ties are financial activities that are operationally could be credited and from which funds could
and functionally similar to the electronic pay- be debited, for an indefinite period of time. The
ment and data processing services provided by company proposed performing accounting func-
banks and bank holding companies in the operations in customer accounts and accounting for
tion of ATM and POS networks. In particular, the level of the vendor’s stored liabilities. In
the proposed benefit services involve the pro- such a capacity, the company would be respon-
cessing of access and authorization requests sible for the settlement and reconciliation of
submitted to, and the processing of electronic these customer and vendor accounts. The com-
payments originating from, financial accounts pany would also perform other functions, such
on the same basis as transactions initiated with as embossing and issuing cards and arranging
traditional credit and debit cards. The Board for funds collection.
thus concluded that such electronic benefit trans-
fer activities are closely related to banking and
permissible for bank holding companies under 3160.2.2.2 Stored-Value-Card Open
the BHC Act. Systems
The applicants anticipate that stored-value cards
3160.2.2 STORED-VALUE-CARD eventually will operate in an open system simi-
SERVICES lar to a POS network, which allows value stored
on a card to be used with a wide range of
Stored-value-card services would involve data participating vendors. The applicants expect that
processing and transmission services and elec-
tronic payment services related to stored-value BHC Supervision Manual June 2004
cards. These cards are similar to credit or debit Page 1
Electronic Benefit Transfer, Stored-Value-Card, and Electronic Data Interchange Services Section 3160.2
the company’s principal stored-value-card processing of banking, financial, or economic

activities would involve the development and data within the meaning of Regulation Y. In
operation of such open systems. addition, aspects of the company’s stored-value-
In an open system, customers’ debit cards card services are functionally similar to the issu-
would hold an integrated computer chip or some ance and sale of consumer payment instruments
type of comparable technology capable of stor- such as traveler’s checks, which are activities
ing value for use in stored-value-card transac- that banks conduct and that the Board has previ-
tions. Value could be placed on the card at an ously determined to be closely related to bank-
ATM adapted to read and place value on the ing within the meaning of the BHC Act. The
chip, at a limited-purpose ATM-type machine Board concluded that the company’s proposed
whose only functions would be to add value to services in connection with stored-value cards,
the chip and to transfer stored value back to the in either an open system or a closed system, are
customer’s account, or at a cash-to-card machine closely related to banking.
or other value-transfer device (collectively, value
terminals). These value terminals would be
operated, in at least some cases, by the com- 3160.2.3 ELECTRONIC DATA
pany. Once value is placed on a card, equivalent INTERCHANGE SERVICES
funds could be transferred to the company,
which would hold the funds for payment of The company also proposes to furnish retail
stored-value-card transactions. Stored value merchants with data collected from sales trans-
would leave the chip when the customer pur- actions consummated at the merchant’s place of
chases goods or services either at a POS termi- business (data services). The data collected and
nal (which may be operated by the company) or furnished would relate to specific items and
at a vending machine, telephone booth, mass quantities of products purchased by the cus-
transit turnstile, or other unmanned delivery tomer, as well as to customer-purchasing pat-
location (collectively, reader terminals), or when terns over a period of time. The data would be
the customer transfers funds back to an account formatted so that it could be used by the mer-
at a value terminal. Reader terminals generally chant for inventory control, targeted marketing,
would be offline devices not connected to the and other purposes. The company’s data ser-
company’s ATM or POS networks. Instead of a vices generally would be furnished to merchants
direct electronic connection, a reader terminal as an adjunct to its POS-transaction-processing
would retain, for a period of time, value repre- services and would be rendered through a retail
senting the amount of customer purchases at the merchant’s POS terminals. The company does
terminal. Then, at the vendor’s convenience, the not intend to offer data services independently.
company, the vendor, or a third party would In addition, the data that are collected by the
collect value from the reader terminals using company would be furnished only to the mer-
specially designed collection cards issued by the chant that is a party to the underlying sales
company. The collection cards would then be transaction; that is, the company does not intend
submitted to the company so that funds can be to provide such information to third parties.
properly credited. Once these transactions occur, The company’s data services would be lim-
the company would be responsible for making ited to capturing, formatting, and furnishing data
settlement by transferring funds to the accounts collected from sales transactions consummated
of participating merchants and other appropriate at a particular merchant’s place of business. In
parties. addition, the data collected would be furnished
The Board concluded that the company’s only to that merchant and only in accordance
activities in providing stored-value-card ser- with the merchant’s specific instructions. The
vices, in both closed and open systems, are company does not intend to provide software,
closely related to banking. The activities involve render advice, or provide other services associ-
processing debits and credits to the stored-value ated with the marketing or other uses of the
cards and performing related accounting and data. The applicants do anticipate, however, that
settlement functions, and are thus a data pro- the company could provide additional related
cessing activity. Financial balances are main- functions, such as issuing store coupons or cred-
tained and adjusted at POS and other terminals its related to a merchant’s marketing programs
as the customer purchases various items or adds at POS terminals. Based on the facts presented,
value to the card, and the activity constitutes the the Board determined that the sales data that
would be processed under the proposed data
BHC Supervision Manual June 2004 services are financial and economic data within
Page 2 the meaning of Regulation Y.
Electronic Benefit Transfer, Stored-Value-Card, and Electronic Data Interchange Services Section 3160.2
3160.2.4 BOARD APPROVAL with their financial data processing, storage, and
transmission activities. The Board raised the
Based on all the facts of record, the Board total annual revenue limit from 30 percent to the
approved the applications. The Board’s approval 49 percent limit that applies to nonfinancial data
is specifically conditioned on compliance with processing activities. Specifically, a company (a
the commitments made in connection with the nonbank subsidiary of a bank holding company)
applications and with the conditions referred to conducting data processing, data storage, and
in the order. (See 1993 FRB 1158.) data transmission activities may conduct nonfi-
Regulation Y provides that a bank holding nancial data processing, data storage, and data
company may render advice to anyone on pro- transmission activities (those that are not finan-
cessing and transmitting banking, financial, and cial, banking, or economic in nature) if the total
economic data. On November 26, 2003, the annual revenue derived from those activities
Board approved an amendment to section does not exceed 49 percent of the company’s
225.28(b)(14) of Regulation Y to expand the total annual revenues derived from data process-
ability of all bank holding companies, including ing, data storage, and data transmission activi-
financial holding companies, to process, store, ties. (See 12 C.F.R. 225.28(b)(14).)
and transmit nonfinancial data in connection

Page 3
Data Processing Activities: Obtaining Travelers’ Checks and Postage
Stamps Using an ATM Card and ATM Terminal Section 3160.3
Eleven bank holding companies (the applicants) purchase those products from the bank owning
applied for the Board’s approval to engage the ATM. The decision on which travelers’
through a joint venture corporation (the com- checks to issue would remain with the bank that
pany) in certain nonbanking activities related to owns the ATM terminal, and the company would
the operation of a retail electronic funds transfer not be the issuer of the travelers’ checks.
network, including data processing and data The company’s primary activities would be
transmission activities related to automated teller processing and transmitting access requests and
machine (ATM) and point-of-sale (POS) trans- payment authorizations. The company would
actions, as well as electronic benefit transfer, also provide terminal-driving services, load ATM
stored-value card, and electronic data capture terminals with postage stamps and travelers’
and interchange services. (A complete list of the checks, and market the products through the
proposed activities is found at 1994 FRB 1110– network.
1111.) The Board determined that the proposed
The applicants also proposed to offer through activities involved the processing of access and
the company certain data processing and data authorization requests submitted to deposit
transmission services not previously considered accounts on the same basis as other transactions
by the Board. Those services consisted of allow- initiated with a traditional debit card. The activ-
ing customers to use their ATM cards at an ity is operationally and functionally similar to
ATM terminal to withdraw funds from a bank the data processing services provided by banks
account in the form of travelers’ checks or post- and bank holding companies in their operation
age stamps. Payment for the transactions would of ATM and POS networks. Traditionally, banks
be accomplished by a debit to a cardholder’s have been permissibly engaged in the sale of
deposit account. travelers’ checks and postage stamps. The Board
The transactions would occur at terminals thus found the company’s proposed data pro-
that would not be owned and operated by the cessing and transmission activities, with respect
company. Cardholders buying postage stamps to these transactions, to be closely related to
or travelers’ checks at an ATM terminal would banking. (See 1994 FRB 1107.)

Page 1
Providing Data Processing for ATM Distribution of Tickets, Gift Certificates,
Telephone Cards, and Other Documents Section 3160.4
Five bank holding companies (the applicants) transmitted by the company would verify that
applied for the Board’s approval to engage, the deposit account or line of credit designated
through a joint venture subsidiary (the com- by the cardholder had sufficient funds to effect
pany), in certain data processing activities pur- the purchase. Following authorization, the ATM
suant to Regulation Y. The applicants, through would dispense the product and issue a receipt.
the company, would provide data processing The card-issuing bank would then debit an amount
and related services to banks and other auto- equal to the cost of the purchase from the card-
mated teller machine (ATM) owners in connec- holder’s designated account and transfer the
tion with the distribution through ATMs of tick- funds to the account of the merchant or ATM
ets, gift certificates, prepaid telephone cards, owner, using settlement procedures established
and other documents evidencing a prepayment by the company’s ATM network.
for goods or services.1 The Board previously determined that a bank
The company would provide the software and holding company could provide data processing
telecommunications channels necessary to trans- and related services necessary to permit custom-
mit cardholder requests, card-issuer authoriza- ers to use an ATM card to debit a deposit
tions, and related switching and account recon- account or line of credit at an ATM terminal for
ciliation services. Specifically, the company cash and credit transactions, and for the pur-
would provide terminal driving services that chase of travelers’ checks, money orders, and
include— postage stamps. The Board has further deter-
mined that a bank holding company may pro-
• establishing and maintaining an electronic vide data processing services that support the
link between an ATM and a telecommunica- use of credit cards by consumers in the direct
tions switch to transmit cardholder requests purchase of goods and services from a mer-
and card-issuer authorizations; and chant. (See 1995 FRB 492, 1990 FRB 549, and
• operating the feature and functions displays 1985 FRB 113.)
on an ATM screen using computer software to The data processing proposed in this case
permit an ATM to dispense various products involves the same type of data processing sup-
in addition to currency. port as the Board has previously approved for
credit card transactions and other more tradi-
The company would also provide switching ser- tional types of ATM transactions. The Board
vices and transaction processing to transmit thus concluded that the activities proposed by
account debiting, transaction authorization, and the applicants are permissible, consisting of data
settlement data between the ATM owner, or its processing and transmission services encom-
bank, and the cardholder’s bank. passed within the Board’s Regulation Y, and are
A typical transaction would consist of an thus closely related to banking within the mean-
ATM cardholder selecting a particular product, ing of section 4(c)(8) of the Bank Holding Com-
such as a concert ticket, from a menu displayed pany Act. (See 1996 FRB 848.)
on the ATM screen. The electronic commands
1. The tickets would include public transportation tickets

and tickets to entertainment events. Gift certificates and pre-
paid telephone cards would be issued in fixed denominations
for a specific merchant or group of merchants, and they would
evidence prepayment of the purchase price of merchandise or
services to be selected by the bearer at some time in the
future. The ATM owners would also sell products that could
be offered for sale directly by a financial institution, such as
mutual fund shares or insurance policies, where permitted by BHC Supervision Manual June 1997
applicable law. Page 1
(Engage in Transmitting Money) Section 3160.5
3160.5.1 ENGAGE IN TRANSMITTING of its subsidiary banks, located near the third
MONEY IN THE UNITED STATES party receiving the funds. The third party would
be notified that money is available at a local
A bank holding company gave notice under disbursement site, which could include a bank
section 4(c)(8) of the Bank Holding Company subsidiary of the bank holding company or con-
Act (BHC Act) (12 U.S.C. 1843(c)(8)) and sec- sumer finance office or an unaffiliated check-
tion 225.23 of the Board’s Regulation Y (12 cashing, finance, or other type of office. Funds
C.F.R. 225.23) to engage de novo through two would be made available to the third party by a
companies (the companies) in the activity of check drawn on the companies’ account almost
transmitting money for customers within the immediately after the transmission order is placed
United States and its territories (‘‘domestic money by the customer.3
transmission services’’) to third parties located A customer would not transmit funds to any
in foreign countries.1 The activity was to be bank account maintained by the customer or any
conducted at first through a network of approxi- third party. Thus, the bank holding company
mately 1,200 ‘‘outside representative offices’’ would not use this service to collect deposits for
located in California, Florida, Illinois, and Texas customers of its subsidiary banks or any other
that are under contract with the companies to bank.
provide money transmission services.2 The bank There was no agreement between a customer
holding company proposes to engage in the and a bank to accept money in an account for
planned activity nationwide. The companies are use by the bank in connection with the proposed
corporations that currently engage in the busi- domestic money transmission services. The com-
ness of money transmission to Mexico through panies and their outside representative would
representatives in California, Florida, Illinois, accept money from a customer for the sole
and Texas. purpose of transmitting funds to a third party. A
Domestic money transmission services would customer would not give funds to the companies
be provided in the following manner: A cus- with the expectation that the companies would
tomer would contact the companies directly by permit the customer to reclaim the funds on
means of a dedicated telephone located in the demand or after a period of time. Moreover, the
outside representative office to request that the companies would not maintain balances or pay
companies transmit funds to a third party for a interest on the money they receive, and they
fee. The outside representative would collect would only hold funds long enough to transmit
cash and a fee from the customer, issue a receipt, them to the designated third party.4
and deposit funds in an account maintained by The Board previously determined that money
the outside representative solely for the purpose transmission abroad is closely related to bank-
of receiving funds in trust to be transmitted to a ing.5 The Office of the Comptroller of the Cur-
third party. The outside representative may main- rency (OCC) also has concluded that it is per-
tain this account at any bank, including a subsid- missible for a national bank to accept money
iary bank, but would have no agreement with from nonbank affiliates for the purpose of trans-
any bank to accept deposits on its behalf. Nei- mitting the funds to a foreign country and that a
ther the outside representatives nor the compa-
nies would be FDIC-insured institutions.
The companies would collect funds deposited 3. The domestic money transmission services do not involve
lending money because only funds provided by the customer
in an outside representative’s account daily would be transmitted to a third party. The plan does not
through an automated clearinghouse (ACH) or involve the paying of checks. Although the third party re-
similar transaction and deposit an amount equal ceives money by means of a check drawn on an account
to the amount to be transmitted into an account maintained by the companies, the receipt of funds in check
form is not the payment of a check (see Independent Bankers
they maintain at a bank, which may include one Ass’n of America v. Smith, 534 F.2d 921, 943–45 (D.C. Cir.
1976)).
4. Many states permit companies that are not chartered as
1. The Board previously approved the bank holding com- banks to transmit money without deeming this activity to
pany’s acquisition of a company to engage in the activity of involve the taking of deposits. The bank holding company is
transmitting funds to third parties in Mexico by using an required to conduct the proposed activities in compliance with
unaffiliated foreign bank to make the cash payments. See licensing and other requirements of relevant state law.
1995 FRB 974. 5. See 1990 FRB 270.
2. Outside representative offices would be expanded to
include consumer finance offices in addition to existing
grocery stores, travel agencies, pharmacies, and insurance BHC Supervision Manual December 1998
agencies. Page 1
Section 4(c)(8) of the BHC Act (Engage in Transmitting Money) 3160.5
nonbank affiliate that participates with the national cial services company to ensure compliance
bank in transmitting money abroad would not with the Bank Secrecy Act.8
become a branch of the bank.6 Based on all the Based on the foregoing and all the facts of
facts of record and for the reasons discussed in record, the Board approved the notice on Octo-
this and the Board’s previous orders, the Board ber 17, 1995 (see 1995 FRB 1130). The Board’s
concludes that domestic money transmission decision was specifically conditioned on the
services are closely related to banking. The bank holding company’s complying with all the
Board has relied on the fact that the companies commitments made in connection with the notice
are subject to licensing and examination by state and obtaining all necessary approvals from state
authorities.7 The companies have committed to regulators.
comply with all applicable reporting require-
ments, including reporting all transactions over
$10,000 to the Internal Revenue Service. The
bank holding company committed to apply the
internal controls currently in place at the finan-
8. These procedures include a weekly review of all transac-
tions over $10,000. In addition, the companies will require
customer identification, including the customer’s current address
6. The OCC has reasoned that nonbank offices that trans- and occupation, for all transmissions above $3,000. The com-
mit funds through a national bank to a third party do not panies also will run a computer match of all remitters and
constitute ‘‘branches’’ under federal law. recipients by name and Social Security number so that report-
7. This order was specifically conditioned on requiring the ing requirements cannot be evaded by means of a series of
bank holding company to obtain all necessary state licenses. transactions.

Page 2
Support Services—Printing and Selling
MICR-encoded items Section 3165.1
The Board has included within Regulation Y to acquire a controlling interest in a printing
(section 225.28(b)(10)(ii)(B)) the authority for company that prints and sells checks and related
bank holding companies to engage in the print- documents. It planned to engage in a joint ven-
ing and selling of magnetic ink character recog- ture with another company that engages in check
nition (MICR)-encoded items as part of support printing and other printing activities. The Board
services. This activity includes this primary concluded for that application that checks and
activity and also the printing and selling of other MICR-encoded documents used in the
corporate image checks, cash tickets, voucher payments process are provided in specialized
checks, deposit slips, savings withdrawal pack- form and that they are an integral part of a
ages, and other forms that require MICR encod- fundamental banking service, and thus the activ-
ing. The activity was initially authorized as a ity is deemed closely related to banking. See
permissible activity by Board order, whereby 1986 FRB 794. The Board included the non-
such documents were to be printed for and sold banking activity in the Regulation Y ‘‘laundry
exclusively to depository institutions. The appli- list,’’ effective April 1997.
cant associated with that Board order proposed

Page 1
Section 4(c)(8) of the BHC Act (Insurance Agency Activities of
Bank Holding Companies) Section 3170.0
3170.0.1 INSURANCE ACTIVITIES sold as a matter of convenience to the public.
PERMISSIBLE FOR BANK HOLDING The opinion also found that the part of the
COMPANIES Board’s regulation relating to the sale of ‘‘con-
venience insurance’’2 exceeded the scope of the
Before the enactment of the 1970 amendments provisions of section 4(c)(8) of the Bank Hold-
to the Bank Holding Company Act, the Board ing Company Act. The sale of this other insur-
by order authorized certain bank holding com- ance was considered impermissible.
panies to engage in insurance activities. The On October 15, 1982, Congress enacted the
specific type of permissible insurance activity Garn–St Germain Depository Institutions Act
for each bank holding company was described (Public Law 97-320). Title VI of that act amended
in its Board order. These few bank holding- section 4(c)(8) of the Bank Holding Company
companies that commenced insurance agency Act. This amendment stated that insurance agency,
activities before January 1, 1971, have grand- brokerage, and underwriting activities are not
father rights under the current statutes and regu- ‘‘closely related’’ to banking within the mean-
lations (section 4(c)(8)), exemption G and 12 ing of section 4(c)(8) of the Bank Holding Com-
(CFR 225.28(b)(11)(vii)). These bank holding pany Act. However, the amendment provided
companies may, with the prior approval of the for seven exceptions to the general prohibition
Board, engage in general insurance agency of bank holding companies engaging in insur-
activities without restriction as to location or to ance activities. One of the seven exceptions
type of insurance sold. (See section 3170.0.3.7) contains grandfather exemptions for insurance
The 1970 amendments to the Bank Holding agency activities conducted on May 1, 1982, or
Company Act authorized the Board to deter- for those insurance activities approved by the
mine permissible nonbanking activities under Board on or before May 1, 1982. As a result,
section 4(c)(8). Subsequently, on September 1, bank holding companies receiving Board approval
1971, the Board amended Regulation Y to per- on or before May 1, 1982, may continue to
mit bank holding companies to engage in cer- engage in their insurance agency activities. (See
tain insurance agency activities. section 3170.0.3.4)
The Board further amended the section of The seven types of insurance activities
Regulation Y concerning permissible insurance allowed as permissible for bank holding compa-
agency activities on September 1, 1981. The nies are as follows:
1981 amendments limited permissible insurance 1. Acting as agent, broker, or principal (i.e.,
activities previously authorized by Regulation underwriter) for credit-related life, accident
Y. The first amendment deleted from the Board’s and health, or unemployment insurance.
regulations the authority for bank holding com- 2. For bank holding company finance subsidi-
panies to act under section 4(c)(8) of the Bank aries, acting as agent or broker for credit-
Holding Company as agent for the sale of insur- related property insurance in connection with
ance for themselves and their subsidiaries. This loans not exceeding $10,000 ($25,000 in the
amendment reflected a court decision of the case of a mobile home loan) made by finance
United States Court of Appeals for the Fifth company subsidiaries of bank holding com-
Circuit that acting as agent for the sale of insur- panies. (The Board interpreted this provision
ance for the bank holding company and its as permitting only the sale of insurance that
nonbanking subsidiaries was impermissible (per- does not exceed the outstanding balance of
missible for banks, however). Such insurance is the loan—vendor’s single interest insurance
permissible, however, if conducted pursuant to rather than general property insurance that
section 4(c)(1)(C) of the BHC Act.1 The second covers the borrower’s equity interest.)
1981 amendment deleted from the Board’s regu-
lations the authority to act as agent for insurance
2. ‘‘Convenience insurance’’ consisted of insurance that
was sold as a matter of convenience to the purchaser. The
1. The Board’s Regulation Y was amended as of Decem- premium income from the sale of this insurance was expected
ber 1983 to include the sale of insurance for a holding to constitute less than 5 percent of the aggregate insurance
company based on the services provision of section 4(c)(1)(C) premium income of the holding company. The sale of this
of the BHC Act, which did not require any prior Board insurance was not designed to permit entry into the general
approval. Included in the regulation were the services of insurance-agency business.
selling, purchasing, or underwriting such insurance as blanket
bond insurance, group insurance for employees, and property
and casualty insurance for the bank holding company or its BHC Supervision Manual December 1997
subsidiaries. Page 1
Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0
3. Acting as agent for the sale of any type of bank subsidiary (excluding bank-owned subsid-
insurance in a place with a population not iaries). Many of the smaller bank holding com-
exceeding 5,000, or with insurance agency panies engage directly in these activities rather
facilities that the bank holding company dem- than through insurance agency subsidiaries. In
onstrates to be inadequate. either arrangement, however, sales are usually
4. Any insurance agency activity engaged in by conducted on the premises of the subsidiary
a bank holding company or its subsidiaries bank by personnel who most often serve as
on May 1, 1982 (or approved as of May 1, officers or employees of the bank or parent
1982), including (i) insurance sales at new company.
locations of the same bank holding company Performance of insurance agency activities
or subsidiaries in the state of the bank hold- has been profitable for most bank holding com-
ing company’s principal place of business or panies with many of the smaller companies rely-
adjacent states or any state or states in which ing heavily on the commissions generated to
insurance activities were conducted by the service acquisition or other related indebted-
bank holding company or any of its subsidi- ness. In most cases, little or no expenditures for
aries on May 1, 1982, or, (ii) insurance cov- fixed assets are required since the premises of
erage functionally equivalent to those engaged the subsidiary banks or parent company are
in or approved by the Board as of May 1, utilized. Likewise, little or no liabilities are
1982. incurred since there are minimal assets to be
5. Acting, on behalf of insurance underwriters, financed.
as supervisor of retail agents who sell fidelity
insurance and property and casualty insur-
ance on holding company assets or group 3170.0.3 PERMISSIBLE TYPES OF
insurance for the employees of a bank hold- COVERAGE INCLUDING
ing company or its subsidiaries. GRANDFATHER PRIVILEGES
6. Any insurance agency activities engaged in
by a bank holding company having total As noted above, the Board, effective November
consolidated assets of $50,000,000 or less. 7, 1986, approved a revision of specific insur-
Life insurance and annuities sold under this ance agency and underwriting activities permis-
provision, however, must be authorized by sible for bank holding companies under section
(1), (2), or (3) above. 4(c)(8) of the BHC Act (section 225.28(b)(11)
7. Any insurance agency activity that is per- of Regulation Y). In clarifying the scope of
formed by a registered bank holding com- insurance activities that are closely related to
pany, which was engaged in some insurance banking and permissible for bank holding com-
activity before January 1, 1971, pursuant to panies under the Garn–St Germain Act, the
the approval of the Board. Board included in its revised Regulation Y the
These seven types of insurance allowed by seven specific exemptions contained in that
the amendment to section 4(c)(8) of the Garn– statute.
St Germain Act are generally consistent with
the types of insurance activities previously autho-
rized by the Board. The one general exception 3170.0.3.1 Insurance Activities
related to the prohibition of the sale of property Permissible for Bank Holding Companies
and casualty insurance. per Section 225.28(b)(11)(i) of the
Board’s Regulation Y
3170.0.2 INSURANCE AGENCY Permissible insurance agency activities include

ACTIVITIES the sale of life, accident and health, and involun-
tary unemployment insurance that is directly
Insurance agency activities are among the most related to an extension of credit by a bank
widely practiced nonbank activities engaged in holding company with respect to its own exten-
by bank holding companies. Many bank holding sions of credit and those of its subsidiaries. For
companies are involved in the sale of insurance the purpose of determining what activities are
at some level in the organization; however, the permissible, the Board interpreted the term
inspection focuses on these activities only when ‘‘extension of credit’’ to include direct loans to
performed by the parent company or by a non- borrowers, loans purchased from other lenders,
and leases of real or personal property so long
BHC Supervision Manual December 1997 as the leases meet all the criteria contained in
Page 2 section 225.28(b)(3) of Regulation Y, which
Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0
defines leases as the functional equivalent of an insurance with respect to a lease transaction,
extension of credit. (See the discussion of leas- provided the lease is the type of nonoperating,
ing in section 3140.0.) full payout lease described as permissible for
The regulation requires that insurance cover- bank holding companies in section 225.28(b)(3)
age be limi

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Division of Banking Supervision and Regulation

Division of Banking Supervision and Regulation

Send comments to:

Copies of this manual may be obtained from:

Section 2068.0 Section 4066.0

1010.0 General Table of Contents, 1010.0 General Table of Contents,

2068.0, pages 1–14

2090.0, pages 1–5 2090.0, pages 1–6

BHC Supervision Manual July 2010

1. In June 2009, the Financial Accounting Standards Board

1010.0 General Table of Contents, 1010.0 General Table of Contents,

2030.0, pages 1–2 2030.0, pages 1–2

2127.0, page 1 2127.0, pages 1–2

BHC Supervision Manual January 2010

1010.0 General Table of Contents, 1010.0 General Table of Contents,

4060.9, pages 1–7

BHC Supervision Manual July 2009

1. The FACT Act authorized the Board to write rules for

BHC Supervision Manual January 2009

1010.0 General Table of Contents, 1010.0 General Table of Contents,

1050.2, pages 1–17

2124.01, pages 1–2 2124.01, pages 1–2

4000 Table of Contents, page 7 4000 Table of Contents, page 7

BHC Supervision Manual January 2009

Section 2128.06 Section 3920.0

BHC Supervision Manual July 2008

1040.0, page 1 1040.0, pages 1–2

3230.0, pages 1–12 3230.0, pages 1–11

3905.0, pages 1–2, 2.1–2.3, 3–5 3905.0, pages 1–9

3906.0, pages 1–2

4070.5, pages 1–3 4070.5, pages 1–3

5030.0, pages 45–46 5030.0, pages 45–46

5040.0, pages 1–4 5040.0, pages 1–4

BHC Supervision Manual July 2008

Bank Holding Company Supervision Manual

BHC Supervision Manual January 2008

1010.0, pages 11–12, 12.1 1010.0, pages 11–12, 12.1

2128.09, pages 1–2 2128.09, pages 1–2

3912.0, pages 1–4

4010.2, pages 1–6 4010.2, pages 1–6

4060.3, pages 1–2, 55–56 4060.3, pages 1–2, 55–56, 56.1–56.2

BHC Supervision Manual January 2008

2065.4, pages 1–2, 2.1 2065.4, pages 1–2

2128.09, pages 1–7

BHC Supervision Manual July 2007

BHC Supervision Manual July 2007

The ‘‘Credit-Supported and Asset-Backed Com-

Section 4060.3 A new section titled ‘‘Consolidated Risk-Based

2128.03, pages 1–7 2128.03, pages 1–8

4060.3, pages 1–6, 6.1–6.8 4060.3, pages 1–6, 6.1–6.7

4070.5, pages 1–3 4070.5, pages 1–3

BHC Supervision Manual January 2007

This revised section, ‘‘Policy Statement on the

BHC Supervision Manual July 2006

1010.0, pages 1–2 1010.0, pages 1–2

2090.2, pages 1–5 2090.2, pages 1–7

2090.7, pages 1–2 2090.7, pages 1–3

3072.8, pages 1–2

6000.0, pages 1–55 6000.0, pages 1–58

BHC Supervision Manual July 2006

to include a summary of the September 8, 2005, developed to incorporate the interagency