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Transcript
Federal Deposit Insurance Corporation
Risk Management Manual of Examination Policies
Effective: 11/2014
RMS Manual of Examination Policies
Table of Contents
Section Title
Index
Section Number
0.1
Part I – Basic Examination Concepts and Guidelines
Basic Examination Concepts and Guidelines
1.1
Part II – CAMELS
Capital Adequacy
Capital
Asset Quality
Asset Quality
Loans
Securities and Derivatives
Cash and Due from Banks
Premises and Equipment
Other Real Estate
Other Assets and Liabilities
Off-Balance Sheet Activities
Management
Management
Internal Routine and Controls
Related Organizations
Fidelity and Other Indemnity Protection
Violations of Laws and Regulations
Miscellaneous Banking Activities
Earnings
Earnings
Liquidity
Liquidity and Funds Management
Sensitivity to Market Risk
Sensitivity to Market Risk
2.1
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
4.1
4.2
4.3
4.4
4.5
4.6
5.1
6.1
7.1
Part III – Other Examination Issues
Bank Secrecy Act, Anti-Money Laundering and
Office of Foreign Assets Control
Bank Fraud and Insider Abuse
Suspicious Activity and Criminal Violations
International Banking
Applications
8.1
9.1
10.1
11.1
12.1
Part IV – Administrative and Enforcement Actions
Memorandums of Understanding
Civil Money Penalties
Formal Administrative Actions
13.1
14.1
15.1
Part V - Examination Reports
Report of Examination Instructions
Bank of Anytown—Report of Examination
Report of Investigation Instructions
Bank of Anytown—Report of Investigation
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
16.1
17.1
18.1
19.1
Table of Contents (3/12)
INDEX
Section 0.1
Section Title
Page Number
PART I - BASIC EXAMINATION CONCEPTS AND GUIDELINES
Section 1.1 - BASIC EXAMINATION CONCEPTS AND GUIDELINES
(Updated March 2012)
A detailed index for this section is included within the updated section.
PART II - CAMELS
Section 2.1 - CAPITAL
Introduction
Capital
Contingent Liabilities
Evaluation of a Bank’s Capital Adequacy
Rating the Capital Factor
2.1-1
2.1-1
2.1-11
2.1-13
2.1-15
Section 3.1 – ASSET QUALITY
(Updated March 2012)
A detailed index for this section is included within the updated section.
Section 3.2 - LOANS
Introduction
Loan Administration
Portfolio Composition
Other Credit Issues
Loan Problems
Loan Appraisal and Classification
Concentrations
Federal Funds Sold and Repurchase Agreements
Fundamental Legal Concepts and Definitions
Consideration of Bankruptcy Law as it Relates to Collectability of a Debt
Syndicated Lending
Credit Scoring
Subprime Lending
3.2-1
3.2-1
3.2-7
3.2-26
3.2-36
3.2-39
3.2-51
3.2-52
3.2-53
3.2-58
3.2-61
3.2-64
3.2-65
Section 3.3 – SECURITIES AND DERIVATIVES
Introduction
Policies, Procedures, and Risk Limits
Internal Controls
Unsuitable Investment Activities
Risk Identification, Measurement, and Reporting
Board and Senior Management Oversight
Compliance
Report of Examination Treatment
Other Guidance
Investment Strategies
Market Risk Modification Strategies
Accounting Guidance
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
3.3-1
3.3-2
3.3-3
3.3-5
3.3-6
3.3-9
3.3-10
3.3-11
3.3-15
3.3-19
3.3-21
3.3-23
0.1-1
Index (03/12)
INDEX
Section 0.1
Section 3.4 - CASH AND DUE FROM BANKS
(Updated March 2012)
A detailed index for this section is included within the updated section.
Section 3.5 - PREMISES AND EQUIPMENT
(Updated March 2012)
A detailed index for this section is included within the updated section.
Section 3.6 - OTHER REAL ESTATE
(Updated March 2012)
A detailed index for this section is included within the updated section.
Section 3.7 - OTHER ASSETS AND LIABILITIES
(Updated March 2012)
A detailed index for this section is included within the updated section.
Section 3.8 - OFF-BALANCE SHEET ACTIVITIES
Introduction
Off-Balance Sheet Items and Derivatives
Off-Balance Sheet Lending Activities
Off-Balance Sheet Asset Transfers
Off-Balance Sheet Contingent Liabilities
Adversely Classified Contingent Liabilities
3.8-1
3.8-1
3.8-1
3.8-4
3.8-5
3.8-5
Section 4.1 – MANAGEMENT
Introduction
Management/Directors
Federal Banking Laws and Regulations Primarily Pertaining to Bank Directors
Other Issues
Evaluation of Management
Rating the Management Factor
4.1-1
4.1-1
4.1-6
4.1-8
4.1-14
4.1-14
Section 4.2 - INTERNAL ROUTINE AND CONTROLS
Introduction
Basic Elements of an Internal Control System
Audit
Corporate Governance
The Examiner's Responsibilities
Other Related Matters
Index (03/12)
4.2-1
4.2-1
4.2-4
4.2-13
4.2-14
4.2-20
0.1-2
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
INDEX
Section 0.1
Section 4.3 - RELATED ORGANIZATIONS
Definitions and Authorities
Gramm-Leach-Bliley Act
Examination Authority
Bank Holding Companies
Parent Companies Which Are Not Bank Holding Companies
Holding Company Effect on Subsidiary Banks
Tying Arrangements
Chain Banking Groups
Affiliates
Subsidiaries
Examination of Subsidiaries
Examination and Investigation of Unaffiliated Third Party Servicers
4.3-1
4.3-1
4.3-3
4.3-3
4.3-4
4.3-6
4.3-11
4.3-11
4.3-12
4.3-16
4.3-19
4.3-20
Section 4.4 - FIDELITY AND OTHER INDEMNITY PROTECTION
Introduction
Fidelity Insurance Protection
Other Desirable Insurance Coverage
4.4-1
4.4-1
4.4-5
Section 4.5 - VIOLATIONS OF LAWS AND REGULATIONS
Introduction
Basic Causes and Significance of Violations
Scheduling Violations
Types of Violations
Contraventions of FDIC Statements of Policy
Violations and the Evaluations of Bank Management
4.5-1
4.5-1
4.5-1
4.5-2
4.5-3
4.5-4
Section 4.6 MISCELLANEOUS BANKING ACTIVITIES
Remote Disbursement Activities and Zero-Balance Accounts
Funds Transfer System Risk
4.6-1
4.6-1
Section 5.1 - EARNINGS
Introduction
Evaluation of Earnings Performance
Rating the Earnings Factor
5.1-1
5.1-7
5.1-7
Section 6.1 - LIQUIDITY AND FUNDS MANAGEMENT
Introduction
Liquidity Management
Warning Indicators and Contingency Liquidity Plan
Funding Sources: Assets
Funding Sources: Liabilities
The Role of Capital and the Bank Holding Company
Evaluation of a Bank’s Liquidity
Rating the Liquidity Factor
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
6.1-1
6.1-1
6.1-3
6.1-5
6.1-6
6.1-15
6.1-16
6.1-16
0.1-3
Index (03/12)
INDEX
Section 0.1
Section 7.1 – SENSITIVITY TO MARKET RISK
Introduction
Examination Standards and Goals
Types of Interest Rate Risk
Management Responsibilities
IRR Measurement Methods
IRR Measurement System Review
Variance Analysis
Other Market Risk Factors
Evaluation of a Bank’s Sensitivity to Market Risk
Rating the Sensitivity to Market Risk Factor
Market Risk Glossary
7.1-1
7.1-1
7.1-1
7.1-3
7.1-6
7.1-9
7.1-13
7.1-15
7.1-15
7.1-15
7.1-16
PART III - OTHER EXAMINATION ISSUES
Section 8.1 –BANK SECRECY ACT, ANTI-MONEYLAUNDERING AND OFFICE
OF FOREIGN ASSETS CONTROL
Introduction to the Bank Secrecy Act
Financial Crimes Enforcement Network Reports and Recordkeeping Requirements
Customer Identification Program
Special Information Sharing Procedures to Deter Money Laundering and Terrorist Activities
Customer Due Diligence
Banking Services and Activities with Greater Potential for Money Laundering and Enhanced
Due Diligence Procedures
Monitoring Bank Secrecy Act Compliance
BSA Violations and Enforcement
Identification of Suspicious Transactions
Suspicious Activity Reporting
Office of Foreign Assets Control
Examples of Proper Citation of Apparent Violations of the BSA Related Regulations in the
Report of Examination
Web-Site References
Section 9.1 - BANK FRAUD AND INSIDER ABUSE
Introduction
Subject Areas
Corporate Culture/Ethics
lnsider Transactions
Loan Participations
Real Estate Lending
Secured Lending
Third Party Obligations
Lending to Buy Tax Shelter Investments
Linked Financing/Brokered Deposits
Credit Cards and ATM Transactions
Advance Fee Schemes
Offshore Transactions
Wire Transfers
Money Laundering
Securities Trading Activities
Miscellaneous
Index (03/12)
8.1-1
8.1-1
8.1-7
8.1-13
8.1-17
8.1-18
8.1-31
8.1-33
8.1-38
8.1-45
8.1-48
8.1-51
8.1-55
9.1-1
9.1-1
9.1-1
9.1-2
9.1-4
9.1-5
9.1-7
9.1-8
9.1-9
9.1-9
9.1-10
9.1-11
9.1-12
9.1-13
9.1-14
9.1-16
9.1-17
0.1-4
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
INDEX
Section 0.1
Section 10.1 – SUSPICIOUS ACTIVITY AND CRIMINAL VIOLATIONS
Introduction
Bank Management’s Role
The Examiner’s Role
Interagency Cooperation
Examiner Assistance to Federal Law Enforcement Authorities
Federal Grand Jury Subpoenas
Safeguarding and Documenting Evidence
Notification to the Bonding Company
Other Matters of Importance
Criminal Statutes
10.1-1
10.1-1
10.1-2
10.1-2
10.1-3
10.1-3
10.1-4
10.1-4
10.1-5
10.1-5
Section 11.1 - INTERNATIONAL BANKING
Introduction
Country Risk Management
International Activities
Supervision of U.S. Operations of Foreign Banks and Other International Banking Entities
Laws and Regulations
Glossary of International Banking Terminology
11.1-1
11.1-2
11.1-6
11.1-20
11.1-28
11.1-30
Section 12.1 - APPLICATIONS
Applications for Deposit Insurance
Applications to Establish a Branch or to Move Main Office or Branch
Applications for Consent to Exercise Trust Powers
Change in Bank Control Act
Application for Retirement of Capital
Applications for Mergers
Applications by Undercapitalized Depository Institutions for a Waiver to Accept, Renew
Or Rollover Brokered Deposits
Policy Statement on Encouragement and Preservation of Minority Ownership of Financial
Institutions
Applications Pursuant to Section 19 of the FDI Act – Crimes Involving Dishonesty or
Breach of Trust or Money Laundering, or Pretrial Diversion Programs for Such
Offenses
Applications Pursuant to Part 362 of the FDIC’s Rules and Regulations – Activities and
Investments of Insured Depository Institutions
Other Applications
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
0.1-5
12.1-1
12.1-12
12.1-12
12.1-15
12.1-17
12.1-18
12.1-20
12.1-21
12.1-22
12.1-23
12.1-23
Index (12-04)
INDEX
Section 0.1
PART IV - ADMINISTRATIVE & ENFORCEMENT ACTIONS
Section 13.1 - MEMORANDUMS OF UNDERSTANDING
Introduction
13.1-1
Section 14.1 - CIVIL MONEY PENALTIES
Introduction
Violations
Assessment of Civil Money Penalties
Examination Procedures
Other Considerations
Guidelines for Using the CMP Matrix
14.1-1
14.1-1
14.1-1
14.1-3
14.1-4
14.1-5
Section 15.1 - FORMAL ADMINISTRATIVE ACTIONS
Introduction
Reports of Examination Containing a Basis for Section 8 Charges
Unsafe or Unsound Practices
Section 8(a) - Termination of Insurance
Cease and Desist Proceedings
Suspension and Removal Procedures
Use of Written Agreements and Capital Directives
Prompt Corrective Action Directive
Orders to Correct Safety and Soundness Deficiencies
Capital Plans
15.1-1
15.1-1
15.1-3
15.1-5
15.1-6
15.1-9
15.1-11
15.1-12
15.1-12
15.1-13
PART V - EXAMINATION REPORT
Section 16.1 – REPORT OF EXAMINATION INSTRUCTIONS
16.1-1
Section 17.1 - BANK OF ANYTOWN-REPORT OF EXAMINATION
17.1-1
Section 18.1 – REPORT OF INVESTIGATION INSTRUCTIONS
18.1-1
Section 19.1 - BANK OF ANYTOWN-REPORT OF INVESTIGATION
19.1-1
Index (03/12)
0.1-6
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
BASIC EXAMINATION CONCEPTS AND GUIDELINES
RATIONALE OF BANK EXAMINATIONS ...................2
CONDUCT OF EXAMINATIONS ...................................2
Prohibition Against Political Communication ...............2
RATING SYSTEM ............................................................2
Introduction ...................................................................2
UFIRS Overview ...........................................................2
Disclosure of Ratings.....................................................3
Discussions with Management.......................................3
Examination Letters .......................................................4
EXAMINATION FREQUENCY .......................................4
Alternate Examinations .................................................5
Specialty Examination Intervals ....................................5
Insured Branches of Foreign Banks ...............................5
EXAMINATION TYPES ..................................................6
Risk Focused Supervision..............................................6
Full Scope Examinations ...............................................6
Limited Scope Examinations and Visitations ................6
Other Situations .............................................................6
Institutions Subject to Corrective Actions .....................6
Newly Chartered Insured Institutions ............................7
Examination and Visitation Cycles ...........................7
Monitoring Activities ................................................7
Changes in Business Plans ........................................7
Converting to Insured Nonmember Status .....................8
Change of Ownership Control .......................................8
COORDINATING EXAM SCHEDULES .........................8
State Authorities ............................................................8
Holding Company Inspections and Subsidiary
Institution Examinations ................................................8
Interstate Banking and Chain Banks ..............................8
SCHEDULING GUIDELINES ..........................................9
Anticipatory Supervision ...............................................9
Scheduling Considerations ............................................9
Offsite Analysis and Monitoring ...............................9
Other Financial Indicators ........................................9
Applications or Other Bank-Provided Data ............10
Known Characteristics ............................................10
Other Bank Regulators............................................10
Media ......................................................................10
Rumors/Observations/Other....................................10
RELYING ON STATE EXAMINATIONS .....................10
PRE-EXAMINATION ACTIVITIES ..............................12
Reviewing External Audit Workpapers .......................12
Shared Loss Agreements .............................................12
Examination Considerations ...................................13
Other Examination Considerations .........................13
MEETINGS WITH MANAGEMENT ............................13
Pre-Examination Planning: .....................................14
First Day .................................................................14
Follow-up on Prior Examination Issues ..................14
Strategic Planning and Budget ................................14
Loan Discussion......................................................14
Material Preliminary Findings ................................14
Management Meeting .............................................14
Meetings with Directors ..............................................14
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 1.1
Banks Assigned a Composite 4 or 5 Rating ........... 14
Banks Assigned a Composite 3 Rating................... 15
Banks Assigned a Composite Rating of 1 or 2 ....... 15
Other Considerations .............................................. 15
OTHER SOURCES OF EXAMINATION
INFORMATION AND POLICY GUIDANCE ............... 15
Trust Department ........................................................ 16
Information Technology (IT) ...................................... 16
Bank Secrecy Act (BSA) ............................................ 16
Consumer Protection ................................................... 17
Summary ..................................................................... 17
DISCLOSING REPORTS OF EXAM ............................ 17
EXAMINATION WORKPAPERS ................................. 17
Introduction................................................................. 17
Safeguarding Examination Information ...................... 17
Examination Documentation Modules ........................ 18
Substance of Workpapers ........................................... 18
Filing of Workpapers .................................................. 18
Retention of Workpapers ............................................ 19
ADDENDUM TO SECTION 1.1 .................................... 20
UFIRS RATINGS DEFINITIONS .................................. 20
Composite Ratings ...................................................... 20
Composite 1 ........................................................... 20
Composite 2 ........................................................... 20
Composite 3 ........................................................... 20
Composite 4 ........................................................... 20
Composite 5 ........................................................... 20
Component Ratings ..................................................... 20
Capital Adequacy ................................................... 21
Asset Quality .......................................................... 21
Management ........................................................... 22
Earnings ................................................................. 23
Liquidity ................................................................. 24
Sensitivity to Market Risk ...................................... 24
1.1-1
Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
Section 1.1
RATIONALE OF BANK EXAMINATIONS
Prohibition Against Political Communication
The Federal Deposit Insurance Corporation conducts bank
examinations to ensure public confidence in the banking
system and to assess compliance with laws and regulations.
Bank examinations help protect the Deposit Insurance Fund
and facilitate the supervisory process.
FDIC employees should avoid any form of political
communication with insured depository institutions that could
be perceived as suggesting the examination process is
influenced by political considerations, or that the bank should
take a particular position on legislative issues. Examinations
must be kept free from political considerations, or the
appearance of being influenced by political considerations, in
order to maintain the integrity and effectiveness of the
examination process. FDIC employees should promptly
inform their regional office of any situation they feel
compromised this policy.
Maintaining public confidence in the integrity of the banking
system is essential because customer deposits are a primary
funding source, without which banks would be unable to
meet fundamental objectives, such as providing financial
services. The financial stability of an institution or the
existence of weak risk management practices are disclosed
through examination of a bank's capital, assets, management,
earnings, liquidity, and sensitivity to market risk.
RATING SYSTEM
Evaluating a bank's adherence to laws and regulations is best
accomplished through periodic onsite examinations.
Compliance with statutory and regulatory requirements is
given high priority by bank supervisors and Congress.
Introduction
The Uniform Financial Institutions Rating System (UFIRS)
was adopted by the Federal Financial Institutions
Examination Council (FFIEC) on November 13, 1979, and
updated in December 1996. Over the years, the UFIRS
proved to be an effective supervisory tool for evaluating
financial institutions on a uniform basis and for identifying
institutions requiring special attention. Changes in the
banking industry and regulatory policies prompted a revision
of the 1979 rating system. The 1996 revisions to UFIRS
include the addition of a sixth component addressing
sensitivity to market risk, the explicit reference to the quality
of risk management processes in the management component,
and the identification of risk elements within the composite
and component rating descriptions.
Bank examinations play a vital role in protecting the integrity
of the Deposit Insurance Fund. Examinations help identify
problem situations and help prevent identified problems from
deteriorating to the point where depositor payoffs or financial
assistance by the FDIC become unavoidable.
Finally, examinations play a key role in the supervisory
process by helping the FDIC to identify the nature, severity,
and cause of a bank's problems; to recognize emerging risks
in the financial services industry; and to develop effective
corrective measures.
CONDUCT OF EXAMINATIONS
The UFIRS takes into consideration certain financial,
managerial, and compliance factors that are common to all
institutions. Under this system, the supervisory agencies
endeavor to ensure all financial institutions are evaluated in a
comprehensive and uniform manner, and that supervisory
attention is appropriately focused on institutions exhibiting
financial and operational weaknesses or adverse trends.
Comprehensive bank examinations enhance the FDIC's
ability to maintain public confidence in financial institutions
and the banking system. Given the fundamental reasons for
conducting examinations, regulatory personnel must have
access to all records and employees of a bank during an
examination.
The UFIRS also serves as a useful vehicle for identifying
institutions with deficiencies in particular component areas.
Further, the rating system assists Congress in assessing the
aggregate strength of the financial industry and following risk
management trends. As such, the UFIRS assists regulatory
agencies in fulfilling their mission of maintaining stability
and public confidence in the nation's financial system.
Sections 10(b) and (c) of the Federal Deposit Insurance Act
empower examiners to make a thorough examination of a
bank’s affairs. Examiners should contact their regional office
for guidance if faced with serious impediments to an
examination, including uncooperative executive officers, or
restricted access to bank employees or records. The regional
office will determine an appropriate solution to enable
examiners to obtain the information needed to complete the
examination. In such cases, examiners should document all
significant examination obstacles and the regional office’s
resolution of the situation.
Basic Examination Concepts and Guidelines (3/12)
UFIRS Overview
Under the UFIRS, each financial institution is assigned a
composite rating based on an evaluation of six financial and
1.1-2
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
BASIC EXAMINATION CONCEPTS AND GUIDELINES
operational components, which are also rated. The
component ratings reflect an institution's capital adequacy,
asset quality, management capabilities, earnings sufficiency,
liquidity position, and sensitivity to market risk (commonly
referred to as CAMELS ratings). When assigning ratings,
examiners take into consideration an institution’s size and
sophistication, the nature and complexity of its activities, and
its general risk profile.
Section 1.1
and directors with the information they need to monitor and
direct day-to-day activities.
Consumer Compliance, Community Reinvestment Act, and
specialty examination findings and ratings are also taken into
consideration, as appropriate, when assigning component and
composite ratings under UFIRS. The specialty examination
areas include: Bank Secrecy Act, Information Technology,
Trust, Government Security Dealers, Municipal Security
Dealers, and Registered Transfer Agent.
Composite and component ratings are assigned based on a
numerical scale from 1 to 5, with 1 indicating the highest
rating, strongest performance and risk management practices,
and least degree of supervisory concern. A 5 rating indicates
the lowest rating, weakest performance and risk management
practices, and highest degree of supervisory concern.
An addendum at the end of this section contains UFIRS
composite and component rating definitions and descriptions.
Disclosure of Ratings
A bank's composite rating generally bears a close relationship
to its component ratings. However, the composite rating is
not derived by averaging the component ratings. Each
component rating is based on a qualitative analysis of the
factors comprising that component and its interrelationship
with other components. When assigning a composite rating,
some components may be given more weight than others
depending on the situation at an institution. In general,
assignment of a composite rating may incorporate any factor
that bears significantly on the overall condition of the
financial institution. Composite and component ratings are
disclosed to an institution’s board of directors and senior
management. However, banks cannot, except in very limited
circumstances, disclose the ratings or any part of a report of
examination (ROE) without the prior written consent of their
primary regulator.
The FDIC believes that disclosure of the UFIRS component
and composite ratings to bank management is appropriate.
The impact the financial services industry has on the general
economy magnifies the importance of sound risk
management practices. In this environment, the examination
process is enhanced through disclosure of the UFIRS ratings
by encouraging a more open and complete discussion of
examination findings and recommendations. Disclosure also
provides management with useful information for making
effective risk management decisions.
Additionally, open discussion of the CAMELS ratings
provides institutions with a better understanding of how
ratings are derived, and enables management to better
address any weaknesses in specific areas.
Management's ability to respond to changing circumstances
and address risks that result from new business conditions,
activities, or products, is an important factor in determining
an institution's risk profile and the level of supervisory
concern. For this reason, the management component is
given special consideration when assigning a composite
rating.
Discussions with Management
Generally, the examiner-in-charge (EIC) should discuss the
recommended component and composite ratings with senior
management and, when appropriate, the board of directors,
within a reasonable proximity to the conclusion of the
examination. Examiners should clearly explain that their
ratings are tentative and subject to the review and final
approval by the regional director or designee. Examiners
should follow regional guidance regarding the disclosure of
component and composite ratings of 3 or worse. Generally,
in these situations, examiners should contact the regional
office overseeing the institution and discuss the proposed
ratings with the case manager or assistant regional director
prior to disclosing the ratings to management or the board.
The ability of management to identify and control the risks of
its operations is also taken into account when assigning each
component rating. All institutions are expected to properly
manage their risks; however, it is recognized that appropriate
management practices vary considerably among financial
institutions depending on their size, complexity, and risk
profile. Less complex institutions engaged solely in
traditional banking activities and whose directors and senior
managers are actively involved in the oversight and
management of day-to-day operations may use relatively
basic risk assessment, risk management, and internal control
systems. At more complex institutions, formal, multifaceted
systems and controls are needed to address their broader
range of financial activities and to provide senior managers
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
Examiners should discuss with management and the board,
the key factors they considered when assigning component
and composite ratings. Examiners should also explain the
composite rating is not based on a numerical average, but
rather a qualitative evaluation of an institution's overall
1.1-3
Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
managerial, operational, and financial performance.
•
The management component rating may be particularly
sensitive and important. The quality of management is often
the single most important element in the successful operation
of an insured institution. It is usually the factor most
indicative of how well risk is identified and controlled. For
this reason, examiners should thoroughly review and explain
the factors considered when assigning the management
rating. Written comments in support of the management
rating should include an assessment of the effectiveness of
existing policies and procedures in identifying and managing
risks.
•
•
•
•
•
The first priority of the Division of Risk Management
Supervision (RMS) is the effective oversight of banks
requiring special attention. The identification and supervision
of banks requiring special attention is best accomplished
through the examination process.
Section 337.12 of the FDIC Rules and Regulations
implements Section 10(d) of the FDI Act and governs the
frequency of examinations for insured state nonmember
banks. Section 347.211 governs the examination frequency
of branches of foreign banks.
Examination Letters
The FDIC’s expectations for troubled institutions should be
clearly communicated to bank management between the close
of an examination and the issuance of an enforcement action.
An examination letter should be delivered by FDIC Field
Supervisors to chief executive officers/presidents during
examination exit meetings, or earlier, for any bank newlyassigned a CAMELS composite 3 rating or worse.
Section 337.12 requires an annual full-scope on-site
examination of every insured state nonmember bank at least
once during each 12-month period. Annual examination
intervals may be extended to 18 months under the following
conditions:
Examination letters should notify management their
institution's composite rating was tentatively downgraded and
convey the expectation that management stabilize their
institution's risk profile and strengthen its financial condition.
The letter should notify management that actions taken to
materially expand the institution's balance sheet or risk
profile are inconsistent with supervisory expectations. The
letter should also inform management they are required to
obtain a non-objection from their regional director before
engaging in any transactions that would materially change the
institution's balance sheet composition, such as significantly
increasing total assets or volatile funding sources. If
practical, state banking departments should be included as a
joint issuer of examination letters relating to FDIC supervised
examinations. Furthermore, arrangements should be made to
issue an examination letter relating to state authority
examinations in which a downgrade is anticipated.
•
•
•
•
•
•
The bank has total assets of $500 million or less,
The bank is well capitalized as defined in Section
325.103 of the FDIC Rules and Regulations,
The bank was assigned a management component
rating of 1 or 2 at the most recent FDIC or applicable
state banking agency examination,
The bank was assigned a composite rating of 1 or 2 at
the most recent FDIC or applicable state examination,
The bank currently is not subject to a formal
enforcement proceeding or order by the FDIC, OCC,
or Federal Reserve System, and
No person acquired control of the bank during the
preceding 12-month period in which a full-scope onsite examination would have been required but for the
above noted exceptions.
These rules apply similarly to U.S. branches or agencies of a
foreign bank with total assets less than $500 million if the
office received a composite ROCA rating of 1 or 2 at its most
recent examination. In all cases, the FDIC reserves the right
to examine more frequently if they deem it necessary.
Immediate corrective measures, including the issuance of a
temporary order requiring an institution to cease and desist,
may be appropriate in higher-risk situations, such as when
management:
The FDIC strives to provide risk management and specialty
examinations of all state nonmember banks within prescribed
Fails to follow instructions in the examination letter,
Basic Examination Concepts and Guidelines (3/12)
Does not acknowledge, or is slow to address, the
institution’s problems,
Takes actions that compound the institution’s
problems,
Increases the use of volatile funding sources,
Extends credit in an unsafe and unsound manner,
Pays excessive dividends, salaries, or bonuses, or
Makes unjustified payments to institution-affiliated
parties.
EXAMINATION FREQUENCY
Finally, management should be reminded that all examination
findings, including the composite and component ratings,
whether disclosed verbally or in the written report of
examination, are subject to the confidentiality rules imposed
by Part 309 of the FDIC's Rules and Regulations.
•
Section 1.1
1.1-4
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
BASIC EXAMINATION CONCEPTS AND GUIDELINES
intervals. If examination frequency requirements, other than
a few nominal and non-recurring exceptions, cannot be met,
regional directors should prepare and submit a memorandum
to the Director of RMS. The memorandum should include a
description of the nature and cause of the situation and a
description of any needed, planned, or implemented
corrective measures designed to maintain an adequate
supervision program.
Section 1.1
examination cycle for 3-rated specialty areas. Specialty areas
rated 4 or 5 should normally not be extended beyond a oneyear interval. Additionally, since Municipal Securities
Dealers are subject to a two-year examination cycle under
Municipal Securities Rulemaking Board rules, any
adjustment in this area should not exceed the two-year
requirement. The possibility of conducting specialty
examinations with state authorities should be explored if
reasonable adjustments can be made.
Alternate Examinations
When the state supervisory authority has examination
responsibility for the safety and soundness examination of an
institution, it will not be the responsibility of the FDIC to
conduct any specialty examinations that are not conducted by
the state supervisory authority, with the exception of BSA
examinations. If safety and soundness examinations are
conducted under the alternating examination cycle program,
and the state does not conduct a BSA examination, then the
FDIC is required to conduct a BSA examination.
Examinations may be conducted in alternate 12 (or 18)
month periods if the FDIC determines that a full-scope, onsite examination completed by the appropriate state
supervisory authority during the interim period is acceptable.
However, such alternate examinations should be accepted
only for the following institutions: composite 1- or 2-rated
institutions, and for stable and improving composite 3-rated
institutions if the composite rating is confirmed by the
Statistical Camels Offsite Review (SCOR) review program
and no adverse trends are noted from other available
information. The length of time between the end of one
examination and the start of the next (whether one or both of
the examinations are conducted by a state supervisory agency
or the FDIC) should not exceed 12 (or 18) months.
Insured Branches of Foreign Banks
Insured branches of foreign banks are required to be
examined every 12 months under Section 10(d) of the FDI
Act. However, Section 347.211 of the FDIC Rules and
Regulations specifies that domestic branches of foreign banks
may be considered for an 18-month examination cycle when
certain criteria are met and no other factors suggest more
frequent examinations are necessary. To be eligible for an
extended 18-month examination cycle, a US branch of a
foreign bank must:
For purposes of monitoring compliance with examination
frequency schedules, the end of the examination is defined as
the earlier of the date the EIC submits the report for review,
or 60 calendar days from the examination start date as
defined in the Report of Examination Instructions.
•
•
Specialty Examination Intervals
The statutory requirements in Section 10(d) of the FDI Act
do not apply to specialty examinations. Thus, specialty
examinations are governed by internal RMS policy.
Specialty examinations should generally be conducted
concurrently with risk management examinations, except
when the size or arrangement of a department makes it
impractical or inefficient to do so. Although there will be
some differences, specialty examinations are generally
subject to the same examination intervals, including
appropriate extensions, as risk management examinations.
•
•
•
•
Regional directors can make reasonable adjustments to
specialty examination intervals to accommodate concurrent
examinations where rating differences or alternate state
examinations result in examination intervals that are not
conducive to scheduling concurrent examinations.
Reasonable adjustments include extending the examination
cycle for 1- and 2-rated specialty areas. Although not
permitted by statute for safety and soundness examinations,
internal policy allows regional directors to also extend the
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
Have total assets of less than $500 million,
Have a composite ROCA supervisory rating of 1 or 2
at its most recent examination,
Not be subject to a formal enforcement action,
Not have undergone a change in control during the
preceding 12-month period; and
Have Tier 1 and total risk-based capital ratios (at the
foreign bank) of at least 6 percent and 10 percent,
respectively, when reported on a consolidated basis; or
Has maintained on a daily basis, over the previous
three quarters, eligible assets in an amount not less
than 108 percent of the preceding quarter's average
third party liabilities, and sufficient liquidity is
currently available to meet its obligations to third
parties.
Additional factors may also be considered in determining
examination frequency, including certain discretionary
standards outlined in Section 347.211.
1.1-5
Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
Agent, Municipal Securities Dealer, and Government
Securities Dealer examination programs.
Summary
comments and ratings should be brought forward and
consolidated
in
the
risk
management
ROE.
Compliance/Community Reinvestment Act examination
activities are included in the overall supervision program,
although separate reports and examination cycles will
continue.
EXAMINATION TYPES
Risk Focused Supervision
Effective risk management has always been central to safe
and sound banking activities and has become more important
as new technologies, product innovation, and the size and
speed of financial transactions have changed the nature of
banking. The objective of a risk-focused examination is to
efficiently and effectively evaluate the safety and soundness
of a bank. Examiners should focus their resources on a
bank’s highest risk areas when assessing risk management
programs, financial conditions, internal controls, etc. The
exercise of examiner judgment to determine the scope and
depth of review in each functional area is crucial to the
success of the risk-focused supervisory process.
Limited Scope Examinations and Visitations
The terms limited scope examination and visitation are
interchangeable and may be defined as any examination that
does not meet the minimum requirements of a full-scope
examination.
Since limited scope examinations and
visitations are not full-scope examinations, they do not satisfy
the requirements of Section 10(d) of the FDI Act. Limited
scope examinations and visitations have a flexible format and
may be used to determine changes in an institution’s risk
profile, monitor compliance with a corrective program, or
comply with SCOR follow-up requirements. They may also
be used to investigate adverse or unusual situations,
determine progress in correcting deficiencies, act as an
investigative or supervisory tool, or to comply with schedules
described under Other Situations below.
The most effective examination approach focuses examiner
resources on assessing management’s ability to identify and
control risks. Internal and external audits, loan reviews, and
other control activities are integral considerations in an
assessment of a bank’s risk profile. Refer to the Internal
Routine and Controls section of this Manual for an in depth
discussion of this area.
Examiners should consider the adequacy of audit and control
practices in determining a bank’s risk profile and, when
appropriate, try to reduce regulatory burdens by testing
rather than duplicating the work of a bank's audit and control
functions. Transaction testing remains a reliable and
essential examination technique for use in the assessment of a
bank’s condition. However, the amount of transaction testing
necessary to evaluate activities generally depends on the
quality of the bank’s risk management processes. Once the
integrity of the bank's risk management system is verified
through testing, conclusions regarding the extent of risks
within an activity can often be based on the results of internal
reports rather than in-depth, onsite assessments.
Limited scope examinations and visitations may address the
overall condition of the institution, including material
changes since the previous examination and areas that exhibit
more than normal risk. Depending on the scope and purpose
of the examination or visitation, examiners can assign
composite ratings, as well as component ratings for areas that
were sufficiently reviewed. Ratings of component areas that
were not reviewed should be carried forward from the
previous examination.
Completion of the standard examination report form is not
required, although appropriate report pages may be included
if considered necessary to clarify a finding or
recommendation. Results should generally be conveyed in a
memorandum from the examiner-in-charge (EIC) to the
regional director. If the examination or visitation results are
to be sent to the institution, they can be in any appropriate
form (letter or other suitable format).
Full Scope Examinations
The minimum requirements of a full-scope examination are
defined as the procedures necessary to complete the
mandatory pages of the uniform ROE and evaluate all
components of the UFIRS/CAMELS (Capital, Asset Quality,
Management, Earnings, Liquidity, and Sensitivity to Market
Risk) rating system. The completion of additional steps and
pages may often be appropriate.
Other Situations
In addition to the preceding instructions, examinations should
be performed in the following situations:
In a full scope examination, all examination activities are
considered in the overall assessment of the institution. These
activities include the Risk Management, Information
Technology, Bank Secrecy Act/Anti-Money Laundering and
Office of Foreign Assets Control, Trust, Registered Transfer
Basic Examination Concepts and Guidelines (3/12)
Section 1.1
Institutions Subject to Corrective Actions
Supervisory strategies for institutions operating under an
enforcement action, particularly formal actions, should, in
1.1-6
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
BASIC EXAMINATION CONCEPTS AND GUIDELINES
most cases, include interim on-site limited scope
examinations or visitations. The on-site reviews should
include an evaluation of management’s understanding of, and
adherence to, the provisions of the corrective program.
Limited scope examinations or visitations should be
scheduled within six months after an enforcement action is
issued to evaluate an institution’s progress in addressing the
corrective program. Particular attention should be focused
on the primary cause of the institution’s problems and the
principal objectives of corrective programs. Where a decision
is made to forego or delay the interim on-site activity, the
reasons should be documented in regional office files.
Section 1.1
supervisory authority.
Monitoring Activities
During the seven-year de novo period, regional offices have a
responsibility to monitor de novo institutions' activities,
review compliance with any conditions of deposit insurance
orders, and track performance in relation to approved
business plans. Significant changes to business plans must be
submitted to the appropriate regional office for approval.
Examiners assist in those monitoring activities by:
•
Newly Chartered Insured Institutions
•
Adverse economic and other factors often negatively affect
newly organized institutions more than they do established
institutions. Further, failures of de novo institutions
demonstrate that unseasoned institutions can pose a
significant risk to the Deposit Insurance Fund and therefore,
warrant enhanced supervision and monitoring.
•
•
•
Conducting general visitation and examination
procedures,
Assessing institutions' overall risk profiles and
management capabilities,
Reviewing institutions' conformity with business plans,
Evaluating compliance with any outstanding
conditions, and
Documenting their findings in reports of examination.
Changes in Business Plans
Some newly organized institutions pursue early changes in
established business plans. In some cases, those changes lead
to increased risk and financial problems if accompanying
controls and risk management practices are inadequate.
Common risk elements observed at troubled or failed de novo
institutions during their first seven years of operation include:
•
•
•
•
•
•
•
•
•
There is a significant degree of judgment involved in
determining a major deviation or material change in a
business plan. Such changes may be evidenced by shifts in
asset or liability mix, variances in loan, deposit, or total asset
volumes from original projections, or the introduction or
deletion of a specific business strategy (such as the initiation
of subprime lending or the gathering of brokered deposits).
Business plans generally address a number of factors which
include, but are not limited to:
Rapid growth,
Over reliance on volatile funding sources,
Concentrations without compensating controls,
Significant deviations from approved business plans,
Non-compliance with the order approving deposit
insurance,
Weak risk management practices,
Unseasoned loan portfolios,
Significant consumer protection problems, or
Problematic third-party relationships.
•
•
•
•
•
•
•
Examination and Visitation Cycles
•
•
If a newly chartered and insured institution is a subsidiary of
a multi-bank holding company that is in satisfactory
condition, normal examination cycles should be followed at
the regional director’s discretion; otherwise, a limited scope
examination should be conducted within the first six months
of operation and a full-scope examination within the first
twelve months of operation. Subsequent to the first
examination and through the seventh year of operation, at
least one examination should be performed each year.
Extended examination intervals should not be applied in the
first seven years of operation. After the initial full-scope
examination, examinations may be alternated with the state
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
•
•
Geographic markets,
Loan products and services,
Investment strategies and levels,
Deposit products and services,
Other services, such as private banking or trust
services,
Liquidity strategies and funding sources,
Delivery channels, particularly through third party
relationships,
Fixed-assets (e.g. branches/loan production offices),
Other activities (on- or off-balance sheet), including
fee-for-service activities,
Customer categories (such as money services
businesses or foreign financial institutions), and
Relationships with parent organizations and affiliates.
State nonmember banks requesting deposit insurance must
agree to obtain the prior approval of the FDIC for any
material change to their business plan. Any significant
change in the items listed above should generally be viewed
as a material change in business plan. Such changes may be
1.1-7
Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
evidenced by significant (+/- 25%) deviation in asset growth
projections; changes in the asset/liability mix or products and
services offered; or the introduction of new business
strategies such as an unplanned establishment of loan
production offices or use of third parties to broker,
underwrite, or originate credit on behalf of the institution.
Section 1.1
consolidated assets and those banking organizations
(generally with assets in excess of $1 billion) that exhibit
financial weaknesses.
Examinations and inspections of insured subsidiary banks
and bank holding companies that do not meet the foregoing
criteria should be coordinated to the extent practical and
where resources permit. regional directors (or designees)
should meet periodically with representatives from other
Federal agencies to develop coordinated schedules that will
maximize the use of examination resources and enhance the
efficiency of bank and bank holding company examinations.
The coordination of examinations should focus on the use of
common financial statement dates, where possible, and allow
for joint discussions of examination findings with
management. However, absolute concurrence, common as-of
dates, and simultaneous starting dates are not required.
Appropriate state regulatory agencies should also be kept
informed and encouraged to participate in the coordinated
Federal efforts affecting state chartered institutions.
Converting to Insured Nonmember Status
A full-scope examination should be conducted within twelve
months of the last examination prior to conversion for
national, state member, and thrift institutions. For noninsured
institutions converting to insured status, a full-scope
examination should be conducted within twelve months of
the last examination prior to conversion. If the last
examination was conducted by the state authority, the
regional director has the discretion to accept it. However,
such an examination should be accepted only for composite
1- or 2-rated institutions.
Change of Ownership Control
A full-scope examination should be conducted within twelve
months after a change of control. Thereafter, standard
examination intervals apply.
Examinations of nonbank affiliates may be conducted at the
discretion of the regional director, but independent
examinations of holding companies supervised by the Federal
Reserve may not be conducted without prior approval of the
Washington Office.
COORDINATING EXAM SCHEDULES
Interstate Banking and Chain Banks
A coordinated supervisory strategy for interstate banking
organizations (both intra- and inter-regional) should be
developed. The supervisory strategy developed should
combine traditional supervision of individual units with an
appropriate top-down approach to assess risks and to monitor
and coordinate supervisory actions. For these organizations,
the regional director has discretion to omit, delay, or modify
existing examination frequencies if the financial condition of
the holding company and lead bank is considered
satisfactory; the condition of the subsidiary units is believed
to be satisfactory; control over all insured banks in the
organization is effectively centralized; and, management is
favorably regarded.
State Authorities
Every effort should be made to coordinate examination
schedules with state authorities to take advantage of state
resources, to minimize duplications of effort, and to lessen
business disruptions to institutions. A representative of the
regional office should meet with representatives from each
state banking authority to determine examination
responsibilities for the upcoming year. Responsibilities may
be defined by ratings, size, or location of institutions, or
assigned by specific institutions as deemed appropriate. Such
agreements should contain flexibility to allow either party to
alter schedules with minimal notice. While state examination
requirements should be considered in the coordination
process, state requirements should not be the determining
factor in the final agreement.
Regional directors are responsible for: (a) designating a lead
Region to design an appropriate supervisory strategy for
interstate banking organizations; and (b) ensuring pertinent
information is conveyed in a timely manner to other RMS
Regions and to appropriate Federal and State agencies.
Holding Company Inspections and Subsidiary
Institution Examinations
Chain banking organizations generally involve a group of
financial institutions or holding companies that are controlled
by one individual or company. Regional directors are
responsible for maintaining a record system for chain banking
organizations and for developing an overall supervisory
Examinations of holding company subsidiaries should be
coordinated with other Federal agencies whenever possible.
Particular emphasis for coordinating examinations should be
placed on banking organizations with over $10 billion in
Basic Examination Concepts and Guidelines (3/12)
1.1-8
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
BASIC EXAMINATION CONCEPTS AND GUIDELINES
strategy for these organizations. It is the policy of the
Division to supervise banks that are part of a chain banking
organization in a manner that considers the financial impact
of the consolidated chain on the individual institutions within
that chain. Refer to Section 4.3, Related Organizations for
additional details on, and a full description of, chain banking
organizations.
comments must be well-supported and based on facts, logic,
and prudent supervisory standards. Although examiners can
not predict future events, they should consider the likelihood
that identified weaknesses will cause material problems in the
future, and consider the severity of damage to an institution if
conditions deteriorate. In questionable circumstances where
formal action is considered, examiners should consult with
their regional office while the examination is in progress
regarding the material needed to support a potential action.
SCHEDULING GUIDELINES
Scheduling Considerations
Periodic onsite examinations are critical to the supervisory
process and are an integral part of the examination program.
Diversified risks in the industry and the volatile performance
and financial condition of individual institutions necessitate
emphasis on more frequent and less structured supervision.
Investigations, phone calls, e-mails, limited scope
examinations, correspondence, and other forms of
customized contact should be made as necessary. The
purpose is to identify and obtain corrections in an institution's
policies and procedures before serious financial problems
develop.
The success of a risk focused examination program depends
largely on the effectiveness of preplanning efforts and
assignment scheduling. The objective of a risk focused
examination process is to identify problems early and devise
solutions in the quickest, most efficient manner possible. In
some instances, evidence of objectionable practices or
conditions may indicate the need for an accelerated
examination or visitation. In less severe situations, the
information is retained and factored into the scheduling of
future examinations.
Pre-examination activities should include efforts to determine
the activities and condition of nonbank subsidiaries. If not
determinable in advance, this information should be obtained
early in the examination in order to assess the necessity for,
and depth of, subsidiary examinations.
In order for examiners to proactively assess potential
deficiencies, it is critical for Field Supervisors and other
personnel to be aware of, and have access to, pertinent
documentation. Regional directors should ensure copies of
relevant correspondence and other information that may
affect scheduling decisions is documented and made
available to scheduling personnel.
A major component of the risk-focused supervisory approach
is the flexibility to conduct examination activities at various
times during the examination cycle based on risk or staffing
considerations. However, it is anticipated that most
examination activities will be conducted as of a single pointin-time near the end of the risk management examination
cycle, particularly in well-rated institutions.
The following list includes sources of information that may
have an influence in prioritizing assignments. Some of these
items, such as involvement in FDIC assistance transactions,
have supervisory schedules specified in internal policies.
Other items are merely information that may or may not raise
a concern depending on what else is known about a bank.
However, these or similar items may signal that further
follow-up is warranted during the examination. The list,
while not all inclusive, reflects the need for supervision to be
anticipatory, and provides a reminder of common information
sources that may warrant consideration when scheduling.
Anticipatory Supervision
To effectively prevent or mitigate serious problems in an
institution, the conditions that caused, or may cause,
problems must be identified and corrected early. Corrective
action should be taken immediately upon identifying
problems or unacceptable risk management practices.
Corrective action taken after conditions have seriously
deteriorated is often too late to avoid institutional failures.
Moral suasion and informal agreements are normally
sufficient when unacceptable risk levels or risk management
practices are identified early, but formal action must be
considered, even when an institution is rated 1 or 2, if
circumstances warrant.
Offsite Analysis and Monitoring
•
•
•
•
•
•
A forward-looking supervisory approach that identifies and
seeks to correct objectionable conditions requires serious
thought and a balanced response by examiners. Critical
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 1.1
SCOR Monitoring System
Comprehensive Analytical Reports
Interim Financial Reports
Growth Monitoring System
UBPR Analysis
Press Releases
Other Financial Indicators
1.1-9
Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
•
•
•
•
•
•
•
•
•
•
•
•
Unusually high or fluctuating profit levels
Significant operating losses
Significant provision expenses to the Allowance for
Loan and Lease Loss (ALLL)
Significant levels of delinquent loans
Significant changes in balance sheet composition
Unusually elevated or rapidly growing asset
concentrations
High reliance on brokered funds
Excessive trading
Excessive dividends
Unusually high or low ratios or numbers
•
•
•
•
•
•
•
•
•
•
•
•
Merger activity
Large defalcation
Change of control
Adverse audit report findings
Newly insured institution
Change in external auditor
New subsidiary(s) or line(s)-of-business
Cancellation of blanket bond insurance
Exercise of a new power or profit center
Acquiring party in an FDIC assisted transaction
Large paydown/payoff of previously classified loans
Affiliation with a problem institution/holding company
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Unusually high or low salaries
Compensation linked to performance (income, loan or
deposit growth)
Significant litigation
Infighting among officers or directors
Officers or directors with past due loans
Dominating or self-serving management
Operating at the margin of laws and regulations
Inexperienced or questionable management
Substantial outside business interests of a key officer
Conducting business with questionable firms
Lack of diversity in business lines
Higher-risk business strategies
Refinancing poor quality loans
Advertising above-market interest rates
Large blocks of bank stock pledged as collateral
Numerous or unusual affiliated loan participations
Improper handling of correspondent bank accounts
Sacrificing price or quality to increase loan volumes
Hiring of a dismissed, unethical, or marginal officer
•
Change in external auditor
High or sudden employee turnover
Significant litigation against the institution or insiders
Unusual activity in stock of the institution (price
movement up or down, or heavy trading volume)
Institution advertising above market rates
Significant change in asset/liability compositions
Questionable loans being booked
Relationships with borrowers of questionable
character
Confidential or anonymous tips
RELYING ON STATE EXAMINATIONS
Section 349 of the Riegle Community Development and
Regulatory Improvement Act of 1994 requires the FFIEC to
issue guidelines establishing standards for the purpose of
determining the acceptability of state reports of examination
under Section 10(d)(3) of the FDI Act. Under Section
10(d)(3), a Federal banking agency may conduct an annual,
on-site examination of an insured depository institution in
alternate 12 (or 18) month periods if the agency determines
that a state examination conducted during the intervening
period is adequate. The standards issued by the FFIEC are to
be used at the discretion of the appropriate Federal banking
agency.
Other Bank Regulators
Basic Examination Concepts and Guidelines (3/12)
New chief executive officer or chief lending officer
Adverse publicity
Annual or interim period losses
Adverse economic event in a community
Natural disaster such as a flood, fire, or earthquake
Large defalcation
Large financial commitment as sponsor or lead bank in
a major project or development
Banker death or disappearance
Announcement of major new activity or department
Rumors/Observations/Other
Known Characteristics
•
•
Improper handling of correspondent bank accounts
Increased or unusual loan participations among
affiliated or closely-held institutions
Large blocks of stock pledged as collateral
Affiliation with a 3-, 4-, or 5-rated institution or
holding company
Large defalcation
Banker with past due loans at another institution
Loans classified at other institutions
Media
Applications or Other Bank-Provided Data
•
•
•
•
•
•
•
•
•
•
•
•
Section 1.1
1.1-10
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
BASIC EXAMINATION CONCEPTS AND GUIDELINES
•
•
The supervisory divisions of the FDIC and the Board of
Governors of the Federal Reserve System responsible for the
examination of state-chartered, insured depository
institutions, and the branches and agencies of foreign banks
that have been chartered by the states, have a long history of
coordinating with state banking departments to fulfill a
mutual goal of promoting a safe and sound banking system.
It is recognized that this close cooperation between the
Federal and State regulators promotes efficiency in the
examination process, reduces the regulatory burden on statechartered, insured depository institutions, and improves the
supervisory process.
•
•
•
•
•
•
A hallmark of a successful program has been the flexibility to
tailor cooperation to the particulars of each state and to the
specifics of individual banks within a state, plus the reality of
changing circumstances at both the Federal and State levels.
The FFIEC guidelines strive to maintain that flexibility.
Conducting alternate, joint, and concurrent
examinations of insured depository institutions, and of
the branches and agencies of foreign banks that have
been chartered by the states;
Processing safety and soundness examination reports
and applications on a timely basis;
Using common examination report and application
forms;
Developing and issuing informal (e.g., board
resolutions, memoranda of understanding or other
similar agreements) and formal enforcement actions;
Exchanging supervisory information;
Offering Federal agency training programs to state
examiners; and
Providing access to the Federal agency databases.
The FDIC will accept and rely on state reports of
examination in all cases in which it is determined that state
examinations enable the FDIC to effectively carry out its
supervisory responsibilities. The following criteria may be
considered, in whole or in part, when determining the
acceptability of a state report of examination under Section
10(d) of the FDI Act:
•
The FDIC intends to continue these cooperative efforts to the
maximum extent possible. It is recognized, however, that the
adequacy of state budgeting, examiner staffing, and training
are important factors to enhancing Federal and State
coordination. The FDIC has entered into formal and
informal arrangements with most state banking departments.
These arrangements or working agreements generally address
the following areas:
•
•
•
•
•
•
•
•
•
The number of state-chartered, insured institutions to
be examined on an alternating basis by the state
banking department and by the FDIC;
The frequency of safety and soundness examinations;
The type of examinations to be conducted
(independent, joint, or concurrent) by each agency;
The pre-examination procedures to be performed;
The responsibilities of each agency for processing
reports of examination;
The responsibilities of each agency for conducting
specialty examinations (Compliance, IT, Trust, etc.);
The procedures for coordinating informal and formal
enforcement actions;
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
The procedures for processing joint applications; and
The procedures for sharing supervisory information.
These arrangements are structured to permit both Federal and
State agencies the flexibility to conduct an independent
examination subject only to notification to the other party.
Generally, only institutions rated 1 or 2 are examined on an
alternating basis allowing for a reasonable interval between
examinations.
The Federal and State banking agencies have worked
together, to varying degrees, in the following areas:
•
Section 1.1
•
The completeness of the state examination report. The
state report of examination should contain sufficient
information to permit a reviewer to make an
independent determination on the overall condition of
the institution as well as each component factor and
composite rating assigned under the UFIRS and
commonly referred to as the CAMELS rating system,
or the ROCA rating system used for branches and
agencies of foreign banks.
The adequacy of documentation maintained by state
examiners to support observations made in
examination reports.
The ability over time of a state banking department to
achieve examination objectives. At a minimum, the
FDIC will consider the adequacy of state budgeting,
examiner staffing and training, and the overall review
and follow-up examination process of a state banking
department. Accreditation of a state banking
department by the Conference of State Bank
Supervisors is among the factors that will be
considered.
The adequacy of any formal or informal arrangement
or working agreement between a state banking
department and the FDIC.
The FDIC, as part of its routine review of state examination
reports, will assess the quality and scope of the reports to
determine whether they continue to meet the general criteria
noted above. The FDIC retains the option to conduct a
follow-up examination in cases in which a state examination
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report appears insufficient or the condition of an insured
institution appears to be seriously deteriorating.
appear to be deteriorating rapidly.
Examiners should make every effort to conduct as many pre-,
post-, and other examination procedures as reasonably
possible off-site in order to minimize disruptions to an
institution’s normal business activities. Additionally,
supervisors should be mindful of an institution’s space and
personnel limitations and schedule the number of examiners
working on bank premises accordingly.
If a state and the FDIC have cooperative examination
programs, regional directors may involve FDIC examiners in
state examinations if an institution's condition is
deteriorating, or areas of concern are identified.
The FDIC will work with state banking departments to
resolve any concerns regarding the acceptability of each
other's work, the operation of cooperative programs, or any
other issues of mutual interest.
An examination procedures module titled Risk Scoping
Activities is included in the Examination Documentation
Modules. This module identifies and lists several activities to
be completed by examiners during the pre-examination
process. Refer to this module for additional guidance.
PRE-EXAMINATION ACTIVITIES
Reviewing External Audit Workpapers
Thorough pre-examination planning is critical to the efficient
completion of an examination. Effective pre-examination
planning helps support scoping decisions in terms of work
performed and areas to receive special attention. It can also
help determine staffing needs in regards to the number and
expertise of personnel required. Finally, it can enhance
examination efficiencies and reduce disruptions at
institutions.
Examiners are generally required to review the workpapers of
the independent public accountant or other auditor
performing the external auditing program of certain insured
institutions that have been or are expected to be assigned a
UFIRS composite rating of 4 or 5. A workpaper review is
intended to provide information prior to or during an
examination relating to an institution’s internal control
environment and its financial reporting practices. Thus, a
workpaper review assists examiners in determining the scope
of the examination and the procedures to be applied to
different areas of operations.
Part of the pre-examination planning should address the need
for, or extent of, branch examinations. It is the FDIC's
practice to examine the various offices of a branch banking
system on an as-needed basis only. Such decisions are within
the province of the regional director or may be delegated by
the regional director to the Field Supervisor or EIC of a
particular examination.
Shared Loss Agreements
A shared loss agreement (SLA) is a contract between the
FDIC and institutions that acquire failed bank assets. Under
the agreements, the FDIC agrees to absorb a portion of the
losses, if incurred, on specific assets (usually loans),
purchased by an institution. If an institution makes
recoveries on covered assets, they must reimburse the FDIC
for part of the recoveries. Loss share agreements cover
specific timeframes and are often written so the FDIC
absorbs 80 percent of incurred losses (up to a stated
threshold), and receives 80 percent of recoveries. To
maintain loss coverage, institutions must adhere to the terms
of their agreement and make good faith efforts to collect
loans.
In general, examinations represent a comprehensive and
coordinated effort between Risk Management and specialty
examiners in the assessment of an institution’s overall risk
profile. Information request letters from various functions
scheduled for the upcoming examination (for example Risk
Management, Information Technology, Bank Secrecy Act,
and Trust examinations) should be coordinated and combined
whenever practical. Examiners should take special care to
tailor information request letters to the specific characteristics
of the institution, and remove unnecessary and redundant
information from the request lists.
As a general rule, bankers should be given at least two weeks
notice of an upcoming safety and soundness examination in
order to provide them with enough time to complete preexamination requests. A shorter period is permissible if the
institution is not unduly burdened, or if a shorter period is
occasionally needed due to resource requirements.
Exceptions to this general policy may include problem
institutions, situations where management and ownership of
the institution are identical, or in situations where conditions
Basic Examination Concepts and Guidelines (3/12)
Section 1.1
Note: The FDIC’s reimbursement for losses on assets
covered by an SLA is measured in relation to an asset’s book
value on the records of the failed institution on the date of its
failure, not in relation to the acquisition-date fair value at
which covered assets must be booked by an acquiring bank.
The FDIC uses different types of agreements for commercial
loans and residential mortgages. Both types cover credit
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
losses and certain related expenses.
However, for
commercial assets, SLAs generally cover losses for five years
and recoveries for eight years. For residential mortgages,
SLAs generally cover losses and recoveries for ten years.
accounting, reporting, and recordkeeping systems; and
review loss-claim certificates. However, risk management
examiners should notify their regional office and DRR staff if
they identify potential problems or nonconformance with an
agreement.
Shared loss agreements are designed to reduce the FDIC’s
burden of managing receivership assets and mitigate
acquirers’ losses. Banks should not allow shared loss
considerations to unduly impact foreclosure decisions. Banks
should only foreclose on properties after exhausting other
loss-mitigation and workout options. To avoid unnecessary
home foreclosures, most residential SLAs specifically require
institutions to engage in loss-mitigation efforts in accordance
with the FDIC’s Mortgage Loan Modification Program or the
national Home Affordable Modification Program.
Examiners should refer to internal directives for additional
information.
Other Examination Considerations
As noted above, if any of a bank's assets are covered by a
SLA, examiners should review the agreement and consider its
implications during examinations or visitations. The
following scheduling considerations apply to FDIC
supervised institutions that received FDIC assistance, or were
involved in purchase and assumption or deposit transfer
transactions.
Examination Considerations
Regional and field office personnel should regularly
communicate with the Division of Resolutions and
Receiverships (DRR) to coordinate activities and share SLA
information. Pre-examination communication between
examiners and DRR allows examiners to determine the type
and extent of SLAs and find out if any issues exist that might
affect an institution’s safety and soundness. If any of a bank's
assets are covered by a SLA, examiners should review the
agreement and consider its implications when:
•
•
•
•
Acquiring institutions with total assets in excess of ten times
the deposits acquired, which are rated composite 2 or better
are exempt from the following requirements. State
nonmember institutions: a visitation or limited scope
examination should be conducted within 30 days of the
transaction date to determine how funds from the FDIC are
being used and whether the bank is in accordance with any
applicable assistance agreement. A second visitation or
limited scope examination should be conducted within six
months of the transaction. A full-scope examination should
be conducted within twelve months of the transaction.
Thereafter, standard examination frequency schedules apply.
A cooperative program should be established with the
appropriate Federal agency for national, state member, and
thrift institutions, to ensure that all institutions receiving
FDIC funds are properly monitored and that the FDIC
Regional Director is informed of important developments.
Performing asset reviews,
Assessing accounting entries,
Assigning asset classifications, and
Determining CAMELS ratings.
Risk management examiners should include a sample of SLA
related commercial assets in their loan scope. The number of
loans sampled should be sufficient to allow examiners to
assess whether the assets are administered in a manner
consistent with commercial assets not covered by SLAs.
Examiners may determine it is unnecessary to include SLA
related residential mortgages in their loan scope; however,
SLA coverage should be considered when assigning adverse
classifications to residential credits covered by SLAs.
MEETINGS WITH MANAGEMENT
Ongoing communication between the examination staff and
bank management is a critical element of effective bank
supervision. Open communication helps ensure examination
requests are met and disruptions to an institution’s daily
activities are minimized. During the pre-examination
process, or on the first day of the examination, board
members should be encouraged to attend any or all meetings
conducted during an examination. Their attendance often
improves communication with outside directors and increases
director knowledge of the examination process. These
meetings also provide an opportunity for directors to discuss
their views with examiners on banking related matters, and
give examiners the opportunity to gain further insight into the
experience levels and leadership qualities of bank
In most cases, the portion of an asset covered by an SLA
should not be subject to adverse classification because loss
sharing represents a conditional guarantee from the FDIC.
Generally, the amount that would otherwise be adversely
classified (Substandard, Doubtful, or Loss), should be
reduced by the applicable coverage rate (often 80 or 95
percent).
Risk management examiners are not expected to evaluate an
institution's compliance with SLAs. Personnel from DRR
evaluate compliance with SLAs; assess SLA related
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Section 1.1
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management. While encouraging participation in these
meetings, the EIC should emphasize that attendance is
voluntary and that a lack of participation will not be viewed
negatively.
information, and to discuss other general examination
requirements. Such meetings provide an opportunity to
establish open lines of communication.
Follow-up on Prior Examination Issues Early in the
examination, it is useful for the EIC to meet with senior
management and discuss the bank’s progress in responding to
prior supervisory recommendations, as well as outstanding
internal and external audit recommendations. This is also a
good opportunity for examiners to gain management’s
perspectives on other bank-specific concerns.
Pre-planning communication to coordinate examination
activities should address information requests (including the
names of contact individuals), work space plans, and the
general scope of the examination. Other informal meetings
should be held as needed throughout the examination to
discuss various topics and to gain management’s perspective
on local economic conditions and bank-specific issues. Prior
to the conclusion of the examination, examiners should
thoroughly discuss their findings and recommendations with
senior management.
Such meetings are critical in
communicating examination findings to the bank and
providing management an opportunity to respond. Exit
meetings should fully apprise bank management of all
deficiencies and recommendations that will be cited in the
Report of Examination.
Strategic Planning and Budget The EIC and management
should discuss asset and/or capital growth plans, new
business or business products, and other strategic and budget
issues during the course of the examination.
Loan Discussion Management should participate in loan
discussions and the initial review of adverse classifications,
as appropriate, considering the size and condition of the
institution and loan portfolio.
The following examples represent situations that will prompt
meetings and encourage dialogue between examiners and
management during the course of an examination. The
circumstances of each examination will determine the type
and number of meetings necessary, as well as the degree of
formality required to schedule and conduct the meetings.
Material Preliminary Findings Normally, the EIC should
notify senior management of major findings and possible
recommendations before the final management meeting.
Management Meeting All major examination issues should
be discussed with senior management as soon as practical
during an examination. At a minimum, all significant issues
should be discussed at the end of the examination, prior to
meeting with the board of directors. As noted in the
Examination Letters for Troubled Institutions section above,
the FDIC's expectations for troubled institutions should be
clearly communicated to bank management between the close
of an examination and the issuance of an enforcement action.
Pre-Examination Planning: The EIC or designee should
conduct an on-site pre-examination meeting with bank
management, or conduct a telephone conversation with
management if an on-site meeting is not feasible, well in
advance of the examination. The discussion should focus on
topics that assist the EIC in scoping the examination,
identifying information needs, gathering documents, and
planning examination logistics. The meeting provides an
opportunity to get management's perspective on economic
conditions, primary challenges/risks, significant audit
findings since the prior examination, and key riskmanagement processes. Primary topics of conversation
should generally include current financial conditions;
significant changes (planned or completed) to bank policies,
personnel, or strategic direction; and any other significant
changes since the previous examination. The EIC should
also discuss how and when information requests will be sent
to the bank (electronic or hard copies), and the method and
timing any requested information will be delivered to
examiners (FDICconnect, external media, or hard copies).
Importantly, the delivery method(s) must meet the security
measures discussed in the FDIC's e-Exam policies for the
exchange, use, and storage of electronic information.
Regardless of the number or type of meetings held, it is
critical that examiners ensure on-going two-way
communication with management. Such communication
enhances the effectiveness of the examination process by
allowing all parties to freely exchange information.
Meetings with Directors
The following policies have been established for meetings
with boards of directors. These policies are designed to
encourage director involvement in, and enhance director
awareness of, FDIC supervisory efforts, and to increase the
effectiveness of such efforts. The bank’s composite rating is
the most important variable in deciding if and when these
meetings should be held. .
First Day Generally, the EIC and examination team should
meet with senior management and staff during the first day of
the examination for introductions, to request additional
Basic Examination Concepts and Guidelines (3/12)
Section 1.1
Banks Assigned a Composite 4 or 5 Rating
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
The EIC and the regional director or designee should meet
with the board of directors (with the required quorum in
attendance) during or subsequent to the examination.
Additional meetings or contacts with the board of directors or
appropriate board committee may be scheduled at the
regional director's discretion.
committee must be based on the group's actual
responsibilities and functions rather than its title. In all cases,
the committee chosen should include an acceptable
representation of board members who are not full-time
officers.
The success of a board meeting is highly dependent upon the
examiner's preparation. A written agenda that lists all areas
to be discussed and provides supporting documents or
schedules generally enhances examiners' explanations of
findings and recommendations. Failure to adequately prepare
for a meeting can substantially diminish the supervisory value
of an examination.
Banks Assigned a Composite 3 Rating
The EIC should meet with the board (with the required
quorum in attendance) during or subsequent to the
examination. Regional office representation is at the
discretion of the regional director. Additional meetings or
other contacts with the board of directors or appropriate
board committee may be scheduled at the discretion of the
regional director or designee.
To encourage awareness and participation, examiners should
inform bank management that the examination report (or
copies thereof) should be made available to each director for
thorough and timely review, and that a signature page is
included in the examination report to be signed by each
director after review of the report. Management should also
be reminded that the report is confidential, remains the
property of the FDIC, and that utmost care should be
exercised in its reproduction and distribution. The bank
should be advised to retrieve, destroy, and record the fact of
destruction of any reproduced copies when they have served
their purpose.
Banks Assigned a Composite Rating of 1 or 2
The EIC will meet with the board or a board committee
during or subsequent to the examination when: 36 months or
more have elapsed since the last such meeting; the
management component of the CAMELS rating is 3, 4 or 5;
any other CAMELS performance rating is 4 or 5; or any two
performance ratings are 3, 4 or 5. It is important to note that
meeting with a board committee (in lieu of the entire board)
in conjunction with an examination is permissible only when
the committee is influential as to policy, meets regularly,
contains reasonable outside director representation and
reports regularly to the entire board. Other factors that may
be relevant to the decision of holding a board meeting
include recent changes in control, ownership, or top
management; adverse economic conditions; requests by
management or the board for a meeting; or any unique
conditions or trends pertinent to the institution. Regional
office participation in meetings with composite-rated 1 or 2
banks is at the regional director's discretion.
OTHER SOURCES OF EXAMINATION
INFORMATION AND POLICY GUIDANCE
The primary purpose of this Manual is to provide policy
guidance and direction to the field examiner that should be
applied in the risk management examination process. Other
policy manuals or other instructional materials pertaining to
additional areas of examination interest, such as trust
department operations, IT activities, transfer agent, and
consumer compliance have also been developed. Those areas
were not addressed significantly in this Manual in order to
enhance the organization of the primary risk management
material and to keep the document reasonable in length.
However, exclusion of these topics in no way implies that
these activities do not impact a safety and soundness
examination. To the contrary, deficiencies in other aspects of
a bank's operations can have a major impact on an
institution's overall condition. Therefore, it is critical for
examiners to be aware of the existence and understand the
significance of deficiencies in other areas.
Other Considerations
When a meeting is held in conjunction with an examination,
reference should be made on the Examination Conclusions
and Comments schedule as to the committee or board
members, bank managers or personnel, and regulators in
attendance. A clear but concise presentation of the items
covered at the meeting, including corrective commitments
and/or reactions of management, should also be indicated. If
a meeting is held, but not in conjunction with an examination,
a summary of the meeting, including the items noted above,
should be prepared and a copy mailed to the institution, via
certified mail, for consideration by the board and inclusion in
the official minutes of the directorate's next meeting.
Specialty examination findings should be addressed in the
ECC section of the risk management report of examination
(ROE). The placement and length of related comments
should be commensurate with the significance of the findings
and the impact on risk management ratings. There are no
When it is concluded that a meeting with a board committee
rather than the full board is appropriate, selection of the
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Section 1.1
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
mandatory specialty examination pages; however, examiners
may include specialty pages in the risk management ROE
when separate pages are the most effective means to
communicate findings.
Section 1.1
recordkeeping and operational areas in banks. These IT
services may be managed internally on a bank's own in-house
computer system, or outsourced, wholly or in part, to an
independent data center that performs most IT functions.
Although some or all IT services may be outsourced,
management and the board retain oversight responsibilities.
If a specialty examination is conducted at a date substantially
removed from other examination activities, examiners may
communicate their findings through a visitation report and
letter to the institution if warranted. However, summary
comments should also be included in the risk management
ROE and factored into risk management ratings.
The potential consequences of receiving faulty data or
suffering an interruption of services are serious and warrant
comprehensive IT policies and procedures and thorough IT
examinations. A primary objective of an IT examination is to
determine the confidentiality, integrity, and availability of
records produced by automated systems. Examination
priorities include an evaluation of management's ability to
identify risks and maintain appropriate compensating
controls.
In some situations, it may be necessary for examiners to
conduct specialty examinations separately from the Risk
Management examination. In these rare cases, a separate
specialty examination report may be prepared, consistent
with regional guidance and outstanding report preparation
instructions.
IT operations are rated in accordance with the Uniform
Interagency Rating System for Information Technology
(URSIT), which is based on an evaluation of four critical
components: audit; management; development and
acquisition; and support and delivery. The composite IT
rating is influenced by the performance of the four
component functions and reflects the effectiveness of a
bank’s IT risk management and information security
programs and practices. A scale of 1 through 5 is used,
wherein 1 indicates strong performance and 5 denotes
critically deficient operating performance.
To emphasize and illustrate how weaknesses in these
ancillary activities can adversely affect the whole bank, a
brief overview of trust, IT, BSA, and consumer protection
activities is provided.
Trust Department
A bank's trust department acts in a fiduciary capacity when
the assets it manages are not the bank’s, but belong to and are
for the benefit of others. This type of relationship
necessitates a great deal of confidence on the part of
customers and demands a high degree of good faith and
responsibility on a bank’s part. The primary objective of a
trust department examination is to determine whether its
operations or the administration of its accounts have given
rise to possible or contingent liabilities, or direct liabilities
(estimated losses), which could reduce the bank's capital
accounts. If the terms of trust instruments are violated, if
relevant laws and regulations are not complied with, or if
generally accepted fiduciary standards are not adhered to, the
department, and hence the bank, may become liable and
suffer losses. If the magnitude of these losses is very high,
the viability of the bank may be threatened. To aid
examiners in evaluating a trust department, the Uniform
Interagency Trust Rating System was devised. Composite
ratings of 1 (highest level of performance) through 5 (most
critically deficient level of performance) are assigned based
on analysis of five critical areas of a trust department's
administration and operations. These include Management;
Operations, Internal Controls and Audits; Earnings;
Compliance; and Asset Management.
Most IT examinations are embedded in risk management
ROEs and only include an URSIT composite rating.
However, with approval from a regional director or their
designee, examiners may conduct full-scope IT examinations
that include composite and component ratings.
Bank Secrecy Act (BSA)
The Financial Recordkeeping and Reporting of Currency and
Foreign Transactions Act of 1970 is often referred to as the
Bank Secrecy Act (BSA). The purpose of the BSA is to
ensure U.S. financial institutions maintain appropriate
records and file certain reports involving currency
transactions and customer relationships. Several acts and
regulations that strengthen the scope and enforcement of
BSA, anti-money laundering, and counter-terrorist-financing
measures have been signed into law. Some of these include:
Information Technology (IT)
Money Laundering Control Act - 1986
Annuzio-Wylie Anti-Money Laundering Act - 1992
Money Laundering Suppression Act - 1994
Money Laundering and Financial Crimes Strategy Act - 1998
USA PATRIOT Act - 2001
Information technology services apply to virtually all
Findings from BSA examinations are generally included
Basic Examination Concepts and Guidelines (3/12)
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
within the safety and soundness report; however, separate
BSA examinations can be conducted. Although a separate
rating system for BSA does not exist, BSA findings can
affect both the management rating and the overall composite
rating of the institution. Refer to the BSA section of this
Manual for additional information.
by a bank to its parent holding company or majority
shareholder.
Standard FDIC regulations do not prohibit employees or
agents of a bank from reviewing the Report of Examination if
it is necessary for purposes of their employment. Accountants
and attorneys acting in their capacities as bank employees or
agents may review an examination report without prior FDIC
approval, but only insofar as it relates to their scope of
employment. The FDIC believes the definition of agent
includes an accountant or accounting firm which performs an
audit of the bank.
Consumer Protection
The principal objective of consumer protection examinations
is to determine a bank's compliance with various consumer,
mortgage, and civil rights laws and regulations. Consumer
protection statutes include, but are not limited to, Truth in
Lending, Truth in Savings, Community Reinvestment Act,
and Fair Housing regulations. Noncompliance with these
regulatory restrictions and standards may result in an
injustice to affected individual(s) and reflects adversely on
an institution's management and reputation. Moreover,
violations of consumer laws can result in civil or criminal
liabilities, and consequently, financial penalties. If significant
in amount, such losses could have an adverse financial impact
on a bank. As is the case for IT and trust operations, an
interagency rating system for consumer compliance has been
designed. It provides a general framework for evaluating an
institution's conformance with consumer protection and civil
rights laws and regulations. A numbering scheme of 1
through 5 is used with 1 signifying the best performance and
5 the worst performance. A separate examination rating is
assigned to each institution based on its performance in the
area of community reinvestment. The four ratings are
outstanding; satisfactory; needs to improve; and substantial
noncompliance.
Reports of Examination are routinely provided to a bank's
chartering authority. Therefore, state bank examiners may
review the bank's copy of an FDIC examination during a state
examination.
EXAMINATION WORKPAPERS
Introduction
Examiners should document their findings through a
combination of brief summaries, source documents, report
comments, and other workpapers that clearly describe
financial conditions, management practices, and examination
conclusions. Documentation should generally describe:
•
•
•
Summary
Key audit/risk scoping decisions,
Core source documents reviewed, and
General examination procedures performed.
Documentation should include summary statements.
Summary statements can take many forms, including
notations on copies of source documents, separate handwritten notes, comments in Examination Documentation
(ED) modules, and electronic or hard-copy memorandums.
At a minimum, summary comments should:
Risk management examiners should have a general
knowledge of the key principles, policies, and practices
relating to IT, BSA, consumer protection, trust, and other
specialty examinations. Additionally, examiners should be
knowledgeable of state laws and regulations that apply to the
banks they examine; the rules, regulations, statements of
policy and various banking-related statutes contained in the
FDIC’s rule and regulations; and the instructions for
completing Consolidated Reports of Condition and Income.
•
•
•
Detail examination findings and recommendations,
Describe supporting facts and logic, and
Record management responses.
Although examination documentation may be maintained in
various ways, examiners must securely retain appropriate
supporting records of all major examination conclusions,
recommendations, and assertions detailed in the Report of
Examination.
DISCLOSING REPORTS OF EXAM
The Report of Examination is highly confidential. Although
a copy is provided to a bank, that copy remains the property
of the FDIC. Without the FDIC's prior authorization,
directors, officers, employees, and agents of a bank are not
permitted to disclose the contents of a report. Under
specified circumstances, FDIC regulations permit disclosures
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Section 1.1
Safeguarding Examination Information
Examination information may contain non-public customer
information as defined in Section 501(b) of the Gramm1.1-17
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Leach-Bliley Act. Therefore, examiners must exercise a high
degree of care to safeguard information and control the
access, storage and transport of information stored on
laptops, retained on other storage media, or paper copies.
conclude their review after documenting conclusions
concerning the Core Analysis Decision Factors and carrying
forward any applicable comments to the Report of
Examination. The Expanded Analysis section provides
guidance to examiners to help determine if weaknesses are
material to a bank’s condition or if an activity is inadequately
managed.
Examiners must protect FDIC property and data and respond
quickly to any security breech. Examiners should:
•
•
•
The use of the modules should be tailored to the
characteristics of each bank based on its size, complexity,
and risk profile. As a result, the extent to which each module
is completed will vary. Individual procedures presented for
each level are meant only to serve as a guide for answering
the decision factors. Each procedure does not require an
individual response.
Protect computer equipment and data in transit,
Track data in transit, and
Secure unattended equipment and data.
Examiners must report unauthorized access to data and
equipment on a timely basis. Examiners should contact the
FDIC’s Help Desk Staff within one hour after discovery;
their supervisor as soon as possible; and in instances where
theft of equipment is involved, contact the local police.
Substance of Workpapers
FDIC regional offices must develop procedures for accessing,
transporting, storing, and disposing of electronic and paper
information. The procedures should include minimum
technical, physical, and administrative safeguards, and
include an incident response program.
Appropriate documentation should be prepared and retained
in the workpapers for each significant job task performed. A
checklist of examination procedures performed may be used
to document completed tasks and included as part of the
examination workpapers. The checklist may also be used as
the final documentation of lower-risk areas that receive
limited reviews and findings are not material.
Refer to internal directives for additional information.
Examiners should use standardized loan line sheets except in
special situations where alternative forms, such as institution
generated line sheets, provide a clear and substantial time
savings and the same general loan information. Line sheets
must contain sufficient, albeit sometimes brief, supporting
data to substantiate a pass or adverse classification.
Examination Documentation Modules
Examination procedures have been developed jointly by the
FDIC, the Federal Reserve, and various state agencies to
provide examiners with tools to scope examination activities,
evaluate financial conditions and risk-management practices,
and document examination findings. The use of these
modules is discretionary. When not used, examination
findings should be documented as discussed above.
For BSA examinations, examiners should document
preliminary, core, and expanded procedures as needed, in
accordance with current guidance relating to BSA/AML
workprograms for examination procedures.
The ED modules incorporate questions and points of
consideration into examination procedures that specifically
address a bank’s risk management strategies for each of its
major business activities. The modules direct examiners to
evaluate areas of risk and associated risk-control practices,
thereby facilitating an effective supervisory program. The
ED module examination procedures are generally separated
into three distinct tiers: Core Analysis, Expanded Analysis,
and Impact Analysis. The extent to which an examiner works
through each of these levels of analysis depends upon the
conclusions reached regarding the presence of significant
concerns or deficiencies.
Workpaper forms are available in GENESYS to supplement
report pages for certain areas of review, such as riskweighted assets and cash flow projections. When warranted,
supplemental workpapers may be included in the Report of
Examination to the extent that they provide material support
for significant findings.
Filing of Workpapers
Workpapers relating to major assignments should be
segregated and securely stored in separate folders, envelopes,
or indexed binders. For example, workpapers generated for
evaluating internal routines and controls may be filed
together under one major heading or separately under the
major categories reviewed. Line cards should be segregated
from other workpapers, alphabetized, and securely banded.
Where significant deficiencies or weaknesses are noted in the
Core Analysis review, the examiner should complete the
Expanded Analysis section, but only for the decision factors
that present the greatest degree of risk to the bank. On the
other hand, if risks are properly managed, examiners can
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Section 1.1
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Section 1.1
When electronic workpapers are retained, the electronic
media must be encrypted, password protected, and stored in a
locked facility. Non-FDIC issued laptops, desktops, or other
electronic devices may not be used to store institutionprovided information or examination workpapers.
BSA workpapers should be maintained separately from the
workpapers of the risk management examination and must be
retained for five years. The separate retention of BSA
workpapers will expedite their submission to the Treasury
Department in the event that they are requested for an
investigation.
Each folder, envelope, or binder should be labeled with the
institution’s name and location, the date of examination, and
a list of documents that have been prepared and retained for
each category. At its discretion, each region and field office
may designate the major documentation categories and
supplemental lists for their respective office(s). The
workpaper folders, envelopes, or binders should then be
organized in a labeled box, expandable file, or other
appropriate centralized filing system and retained at the
conclusion of the examination. The EIC is responsible for
ensuring outdated workpapers are appropriately purged and
current workpapers are properly organized and filed.
Retention of Workpapers
Line sheets should generally be retained for one examination
cycle, after which they may be purged from the active loan
deck. Risk Management, IT, and Trust Officer's
Questionnaires and BSA workpapers should be retained for a
minimum of five years from the examination start date.
Officer Questionnaires should be retained indefinitely when
irregularities are discovered or suspected, especially if the
signed questionnaire may provide evidence of these
irregularities. The examiner may submit a copy of the
Officer’s Questionnaire with the Report of Examination if
circumstances warrant, such as when the examiner suspects
that an officer knowingly provided incorrect information on
the document. Retention of other workpapers beyond one
examination should generally be confined to those banks with
existing or pending administrative actions, special documents
relating to past insider abuse, documents which are the
subject of previous criminal referral letters, or other such
sensitive documents. While the retention of workpapers
beyond one examination cycle is generally discouraged,
major schedules and other pertinent workpapers can be
retained if deemed useful. Additionally, if a bank’s
composite rating is 3 or worse, most workpapers should be
maintained until the bank returns to a satisfactory condition.
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Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
address weaknesses within appropriate time frames.
Financial institutions in this group generally are less capable
of withstanding business fluctuations and are more vulnerable
to outside influences than those institutions rated a composite
1 or 2. Additionally, these financial institutions may be in
significant noncompliance with laws and regulations. Risk
management practices may be less than satisfactory relative
to the institution’s size, complexity, and risk profile. These
financial institutions require more than normal supervision,
which may include formal or informal enforcement actions.
Failure appears unlikely, however, given the overall strength
and financial capacity of these institutions.
ADDENDUM TO SECTION 1.1
UFIRS RATINGS DEFINITIONS
Composite Ratings
Composite ratings are based on a careful evaluation of an
institution’s managerial, operational, financial, and
compliance performance. The six key components used to
assess an institution’s financial condition and operations are:
capital adequacy, asset quality, management capability,
earnings quantity and quality, liquidity adequacy, and
sensitivity to market risk. The composite ratings are defined
as follows:
Composite 4
Financial institutions in this group generally exhibit unsafe
and unsound practices or conditions. There are serious
financial or managerial deficiencies that result in
unsatisfactory performance. The problems range from severe
to critically deficient. The weaknesses and problems are not
being satisfactorily addressed or resolved by the board of
directors and management. Financial institutions in this
group generally are not capable of withstanding business
fluctuations. There may be significant noncompliance with
laws and regulations. Risk management practices are
generally unacceptable relative to the institution’s size,
complexity, and risk profile. Close supervisory attention is
required, which means, in most cases, formal enforcement
action is necessary to address the problems. Institutions in
this group pose a risk to the deposit insurance fund. Failure
is a distinct possibility if the problems and weaknesses are
not satisfactorily addressed and resolved.
Composite 1
Financial institutions in this group are sound in every respect
and generally have components rated 1 or 2. Any
weaknesses are minor and can be handled in a routine manner
by the board of directors and management. These financial
institutions are the most capable of withstanding the vagaries
of business conditions and are resistant to outside influences
such as economic instability in their trade area. These
financial institutions are in substantial compliance with laws
and regulations. As a result, these financial institutions
exhibit the strongest performance and risk management
practices relative to the institution’s size, complexity, and
risk profile, and give no cause for supervisory concern.
Composite 2
Financial institutions in this group are fundamentally sound.
For a financial institution to receive this rating, generally no
component rating should be more severe than 3. Only
moderate weaknesses are present and are well within the
board of directors’ and management’s capabilities and
willingness to correct. These financial institutions are stable
and are capable of withstanding business fluctuations. These
financial institutions are in substantial compliance with laws
and regulations. Overall risk management practices are
satisfactory relative to the institution’s size, complexity, and
risk profile. There are no material supervisory concerns and,
as a result, the supervisory response is informal and limited.
Composite 5
Financial institutions in this group exhibit extremely unsafe
and unsound practices or conditions; exhibit a critically
deficient performance; often contain inadequate risk
management practices relative to the institution’s size,
complexity, and risk profile; and are of the greatest
supervisory concern. The volume and severity of problems
are beyond management’s ability or willingness to control or
correct. Immediate outside financial or other assistance is
needed in order for the financial institution to be viable.
Ongoing supervisory attention is necessary. Institutions in
this group pose a significant risk to the deposit insurance
fund and failure is highly probable.
Composite 3
Financial institutions in this group exhibit some degree of
supervisory concern in one or more of the component areas.
These financial institutions exhibit a combination of
weaknesses that may range from moderate to severe;
however, the magnitude of the deficiencies generally will not
cause a component to be rated more severely than 4.
Management may lack the ability or willingness to effectively
Basic Examination Concepts and Guidelines (3/12)
Section 1.1
Component Ratings
Each of the component rating descriptions are divided into an
introductory paragraph, a list of principal evaluation factors,
and a brief description of each numerical rating. Some of the
evaluation factors are reiterated under one or more of the
1.1-20
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
other components to reinforce the interrelationship between
components. The evaluation factors for each component
rating are in no particular order of importance.
institution's capital level exceeds minimum regulatory and
statutory requirements.
A rating of 4 indicates a deficient level of capital. In light of
the institution’s risk profile, viability of the institution may be
threatened. Assistance from shareholders or other external
sources of financial support may be required.
Capital Adequacy
A financial institution is expected to maintain capital
commensurate with the nature and extent of risks to the
institution and the ability of management to identify,
measure, monitor, and control these risks. The effect of
credit, market, and other risks on the institution’s financial
condition should be considered when evaluating the adequacy
of capital. The types and quantity of risk inherent in an
institution's activities will determine the extent to which it
may be necessary to maintain capital at levels above required
regulatory minimums to properly reflect the potentially
adverse consequences that these risks may have on the
institution's capital.
A rating of 5 indicates a critically deficient level of capital
such that the institution's viability is threatened. Immediate
assistance from shareholders or other external sources of
financial support is required.
Asset Quality
The asset quality rating reflects the quantity of existing and
potential credit risk associated with the loan and investment
portfolios, other real estate owned, and other assets, as well
as off-balance sheet transactions. The ability of management
to identify, measure, monitor, and control credit risk is also
reflected here. The evaluation of asset quality should
consider the adequacy of the Allowance for Loan and Lease
Losses (ALLL) and weigh the exposure to counter-party,
issuer, or borrower default under actual or implied
contractual agreements. All other risks that may affect the
value or marketability of an institution's assets, including, but
not limited to, operating, market, reputation, strategic, or
compliance risks, should also be considered.
The capital adequacy of an institution is rated based upon,
but not limited to, an assessment of the following evaluation
factors:
•
•
•
•
•
•
•
•
The level and quality of capital and the overall
financial condition of the institution;
The ability of management to address emerging needs
for additional capital;
The nature, trend, and volume of problem assets, and
the adequacy of allowances for loan and lease losses
and other valuation reserves;
Balance sheet composition, including the nature and
amount of intangible assets, market risk, concentration
risk, and risks associated with nontraditional activities;
Risk exposure represented by off-balance sheet
activities;
The quality and strength of earnings, and the
reasonableness of dividends;
Prospects and plans for growth, as well as past
experience in managing growth; and
Access to capital markets and other sources of capital
including support provided by a parent holding
company.
The asset quality of a financial institution is rated based
upon, but not limited to, an assessment of the following
evaluation factors:
•
•
•
•
Ratings
A rating of 1 indicates a strong capital level relative to the
institution’s risk profile.
•
•
A rating of 2 indicates a satisfactory capital level relative to
the financial institution’s risk profile.
•
•
A rating of 3 indicates a less than satisfactory level of capital
that does not fully support the institution's risk profile. The
rating indicates a need for improvement, even if the
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Section 1.1
•
1.1-21
The adequacy of underwriting standards, soundness of
credit administration practices, and appropriateness of
risk identification practices;
The level, distribution, severity, and trend of problem,
classified, nonaccrual, restructured, delinquent, and
nonperforming assets for both on- and off-balance
sheet transactions;
The adequacy of the allowance for loan and lease
losses and other asset valuation reserves;
The credit risk arising from or reduced by off-balance
sheet transactions, such as unfunded commitments,
credit derivatives, commercial and standby letters of
credit, and lines of credit;
The diversification and quality of the loan and
investment portfolios;
The extent of securities underwriting activities and
exposure to counter-parties in trading activities;
The existence of asset concentrations;
The adequacy of loan and investment policies,
procedures, and practices;
The ability of management to properly administer its
Basic Examination Concepts and Guidelines (10/12)
BASIC EXAMINATION CONCEPTS AND GUIDELINES
•
•
assets, including the timely identification and
collection of problem assets;
The adequacy of internal controls and management
information systems; and
The volume and nature of credit-documentation
exceptions.
Depending on the nature and scope of an institution’s
activities, management practices may need to address some
or all of the following risks: credit, market, operating or
transaction, reputation, strategic, compliance, legal, liquidity,
and other risks.
Sound management practices are
demonstrated by active oversight by the board of directors
and management; competent personnel; adequate policies,
processes, and controls taking into consideration the size and
sophistication of the institution; maintenance of an
appropriate audit program and internal control environment;
and effective risk monitoring and management information
systems. This rating should reflect the board’s and
management’s ability as it applies to all aspects of banking
operations as well as other financial service activities in
which the institution is involved.
Ratings
A rating of 1 indicates strong asset quality and credit
administration practices. Identified weaknesses are minor in
nature and risk exposure is modest in relation to capital
protection and management’s abilities. Asset quality in such
institutions is of minimal supervisory concern.
A rating of 2 indicates satisfactory asset quality and credit
administration practices.
The level and severity of
classifications and other weaknesses warrant a limited level
of supervisory attention. Risk exposure is commensurate
with capital protection and management’s abilities.
The capability and performance of management and the
board of directors is rated based upon, but not limited to, an
assessment of the following evaluation factors:
•
A rating of 3 is assigned when asset quality or credit
administration practices are less than satisfactory. Trends
may be stable or indicate deterioration in asset quality or an
increase in risk exposure. The level and severity of classified
assets, other weaknesses, and risks require an elevated level
of supervisory concern. There is generally a need to improve
credit administration and risk management practices.
•
•
A rating of 4 is assigned to financial institutions with
deficient asset quality or credit administration practices. The
levels of risk and problem assets are significant, inadequately
controlled, and subject the financial institution to potential
losses that, if left unchecked, may threaten its viability.
•
•
A rating of 5 represents critically deficient asset quality or
credit administration practices that present an imminent threat
to the institution's viability.
•
•
Management
The capability of the board of directors and management, in
their respective roles to identify, measure, monitor, and
control the risks of an institution’s activities and to ensure a
financial institution’s safe, sound, and efficient operation in
compliance with applicable laws and regulations is reflected
in this rating. Generally, directors need not be actively
involved in day-to-day operations; however, they must
provide clear guidance regarding acceptable risk exposure
levels and ensure that appropriate policies, procedures, and
practices have been established. Senior management is
responsible for developing and implementing policies,
procedures, and practices that translate the board’s goals,
objectives, and risk limits into prudent operating standards.
Basic Examination Concepts and Guidelines (3/12)
Section 1.1
•
•
•
•
•
The level and quality of oversight and support of all
institution activities by the board of directors and
management;
The ability of the board of directors and management,
in their respective roles, to plan for, and respond to,
risks that may arise from changing business conditions
or the initiation of new activities or products;
The adequacies of, and conformance with, appropriate
internal policies and controls addressing the operations
and risks of significant activities;
The accuracy, timeliness, and effectiveness of
management information and risk monitoring systems
appropriate for the institution’s size, complexity, and
risk profile;
The adequacy of audits and internal controls to:
promote effective operations and reliable financial and
regulatory reporting; safeguard assets; and ensure
compliance with laws, regulations, and internal
policies;
Compliance with laws and regulations;
Responsiveness to recommendations from auditors and
supervisory authorities;
Management depth and succession;
The extent that the board of directors and management
is affected by, or susceptible to, dominant influence or
concentration of authority;
Reasonableness of compensation policies and
avoidance of self-dealing;
Demonstrated willingness to serve the legitimate
banking needs of the community; and
The overall performance of the institution and its risk
profile.
Ratings
1.1-22
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
interest rates. The quality of earnings may also be
diminished by undue reliance on extraordinary gains,
nonrecurring events, or favorable tax effects. Future earnings
may be adversely affected by an inability to forecast or
control funding and operating expenses, improperly executed
or ill-advised business strategies, or poorly managed or
uncontrolled exposure to other risks.
A rating of 1 indicates strong performance by management
and the board of directors and strong risk management
practices relative to the institution’s size, complexity, and
risk profile. All significant risks are consistently and
effectively identified, measured, monitored, and controlled.
Management and the board have demonstrated the ability to
promptly and successfully address existing and potential
problems and risks.
The rating of an institution's earnings is based upon, but not
limited to, an assessment of the following evaluation factors:
A rating of 2 indicates satisfactory management and board
performance and risk management practices relative to the
institution’s size, complexity, and risk profile. Minor
weaknesses may exist, but are not material to the safety and
soundness of the institution and are being addressed. In
general, significant risks and problems are effectively
identified, measured, monitored, and controlled.
•
•
•
•
•
A rating of 3 indicates management and board performance
that need improvement or risk management practices that are
less than satisfactory given the nature of the institution’s
activities. The capabilities of management or the board of
directors may be insufficient for the type, size, or condition
of the institution. Problems and significant risks may be
inadequately identified, measured, monitored, or controlled.
•
•
The level of earnings, including trends and stability;
The ability to provide for adequate capital through
retained earnings;
The quality and sources of earnings;
The level of expenses in relation to operations;
The adequacy of the budgeting systems, forecasting
processes, and management information systems in
general;
The adequacy of provisions to maintain the allowance
for loan and lease losses and other valuation allowance
accounts; and
The earnings exposure to market risk such as interest
rate, foreign exchange, and price risks.
Ratings
A rating of 4 indicates deficient management and board
performance or risk management practices that are
inadequate considering the nature of an institution’s
activities. The level of problems and risk exposure is
excessive. Problems and significant risks are inadequately
identified, measured, monitored, or controlled and require
immediate action by the board and management to preserve
the soundness of the institution. Replacing or strengthening
management or the board may be necessary.
A rating of 1 indicates earnings that are strong. Earnings are
more than sufficient to support operations and maintain
adequate capital and allowance levels after consideration is
given to asset quality, growth, and other factors affecting the
quality, quantity, and trend of earnings.
A rating of 2 indicates earnings that are satisfactory.
Earnings are sufficient to support operations and maintain
adequate capital and allowance levels after consideration is
given to asset quality, growth, and other factors affecting the
quality, quantity, and trend of earnings. Earnings that are
relatively static, or even experiencing a slight decline, may
receive a 2 rating provided the institution’s level of earnings
is adequate in view of the assessment factors listed above.
A rating of 5 indicates critically deficient management and
board performance or risk management practices.
Management and the board of directors have not
demonstrated the ability to correct problems and implement
appropriate risk management practices. Problems and
significant risks are inadequately identified, measured,
monitored, or controlled and now threaten the continued
viability of the institution. Replacing or strengthening
management or the board of directors is necessary.
A rating of 3 indicates earnings that need to be improved.
Earnings may not fully support operations and provide for the
accretion of capital and allowance levels in relation to the
institution's overall condition, growth, and other factors
affecting the quality, quantity, and trend of earnings.
Earnings
This rating reflects not only the quantity and trend of
earnings, but also factors that may affect the sustainability or
quality of earnings. The quantity as well as the quality of
earnings can be affected by excessive or inadequately
managed credit risk that may result in loan losses and require
additions to the ALLL, or by high levels of market risk that
may unduly expose an institution's earnings to volatility in
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Federal Deposit Insurance Corporation
Section 1.1
A rating of 4 indicates earnings that are deficient. Earnings
are insufficient to support operations and maintain
appropriate capital and allowance levels. Institutions so rated
may be characterized by erratic fluctuations in net income or
net interest margin, the development of significant negative
trends, nominal or unsustainable earnings, intermittent losses,
1.1-23
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
or a substantive drop in earnings from the previous years.
A rating of 1 indicates strong liquidity levels and welldeveloped funds management practices. The institution has
reliable access to sufficient sources of funds on favorable
terms to meet present and anticipated liquidity needs.
A rating of 5 indicates earnings that are critically deficient.
A financial institution with earnings rated 5 is experiencing
losses that represent a distinct threat to its viability through
the erosion of capital.
A rating of 2 indicates satisfactory liquidity levels and funds
management practices. The institution has access to
sufficient sources of funds on acceptable terms to meet
present and anticipated liquidity needs. Modest weaknesses
may be evident in funds management practices.
Liquidity
In evaluating the adequacy of a financial institution’s
liquidity position, consideration should be given to the
current level and prospective sources of liquidity compared
to funding needs, as well as to the adequacy of funds
management practices relative to the institution’s size,
complexity, and risk profile. In general, funds management
practices should ensure that an institution is able to maintain
a level of liquidity sufficient to meet its financial obligations
in a timely manner and to fulfill the legitimate banking needs
of its community. Practices should reflect the ability of the
institution to manage unplanned changes in funding sources,
as well as react to changes in market conditions that affect the
ability to quickly liquidate assets with minimal loss. In
addition, funds management practices should ensure that
liquidity is not maintained at a high cost, or through undue
reliance on funding sources that may not be available in times
of financial stress or adverse changes in market conditions.
A rating of 3 indicates liquidity levels or funds management
practices in need of improvement. Institutions rated 3 may
lack ready access to funds on reasonable terms or may
evidence significant weaknesses in funds management
practices.
A rating of 4 indicates deficient liquidity levels or inadequate
funds management practices. Institutions rated 4 may not
have or be able to obtain a sufficient volume of funds on
reasonable terms to meet liquidity needs.
A rating of 5 indicates liquidity levels or funds management
practices so critically deficient that the continued viability of
the institution is threatened. Institutions rated 5 require
immediate external financial assistance to meet maturing
obligations or other liquidity needs.
Liquidity is rated based upon, but not limited to, an
assessment of the following evaluation factors:
•
•
•
•
•
•
•
•
Sensitivity to Market Risk
The sensitivity to market risk component reflects the degree
to which changes in interest rates, foreign exchange rates,
commodity prices, or equity prices can adversely affect a
financial institution’s earnings or economic capital. When
evaluating this component, consideration should be given to:
management’s ability to identify, measure, monitor, and
control market risk; the institution’s size; the nature and
complexity of its activities; and the adequacy of its capital
and earnings in relation to its level of market risk exposure.
The adequacy of liquidity sources compared to present
and future needs and the ability of the institution to
meet liquidity needs without adversely affecting its
operations or condition;
The availability of assets readily convertible to cash
without undue loss;
Access to money markets and other sources of
funding;
The level of diversification of funding sources, both
on- and off-balance sheet;
The degree of reliance on short-term, volatile sources
of funds, including borrowings and brokered deposits,
to fund longer term assets;
The trend and stability of deposits;
The ability to securitize and sell certain pools of
assets; and
The capability of management to properly identify,
measure, monitor, and control the institution’s
liquidity position, including the effectiveness of funds
management strategies, liquidity policies, management
information systems, and contingency funding plans.
For many institutions, the primary source of market risk
arises from nontrading positions and their sensitivity to
changes in interest rates. In some larger institutions, foreign
operations can be a significant source of market risk. For
some institutions, trading activities are a major source of
market risk.
Market risk is rated based upon, but not limited to, an
assessment of the following evaluation factors:
•
Ratings
•
Basic Examination Concepts and Guidelines (3/12)
Section 1.1
1.1-24
The sensitivity of the financial institution's earnings or
the economic value of its capital to adverse changes in
interest rates, foreign exchange rates, commodity
prices, or equity prices;
The ability of management to identify, measure,
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BASIC EXAMINATION CONCEPTS AND GUIDELINES
•
•
Section 1.1
monitor, and control exposure to market risk given the
institution’s size, complexity, and risk profile;
The nature and complexity of interest rate risk
exposure arising from nontrading positions; and
Where appropriate, the nature and complexity of
market risk exposure arising from trading and foreign
operations.
Ratings
A rating of 1 indicates that market risk sensitivity is well
controlled and that there is minimal potential that the
earnings performance or capital position will be adversely
affected. Risk management practices are strong for the size,
sophistication, and market risk accepted by the institution.
The level of earnings and capital provide substantial support
for the degree of market risk taken by the institution.
A rating of 2 indicates that market risk sensitivity is
adequately controlled and that there is only moderate
potential that the earnings performance or capital position
will be adversely affected. Risk management practices are
satisfactory for the size, sophistication, and market risk
accepted by the institution. The level of earnings and capital
provide adequate support for the degree of market risk taken
by the institution.
A rating of 3 indicates that control of market risk sensitivity
needs improvement or that there is significant potential that
the earnings performance or capital position will be adversely
affected. Risk management practices need to be improved
given the size, sophistication, and level of market risk
accepted by the institution. The level of earnings and capital
may not adequately support the degree of market risk taken
by the institution.
A rating of 4 indicates that control of market risk sensitivity
is unacceptable or that there is high potential that the earnings
performance or capital position will be adversely affected.
Risk management practices are deficient for the size,
sophistication, and level of market risk accepted by the
institution. The level of earnings and capital provide
inadequate support for the degree of market risk taken by the
institution.
A rating of 5 indicates that control of market risk sensitivity
is unacceptable or that the level of market risk taken by the
institution is an imminent threat to its viability. Risk
management practices are wholly inadequate for the size,
sophistication, and level of market risk accepted by the
institution.
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Basic Examination Concepts and Guidelines (10/12)
CAPITAL
Section 2.1
with trust department activities, litigation in which the
institution is the defendant, or that emanate from other
sources, are carefully scrutinized since they may lead to
capital depletion.
INTRODUCTION
Purpose of Capital
Bank capital performs several very important functions. It
absorbs losses, promotes public confidence, helps restricts
excessive asset growth, and provides protection to
depositors and the FDIC insurance funds.
CAPITAL
Capital-based Regulations and Guidance
Absorbs Losses
The FDIC issued several capital-based regulations
affecting either insured state nonmember banks or all
insured institutions. These regulations establish minimum
capital standards, a framework for taking supervisory
actions for institutions that are not adequately capitalized, a
risk-related deposit insurance premium system based, in
part, on capital levels, and restrictions prohibiting certain
bank related activities.
Capital allows institutions to continue operating as going
concerns during periods when operating losses or other
adverse financial results are experienced.
Promotes Public Confidence
Capital provides a measure of assurance to the public that
an institution will continue to provide financial services
even when losses have been incurred, thereby helping to
maintain confidence in the banking system and minimize
liquidity concerns.
An introduction to these capital-based regulations is as
follows with more detail following later in this section:
Minimum Leverage Capital Standard
Restricts Excessive Asset Growth
Part 325 of the FDIC Rules and Regulations establishes the
criteria and standards the FDIC will use in calculating the
minimum leverage capital requirement and in determining
capital adequacy.
Capital, along with minimum capital ratio standards,
restrains unjustified asset expansion by requiring that asset
growth be funded by a commensurate amount of additional
capital.
Minimum Risk-Based Capital Standard
Provides Protection to Depositors and the FDIC
Insurance Funds
Part 325 Appendix A - Statement of Policy on Risk-Based
Capital, establishes a risk adjusted capital framework,
which, together with the leverage capital standard, is used
in the examination and supervisory process. The riskbased framework includes a definition of capital for riskbased capital purposes, a system for calculating riskweighted assets by assigning assets and off-balance sheet
items to broad risk categories, and a minimum supervisory
ratio of capital to risk-weighted assets.
Placing owners at significant risk of loss, should the
institution fail, helps to minimize the potential "moral
hazard" and promotes safe and sound banking practices.
As the insuring agency whose primary purpose is the
protection of depositors, the FDIC has a direct and obvious
financial stake in the last-mentioned function.
Consequently, the FDIC focuses a great deal of attention in
examination and supervisory programs relating to capital
positions. For example, the appraisal of assets provides a
determination of adjusted, as opposed to book, capital.
Similarly, Substandard and Doubtful assets, or those listed
for Special Mention or as Concentrations, are identified
because these may have the potential of resulting in losses
and a weakened capital position at some future point.
Moreover, review of the policies and practices of
management can disclose weaknesses that may bring about
losses and dissipation of capital. An institution's earnings
performance and dividend policies are analyzed for impact
on the present and expected capitalization level. Also,
serious contingent liabilities that may arise in conjunction
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Statement of Policy on Capital Adequacy
Part 325 Appendix B – Statement of Policy on Capital
Adequacy, provides some interpretational and definitional
guidance as to how Part 325 will be administered and
enforced.
Risk-Based Capital Standard - Market Risk
Part 325 Appendix C – Risk-Based Capital for State NonMember Banks: Market Risk, was established to ensure
that banks with significant exposure to market risk
maintain adequate capital to support that exposure. This
2.1-1
Capital (12-04)
CAPITAL
Section 2.1
Appendix supplements and adjusts the risk-based capital
ratio calculations under Appendix A of Part 325.
Markets Website (Resources) for more complete and upto-date information.
Prompt Corrective Action (PCA)
FIL 54-2002: Capital Standards/Interagency Questions
and Answers on the Capital Treatment of Recourse,
Direct Credit Substitutes, and Residual Interests in
Asset Securitizations
Part 325 of the FDIC Rules and Regulations implements
Section 38 of the Federal Deposit Insurance (FDI) Act by
establishing a framework for taking prompt supervisory
actions against insured state nonmember banks that are not
adequately capitalized. A more thorough discussion is
presented later in this section, as well as within the Formal
Administrative Actions Section of this manual. Certain
provisions of the FDIC's PCA rules apply to all insured
depository institutions that are critically undercapitalized.
This document clarifies several issues arising from the final
rule on the capital treatment of these exposures as
originally presented in FIL 99-2001.
FIL 52-2002: Capital Standards/Interagency Guidance
on Implicit Recourse in Asset Securitizations
This guidance highlights the fundamental concern that
implicit recourse may expose a bank’s earnings and capital
to potential losses. The guidance sets forth a range of
supervisory actions that may be taken against a bank that
provides implicit support to its securitizations.
Other Areas
Capital-based standards are used in the following
regulations to restrict or prohibit an institution's activities.
Risk-Related Insurance
Premiums
Part 327 of the
FDIC Rules and
Regulations
Brokered Deposits
Section 337.6 of the
FDIC
Rules
and
Regulations
Limits on Extensions of
Credit to Insiders
Section 337.3 of the
FDIC Rules and
Regulations & FRB
Regulation O
Activities and Investments
of Insured State Nonmember
Part 362 of the
FDIC Rules and Banks
Regulations
FIL 48-2002: Capital Standards/Interagency Advisory
on the Regulatory Capital Treatment of Accrued
Interest Receivable Related to Credit Card
Securitizations
This Advisory clarifies the appropriate risk-based capital
treatment for banking organizations that securitize credit
card receivables and record an on-balance sheet asset
commonly referred to as Accrued Interest Receivable
(AIR). The advisory describes how the AIR asset is
created, explains why this asset is considered a
subordinated retained interest for regulatory capital
purposes, and describes the regulatory capital treatment
that applies to the AIR asset.
FIL 31-2002: Capital Standards/Final Rule Lowers
Risk-Weightings for Claims on Securities Firms
Limitations on Interbank
Liabilities
Part 206 of FRB
Regulations
Limitations on Federal
Reserve Discount Window
Advances
Section
10B
of
the Federal Reserve
Act
Grounds for Appointing
Conservator or Receiver
Section 11(c)(5)
the FDI Act
This rule lowers the risk weight applied to certain claims
on qualifying securities firms from 100 percent to 20
percent.
FIL 06-2002: Capital Standards/Final Capital Rule for
Nonfinancial Equity Investments
of
Under this rule, covered equity investments are subject to a
Tier 1 capital charge (for both risk-based and leverage
capital purposes) that increases in steps as the banking
organization’s level of concentration in equity investments
increases.
Capital-based Guidance
The FDIC issued substantive capital-based guidance and
rules affecting either insured state nonmember banks or all
insured institutions. A few of the more recent FILs are
presented below. Examiners should refer to the Capital
Capital (12-04)
FIL 99-2001: Capital Standards (Final Rule to Amend
the Regulatory Capital Treatment of Recourse
Arrangements, Direct Credit Substitutes, Residual
2.1-2
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Federal Deposit Insurance Corporation
CAPITAL
Section 2.1
Interests in Asset Securitizations, and Asset-Backed
and Mortgage-Backed Securities)
This rule amends the regulatory capital treatment of
recourse arrangements, direct credit substitutes, residual
interests in asset securitizations, and asset- and mortgagebacked securities, better aligning regulatory capital
requirements with the risk associated with these positions.
The rule primarily affects banks involved in securitizationrelated activities. However, it also includes banks that
service assets, guarantee the performance of a third party’s
assets, or invest in asset-backed and mortgage-backed
securities.
Components of Capital
Leverage Capital
•
Banks must maintain at least the minimum leverage ratio
requirement set forth in Part 325. The minimum leverage
ratio requirement consists only of Tier 1 (Core) Capital.
Tier 1 Capital or Core Capital is defined in Part 325 and
means the sum of:
•
common stockholders' equity – the sum of common
stock and related surplus, undivided profits, disclosed
capital reserves that represent a segregation of
undivided profits, and foreign currency translation
adjustments, less net unrealized losses on availablefor-sale equity securities with readily determinable fair
values;
• noncumulative perpetual preferred stock – perpetual
preferred stock (and related surplus) where the issuer
has the option to waive payment of dividends and
where the dividends so waived do not accumulate to
future periods nor do they represent a contingent claim
on the issuer. Preferred stock issues where the
dividend is reset periodically based, in whole or in
part, upon the bank's current credit standing, including
but not limited to, auction rate, money market and
remarketable preferred stock, are excluded from this
definition of noncumulative perpetual preferred stock,
regardless of whether the dividends are cumulative or
noncumulative;
• minority interests in consolidated subsidiaries –
minority interests in equity capital accounts of those
subsidiaries that have been consolidated for the
purpose of computing regulatory capital, except that
minority interests which fail to provide meaningful
capital support are excluded from this definition;
minus
• all intangible assets other than mortgage servicing
assets, nonmortgage servicing assets, and purchased
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
•
•
2.1-3
credit card relationships eligible for inclusion in core
capital as prescribed in Section 325.5. (F) –
Intangible assets represent those assets that are
required to be reported as intangible assets in a
banking institution’s "Reports of Condition and
Income" (Call Report) or in a savings association's
"Thrift Financial Report." Mortgage servicing assets
and nonmortgage servicing assets (collectively
servicing assets) as well as purchased credit card
relationships (PCCRs) are eligible for inclusion in core
capital with certain limitations. Generally, servicing
assets and PCCRs are limited to 100 percent of Tier 1
capital. In addition, nonmortgage servicing assets and
PCCRs are subject to a separate sublimit of 25 percent
of Tier 1 capital. Section RC-R of the Call Report
Instructions provides a worksheet that banks may use
to determine the amount of disallowed servicing assets
and PCCRs;
noneligible credit-enhancing interest-only strips – A
credit-enhancing interest-only strip is defined in the
capital guidelines as "an on-balance sheet asset that, in
form or in substance represents the contractual right to
receive some or all of the interest due on transferred
assets; and exposes the bank to credit risk directly or
indirectly associated with the transferred assets that
exceeds a pro rata share of the bank’s claim on the
assets, whether through subordination provisions or
other credit enhancement techniques."
Creditenhancing interest-only strips include other similar
"spread" assets and can be either retained or
purchased. In general, credit-enhancing interest-only
strips are limited to 25 percent of Tier 1 capital.
Section RC-R of the Call Report Instructions provides
a worksheet that banks may use to determine the
amount of noneligible credit-enhancing interest-only
strips;
deferred tax assets in excess of the limit set forth in
Section 325.5(g) – Deferred tax assets represent
reductions in future taxes payable as a result of
"temporary differences" and net operating loss or tax
credit carryforwards that exist at the reporting date.
Generally, deferred tax assets that are dependent upon
future taxable income are limited to the lesser of: (i)
the amount of such deferred tax assets that the bank
expects to realize within one year of the calendar
quarter-end date, based on its projected future taxable
income for that year or (ii) 10% of the amount of the
bank's Tier 1 capital; prior to deductions.
identified losses (to the extent that Tier 1 capital
would have been reduced if the appropriate
accounting entries to reflect the identified losses had
been recorded on the institution's books) – Identified
losses represent those items that have been determined
by an evaluation made by a state or federal examiner
to be chargeable against income, capital, and/or
Capital (12-04)
CAPITAL
•
•
Section 2.1
general valuation allowances such as the allowance for
loan and lease losses (examples of identified losses
would be assets classified loss, off-balance sheet items
classified loss, any provision expenses that are
necessary for the institution to record in order to
replenish its general valuation allowances to an
adequate level, liabilities not shown on the institution's
books, estimated losses in contingent liabilities, and
differences in accounts which represent shortages);
investments in financial subsidiaries subject to 12
CFR Part 362 (Subpart E)– Any insured state bank
that wishes to conduct or continue to conduct as
principal activities through a subsidiary that are not
permissible for a subsidiary of a national bank must
deduct from its Tier one capital the investment in
equity investment of the subsidiary as well as the
bank’s pro rata share of any retained earnings of the
subsidiary; and
the amount of the total adjusted carrying value of
nonfinancial equity investments subject to deduction
as set forth in Appendix A of Part 325 – If a bank has
nonfinancial equity investments that are subject to Tier
1 capital deductions, these deductions should be
reported in this item. Under the capital rules on
nonfinancial equity investments, a nonfinancial equity
investment is any equity investment that a bank holds
in a nonfinancial company through a small business
investment company (SBIC), under the portfolio
investment provisions of Federal Reserve Regulation
K, or under section 24 of the Federal Deposit
Insurance Act. The capital rules impose Tier 1 capital
deductions on nonfinancial equity investments that
increase as the aggregate amount of nonfinancial
equity investments held by a bank increases. These
marginal capital charges are based on the adjusted
carrying value of the investments as a percent of the
bank's Tier 1 capital as presented in the Call Report
Instructions.
provisions that are inconsistent with safe and sound
banking practices.
Tier 1 Capital for risk-based capital standards is the same
as under the leverage capital standard.
Tier 2 (Supplementary) Capital consists of:
•
•
•
Risk-Based Capital
•
While the leverage capital standard serves as a useful tool
for assessing capital adequacy, there is a need for a capital
measure that is more explicitly and systematically sensitive
to the risk profiles of individual banks. As a result, the
Statement of Policy on Risk-Based Capital (Appendix A to
Part 325) was adopted to supplement the existing Part 325
leverage capital regulation.
Under the risk-based framework, a bank's qualifying total
capital base consists of two types of capital elements, "core
capital elements" (Tier 1) and "supplementary capital
elements" (Tier 2). To qualify as an element of Tier 1 or
Tier 2 capital, a capital instrument should not contain or be
subject to any conditions, covenants, terms, restrictions, or
Capital (12-04)
•
2.1-4
allowances for loan and lease losses (ALLL), up to a
maximum of 1.25 percent of gross risk-weighted
assets – For risk-based capital purposes, the allowance
for loan and lease losses equals Schedule RC, item 4.c,
"Allowance for loan and lease losses," less Schedule
RI-B, part II, Memorandum item 1, "Allocated transfer
risk reserve included in Schedule RI-B, part II, item 7,
above," plus Schedule RC-G, item 3, "Allowance for
credit losses on off-balance sheet credit exposures";
cumulative perpetual preferred stock, long-term
preferred stock (original maturity of at least 20
years) and any related surplus – Perpetual preferred
stock is defined as preferred stock that does not have a
maturity date, that cannot be redeemed at the option of
the holder, and that has no other provisions that will
require future redemption of the issue.
The
cumulative nature entails that dividends, if omitted,
accumulate until paid out. Long-term preferred stock
is preferred stock with an original weighted average
maturity of at least 20 years. The portion of qualifying
long-term preferred stock includible in Tier 2 capital is
discounted in accordance with the worksheet in the
Call Report Instructions. The discounting begins
when the remaining maturity falls below five years;
perpetual preferred stock where the dividend is reset
periodically based, in whole or part, on the bank’s
current credit standing – This entails perpetual
preferred stock issues that were excluded from Tier 1
capital such as noncumulative perpetual preferred
where the dividend is reset periodically based, in
whole or in part, upon the bank's current credit
standing (including, but not limited to, auction rate,
money market, and remarketable preferred stock);
hybrid capital instruments, including mandatory
convertible debt – Hybrid capital instruments include
instruments that are essentially permanent in nature
and that have certain characteristics of both equity and
debt. Such instruments may be included in Tier 2
without limit. This category also includes mandatory
convertible debt, i.e., equity contract notes, which is a
form of subordinated debt that obligates the holder to
take the common or perpetual preferred stock of the
issuer in lieu of cash for repayment of principal;
term subordinated debt and intermediate-term
preferred stock (original average maturity of five
years or more and not redeemable at the option of
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Federal Deposit Insurance Corporation
CAPITAL
•
Section 2.1
the holder prior to maturity, except with the prior
approval of the FDIC) – Subordinated debt is debt
over which senior debt takes priority. In the event of
bankruptcy, subordinated debtholders receive payment
only after senior debt claims are paid in full.
Intermediate-term preferred stock is preferred stock
with an original weighted average maturity of between
five and twenty years. The portion of qualifying term
subordinated debt and intermediate-term preferred
stock includible in Tier 2 capital is discounted in
accordance with the worksheet in the Call Report
Instructions.
The discounting begins when the
remaining maturity falls below five years. The portion
of qualifying term subordinated debt and intermediateterm preferred stock that remains after discounting and
is includible in Tier 2 capital is limited to 50 percent
of Tier 1 capital; and
net unrealized holding gains on equity securities, up
to 45%, pretax – the pretax net unrealized holding
gain (i.e., the excess of fair value as reported in
Schedule RC-B, item 7, column D, over historical cost
as reported in Schedule RC-B, item 7, column C), if
any, on available-for-sale equity securities is subject to
the limits specified by the capital guidelines of the
reporting bank's primary federal supervisory authority.
The amount reported in this item cannot exceed 45
percent of the bank's pretax net unrealized holding
gain on available-for-sale equity securities with readily
determinable fair values.
measure that is based on value-at-risk capital charges,
specific add-ons, and de minimis exposures.
A bank subject to the market risk rules must:
• use a value-at-risk model to estimate the maximum
amount that the bank’s covered positions could decline
during a fixed holding period,
• have a risk management system, which defines a risk
control unit that reports directly to senior management
and is independent from business trading units, and
• have an internal risk measurement model that is
integrated into the daily management process, and
must have policies and procedures that identify
appropriate stress tests and back tests, which the bank
must conduct.
Total Capital (used in the risk-based calculation) is
calculated by summing Tier 1 capital and Tier 2 capital,
less investments in unconsolidated banking and finance
subsidiaries and reciprocal holdings of capital instruments
of other banks. The FDIC may also consider deducting
investments in other subsidiaries, either on a case-by-case
basis or, as with securities subsidiaries, based on the
general characteristics or function nature of the
subsidiaries.
Capital Account Adjustments
Various adjustments need to be made when calculating the
capital elements based on the rules outlined in the
regulations.
The maximum amount of Tier 2 capital that may be
recognized for risk-based capital purposes is limited to 100
percent of Tier 1 capital. Additionally, the combined
amount of term subordinated debt and intermediate-term
preferred stock that may be treated as Tier 2 capital is
limited to 50 percent of Tier 1 capital.
Deductions from Tier 1 Capital for Identified Losses
and Inadequate ALLL
Part 325 provides that, on a case-by-case basis and in
conjunction with supervisory examinations, other
deductions from capital may be required, including any
adjustments deemed appropriate for assets classified Loss.
Further, the definition of Tier 1 capital under the Part 325
leverage capital standard specifically provides for the
deduction of identified losses (which may include items
classified Loss and any provision expenses that are
necessary to replenish the ALLL to an adequate level).
Tier 3 Capital is limited in use to situations where the
market risk risk-based capital rules apply. The market risk
risk-based capital rules and calculations only apply to
insured state nonmember banks whose trading activity (on
a worldwide basis) equals 10 percent or more of total
assets or $1 billion or more (the FDIC can apply the rules
to other institutions if necessary for safe and sound banking
practices). The rules supplement and adjust calculations
under Appendix A of Part 325. The calculations are used
to ensure that banks with significant exposures have
adequate capital allocated for market risk. Appendix C to
Part 325 outlines how risk-based capital calculations are
adjusted for banks with applicable trading activity and
introduces Tier 3 capital.
Tier 3 capital includes
subordinated debt with specific characteristics and just
applies to these market risk rules. Tier 3 capital is used in
conjunction with Tier 1 and Tier 2 capital (subject to
certain limitations) to calculate a market risk capital
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
When it is deemed appropriate during an examination to
adjust capital for items classified Loss or for an inadequate
ALLL, the following method should be used by examiners.
This method avoids adjustments that may otherwise result
in a "double deduction" (e.g., for loans classified Loss),
particularly when Tier 1 capital already has been
effectively reduced through provision expenses recorded in
establishing an adequate ALLL.
Additionally, the
following method addresses those situations where an
2.1-5
Capital (12-04)
CAPITAL
Section 2.1
institution overstated the amount of Tier 1 capital by
failing to take necessary provision expenses to establish
and maintain an adequate ALLL.
Method
example of non-book liabilities for which an adjustment
should be made in the examination capital analysis.
Similarly, an adjustment to capital should be made for
material deferred tax liabilities or for a significant amount
of unpaid bills that are not reflected on the bank’s books.
•
Regulatory Capital Minimum and Categories
•
•
•
Deduct the amount of Loss for items other than loans
and leases in the calculation of Tier 1 capital. If Other
Real Estate (ORE) general reserves exist, see the
following discussion of "Capital Treatment of ORE
Reserves."
Deduct the amount of Loss for loans and leases from
the ALLL in the calculation of Tier 2 capital.
If the ALLL is considered inadequate, an estimate of
the provision expense needed for an adequate ALLL
should be made. The estimate is after identified losses
have been deducted from the ALLL. Loans and leases
classified Doubtful should not be directly deducted
from capital. Rather, they should be included in the
evaluation of the ALLL and, if appropriate, will be
accounted for by the inadequate ALLL adjustment.
An adjustment from Tier 1 capital to Tier 2 capital for
an inadequate ALLL should be made only when the
amount is considered significant. The decision as to
what is significant is a matter of judgment.
Institutions are expected, at a minimum, to maintain capital
levels that meet both the leverage capital ratio requirement
and the risk-based capital ratio requirement.
Part 325 sets forth minimum acceptable capital
requirements for fundamentally sound, well-managed
institutions having no material or significant weaknesses.
The FDIC is not precluded from requiring an institution to
maintain a higher capital level based on the institution's
particular risk profile. Where the FDIC determines that the
financial history or condition, managerial resources and/or
the future earnings prospects of an institution are not
adequate, or where an institution has sizeable off-balance
sheet or funding risks, significant risks from concentrations
of credit or nontraditional activities, excessive interest rate
risk exposure, or a significant volume of assets adversely
classified, the FDIC may determine that the minimum
amount of capital for that institution is greater than the
minimum standards outlined below.
Capital Treatment of Other Real Estate Reserves
ORE reserves, whether considered general reserves or
specific reserves, are not recognized as a component of
capital for either risk-based capital or leverage capital
standards. However, these reserves would be considered
when accounting for ORE that is classified Loss.
Examiners should take into account the existence of any
general ORE reserves when deducting ORE classified
Loss. To the extent ORE reserves adequately cover the
risks inherent in the ORE portfolio as a whole, including
any individual ORE properties classified Loss, there would
be no actual deduction from Tier 1 capital. The ORE Loss
in excess of ORE reserves should be deducted from Tier 1
capital under “Assets Other Than Loans & Leases
Classified Loss.”
Minimum Leverage Capital Requirement:
•
•
.
Any bank that has less than the minimum leverage capital
requirement is deemed to be in violation of Part 325 and
engaged in an unsafe or unsound practice pursuant to
section 8(b) and/or 8(c) of the FDI Act, unless the bank has
entered into and is in compliance with a written plan
approved by the FDIC.
Liabilities Not Shown on Books
Non-book liabilities have a direct bearing on the adjusted
capital computation. These definite and direct, but
unbooked liabilities (contingent liabilities are treated
differently) should be carefully verified and supported by
factual comments. Examiners are to recommend that bank
records be adjusted so that all liabilities are properly
reflected. Deficiencies in a bank's accrual accounting
system, which are of such magnitude that the institution's
capital accounts are significantly overstated constitutes an
Capital (12-04)
Not less than 3 percent Tier 1 capital to total assets if
the bank has a composite "1" rating and is not
anticipating or experiencing any significant growth
and has well-diversified risk, including interest rate
risk, excellent asset quality, high liquidity, and good
earnings.
All others not meeting the above criteria should
maintain a ratio of Tier 1 capital to total assets of not
less than 4 percent.
If a bank has a leverage ratio less than two percent, it is
deemed to be operating in an unsafe or unsound condition
pursuant to section 8(a) of the FDI Act.
Minimum Risk-Based Capital Requirement:
2.1-6
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
CAPITAL
•
Section 2.1
equivalent amounts of derivative contracts and off-balance
sheet items that are assigned to a risk weight category of
less than 100 percent may be included in the amount
reported for a higher risk weight category (e.g., the 100
percent category) than the risk weight category to which
the asset or credit equivalent amount of the off-balance
sheet item would otherwise be assigned.
Qualifying total capital to risk-weighted assets must be
at least 8 percent, at least half of which (4 percentage
points) must be comprised of Tier 1 capital.
Capital Categories
Part 325 Subpart B – Prompt Corrective Action (PCA) is
issued by the FDIC pursuant to Section 38 of the FDI Act.
The purpose is to define, for FDIC-insured state-chartered
nonmember banks, the capital measures and capital levels
used for determining the supervisory actions authorized
under Section 38 of the FDI Act. This Subpart also
establishes procedures for submission and review of capital
restoration plans and for issuance and review of directive
and orders pursuant to Section 38.
Although the majority of assets and off-balance sheet items
fall within one of the four broad risk categories, there are
exceptions that fall outside of the general categories. Other
off-balance sheet credit equivalent conversions are
available for derivative contracts and short-term liquidity
facilities supporting asset-backed commercial paper
programs. There is also a ratings-based approach that
applies only to recourse obligations, direct credit
substitutes, residual interests, and asset- and mortgagebacked securities in connection with asset securitizations
and structured financings. In a 1999 Financial Institution
Letter (FIL-99-2001), the agencies introduced a 200
percent risk weight category. This category applies to
externally rated recourse obligations, direct credit
substitutes, residual interest (other than credit-enhancing
interest-only strips), and asset- and mortgage-backed
securities that are rated one category below the lowest
investment grade category or non-rated positions for which
the bank deems that the credit risk is equivalent to one
category below investment grade (e.g., BB).
The following chart summarizes the PCA categories; refer
to Section 10 of this manual for a discussion of PCA
directives.
Prompt Corrective Action Categories
Leverage
Tier 1
Total
RiskRiskBased
Based
Well Capitalized ≥ 5% and
≥ 6% and
≥ 10%
And is not subject to any written
agreement, order, capital directive, or
prompt corrective action directive to
meet and maintain a specific capital
level for any capital measure.
Adequately
≥ 4% and
≥ 8%
≥ 4%* and
Capitalized
And does not meet the definition of a
well capitalized bank.
*or a Leverage ratio of ≥ 3% if the
bank is rated a composite 1 and is not
experiencing or anticipating significant
growth
Undercapitalized < 4%* or
< 4% or
< 8%
*or < 3% if the bank is rated composite
1 and is not experiencing or
anticipating significant growth
Significantly
< 3% or
< 3% or
< 6%
Undercapitalized
Critically
Tangible equity capital ratio that is ≤
Undercapitalized 2%
Risk-Weight Calculations
The term recourse refers to the credit risk that a bank
organization retains in connection with the transfer of its
assets. Today, recourse arrangements frequently are also
associated with asset securitization programs. Depending
on the type of securitization transaction, the sponsor of a
securitization may provide a portion of the total credit
enhancement internally. When internal enhancements are
provided, the enhancements are residual interests for
regulatory capital purposes. Such residual interests are a
form of recourse. A residual interest is an on-balance sheet
asset created in an asset sale that exposes a bank to credit
risk in excess of its pro rata claim on the asset. Examples
of residual interests include credit-enhancing interest-only
strips receivable; spread accounts; cash collateral accounts;
retained subordinated interests; accrued but uncollected
interest on transferred assets that, when collected, will be
available to serve in a credit-enhancing capacity; and
similar on-balance sheet assets that function as a credit
enhancement.
Under the risk-based capital framework, a bank’s balance
sheet assets and credit equivalent amounts of off-balance
sheet items are generally assigned to one of four broad risk
categories (0, 20, 50, and 100 percent) according to the
obligor, or if relevant, the guarantor or the nature of the
collateral. At each bank’s option, assets and the credit
A seller may also arrange for a third party to provide credit
enhancement in an asset securitization. If the third-party
enhancement is provided by another banking organization,
that organization assumes some portion of the assets’ credit
risk. All arrangements in which a banking organization
assumes credit risk from third-party assets or other claims
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Federal Deposit Insurance Corporation
2.1-7
Capital (12-04)
CAPITAL
Section 2.1
that it has not transferred, are referred to as direct credit
substitutes.
The risk-based capital standards include a low-level
exposure rule, which states that if the maximum exposure
to loss retained or assumed by a bank in connection with a
recourse arrangement, a direct credit substitute, or a
residual interest, is less than the effective risk-based capital
requirement for the credit-enhanced assets (generally, four
percent for qualifying first lien 1-4 family residential
mortgages and eight percent for most other assets), the
risk-based capital requirement is limited to the bank's
maximum contractual exposure, less any recourse liability
account established in accordance with generally accepted
accounting principles. However, for residual interests
(other than credit-enhancing interest-only strips that have
been deducted from Tier 1 capital and assets) not eligible
for the ratings-based approach, a bank must maintain riskbased capital equal to the face amount of the residual
interest, even if the amount of risk-based capital required
to be maintained exceeds the full risk-based capital
requirement for the assets transferred. The effect of this
requirement is that, notwithstanding the low level exposure
rule, a bank must hold one dollar in total risk-based capital
against every dollar of the face amount of its residual
interests, which are not eligible for the ratings based
approach (a dollar-for-dollar capital requirement).
For a residual interest or other recourse exposure in a
securitization that qualifies for the ratings-based approach,
the required amount of risk-based capital is determined
based on its relative risk of loss. The face amount of the
position is multiplied by a risk weight that ranges from 20
percent to 200 percent, depending upon the ratings
assigned by one or more nationally recognized statistical
rating organizations and whether the position is traded.
Additionally, when certain banks engage in trading
activities, they must refer to Appendix C of Part 325 to
calculate their risk-based capital ratio, which incorporates
capital charges for certain market risks.
Note: Typically, any asset deducted from a bank’s capital
accounts when computing the numerator of the risk-based
capital ratio will also be excluded from risk-weighted
assets when calculating the denominator for the ratio.
Ratings-Based Approach
The risk-based capital guidelines include a ratings-based
approach that sets requirements for asset- and mortgagebacked securities and other positions in securitization
transactions (except credit-enhancing interest-only strips)
using credit ratings from nationally recognized statistical
rating organizations. (The ratings-based approach does
not apply to corporate bonds, municipal bonds, or other
debt securities that have been rated by a rating agency.) In
general, under the ratings-based approach, the risk-based
capital requirement is computed by multiplying the face
amount of the position by the risk-weight appropriate for
the external credit rating of the position as presented in the
Call Report Instructions. There is also specific guidance
for the regulatory capital treatment of recourse obligations,
direct credit substitutes, and residual interests in asset
securitizations.
When an examiner encounters these items (commonly
found in securitization and mortgage banking operations)
they should refer to the outstanding Financial Institution
Letters, the Call Report Instructions, and Part 325 of the
FDIC Rules and Regulations for more information.
Off-Balance Sheet Items
The risk-weighted amounts for all off-balance sheet items
are determined by a two-step process. First, the “credit
equivalent amount” is determined by multiplying the face
value or notional amount of the off-balance sheet item by a
credit conversion factor. Second, the credit equivalent
amount is assigned to the appropriate risk category, like
any other balance sheet asset.
Recourse and Direct Credit Substitutes
Enforcement of Capital Standards
A recourse obligation typically arises when an institution
transfers assets in a sale and retains an obligation to
repurchase the assets or absorb losses due to a default of
principal or interest or any other deficiency in the
performance of the underlying obligor or some other party.
Recourse may also exist implicitly where a bank provides
credit enhancement beyond any contractual obligation to
support assets it sold. In general, a bank must hold riskbased capital against the entire outstanding amount of
assets sold with recourse; however, there are some
exceptions to this general rule.
Capital (12-04)
The Statement of Policy on capital adequacy, which is
Appendix B to Part 325, provides some interpretational
and definitional guidance as to how the regulation will be
administered and enforced by the FDIC. Additionally, the
PCA provisions of Section 38 of the FDI Act and the
previously discussed Subpart B of Part 325 also provide
guidance regarding institutions with inadequate capital
levels.
Banks failing to meet the minimum leverage and/or riskbased capital ratios normally can expect to have any
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Section 2.1
application submitted to the FDIC denied (if such
application requires the FDIC to evaluate the adequacy of
the institution's capital structure) and also can expect to be
subject to the use of capital directives or other formal
enforcement action by the FDIC to increase capital.
Section 325.4(b) specifies that any bank that has less than
its minimum leverage capital requirement is deemed to be
engaging in an unsafe and unsound banking practice unless
it has submitted, and is in compliance with, a plan
approved by the FDIC to increase its Tier 1 leverage
capital ratio to a level that the FDIC deems appropriate.
Under the PCA regulations, a bank must file a written
capital restoration plan within 45 days of the date that the
bank receives notice or is deemed to have notice that the
bank is undercapitalized, significantly undercapitalized, or
critically undercapitalized, unless the FDIC notifies the
bank in writing that the plan is to be filed within a different
period.
Capital Adequacy
Capital adequacy in banks that have capital ratios at or
above the minimums will be assessed based on the
following factors.
Banks which are Fundamentally Sound and WellManaged
Written Agreements
The minimum leverage and risk-based capital ratios
generally will be viewed as the minimum acceptable
standards for banks whose overall financial condition is
fundamentally sound, which are well-managed, and which
have no material or significant financial weaknesses.
While the FDIC will make this determination in each case
based on the bank's own condition and specific
circumstances, the definition generally applies to those
banks evidencing a level of risk, which is no greater than
that normally associated with a Composite rating of “1” or
“2.”
Banks meeting this definition, which are in
compliance with the minimum capital requirements, will
not generally be required by the FDIC to raise new capital
from external sources.
Section 325.4(c) provides that any insured depository
institution with a Tier 1 capital to total assets ratio of less
than 2 percent must enter into and be in compliance with a
written agreement with the FDIC (or with its primary
Federal regulator with the FDIC as a party to the
agreement) to increase its Tier 1 leverage capital ratio to a
level that the FDIC deems appropriate or may be subject to
a Section 8(a) termination of insurance action by the FDIC.
Except in the very rarest of circumstances, the FDIC will
require that such agreements contemplate immediate
efforts by the depository institution to acquire the required
capital. The guidance in this section is not intended to
preclude the FDIC from taking Section 8(a) or other
enforcement action against any institution, regardless of its
capital level, if the specific circumstances deem such
action to be appropriate.
Problem Banks
Banks evidencing a level of risk at least as great as that
normally associated with a Composite rating of “3,” “4,” or
“5,” will be required to maintain capital higher than the
minimum regulatory requirement and at a level deemed
appropriate in relation to the degree of risk within the
institution. These higher capital levels should normally be
addressed through Memoranda of Understanding between
the FDIC and the bank or, in cases of more pronounced
risk, through the use of formal enforcement actions under
Section 8 of the FDI Act.
Regulatory Authority to Enforce Capital
Standards
The FDIC's authority to enforce capital standards in
operating banks includes the use of written agreements and
capital directives, as well as discretionary action in
connection with FDI Act Section 18 matters (capital
retirements, capital adjustments, branch bank applications,
and changes in location) and recourse to the enforcement
provisions of Section 8(a) and 8(b) of the FDI Act and the
PCA provisions in Section 38 of the FDI Act and FDIC's
Part 325 Regulation. A discussion on the use of these
powers is included in the Formal Administrative Actions
Section. Specific recommendations regarding capital
adequacy should not be made solely on the examiner's
initiative; coordination between the examiner and Regional
Director is essential in this often sensitive area. If the level
or trend of the bank's capital position is adverse, the matter
should be discussed with management with a comment
included in the examination report. It is particularly
Capital Requirements of Primary Regulator
Notwithstanding the above, all banks will be expected to
meet any capital requirements established by their primary
State or Federal regulator, which exceed the minimum
capital requirement set forth by regulation. The FDIC will
consult with the bank's primary State or Federal regulator
when establishing capital requirements higher than the
minimum set forth by regulation.
Capital Plans
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important that management’s plans to correct the capital
deficiency be accurately determined and noted in the
report, along with the examiner's assessment of the
feasibility and sufficiency of those plans.
of loans, fees, or service charges; upgrading credit
standards and administration to reduce loan or securities
losses, or through various other adjustments. An increase
in retained earnings will improve capital ratios assuming
the increase exceeds asset growth.
Disallowing the Use of Bankruptcy to Evade
Commitment to Maintain the Capital of a Federally
Insured Depository Institution
Sale of Additional Capital Stock
Sometimes increased earnings retention is insufficient to
address capital requirements and the sale of new equity
must be pursued. One adverse effect of this option is
shareholder dilution. If the sale of additional stock is a
consideration, examiners should indicate in the
examination report the sources from which such funds
might be obtained. This notation will be helpful as
background data for preliminary discussions with the State
banking supervisor on corrective programs to be developed
and serves to inform the Regional Director as to the
practical possibilities of new stock sales. The following
information could be incorporated into the report, at the
examiner's discretion:
Section 2522(c) of the Crime Control Act of 1990
amended the Bankruptcy Code to require that in Chapter
11 bankruptcy cases the trustee shall seek to immediately
cure any deficit under any commitment by a debtor to
maintain the capital of an insured depository institution.
Chapter 11 cases are those in which a debtor company
seeks to reorganize its debt. In addition, Section 2522(d)
provides an eighth priority in distribution for such
commitments. These provisions place the FDIC in a
strong, preferred position with respect to a debtor if a
commitment to maintain capital is present and the
institution is inadequately capitalized.
•
This provision will only be useful to the FDIC if
commitments to maintain capital can be obtained from
owners of institutions such as holding companies, or other
corporations or financial conglomerates. Examples of
situations where opportunities might exist include
situations where a prospective owner might be attempting
to mitigate a factor such as potential future risk to the
insurance funds or when the FDIC is providing assistance
to an acquirer. Also, in accordance with the PCA
provisions in Part 325, undercapitalized state nonmember
banks are required to file a capital plan with the FDIC and,
before such a capital plan can be accepted, any company
having control over the institution would need to guarantee
the bank's compliance with the plan. However, in any case,
a commitment to maintain capital should be considered
only as an additional enhancement and not as a substitute
for actual capital.
•
•
•
Any other data bearing upon the issue of raising new
capital, along with the examiner's opinions regarding the
most likely prospects for the sale of new equity, should be
included in the examination report. Obviously, the more
severe the capital deficiency, the more detailed these
background facts and circumstances need to be.
Increasing Capital in Operating Banks
To raise capital ratios, management of an institution must
increase capital levels and/or reduce asset growth to the
point that the capital formation rate exceeds asset growth.
The following is a description of alternatives available for
increasing the capital level in banks.
Reduce Asset Growth
Bank management may also increase capital ratios by
reducing asset growth to a level below that of capital
formation. Some institutions will respond to supervisory
concerns regarding the bank's capitalization level by
attempting to reduce the institution's total assets.
Sometimes this intentional asset shrinkage will be
accomplished by disposing of short-term, marketable assets
and allowing volatile liabilities to run off. This reduction
results in a relatively higher capital-to-assets ratio, but it
Increased Earnings Retention
Management may attempt to increase earnings retention
through a combination of higher earnings and lower cash
dividend rates. Earnings may be improved, for example,
by tighter controls over certain expense outlays; repricing
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A complete list of present shareholders, indicating
amounts of stock held and their financial worth,
insofar as available.
Small holdings may be
aggregated if a complete listing is impractical.
Information concerning individual directors relative to
their capacity and willingness to purchase stock.
A list of prominent customers and depositors who are
not shareholders, but who might possibly be interested
in acquiring stock.
A list of other individuals or possible sources of
support in the community who, because of known
wealth or for other reasons, might desire to subscribe
to new stock.
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may leave the bank with a strained liquidity posture.
Therefore, it is a strategy that can have adverse
consequences from a safety and soundness perspective and
examiners should be alert to the possible impact this
strategy could have in banks that are experiencing capital
adequacy problems.
the examination process and this analysis is important in
the assessment of the capital rating. Examiners should
consider the degree of off-balance sheet risk in their
analysis of the bank's overall capital adequacy and the
determination of compliance with Part 325 of the FDIC
Rules and Regulations. Part 325 does not explicitly
include off-balance sheet activities in the leverage capital
calculations, but it does indicate that off-balance sheet risk
is one of the factors that will be considered in determining
whether a higher minimum amount of capital should be
required for any particular bank. Off-balance sheet risks
are explicitly included in the risk-based capital
calculations. The total dollar amount of all contingent
liabilities is included in the memorandum section of the
Capital Calculations schedule of the examination report.
CONTINGENT LIABILITIES
Contingent liabilities may be described as potential claims
on bank assets for which any actual or direct liability is
contingent upon some future event or circumstance. For
examination purposes, contingent liabilities are divided
into two general categories: Category I and Category II.
Category I contingent liabilities are those that will result in
a concomitant increase in bank assets if the contingencies
convert to actual liabilities. These contingencies usually
result from off-balance sheet lending activities such as loan
commitments and letters of credit. When a bank is
required to fund a loan commitment or honor a draft drawn
on a letter of credit, it generally originates a loan for the
amount of liability incurred. Additional information on
off-balance sheet lending activities is contained in the OffBalance Sheet Activities section of this Manual.
A distinction is made between Category I and Category II
contingent liabilities in determining adjustments to be
made to capital. The examination procedures for adversely
classified Category I contingent liabilities are described
under the heading for Adversely Classified Contingent
Liabilities in the Off-Balance Sheet Activities section,
while procedures for Category II contingencies are
included below under the heading for Potential and
Estimated Losses in Contingent Liabilities.
Potential and Estimated Losses in Contingent
Liabilities
Category II contingent liabilities include those in which a
claim on assets arises without an equivalent increase in
assets. Common examples of this category are pending
litigation in which the bank is defendant and contingent
liabilities arising from trust operations.
As described above, Category I contingent liabilities are
defined as those which will give rise to a concomitant
increase in bank assets if the contingencies convert into
actual liabilities. Such contingencies should be evaluated
for credit risk and, if appropriate, listed for Special
Mention or subjected to adverse classification. If a
Category I contingent liability is classified Loss, it would
be included in the Assets Other Than Loans & Leases
Classified Loss category on the Capital Calculations page.
This examination treatment does not apply to Category II
contingent liabilities since there is no equivalent increase
in assets if a contingency becomes a direct liability.
Examination Policies
Examination interest in contingent liabilities is predicated
upon an evaluation of the impact contingencies may have
on a bank's condition. Contingent liabilities that are
significant in amount and/or have a high probability of
becoming direct liabilities must be considered when the
bank's component ratings are assigned. The amount of
contingent liabilities and the extent to which they may be
funded must be considered in the analysis of liquidity, for
example. Determination of the management component
may appropriately include consideration of contingencies,
particularly off-balance sheet lending practices.
Contingent liabilities arising from off-balance sheet fee
producing activities have increased in significance as a
means of enhancing bank earnings. In rating earnings, the
impact of this type of fee income should be analyzed with
consideration given to the present amount, quality, and
expected future level.
A bank's exposure to Category II contingent liabilities
normally depends solely on the probability of the
contingencies becoming direct liabilities. To reflect the
degree of likelihood that a contingency may result in a
charge to the capital accounts, the terms Potential Loss and
Estimated Loss are used. A loss contingency is an existing
condition, situation, or set of circumstances that involves
uncertainty as to possible loss that will be resolved when
one or more future events occur or fail to occur. Potential
Loss refers to contingent liabilities in which there is
substantial and material risk of loss to the bank. An
Estimated Loss from a loss contingency (for example,
The extent to which contingent liabilities may ultimately
result in charges against capital accounts is always part of
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Section 2.1
pending or threatened litigation) should be recognized if it
is probable that an asset has been impaired or a liability
incurred as of the examination date and the amount of the
loss can be reasonably estimated. For further information,
examiners should refer to Statement of Financial
Accounting Standards No. 5 (FAS 5) Accounting for
Contingencies.
Trust Activities
Contingent liabilities may develop within the trust
department from actions or inactions on the part of the
bank in its fiduciary capacity. These contingencies may
arise from failure to abide by governing instruments, court
orders, generally accepted fiduciary standards, or
controlling statutes and regulations.
Deficiencies in
administration by the trust department can lead to lawsuits,
surcharges, or other penalties, which must be absorbed by
the bank's capital accounts. Therefore, the dollar volume
and severity of such contingencies must be analyzed during
the safety and soundness examination.
For further
information refer to the Trust Examination Manual.
The memorandum section of the Capital Calculations page
includes the dollar amount of Category II contingent
liabilities, as well as the Category I contingencies. Any
Potential Loss identified is also reflected in the
memorandum section and only refers to Category II
contingent liabilities. Estimated Losses related to Category
II contingent liabilities are reflected in this schedule as
adjustments to capital by including them in the Other
Adjustments to (from) Tier 1 capital line item. Estimated
Losses are not included as adjustments to assets.
Consigned Items and Other Nonledger Control
Accounts
Banks often provide a large number of customer services
that normally do not result in transactions subject to entry
on the general ledger. These customer services include
safekeeping, rental of safe deposit box facilities, purchase
and sale of investments for customers, sale of traveler's
checks, sale of United States Savings Bonds, and collection
department services. It is management’s responsibility to
ensure that collateral and other nonledger items are
properly recorded and protected by effective custodial
controls. Proper insurance protection must be obtained to
protect against claims arising from mishandling,
negligence, mysterious disappearance, or other unforeseen
occurrences. Failure to take protective steps may lead to
contingent liabilities. The following is a brief description
of customer service activities involving consigned items.
Common Forms of Contingent Liabilities
It is impossible to enumerate all the types and
characteristics of contingent liabilities encountered in bank
examinations. Some of the more common ones are
discussed below. In all cases, the examiner's fundamental
objectives are to ascertain the likelihood that such
contingencies may result in losses to the bank and assess
the pending impact on the financial condition.
Litigation
If the bank is involved in a lawsuit where the outcome may
impact the bank’s financial condition, the examiner should
include the facts in the examination report. Comments
should address the essential points upon which the suit is
based, the total dollar amount of the plaintiff's claim, the
basis of the bank's defense, the status of any negotiations
toward a compromise settlement, and the opinion of bank
management and/or counsel relative to the probability of a
successful defense.
In addition, corroboration of
information and opinions provided by bank management
regarding significant lawsuits should be obtained from the
bank's legal counsel.
At the examiner's discretion,
reference to suits that are small or otherwise of no
consequence may be omitted from the examination report.
Customer Safekeeping
Determination of Potential or Estimated Losses in
connection with lawsuits is often difficult. There may be
occasions where damages sought are of such magnitude
that, if the bank is unsuccessful in its defense, it could be
rendered insolvent. In such instances, examiners should
consult their Regional Office for guidance. All Potential
and Estimated Losses must be substantiated by comments
detailing the specific reasons leading to the conclusion.
Capital (12-04)
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2.1-12
•
Safe Deposit Boxes - The bank and customer enter into
a contract whereby the bank receives a fee for renting
safe deposit boxes and assumes responsibility of
exercising reasonable care and precaution against loss
of the box's contents. When a loss does occur, unless
the bank can demonstrate that it employed "reasonably
prudent" care, it could be held liable. Safe deposit
box access should be granted only after verifying the
lessee's signature at each visit. The bank generally
cannot gain access to a customer's safe deposit box
except as allowed under certain statutes and/or court
orders.
•
Safekeeping - In addition to items held as collateral for
loans, banks occasionally hold customers' valuables.
Banks should attempt to discourage this practice by
emphasizing the benefits of a safe deposit box, but
when not possible or practical to do so, the same
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procedures employed in handling loan collateral must
be followed.
•
combined Director and Officer Liability insurance,
Financial Institution Bond, and such other coverages
written by Progressive." No funds are actually placed with
or transferred to ABPFIC when a Reserve Premium
Account is established. Rather, a bank can satisfy this
"deposit" requirement by pledging or otherwise earmarking
specific bank assets for this purpose.
Custodial Accounts - Banks may act as custodian for
customers' investments such as stocks, bonds, or gold.
When serving as custodian, the bank has only the
duties of safekeeping the property involved and
performing ministerial acts as directed by the
principal. As a rule, no management or advisory
duties are exercised. Before providing such services,
the bank should seek advice of legal counsel
concerning applicable State and Federal laws
governing this type of relationship. In addition, use of
signed agreements or contracts, which clearly define
the bank’s duties and responsibilities and the functions
it is to perform, is a vitally important first step in
limiting potential liability.
Unless ABPFIC makes a demand for payment from
Reserve Premium Accounts to cover losses, the assets in
such accounts remain bank assets and any associated
earnings are the banks’. Any demand for payment would
reportedly be made on a pro rata basis to all banks that
must maintain a Reserve Premium Account. Establishing a
Reserve Premium Account results in a Category II
contingent liability equal to the bank's "deposit" into the
account.
Under FAS 5 a bank would accrue an estimated loss from
the contingent liability resulting from having entered into a
Reserve Premium Account Agreement with ABPFIC when
and if available information indicates that (1) it is probable
that ABPFIC will make a demand for payment from the
account and (2) the amount of the payment can be
reasonably estimated.
The asset used to satisfy the Reserve Premium Account
requirement should be shown in the proper balance sheet
category and considered a pledged asset. If a bank pledged
or otherwise earmarked any "short term and marketable
assets" (e.g., securities) for its Reserve Premium Account,
the amount of the bank's contingent liability should be
reflected in management’s internal liquidity analysis since
the assets used to satisfy Reserve requirement are not
available to meet liquidity needs.
Collection Items
The collection department may act as an agent for others in
receiving, collecting, and liquidating items.
In
consideration for this service, a fee is generally received.
An audit trail must be in place to substantiate proper
handling of all items to reduce the bank's potential liability.
Consigned Items
These typically include traveler's checks and United States
Savings Bonds. Banks share a fee with the consignor of
traveler's checks. Savings Bond proceeds are retained until
remitted to the Federal Reserve. A working supply is
generally maintained at the selling station(s) and the
reserve supply should be maintained under dual control in
the bank's vault.
Reserve Premium Accounts
EVALUATION OF A BANK'S CAPITAL
ADEQUACY
The American Bankers Association (ABA) sponsored the
creation of the American Bankers Professional and Fidelity
Insurance Company Ltd. (ABPFIC). The ABPFIC is a
mutual insurance company that reinsures a portion of
Progressive Company's directors and officers liability and
fidelity bond insurance programs, which are available to
banks that are ABA members. Banks that obtain insurance
coverage from Progressive become members of ABPFIC.
As a mutual reinsurance company, ABPFIC established a
mechanism (a Reserve Premium Account) by which its
members are required to provide additional funds to
ABPFIC to cover losses.
Banks are expected to meet any capital requirements
properly established by its primary State or Federal
regulator, which exceed the minimum capital requirement
set forth in the regulation. Once these minimum capital
requirements are met, the evaluation of capital adequacy
extends to factors that require a combination of analysis
and judgment. Banks are too dissimilar to permit use of
standards based on one or only a few criteria. Generally, a
financial institution is expected to maintain capital
commensurate with the nature and extent of risks to the
institution and the ability of management to identify,
measure, monitor, and control these risks.
The "Reserve Premium Account Agreement" between the
bank and the ABPFIC provides for the bank "to deposit
into the Account an amount equal to the insurance
premiums quoted by Progressive for the bank's first year
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It is important to note that what is adequate capital for
safety and soundness purposes may differ significantly
2.1-13
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CAPITAL
Section 2.1
from minimum leverage and risk-based standards and the
"Well Capitalized" and "Adequately Capitalized"
definitions that are used in the PCA regulations and certain
other capital-based rules. The minimums set forth in the
leverage and risk-based capital standards apply to sound,
well-run institutions. Most banks do, and generally are
expected to, maintain capital levels above the minimums,
based on the institution's particular risk profile. In all
cases, institutions should maintain capital commensurate
with the level and nature of risks to which they are
exposed, including the volume and severity of adversely
classified assets.
problem assets will require a careful analysis of
examination findings. The examiner may find the optional
Analysis of Loans Subject to Adverse Classification page
of the Report helpful in performing this analysis. In
reviewing the ALLL adequacy, the examiner will review
the bank’s ALLL methodology in accordance with
outstanding regulatory and accounting pronouncements.
The capital adequacy of an institution is rated based upon,
but not limited to, an assessment of the following
evaluation factors:
The quality, type, and diversification of on- and offbalance sheet items are important with respect to the
review of capital adequacy. Examiners should ensure that
management identifies, measures, monitors, and controls
the balance sheet risks and that the economic substance of
the risks are recognized and appropriately managed. Riskweighted capital ratios will help the examiner to a degree,
but judgment is required to adequately address capital
adequacy. Specifically, a portfolio of 100 percent riskweighted commercial loans at two different institutions
may have different risk characteristics depending on the
risk tolerance of the management teams. Additionally,
regulatory capital ratios alone do not account for
concentration risk, market risk, or risks associated with
nontraditional activities on the balance sheet. Examiner
judgment is integral in assessing both the level of risk and
management’s ability to adequately manage such risk.
Balance Sheet Composition, Including the Nature and
Amount of Intangible Assets, Market Risk,
Concentration Risk, and Risks Associated with
Nontraditional Activities
The Level and Quality of Capital and the Overall
Financial Condition of the Institution
Capital, like all of the CAMELS components, cannot be
reviewed in a vacuum. The institution’s overall condition
is vitally important to the assessment of capital adequacy.
Asset quality problems can quickly deplete capital. Poor
earnings performance can hinder internal capital formation.
Examiner judgment is required to review capital adequacy
in relation to the institution’s overall condition.
Additionally, all capital is not created equally. While two
institutions may have very similar regulatory capital ratios,
the composition of such capital is important. For instance,
all things being equal, voting common equity is a preferred
capital source compared to hybrid capital instruments
given the debt-like features inherent in the latter.
Risk Exposure Represented By Off-Balance Sheet
Activities
The risk exposure from off-balance sheet activities will
vary between institutions, but must be considered in the
capital evaluation. The volume and nature of business
transacted in a fiduciary capacity can be significant in the
assessment of capital needs. Contingencies where the bank
is acting in a fiduciary or nontraditional banking capacity
can expose the bank to surcharges and therefore,
operations, controls, and potential exposures must be
carefully appraised. Similarly, lawsuits involving the bank
as defendant or any other contingent liability, such as offbalance sheet lending, may indicate a need for a greater
level of capital protection. Refer to the Contingent
Liabilities and Off-Balance Sheet Activities sections for
additional discussion.
The Ability of Management to Address Emerging
Needs for Additional Capital
Management’s ability to address emerging needs for
additional capital depends on many factors. A few of these
factors include earnings performance and growth
prospects, the financial capacity of the directorate, and the
strength of a holding company. A combination of ratio
analysis and examiner judgment is required to address this
evaluation factor.
The Nature, Trend, and Volume of Problem Assets, and
the Adequacy of the ALLL and Other Valuation
Reserves
The nature, trend, and volume of problem assets (including
off-balance sheet activity) and the ALLL adequacy are
vital factors in determining capital adequacy.
The
examiner should reference prior Reports of Examination
and Uniform Bank Performance Report ratios to perform a
level and trend analysis. The review of the nature of
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The Quality and Strength of Earnings, and the
Reasonableness of Dividends
A bank's current and historical earnings record is one of the
key elements to consider when assessing capital adequacy.
Good earnings performance enables a bank to fund asset
2.1-14
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Section 2.1
growth and remain competitive in the marketplace while at
the same time retaining sufficient equity to maintain a
strong capital position. The institution's dividend policy is
also of importance. Excessive dividends can negate even
exceptional earnings performance and result in a weakened
capital position, while an excessively low dividend return
lowers the attractiveness of the stock to investors, which
can be a detriment should the bank need to raise additional
equity. Generally, earnings should first be applied to the
elimination of losses and the establishment of necessary
reserves and prudent capital levels. Thereafter, dividends
can be disbursed in reasonable amounts. Refer to the
Earnings section for additional discussion on the subject.
guidelines that have been discussed throughout this
Section. The rating scheme itself is based on a scale of "1"
through "5." Banks with capital ratings of "1" or "2" are
considered to presently have adequate capital and are
expected to continue to maintain adequate capital in future
periods. Although both have adequate capital, "1" rated
banks will generally have capital ratios that exceed ratios
in "2" rated banks and/or their qualitative and quantitative
factors will be such that a lower capital level is acceptable.
A "3" rating should be assigned when the relationship of
the capital structure to the various qualitative and
quantitative factors comprising the analysis is adverse, or is
expected to become adverse in the relatively near future
(12 to 24 months) even after giving weight to management
as a mitigating factor. Banks rated "4" or "5" are clearly
inadequately capitalized, the latter representing a situation
of such gravity as to threaten viability and solvency.
Prospects and Plans for Growth, as well as Past
Experience in Managing Growth
Management’s ability to adequately plan for and manage
growth is important with respect to assessing capital
adequacy. A review of past performance and future
prospects would be a good starting point for this review.
The examiner may want to compare asset growth to capital
formation during recent periods. The examiner may also
want to review the current budget and strategic plan to
review growth plans. Through this analysis, the examiner
will be able to assess management’s ability to both forecast
and manage growth.
Uniform Financial Institution Rating System
A financial institution is expected to maintain capital
commensurate with the nature and extent of risks to the
institution and the ability of management to identify,
measure, monitor, and control these risks. The effect of
credit, market, and other risks on the institution’s financial
condition should be considered when evaluating the
adequacy of capital. The types and quantity of risk
inherent in an institution's activities will determine the
extent to which it may be necessary to maintain capital at
levels above required regulatory minimums to properly
reflect the potentially adverse consequences that these risks
may have on the institution's capital. The capital adequacy
of an institution is rated based upon, but not limited to, an
assessment of the following evaluation factors:
Access to Capital Markets and Other Sources of
Capital, Including Support Provided by a Parent
Holding Company
Management’s access to capital sources, including holding
company support is a vital factor in analyzing capital. If
management has ample access to capital on reasonable
terms, the institution may be able to operate with less
capital than an institution without such access. Also, the
strength of a holding company will factor into capital
requirements. If a holding company previously borrowed
funds to purchase newly issued stock of a subsidiary bank
(a process referred to as double leverage), the holding
company may be less able to provide additional capital.
The examiner would need to extend beyond ratio analysis
of the bank to assess management’s access to capital
sources.
•
•
•
•
•
RATING THE CAPITAL FACTOR
•
Adequacy of the capital base is one of the elements that
must be evaluated to arrive at a composite rating in
accordance with the Uniform Financial Institutions Rating
System. This determination is a judgmental process and
necessitates that the examiner take into account all of the
subjective and objective variables, concepts, and
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Federal Deposit Insurance Corporation
•
•
2.1-15
The level and quality of capital and the overall
financial condition of the institution.
The ability of management to address emerging needs
for additional capital.
The nature, trend, and volume of problem assets, and
the adequacy of allowances for loan and lease losses
and other valuation reserves.
Balance sheet composition, including the nature and
amount of intangible assets, market risk, concentration
risk, and risks associated with nontraditional activities.
Risk exposure represented by off-balance sheet
activities.
The quality and strength of earnings, and the
reasonableness of dividends.
Prospects and plans for growth, as well as past
experience in managing growth.
Access to capital markets and other sources of capital,
including support provided by a parent holding
company.
Capital (12-04)
CAPITAL
Section 2.1
Ratings
A rating of 1 indicates a strong capital level relative to the
institution’s risk profile.
A rating of 2 indicates a satisfactory capital level relative
to the financial institution’s risk profile.
A rating of 3 indicates a less than satisfactory level of
capital that does not fully support the institution's risk
profile. The rating indicates a need for improvement, even
if the institution's capital level exceeds minimum
regulatory and statutory requirements.
A rating of 4 indicates a deficient level of capital. In light
of the institution’s risk profile, viability of the institution
may be threatened. Assistance from shareholders or other
external sources of financial support may be required.
A rating of 5 indicates a critically deficient level of capital
such that the institution's viability is threatened. Immediate
assistance from shareholders or other external sources of
financial support is required.
Capital (12-04)
Policies
2.1-16
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Federal Deposit Insurance Corporation
ASSET QUALITY
Section 3.1
INTRODUCTION..............................................................2
EVALUATION OF ASSET QUALITY ............................2
RATING THE ASSET QUALITY FACTOR....................2
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3.1-1
Asset Quality (3/12)
ASSET QUALITY
Section 3.1
INTRODUCTION
Asset quality is one of the most critical areas in determining
the overall condition of a bank. The primary factor affecting
overall asset quality is the quality of the loan portfolio and
the credit administration program. Loans typically comprise
a majority of a bank's assets and carry the greatest amount of
risk to their capital. Securities may also comprise a large
portion of the assets and also contain significant risks. Other
items which can impact asset quality are other real estate,
other assets, off-balance sheet items and, to a lesser extent,
cash and due from accounts, and premises and fixed assets.
Management often expends significant time, energy, and
resources administering their assets, particularly the loan
portfolio. Problems within this portfolio can detract from
their ability to successfully and profitably manage other areas
of the institution. Examiners should be diligent and focused
when reviewing a bank's assets, as they can significantly
impact most other facets of bank operations.
EVALUATION OF ASSET QUALITY
When assigning component ratings, the above factors, among
others, should be evaluated not only according to current
adverse classification levels and risk management practices,
but also considering any ongoing trends. The same
classification levels and management practices might be
looked on more or less favorably depending on any
improving or deteriorating trends in one or more factors. The
examiner should never look at things in a vacuum, instead,
noting how the current level or status of each factor relates to
previous and expected performance and the performance of
other similar institutions.
The asset quality rating reflects the quantity of existing and
potential credit risk associated with the loan and investment
portfolios, other real estate owned, and other assets, as well
as off-balance sheet transactions. The ability of management
to identify and manage credit risk is also reflected here. The
evaluation of asset quality should consider the adequacy of
the Allowance for Loan and Lease Losses (ALLL) and weigh
the exposure to counter-party, issuer, or borrower default
under actual or implied contractual agreements. All other
risks that may affect the value or marketability of an
institution's assets, including, but not limited to, operating,
market, reputation, strategic, or compliance risks, should also
be considered.
RATING THE ASSET QUALITY FACTOR
The asset quality rating definitions are applied following a
thorough evaluation of existing and potential risks and the
mitigation of those risks. The definitions of each rating
follow.
Prior to assigning an asset quality rating, several factors
should be considered. The factors should be reviewed within
the context of any local and regional conditions that might
impact bank performance. Also, any systemic weaknesses,
as opposed to isolated problems, should be given appropriate
consideration. The following is not a complete list of all
possible factors that may influence an examiner’s
assessment; however, all assessments should consider the
following:
A rating of 1 indicates strong asset quality and credit
administration practices. Identified weaknesses are minor in
nature and risk exposure is modest in relation to capital
protection and management’s abilities. Asset quality in such
institutions is of minimal supervisory concern.
A rating of 2 indicates satisfactory asset quality and credit
administration practices.
The level and severity of
classifications and other weaknesses warrant a limited level
of supervisory attention. Risk exposure is commensurate
with capital protection and management’s abilities.
The adequacy of underwriting standards, soundness of
credit administration practices, and appropriateness of
risk identification practices.
The level, distribution, severity, and trend of problem,
classified, nonaccrual, restructured, delinquent, and
Asset Quality (3/12)
nonperforming assets for both on- and off-balance sheet
transactions.
The adequacy of the ALLL and other asset valuation
reserves.
The credit risk arising from or reduced by off-balance
sheet transactions, such as unfunded commitments,
credit derivatives, commercial and standby letters of
credit, and lines of credit.
The diversification and quality of the loan and
investment portfolios.
The extent of securities underwriting activities and
exposure to counter-parties in trading activities.
The existence of asset concentrations.
The adequacy of loan and investment policies,
procedures, and practices.
The ability of management to properly administer its
assets, including the timely identification and collection
of problem assets.
The adequacy of internal controls and management
information systems.
The volume and nature of credit documentation
exceptions.
3.1-2
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ASSET QUALITY
Section 3.1
A rating of 3 is assigned when asset quality or credit
administration practices are less than satisfactory. Trends
may be stable or indicate deterioration in asset quality or an
increase in risk exposure. The level and severity of classified
assets, other weaknesses, and risks require an elevated level
of supervisory concern. There is generally a need to improve
credit administration and risk management practices.
A rating of 4 is assigned to financial institutions with
deficient asset quality or credit administration practices. The
levels of risk and problem assets are significant, inadequately
controlled, and subject the financial institution to potential
losses that, if left unchecked, may threaten its viability.
A rating of 5 represents critically deficient asset quality or
credit administration practices that present an imminent
threat to the institution's viability.
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3.1-3
Asset Quality (3/12)
LOANS
Section 3.2
however, certain broad areas of consideration and concern
that should be addressed in the lending policies of all banks
regardless of size or location. These include the following,
as minimums:
INTRODUCTION
The examiner’s evaluation of a bank’s lending policies,
credit administration, and the quality of the loan portfolio
is among the most important aspects of the examination
process. To a great extent, it is the quality of a bank's loan
portfolio that determines the risk to depositors and to the
FDIC's insurance fund. Conclusions regarding the bank’s
condition and the quality of its management are weighted
heavily by the examiner's findings with regard to lending
practices. Emphasis on review and appraisal of the loan
portfolio and its administration by bank management
during examinations recognizes, that loans comprise a
major portion of most bank’s assets; and, that it is the asset
category which ordinarily presents the greatest credit risk
and potential loss exposure to banks. Moreover, pressure
for increased profitability, liquidity considerations, and a
vastly more complex society have produced great
innovations in credit instruments and approaches to
lending. Loans have consequently become much more
complex. Examiners therefore find it necessary to devote a
large portion of time and attention to loan portfolio
examination.
•
•
•
•
•
•
•
•
•
•
LOAN ADMINISTRATION
Lending Policies
•
The examiner's evaluation of the loan portfolio involves
much more than merely appraising individual loans.
Prudent management and administration of the overall loan
account, including establishment of sound lending and
collection policies, are of vital importance if the bank is to
be continuously operated in an acceptable manner.
•
•
•
Lending policies should be clearly defined and set forth in
such a manner as to provide effective supervision by the
directors and senior officers. The board of directors of
every bank has the legal responsibility to formulate lending
policies and to supervise their implementation. Therefore
examiners
should
encourage
establishment
and
maintenance of written, up-to-date lending policies which
have been approved by the board of directors. A lending
policy should not be a static document, but must be
reviewed periodically and revised in light of changing
circumstances surrounding the borrowing needs of the
bank's customers as well as changes that may occur within
the bank itself. To a large extent, the economy of the
community served by the bank dictates the composition of
the loan portfolio. The widely divergent circumstances of
regional economies and the considerable variance in
characteristics of individual loans preclude establishment
of standard or universal lending policies. There are,
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Federal Deposit Insurance Corporation
•
•
•
General fields of lending in which the bank will
engage and the kinds or types of loans within each
general field;
Lending authority of each loan officer;
Lending authority of a loan or executive committee, if
any;
Responsibility of the board of directors in reviewing,
ratifying, or approving loans;
Guidelines under which unsecured loans will be
granted;
Guidelines for rates of interest and the terms of
repayment for secured and unsecured loans;
Limitations on the amount advanced in relation to the
value of the collateral and the documentation required
by the bank for each type of secured loan;
Guidelines for obtaining and reviewing real estate
appraisals as well as for ordering reappraisals, when
needed;
Maintenance and review of complete and current
credit files on each borrower;
Appropriate and adequate collection procedures
including, but not limited to, actions to be taken
against borrowers who fail to make timely payments;
Limitations on the maximum volume of loans in
relation to total assets;
Limitations on the extension of credit through
overdrafts;
Description of the bank's normal trade area and
circumstances under which the bank may extend credit
outside of such area;
Guidelines, which at a minimum, address the goals for
portfolio mix and risk diversification and cover the
bank's plans for monitoring and taking appropriate
corrective action, if deemed necessary, on any
concentrations that may exist;
Guidelines addressing the bank's loan review and
grading system ("Watch list");
Guidelines addressing the bank's review of the
Allowance for Loan and Lease Losses (ALLL); and
Guidelines for adequate safeguards to minimize
potential environmental liability.
The above are only as guidelines for areas that should be
considered during the loan policy evaluation. Examiners
should also encourage management to develop specific
guidelines for each lending department or function. As
with overall lending policies, it is not the FDIC's intent to
suggest universal or standard loan policies for specific
types of credit. The establishment of these policies is the
3.2-1
Loans (12-04)
LOANS
Section 3.2
responsibility of each bank's Board and management.
Therefore, the following discussion of basic principles
applicable to various types of credit will not include or
allude to acceptable ratios, levels, comparisons or terms.
These matters should, however, be addressed in each
bank's lending policy, and it will be the examiner's
responsibility to determine whether the policies are
realistic and being followed.
Accurate and timely credit grading is a primary component
of an effective loan review system. Credit grading
involves an assessment of credit quality, the identification
of problem loans, and the assignment of risk ratings. An
effective system provides information for use in
establishing valuation allowances for specific credits and
for the determination of an overall ALLL level.
Much of the rest of this section of the Manual discusses
areas that should be considered in the bank's lending
policies. Guidelines for their consideration are discussed
under the appropriate areas.
Credit grading systems often place primary reliance on
loan officers for identifying emerging credit problems.
However, given the importance and subjective nature of
credit grading, a loan officer’s judgement regarding the
assignment of a particular credit grade should generally be
subject to review. Reviews may be performed by peers,
superiors, loan committee(s), or other internal or external
credit review specialists.
Credit grading reviews
performed by individuals independent of the lending
function are preferred because they can often provide a
more objective assessment of credit quality. A loan review
system should, at a minimum, include the following:
Loan Review Systems
The term loan review system refers to the responsibilities
assigned to various areas such as credit underwriting, loan
administration, problem loan workout, or other areas.
Responsibilities may include assigning initial credit grades,
ensuring grade changes are made when needed, or
compiling information necessary to assess ALLL.
•
The complexity and scope of a loan review system will
vary based upon an institution’s size, type of operations,
and management practices.
Systems may include
components that are independent of the lending function,
or may place some reliance on loan officers. Although
smaller institutions are not expected to maintain separate
loan review departments, it is essential that all institutions
have an effective loan review system. Regardless of its
complexity, an effective loan review system is generally
designed to address the following objectives:
•
•
•
•
•
•
•
•
•
•
A formal credit grading system that can be reconciled
with the framework used by Federal regulatory
agencies;
An identification of loans or loan pools that warrant
special attention;
A mechanism for reporting identified loans, and any
corrective action taken, to senior management and the
board of directors; and
Documentation of an institution’s credit loss
experience for various components of the loan and
lease portfolio.
Loan Review System Elements
To promptly identify loans with well-defined credit
weaknesses so that timely action can be taken to
minimize credit loss;
To provide essential information for determining the
adequacy of the ALLL;
To identify relevant trends affecting the collectibility
of the loan portfolio and isolate potential problem
areas;
To evaluate the activities of lending personnel;
To assess the adequacy of, and adherence to, loan
policies and procedures, and to monitor compliance
with relevant laws and regulations;
To provide the board of directors and senior
management with an objective assessment of the
overall portfolio quality; and
To provide management with information related to
credit quality that can be used for financial and
regulatory reporting purposes.
Management should maintain a written loan review policy
that is reviewed and approved at least annually by the
board of directors. Policy guidelines should include a
written description of the overall credit grading process,
and establish responsibilities for the various loan review
functions.
The policy should generally address the
following items:
•
•
•
•
•
•
•
Qualifications of loan review personnel;
Independence of loan review personnel;
Frequency of reviews;
Scope of reviews;
Depth of reviews;
Review of findings and follow-up; and
Workpaper and report distribution.
Credit Grading Systems
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3.2-2
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LOANS
Section 3.2
Qualifications of Loan Review Personnel
repayment factors. The percentage of the portfolio
selected for review should provide reasonable assurance
that all major credit risks have been identified.
Personnel involved in the loan review function should be
qualified based on level of education, experience, and
extent of formal training. They should be knowledgeable
of both sound lending practices and their own institution’s
specific lending guidelines. In addition, they should be
knowledgeable of pertinent laws and regulations that affect
lending activities.
Depth of Reviews
Loan reviews should analyze a number of important credit
factors, including:
•
•
•
•
•
•
Loan Review Personnel Independence
Loan officers should be responsible for ongoing credit
analysis and the prompt identification of emerging
problems.
Because of their frequent contact with
borrowers, loan officers can usually identify potential
problems before they become apparent to others.
However, institutions should be careful to avoid over
reliance upon loan officers. Management should ensure
that, when feasible, all significant loans are reviewed by
individuals that are not part of, or influenced by anyone
associated with, the loan approval process.
•
Review of Findings and Follow-up
Loan review findings should be reviewed with appropriate
loan officers, department managers, and members of senior
management. Any existing or planned corrective action
(including estimated timeframes) should be obtained for all
noted deficiencies. All deficiencies that remain unresolved
should be reported to senior management and the board of
directors.
Larger institutions typically establish separate loan review
departments staffed by independent credit analysts. Cost
and volume considerations may not justify such a system in
smaller institutions.
Often, members of senior
management that are independent of the credit
administration process, a committee of outside directors, or
an outside loan review consultant fill this role. Regardless
of the method used, loan review personnel should report
their findings directly to the board of directors or a board
committee.
Workpaper and Report Distribution
A list of the loans reviewed, including the review date, and
documentation supporting assigned ratings should be
prepared. A report that summarizes the results of the
review should be submitted to the board at least quarterly.
Findings should address adherence to internal policies and
procedures, and applicable laws and regulations, so that
deficiencies can be remedied in a timely manner. A written
response from management with corrective action outlined,
should be provided in response to any substantive
criticisms or recommendations.
Frequency of Reviews
The loan review function should provide feedback on the
effectiveness of the lending process in identifying
emerging problems. Reviews of significant credits should
generally be performed annually, upon renewal, or more
frequently when factors indicate a potential for
deteriorating credit quality. A system of periodic reviews
is particularly important to the ALLL determination
process.
Allowance for Loan and Lease Losses (ALLL)
Each bank must maintain an ALLL adequate to absorb
estimated credit losses associated with the loan and lease
portfolio, i.e., loans and leases that the bank has the intent
and ability to hold for the foreseeable future or until
maturity or payoff. Each bank should also maintain, as a
separate liability account, an allowance sufficient to absorb
estimated credit losses associated with off-balance sheet
credit instruments such as off-balance sheet loan
commitments, standby letters of credit, and guarantees.
This separate allowance for credit losses on off-balance
Scope of Reviews
Reviews should cover all loans that are considered
significant. In addition to loans over a predetermined size,
management will normally review smaller loans that
present elevated risk characteristics such as credits that are
delinquent, on nonaccrual status, restructured, previously
classified, or designated as Special Mention. Additionally,
management may wish to periodically review insider loans,
recently renewed credits, or loans affected by common
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Credit quality;
Sufficiency of credit and collateral documentation;
Proper lien perfection;
Proper loan approval;
Adherence to loan covenants;
Compliance with internal policies and procedures, and
applicable laws and regulations; and
The accuracy and timeliness of credit grades assigned
by loan officers.
3.2-3
Loans (12-04)
LOANS
Section 3.2
sheet credit exposures should not be reported as part of the
ALLL on a bank’s balance sheet. Because loans and leases
held for sale are carried on the balance sheet at the lower
of cost or fair value, no ALLL should be established for
such loans and leases.
For purposes of Reports of Condition and Income (Call
Reports) and Thrift Financial Reports (TFR) an adequate
ALLL should, after deduction of all assets classified loss,
be no less than the sum of the following items:
•
The term "estimated credit losses" means an estimate of the
current amount of the loan and lease portfolio (net of
unearned income) that is not likely to be collected; that is,
net chargeoffs that are likely to be realized for a loan, or
pool of loans. The estimated credit losses should meet the
criteria for accrual of a loss contingency (i.e., a provision
to the ALLL) set forth in generally accepted accounting
principles (GAAP). When available information confirms
specific loans and leases, or portions thereof, to be
uncollectible, these amounts should be promptly chargedoff against the ALLL.
•
•
Furthermore, management’s analysis of an adequate
reserve level should be conservative to reflect a margin for
the imprecision inherent in most estimates of expected
credit losses.
This additional margin might be
incorporated through amounts attributed to individual loans
or groups of loans, or in an unallocated portion of the
ALLL.
Estimated credit losses should reflect consideration of all
significant factors that affect repayment as of the
evaluation date. Estimated losses on loan pools should
reflect historical net charge-off levels for similar loans,
adjusted for changes in current conditions or other relevant
factors. Calculation of historical charge-off rates can range
from a simple average of net charge-offs over a relevant
period, to more complex techniques, such as migration
analysis.
When determining an appropriate allowance, primary
reliance should normally be placed on analysis of the
various components of a portfolio, including all significant
credits reviewed on an individual basis. Examiners should
refer to Statement of Financial Accounting Standards No.
(FAS) 114, Accounting by Creditors for Impairment of a
Loan, for guidance in establishing reserves for impaired
credits that are reviewed individually. When analyzing the
adequacy of an allowance, portfolios should be segmented
into as many components as practical. Each component
should normally have similar characteristics, such as risk
classification, past due status, type of loan, industry, or
collateral. A depository institution may, for example,
analyze the following components of its portfolio and
provide for them in the ALLL:
Portions of the ALLL can be attributed to, or based upon
the risks associated with, individual loans or groups of
loans. However, the ALLL is available to absorb credit
losses that arise from the entire portfolio. It is not
segregated for any particular loan, or group of loans.
Responsibility of the Board and Management
It is the responsibility of the board of directors and
management to maintain the ALLL at an adequate level.
The allowance adequacy should be evaluated, and
appropriate provisions made, at least quarterly. In carrying
out their responsibilities, the board and management are
expected to:
•
•
•
•
•
Establish and maintain a loan review system that
identifies, monitors, and addresses asset quality
problems in a timely manner.
Ensure the prompt charge-off of loans, or portions of
loans, deemed uncollectible.
Ensure that the process for determining an adequate
allowance level is based on comprehensive,
adequately documented, and consistently applied
analysis.
Loans (12-04)
For loans and leases classified Substandard or
Doubtful, whether analyzed and provided for
individually or as part of pools, all estimated credit
losses over the remaining effective lives of these loans.
For loans and leases that are not classified, all
estimated credit losses over the upcoming 12 months.
Amounts for estimated losses from transfer risk on
international loans.
•
•
Significant credits reviewed on an individual basis;
Loans and leases that are not reviewed individually,
but which present elevated risk characteristics, such as
delinquency, adverse classification, or Special
Mention designation;
Homogenous loans that are not reviewed individually,
and do not present elevated risk characteristics; and
All other loans and loan commitments that have not
been considered or provided for elsewhere.
In addition to estimated credit losses, the losses that arise
from the transfer risk associated with an institution’s crossborder lending activities require special consideration.
Over and above any minimum amount that is required by
the Interagency Country Exposure Review Committee to
be provided in the Allocated Transfer Reserve (or charged
3.2-4
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Federal Deposit Insurance Corporation
LOANS
Section 3.2
to the ALLL), an institution must determine if their ALLL
is adequate to absorb estimated losses from transfer risk
associated with its cross-border lending exposure.
portfolio. Examination procedures for reviewing the
adequacy of the ALLL are included in the Examination
Documentation (ED) Modules..
Factors to Consider in Estimating Credit Losses
Estimated credit losses should reflect consideration of all
significant factors that affect the portfolio’s collectibility as
of the evaluation date. While historical loss experience
provides a reasonable starting point, historical losses, or
even recent trends in losses, are not by themselves, a
sufficient basis to determine an adequate level.
Management should also consider any factors that are
likely to cause estimated losses to differ from historical
loss experience, including, but not limited to:
In assessing the overall adequacy of an ALLL, it is
important to recognize that the related process,
methodology, and underlying assumptions require a
substantial degree of judgement. Credit loss estimates will
not be precise due to the wide range of factors that must be
considered. Furthermore, the ability to estimate credit
losses on specific loans and categories of loans improves
over time. Therefore, examiners will generally accept
management’s estimates of credit losses in their assessment
of the overall adequacy of the ALLL when management
has:
•
•
•
•
•
•
•
•
Changes in lending policies and procedures, including
underwriting, collection, charge-off and recovery
practices;
Changes in local and national economic and business
conditions;
Changes in the volume or type of credit extended;
Changes in the experience, ability, and depth of
lending management;
Changes in the volume and severity of past due,
nonaccrual, restructured, or classified loans;
Changes in the quality of an institution’s loan review
system or the degree of oversight by the board of
directors; and,
The existence of, or changes in the level of, any
concentrations of credit.
•
•
If, after the completion of all aspects of the ALLL review
described in this section, the examiner does not concur that
the reported ALLL level is adequate, or the ALLL
evaluation process is deficient, recommendations for
correcting these problems, including any examiner
concerns regarding an appropriate level for the ALLL,
should be noted in the Report of Examination.
Regulatory Reporting of the ALLL
Institutions are also encouraged to use ratio analysis as a
supplemental check for evaluating the overall
reasonableness of an ALLL. Ratio analysis can be useful
in identifying trends in the relationship of the ALLL to
classified and nonclassified credits, to past due and
nonaccrual loans, to total loans and leases and binding
commitments, and to historical chargeoff levels. However,
while such comparisons can be helpful as a supplemental
check of the reasonableness of management’s assumptions
and analysis, they are not, by themselves, a sufficient basis
for determining an adequate ALLL level.
Such
comparisons do not eliminate the need for a comprehensive
analysis of the loan and lease portfolio and the factors
affecting its collectibility.
An ALLL established in accordance with the guidelines
provided above should fall within a range of acceptable
estimates.
When an ALLL is deemed inadequate,
management will be required to increase the provision for
loan and lease loss expense sufficiently to restore the
ALLL reported in its Call Report or TFR to an adequate
level.
Accounting and Reporting Treatment
FAS 5, Accounting for Contingencies, provides the basic
guidance for recognition of a loss contingency, such as the
collectibility of loans (receivables), when it is probable that
a loss has been incurred and the amount can be reasonably
estimated. FAS 114, provides more specific guidance
about the measurement and disclosure of impairment for
certain types of loans. Specifically, FAS 114 applies to
loans that are identified for evaluation on an individual
basis. Loans are considered impaired when, based on
current information and events, it is probable that the
Examiner Responsibilities
Generally, following the quality assessment of the loan and
lease portfolio, the loan review system, and the lending
policies, examiners are responsible for assessing the
adequacy of the ALLL. Examiners should consider all
significant factors that affect the collectibility of the
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Maintained effective systems and controls for
identifying, monitoring and addressing asset quality
problems in a timely manner;
Analyzed all significant factors that affect the
collectibility of the portfolio; and
Established an acceptable ALLL evaluation process
that meets the objectives for an adequate ALLL.
3.2-5
Loans (12-04)
LOANS
Section 3.2
creditor will be unable to collect all interest and principal
payments due according to the contractual terms of the
loan agreement.
•
For individually impaired loans, FAS 114 provides
guidance on the acceptable methods to measure
impairment. Specifically, FAS 114 states that when a loan
is impaired, a creditor should measure impairment based
on the present value of expected future principal and
interest cash flows discounted at the loan’s effective
interest rate, except that as a practical expedient, a creditor
may measure impairment based on a loan’s observable
market price or the fair value of collateral, if the loan is
collateral dependent. When developing the estimate of
expected future cash flows for a loan, an institution should
consider all available information reflecting past events
and current conditions, including the effect of existing
environmental factors.
•
Large groups of smaller-balance homogenous loans that
are collectively evaluated for impairment are not included
in the scope of FAS 114. Such groups of loans may
include, but are not limited to, credit card, residential
mortgage, and consumer installment loans.
FAS 5
addresses the accounting for impairment of these loans.
Also, FAS 5 provides the accounting guidance for
impairment of loans that are not identified for evaluation
on an individual basis and loans that are individually
evaluated but are not individually considered impaired.
A systematic methodology that is properly designed and
implemented should result in an institution’s best estimate
of the ALLL. Accordingly, institutions should adjust their
ALLL balance, either upward or downward, in each period
for differences between the results of the systematic
determination process and the unadjusted ALLL balance in
the general ledger.
•
•
•
•
•
•
Examiners are encouraged, with the acknowledgement of
management, to communicate with an institution’s external
auditors and request an explanation of their rationale and
findings, when differences in judgment concerning the
adequacy of the institution's ALLL exist. In case of
controversy, the auditors may be reminded of the
consensus reached by the Financial Accounting Standards
Board's Emerging Issues Task Force (EITF) on Issue No.
85-44, Differences Between Loan Loss Allowances for
GAAP and RAP. This issue deals with the situation where
regulators mandated that institutions establish loan loss
allowances under regulatory accounting principles (RAP)
that may be in excess of amounts recorded by the
institution in preparing its financial statement
under"GAAP. The EITF was asked whether and under
what circumstances this can occur.
The consensus
indicated that auditors should be particularly skeptical in
the case of GAAP/RAP differences and must justify them
based on the particular facts and circumstances.
Institutions should not layer their loan loss allowances.
Layering is the inappropriate practice of recording in the
ALLL more than one amount for the same probable loan
loss. Layering can happen when an institution includes a
loan in one segment, determines its best estimate of loss for
that loan either individually or on a group basis (after
taking into account all appropriate environmental factors,
conditions, and events), and then includes the loan in
another group, which receives an additional ALLL amount.
While different institutions may use different methods,
there are certain common elements that should be included
in any ALLL methodology. Generally, an institution’s
methodology should:
•
•
•
Include a detailed loan portfolio analysis, performed
regularly;
Consider all loans (whether on an individual or group
basis);
Identify loans to be evaluated for impairment on an
individual basis under FAS 114 and segment the
remainder of the portfolio into groups of loans with
similar risk characteristics for evaluation and analysis
under FAS 5;
Loans (12-04)
Consider all known relevant internal and external
factors that may affect loan collectibility;
Be applied consistently but, when appropriate, be
modified for new factors affecting collectibility;
Consider the particular risks inherent in different kinds
of lending;
Consider current collateral values (less costs to sell),
where applicable;
Require that analyses, estimates, reviews and other
ALLL methodology functions be performed by
competent and well-trained personnel;
Be based on current and reliable data;
Be well-documented, in writing, with clear
explanations of the supporting analyses and rationale;
and,
Include a systematic and logical method to consolidate
the loss estimates and ensure the ALLL balance is
recorded in accordance with GAAP.
Additional guidance on the establishment of loan review
systems and an adequate ALLL is provided in the
Interagency Statement of Policy on the ALLL dated
December 21, 1993, and the Interagency Policy Statement
on Allowance for Loan and Lease Losses Methodologies
and Documentation for Banks and Savings Associations,
dated June 29, 2001.
3.2-6
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Federal Deposit Insurance Corporation
LOANS
Section 3.2
Accounts receivable financing is a specialized area of
commercial lending in which borrowers assign their
interests in accounts receivable to the lender as collateral.
Typical characteristics of accounts receivable borrowers
are those businesses that are growing rapidly and need
year-round financing in amounts too large to justify
unsecured credit, those that are nonseasonal and need
year-round financing because working capital and profits
are insufficient to permit periodic cleanups, those whose
working capital is inadequate for the volume of sales and
type of operation, and those whose previous unsecured
borrowings are no longer warranted because of various
credit factors.
PORTFOLIO COMPOSITION
Commercial Loans
General
Loans to business enterprises for commercial or industrial
purposes, whether proprietorships, partnerships or
corporations, are commonly described as commercial
loans. In asset distribution, commercial or business loans
frequently comprise one of the most important assets of a
bank. They may be secured or unsecured and have short or
long-term maturities. Such loans include working capital
advances, term loans and loans to individuals for business
purposes.
Several advantages of accounts receivable financing from
the borrower's viewpoint are: it is an efficient way to
finance an expanding operation because borrowing
capacity expands as sales increase; it permits the borrower
to take advantage of purchase discounts because the
company receives immediate cash on its sales and is able to
pay trade creditors on a satisfactory basis; it insures a
revolving, expanding line of credit; and actual interest paid
may be no more than that for a fixed amount unsecured
loan.
Short-term working capital and seasonal loans provide
temporary capital in excess of normal needs. They are
used to finance seasonal requirements and are repaid at the
end of the cycle by converting inventory and accounts
receivable into cash. Such loans may be unsecured;
however, many working capital loans are advanced with
accounts receivable and/or inventory as collateral. Firms
engaged in manufacturing, distribution, retailing and
service-oriented businesses use short-term working capital
loans.
Advantages from the bank's viewpoint are: it generates a
relatively high yield loan, new business, and a depository
relationship; permits continuing banking relationships with
long-standing customers whose financial conditions no
longer warrant unsecured credit; and minimizes potential
loss when the loan is geared to a percentage of the accounts
receivable collateral. Although accounts receivable loans
are collateralized, it is important to analyze the borrower's
financial statements. Even if the collateral is of good
quality and in excess of the loan, the borrower must
demonstrate financial progress. Full repayment through
collateral liquidation is normally a solution of last resort.
Term business loans have assumed increasing importance.
Such loans normally are granted for the purpose of
acquiring capital assets, such as plant and equipment.
Term loans may involve a greater risk than do short-term
advances, because of the length of time the credit is
outstanding. Because of the potential for greater risk, term
loans are usually secured and generally require regular
amortization. Loan agreements on such credits may
contain restrictive covenants during the life of the loan. In
some instances, term loans may be used as a means of
liquidating, over a period of time, the accumulated and
unpaid balance of credits originally advanced for seasonal
needs. While such loans may reflect a borrower's past
operational problems, they may well prove to be the most
viable means of salvaging a problem situation and effecting
orderly debt collection.
Banks use two basic methods to make accounts receivable
advances. First, blanket assignment, wherein the borrower
periodically informs the bank of the amount of receivables
outstanding on its books. Based on this information, the
bank advances the agreed percentage of the outstanding
receivables. The receivables are usually pledged on a
non-notification basis and payments on receivables are
made directly to the borrower who then remits them to the
bank. The bank applies all or a portion of such funds to
the borrower's loan. Second, ledgering the accounts,
wherein the lender receives duplicate copies of the invoices
together with the shipping documents and/or delivery
receipts. Upon receipt of satisfactory information, the
bank advances the agreed percentage of the outstanding
receivables. The receivables are usually pledged on a
notification basis. Under this method, the bank maintains
complete control of the funds paid on all accounts pledged
At a minimum, commercial lending policies should address
acquisition of credit information, such as property,
operating and cash flow statements; factors that might
determine the need for collateral acquisition; acceptable
collateral margins; perfecting liens on collateral; lending
terms, and charge-offs.
Accounts Receivable Financing
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
3.2-7
Loans (12-04)
LOANS
Section 3.2
by requiring the borrower's customer to remit directly to
the bank.
other equity "kickers" received as part of a financing
package. Institutions also may invest in leveraged loan
funds managed by investment banking companies or other
third parties. Although leveraged financing is far more
prevalent in large institutions, this type of lending can be
found in institutions of all sizes.
In the area of accounts receivable financing, a bank's
lending policy should address at least the acquisition of
credit information such as property, operating and cash
flow statements. It should also address maintenance of an
accounts receivable loan agreement that establishes a
percentage advance against acceptable receivables, a
maximum dollar amount due from any one account debtor,
financial strength of debtor accounts, insurance that
"acceptable receivables" are defined in light of the
turnover of receivables pledged, aging of accounts
receivable, and concentrations of debtor accounts.
The extent to which institutions should apply these
practices will depend on the size and risk profile of their
leveraged exposures relative to assets, earnings, and
capital; and the nature of their leveraged financing
activities (i.e., origination and distribution, participant,
equity investor, etc.).
Risk Management Guidelines
Leveraged Financing
Institutions substantively engaged in leveraged financing
should adequately risk rate, track, and monitor these
transactions and should maintain policies specifying
conditions that would require a change in risk rating,
accrual status, loss recognition, or reserves. In general, the
risk management framework for leveraged finance is no
different from that which should be applied to all lending
activities. However, because of the potential higher level of
risk, the degree of oversight should be more intensive.
The Federal bank regulatory agencies issued guidance on
April 9, 2001 concerning sound risk management practices
for institutions engaged in leveraged financing.
Leveraged financing is an important financing vehicle for
mergers and acquisitions, business re-capitalizations and
refinancings, equity buyouts, and business or product line
build-outs and expansions. It is also used to increase
shareholder returns and to monetize perceived "enterprise
value" or other intangibles. A transaction is considered
leveraged when the obligor's post-financing leverage as
measured by debt-to-assets, debt-to-equity, cash flow-tototal debt, or other such standards unique to particular
industries significantly exceeds industry norms for
leverage.
Leveraged borrowers typically have a
diminished ability to adjust to unexpected events and
changes in business conditions because of their higher ratio
of total liabilities to capital. Consequently, leveraged
financing can have significant implications for a banking
organization's overall credit risk and presents unique
challenges for its risk management systems.
Loan Policy
The loan policy should specifically address the institutions'
leveraged lending activities by including:
•
•
•
•
Much of the leveraged financing activity ties into the
merger and acquisition activity and the increasing values
that were ascribed to firms as a result of a strong
expansionary business climate. Leveraged financing
transactions account for a sizeable portion of syndicated
bank loans.
Underwriting Standards
Either the loan policy or separate underwriting guidelines
should prescribe specific underwriting criteria for
leveraged financing.
The standards should avoid
compromising sound banking practices in an effort to
broaden market share or realize substantial fees. The policy
should:
Institutions participate in leveraged financing on a number
of levels. In addition to providing senior secured financing,
they extend credit on a subordinated basis (mezzanine
financing). Institutions and their affiliates also may take
equity positions in leveraged companies with direct
investments through affiliated securities firms, small
business investment companies (SBICs), and venture
capital companies or take equity interests via warrants and
Loans (12-04)
A definition of leveraged lending;
An approval policy that requires sufficient senior
management oversight;
Pricing policies that ensure a prudent tradeoff between
risk and return; and
A requirement for action plans whenever cash flow,
asset sale proceeds, or collateral values decline
significantly from projections. Action plans should
include remedial initiatives and triggers for rating
downgrades, changes to accrual status, and loss
recognition.
•
3.2-8
Describe appropriate leveraged loan structures;
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Federal Deposit Insurance Corporation
LOANS
•
•
•
•
•
Section 3.2
Require reasonable amortization of term loans (i.e.,
allow a moderate time period to realize the benefit of
synergies or augment revenues and institute
meaningful repayment);
Specify collateral policies including acceptable types
of collateral, loan to value limits, collateral margins,
and proper valuation methodologies;
Establish
covenant
requirements,
particularly
minimum interest and fixed charge coverage and
maximum leverage ratios;
Describe how enterprise values and other intangible
business values may be used; and
Establish minimum documentation requirements for
appraisals and valuations, including enterprise values
and other intangibles.
•
•
•
•
•
thereof, and the accuracy of risk ratings and accrual
status;
Collateral valuations are derived with a proper degree
of independence and consider potential value erosion;
Collateral liquidation and asset sale estimates are
conservative;
Potential collateral shortfalls are identified and
factored into risk rating and accrual decisions;
Contingency plans anticipate changing conditions in
debt or equity markets when exposures rely on
refinancing or re-capitalization; and
The borrower is adequately protected from interest
rate and foreign exchange risk.
Enterprise Value
Limits
Enterprise value can be defined as the imputed value of a
business. This valuation is often based on the anticipated
or imputed sale value, market capitalization, or net worth
of the borrower. The sale value is normally some multiple
of sales or cash flow based on recent mergers or
acquisitions of other firms in the borrower’s industry.
Leveraged finance and other loan portfolios with aboveaverage default probabilities tend to behave similarly
during an economic or sectoral downturn. Consequently,
institutions should take steps to avoid undue concentrations
by setting limits consistent with their appetite for risk and
their financial capacity. Institutions should ensure that they
monitor and control as separate risk concentrations those
loan segments most vulnerable to default. Institutions may
wish to identify such concentrations by the leveraged
characteristics of the borrower, by the institution's internal
risk grade, by particular industry or other factors that the
institution determines are correlated with an above-average
default probability. In addition, sub-limits may be
appropriate by collateral type, loan purpose, industry,
secondary sources of repayment, and sponsor relationships.
Institutions should also establish limits for the aggregate
number of policy exceptions.
This enterprise value is often relied upon in the
underwriting of leveraged loans to evaluate the feasibility
of a loan request, determine the debt reduction potential of
planned asset sales, assess a borrower's ability to access the
capital markets, and to provide a secondary source of
repayment.
Consideration of enterprise value is
appropriate in the credit underwriting process. However,
enterprise value and other intangible values, which can be
difficult to determine, are frequently based on projections,
and may be subject to considerable change. Consequently,
reliance upon them as a secondary source of repayment can
be problematic.
Credit Analysis
Because enterprise value is commonly derived from the
cash flows of a business, it is closely correlated with the
primary source of repayment. This interdependent
relationship between primary and secondary repayment
sources increases the risk in leveraged financing, especially
when credit weaknesses develop. Events or changes in
business conditions that negatively affect a company's cash
flow will also negatively affect the value of the business,
simultaneously eroding both the lender's primary and
secondary source of repayment. Consequently, lenders that
place undue reliance upon enterprise value as a secondary
source of repayment or that utilize unrealistic assumptions
to determine enterprise value are likely to approve unsound
loans at origination or experience sizeable losses upon
default.
It is essential that institutions establish sound valuation
methodologies for enterprise value, apply appropriate
Effective management of leveraged financing risk is highly
dependent on the quality of analysis during the approval
process and after the loan is advanced. At a minimum,
analysis of leveraged financing transactions should ensure
that:
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•
•
Cash flow analyses do not rely on overly optimistic or
unsubstantiated projections of sales, margins, and
merger and acquisition synergies;
Projections provide an adequate margin for
unanticipated merger-related integration costs;
Projections are stress tested for one or two downside
scenarios;
Transactions are reviewed quarterly to determine
variance from financial plans, the risk implications
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Federal Deposit Insurance Corporation
3.2-9
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LOANS
Section 3.2
margins to protect against potential changes in value, and
conduct ongoing stress testing and monitoring.
For adversely rated borrowers and other high-risk
borrowers who significantly depart from planned cash
flows, asset sales, collateral values, or other important
targets; institutions should formulate individual action
plans with critical objectives and timeframes. Actions may
include working with the borrower for an orderly
resolution while preserving the institution's interests, sale
in the secondary market, and liquidation. Regardless of the
action, examiners and bankers need to ensure such credits
are reviewed regularly for risk rating accuracy, accrual
status, recognition of impairment through specific
allocations, and charge-offs.
Rating Leveraged Finance Loans
Institutions need thoroughly articulated policies that
specify requirements and criteria for risk rating
transactions, identifying loan impairment, and recognizing
losses. Such specificity is critical for maintaining the
integrity of an institution's risk management system.
Institutions should incorporate both the probability of a
default and loss given a default in their ratings and rating
systems to ensure that both the borrower and transaction
risk are clearly evaluated. This is particularly germane to
leverage finance transaction structures, which in many
recent cases have resulted in large losses upon default.
Portfolio Analysis
Higher risk credits, including leveraged finance
transactions, require frequent monitoring by banking
organizations. At least quarterly, management and the
board of directors should receive comprehensive reports
about the characteristics and trends in such exposures.
These reports at a minimum should include:
In cases where a borrower's condition or future prospects
have significantly weakened, leverage finance loans will
likely merit a Substandard classification based on the
existence of well-defined weaknesses. If such weaknesses
appear to be of a lasting nature and it is probable that a
lender will be unable to collect all principal and interest
owed, the loan should be placed on non-accrual and will
likely have a Doubtful component. Such loans should be
reviewed for impairment in accordance with FAS 114. If
the primary source of repayment is inadequate and a loan is
considered collateral dependent, it is generally
inappropriate to consider enterprise value unless the value
is well supported. Well supported enterprise values may
be evidenced by a binding purchase and sale agreement
with a qualified third party or through valuations that fully
consider the effect of the borrower's distressed
circumstances and potential changes in business and
market conditions. For such borrowers, where a portion of
the loan is not protected by pledged assets or a well
supported enterprise value, examiners will generally
classify the unprotected portion of the loan Doubtful or
Loss.
•
•
•
•
Institutions with significant exposure levels to higher risk
credits should consider additional reports covering:
•
In addition, institutions need to ensure that the risks in
leveraged lending activities are fully incorporated in the
ALLL and capital adequacy analysis. For allowance
purposes, leverage exposures should be taken into account
either through analysis of the expected losses from the
discrete portfolio 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 heavily
reliant on enterprise value as a secondary source of
repayment should be scrutinized to determine the need for
and adequacy of specific allocations.
•
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Problem Loan Management
Loans (12-04)
Total exposure and segment exposures, including
subordinated debt and equity holdings, compared to
established limits;
Risk rating distribution and migration data;
Portfolio performance, noncompliance with covenants,
restructured loans, delinquencies, non-performing
assets, and impaired loans; and
Compliance with internal procedures and the
aggregate level of exceptions to policy and
underwriting standards.
3.2-10
Collateral composition of the portfolio. For example,
percentages supported by working assets, fixed assets,
intangibles, blanket liens, and stock of borrower's
operating subsidiaries;
Unsecured or partially secured exposures, including
potential collateral shortfalls caused by defaults that
trigger pari passu collateral treatment for all lender
classes;
Absolute amount and percentage of the portfolio
dependent on refinancing, recapitalization, asset sales,
and enterprise value;
Absolute amounts and percentages of scheduled and
actual annual portfolio amortizations; and
Secondary market pricing data and trading volume for
loans in the portfolio.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
LOANS
Section 3.2
Process to Identify Potential Conflicts
Internal Controls
Examiners should determine whether an institution's board
of directors and management have established policies for
leveraged finance that minimize the risks posed by
potential legal issues and conflicts of interest.
Institutions engaged in leveraged finance need to ensure
their internal review function is appropriately staffed to
provide timely, independent assessments of leveraged
credits. Reviews should evaluate risk rating integrity,
valuation methodologies, and the quality of risk
management. Because of the volatile nature of these
credits, portfolio reviews should be conducted on at least
an annual basis. For many institutions, the risk
characteristics of the leveraged portfolio, such as high
reliance on enterprise value, concentrations, adverse risk
rating trends or portfolio performance, will dictate more
frequent reviews.
Conflicts of Interest
When a banking company plays multiple roles in leveraged
finance, the interests of different customers or the divisions
of the institution may conflict. For example, a lender may
be reluctant to employ an aggressive collection strategy
with a problem borrower because of the potential impact
on the value of the organization's equity interest. A lender
may also be pressured to provide financial or other
privileged client information that could benefit an affiliated
equity investor. Institutions should develop appropriate
policies to address potential conflicts of interest.
Institutions should also track aggregate totals for borrowers
and sponsors to which it has both a lending and equity
relationship. Appropriate limits should be established for
such relationships.
Distributions
Asset sales, participations, syndication, and other means of
distribution are critical elements in the rapid growth of
leveraged financing. Both lead and purchasing institutions
to adopt formal policies and procedures addressing the
distribution and acquisition of leveraged financing
transactions. Policies should include:
Securities Laws
•
•
•
•
•
•
•
Procedures for defining, managing, and accounting for
distribution fails;
Identification of any sales made with recourse and
procedures for fully reflecting the risk of any such
sales.
A process to ensure that purchasers are provided with
timely, current financial information;
A process to determine the portion of a transaction to
be held for investment and the portion to be held for
sale;
Limits on the length of time transactions can be held in
the held-for-sale account and policies for handling
items that exceed those limits;
Prompt recognition of losses in market value for loans
classified as held-for-sale; and
Procedural safeguards to prevent conflicts of interest
for both bank and affiliated securities firms.
Equity interests and certain debt instruments used in
leveraged lending may constitute "securities" for the
purposes of Federal securities laws. When securities are
involved, institutions should ensure compliance with
applicable securities law requirements, including
disclosure and regulatory requirements. Institutions should
also establish procedures to restrict the internal
dissemination of material nonpublic information about
leveraged finance transactions.
Compliance Function
The legal and regulatory issues raised by leveraged
transactions are numerous and complex. To ensure that
potential conflicts are avoided and laws and regulations are
adhered to, an independent compliance function should
review all leveraged financing activity.
Participations Purchased
Mezzanine Financing
Institutions purchasing participations and assignments in
leveraged finance must make a thorough, independent
evaluation of the transaction and the risks involved before
committing any funds. They should apply the same
standards of prudence, credit assessment, approval criteria,
and "in-house" limits that would be employed if the
purchasing organization were originating the loan.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Mezzanine financing represents those parts of a leveraged
financing package that are neither equity nor senior debt.
It usually is extended through subsidiaries of banks or
nonbank subsidiaries of bank holding companies.
Examiners should review policies for mezzanine financing
to ensure that they generally include:
3.2-11
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Section 3.2
cash flows, or if orderly repayment of the debt is in doubt.
Credits with only minimal cash flow for debt service are
usually subject to an adverse rating.
Limits for both aggregate volume and individual
transactions;
Designated booking units;
Credit approval and reporting processing;
Management and other reporting requirements;
An internal risk rating system and requirements for
periodic reviews; and
Procedures for legal review.
Enterprise Value
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 income or cash flow of the firm. The
methodology and assumptions underlying the valuation
should be clearly disclosed, well supported, and
understood by appropriate decision-makers and risk
oversight units. Examiners should ensure that the valuation
approach is appropriate for the company's industry and
condition.
Allowance for Loan and Lease Losses
The potential impact of a bank's participation in leveraged
financing should be carefully considered when reviewing
the adequacy of the ALLL. The aggregate size and overall
condition of the leveraged financing portfolio should be
specifically addressed in any review of the overall ALLL
adequacy.
Examiners should review the bank's
methodology for incorporating the special risks related to
this financing in its determination of the adequacy of
ALLL. Management's internal risk rating system is
expected to include assessment of its equity and mezzanine
financing portfolio in determining the need for valuation
reserves.
Enterprise value is often viewed as a secondary source of
repayment and as such would be relied upon under
stressful conditions. In such cases the assumptions used
for key variables such as cash flow, earnings, and sale
multiples should reflect those adverse conditions. These
variables can have a high degree of uncertainty - sales and
cash flow projections may not be achieved; comparable
sales may not be available; changes can occur in a firm's
competitive position, industry outlook, or the economic
environment. Given these uncertainties, changes in the
value of a firm's assets need to be tested under a range of
stress scenarios, including business conditions more
adverse than the base case scenario. Stress testing of
enterprise values and their underlying assumptions should
be conducted upon origination of the loan and periodically
thereafter incorporating the actual performance of the
borrower and any adjustments to projections. The bank
should in all cases perform its own discounted cash flow
analysis to validate "enterprise value" implied by proxy
measures such as multiples of cash flow, earnings or sales.
Examination Risk Rating Guidance for Leveraged
Financing
When evaluating individual borrowers, examiners should
pay particular attention to:
•
•
•
The overall performance and profitability of a
borrower and its industry over time, including periods
of economic or financial adversity;
The history and stability of a borrower's market share,
earnings, and cash flow, particularly over the most
recent business cycle and last economic downturn; and
The relationship between a borrowing company's
projected cash flow and debt service requirements and
the resulting margin of debt service coverage.
Finally, it must be recognized that valuations derived with
even the most rigorous valuation procedures are imprecise
and may not be realized when needed by an institution.
Therefore, institutions relying on enterprise value or
illiquid and hard-to-value collateral must have lending
policies that provide for appropriate loan-to-value ratios,
discount rates and collateral margins.
Cash Flow/Debt Service Coverage
Particular attention should be paid to the adequacy of the
borrower's cash flow and the reasonableness of projections.
Before entering into a leveraged financing transaction,
bankers should conduct an independent, realistic
assessment of the borrower's ability to achieve the
projected cash flow under varying economic and interest
rate scenarios. This assessment should take into account
the potential effects of an economic downturn or other
adverse business conditions on the borrower's cash flow
and collateral values. Normally bankers and examiners
should adversely rate a credit if material questions exist as
to the borrower's ability to achieve the projected necessary
Loans (12-04)
Deal Sponsors
Deal sponsors can be an important source of financial
support for a borrower that fails to achieve cash flow
projections. However, support from this source should only
be considered positively in a risk rating decision when the
sponsor has a history of demonstrated support as well as
the economic incentive, capacity, and stated intent to
3.2-12
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LOANS
Section 3.2
continue to support the transaction. Even with capacity and
a history of support, a sponsor's potential contributions
should not mitigate criticism unless there is clear reason to
believe it is in the best interests of the sponsor to continue
that support or unless there is a formal guarantee.
percentage should be used when the discounted PWFNI is
determined using historical production data. When less
than 75 percent of the reserve estimate is determined using
historical production data, or the discounted PWFNI is
predicated on engineering estimates of the volume of
oil/gas flow (volumetric and/or analogy-based engineering
data), the collateral value assigned to Substandard should
be reduced accordingly. The balance, but not more than
100 percent of discounted PWFNI of PDP reserves, should
be classified Doubtful. Any remaining deficiency balance
should be classified Loss.
Oil and/or Gas Reserve-Based Loans
These guidelines apply to oil and/or gas reserve-based
loans that are considered collateral dependent and are
devoid of repayment capacity from other tangible sources.
In addition to PDP, many reserve-based credit collateral
values will include items variously referred to as proved
(or proven) developed non-producing reserves, shut-in
reserves, behind-the-pipe reserves and proved undeveloped
properties (PUP) as collateral. Due to the nature of these
other reserves, there are no strict percentage guidelines for
the proportion of the credit supported by this type of
collateral that should remain as a bankable asset.
However, only in very unusual situations would the
proportion of collateral values for these other reserves
assigned to a classification category approach values for
PDP.
The initial step to assessing the credit worthiness of
reserve-based loans is an analysis of the engineering
function. Cash flow generated from the future sale of
encumbered oil and/or gas reserves is the primary, and in
most cases the only intended, source of repayment.
Therefore, engineering data integrity which depicts future
cash stream, is critical to the initial lending decision and
equally important to an examiner in the assessment of
credit quality. For evaluation purposes, an acceptable
engineering report must be an independent, detailed
analysis of the reserve prepared by a competent
engineering group. The report must address three critical
concerns: pricing; discount factors; and timing. In those
cases where the engineering reports do not meet one or
more of these criteria, the examiner may need to use other
methods, e.g., recent cash flow histories, to determine the
current collateral value.
The examiner must ascertain the current status of each
reserve and develop an appropriate collateral value.
Examples could be reserves that are shut-in due to
economic conditions versus reserves that are shut-in due to
the absence of pipeline or transportation. PDP require
careful evaluation before allowing any bankable collateral
value.
The extent of examiner analysis is a matter of judgment,
but comprehensive analysis of the credit should definitely
take place if:
Real Estate Loans
•
•
•
The loan balance exceeds 65 percent of the discounted
present worth of future net income (PWFNI) of proved
developed producing properties (PDP), or the cash
flow analysis indicates that the loan will not amortize
over four to five years;
The credit is not performing in accordance with terms
or repayment of interest and/or principal; or
The credit is identified by the bank as a "problem"
credit.
General
Real estate loans are part of the loan portfolios of almost
all commercial banks. Real estate loans include credits
advanced for the purchase of real property. However, the
term may also encompass extensions granted for other
purposes, but for which primary collateral protection is real
property.
The degree of risk in a real estate loan depends primarily
on the loan amount in relation to collateral value, the
interest rate, and most importantly, the borrower's ability to
repay in an orderly fashion. It is extremely important that a
bank's real estate loan policy ensure that loans are granted
with the reasonable probability the debtor will be able and
willing to meet the payment terms. Placing undue reliance
upon a property's appraised value in lieu of an adequate
initial assessment of a debtor's repayment ability is a
potentially dangerous mistake.
After performing the analysis, the examiner must determine
if classification is warranted. The following guidelines are
to be applied in instances where the obligor is devoid of
primary and secondary repayment capacity or other reliable
means of repayment, with total support of the debt
provided solely by the pledged collateral. First, 65 percent
of discounted PWFNI should be classified Substandard. A
lesser percentage or less severe criticism may be
appropriate in cases where a reliable alternate means of
repayment exists for a portion of the debt. The 65 percent
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3.2-13
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LOANS
Section 3.2
•
•
Historically, many banks have jeopardized their capital
structure by granting ill-considered real estate mortgage
loans. Apart from unusual, localized, adverse economic
conditions which could not have been foreseen, resulting in
a temporary or permanent decline in realty values, the
principal errors made in granting real estate loans include
inadequate regard to normal or even depressed realty
values during periods when it is in great demand thus
inflating the price structure, mortgage loan amortization,
the maximum debt load and repayment capacity of the
borrower, and failure to reasonably restrict mortgage loans
on properties for which there is limited demand.
•
These policies also should reflect consideration of the
Interagency Guidelines for Real Estate Lending Policies
and must be reviewed and approved annually by the
institution's board of directors.
The interagency guidelines, which are an appendix to Part
365, are intended to help institutions satisfy the regulatory
requirements by outlining the general factors to consider
when developing real estate lending standards. The
guidelines suggest maximum supervisory loan-to-value
(LTV) limits for various categories of real estate loans and
explain how the agencies will monitor their use.
A principal indication of a troublesome real estate loan is
an improper relationship between the amount of the loan,
the potential sale price of the property, and the availability
of a market. The potential sale price of a property may or
may not be the same as its appraised value. The current
potential sale price or liquidating value of the property is
of primary importance and the appraised value is of
secondary importance. There may be little or no current
demand for the property at its appraised value and it may
have to be disposed of at a sacrifice value.
Institutions are expected to establish their own internal
LTV limits consistent with their needs. These internal
limits should not exceed the following recommended
supervisory limits:
•
•
•
Examiners must appraise not only individual mortgage
loans, but also the overall mortgage lending and
administration policies to ascertain the soundness of its
mortgage loan operations as well as the liquidity contained
in the account. The bank should establish policies that
address the following factors: the maximum amount that
may be loaned on a given property, in a given category,
and on all real estate loans; the need for appraisals
(professional judgments of the present and/or future value
of the real property) and for amortization on certain loans.
•
•
•
Real Estate Lending Standards
Section 18(o) of the FDI Act requires the Federal banking
agencies to adopt uniform regulations prescribing
standards for loans secured by liens on real estate or made
for the purpose of financing permanent improvements to
real estate. For FDIC-supervised institutions, Part 365 of
the FDIC Rules and Regulations requires each institution
to adopt and maintain written real estate lending policies
that are consistent with sound lending principles,
appropriate for the size of the institution and the nature and
scope of its operations. Within these general parameters,
the regulation specifically requires an institution to
establish policies that include:
•
•
65 percent for raw land;
75 percent for land development;
80 percent for commercial, multi-family, and other
non-residential construction;
85 percent for construction of a 1-to-4 family
residence;
85 percent for improved property; and
Owner-occupied 1-to-4 family home loans have no
suggested supervisory LTV limits. However, for any
such loan with an LTV ratio that equals or exceeds 90
percent at origination, an institution should require
appropriate credit enhancement in the form of either
mortgage insurance or readily marketable collateral.
Certain real estate loans are exempt from the supervisory
LTV limits because of other factors that significantly
reduce risk. These include loans guaranteed or insured by
the Federal, State or local government as well as loans to
be sold promptly in the secondary market without recourse.
A complete list of excluded transactions is included in the
guidelines.
Because there are a number of credit factors besides LTV
limits that influence credit quality, loans that meet the
supervisory LTV limits should not automatically be
considered sound, nor should loans that exceed the
supervisory LTV limits automatically be considered high
risk. However, loans that exceed the supervisory LTV
limit should be identified in the institution's records and the
aggregate amount of these loans reported to the institution's
Portfolio diversification standards;
Prudent underwriting standards including loan-tovalue limits;
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Loan administration procedures;
Documentation, approval and reporting requirements;
and
Procedures for monitoring real estate markets within
the institution's lending area.
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Section 3.2
board of directors at least quarterly. The guidelines further
State that the aggregate amount of loans in excess of the
supervisory LTV limits should not exceed the institution's
total capital. Moreover, within that aggregate limit, the
total loans for all commercial, agricultural and multi-family
residential properties (excluding 1-to-4 family home loans)
should not exceed 30 percent of total capital.
•
•
•
Institutions should develop policies that are clear, concise,
consistent with sound real estate lending practices, and
meet their needs. Policies should not be so complex that
they place excessive paperwork burden on the institution.
Therefore, when evaluating compliance with Part 365,
examiners should carefully consider the following:
•
•
•
•
•
•
•
•
The size and financial condition of the institution;
The nature and scope of the institution's real estate
lending activities;
The quality of management and internal controls;
The size and expertise of the lending and
administrative staff; and
Market conditions.
•
Real Estate Construction Loans
A construction loan is used to construct a particular project
within a specified period of time and should be controlled
by supervised disbursement of a predetermined sum of
money. It is generally secured by a first mortgage or deed
of trust and backed by a purchase or takeout agreement
from a financially responsible permanent lender.
Construction loans are vulnerable to a wide variety of
risks. The major risk arises from the necessity to complete
projects within specified cost and time limits. The risk
inherent in construction lending can be limited by
establishing policies which specify type and extent of bank
involvement. Such policies should define procedures for
controlling disbursements and collateral margins and
assuring timely completion of the projects and repayment
of the bank's loans.
It is important to distinguish between the regulation and the
interagency guidelines. While the guidelines are included
as an appendix to the regulation, they are not part of the
regulation. Therefore, when an apparent violation of Part
365 is identified, it should be listed in the Report of
Examination in the same manner as other apparent
violations. Conversely, when an examiner determines that
an institution is not in conformance with the guidelines and
the deficiency is a safety and soundness concern, an
appropriate comment should be included in the
examination report; however, the deficiency would not be a
violation of the regulation.
Examination procedures for various real estate loan
categories are included in the ED Modules.
Before a construction loan agreement is entered into, the
bank should investigate the character, expertise, and
financial standing of all related parties. Documentation
files should include background information concerning
reputation, work and credit experience, and financial
statements. Such documentation should indicate that the
developer,
contractor,
and
subcontractors
have
demonstrated the capacity to successfully complete the
type of project to be undertaken. The appraisal techniques
used to value a proposed construction project are
essentially the same as those used for other types of real
estate. The bank should realize that appraised collateral
values are not usually met until funds are advanced and
improvements made.
Commercial Real Estate Loans
These loans comprise a major portion of many banks' loan
portfolios. When problems exist in the real estate markets
that the bank is servicing, it is necessary for examiners to
devote additional time to the review and evaluation of
loans in these markets.
There are several warning signs that real estate markets or
projects are experiencing problems that may result in real
estate values decreasing from original appraisals or
projections. Adverse economic developments and/or an
overbuilt market can cause real estate projects and loans to
become troubled. Signs of troubled real estate markets or
projects include, but are not limited to:
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Federal Deposit Insurance Corporation
Rent concessions or sales discounts resulting in cash
flow below the level projected in the original
appraisal.
Changes in concept or plan: for example, a
condominium project converting to an apartment
project.
Construction delays resulting in cost overruns which
may require renegotiation of loan terms.
Slow leasing or lack of sustained sales activity and/or
increasing cancellations which may result in protracted
repayment or default.
Lack of any sound feasibility study or analysis.
Periodic construction draws which exceed the amount
needed to cover construction costs and related
overhead expenses.
Identified problem credits, past due and non-accrual
loans.
The bank, the builder and the property owner should join
in a written building loan agreement that specifies the
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Section 3.2
performance of each party during the entire course of
construction. Loan funds are generally disbursed based
upon either a standard payment plan or a progress payment
plan. The standard payment plan is normally used for
residential and smaller commercial construction loans and
utilizes a preestablished schedule for fixed payments at the
end of each specified stage of construction. The progress
payment plan is normally used for larger, more complex,
building projects. The plan is generally based upon
monthly disbursements totaling 90 percent of the value
with 10 percent held back until the project is completed.
Repayment often comes from the first draw against
construction financing. Unsecured front money loans
used for a developer's equity investment in a project or
to cover initial costs overruns are symptomatic of an
undercapitalized, inexperienced or inept builder.
Although many credits advanced for real estate acquisition,
development or construction are properly considered loans
secured by real estate, other such credits are, in economic
substance, "investments in real estate ventures" and
categorization of the asset as "other real estate owned" may
be appropriate. A key feature of these transactions is that
the bank as lender plans to share in the expected residual
profit from the ultimate sale or other use of the
development. These profit sharing arrangements may take
the form of equity kickers, unusually high interest rates, a
percentage of the gross rents or net cash flow generated by
the project, or some other form of profit participation over
and above a reasonable amount for interest and related loan
fees. These extensions of credit may also include such
other characteristics as nonrecourse debt, 100 percent
financing of the development cost (including origination
fees, interest payments, construction costs, and even profit
draws by the developer), and lack of any substantive
financial support from the borrower or other guarantors.
Acquisition, Development, and Construction (ADC)
arrangements that are in substance real estate investments
of the bank should be reported accordingly.
•
Land Development Loans - Land development loans
are generally secured purchase or development loans
or unsecured advances to investors and speculators.
Secured purchase or development loans are usually a
form of financing involving the purchase of land and
lot development in anticipation of further construction
or sale of the property. A land development loan
should be predicated upon a proper title search and/or
mortgage insurance. The loan amount should be based
on appraisals on an "as is" and "as completed" basis.
Projections should be accompanied by a study
explaining the effect of property improvements on the
market value of the land. There should be a sufficient
spread between the amount of the development loan
and the estimated market value to allow for unforeseen
expenses.
The repayment program should be
structured to follow the sales or development program.
In the case of an unsecured land development loan to
investors or speculators, bank management should
analyze the borrower's financial statements for sources
of repayment other than the expected return on the
property development.
•
Commercial Construction Loans - Loans financing
commercial construction projects are usually
collateralized, and such collateral is generally identical
to that for commercial real estate loans. Supporting
documentation should include a recorded mortgage or
deed of trust, title insurance policy and/or title
opinions, appropriate liability insurance and other
coverages, land appraisals, and evidence that taxes
have been paid to date. Additional documents relating
to commercial construction loans include loan
agreements, takeout commitments, tri-party (buy/sell)
agreements, completion or corporate bonds, and
inspection or progress reports.
•
Residential Construction Loans - Residential
construction loans may be made on a speculative basis
or as prearranged permanent financing. Smaller banks
often engage in this type of financing and the
aggregate total of individual construction loans may
equal a significant portion of their capital funds.
Prudence dictates that permanent financing be assured
in advance because the cost of such financing can have
a substantial affect on sales. Proposals to finance
speculative housing should be evaluated in accordance
with predetermined policy standards compatible with
On the other hand, if the bank will receive less than a
majority of the expected residual profit, the ADC loan may
be analogous to an interest in a joint real estate venture,
which would be, considered an investment in
unconsolidated subsidiaries and associated companies.
The following are the basic types of construction lending:
•
Unsecured Front Money - Unsecured front money
loans are working capital advances to a borrower who
may be engaged in a new and unproven venture.
Many bankers believe that unsecured front money
lending is not prudent unless the bank is involved in
the latter stages of construction financing. A builder
planning to start a project before construction funding
is obtained often uses front money loans. The funds
may be used to acquire or develop a building site,
eliminate title impediments, pay architect or standby
fees, and/or meet minimum working capital
requirements established by construction lenders.
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3.2-16
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Section 3.2
the institution's size, technical competence of its
management, and housing needs of its service area.
The prospective borrower's reputation, experience, and
financial condition should be reviewed. The finished
project's marketability in favorable and unfavorable
market conditions should be realistically considered.
Home Equity Loans
A home equity loan is a loan secured by the equity in a
borrower's residence. It is generally structured in one of
two ways. First, it can be structured as a traditional second
mortgage loan, wherein the borrower obtains the funds for
the full amount of the loan immediately and repays the debt
with a fixed repayment schedule. Second, the home equity
borrowing can be structured as a line of credit, with a
check, credit card, or other access to the line over its life.
In addition to normal safeguards such as a recorded
first mortgage, acceptable appraisal, construction
agreement, draws based on progress payment plans
and inspection reports, a bank dealing with speculative
contractors should institute control procedures tailored
to the individual circumstances. A predetermined
limit on the number of unsold units to be financed at
any one time should be included in the loan agreement
to avoid overextending the contractor's capacity.
Loans on larger residential construction projects are
usually negotiated with prearranged permanent
financing. Documentation of tract loans frequently
includes a master note allocated for the entire project
and a master deed of trust or mortgage covering all
land involved in the project. Payment of the loan will
depend largely upon the sale of the finished homes.
As each sale is completed, the bank makes a partial
release of the property covered by its master collateral
document. In addition to making periodic inspections
during the course of construction, periodic progress
reports (summary of inventory lists maintained for
each tract project) should be made on the entire
project. The inventory list should show each lot
number, type of structure, release price, sales price,
and loan balance.
The home equity line of credit has evolved into the
dominant form of home equity lending. This credit
instrument generally offers variable interest rates and
flexible repayment terms. Additional characteristics of this
product line include relatively low interest rates as
compared to other forms of consumer credit, absorption by
some banks of certain fees (origination, title search,
appraisal, recordation cost, etc.) associated with
establishing a real estate-related loan. The changes
imposed by the Tax Reform Act of 1986 relating to the
income tax deductibility of interest paid on consumer debt
led to the increased popularity of home equity lines of
credit.
Home equity lending is widely considered to be a low-risk
lending activity. These loans are secured by housing assets,
the value of which historically has performed well.
Nevertheless, the possibility exists that local housing
values or household purchasing power may decline,
stimulating abandonment of the property and default on the
debt secured by the housing. Certain features of home
equity loans make them particularly susceptible to such
risks. First, while the variable rate feature of the debt
reduces the interest rate risk of the lender, the variable
payment size exposes the borrower to greater cash flow
risks than would a fixed-rate loan, everything else being
equal. This, in turn, exposes the lender to greater credit
risk. Another risk is introduced by the very nature of the
home equity loan. Such loans are generally secured by a
junior lien. Thus, there is less effective equity protection
than in a first lien instrument. Consequently, a decline in
the value of the underlying housing results in a much
greater than proportional decline in the coverage of a home
equity loan.
This added leverage makes them
correspondingly riskier than first mortgages.
The exposure in any type of construction lending is that the
full value of the collateral does not exist at the time the
loan is granted. The bank must ensure funds are used
properly to complete construction or development of the
property serving as collateral. If default occurs, the bank
must be in a position to either complete the project or to
salvage its construction advances. The various mechanic's
and materialmen's liens, tax liens, and other judgments that
arise in such cases are distressing to even the most
seasoned lender. Every precaution should be taken by the
lender to minimize any outside attack on the collateral.
The construction lender may not be in the preferred
position indicated by documents in the file. Laws of some
states favor the subcontractors (materialmen's liens, etc.),
although those of other states protect the construction
lender to the point of first default, provided certain legal
requirements have been met. Depending on the type and
size of project being funded, construction lending can be a
complex and fairly high-risk venture. For this reason, bank
management should ensure that it has enacted policies and
retained sufficiently trained personnel before engaging in
this type of lending.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Banks that make these kinds of loans should adopt specific
policies and procedures for dealing with this product line.
Management should have expertise in both mortgage
lending as well as open-end credit procedures. Another
major concern is that borrowers will become overextended
and the bank will have to initiate foreclosure proceedings.
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Section 3.2
Therefore, underwriting standards should emphasize the
borrower's ability to service the line from cash flow rather
than the sale of the collateral, especially if the home equity
line is written on a variable rate basis. If the bank has
offered a low introductory interest rate, repayment capacity
should be analyzed at the rate that could be in effect at the
conclusion of the initial term.
to two risk factors that are largely outside the control of
individual lenders and borrowers: commodity prices and
weather conditions. While examiners must be alert to, and
critical of, operational and managerial weaknesses in
agricultural lending activities, they must also recognize
when the bank is taking reasonable steps to deal with these
external risk factors. Accordingly, loan restructurings or
extended repayment terms, or other constructive steps to
deal with financial difficulties faced by agricultural
borrowers because of adverse weather or commodity
conditions, will not be criticized if done in a prudent
manner and with proper risk controls and management
oversight. Examiners should recognize these constructive
steps and fairly portray them in oral and written
communications regarding examination findings. This
does not imply, however, that analytical or classification
standards should be compromised. Rather, it means that
the bank’s response to these challenges will be considered
in supervisory decisions.
Other important considerations include acceptable loan-tovalue and debt-to-income ratios, and proper credit and
collateral documentation, including adequate appraisals
and written evidence of prior lien status. Another
significant risk concerns the continued lien priority for
subsequent advances under a home equity line of credit.
State law governs the status of these subsequent advances.
It is also important that the bank's program include
periodic reviews of the borrower's financial condition and
continuing ability to repay the indebtedness.
The variation in contract characteristics of home equity
debt affects the liquidity of this form of lending. For debt
to be easily pooled and sold in the secondary market, it
needs to be fairly consistent in its credit and interest rate
characteristics. The complexity of the collateral structures,
coupled with the uncertain maturity of revolving credit,
makes home equity loans considerably less liquid than
straight first lien, fixed maturity mortgage loans.
Agricultural Loan Types and Maturities
Production or Operating Loans - Short-term (one year or
less) credits to finance seed, fuel, chemicals, land and
machinery rent, labor, and other costs associated with the
production of crops. Family living expenses are also
sometimes funded, at least in part, with these loans. The
primary repayment source is sale of the crops at the end of
the production season when the harvest is completed.
While home equity lending is considered to be fairly lowrisk, subprime home equity loans and lending programs
exist at some banks. These programs have a higher level
of risk than traditional home equity lending programs.
Individual or pooled home equity loans that have subprime
characteristics should be analyzed using the guidance
provided in the subprime section of this Manual.
Feeder Livestock Loans - Short-term loans for the purchase
of, or production expenses associated with, cattle, hogs,
sheep, poultry or other livestock. When the animals attain
market weight and are sold for slaughter, the proceeds are
used to repay the debt.
Breeder Stock Loans - Intermediate-term credits (generally
three to five years) used to fund the acquisition of breeding
stock such as beef cows, sows, sheep, dairy cows, and
poultry. The primary repayment source is the proceeds
from the sale of the offspring of these stock animals, or
their milk or egg production.
Agricultural Loans
Introduction
Agricultural loans are an important component of many
community bank loan portfolios.
Agricultural banks
represent a material segment of commercial banks and
constitute an important portion of the group of banks over
which the FDIC has the primary Federal supervisory
responsibility.
Machinery and Equipment Loans - Intermediate-term loans
for the purchase of a wide array of equipment used in the
production and handling of crops and livestock. Cash flow
from farm earnings is the primary repayment source.
Loans for grain handling and storage facilities are also
sometimes included in this category, especially if the
facilities are not permanently affixed to real estate.
Agricultural loans are used to fund the production of crops,
fruits, vegetables, and livestock, or to fund the purchase or
refinance of capital assets such as farmland, machinery and
equipment, breeder livestock, and farm real estate
improvements (for example, facilities for the storage,
housing, and handling of grain or livestock). The
production of crops and livestock is especially vulnerable
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Farm Real Estate Acquisition Loans - Long-term credits
for the purchase of farm real estate, with cash flow from
earnings representing the primary repayment source.
Significant, permanent improvements to the real estate,
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Section 3.2
such as for livestock housing or grain storage, may also be
included within this group.
examiner to insist that all agricultural borrowers be
supported with the full complement of balance sheets,
income statements, and other data discussed above,
regardless of the nature and amount of the credit or the
debtor’s financial strength and payment record.
Nonetheless, while recognizing some leeway is
appropriate, most of the bank’s agricultural credit lines,
and all of its larger or more significant ones, should be
sufficiently supported by the financial information
mentioned.
Carryover Loans - This term is used to describe two types
of agricultural credit. The first is production or feeder
livestock loans that are unable to be paid at their initial,
short-term maturity, and which are rescheduled into an
intermediate or long-term amortization. This situation
arises when weather conditions cause lower crop yields,
commodity prices are lower than anticipated, production
costs are higher than expected, or other factors result in a
shortfall in available funds for debt repayment. The
second type of carryover loan refers to already-existing
term debt whose repayment terms or maturities need to be
rescheduled because of inadequate cash flow to meet
existing repayment requirements.
This need for
restructuring can arise from the same factors that lead to
carryover production or feeder livestock loans. Carryover
loans are generally restructured on an intermediate or longterm amortization, depending upon the type of collateral
provided, the borrower’s debt service capacity from
ongoing operations, the debtor’s overall financial condition
and trends, or other variables. The restructuring may also
be accompanied by acquisition of Federal guarantees
through the farm credit system to lessen risk to the bank.
Cash Flow Analysis - History clearly demonstrated that
significant problems can develop when banks fail to pay
sufficient attention to cash flow adequacy in underwriting
agricultural loans. While collateral coverage is important,
the primary repayment source for intermediate and longterm agricultural loans is not collateral but cash flow from
ordinary operations. This principle should be incorporated
into the bank’s agricultural lending policies and
implemented in its actual practices. Cash flow analysis is
therefore an important aspect of the examiner’s review of
agricultural loans. Assumptions in cash flow projections
should be reasonable and consider not only current
conditions but also the historical performance of the
farming operation.
Financial and Other Credit Information - As with any type
of lending, sufficient information must be available so that
the bank can make informed credit decisions. Basic
information includes balance sheets, income statements,
cash flow projections, loan officer file comments, and
collateral inspections, verifications, and valuations.
Generally, financial information should be updated not less
than annually (loan officer files should be updated as
needed and document all significant meetings and events).
Credit information should be analyzed by management so
that appropriate and timely actions are taken, as necessary,
to administer the credit.
Collateral Support - Whether a loan or line of credit
warrants unsecured versus secured status in order to be
prudent and sound is a matter the examiner has to
determine based on the facts of the specific case. The
decision should generally consider such elements as the
borrower’s overall financial strength and trends,
profitability, financial leverage, degree of liquidity in asset
holdings, managerial and financial expertise, and amount
and type of credit. Nonetheless, as a general rule,
intermediate and long-term agricultural credit is typically
secured, and many times production and feeder livestock
advances will also be collateralized. Often the security
takes the form of an all-inclusive lien on farm personal
property, such as growing crops, machinery and
equipment, livestock, and harvested grain. A lien on real
estate is customarily taken if the loan was granted for the
purchase of the property, or if the borrower’s debts are
being restructured because of debt servicing problems. In
some cases, the bank may perfect a lien on real estate as an
abundance of caution.
Banks should be given some reasonable flexibility as to the
level of sophistication or comprehensiveness of the
aforementioned financial information, and the frequency
with which it is obtained, depending upon such factors as
the credit size, the type of loans involved, the financial
strength and trends of the borrower, and the economic,
climatic or other external conditions which may affect loan
repayment. It may therefore be inappropriate for the
Examiner review of agricultural related collateral
valuations varies depending on the type of security
involved. Real estate collateral should be reviewed using
normal procedures and utilizing Part 323 of the FDIC’s
Rules and Regulations as needed. Feeder livestock and
grain are highly liquid commodities that are bought and
sold daily in active, well-established markets. Their prices
are widely reported in the daily media; so, obtaining their
Agricultural Loan Underwriting Guidelines
Many underwriting standards applicable to commercial
loans also apply to agricultural credits. The discussion of
those shared standards is therefore not repeated. Some
items, however, are especially pertinent to agricultural
credit and therefore warrant emphasis.
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Federal Deposit Insurance Corporation
3.2-19
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Section 3.2
market values is generally easy. The market for breeder
livestock may be somewhat less liquid than feeder
livestock or grain, but values are nonetheless reasonably
well known and reported through local or regional media
or auction houses. If such information on breeding
livestock is unavailable or is considered unreliable,
slaughter prices may be used as an alternative (these
slaughter prices comprise “liquidation” rather than “going
concern” values). The extent of use and level of
maintenance received significantly affect machinery and
equipment values. Determining collateral values can
therefore be very difficult as maintenance and usage levels
vary significantly. Nonetheless, values for certain preowned machinery and equipment, especially tractors,
combines, and other harvesting or crop tillage equipment,
are published in specialized guides and are based on prices
paid at farm equipment dealerships or auctions. These
used machinery guides may be used as a reasonableness
check on the valuations presented on financial statements
or in management’s internal collateral analyses.
Two aspects of prudent loan administration deserve
emphasis: collateral control and renewal practices for
production loans.
Collateral Control - Production and feeder livestock loans
are sometimes referred to as self liquidating because sale of
the crops after harvest, and of the livestock when they
reach maturity, provides a ready repayment source for
these credits. These self-liquidating benefits may be lost,
however, if the bank does not monitor and exercise
sufficient control over the disposition of the proceeds from
the sale. In agricultural lending, collateral control is
mainly accomplished by periodic on-site inspections and
verifications of the security pledged, with the results of
those inspections documented, and by implementing
procedures to ensure sales proceeds are applied to the
associated debt before those proceeds are released for
other purposes. The recommended frequency of collateral
inspections varies depending upon such things as the nature
of the farming operation, the overall credit soundness, and
the turnover rate of grain and livestock inventories.
Prudent agricultural loan underwriting also includes
systems and procedures to ensure that the bank has a valid
note receivable from the borrower and an enforceable
security interest in the collateral, should judicial collection
measures be necessary. Among other things, such systems
and procedures will confirm that promissory notes, loan
agreements, collateral assignments, and lien perfection
documents are signed by the appropriate parties and are
filed, as needed, with the appropriate State, county, and/or
municipal authorities. Flaws in the legal enforceability of
loan instruments or collateral documents will generally be
unable to be corrected if they are discovered only when the
credit is distressed and the borrower relationship strained.
Renewal of Production Loans - After completion of the
harvest, some farm borrowers may wish to defer repayment
of some or all of that season’s production loans, in
anticipation of higher market prices at a later point
(typically, crop prices are lower at harvest time when the
supply is greater). Such delayed crop marketing will
generally require production loan extensions or renewals..
In these situations, the bank must strike an appropriate
balance of, on the one hand, not interfering with the
debtor’s legitimate managerial decisions and marketing
plans while, at the same time, taking prudent steps to
ensure its production loans are adequately protected and
repaid on an appropriate basis.
Examiners should
generally not take exception to reasonable renewals or
extensions of production loans when the following factors
are favorably resolved:
Structuring - Orderly liquidation of agricultural debt, based
on an appropriate repayment schedule and a clear
understanding by the borrower of repayment expectations,
helps prevent collection problems from developing.
Amortization periods for term indebtedness should
correlate with the useful economic life of the underlying
collateral and with the operation’s debt service capacity. A
too-lengthy amortization period can leave the bank under
secured in the latter part of the life of the loan, when the
borrower’s financial circumstances may have changed. A
too-rapid amortization, on the other hand, can impose an
undue burden on the cash flow capacity of the farming
operation and thus lead to loan default or disruption of
other legitimate financing needs of the enterprise. It is also
generally preferable that separate loans or lines of credit be
established for each loan purpose category financed by the
institution.
•
•
•
Administration of Agricultural Loans
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3.2-20
The borrower has sufficient financial strength to
absorb market price fluctuations. Leverage and
liquidity in the balance sheet, financial statement
trends, profitability of the operation, and past
repayment performance are relevant indices.
The borrower has sufficient financial capacity to
support both old and new production loans. That is, in
a few months subsequent to harvest, the farmer will
typically be incurring additional production debt for
the upcoming crop season.
The bank has adequately satisfied itself of the amount
and condition of grain in inventory, so that the
renewed or extended production loans are adequately
supported. Generally, this means that a current
inspection report will be available.
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Federal Deposit Insurance Corporation
LOANS
Section 3.2
•
Classification Guidelines for Agricultural Credit
•
When determining the level of risk in a specific lending
relationship, the relevant factual circumstances must be
reviewed in total. This means, among other things, that
when an agricultural loan’s primary repayment source is
jeopardized or unavailable, adverse classification is not
automatic. Rather, such factors as the borrower’s historical
performance and financial strength, overall financial
condition and trends, the value of any collateral, and other
sources of repayment must be considered. In considering
whether a given agricultural loan or line of credit should be
adversely classified, collateral margin is an important,
though not necessarily the determinative, factor. If that
margin is so overwhelming as to remove all reasonable
prospect of the bank sustaining some loss, it is generally
inappropriate to adversely classify such a loan. Note,
however, that if there is reasonable uncertainty as to the
value of that security, because of an illiquid market or
other reasons, that uncertainty can, when taken in
conjunction with other weaknesses, justify an adverse
classification of the credit, or, at minimum, may mean that
the margin in the collateral needs to be greater to offset this
uncertainty. Moreover, when assessing the adequacy of the
collateral margin, it must be remembered that deteriorating
financial trends will, if not arrested, typically result in a
shrinking of that margin. Such deterioration can also
reduce the amount of cash available for debt service needs.
•
•
Examiners should exercise great caution in granting the
grain and livestock exclusion from adverse classification in
those instances where the borrower is highly leveraged, or
where the debtor’s basic operational viability is seriously
in question, or if the bank is in an under-secured position.
The issue of control over proceeds becomes extremely
critical in such highly distressed credit situations. If the
livestock and grain exclusion from adverse classification is
not given in a particular case, bank management should be
informed of the reasons why.
That portion of an agricultural loan(s) or line of credit,
which is secured by grain, feeder livestock, and/or breeder
livestock, will generally be withheld from adverse
classification. The basis for this approach is that grain and
livestock are highly marketable and provide good
protection from credit loss.
However, that high
marketability also poses potential risks that must be
recognized and controlled. The following conditions must
therefore be met in order for this provision to apply:
•
With the above principles, requirements, and standards in
mind, the general guidelines for determining adverse
classification for agricultural loans are as follows, listed by
loan type.
Feeder Livestock Loans - The self-liquidating nature of
these credits means that they are generally not subject to
adverse classification. However, declines in livestock
prices, increases in production costs, or other unanticipated
developments may result in the revenues from the sale of
the livestock not being adequate to fully repay the loans.
Adverse classification may then be appropriate, depending
upon the support of secondary repayment sources and
collateral, and the borrower’s overall financial condition
and trends.
The bank must take reasonable steps to verify the
existence and value of the grain and livestock. This
generally means that on-site inspections must be made
and documented. Although the circumstances of each
case must be taken into account, the general policy is
that, for the classification exclusion to apply,
inspections should have been performed not more than
90 days prior to the examination start date for feeder
livestock and grain collateral, and not more than six
months prior to the examination start date for breeder
stock collateral. Copies of invoices or bills of sale are
acceptable substitutes for inspection reports prepared
by bank management, in the case of loans for the
purchase of livestock.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Loans secured by grain warehouse receipts are
generally excluded from adverse classification, up to
the market value of the grain represented by the
receipts.
The amount of credit to be given for the livestock or
grain collateral should be based on the daily,
published, market value as of the examination start
date, less marketing and transportation costs, feed and
veterinary expenses (to the extent determinable), and,
if material in amount, the accrued interest associated
with the loan(s). Current market values for breeder
stock may be derived from local or regional
newspapers, area auction barns, or other sources
considered reliable. If such valuations for breeding
livestock cannot be obtained, the animals’ slaughter
values may be used.
The bank must have satisfactory practices for
controlling sales proceeds when the borrower sells
livestock and feed and grain.
The bank must have a properly perfected and
enforceable security interest in the assets in question.
Production Loans - These loans are generally not subject to
adverse classification if the debtor has good liquidity
and/or significant fixed asset equities, or if the cash flow
information suggests that current year’s operations should
be sufficient to repay the advances. The examiner should
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Section 3.2
also take into account any governmental support programs
or Federal crop insurance benefits from which the
borrower may benefit.
If cash flow from ongoing
operations appears insufficient to repay production loans,
adverse classification may be in order, depending upon the
secondary repayment sources and collateral, and the
borrower’s overall financial condition and trends.
affected crop yields; or from other causes? In many
instances, it will be in the long-term best interests of both
the bank and the debtor to restructure the obligations. The
restructured obligation should generally be rescheduled on
a term basis and require clearly identified collateral,
amortization period, and payment amounts.
The
amortization period may be intermediate or long term
depending upon the useful economic life of the available
collateral, and on realistic projections of the operation’s
payment capacity.
Breeder Stock Loans - These loans are generally not
adversely classified if they are adequately secured by the
livestock and if the term debt payments are being met
through the sale of offspring (or milk and eggs in the case
of dairy and poultry operations). If one or both of these
conditions is not met, adverse classification may be in
order, depending upon the support of secondary repayment
sources and collateral, and the borrower’s overall financial
condition and trends.
There are no hard and fast rules on whether carryover debt
should be adversely classified, but the decision should
generally consider the following: borrower’s overall
financial condition and trends, especially financial leverage
(often measured in farm debtors with the debt-to-assets
ratio); profitability levels, trends, and prospects; historical
repayment performance; the amount of carryover debt
relative to the operation’s size; realistic projections of debt
service capacity; and the support provided by secondary
collateral. Accordingly, carryover loans to borrowers who
are moderately to highly leveraged, who have a history of
weak or no profitability and barely sufficient cash flow
projections, as well as an adequate but slim collateral
margin, will generally be adversely classified, at least until
it is demonstrated through actual repayment performance
that there is adequate capacity to service the rescheduled
obligation. The classification severity will normally
depend upon the collateral position. At the other extreme
are cases where the customer remains fundamentally
healthy financially, generates good profitability and ample
cash flow, and who provides a comfortable margin in the
security pledged. Carryover loans to this group of
borrowers will not ordinarily be adversely classified.
Machinery and Equipment Loans - Loans for the
acquisition of machinery and equipment will generally not
be subject to adverse classification if they are adequately
secured, structured on an appropriate amortization program
(see above), and are paying as agreed. Farm machinery
and equipment is often the second largest class of
agricultural collateral, hence its existence, general state of
repair, and valuation should be verified and documented
during the bank’s periodic on-site inspections of the
borrower’s operation. Funding for the payments on
machinery and equipment loans sometimes comes, at least
in part, from other loans provided by the bank, especially
production loans. When this is the case, the question arises
whether the payments are truly being “made as agreed.”
For examination purposes, such loans will be considered to
be paying as agreed if cash flow projections, payment
history, or other available information, suggests there is
sufficient capacity to fully repay the production loans when
they mature at the end of the current production cycle. If
the machinery and equipment loan is not adequately
secured, or if the payments are not being made as agreed,
adverse classification should be considered.
Installment Loans
An installment loan portfolio is usually comprised of a
large number of small loans scheduled to be amortized
over a specific period. Most installment loans are made
directly for consumer purchases, but business loans granted
for the purchase of heavy equipment or industrial vehicles
may also be included. In addition, the department may
grant indirect loans for the purchase of consumer goods.
Carryover Debt - Carryover debt results from the debtor’s
inability to generate sufficient cash flow to service the
obligation as it is currently structured. It therefore tends to
contain a greater degree of credit risk and must receive
close analysis by the examiner. When carryover debt
arises, the bank should determine the basic viability of the
borrower’s operation, so that an informed decision can be
made on whether debt restructuring is appropriate. It will
thus be useful for bank management to know how the
carryover debt came about: Did it result from the obligor’s
financial, operational or other managerial weaknesses;
from inappropriate credit administration on the bank’s part,
such as over lending or improper debt structuring; from
external events such as adverse weather conditions that
Loans (12-04)
The examiner's emphasis in reviewing the installment loan
department should be on the overall procedures, policies
and credit qualities. The goal should not be limited to
identifying current portfolio problems, but should include
potential future problems that may result from ineffective
policies, unfavorable trends, potentially dangerous
concentrations, or nonadherence to established policies. At
a minimum, the direct installment lending policies should
address the following factors: loan applications and credit
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Section 3.2
checks; terms in relation to collateral; collateral margins;
perfection of liens; extensions, renewals and rewrites;
delinquency notification and follow-up; and charge-offs
and collections.
For indirect lending, the policy
additionally should address direct payment to the bank
versus payment to the dealer, acquisition of dealer financial
information, possible upper limits for any one dealer's
paper, other standards governing acceptance of dealer
paper, and dealer reserves and charge-backs.
•
•
Direct Lease Financing
Leasing is a recognized form of term debt financing for
fixed assets. While leases differ from loans in some
respects, they are similar from a credit viewpoint because
the basic considerations are cash flow, repayment capacity,
credit history, management and projections of future
operations.
Additional considerations for a lease
transaction are the property type and its marketability in
the event of default or lease termination. Those latter
considerations do not radically alter the manner in which
an examiner evaluates collateral for a lease.
The
assumption is that the lessee/borrower will generate
sufficient funds to liquidate the lease/debt. Sale of leased
property/collateral remains a secondary repayment source
and, except for the estimated residual value at the
expiration of the lease, will not, in most cases, become a
factor in liquidating the advance. When the bank is
requested to purchase property of significant value for
lease, it may issue a commitment to lease, describing the
property, indicating cost, and generally outlining the lease
terms. After all terms in the lease transaction are resolved
by negotiation between the bank and its customer, an order
is usually written requesting the bank to purchase the
property. Upon receipt of that order, the bank purchases
the property requested and arranges for delivery and, if
necessary, installation.
A lease contract is drawn
incorporating all the points covered in the commitment
letter, as well as the rights of the bank and lessee in the
event of default. The lease contract is generally signed
simultaneously with the signing of the order to purchase
and the agreement to lease.
•
Bank management should carefully evaluate all lease
variables, including the estimate of the residual value.
Banks may be able to realize unwarranted lease income in
the early years of a contract by manipulating the lease
variables. In addition, a bank can offer the lessee a lower
payment by assuming an artificially high residual value
during the initial structuring of the lease. But this
technique may present the bank with serious long-term
problems because of the reliance on speculative or
nonexistent residual values.
Often, lease contracts contain an option permitting the
lessee to continue use of the property at the end of the
original term, working capital restrictions and other
restrictions or requirements similar to debt agreements and
lease termination penalties. Each lease is an individual
contract written to fulfill the lessee's needs. Consequently,
there may be many variations of each of the above
provisions. However, the underlying factors remain the
same: there is a definite contractual understanding of the
positive right to use the property for a specific period of
time, and required payments are irrevocable.
The types of assets that may be leased are numerous, and
the accounting for direct leasing is a complex subject
which is discussed in detail in FAS 13. Familiarity with
FAS 13 is a prerequisite for the management of any bank
engaging in or planning to engage in direct lease financing.
The following terms are commonly encountered in direct
lease financing:
•
Examination procedures for reviewing direct lease
financing activities are included in the ED Modules in the
Loan References section.
Net Lease, one in which the bank is not directly or
indirectly obligated to assume the expenses of
maintaining the equipment. This restriction does not
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
prohibit the bank from paying delivery and set up
charges on the property.
Full Payout Lease, one for which the bank expects to
realize both the return of its full investment and the
cost of financing the property over the term of the
lease. This payout can come from rentals, estimated
tax benefits, and estimated residual value of the
property.
Leveraged Lease, in which the bank as lessor
purchases and becomes the equipment owner by
providing a relatively small percentage (20-40%) of
the capital needed. Balance of the funds is borrowed
by the lessor from long-term lenders who hold a first
lien on the equipment and assignments of the lease and
lease rental payments. This specialized and complex
form of leasing is prompted mainly by a desire on the
part of the lessor to shelter income from taxation.
Creditworthiness of the lessee is paramount and the
general rule is a bank should not enter into a leveraged
lease transaction with any party to whom it would not
normally extend unsecured credit.
Rentals, which include only those payments
reasonably anticipated by the bank at the time the
lease is executed.
Floor Plan Loans
3.2-23
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Section 3.2
Floor plan (wholesale) lending is a form of retail goods
inventory financing in which each loan advance is made
against a specific piece of collateral. As each piece of
collateral is sold by the dealer, the loan advance against
that piece of collateral is repaid. Items commonly subject
to floor plan debt are automobiles, home appliances,
furniture, television and stereophonic equipment, boats,
mobile homes and other types of merchandise usually sold
under a sales finance contract. Drafting agreements are a
relatively common approach utilized in conjunction with
floor plan financing. Under this arrangement, the bank
establishes a line of credit for the borrower and authorizes
the good’s manufacturer to draw drafts on the bank in
payment for goods shipped. The bank agrees to honor
these drafts, assuming proper documentation (such as
invoices, manufacturer's statement of origin, etc.) is
provided. The method facilitates inventory purchases by,
in effect, guaranteeing payment to the manufacturer for
merchandise supplied. Floor plan loans involve all the
basic risks inherent in any form of inventory financing.
However, because of the banker's inability to exercise full
control over the floored items, the exposure to loss may be
greater than in other similar types of financing. Most
dealers have minimal capital bases relative to debt. As a
result, close and frequent review of the dealer's financial
information is necessary. As with all inventory financing,
collateral value is of prime importance. Control requires
the bank to determine the collateral value at the time the
loan is placed on the books, frequently inspect the
collateral to determine its condition, and impose a
curtailment requirement sufficient to keep collateral value
in line with loan balances.
Check Credit and Credit Card Loans
Check credit is defined as the granting of unsecured
revolving lines of credit to individuals or businesses.
Check credit services are provided by the overdraft system,
cash reserve system, and special draft system. The most
common is the overdraft system. In that method, a transfer
is made from a preestablished line of credit to a customer's
demand deposit account when a check which would cause
an overdraft position is presented. Transfers normally are
made in stated increments, up to the maximum line of
credit approved by the bank, and the customer is notified
that the funds have been transferred. In a cash reserve
system, customers must request that the bank transfer funds
from their preestablished line of credit to their demand
deposit account before negotiating a check against them.
A special draft system involves the customer negotiating a
special check drawn directly against a preestablished line
of credit. In that method, demand deposit accounts are not
affected. In all three systems, the bank periodically
provides its check credit customers with a statement of
account activity.
Required minimum payments are
computed as a fraction of the balance of the account on the
cycle date and may be made by automatic charges to a
demand deposit account.
Most bank credit card plans are similar. The bank solicits
retail merchants, service organizations and others who
agree to accept a credit card in lieu of cash for sales or
services rendered. The parties also agree to a discount
percentage of each sales draft and a maximum dollar
amount per transaction. Amounts exceeding that limit
require prior approval by the bank. Merchants also may be
assessed a fee for imprinters or promotional materials. The
merchant deposits the bank credit card sales draft at the
bank and receives immediate credit for the discounted
amount. The bank assumes the credit risk and charges the
nonrecourse sales draft to the individual customer's credit
card account. Monthly statements are rendered by the
bank to the customer who may elect to remit the entire
amount, generally without service charge, or pay in
monthly installments, with an additional percentage
charged on the outstanding balance each month. A
cardholder also may obtain cash advances from the bank or
dispensing machines. Those advances accrue interest from
the transaction date. A bank may be involved in a credit
card plan in three ways:
Handling procedures for floor plan lines will vary greatly
depending on bank size and location, dealer size and the
type of merchandise being financed. In many cases, the
term "trust receipt" is used to describe the debt instrument
existing between the bank and the dealer. Trust receipts
may result from drafting agreements between a bank and a
manufacturer for the benefit of a dealer. In other instances,
the dealer may order inventory, bring titles or invoices to
the bank, and then obtain a loan secured or to be secured
by the inventory. Some banks may use master debt
instruments, and others may use a trust receipt or note for
each piece of inventory. The method of perfecting a
security interest also varies from state to state. The
important point is that a bank enacts realistic handling
policies and ensures that its collateral position is properly
protected.
•
Examination procedures and examiner considerations for
reviewing floor plan lending activities are included in the
ED Modules in the Loan References section.
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3.2-24
Agent Bank, which receives credit card applications
from customers and sales drafts from merchants and
forwards such documents to banks described below,
and is accountable for such documents during the
process of receiving and forwarding.
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•
•
Section 3.2
clearing services should be financially sound and honestly
operated. To this end, safe and sound merchant credit card
activities should include clear and detailed acceptance
standards for merchants. These standards include the
following:
Sublicensee Bank, which maintains accountability for
credit card loans and merchant's accounts; may
maintain its own center for processing payments and
drafts; and may maintain facilities for embossing
credit cards.
Licensee Bank, which is the same as sublicensee bank,
but in addition may perform transaction processing
and credit card embossing services for sublicensee
banks, and also acts as a regional or national
clearinghouse for sublicensee banks.
•
•
Check credit and credit card loan policies should address
procedures for careful screening of account applicants;
establishment of internal controls to prevent interception of
cards before delivery, merchants from obtaining control of
cards, or customers from making fraudulent use of lost or
stolen card; frequent review of delinquent accounts,
accounts where payments are made by drawing on
reserves, and accounts with steady usage; delinquency
notification procedures; guidelines for realistic charge-offs;
removal of accounts from delinquent status (curing)
through performance not requiring a catch-up of delinquent
principal; and provisions that preclude automatic
reissuance of expired cards to obligors with charged-off
balances or an otherwise unsatisfactory credit history with
the bank.
•
•
•
Examination procedures for reviewing these activities are
included in the ED Modules. Also, the FDIC has separate
manuals on Credit Card Specialty Bank Examination
Guidelines and Credit Card Securitization Activities.
Another possible problem with merchant activities involves
clearing institutions that sometimes engage the services of
agents, such as an independent sales organization (ISO).
ISOs solicit merchants' credit card transactions for a
clearing institution. In some cases, the ISOs actually
contract with merchants on behalf of clearing institutions.
Some of these contracts are entered into by the ISOs
without the review and approval of the clearing
institutions. At times, clearing institutions unfortunately
rely too much on the ISOs to oversee account activity. In
some cases, clearing institutions have permitted ISOs to
contract with disreputable merchants. Because of the poor
condition of the merchant, or ISO, or both, these clearing
institutions can ultimately incur heavy losses.
Credit Card-related Merchant Activities
Merchant credit card activities basically involve the
acceptance of credit card sales drafts for clearing by a
financial institution (clearing institution). For the clearing
institution, these activities are generally characterized by
thin profit margins amidst high transactional and sales
volumes. Typically, a merchant's customer will charge an
item on a credit card, and the clearing institution will give
credit to the merchant's account. Should the customer
dispute a charge transaction, the clearing institution is
obligated to honor the customer's legitimate request to
reverse the transaction. The Clearing Institution must then
seek reimbursement from the merchant. Problems arise
when the merchant is not creditworthy and is unable, or
unwilling, to reimburse the clearing institution. In these
instances, the clearing institution will incur a loss.
Examiners should review for the existence of any such
contingent liabilities.
In order to avoid losses and to ensure the safe and
profitable operation of a clearing institution's credit card
activities, the merchants with whom it contracts for
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
A clearing institution should scrutinize prospective
merchants with the same care and diligence that it uses
in evaluating prospective borrowers.
Financial institutions engaging in credit card clearing
operations must closely monitor their merchants.
Controls should be in place to ensure that early
warning signs are recognized so that problem
merchants can be removed from a clearing institution's
program promptly to minimize loss exposure.
In cases of merchants clearing large dollar volumes, a
clearing institution should establish an account
administration program that, at a minimum,
incorporates periodic reviews of the merchants'
financial statements and business activities.
A clearing institution should establish an internal
periodic reporting system of merchant account
activities regardless of the amount or number of
transactions cleared, and these reports should be
reviewed for irregularities so that the Clearing
Institution alerts itself quickly to problematic merchant
activity.
Clearing institutions should follow the guidelines that
are established by the card issuing networks.
A financial institution with credit card clearing activities
should develop its own internal controls and procedures to
ensure sound agent selection standards before engaging an
ISO. ISOs that seek to be compensated solely on the basis
of the volume of signed-up merchants should be carefully
scrutinized. A clearing institution should adequately
supervise the ISO's activities, just as the institution should
supervise any third party engaged to perform services for
any aspect of the institution's operations. Also, it should
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Section 3.2
•
reserve the right to ratify or reject any merchant contract
that is initiated by an ISO.
Examination procedures for reviewing credit card related
merchant activities are included in the Examination
Documentation Modules in the Supplemental Modules
Section and in the Credit Card Specialty Bank Examination
Guidelines.
OTHER CREDIT ISSUES
Appraisals
Appraisals are professional judgments of the market value
of real property. Three basic valuation approaches are
used by professional appraisers in estimating the market
value of real property; the cost approach, the market data
or direct sales comparison approach, and the income
approach. The principles governing the three approaches
are widely known in the appraisal field and are referenced
in parallel regulations issued by each of the Federal bank
and thrift regulatory agencies. When evaluating collateral,
the three valuation approaches are not equally appropriate.
•
•
Cost Approach - In this approach, the appraiser
estimates the reproduction cost of the building and
improvements, deducts estimated depreciation, and
adds the value of the land. The cost approach is
particularly helpful when reviewing draws on
construction loans.
However, as the property
increases in age, both reproduction cost and
depreciation become more difficult to estimate.
Except for special purpose facilities, the cost approach
is usually inappropriate in a troubled real estate market
because construction costs for a new facility normally
exceed the market value of existing comparable
properties.
Market Data or Direct Sales Comparison
Approach - This approach examines the price of
similar properties that have sold recently in the local
market, estimating the value of the subject property
based on the comparable properties' selling prices. It
is very important that the characteristics of the
observed transactions be similar in terms of market
location, financing terms, property condition and use,
timing, and transaction costs. The market approach
generally is used in valuing owner-occupied
residential property because comparable sales data is
typically available. When adequate sales data is
available, an analyst generally will give the most
weight to this type of estimate. Often, however, the
available sales data for commercial properties is not
sufficient to justify a conclusion.
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The Income Approach - The economic value of an
income-producing property is the discounted value of
the future net operating income stream, including any
"reversion" value of property when sold.
If
competitive markets are working perfectly, the
observed sales price should be equal to this value. For
unique properties or in depressed markets, value based
on a comparable sales approach may be either
unavailable or distorted. In such cases, the income
approach is usually the appropriate method for valuing
the property. The income approach converts all
expected future net operating income into present
value terms. When market conditions are stable and
no unusual patterns of future rents and occupancy rates
are expected, the direct capitalization method is often
used to estimate the present value of future income
streams. For troubled properties, however, the more
explicit discounted cash flow (net present value)
method is more typically utilized for analytical
purposes. In the rent method, a time frame for
achieving a "stabilized", or normal, occupancy and
rent level is projected. Each year's net operating
income during that period is discounted to arrive at
present value of expected future cash flows. The
property's anticipated sales value at the end of the
period until stabilization (its terminal or reversion
value) is then estimated.
The reversion value
represents the capitalization of all future income
streams of the property after the projected occupancy
level is achieved. The terminal or reversion value is
then discounted to its present value and added to the
discounted income stream to arrive at the total present
market value of the property.
Valuation of Troubled Income-Producing Properties
When an income property is experiencing financial
difficulties due to general market conditions or due to its
own characteristics, data on comparable property sales is
often difficult to obtain. Troubled properties may be hard
to market, and normal financing arrangements may not be
available. Moreover, forced and liquidation sales can
dominate market activity. When the use of comparables is
not feasible (which is often the case for commercial
properties), the net present value of the most reasonable
expectation of the property's income-producing capacity not just in today's market but over time - offers the most
appropriate method of valuation in the supervisory process.
Estimates of the property's value should be based upon
reasonable and supportable projections of the determinants
of future net operating income: rents (or sales), expenses,
and rates of occupancy. The primary considerations for
these projections include historical levels and trends, the
current market performance achieved by the subject and
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Section 3.2
similar properties, and economically feasible and
defensible projections of future demand and supply
conditions. If current market activity is dominated by a
limited number of transactions or liquidation sales, high
capitalization and discount rates implied by such
transactions should not be used. Rather, analysts should
use rates that reflect market conditions that are neither
highly speculative nor depressed.
the ASB. The ASB has issued The Uniform Standards of
Professional Appraisal Practice (USPAP) which set the
appraisal industry standards for conducting an appraisal of
real estate. To the appraisal industry, USPAP is analogous
to generally accepted accounting principles for the
accounting profession.
In conformance with Title XI, Part 323 of the FDIC
regulations identifies which real estate related transactions
require an appraisal by a certified or licensed appraiser and
establishes minimum standards for performing appraisals.
Substantially similar regulations have been adopted by
each of the Federal financial institutions regulatory
agencies.
Appraisal Regulation
Title XI of the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 requires that appraisals
prepared by certified or licensed appraisers be obtained in
support of real estate lending and mandates that the Federal
financial institutions regulatory agencies adopt regulations
regarding the preparation and use of appraisals in certain
real estate related transactions by financial institutions
under their jurisdiction. In addition, Title XI created the
Appraisal Subcommittee (Subcommittee) of the Federal
Financial Institutions Examination Council (FFIEC) to
provide oversight of the real estate appraisal process as it
relates to federally related real estate transactions. The
Subcommittee is composed of six members, each of whom
is designated by the head of their respective agencies.
Each of the five financial institution regulatory agencies
which comprise the FFIEC and the U.S. Department of
Housing and Urban Development are represented on
Subcommittee. A responsibility of the Subcommittee is to
monitor the state certification and licensing of appraisers.
It has the authority to disapprove a state appraiser
regulatory program, thereby disqualifying the state's
licensed and certified appraisers from conducting
appraisals for federally related transactions.
The
Subcommittee gets its funding by charging state certified
and licensed appraisers an annual registration fee. The fee
income is used to cover Subcommittee administrative
expenses and to provide grants to the Appraisal
Foundation.
Real estate-related transactions include real estate loans,
mortgage-backed securities, bank premises, real estate
investments, and other real estate owned. All real estaterelated transactions by FDIC-insured institutions not
specifically exempt are, by definition, "federally related
transactions" subject to the requirements of the regulation.
Exempt real estate-related transactions include:
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Formed in 1987, the Appraisal Foundation was established
as a private not for profit corporation bringing together
interested parties within the appraisal industry, as well as
users of appraiser services, to promote professional
standards within the appraisal industry. The Foundation
sponsors two independent boards referred to in Title XI,
The Appraiser Qualifications Board (AQB) and The
Appraisal Standards Board (ASB). Title XI specifies that
the minimum standards for state appraiser certification are
to be the criteria for certification issued by the AQB. Title
XI does not set specific criteria for the licensed
classification. These are individually determined by each
state. Additionally, Title XI requires that the appraisal
standards prescribed by the Federal agencies, at a
minimum, must be the appraisal standards promulgated by
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3.2-27
The transaction value is $250,000 or less;
A lien on real estate has been taken as collateral in an
abundance of caution;
The transaction is not secured by real estate;
A lien on real estate has been taken for purposes other
than the real estate’s value;
The transaction is a business loan that: (i) has a
transaction value of $1 million or less; and (ii) is not
dependent on the sale of, or rental income derived
from, real estate as the primary source of repayment;
A lease of real estate is entered into, unless the lease is
the economic equivalent of a purchase or sale of the
leased real estate;
The transaction involves an existing extension of
credit at the lending institution, provided that: (i)
There has been no obvious and material change in the
market conditions or physical aspects of the property
that threatens the adequacy of the institution’s real
estate collateral protection after the transaction, even
with the advancement of new monies; or (ii) There is
no advancement of new monies, other than funds
necessary to cover reasonable closing costs;
The transaction involves the purchase, sale, investment
in, exchange of, or extension of credit secured by, a
loan or interest in a loan, pooled loans, or interests in
real property, including mortgage-backed securities,
and each loan or interest in a loan, pooled loan, or real
property interest met FDIC regulatory requirements
for appraisals at the time of origination;
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Section 3.2
The transaction is wholly or partially insured or
guaranteed by a United States government agency or
United States government sponsored agency;
The transaction either; (i) Qualifies for sale to a
United States government agency or United States
government sponsored agency; or (ii) Involves a
residential real estate transaction in which the
appraisal conforms to the Federal National Mortgage
Association or Federal Home Loan Mortgage
Corporation appraisal standards applicable to that
category of real estate;
The regulated institution is acting in a fiduciary
capacity and is not required to obtain an appraisal
under other law; or
The FDIC determines that the services of an appraiser
are not necessary in order to protect Federal financial
and public policy interests in real estate-related
financial transaction or to protect the safety and
soundness of the institution.
explain assumptions, is not logical, or has other major
deficiencies that cast doubt as to the validity of its opinion
of value. Examination procedures regarding appraisal
reviews are included in the Examination Documentation
Modules.
Section 323.4 establishes minimum standards for all
appraisals in connection with federally related transactions.
Appraisals performed in conformance with the regulation
must conform to the requirements of the USPAP and
certain other listed standards. The applicable sections of
USPAP are the Preamble (ethics and competency),
Standard 1 (appraisal techniques), Standard 2 (report
content), and Standard 3 (review procedures). USPAP
Standards 4 through 10 concerning appraisal services and
appraising personal property do not apply to federally
related transactions.
These Interagency Appraisal and Evaluation Guidelines
dated October 27, 1994 address supervisory matters
relating to real estate-related financial transactions and
provide guidance to examining personnel and federally
regulated institutions about prudent appraisal and
evaluation policies, procedures, practices, and standards.
The guidelines were reiterated and clarified in a Statement
issued by the regulatory agencies on October 27, 2003.
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Loans in a pool such as an investment in mortgage- backed
securities or collateralized mortgage obligations should
have some documented assurance that each loan in the pool
has an appraisal in accordance with the regulation.
Appropriate evidence could include an issuer's certification
of compliance.
All apparent violations of Part 323 should be listed in the
examination report in the usual manner. Significant
systemic failures to meet standards and procedures could
call for formal corrective measures.
Interagency Appraisal and Evaluation Guidelines
An institution's real estate appraisal and evaluation policies
and procedures will be reviewed as part of the examination
of the institution's overall real estate-related activities. An
institution's policies and procedures should be incorporated
into an effective appraisal and evaluation program.
Examiners will consider the institution's size and the nature
of its real estate-related activities when assessing the
appropriateness of its program.
An appraisal satisfies the regulation if it is performed in
accordance with all of its provisions and it is still current
and meaningful. In other words, a new appraisal does not
necessarily have to be done every time there is a
transaction, provided the institution has an acceptable
process in place to review existing appraisals.
When analyzing individual transactions, examiners should
review an appraisal or evaluation to determine whether the
methods, assumptions, and findings are reasonable and in
compliance with the agencies' appraisal regulations,
policies, supervisory guidelines, and internal policies.
Examiners also will review the steps taken by an institution
to ensure that the individuals who perform its appraisals
and evaluations are qualified and are not subject to
conflicts of interest. Institutions that fail to maintain a
sound appraisal or evaluation program or to comply with
the agencies' appraisal regulations, policies, or these
supervisory guidelines will be cited in examination reports
and may be criticized for unsafe and unsound banking
practices. Deficiencies will require corrective action.
Adherence to the appraisal regulation and appraisal
guidelines should be part of the examiner's overall review
of the lending function. An institution's written appraisal
program should contain specific administrative review
procedures that provide some evidence, such as a staff
member's signature on an appraisal checklist that indicates
the appraisal was reviewed and that all standards were met.
In addition, the regulation requires that the appraisal
contain the appraiser's certification that it was prepared in
conformance with USPAP. When analyzing individual
transactions, examiners should review appraisal reports to
determine the institution's conformity to its own internal
appraisal policies and for compliance with the regulation.
Examiners may need to conduct a more detailed review if
the appraisal does not have sufficient information, does not
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Appraisal and Evaluation Program - An institution's board
of directors is responsible for reviewing and adopting
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policies and procedures that establish an effective real
estate appraisal and evaluation program. The program
should:
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Independence of the Appraisal And Evaluation Function Because the appraisal and evaluation process is an integral
component of the credit underwriting process, it should be
isolated from influence by the institution's loan production
process.
An appraiser and an individual providing
evaluation services should be independent of the loan and
collection functions of the institution and have no interest,
financial or otherwise, in the property or the transaction.
In addition, individuals independent from the loan
production area should oversee the selection of appraisers
and individuals providing evaluation services. If absolute
lines of independence cannot be achieved, an institution
must be able to clearly demonstrate that it has prudent
safeguards to isolate its collateral evaluation process from
influence or interference from the loan production process.
That is, no single person should have sole authority to
render credit decisions on loans which they ordered or
reviewed appraisals or evaluations.
Establish selection criteria and procedures to evaluate
and monitor the ongoing performance of individuals
who perform appraisals or evaluations;
Provide for the independence of the person performing
appraisals or evaluations;
Identify the appropriate appraisal for various lending
transactions;
Establish criteria for contents of an evaluation;
Provide for the receipt of the appraisal or evaluation
report in a timely manner to facilitate the underwriting
decision;
Assess the validity of existing appraisals or
evaluations to support subsequent transactions;
Establish criteria for obtaining appraisals or
evaluations for transactions that are otherwise exempt
from the agencies' appraisal regulations; and
Establish internal controls that promote compliance
with these program standards.
The agencies recognize, however, that it is not always
possible or practical to separate the loan and collection
functions from the appraisal 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
collateral may also be a loan officer, other officer, or
director of the institution. To ensure their independence,
such lending officials, officers, or directors should abstain
from any vote or approval involving loans on which they
performed an appraisal or evaluation.
Selection of Individuals Who May Perform Appraisals and
Evaluations - An institution's program should establish
criteria to select, evaluate, and monitor the performance of
the individual(s) who performs a real estate appraisal or
evaluation. The criteria should ensure that:
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The institution's selection process is non-preferential
and unbiased;
The individual selected possesses the requisite
education, expertise and competence to complete the
assignment;
The individual selected is capable of rendering an
unbiased opinion; and
The individual selected is independent and has no
direct or indirect interest, financial or otherwise, in the
property or the transaction.
Transactions That Require Appraisals - Although the
agencies' appraisal regulations exempt certain categories of
real estate-related financial transactions from the appraisal
requirements, most real estate transactions over $250,000
are considered federally related transactions and thus
require appraisals. A "federally related transaction" means
any real estate-related financial transaction, in which the
agencies engage, contract for, or regulate and that requires
the services of an appraiser. An agency also may impose
more stringent appraisal requirements than the appraisal
regulations require, such as when an institution's troubled
condition is attributable to real estate loan underwriting
problems.
Under the agencies' appraisal regulations, the appraiser
must be selected and engaged directly by the institution or
its agent. The appraiser's client is the institution, not the
borrower. Also, an institution may not use an appraisal
that has been “readdressed” – appraisal reports that are
altered by the appraiser to replace any references to the
original client with the institution’s name. An institution
may use an appraisal that was prepared by an appraiser
engaged directly by another financial services institution,
as long as the institution determines that the appraisal
conforms to the agencies' appraisal regulations and is
otherwise acceptable.
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Minimum Appraisal Standards - The agencies' appraisal
regulations include five minimum standards for the
preparation of an appraisal. The appraisal must:
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3.2-29
Conform to generally accepted appraisal standards as
evidenced by the Uniform Standards of Professional
Appraisal Practice (USPAP) promulgated by the
Appraisal Standards Board (ASB) of the Appraisal
Foundation unless principles of safe and sound
banking require compliance with stricter standards.
Although allowed by USPAP, the agencies' appraisal
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Section 3.2
regulations do not permit an appraiser to appraise any
property in which the appraiser has an interest, direct
or indirect, financial or otherwise;
Be written and contain sufficient information and
analysis to support the institution's decision to engage
in the transaction. As discussed below, appraisers
have available various appraisal development and
report options; however, not all options may be
appropriate for all transactions. A report option is
acceptable under the agencies' appraisal regulations
only if the appraisal report contains sufficient
information and analysis to support an institution's
decision to engage in the transaction.
Analyze and report appropriate deductions and
discounts for proposed construction or renovation,
partially leased buildings, non-market lease terms, and
tract developments with unsold units. This standard is
designed to avoid having appraisals prepared using
unrealistic assumptions and inappropriate methods.
For federally related transactions, an appraisal is to
include the current market value of the property in its
actual physical condition and subject to the zoning in
effect as of the date of the appraisal. For properties
where improvements are to be constructed or
rehabilitated, the regulated institution may also request
a prospective market value based on stabilized
occupancy or a value based on the sum of retail sales.
However, the sum of retail sales for a proposed
development is not the market value of the
development for the purpose of the agencies' appraisal
regulations. For proposed developments that involve
the sale of individual houses, units, or lots, the
appraiser must analyze and report appropriate
deductions and discounts for holding costs, marketing
costs and entrepreneurial profit. For proposed and
rehabilitated rental developments, the appraiser must
make appropriate deductions and discounts for items
such as leasing commission, rent losses, and tenant
improvements from an estimate based on stabilized
occupancy;
Be based upon the definition of market value set forth
in the regulation. Each appraisal must contain an
estimate of market value, as defined by the agencies'
appraisal regulations; and,
Be performed by state licensed or certified appraisers
in accordance with requirements set forth in the
regulation.
property. An appraiser must certify that he/she has
complied with USPAP and is independent. Also, the
appraiser must disclose whether the subject property was
inspected and whether anyone provided significant
assistance to the person signing the appraisal report.
An institution may engage an appraiser to perform either a
Complete or Limited Appraisal. When performing a
Complete Appraisal assignment, an appraiser must comply
with all USPAP standards - without departing from any
binding requirements - and specific guidelines when
estimating market value. When performing a Limited
Appraisal, the appraiser elects to invoke the Departure
Provision which allows the appraiser to depart, under
limited conditions, from standards identified as specific
guidelines. For example, in a Limited Appraisal, the
appraiser might not utilize all three approaches to value;
however, departure from standards designated as binding
requirements is not permitted. There are numerous binding
requirements which are detailed in the USPAP. Use of the
USPAP Standards publication as a reference is
recommended.
The book provides details on each
appraisal standard and advisory opinions issued by the
Appraisal Standards Board.
An institution and appraiser must concur that use of the
Departure Provision is appropriate for the transaction
before the appraiser commences the appraisal assignment.
The appraiser must ensure that the resulting appraisal
report will not mislead the institution or other intended
users of the appraisal report. The agencies do not prohibit
the use of a Limited Appraisal for a federally related
transaction, but the agencies believe that institutions should
be cautious in their use of a Limited Appraisal because it
will be less thorough than a Complete Appraisal.
Complete and Limited Appraisal assignments may be
reported in three different report formats: a Self-Contained
Report, a Summary Report, or a Restricted Report. The
major difference among these three reports relates to the
degree of detail presented in the report by the appraiser.
The Self-Contained Appraisal Report provides the most
detail, while the Summary Appraisal Report presents the
information in a condensed manner. The Restricted Report
provides a capsulated report with the supporting details
maintained in the appraiser's files.
The agencies believe that the Restricted Report format will
not be appropriate to underwrite a significant number of
federally related transactions due to the lack of sufficient
supporting information and analysis in the appraisal report.
However, it might be appropriate to use this type of
appraisal report for ongoing collateral monitoring of an
institution's real estate transactions and under other
circumstances when an institution's program requires an
evaluation.
Appraisal Options - An appraiser typically uses three
market value approaches to analyze the value of a property
cost, income, and sales market. The appraiser reconciles
the results of each approach to estimate market value. An
appraisal will discuss the property's recent sales history and
contain an opinion as to the highest and best use of the
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Section 3.2
or as its overall exposure increases, a more detailed
evaluation should be performed.
For example, an
evaluation for a home equity loan might be based primarily
on information derived from a sales data services
organization or current tax assessment information, while
an evaluation for an income-producing real estate property
should fully describe the current and expected use of the
property and include an analysis of the property's rental
income and expenses.
Moreover, since the institution is responsible for selecting
the appropriate appraisal report to support its underwriting
decisions, its program should identify the type of appraisal
report that will be appropriate for various lending
transactions. The institution's program should consider the
risk, size, and complexity of the individual loan and the
supporting collateral when determining the level of
appraisal development and the type of report format that
will be ordered. When ordering an appraisal report,
institutions may want to consider the benefits of a written
engagement letter that outlines the institution's expectations
and delineates each party's responsibilities, especially for
large, complex, or out-of-area properties.
Qualifications of Evaluation Providers - Individuals who
prepare evaluations should have real estate-related training
or experience and knowledge of the market relevant to the
subject property.
Based upon their experience and
training, professionals from several fields may be qualified
to prepare evaluations of certain types of real estate
collateral. Examples include individuals with appraisal
experience, real estate lenders, consultants or sales
persons, agricultural extension agents, or foresters.
Institutions should document the qualifications and
experience level of individuals whom the institution deems
acceptable to perform evaluations. An institution might
also augment its in-house expertise and hire an outside
party familiar with a certain market or a particular type of
property. Although not required, an institution may use
state licensed or certified appraisers to prepare evaluations.
As such, Limited Appraisals reported in a Summary or
Restricted format may be appropriate for evaluations of
real estate-related financial transactions exempt from the
agencies' appraisal requirements.
Transactions That Require Evaluations - A formal opinion
of market value prepared by a state licensed or certified
appraiser is not always necessary. Instead, less formal
evaluations of the real estate may suffice for transactions
that are exempt from the agencies' appraisal requirements.
Institutions should also establish criteria for obtaining
appraisals or evaluations for safety and soundness reasons
for transactions that are otherwise exempt from the
agencies' appraisal regulations.
Evaluation Content - An institution should establish
prudent standards for the preparation of evaluations. At a
minimum, an evaluation should:
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Be written;
Include the preparer's name, address, and signature,
and the effective date of the evaluation;
Describe the real estate collateral, its condition, its
current and projected use;
Describe the source(s) of information used in the
analysis;
Describe the analysis and supporting information, and;
Provide an estimate of the real estate's market value,
with any limiting conditions.
Valid Appraisals and Evaluations - The agencies allow an
institution to use an existing appraisal or evaluation to
support a subsequent transaction, if the institution
documents that the existing estimate of value remains
valid.
Therefore, a prudent appraisal and evaluation
program should include criteria to determine whether an
existing appraisal or evaluation remains valid to support a
subsequent transaction. Criteria for determining whether
an existing appraisal or evaluation remains valid will vary
depending upon the condition of the property and the
marketplace, and the nature of any subsequent transaction.
Factors that could cause changes to originally reported
values include: the passage of time; the volatility of the
local market; the availability of financing; the inventory of
competing properties; improvements to, or lack of
maintenance of, the subject property or competing
surrounding properties; changes in zoning; or
environmental contamination.
The institution must
document the information sources and analyses used to
conclude that an existing appraisal or evaluation remains
valid for subsequent transactions.
An evaluation report should include calculations,
supporting assumptions, and, if utilized, a discussion of
comparable sales. Documentation should be sufficient to
allow an institution to understand the analysis,
assumptions, and conclusions. An institution's own real
estate loan portfolio experience and value estimates
prepared for recent loans on comparable properties might
provide a basis for evaluations.
An evaluation should provide an estimate of value to assist
the institution in assessing the soundness of the transaction.
Prudent practices also require that as an institution engages
in more complex real estate-related financial transactions,
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Renewals, Refinancings, and Other Subsequent
Transactions - The agencies' appraisal regulations
3.2-31
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generally allow appropriate evaluations of real estate
collateral in lieu of an appraisal for loan renewals and
refinancings; however, in certain situations an appraisal is
required. If new funds are advanced in excess of
reasonable closing costs, an institution is expected to
obtain a new appraisal for the renewal of an existing
transaction when there is a material change in market
conditions or in the physical aspects of the property that
threatens the institution's real estate collateral protection.
overall credit analysis and may take the form of either a
narrative or a checklist. Corrective action should be
undertaken for noted deficiencies by the individual who
prepared the appraisal or evaluation.
An institution's appraisal and evaluation program should
also have comprehensive analytical procedures that focus
on certain types of loans, such as large-dollar credits, loans
secured by complex or specialized properties, nonresidential real estate construction loans, or out-of-area real
estate. These comprehensive analytical procedures should
be designed to verify that the methods, assumptions, and
conclusions are reasonable and appropriate for the
transaction and the property. These procedures should
provide for a more detailed review of selected appraisals
and evaluations prior to the final credit decision. The
individual(s) performing these reviews should have the
appropriate training or experience, and be independent of
the transaction.
The decision to reappraise or reevaluate the real estate
collateral should be guided by the exemption for renewals,
refinancings, and other subsequent transactions. Loan
workouts, debt restructurings, loan assumptions, and
similar transactions involving the addition or substitution
of borrowers may qualify for the exemption for renewals,
refinancings, and other subsequent transactions. Use of
this exemption depends on the condition and quality of the
loan, the soundness of the underlying collateral and the
validity of the existing appraisal or evaluation.
Appraisers and persons performing evaluations should be
responsible for any deficiencies in their reports. Deficient
reports should be returned to them for correction.
Unreliable appraisals or evaluations should be replaced
prior to the final credit decision. Changes to an appraisal's
estimate of value are permitted only as a result of a review
conducted by an appropriately qualified state licensed or
certified appraiser in accordance with Standard III of
USPAP.
A reappraisal would not be required when an institution
advances funds to protect its interest in a property, such as
to repair damaged property, because these funds should be
used to restore the damaged property to its original
condition. If a loan workout involves modification of the
terms and conditions of an existing credit, including
acceptance of new or additional real estate collateral,
which facilitates the orderly collection of the credit or
reduces the institution's risk of loss, a reappraisal or
reevaluation may be prudent, even if it is obtained after the
modification occurs.
Portfolio Monitoring - The institution should also develop
criteria for obtaining reappraisals or reevaluations as part
of a program of prudent portfolio review and monitoring
techniques, even when additional financing is not being
contemplated. Examples of such types of situations
include large credit exposures and out-of-area loans.
An institution may engage in a subsequent transaction
based on documented equity from a valid appraisal or
evaluation, if the planned future use of the property is
consistent with the use identified in the appraisal or
evaluation.
If a property, however, has reportedly
appreciated because of a planned change in use of the
property, such as rezoning, an appraisal would be required
for a federally related transaction, unless another
exemption applied.
Referrals - Financial institutions are encouraged to make
referrals directly to state appraiser regulatory authorities
when a state licensed or certified appraiser violates
USPAP, applicable State law, or engages in other unethical
or unprofessional conduct. Examiners finding evidence of
unethical or unprofessional conduct by appraisers will
forward their findings and recommendations to their
supervisory office for appropriate disposition and referral
to the State, as necessary.
Program Compliance - An institution's appraisal and
evaluation program should establish effective internal
controls that promote compliance with the program's
standards. An individual familiar with the appropriate
agency's appraisal regulation should ensure that the
institution's appraisals and evaluations comply with the
agencies' appraisal regulations, these guidelines, and the
institution's program. Loan administration files should
document this compliance review, although a detailed
analysis or comprehensive analytical procedures are not
required for every appraisal or evaluation. For some loans,
the compliance review may be part of the loan officer's
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Examination Treatment
All apparent violations of the appraisal regulation should
be described in the schedule of violations of laws and
regulations.
Management's comments and any
commitments for correcting the practices that led to the
apparent violation should be included. Violations that are
technical in nature and do not impact the value conclusion
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•
generally should not require a new appraisal. (These
technical violations should not be relisted in subsequent
examinations.) Since the point of an appraisal is to help
make sound loan underwriting decisions, getting an
appraisal on a loan already made simply to fulfill the
requirements of the appraisal regulation, would be of little
benefit. However, an institution should be expected to
obtain a new appraisal on a loan in violation of the
appraisal regulation when there is a safety and soundness
reason for such action. For example, construction loans
and lines of credit need to have the value of the real estate
reviewed frequently in order for the institution to properly
manage the credit relationship. A new appraisal might also
be needed to determine the proper classification for
examination purposes of a collateral dependent loan.
•
•
The purchaser's interest in the loan must be isolated
from the seller, meaning that the purchaser's interest in
the loan is presumptively beyond the reach of the
seller and its creditors, even in bankruptcy or other
receivership;
Each purchaser has the right to pledge or exchange its
interest in the loan, and there are no conditions that
both constrain the purchaser from taking advantage of
that right and provide more than a trivial benefit to the
seller; and
The agreement does not both entitle and obligate the
seller to repurchase or redeem the purchaser's interest
in the loan prior to the loan's maturity, and it does not
provide the seller with the ability to unilaterally cause
the purchaser to return its interest in the loan to the
seller (other than through a cleanup call).
Loan Participations
Right to Repurchase - Some loan participation
agreements may give the seller a contractual right to
repurchase the participated interest in the loan at any time.
In this case, the seller's right to repurchase the participation
effectively provides the seller with a call option on a
specific asset and precludes sale accounting. If a loan
participation agreement contains such a provision, the
participation should be accounted for as a secured
borrowing.
A loan participation is a sharing or selling of ownership
interests in a loan between two or more financial
institutions. Normally, a lead bank originates the loan and
sells ownership interests to one or more participating banks
at the time the loan is closed. The lead (originating) bank
retains a partial interest in the loan, holds all loan
documentation in its own name, services the loan, and
deals directly with the customer for the benefit of all
participants. Properly structured, loan participations allow
selling banks to accommodate large loan requests which
would otherwise exceed lending limits, diversify risk, and
improve liquidity.
Participating banks are able to
compensate for low local loan demand or invest in large
loans without servicing burdens and origination costs. If
not appropriately structured and documented, a
participation loan can present unwarranted risks to both the
seller and purchaser of the loan. Examiners should
determine the nature and adequacy of the participation
arrangement as well as analyze the credit quality of the
loan.
Recourse Arrangements - Recourse arrangements may, or
may not, preclude loan participations from being accounted
for as sales for financial reporting purposes. The date of
the participation and the formality of the recourse
provision affect the accounting for the transaction. Formal
recourse provisions may affect the accounting treatment of
a participation depending upon the date that the
participation is transferred to another institution. Implicit
recourse provisions would not affect the financial reporting
treatment of a participation because the accounting
standards look to the contractual terms of asset transfers in
determining whether or not the criteria necessary for sales
accounting treatment have been met. Although implicit
recourse provisions would not affect the accounting
treatment of a loan participation, they may affect the riskbased capital treatment of a participation.
Accounting and Capital Treatment - The proper
accounting treatment for loan participations is governed by
FAS 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. FAS
applies to both the transferor (seller) of assets and the
transferee (purchaser).
Loan participations transferred prior to April 1, 2001, are
accounted for based on FAS 125, Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of
Liabilities. The sales criteria contained in FAS 125 are
very similar to those contained in FAS 140, which are
summarized above.
However, for FDIC-insured
institutions, the first of the sales criteria in FAS 140,
known as the isolation test, applies to transfers occurring
after December 31, 2001. As a result, loan participations
transferred from April 1 through December 31, 2001, are
Loan participations are accounted for as sales provided the
sales criteria in FAS 140 are met. If the sales criteria are
not met, participations are accounted for as secured
borrowings. The sales criteria focus on whether or not
control is effectively transferred to the purchaser. To
qualify for sales treatment three criteria must be met:
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subject to the isolation test in FAS 125, but are otherwise
accounted for based on FAS 140. Based upon the FASB's
initial understanding of the nature of the FDIC's
receivership power to reclaim certain assets sold by
institutions that subsequently failed when it was drafting
FAS 125, the FASB deemed assets sold by FDIC-insured
institutions to be beyond the reach of creditors in an FDIC
receivership. Therefore in FAS 125, the FASB concluded
that assets transferred by an FDIC-insured institution,
including participations, generally met the isolation test for
sales accounting treatment with respect to receiverships.
(Depending on the terms of the transfer, the transferred
assets might not meet the isolation test for other reasons.)
As a result, the mere existence of formal (written,
contractual) recourse provisions would not, in and of
themselves, preclude loan participations transferred prior
to January 1, 2002, from being accounted for as sales
provided all other criteria necessary for sales accounting
treatment are met. However, participations transferred
prior to January 1, 2002, which are subject to formal
recourse provisions, as well as those subject to implicit
(unwritten, noncontractual) recourse provisions in which
the seller demonstrates intent to repurchase participations
in the event of default even in the absence of a formal
obligation to do so, would be considered assets sold with
recourse when calculating the seller's risk-based capital
ratios.
borrowings by both the seller and the purchaser for
financial reporting purposes. This means that the seller
must not reduce the loan assets on its balance sheet for the
participation, and that the entire amount of the loan must
be included in the seller's assets for both leverage and riskbased capital purposes. Participations transferred after
December 31, 2001, which are subject to implicit
(unwritten, noncontractual) recourse provisions may be
accounted for as sales by both the seller and the purchaser
for financial reporting purposes, provided the other sales
criteria addressed above are met. However, if the seller
demonstrates intent to repurchase participations sold in the
event of default even in the absence of a formal obligation
to do so, then these participations will be treated as assets
sold with recourse when calculating the seller's risk-based
capital ratios.
Consistent with an AICPA auditing
interpretation, FDIC-insured institutions which account for
loan participations transferred after December 31, 2001, as
sales rather than as secured borrowings for financial
reporting purposes should generally do so only if the
participation agreement is supported by a legal opinion
explaining how the isolation test for sales accounting
treatment is met given the FDIC's receivership powers.
Call Report Treatment - When a loan participation is
accounted for as a sale, the seller removes the participated
interest in the loan from its books. The purchaser reports
its interest in the loan as Loans in the Report of Condition,
and in Call Report Schedule RC-C - Loans and Lease
Financing Receivables, based upon collateral, borrower, or
purpose. If a loan participation is accounted for as a
secured borrowing, the seller does not remove the loan
from its books. The participated portion of the loan is
reported as both Loans and Other Borrowed Money in the
Report of Condition. The purchaser would report its
interest in the loan as Loans in the Report of Condition,
and as Loans to depository institutions and acceptances of
other banks in Schedule RC-C. More detailed guidance on
accounting for transfers of financial assets, including loan
participations, is contained in the Transfers of Financial
Assets entry in the Glossary of the Call Report Instructions.
After the issuance of FAS 125, the FASB further clarified
its understanding of the FDIC's ability to reclaim certain
assets in a receivership, and the FDIC clarified when it
would not seek to reclaim loan participations sold in Part
360 of the FDIC Rules and Regulations. Section 360.6
limits the FDIC's ability to reclaim certain loan
participations sold without recourse, but does not limit the
FDIC's ability to reclaim loan participations sold with
recourse. For purposes of Section 360.6, the phrase
"without recourse" means that the participation is not
subject to any agreement which requires the lead bank
(seller) to repurchase the participant's (purchaser's) interest
in the loan or to otherwise compensate the participant due
to a default on the underlying loan. The FASB's new
understanding of the FDIC's receivership powers, including
Part 360, is addressed in FAS 140.
Independent Credit Analysis - A bank purchasing a
participation loan is expected to perform the same degree
of independent credit analysis on the loan as if it were the
originator. To determine if a participation loan meets its
credit standards, a participating bank must obtain all
relevant credit information and details on collateral values,
lien status, loan agreements and participation agreements
before a commitment is made to purchase. The absence of
such information may be evidence that the participating
bank has not been prudent in its credit decision.
Loan participations transferred after December 31, 2001,
must be accounted for pursuant to all of the provisions of
FAS 140, including its isolation test. In accordance with
FAS 140, loan participations sold by FDIC-insured
institutions with recourse generally will not be considered
isolated from creditors in the event of receivership due to
the FDIC's power to reclaim the participated assets. As a
result, loan participations transferred after December 31,
2001, which are subject to formal (written, contractual)
recourse provisions should be accounted for as secured
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During the life of the participation, the participant should
monitor the servicing and the status of the loan. In order to
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exercise control of its ownership interest, a purchasing
bank must ascertain that the selling bank will provide
complete and timely credit information on a continuing
basis.
subsequent payments and collections in proportion to their
respective ownership interest at the time of default.
Without such a provision, the banks would not have a prorata sharing of credit risk. Provided the sales criteria
contained in FAS 140 are met, loan participations sold in
which the participation agreements provide for the
allocation of loan payments, absent default, on some basis
other than proportional ownership interests, may be treated
as sold and removed from the balance sheet for financial
reporting purposes.
However, if the participation
agreements do not also contain a provision requiring that
all payments and collections received subsequent to default
be allocated based on ownership interests in the loan as of
the date of default, those participations will be treated as
loans sold with recourse for risk-based capital purposes
regardless of the financial reporting treatment. Further
discussion of loans sold with recourse is contained in the
Sales of Assets for Risk-Based Capital Purposes entry in
the glossary of the Call Report Instructions.
The procedures for purchasing loan participations should
be provided for in the bank's formal lending policy. The
criteria for participation loans should be consistent with
that for similar direct loans. The policy would normally
require the complete analysis of the credit quality of
obligations to be purchased, determination of value and
lien status of collateral, and the maintenance of full credit
information for the life of the participation.
Participation Agreements - A participation loan can
present unique problems if the borrower defaults, the lead
bank becomes insolvent, or a party to the participation
arrangement does not perform as expected.
These
contingencies should be considered in a written
participation agreement. The agreement should clearly
state the limitations the originating and participating banks
impose on each other and the rights all parties retain. In
addition to the general terms of the participation
transaction, participation agreements should specifically
include the following considerations:
•
•
•
•
•
•
Participations Between Affiliated Institutions Examiners should ascertain that banks do not relax their
credit standards when dealing with affiliated institutions
and that participation loans between affiliated institutions
are in compliance with Section 23A of the Federal Reserve
Act. The Federal Reserve Board Staff has interpreted that
the purchase of a participation loan from an affiliate is
exempt from Section 23A provided that the commitment to
purchase is obtained by the affiliate before the loan is
consummated by the affiliate, and the decision to
participate is based upon the bank's independent evaluation
of the creditworthiness of the loan. If these criteria are not
strictly met, the loan participation could be subject to the
qualitative and/or quantitative restrictions of Section 23A.
Refer to the Related Organizations Section of this Manual
which describes transactions with affiliates.
The obligation of the lead bank to furnish timely credit
information and to provide notification of material
changes in the borrower's status;
Requirements that the lead bank consult with
participants prior to modifying any loan, guaranty, or
security agreements and before taking any action on
defaulted loans;
The specific rights and remedies available to the lead
and participating banks upon default of the borrower;
Resolution procedures when the lead and participating
banks cannot agree on the handling of a defaulted
loan;
Resolution of any potential conflicts between the lead
bank and participants in the event that more than one
loan to the borrower defaults; and
Provisions for terminating the agency relationship
between the lead and participating banks upon such
events as insolvency, breach of duty, negligence, or
misappropriation by one of the parties.
Sales of 100 Percent Loan Participations - In some
cases, depository institutions structure loan originations
and participations with the intention of selling off 100
percent of the underlying loan amount. Certain 100
percent loan participation programs raise unique safety and
soundness issues that should be addressed by an
institution’s policies, procedures and practices.
If not appropriately structured, these 100 percent
participation programs can present unwarranted risks to the
originating institution including legal, reputation and
compliance risks. While this statement applies only to a
small number of mostly very large insured depository
institutions, the agreements should clearly state the
limitations the originating and participating institutions
impose on each other and the rights all parties retain. The
originating institution should state that loan participants are
participating in loans and are not investing in a business
In some loan participation agreements, the participation
agreement provides for the allocation of loan payments on
some basis other than in proportion to ownership interest.
For example, principal payments may be applied first to
the participant’s ownership interest and all remaining
payments to the lead bank’s ownership interest. In these
instances, the participation agreement must also specify
that in case of loan default, participants will share in all
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enterprise. The policies of an institution engaged in these
originations should address safety and soundness concerns
and include criteria to address:
•
•
•
•
As part of the institution's overall decision-making process,
the environmental risk program should establish
procedures for identifying and evaluating potential
environmental concerns associated with lending practices
and other actions relating to real property. The board of
directors should review and approve the program and
designate a senior officer knowledgeable in environmental
matters responsible for program implementation. The
environmental risk program should be tailored to the needs
of the lending institution. That is, institutions that have a
heavier concentration of loans to higher risk industries or
localities of known contamination may require a more
elaborate and sophisticated environmental risk program
than institutions that lend more to lower risk industries or
localities. The environmental risk program should provide
for staff training, set environmental policy guidelines and
procedures, require an environmental review or analysis
during the application process, include loan documentation
standards, and establish appropriate environmental risk
assessment safeguards in loan workout situations and
foreclosures.
The program’s objectives – these should be of a
commercial nature (structured as commercial
undertakings and not as investments in securities).
The plan of distribution – participants should be
limited to sophisticated financial and commercial
entities and sophisticated persons and the
participations should not be sold directly to the public.
The credit requirements applicable to the borrower the originating institution should structure 100% loan
participation programs only for borrowers who meet
the originating institution’s credit requirements.
Access afforded program participants to financial
information on the borrower - the originating
institution should allow potential loan participants to
obtain and review appropriate credit and other
information to enable the participants to make an
informed credit decision.
Environmental Risk Program
Examination Procedures
A lending institution should have in place appropriate
safeguards and controls to limit exposure to potential
environmental liability associated with real property held
as collateral. The potential adverse effect of environmental
contamination on the value of real property and the
potential for liability under various environmental laws
have become important factors in evaluating real estate
transactions and making loans secured by real estate.
Environmental contamination, and liability associated with
environmental contamination, may have a significant
adverse effect on the value of real estate collateral, which
may in certain circumstances cause an insured institution to
abandon its right to the collateral. It is also possible for an
institution to be held directly liable for the environmental
cleanup of real property collateral acquired by the
institution. The cost of such a cleanup may exceed by
many times the amount of the loan made to the borrower.
A loan may be affected adversely by potential
environmental liability even where real property is not
taken as collateral. For example, a borrower's capacity to
make payments on a loan may be threatened by
environmental liability to the borrower for the cost of a
hazardous contamination cleanup on property unrelated to
the loan with the institution.
The potential for
environmental liability may arise from a variety of Federal
and State environmental laws and from common law tort
liability.
Examiners should review an institution's environmental
risk program as part of the examination of its lending and
investment activities. When analyzing individual credits,
examiners should review the institution's compliance with
its own environmental risk program. Failure to establish or
comply with an appropriate environmental program should
be criticized and corrective action required.
LOAN PROBLEMS
It would be impossible to list all sources and causes of
problem loans. They cover a multitude of mistakes a bank
may permit a borrower to make, as well as mistakes
directly attributable to weaknesses in the bank's credit
administration and management. Some well-constructed
loans may develop problems due to unforeseen
circumstances on the part of the borrower; however, bank
management must endeavor to protect a loan by every
means possible. One or more of the items in the following
list is often basic to the development of loan problems.
Many of these items may also be indicative of potential
bank fraud and/or insider abuse. Additional information
on the warning signs and suggested areas for investigation
are included in the Bank Fraud and Insider Abuse Section
of this Manual.
Poor Selection of Risks
Guidelines for an Environmental Risk Program
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Section 3.2
Problems in this area may reflect the absence of sound
lending policies, and/or management's lack of sound credit
judgment in advancing certain loans. The following are
general types of loans which may fall within the category
of poor risk selection. It should be kept in mind that these
examples are generalizations, and the examiner must weigh
all relevant factors in determining whether a given loan is
indeed a poor risk.
•
•
•
•
•
•
•
•
•
•
•
•
Loans granted without a well-defined repayment program
violate a fundamental principle of sound lending.
Regardless of what appears to be adequate collateral
protection, failure to establish at inception or thereafter
enforce a program of repayment almost invariably leads to
troublesome and awkward servicing problems, and in many
instances is responsible for serious loan problems including
eventual losses. This axiom of sound lending is important
not only from the lender's standpoint, but also the
borrower's.
Loans to finance new and untried business ventures
which are inadequately capitalized.
Loans based more upon the expectation of successfully
completing a business transaction than on sound worth
or collateral.
Loans for the speculative purchase of securities or
goods.
Collateral loans made without adequate margin of
security.
Loans made because of other benefits, such as the
control of large deposit balances, and not based upon
sound worth or collateral.
Loans made without adequate owner equity in
underlying real estate security.
Loans predicated on collateral which has questionable
liquidation value.
Loans predicated on the unmarketable stock of a local
corporation when the bank is at the same time lending
directly to the corporation. Action which may be
beneficial to the bank from the standpoint of the one
loan may be detrimental from the standpoint of the
other loan.
Loans which appear to be adequately protected by
collateral or sound worth, but which involve a
borrower of poor character risk and credit reputation.
Loans which appear to be adequately protected by
collateral, but which involve a borrower with limited
or unassessed repayment ability.
An abnormal amount of loans involving
out-of-territory borrowers (excluding large banks
properly staffed to handle such loans).
Loans involving brokered deposits or link financing.
Incomplete Credit Information
Lending errors frequently result because of management's
failure to obtain and properly evaluate credit information.
Adequate comparative financial statements, income
statements, cash flow statements and other pertinent
statistical support should be available. Other essential
information, such as the purpose of the borrowing and
intended plan or sources of repayment, progress reports,
inspections, memoranda of outside information and loan
conferences, correspondence, etc., should be contained in
the bank's credit files. Failure of a bank's management to
give proper attention to credit files makes sound credit
judgment difficult if not impossible.
Overemphasis on Loan Income
Misplaced emphasis upon loan income, rather than
soundness, almost always leads to the granting of loans
possessing undue risk. In the long run, unsound loans
usually are far more expensive than the amount of revenue
they may initially produce.
Self-Dealing
Pronounced self-dealing practices are often present in
serious problem bank situations and in banks which fail.
Such practices with regard to loans are found in the form of
overextensions of unsound credit to insiders, or their
interests, who have improperly used their positions to
obtain unjustified loans. Active officers, who serve at the
pleasure of the ownership interests, are at times subjected
to pressures which make it difficult to objectively evaluate
such loans. Loans made for the benefit of ownership
interests that are carried in the name of a seemingly
unrelated party are sometimes used to conceal self-dealing
loans.
Overlending
It is almost as serious, from the standpoint of ultimate
losses, to lend a sound financial risk too much money as it
is to lend to an unsound risk. Loans beyond the reasonable
capacity of the borrower to repay invariably lead to the
development of problem loans.
Technical Incompetence
Failure to Establish or Enforce Liquidation
Agreements
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Technical incompetence usually is manifested in
management's inability to obtain and evaluate credit
information or put together a well-conceived loan package.
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Management weaknesses in this area are almost certain to
lead to eventual loan losses. Problems can also develop
when management, technically sound in some forms of
lending, becomes involved in specialized types of credit in
which it lacks expertise and experience.
The preceding discussions describe various practices or
conditions which may serve as a source or cause of weak
loans. Weak loans resulting from these practices or
conditions may manifest themselves in a variety of ways.
While it is impossible to provide a complete detailing of
potential "trouble indicators", the following list, by
document, may aid the examiner in identifying potential
problem loans during the examination process.
Lack of Supervision
Loan problems encountered in this area normally arise for
one of two reasons:
•
•
Absence of effective active management supervision
of loans which possessed reasonable soundness at
inception. Ineffective supervision almost invariably
results from lack of knowledge of a borrower's affairs
over the life of the loan. It may well be coupled with
one or more of the causes and sources of loan
problems previously mentioned.
Failure of the board and/or senior management to
properly oversee subordinates to determine that sound
policies are being carried out.
•
Lack of Attention to Changing Economic
Conditions
•
•
Economic conditions, both national and local, are
continuously changing, management must be responsive to
these changes. This is not to suggest that lending policies
should be in a constant state of flux, nor does it suggest
that management should be able to forecast totally the
results of economic changes. It does mean, however, that
bankers should realistically evaluate lending policies and
individual loans in light of changing conditions. Economic
downturns can adversely affect borrowers' repayment
potential and can lessen a bank's collateral protection.
Reliance on previously existing conditions as well as
optimistic hopes for economic improvement can,
particularly when coupled with one or more of the causes
and sources of loan problems previously mentioned, lead
to serious loan portfolio deterioration.
•
Competition
•
Competition among financial institutions for growth,
profitability, and community influence sometimes results in
the compromise of sound credit principles and acquisition
of unsound loans. The ultimate cost of unsound loans
outweighs temporary gains in growth, income and
influence.
Potential Problem Indicators by Document
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3.2-38
Debt Instrument - Delinquency; irregular payments
or payments not in accordance with terms; unusual or
frequently modified terms; numerous renewals with
little or no principal reduction; renewals that include
interest; and extremely high interest rate in relation to
comparable loans granted by the bank or the going rate
for such loans in the bank's market area.
Liability Ledger - Depending on the type of debt,
failure to amortize in a regular fashion over a
reasonable period of time, e.g., on an annual basis,
seasonally, etc.; and a large number of out-of-territory
borrowers, particularly in cases where these types of
loans have increased substantially since the previous
examination.
Financial and Operating Statements - Inadequate or
declining working capital position; excessive volume
or negative trend in receivables; unfavorable level or
negative trend in inventory; no recent aging of
receivables, or a marked slowing in receivables;
drastic increase in volume of payables; repeated and
increasing renewals of carry-over operating debt;
unfavorable trends in sales and profits; rapidly
expanding expenses; heavy debt-to-worth level and/or
deterioration in this relationship; large dividend or
other payments without adequate or reasonable
earnings retention; and net worth enhancements
resulting solely from reappraisal in the value of fixed
assets.
Cash Flow Documentation - Absence of cash flow
statements or projections, particularly as related to
newly established term borrowers; projections
indicating an inability to meet required interest and
principal payments; and statements reflecting that cash
flow is being provided by the sale of fixed assets or
nonrecurring situations.
Correspondence and Credit Files - Missing and/or
inadequate collateral or loan documentation, such as
financial statements, security agreements, guarantees,
assignments, hypothecation agreements, mortgages,
appraisals, legal opinions and title insurance, property
insurance, loan applications; evidence of borrower
credit checks; corporate or partnership borrowing
authorizations; letters indicating that a borrower has
suffered financial difficulties or has been unable to
meet established repayment programs; and documents
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•
Section 3.2
•
that reveal other unfavorable factors relative to a line
of credit.
Collateral - Collateral evidencing a speculative loan
purpose or collateral with inferior marketability
characteristics (single purpose real estate, restricted
stock, etc.) which has not been compensated for by
other reliable repayment sources; and collateral of
questionable value acquired subsequent to the
extension of the credit.
•
•
•
The degree of analysis and/or time devoted to the above
loans may vary. For example, the time devoted to a
previously classified loan which has been substantially
reduced or otherwise improved may be significantly less
than other loans. Watch list loans should initially be
sampled to assess if management’s ratings are accurate.
The reworking of certain loan files, such as seasoned real
estate mortgages, which are not subject to significant
change, should be kept to a minimum or omitted. This
does not mean that an examiner should not briefly review
new file information (since the previous examination) to
determine any adverse trends with respect to significant
loans. In addition, the examiner should review a sufficient
volume of different types of loans offered by the bank to
determine that bank policies are adequate and being
followed.
LOAN APPRAISAL AND
CLASSIFICATION
Loan Appraisal
In order to properly analyze any credit, an examiner must
acquire certain fundamental information about a borrower's
financial condition, purpose and terms of the borrowing,
and prospects for its orderly repayment. The process
involved in acquiring the foregoing information will
necessarily vary with the size of the bank under
examination and the type and sophistication of records
utilized by the bank.
Because of the sheer volume of loans, it is necessary to
focus attention on the soundness of larger lines of credit.
Relatively smaller loans that appear to be performing
satisfactorily may ordinarily be omitted from individual
appraisal. The minimum size of the loan to be appraised
depends upon the characteristics of the individual bank.
The cut-off point should be low enough to permit an
accurate appraisal of the loan portfolio as a whole, yet not
so high as to preclude a thorough analysis of a
representative portion of total loans. This procedure does
not prevent an examiner from analyzing smaller loans
which do not show adequate amortization for long periods
of time, are overdue, are deficient in collateral coverage, or
otherwise possess characteristics which would cause them
to be subject to further scrutiny. In most instances, there
should be direct correlation between the cut-off point
utilized, the percentage of loans lined, and the asset quality
and management ratings assigned at the previous
examination.
Review of Files and Records
Commercial loan liability ledgers or comparable subsidiary
records vary greatly in quality and detail. Generally, they
will provide the borrower's total commercial loan liability
to the bank, and the postings thereto will depict a history of
the debt. Collateral records should be scrutinized to
acquire the necessary descriptive information and to
ascertain that the collateral held to secure the notes is as
transcribed.
Gathering credit information is an important process and
should be done with care to obtain the essential
information, which will enable the examiner to appraise the
loans accurately and fairly. Failure to obtain and record
pertinent information contained in the credit files can
reflect unfavorably on examiners, and a good deal of
examiner and loan officer time can be saved by carefully
analyzing the files. Ideally, credit files will also contain
important correspondence between the bank and the
borrower. However, this is not universally the case; in
some instances, important correspondence is deliberately
lodged in separate files because of its sensitive character.
Correspondence between the bank and the borrower can be
especially valuable to the examiner in developing added
insight into the status of problem credits.
The following types of loans or lines of credit should be
analyzed at each examination:
•
Loans or lines of credit listed for Special Mention or
adversely classified at the previous FDIC examination
or State examination, if applicable as a result of an
alternating examination program;
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Federal Deposit Insurance Corporation
Loans reflected on the bank's problem loan list, if such
a list exists, or identified as problem loans by the
bank’s credit grading system;
Significant overdue loans as determined from the
bank's delinquency list;
Other significant loans which exhibit a high degree of
risk that have come to the examiner's attention in the
review of minutes, audit reports or other sources; and
Loans to the bank's insiders, and their related interests
and insiders of other banks.
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LOANS
Section 3.2
place for antagonistic remarks and snide comments
directed at loan officers. The examiner should listen
carefully to what the banker has to say, and concisely and
accurately note this information. Failure to do so can result
in inaccuracies and make follow-up at the next examination
more difficult.
Verification of loan proceeds is one of the most valuable
and effective loan examining techniques available to the
examiner and often one of the most ignored. This
verification process can disclose fraudulent or fictitious
notes, misapplication of funds, loans made for the benefit
or accommodation of parties other than the borrower of
record, or utilization of loans for purposes other than those
reflected in the bank's files.
Verification of the
disbursement of a selected group of large or unusual loans,
particularly those subject to classification or Special
Mention and those granted under circumstances which
appear illogical or incongruous is important. However, it
is more important to carry the verification process one step
further to the apparent utilization of loan proceeds as
reflected by the customer's deposit account or other related
bank records. The examiner should also determine the
purpose of the credit and the expected source of
repayment.
Loan Analysis
In the appraisal of individual loans, the examiner should
weigh carefully the information obtained and arrive at a
judgment as to the credit quality of the loans under review.
Each loan is appraised on the basis of its own
characteristics. Consideration is given to the risk involved
in the project being financed; the nature and degree of
collateral security; the character, capacity, financial
responsibility, and record of the borrower; and the
feasibility and probability of its orderly liquidation in
accordance with specified terms. The willingness and
ability of a debtor to perform as agreed remains the
primary measure of a loan’s risk. This implies that the
borrower must have earnings or liquid assets sufficient to
meet interest payments and provide for reduction or
liquidation of principal as agreed at a reasonable and
foreseeable date.
However, it does not mean that
borrowers must at all times be in a position to liquidate
their loans, for that would defeat the original purpose of
extending credit.
Examination Procedures regarding loan portfolio analysis
are included in the Examination Documentation Modules.
Loan Discussion
The examiner must comprehensively review all data
collected on the individual loans. In most banks, this
review should allow the majority of loans to be passed
without criticism, eliminating the need for discussing these
lines with the appropriate bank officer(s). No matter how
thoroughly the supporting loan files have been reviewed,
there will invariably be a number of loans which will
require additional information or discussion before an
appropriate judgment can be made as to their credit
quality, relationship to other loans, proper documentation,
or other circumstances related to the overall examination of
the loan portfolio. Such loans require discussion with the
appropriate bank officer(s) as do other loans for which
adequate information has been assembled to indicate that
classification or Special Mention is warranted.
Following analysis of specific credits, it is important that
the examiner ascertain whether troublesome loans result
from inadequate lending and collection policies and
practices or merely reflect exceptions to basically sound
credit policies and practices.
In instances where
troublesome loans exist due to ineffective lending practices
and/or inadequate supervision, it is quite possible that
existing problems will go uncorrected and further loan
quality deterioration may occur. Therefore, the examiner
should not only identify problem loans, but also ascertain
the cause(s) of these problems. Weaknesses in lending
policies or practices should be stressed, along with possible
corrective measures, in discussions with the bank's senior
management and/or the directorate and in the Report of
Examination.
Proper preparation for the loan discussion is essential, and
the following points should be given due consideration by
the examiner. Loans which have been narrowed down for
discussion should be reviewed in depth to insure a
comprehensive grasp of all factual material. Careful
advance preparation can save time for all concerned.
Particularly with regard to large, complicated lines, undue
reliance should not be placed on memory to cover
important points in loan discussion. Important weaknesses
and salient points to be covered in discussion, questions to
be asked, and information to be sought should be noted.
The loan discussion should not involve discussion of
trivialities since the banker's time is valuable, and it is no
Loans (12-04)
Loan Classification
To quantify and communicate the results of the loan
appraisal, the examiner must arrive at a decision as to
which loans are to be subjected to criticism and/or
comment in the examination report. Adversely classified
loans are allocated on the basis of risk to three categories:
Substandard; Doubtful; and Loss.
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Federal Deposit Insurance Corporation
LOANS
Section 3.2
Other loans of questionable quality, but involving
insufficient risk to warrant classification, are designated as
Special Mention loans. Loans lacking technical or legal
support, whether or not adversely classified, should be
brought to the attention of the bank's management. If the
deficiencies in documentation are severe in scope or
volume, a schedule of such loans should be included in the
Report of Examination.
Definitions
•
Loan classifications are expressions of different degrees of
a common factor, risk of nonpayment. All loans involve
some risk, but the degree varies greatly. It is incumbent
upon examiners to avoid classification of sound loans. The
practice of lending to sound businesses or individuals for
reasonable periods is a legitimate banking function.
Adverse classifications should be confined to those loans
which are unsafe for the investment of depositors' funds.
•
•
If the internal grading system is determined to be accurate
and reliable, examiners can use the institution’s data for
preparing the applicable examination report pages and
schedules, for determining the overall level of
classifications, and for providing supporting comments
regarding the quality of the loan portfolio. If the internal
classifications are overly conservative, examiners should
make appropriate adjustments and include explanations in
the report’s comments.
There is a close relationship between classifications, and
no classification category should be viewed as more
important than the other. The uncollectibility aspect of
Doubtful and Loss classifications makes their segregation
of obvious importance. The function of the Substandard
classification is to indicate those loans which are unduly
risky and, if unimproved, may be a future hazard.
A uniform agreement on the classification of assets and
appraisal of securities in bank examinations was issued
jointly on June 15, 2004, by the Office of the Comptroller
of the Currency, the FDIC, the Federal Reserve Board, and
the Office of Thrift Supervision.
This interagency
statement provides definitions of Substandard, Doubtful,
and Loss categories used for adversely classifying bank
assets. Amounts classified Loss should be promptly
eliminated from the bank's books.
A complete list of adversely classified loans is to be
provided to management, either during or at the close of an
examination.
Special Mention Assets
Uniform guidelines have been established by the FDIC
regarding the Report of Exam treatment of assets classified
Doubtful. The general policy is not to require charge-off
or similar action for Doubtful classifications. Examiners
should make a statement calling for a bank to charge-off a
portion of loans classified Doubtful only when State law or
policy requires. Further, any such statement should be
clear as to the intended purpose of bringing the bank into
conformity with those State requirements. An exception is
made for formal actions under Section 8 of the FDI Act.
Definition - A Special Mention asset has potential
weaknesses that deserve management's close attention. If
left uncorrected, these potential weaknesses may result in
deterioration of the repayment prospects for the asset or in
the institution's credit position at some future date. Special
Mention assets are not adversely classified and do not
expose an institution to sufficient risk to warrant adverse
classification.
Use of Special Mention - The Special Mention category is
not to be used as a means of avoiding a clear decision to
classify a loan or pass it without criticism. Neither should
it include loans listed merely "for the record" when
uncertainties and complexities, perhaps coupled with large
size, create some reservations about the loan.
If
A statement addressing the chargeoff of loans classified
Loss is a required comment Report of Examination when
the amount is material. Amounts classified Loss should be
promptly eliminated from the bank's books.
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Federal Deposit Insurance Corporation
Substandard - Substandard loans are inadequately
protected by the current sound worth and paying
capacity of the obligor or of the collateral pledged, if
any. Loans so classified must have a well-defined
weakness or weaknesses that jeopardize the liquidation
of the debt. They are characterized by the distinct
possibility that the bank will sustain some loss if the
deficiencies are not corrected.
Doubtful - Loans classified Doubtful have all the
weaknesses inherent in those classified Substandard
with the added characteristic that the weaknesses make
collection or liquidation in full, on the basis of
currently known facts, conditions and values, highly
questionable and improbable.
Loss - Loans classified Loss are considered
uncollectible and of such little value that their
continuance as bankable assets is not warranted. This
classification does not mean that the loan has
absolutely no recovery or salvage value but rather it is
not practical or desirable to defer writing off this
basically worthless asset even though partial recovery
may be effected in the future.
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Section 3.2
weaknesses or evidence of imprudent handling cannot be
identified, inclusion of such loans in Special Mention is not
justified.
Ordinarily, Special Mention credits have characteristics
which corrective management action would remedy. Often
weak origination and/or servicing policies are the cause for
the Special Mention designation. Examiners should not
misconstrue the fact that most Special Mention loans
contain management correctable deficiencies to mean that
loans involving merely technical exceptions belong in this
category. However, instances may be encountered where
technical exceptions are a factor in scheduling loans for
Special Mention.
•
Careful identification of loans which properly belong in
this category is important in determining the extent of risk
in the loan portfolio and providing constructive criticism
for bank management. While Special Mention Assets
should not be combined with adversely classified assets,
their total should be considered in the analysis of asset
quality and management, as appropriate.
•
The nature of this category precludes inclusion of smaller
lines of credit unless those loans are part of a large
grouping listed for related reasons. Comments on loans
listed for Special Mention in the Report of Examination
should be drafted in a fashion similar to those for adversely
classified loans. There is no less of a requirement upon the
examiner to record clearly the reasons why the loan is
listed. The major thrust of the comments should be
towards achieving correction of the deficiencies identified.
Technical Exceptions
Deficiencies in documentation of loans should be brought
to the attention of management for remedial action. Failure
of management to effect corrections may lead to the
development of greater credit risk in the future. Moreover,
an excessive number of technical exceptions may be a
reflection on management's quality and ability. Inclusion
of the schedule "Assets With Credit Data or Collateral
Documentation Exceptions" and various comments in the
Report of Examination is appropriate in certain
circumstances. Refer to the Report of Examination
Instructions for further guidance.
Troubled Commercial Real Estate Loan
Classification Guidelines
Additional classification guidelines have been developed to
aid the examiner in classifying troubled commercial real
estate loans. These guidelines are intended to supplement
the uniform guidelines discussed above. After performing
an analysis of the project and its appraisal, the examiner
must determine the classification of any exposure.
Past Due and Nonaccrual
Overdue loans are not necessarily subject to adverse
criticism. Nevertheless, a high volume of overdue loans
almost always indicates liberal credit standards, weak
servicing practices, or both. Because loan renewal and
extension policies vary among banks, comparison of their
delinquency ratios may be misleading. A more significant
method of evaluating this factor lies in determination of the
trend within the bank under examination, keeping in mind
the distortion resulting from seasonal influences, economic
conditions, or the timing of examinations. It is important
for the examiner to carefully consider the makeup and
reasons for the volume of overdue loans. Only then can it
The following guidelines are to be applied in instances
where the obligor is devoid of other reliable means of
repayment, with support of the debt provided solely by the
project. If other types of collateral or other sources of
repayment exist, the project should be evaluated in light of
these mitigating factors.
•
Substandard - Any such troubled real estate loan or
portion thereof should be classified Substandard when
well-defined weaknesses are present which jeopardize
the orderly liquidation of the debt. Well-defined
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weaknesses include a project's lack of marketability,
inadequate cash flow or collateral support, failure to
complete construction on time or the project's failure
to fulfill economic expectations.
They are
characterized by the distinct possibility that the bank
will sustain some loss if the deficiencies are not
corrected.
Doubtful - Doubtful classifications have all the
weaknesses inherent in those classified Substandard
with the added characteristic that the weaknesses make
collection or liquidation in full, on the basis of
currently known facts, conditions and values, highly
questionable and improbable.
A Doubtful
classification may be appropriate in cases where
significant risk exposures are perceived, but Loss
cannot be determined because of specific reasonable
pending factors which may strengthen the credit in the
near term. Examiners should attempt to identify Loss
in the credit where possible thereby limiting the
excessive use of the Doubtful classification.
Loss - Advances in excess of calculated current fair
value which are considered uncollectible and do not
warrant continuance as bankable assets. There is little
or no prospect for near term improvement and no
realistic strengthening action of significance pending.
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LOANS
Section 3.2
be determined whether the volume of past due paper is a
significant factor reflecting adversely on the quality or
soundness of the overall loan portfolio or the efficiency
and quality of management. It is important that overdue
loans be computed on a uniform basis. This allows for
comparison of overdue totals between examinations and/or
with other banks.
discharge the debt in full; or by the guarantee of a
financially responsible party. A debt is in process of
collection if collection is proceeding in due course either
through legal action, including judgment enforcement
procedures, or, in appropriate circumstances, through
collection efforts not involving legal action which are
reasonably expected to result in repayment of the debt or
its restoration to a current status. Banks are strongly
encouraged to follow this guideline not only for reporting
purposes but also bookkeeping purposes. There are
several exceptions, modifications and clarifications to this
general standard. First, consumer loans and real estate
loans secured by one-to-four family residential properties
are exempt from the nonaccrual guidelines. Nonetheless,
these exempt loans should be subject to other alternative
methods of evaluation to assure the bank's net income is
not materially overstated. Second, any State statute,
regulation or rule which imposes more stringent standards
for nonaccrual of interest should take precedence over
these instructions. Third, reversal of previously accrued
but uncollected interest applicable to any asset placed in a
nonaccrual status, and treatment of subsequent payments as
either principal or interest, should be handled in
accordance with generally accepted accounting principles.
Acceptable accounting treatment includes reversal of all
previously accrued but uncollected interest against
appropriate income and balance sheet accounts.
The Report of Examination includes information on
overdue and nonaccrual loans. Loans which are still
accruing interest but are past their maturity or on which
either interest or principal is due and unpaid (including
unplanned overdrafts) are separated by loan type into two
distinct groupings: 30 to 89 days past due and 90 days or
more past due. Nonaccrual loans may include both current
and past due loans. In the case of installment credit, a loan
will not be considered overdue until at least two monthly
payments are delinquent. The same will apply to real
estate mortgage loans, term loans or any other loans
payable on regular monthly installments of principal and
interest.
Some modification of the overdue criteria may be
necessary because of applicable State law, joint
examinations, or unusual circumstances surrounding
certain kinds of loans or in individual loan situations. It
will always be necessary for the examiner to ascertain the
bank's renewal and extension policies and procedures for
collecting interest prior to determining which loans are
overdue, since such practices often vary considerably from
bank to bank. This is important not only to validate which
loans are actually overdue, but also to evaluate the
soundness of such policies. Standards for renewal should
be aimed at achieving an orderly liquidation of loans and
not at maintaining a low ratio of past due paper through
unwarranted extensions or renewals.
Nonaccrual Loans That Have Demonstrated
Sustained Contractual Performance
The following guidance applies to borrowers who have
resumed paying the full amount of scheduled contractual
interest and principal payments on loans that are past due
and in nonaccrual status. Although a prior arrearage may
not have been eliminated by payments from a borrower, the
borrower may have demonstrated sustained performance
over a period of time in accordance with the contractual
terms. Such loans to be returned to accrual status, even
though the loans have not been brought fully current,
provided two criteria are met:
In larger departmentalized banks or banks with large
branch systems, it may be informative to analyze
delinquencies by determining the source of overdue loans
by department or branch. This is particularly true if a large
volume of overdue loans exist. The production of
schedules delineating overdue loans by department or
branch is encouraged if it will aid in pinpointing the source
of a problem or be otherwise informative..
•
•
Continuing to accrue income on assets which are in default
as to principal and interest overstates a bank's assets,
earnings and capital. Call Report Instructions indicate that
where the period of default of principal or interest equals
or exceeds 90 days, the accruing of income should be
discontinued unless the asset is well-secured and in process
of collection. A debt is well-secured if collateralized by
liens on or pledges of real or personal property, including
securities that have a realizable value sufficient to
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
All principal and interest amounts contractually due
(including arrearage) are reasonably assured of
repayment within a reasonable period, and
There is a sustained period of repayment performance
(generally a minimum of six months) by the borrower,
in accordance with the contractual terms involving
payments of cash or cash equivalents.
When the regulatory reporting criteria for restoration to
accrual status are met, previous charge-offs taken would
not have to be fully recovered before such loans are
returned to accrual status. Loans that meet the above
3.2-43
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LOANS
Section 3.2
criteria would continue to be disclosed as past due, as
appropriate, until they have been brought fully current.
Under existing reporting requirements, the "A" note would
be disclosed as a TDR. In accordance with these
requirements, if the "A" note yields a market rate of
interest and performs in accordance with the restructured
terms, such disclosures could be eliminated in the year
following restructuring. To be considered a market rate of
interest, the interest rate on the "A" note at the time of
restructuring must be equal to or greater than the rate that
the institution is willing to accept for a new receivable with
comparable risk.
Troubled Debt Restructuring - Multiple Note
Structure
The basic example of a trouble debt restructure (TDR)
multiple note structure is a troubled loan that is
restructured into two notes where the first or "A" note
represents the portion of the original loan principal amount
which is expected to be fully collected along with
contractual interest. The second part of the restructured
loan, or "B" note, represents the portion of the original
loan that has been charged-off.
Interagency Retail Credit
Classification Policy
The quality of consumer credit soundness is best indicated
by the repayment performance demonstrated by the
borrower. Because retail credit generally is comprised of a
large number of relatively small balance loans, evaluating
the quality of the retail credit portfolio on a loan-by-loan
basis is burdensome for the institution being examined and
examiners. To promote an efficient and consistent credit
risk evaluation, the FDIC, the Comptroller of Currency, the
Federal Reserve and the Office of Thrift Supervision
adopted the Uniform Retail Credit Classification and
Account Management Policy (Retail Classification Policy.)
Such TDRs generally may take any of three forms. In
certain TDRs, the "B" note may be a contingent receivable
that is payable only if certain conditions are met (e.g.,
sufficient cash flow from property). For other TDRs, the
"B" note may be contingently forgiven (e.g., note "B" is
forgiven if note "A" is paid in full). In other instances, an
institution would have granted a concession (e.g., rate
reduction) to the troubled borrower 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
books and is unlikely to be collected, for reporting
purposes the "B" note could be viewed as a contingent
receivable.
Retail credit includes open-end and closed-end credit
extended to individuals for household, family, and other
personal expenditures. It includes consumer loans and
credit cards. For purposes of the policy, retail credit also
includes loans to individuals secured by their personal
residence, including home equity and home improvement
loans.
Institutions may return the "A" note to accrual status
provided the following conditions are met:
•
•
•
•
The restructuring qualifies as a TDR as defined by
FAS 15 and there is economic substance to the
restructuring.
The portion of the original loan represented by the "B"
note has been charged-off. The charge-off must be
supported by a current, well-documented credit
evaluation of the borrower's financial condition and
prospects for repayment under the revised terms. The
charge-off must be recorded before or at the time of
the restructuring.
The "A" note is reasonably assured of repayment and
of performance in accordance with the modified terms.
In general, the borrower must have demonstrated
sustained repayment performance (either immediately
before or after the restructuring) in accordance with
the modified terms for a reasonable period prior to the
date on which the "A" note is returned to accrual
status. A sustained period of payment performance
generally would be a minimum of six months and
involve payments in the form of cash or cash
equivalents.
Loans (12-04)
In general, retail credit should be classified based on the
following criteria:
•
•
•
3.2-44
Open-end and closed-end retail loans past due 90
cumulative days from the contractual due date should
be classified Substandard.
Closed-end retail loans that become past due 120
cumulative days and open-end retail loans that become
past due 180 cumulative days from the contractual due
date should be charged-off. The charge-off should be
taken by the end of the month in which the 120-or
180-day time period elapses.
Unless the institution can clearly demonstrate and
document that repayment on accounts in bankruptcy is
likely to occur, accounts in bankruptcy should be
charged off within 60 days of receipt of notification of
filing from the bankruptcy court or within the
delinquency time frames specified in this classification
policy, whichever is shorter. The charge-off should be
taken by the end of the month in which the applicable
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Federal Deposit Insurance Corporation
LOANS
•
•
•
Section 3.2
time period elapses. Any loan balance not charged-off
should be classified Substandard until the borrower reestablishes the ability and willingness to repay (with
demonstrated payment performance for six months at a
minimum) or there is a receipt of proceeds from
liquidation of collateral.
Fraudulent loans should be charged off within 90 days
of discovery or within the delinquency time frames
specified in this classification policy, whichever is
shorter. The charge-off should be taken by the end of
the month in which the applicable time period elapses.
Loans of deceased persons should be charged off when
the loss is determined or within the delinquency time
frames adopted in this classification policy, whichever
is shorter. The charge-off should be taken by the end
of the month in which the applicable time period
elapses.
One-to four-family residential real estate loans and
home equity loans that are delinquent 90 days or more
with loan-to-value ratios greater than 60 percent,
should be classified Substandard.
This policy does not preclude an institution from adopting
an internal classification policy more conservative than the
one detailed above. It also does not preclude a regulatory
agency from using the Doubtful or Loss classification in
certain situations if a rating more severe than Substandard
is justified. Loss in retail credit should be recognized when
the institution becomes aware of the loss, but in no case
should the charge-off exceed the time frames stated in this
policy.
Re-aging, Extensions, Deferrals, Renewals, or Rewrites
Re-aging is the practice of bringing a delinquent account
current after the borrower has demonstrated a renewed
willingness and ability to repay the loan by making some,
but not all, past due payments. Re-aging of open-end
accounts, or extensions, deferrals, renewals, or rewrites of
closed-end accounts should only be used to help borrowers
overcome temporary financial difficulties, such as loss of
job, medical emergency, or change in family circumstances
like loss of a family member. A permissive policy on reagings, extensions, deferrals, renewals, or rewrites can
cloud the true performance and delinquency status of the
portfolio. However, prudent use of a policy is acceptable
when it is based on recent, satisfactory performance and
the true improvement in a borrower's other credit factors,
and when it is structured in accordance with internal
policies.
When a residential or home equity loan is 120 days past
due for closed-end credit and 180 days past due for openend credit, a current assessment of value should be made
and any outstanding loan balance in excess of the fair value
of the property, less cost to sell, should be classified Loss.
Properly secured residential real estate loans with loan-tovalue ratios equal to or less than 60 percent are generally
not classified based solely on delinquency status. Home
equity loans to the same borrower at the same institution as
the senior mortgage loan with a combined loan-to-value
ratio equal to or less than 60 percent should not be
classified. However, home equity loans where the
institution does not hold the senior mortgage, that are
delinquent 90 days or more should be classified
Substandard, even if the loan-to-value ratio is equal to, or
less than, 60 percent.
The decision to re-age a loan, like any other modification
of contractual terms, should be supported in the
institution's management information systems. Adequate
management information systems usually identify and
document any loan that is extended, deferred, renewed, or
rewritten, including the number of times such action has
been taken. Documentation normally shows that institution
personnel communicated with the borrower, the borrower
agreed to pay the loan in full, and the borrower shows the
ability to repay the loan.
If an institution can clearly document that the delinquent
loan is well secured and in the process of collection, such
that collection will occur regardless of delinquency status,
then the loan need not be classified. A well secured loan is
collateralized by a perfected security interest in, or pledges
of, real or personal property, including securities, with an
estimated fair value, less cost to sell, sufficient to recover
the recorded investment in the loan, as well as a reasonable
return on that amount. In the process of collection means
that either a collection effort or legal action is proceeding
and is reasonably expected to result in recovery of the loan
balance or its restoration to a current status, generally
within the next 90 days.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Institutions that re-age open-end accounts should establish
a reasonable written policy and adhere to it. An account
eligible for re-aging, extension, deferral, renewal, or
rewrite should exhibit the following:
•
•
•
3.2-45
The borrower should show a renewed willingness and
ability to repay the loan.
The account should exist for at least nine months
before allowing a re-aging, extension, renewal,
referral, or rewrite.
The borrower should make at least three minimum
consecutive monthly payments or the equivalent lump
sum payment before an account is re-aged. Funds may
not be advanced by the institution for this purpose.
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•
•
Section 3.2
No loan should be re-aged, extended, deferred,
renewed, or rewritten more than once within any
twelve-month period; that is, at least twelve months
must have elapsed since a prior re-aging. In addition,
no loan should be re-aged, extended, deferred,
renewed, or rewritten more than two times within any
five-year period.
For open-end credit, an over limit account may be reaged at its outstanding balance (including the over
limit balance, interest, and fees). No new credit may
be extended to the borrower until the balance falls
below the designated predelinquency credit limit.
Examination Treatment
Use of the formula classification approach can result in
numerous small dollar adversely classified items.
Although these classification details are not always
included in the Report of Examination, an itemized list is
to be left with management. A copy of the listing should
also be retained in the examination work papers.
Examiner support packages are available which have built
in parameters of the formula classification policy, and
which generate a listing of delinquent consumer loans to be
classified in accordance with the policy. Use of this
package may expedite the examination in certain cases,
especially in larger banks.
Partial Payments on Open-End and Closed-End Credit
Institutions should use one of two methods to recognize
partial payments. A payment equivalent to 90 percent or
more of the contractual payment may be considered a full
payment in computing delinquency. Alternatively, the
institution may aggregate payments and give credit for any
partial payment received. For example, if a regular
installment payment is $300 and the borrower makes
payments of only $150 per month for a six-month period,
the loan would be $900, or three full months delinquent.
An institution may use either or both methods in its
portfolio, but may not use both methods simultaneously
with a single loan.
Losses are one of the costs of doing business in consumer
installment credit departments. It is important for the
examiner to give consideration to the amount and severity
of installment loan charge-offs when examining the
department. Excessive loan losses are the product of weak
lending and collection policies and therefore provide a
good indication of the soundness of the consumer
installment loan operation. The examiner should be alert
also to the absence of installment loan charge-offs, which
may indicate that losses are being deferred or concealed
through unwarranted rewrites or extensions.
Examination Considerations
Dealer lines should be scheduled in the report under the
dealer's name regardless of whether the contracts are
accepted with or without recourse. Any classification or
totaling of the nonrecourse line can be separately identified
from the direct or indirect liability of the dealer.
Comments and format for scheduling the indirect contracts
will be essentially the same as for direct paper. If there is
direct debt, comments will necessarily have to be more
extensive and probably will help form a basis for the
indirect classification.
Examiners should ensure that institutions adhere to the
Retail Classification Policy. Nevertheless, there may be
instances that warrant exceptions to the general
classification policy. Loans need not be classified if the
institution can document clearly that repayment will occur
regardless of delinquency status. Examples might include
loans well secured by marketable collateral and in the
process of collection, loans for which claims are filed
against solvent estates, and loans supported by valid
insurance claims. Conversely, the Retail Classification
Policy does not preclude examiners from reviewing and
classifying individual large dollar retail credit loans that
exhibit signs of credit weakness regardless of delinquency
status.
No general rule can be established as to the proper
application of dealers' reserves to the examiner's
classifications. Such a rule would be impractical because
of the many methods used by banks in setting up such
reserves and the various dealer agreements utilized.
Generally, where the bank is handling a dealer who is not
financially responsible,
weak
contracts
warrant
classification irrespective of any balance in the dealer's
reserve. Fair and reasonable judgment on the part of the
examiner will determine application of dealer reserves.
In addition to reviewing loan classifications, the examiner
should ensure that the ALLL provides adequate coverage
for inherent losses. Sound risk and account management
systems, including a prudent retail credit lending policy,
measures to ensure and monitor adherence to stated policy,
and detailed operating procedures, should also be
implemented. Internal controls should be in place to ensure
that the policy is followed. Institutions lacking sound
policies or failing to implement or effectively follow
established policies will be subject to criticism.
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If the amount involved would have a material impact on
capital, consumer loans should be classified net of
unearned income. Large business-type loans placed in
consumer installment loan departments should receive
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individual appraisal and, in all cases, the applicable
unearned income discount should be deducted when such
loans are classified.
In certain situations FASB 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, also applies.
It is the FDIC’s policy that restructurings be reflected in
examination reports in accordance with this accounting
guidance. In addition, banks are expected to follow these
principles when filing the Call Report.
Impaired Loans, Troubled Debt
Restructurings, Foreclosures and
Repossessions
Troubled debt restructurings may be divided into two
broad groups: those where the borrower transfers assets to
the creditor to satisfy the claim, which would include
foreclosures; and those in which the terms of a debtor’s
obligation are modified, which may include reduction in
the interest rate to an interest rate that is less than the
current market rate for new obligations with similar risk ,
extension of the maturity date, or forgiveness of principal
or interest. A third type of restructuring combines a receipt
of assets and a modification of loan terms. A loan
extended or renewed at an interest rate equal to the current
interest rate for new debt with similar risk is not reported
as a restructured loan for examination purposes.
Loan Impairment - A loan is impaired when, based on
current information and events, it is likely that an
institution will be unable to collect all amounts due
according to the contractual terms of the loan agreement
(i.e., principal and interest). The accounting standard for
impaired loans is set forth in FAS 114, Accounting by
Creditors for Impairment of a Loan as amended by FAS
118, Accounting by Creditors for Impairment of a Loan Income Recognition and Disclosures. FAS 114 applies to
all loans, except large groups of smaller-balance
homogenous loans that are collectively evaluated for
impairment and loans that are measured at fair value or the
lower of cost or fair value.
When a loan is impaired under FAS 114, the amount of
impairment should be measured based on the present value
of expected future cash flows discounted at the loan’s
effective interest rate (i.e., the contractual interest rate
adjusted for any net deferred loan fees or costs and
premium or discount existing at the origination or
acquisition of the loan). As a practical expedient,
impairment may also be measured based on a loan’s
observable market price, or the fair value of the collateral,
if the loan is collateral dependent. A loan is collateral
dependent if repayment is expected to be provided solely
by the underlying collateral and there are no other
available and reliable sources of repayment.
Transfer of Assets to the Creditor - A bank that receives
assets (except long-lived assets that will be sold) from a
borrower in full satisfaction of the book value of a loan
should record those assets at fair value. If the fair value of
the assets received is less than the institution’s recorded
investment in the loan, a loss is charged to the ALLL.
When property is received in full satisfaction of an asset
other than a loan (e.g., a debt security), the loss should be
reflected in a manner consistent with the balance sheet
classification of the asset satisfied. When long-lived assets
that will be sold, such as real estate, are received in full
satisfaction of a loan, the real estate is recorded at its fair
value less cost to sell. This fair value (less cost to sell)
becomes the “cost” of the foreclosed asset.
If the measure of a loan calculated in accordance with FAS
114 is less than the book value of that loan, impairment
should be recognized as a valuation allowance against the
loan. For regulatory reporting and examination report
purposes, this valuation allowance is included as part of the
general allowance for loan and lease losses. In general,
when the excess amount of the loan’s book value is
determined to be uncollectible, this excess amount should
be promptly charged-off against the ALLL. When a loan is
collateral dependent, any portion of the loan balance in
excess of the fair value of the collateral (or fair value less
cost to sell) should similarly be charged-off.
To illustrate, assume a bank forecloses on a defaulted
mortgage loan of $100,000 and takes title to the property.
If the fair value of the realty at the time of foreclosure is
$90,000 and costs to sell are estimated at $10,000, a
$20,000 loss should be immediately recognized by a
charge to the ALLL. The cost of the foreclosed asset
becomes $80,000. If the bank is on an accrual basis of
accounting, there may also be adjusting entries necessary
to reduce both the accrued interest receivable and loan
interest income accounts. Assume further that in order to
effect sale of the realty to a third party, the bank is willing
to offer a new mortgage loan (e.g., of $100,000) at a
concessionary rate of interest (e.g., 10 percent while the
market rate for new loans with similar risk is 20 percent).
Before booking this new transaction, the bank must
establish its "economic value". Pursuant to Accounting
Principles Board Opinion No. 21 (APB 21, Interest on
Receivables and Payables), the value is represented by the
sum of the present value of the income stream to be
Troubled Debt Restructuring - Troubled debt
restructuring takes placed when a bank grants a concession
to a debtor in financial difficulty. The accounting
standards for troubled debt restructurings are set forth in
FAS 15, Accounting by Debtors and Creditors for
Troubled Debt Restructurings, as amended by FAS 114.
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received from the new loan, discounted at the current
market rate for this type of credit, and the present value of
the principal to be received, also discounted at the current
market rate. This economic value is the proper carrying
value for the asset at its origination date, and if less than
the fair value less cost to sell at time of foreclosure (e.g.,
$78,000 vs. $80,000), an additional loss has been incurred
and should be immediately recognized. This additional
loss should be reflected in the allowance if a relatively
brief period has elapsed between foreclosure and
subsequent resale of the property. However, the loss
should be treated as "other operating expenses" if the asset
has been held for a longer period. The new loan would be
placed on the books at its face value ($100,000) and the
difference between the new loan amount and the
"economic value" ($78,000) is treated as unearned
discount ($22,000). For examination and Call Report
purposes, the asset would be shown net of the unearned
discount which is reduced periodically as it is earned over
the life of the new loan. Interest income is earned on the
restructured loan at the previously established market rate.
This is computed by multiplying the carrying value (i.e.,
face amount of the loan reduced by any principal
payments, less unearned discount) by that rate (20 percent).
capitalize the accrued interest ($10,000) into the note
balance, but the restructured terms will permit the borrower
to repay the debt over 10 years at a six percent interest rate.
The bank does not believe the loan is collateral dependent.
In this situation, the bank would record the restructured
loan at the present value of the new note amount
($110,000) discounted at the 10 percent rate specified in
the original contract. This amount becomes the loan’s fair
value. The difference between the calculated fair value
and the book value of the bank’s restructured loan (which
includes accrued interest, net deferred loan fees or costs,
and unamortized premium or discount) is recognized by
creating a valuation allowance with a corresponding charge
to the provision for loan and lease losses. As a result, the
net book value of the restructured loan is reflected at fair
value.
The basis for this accounting approach is the assumption
that financing the resale of the property at a concessionary
rate exacts an opportunity cost which the bank must
recognize. That is, unearned discount represents the
present value of the "imputed" interest differential between
the concessionary and market rates of interest. Present
value accounting also assumes that both the bank and the
third party who purchased the property are indifferent to a
cash sales price at the "economic value" or a higher
financed price repayable over time.
Examination Report Treatment - Examiners should
continue to classify troubled loans, including any troubled
collateral dependent loans, based on the definitions of
Loss, Doubtful, and Substandard. When a loan is
collateral dependent, any portion of the loan balance which
exceeds the fair value of the collateral should be promptly
charged-off against the ALLL. For other loans that are
impaired or have been restructured, the excess of the book
value of the loan over its fair value (or fair value less cost
to sell, as appropriate) is recognized by creating a
valuation allowance which is included in the ALLL.
However, when available information confirms that loans
and leases (including any recorded accrued interest, net
deferred loan fees or costs, and unamortized premium or
discount) other than collateral dependent loans, or portions
thereof, are uncollectible, these amounts should be
promptly charged-off against the ALLL, regardless of
whether an allowance was established to recognize
impairment under FAS 114.
Combination Approach - In some instances, the bank
may receive assets in partial rather than full satisfaction of
a loan or security and may also agree to alter the original
repayment terms. In these cases, the recorded investment
should be reduced by the fair value of the assets received
and the remaining investment accounted for as a
restructuring involving only modification of terms.
Modification of Terms - When the terms of a TDR
provide for a reduction of interest or principal, the
institution should measure any loss on the restructuring in
accordance with the guidance for impaired loans as set
forth in FAS 114 unless the loans are measured at fair
value or the lower of cost or fair value. If the fair value of
the restructured loan is less than the book value of that
loan, FAS 114 requires impairment to be recognized as a
valuation allowance against the loan. For regulatory
reporting and examination report purposes, this valuation
allowance should be included as part of ALLL. If the
excess amount of the loan’s book value is determined to be
uncollectible, this excess amount should be promptly
charged-off against the ALLL.
An examiner should not automatically require an additional
allowance for credit losses of impaired loans over and
above what is calculated in accordance with these
standards. However, an additional allowance on impaired
loans may be necessary based on consideration of
institution-specific factors, such as historical loss
experience compared with estimates of such losses and
concerns about the reliability of cash flow estimates, the
quality of an institution’s loan review function, and
For example, in lieu of foreclosure, a bank chooses to
restructure a $100,000 loan to a borrower which had
originally been granted with an interest rate of 10 percent
for 10 years. The bank and the borrower have agreed to
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controls over its process for estimating its FAS 114
allowance.
description, collectability, and management plans should
be included in the comments. Comments should be
concise, but brevity is not to be accomplished by omission
of adequate information. Comments should be informative
and factual data emphasized. The important weaknesses of
the loan should not be overshadowed by extraneous
information which might well have been omitted. An
ineffective presentation of a classified loan weakens the
value of a Report of Examination and frequently casts
doubt on the accuracy of the classifications. The essential
test of loan comments is whether they justify the
classification.
Other Considerations - Examiners may encounter
situations where impaired loans and restructured debts are
identified, but the bank has not properly accounted for the
transactions.
Where incorrect accounting treatment
resulted in an overstatement of earnings, capital and assets,
it will be necessary to determine the proper carrying values
for these assets, utilizing the best available information
developed by the examiner after consultation with bank
management. Nonetheless, proper accounting for impaired
and restructured loans is the responsibility of bank
management.
Examiners should not spend a
disproportionate amount of time developing the
appropriate accounting entries, but instead discuss with and
require corrective action by bank management when the
bank’s treatment is not in accordance with accepted
accounting guidelines. It must also be emphasized that
collectability and proper accounting and reporting are
separate matters; restructuring a borrower’s debt does not
ensure collection of the loan or security. As with all other
assets, adverse classification should be assigned if analysis
indicates there is risk of loss present. Examiners should
take care, however, not to discourage or be critical of bank
management’s legitimate and reasonable attempts to
achieve debt settlements through concessionary terms. In
many cases, restructurings offer the only realistic means for
a bank to bring about collection of weak or nonearning
assets.
Finally, the volume of impaired loans and
restructured debts having concessionary interest rates
should be considered when evaluating the bank’s earnings
performance and assigning the earnings performance
rating.
Careful organization is an important ingredient of good
loan comments. Generally, loan comments should include
the following items:
•
•
•
•
Examination procedures for reviewing TDRs are included
in the ED Modules.
Report of Examination
Classified Loans
Treatment
of
•
The Items Subject to Adverse Classification page allows an
examiner to present pertinent and readily understandable
comments related to loans which are adversely classified.
In addition, the Analysis of Loans Subject to Adverse
Classification page permits analysis of present and
previous classifications from the standpoint of source and
disposition. These loan schedules should be prepared in
accordance with the Report of Examination Instructions.
•
An examiner must present, in writing, relevant and readily
understandable comments related to criticized loans.
Therefore, a thorough understanding of all factors
surrounding the loan is required and only those germane to
DSC Risk Management Manual of Examination Policies
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Identification - Indicate the name and occupation or
type of business of the borrower. Cosigners, endorsers
and guarantors should be identified and in the case of
business loans, it should be clear whether the borrower
is a corporation, partnership, or sole proprietorship.
Description - The make-up of the debt should be
concisely described as to type of loan, amount, origin
and terms. The history, purpose, and source of
repayment should also be indicated.
Collateral - Describe and evaluate any collateral,
indicating the marketability and/or condition thereof.
If values are estimated, note the source.
Financial Data - Current balance sheet information
along with operating figures should be presented, if
such data are considered necessary. The examiner
must exercise judgment as to whether a statement
should be detailed in its entirety. When the statement
is relevant to the classification, it is generally more
effective to summarize weaknesses with the entire
statement presented. On the other hand, if the
statement does not significantly support or detract
from the loan, a very brief summarization of the
statement is in order.
Summarize the Problem - The examiner's comments
should explicitly point out reasons for the
classification. Where portions of the line are accorded
different classifications or are not subject to
classification, comments should clearly set forth the
reasoning for the split treatment.
Management's Intentions - Comments should
include any corrective program contemplated by
management.
Examiners should avoid arbitrary or penalty classifications,
nor should "conceded" or "agreed" be given as the
principal reason for adverse classifications. Management's
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opinions and ideas should not have to be emphasized; if a
classification is well-founded, the facts will speak for
themselves. If well-written, there is little need for long
summary comments reemphasizing major points of the
loan write-up.
letter must be obtained at the first examination involving
the loan review process after October 1, 1992. If the letter
is not issued by the supervisory authority at the
examination, the election is revoked retroactively.
Once the first examination of the loan review process after
October 1, 1992, has been performed by an institution's
primary Federal supervisory authority, the transition rules
no longer apply and the institution must have the "express
determination" letter before making the election. To
continue using the tax-book conformity method, the
institution must request a new letter at each subsequent
examination that covers the loan review process. If the
examiner does not issue an "express determination" letter
at the end of such an examination, the institution's election
of the tax-book conformity method is revoked
automatically as of the beginning of the taxable year that
includes the date of examination.
However, that
examiner's decision not to issue an "express determination"
letter does not invalidate an institution's election for any
prior years. The supervisory authority is not required to
rescind any previously issued "express determination"
letters.
When the volume of loan classifications reaches the point
of causing supervisory concern, analysis of present and
previous classifications from the standpoint of source and
disposition becomes very important. For this reason, the
Analysis of Loans Subject to Adverse Classification page
should be completed in banks possessing characteristics
which present special supervisory problems; when the
volume or composition of adversely classified loans has
changed significantly since the previous examination,
including both upward and downward movements; and, in
such other special or unusual situations as examiners deem
appropriate. Generally, the page should not include
consumer loans and overdrafts and it should be footnoted
to indicate that these assets are not included.
Issuance of "Express Determination" Letters
to Banks for Federal Income Tax Purposes
When an examiner does not issue an "express
determination" letter, the institution is still allowed tax
deductions for loans that are wholly or partially worthless.
However, the burden of proof is placed on the institution to
support its tax deductions for loan charge-offs.
Tax Rules - The Internal Revenue Code and tax
regulations allow a deduction for a loan that becomes
wholly or partially worthless. All pertinent evidence is
taken into account in determining worthlessness. Special
tax rules permit a federally supervised depository
institution to elect a method of accounting under which it
conforms its tax accounting for bad debts to its regulatory
accounting for loan charge-offs, provided certain
conditions are satisfied. Under these rules, loans that are
charged-off pursuant to specific orders of the institution's
supervisory authority or that are classified by the institution
as Loss assets under applicable regulatory standards are
conclusively presumed to have become worthless in the
taxable year of the charge-offs. These special tax rules are
effective for taxable years ending on or after December 31,
1991.
Examination Guidelines - Banks are responsible for
requesting "express determination" letters during
examinations that cover their loan review process, i.e.,
during safety and soundness examinations. Examiners
should not alter the scope or frequency of examinations
merely to permit banks to use the tax-book conformity
method.
When requested by a bank that has made or intends to
make the election under Section 1.166-2(d)(3) of the tax
regulations, the examiner-in-charge should issue an
"express determination" letter, provided the bank does
maintain and apply loan loss classification standards that
are consistent with the FDIC's regulatory standards. The
letter should only be issued at the completion of a safety
and soundness examination at which the examiner-incharge has concluded that the issuance of the letter is
appropriate.
To be eligible for this accounting method for tax purposes,
an institution must file a conformity election with its
Federal income tax return. The tax regulations also require
the institution's primary Federal supervisory authority to
expressly determine that the institution maintains and
applies loan loss classification standards that are consistent
with the regulatory standards of its supervisory authority.
An "express determination" letter should be issued to a
bank only if:
For taxable years ending before the completion of the first
examination of an institution's loan review process that is
after October 1, 1992, transition rules allow an institution
to make the conformity election without the determination
letter from its primary supervisory authority. However, the
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•
3.2-50
The examination indicates that the bank maintains and
applies loan loss classification standards that are
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•
Section 3.2
When an "express determination" letter is issued to a bank,
a copy of the letter as well as documentation of the work
performed by examiners in their review of the bank's loan
loss classification standards should be maintained in the
workpapers. A copy of the letter should also be forwarded
to the Regional Office with the Report of Examination.
The issuance of an “express determination” letter should be
noted in the Report of Examination according to procedure
in the Report of Examination Instructions.
consistent with the FDIC's standards regarding the
identification and charge-off of such loans; and
There are no material deviations from the FDIC's
standards.
Minor criticisms of the bank's loan review process as it
relates to loan charge-offs or immaterial individual
deviations from the FDIC's standards should not preclude
the issuance of an "express determination" letter.
When an examiner-in-charge concludes that the conditions
for issuing a requested "express determination" letter have
not been met, the examiner-in-charge should discuss the
reasons for this conclusion with the Regional Office. The
examiner-in-charge should then advise bank management
that the letter cannot be issued and explain the basis for
this conclusion. A comment indicating that a requested
"express determination" letter could not be issued, together
with a brief statement of the reasons for not issuing the
letter are addressed in the Report of Examination
Instructions.
An "express determination" letter should not be issued if:
•
•
•
The bank's loan review process relating to charge-offs
is subject to significant criticism;
Loan charge-offs reported in the Report of Condition
and Income (Call Reports) are consistently overstated
or understated; or
There is a pattern of loan charge-offs not being
recognized in the appropriate year.
When the issuance of an "express determination" letter is
appropriate, it should be prepared on FDIC letterhead
using the following format. The letter should be signed
and dated by the examiner-in-charge and provided to the
bank for its files. The letter is not part of the Report of
Examination.
CONCENTRATIONS
Generally a concentration is a significantly large volume of
economically-related assets that an institution has advanced
or committed to one person, entity, or affiliated group.
These assets may in the aggregate present a substantial risk
to the safety and soundness of the institution. Adequate
diversification of risk allows the institution to avoid the
excessive risks imposed by credit concentrations. It should
also be recognized, however, that factors such as location
and economic environment of the area limit some
institutions' ability to diversify.
Where reasonable
diversification realistically cannot be achieved, the
resultant concentration calls for capital levels higher than
the regulatory minimums.
Express Determination Letter for IRS Regulation 1.1662(d)(3)
“In connection with the most recent examination of [Name
of Bank], by the Federal Deposit Insurance Corporation, as
of [examination date], we reviewed the institution’s loan
review process as it relates to loan charge-offs. Based on
our review, we concluded that the bank, as of that date,
maintained and applied loan loss classification standards
that were consistent with regulatory standards regarding
loan charge-offs.
Concentrations generally are not inherently bad, but do add
a dimension of risk which the management of the
institution should consider when formulating plans and
policies. In formulating these policies, management
should, at a minimum, address goals for portfolio mix and
limits within the loan and other asset categories. The
institution's business strategy, management expertise and
location should be considered when reviewing the policy.
Management should also consider the need to track and
monitor the economic and financial condition of specific
geographic locations, industries and groups of borrowers in
which the bank has invested heavily. All concentrations
should be monitored closely by management and receive a
more in-depth review than the diversified portions of the
institution's assets. Failure to monitor concentrations can
This statement is made on the basis of a review that was
conducted in accordance with our normal examination
procedures and criteria. It does not in any way limit or
preclude any formal or informal supervisory action
(including enforcement actions) by this supervisory
authority relating to the institution’s loan review process or
the level at which it maintains its allowance for loan and
lease losses.
[signature]
Examiner-in-charge
[date signed]
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result in management being unaware how significant
economic events might impact the overall portfolio. This
will also allow management to consider areas where
concentration reductions may be necessary. Management
and the board can monitor any reduction program using
accurate concentration reports. If management is not
properly monitoring concentration levels and limits,
examiners may consider criticizing management.
and analysis. If this becomes the case, the selling bank
may be taking an unacceptable risk unknowingly.
Another area of potential risk involves selling Federal
funds to a bank which may be acting as an intermediary
between the selling bank and the ultimate buying bank. In
this instance, the intermediary bank is acting as agent with
the true liability for repayment accruing to the third bank.
Therefore, it is particularly important that the original
selling bank be aware of this situation, ascertain the
ultimate disposition of its funds, and be satisfied as to the
creditworthiness of the ultimate buyer of the funds.
To establish a meaningful tracking system for
concentrations of credit, financial institutions should be
encouraged to consider the use of codes to track individual
borrowers, related groups of borrowers, industries, and
individual foreign countries. Financial institutions should
also be encouraged to use the standard industrial
classification (SIC) or similar code to track industry
concentrations.
Any monitoring program should be
reported regularly to the board of directors.
Clearly, the "risk free" philosophy regarding the sale of
Federal funds is inappropriate. Selling banks must take the
necessary steps to assure protection of their position. The
examiner is charged with the responsibility of ascertaining
that selling banks have implemented and adhered to policy
directives in this regard to forestall any potentially
hazardous situations.
Refer to the Report of Examination Instructions for
guidance in identifying and listing concentrations in the
examination report.
Examiners should encourage management of banks
engaged in selling Federal funds to implement a policy
with respect to such activity. This policy should include
consideration of such matters as the aggregate sum to be
sold at any one time, the maximum amount to be sold to
any one buyer, the maximum duration of time the bank will
sell to any one buyer, a list of acceptable buyers, and the
terms under which a sale will be made. As in any form of
lending, thorough credit evaluation of the prospective
purchaser, both before granting the credit extension and on
a continuing basis, is a necessity. Such credit analysis
should emphasize the borrower's ability to repay, the
source of repayment, and alternative sources of repayment
should the primary source fail to materialize. While sales
of Federal funds are normally unsecured unless otherwise
regulated by State statutes, and while collateral protection
is no substitute for thorough credit review, the selling bank
should consider the possibility of requiring security if sales
agreements are entered into on a continuing basis for
specific but extended periods of time, or for overnight
transactions which have evolved into longer term sales.
Where the decision is made to sell Federal funds on an
unsecured basis, the selling bank should be able to present
logical reasons for such action based on conclusions drawn
from its credit analysis of the buyer and bearing in mind
the potential risk involved.
FEDERAL FUNDS SOLD AND
REPURCHASE AGREEMENTS
Federal funds sold and securities purchased under
agreement for resale represent convenient methods to
employ excess funds to enhance earnings. Federal funds
are excess reserve balances and take the form of a one-day
transfer of funds between banks. These funds carry a
specified rate of interest and are free of the risk of loss due
to fluctuations in market prices entailed in buying and
selling securities. However, these transactions are usually
unsecured and therefore do entail potential credit risk.
Securities purchased under agreement for resale represent
an agreement between the buying and selling banks that
stipulates the selling bank will buy back the securities sold
at an agreed price at the expiration of a specified period of
time.
Federal funds sold are not "risk free" as is often supposed,
and the examiner will need to recognize the elements of
risk involved in such transactions. While the selling of
funds is on a one-day basis, these transactions may evolve
into a continuing situation. This development is usually
the result of liability management techniques whereby the
buying bank attempts to utilize the acquired funds to
support a rapid expansion of its loan-investment posture
and as a means of enhancing profits. Of particular concern
to the examiner is that, in many cases, the selling bank will
automatically conclude that the buying bank's financial
condition is above reproach without proper investigation
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A review of Federal funds sold between examinations may
prompt examiners to broaden the scope of their analysis of
such activity if the transactions are not being handled in
accordance with sound practices as outlined above. Where
the bank has not developed a formal policy regarding the
sale of Federal funds or fails to conduct a credit analysis of
the buyer prior to a sale and during a continuous sale of
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such funds, the matter should be discussed with
management. In such discussion, it is incumbent upon
examiners to inform management that their remarks are not
intended to cast doubt upon the financial strength of any
bank to whom Federal funds are sold. Rather, the intent is
to advise the banker of the potential risks of such practices
unless safeguards are developed. The need for policy
formulation and credit review on all Federal funds sold
should be reinforced via a comment in the Report of
Examination. Also, if Federal funds sold to any one buyer
equals or exceeds 100 percent of the selling bank's Tier 1
Capital, it should be listed on the Concentrations schedule
unless secured by U.S. Government securities. Based on
the circumstances, the examiner should determine the
appropriateness of additional comments regarding risk
diversification.
if proper documentation procedures and practices are being
utilized. While examiners are not expected to be experts
on legal matters, it is important they be familiar with the
Uniform Commercial Code (UCC) adopted by their
respective states as well as other applicable State laws
governing credit transactions. A good working knowledge
of the various documents necessary to attain the desired
collateral or secured position, and how those documents
are to be used or handled in the jurisdiction relevant to the
bank under examination, is also essential.
Uniform Commercial Code –
Secured Transactions
Article 9 of the UCC governs secured transactions; i.e.,
those transactions which create a security interest in
personal property or fixtures including goods, documents,
instruments, general intangibles, chattel paper or accounts.
Article 9 was significantly revised effective July 1, 2001,
but each individual state must adopt the changes for it to
become law. Because some states have enacted modified
versions of the UCC and subsequent revisions, each
applicable State statute should be consulted.
Securities purchased under an agreement to resell are
generally purchased at prevailing market rates of interest.
The purchasing bank must keep in mind that the
transaction merely represents another form of lending.
Therefore, considerations normally associated with
granting secured credit should be made. Repayment or
repurchases by the selling bank is a major consideration,
and the buying bank should satisfy itself that the selling
bank will be able to generate the necessary funds to
repurchase the securities on the prescribed date. Policy
guidelines should limit the amount of money extended to
one seller. Collateral coverage arrangements should be
controlled by procedures similar to the safeguards used to
control any type of liquid collateral. Securities held under
such an arrangement should not be included in the bank's
investment portfolio but should be reflected in the Report
of Examination under the caption Securities Purchased
Under Agreements to Resell. Transactions of this nature
do not require entries to the securities account of either
bank with the selling bank continuing to collect all interest
and transmit such payments to the buying bank.
General Provisions
A Security Agreement is an agreement between a debtor
and a secured party that creates or provides for a security
interest. The Debtor is the person that has an interest in
the collateral other than a security interest. The term
Debtor also includes a seller of payment intangibles or
promissory notes. The obligor is the person who owes on a
secured transaction. The Secured Party is the lender, seller
or other person in whose favor there is a security interest.
Grant of Security Interest
For a security interest to be enforceable against the debtor
or third party with respect to the collateral, the collateral
must be in the possession of the secured party pursuant to
agreement, or the debtor must sign a security agreement
which covers the description of the collateral.
FUNDAMENTAL LEGAL CONCEPTS
AND DEFINITIONS
Collateral
Laws and regulations that apply to credit extended by
banks are more complicated and continually in a state of
change. However, certain fundamental legal principles
apply no matter how complex or innovative a lending
transaction. To avoid needless litigation and ensure that
each loan is a legally enforceable claim against the
borrower or collateral, adherence to certain rules and
prudent practices relating to loan transactions and
documentation is essential. An important objective of the
examiner's analysis of collateral and credit files is not only
to obtain information about the loan, but also to determine
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Any description of personal property or real estate is a
sufficient description of the collateral whether or not it is
specific if it reasonably identifies what is described. If the
parties seek to include property acquired after the signing
of the security agreement as collateral, additional
requirements must be met.
Unless otherwise agreed a security agreement gives the
secured party the rights to proceeds from the sale,
exchange, collection or disposition of the collateral.
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available to the secured party at a place to be designated by
the secured party which is reasonably convenient to both
parties.
In some cases, the collateral that secures an obligation
under one security agreement can be used to secure a new
loan, too. This can be done by using a crosscollateralization clause in the security agreement.
A secured party may then sell, lease or otherwise dispose
of the collateral with the proceeds applied as follows: (a)
foreclosure expenses, including reasonable attorneys' fees
and legal expenses; (b) the satisfaction of indebtedness
secured by the secured party's security interest in the
collateral; and (c) the satisfaction of indebtedness secured
by any subordinate security interest in the collateral if the
secured party receives written notification of demand
before the distribution of the proceeds is completed. If
requested by the secured party, the holder of a subordinate
security interest must furnish reasonable proof of his
interest, and unless he does so, the secured party need not
comply with his demand.
Perfecting the Security Interest
Three terms basic to secured transactions are attachment,
security agreement and security interest. Attachment refers
to that point when the creditor's legal rights in the debtor's
property come into existence or "attach.” This does not
mean the creditor necessarily takes physical possession of
the property, or does it mean acquisition of ownership of
the property. Rather, it means that before attachment, the
borrower's property is free of any legal encumbrance, but
after attachment, the property is legally bound by the
creditor's security interest. In order for the creditor's
security interest to attach, there must be a security
agreement in which the debtor authenticates and provides a
description of the collateral. A creditor's security interest
can be possessory or nonpossessory, a secured party with
possession pursuant to “agreement” means that the
“agreement” for possession has to be an agreement that the
person will have possession for purposes of security. The
general rule is a bank must take possession of deposit
accounts (proprietary), letter of credit rights, electronic
chattel, paper, stocks and bonds to perfect a security
interest therein. In a transaction involving a nonpossessory
security interest, the debtor retains possession of the
collateral. A security interest in collateral automatically
attaches to the proceeds of the collateral and is
automatically perfected in the proceeds if the credit was
advanced to enable the purchase
Examiners should determine bank policy concerning the
verification of lien positions prior to advancing funds.
Failure to perform this simple procedure may result in the
bank unknowingly assuming a junior lien position and,
thereby, greater potential loss exposure. Management may
check filing records personally or a lien search may be
performed by the filing authority or other responsible
party. This is especially important when the bank grants
new credit lines.
Agricultural Liens
An agricultural lien is generally defined as an interest,
other than a security interest, in farm products that meets
the following three conditions:
•
A party's security interest in personal property is not
protected against a debtor's other creditors unless it has
been perfected. A security interest is perfected when it has
attached and when all of the applicable steps required for
perfection, such as the filing of a financing statement or
possession of the collateral, have been taken. These
provisions are designed to give notice to others of the
secured party's interest in the collateral, and offer the
secured party the first opportunity at the collateral if the
need to foreclose should arise. If the security interest is not
perfected, the secured party loses its secured status.
•
•
Right to Possess and Dispose of Collateral
An agricultural lien is therefore non-possessory. Law
outside of UCC-9 governs creation of agricultural liens and
their attachment to collateral. An agricultural lien cannot
be created or attached under Article 9. Article 9, however,
does govern perfection. In order to perfect an agricultural
lien, a financing statement must be filed. A perfected
agricultural lien on collateral has priority over a conflicting
Unless otherwise agreed, when a debtor defaults on a
secured loan, a secured party has the right to take
possession of the collateral without going to court if this
can be done without breaching the peace. Alternatively, if
the security agreement so provides, the secured party may
require the debtor to assemble the collateral and make it
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The lien secures payment or performance of an
obligation for goods or services furnished in
connection with a debtor’s farming operation or rent
on real property leased by a debtor in connection with
its farming operation.
The lien is created by statute in favor of a person that
in the ordinary course of its business furnished goods
or services to a debtor in connection with a debtor’s
farming operation or leased property to a debtor in
connection with the debtor’s farming operation.
The lien’s effectiveness does not depend on the
person’s possession of the personal property.
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security interest in or agricultural lien on the same
collateral if the statute creating the agricultural lien
provides for such priority. Otherwise, the agricultural lien
is subject to the same priority rules as security interests (for
example, date of filing).
repossessed. Generally, the borrower must pay the entire
balance of the debt plus all expenses incurred by the bank
in repossessing and holding the collateral. The third
concept is retention that allows the bank to retain the
collateral in return for releasing the debtor from all further
liability on the loan. The borrower must agree to this
action, hence would likely be so motivated only when the
value of the security is likely to be less than or about equal
to the outstanding debt. Finally, if retention is not
agreeable to both borrower and lender, the fourth concept,
resale of the security, comes into play. Although sale of
the collateral may be public or private, notice to the debtor
and other secured parties must generally be given. The
sale must be commercially reasonable in all respects.
Debtors are entitled to any surplus resulting from sale price
of the collateral less any unpaid debt. If a deficiency
occurs (i.e., the proceeds from sale of the collateral were
inadequate to fully extinguish the debt obligation), the
bank has the right to sue the borrower for this shortfall.
This is a right it does not have under the retention concept.
A distinction is made with respect to proceeds of collateral
for security interests and agricultural liens. For security
interests, collateral includes the proceeds under Article 9.
For agricultural liens, the collateral does not include
proceeds unless State law creating the agricultural lien
gives the secured party a lien on proceeds of the collateral
subject to the lien.
Special Filing Requirements – There is a national
uniform Filing System form. Filers, however are not
required to use them. If permitted by the filing office,
parties may file and otherwise communicate by means of
records communicated and stored in a media other than
paper. A peculiarity common to all states is the filing of a
lien on aircraft; the security agreement must be submitted
to the Federal Aviation Administration in Oklahoma City,
Oklahoma.
Exceptions to the Rule of Priority - There are three
exceptions to the general rule that the creditor with the
earliest perfected security interest has priority. The first
concerns a specific secured transaction in which a creditor
makes a loan to a dealer and takes a security interest in the
dealer's inventory. Suppose such a creditor files a
financing statement with the appropriate public official to
perfect the security interest. While it might be possible for
the dealer's customers to determine if an outstanding
security interest already exists against the inventory, it
would be impractical to do so. Therefore, an exception is
made to the general rule and provides that a buyer in the
ordinary course of business, i.e., an innocent purchaser for
value who buys in the normal manner, cuts off a prior
perfected security interest in the collateral.
Default and Foreclosure - As a secured party, a bank's
rights in collateral only come into play when the obligor is
in default. What constitutes default varies according to the
specific provisions of each promissory note, loan
agreement, security agreement, or other related documents.
After an obligor has defaulted, the creditor usually has the
right to foreclose, which means the creditor seizes the
security pledged to the loan, sells it and applies the
proceeds to the unpaid balance of the loan. For consumer
transactions, there are strict consumer notification
requirements prior to disposition of the collateral. For
consumer transactions, the lender must provide the debtor
with certain information regarding the surplus or deficiency
in the disposition of collateral. There may be more than
one creditor claiming a right to the sale proceeds in
foreclosure situations. When this occurs, priority is
generally established as follows: (1) Creditors with a
perfected security interest (in the order in which lien
perfection was attained); (2) Creditors with an unperfected
security interest; and (3) General creditors.
The second exception to the rule of priority concerns the
vulnerability of security interests perfected by doing
nothing. While these interests are perfected automatically,
with the date of perfection being the date of attachment,
they are extremely vulnerable at the hands of subsequent
bona fide purchasers. Suppose, for example, a dealer sells
a television set on a secured basis to an ultimate consumer.
Since the collateral is consumer goods, the security interest
is perfected the moment if attaches. But if the original
buyer sells the television set to another person who buys it
in good faith and in ignorance of the outstanding security
interest, the UCC provides that the subsequent purchase
cuts off the dealer's security interest. This second
exception is much the same as the first except for one
important difference: the dealer (creditor) in this case can
be protected against purchase of a customer's collateral by
filing a financing statement with the appropriate public
official.
Under the UCC procedure for foreclosing security
interests, four concepts are involved. First is repossession
or taking physical possession of the collateral, which may
be accomplished with judicial process or without judicial
process (known as self-help repossession), so long as the
creditor commits no breach of the peace. The former is
usually initiated by a replevin action in which the sheriff
seizes the collateral under court order. A second important
concept of UCC foreclosure procedures is redemption or
the debtor's right to redeem the security after it has been
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documents which allow the bank to sell the securities if the
borrower defaults are called stock powers and bond
powers. The examiner should ensure the bank has, for
each borrower who has pledged stocks or bonds, one
signed stock power for all stock certificates of a single
issuer, and a separate signed bond power for each bond
instrument. The signature must agree with the name on the
actual stock certificate or bond instrument. Refer to
Federal Reserve Board Regulations Part 221 (Reg U) for
further information on loans secured by investment
securities.
The third exception regards the after-acquired property
clause that protects the value of the collateral in which the
creditor has a perfected security interest.
The
after-acquired property clause ordinarily gives the original
creditor senior priority over creditors with later perfected
interests. However, it is waived as regards the creditor
who supplies replacements or additions to the collateral or
the artisan who supplies materials and services that
enhance the value of the collateral as long as a perfected
security interest in the replacement or additions, or
collateral is held.
Comaker
Borrowing Authorization
Two or more persons who are parties to a contract or
promise to pay are known as comakers. They are a unit to
the performance of one act and are considered primarily
liable. In the case of default on an unsecured loan, a
judgment would be obtained against all. A release against
one is a release against all because there is but one
obligation and if that obligation is released as to one
obligor, it is released as to all others.
Borrowing authorizations in essence permit one party to
incur liability for another. In the context of lending, this
usually concerns corporations. A corporation may enter
into contracts within the scope of the powers authorized by
its charter. In order to make binding contracts on behalf of
the corporation, the officers must be authorized to do so
either by the board of directors or by expressed or implied
general powers. Usually a special resolution expressly
gives certain officers the right to obligate the corporate
entity, pledge assets as collateral, agree to other terms of
the indebtedness and sign all necessary documentation on
behalf of the corporate entity.
Loan Guarantee
Since banks often condition credit advances upon the
backup support provided by third party guarantees,
examiners should understand the legal fundamentals
governing guarantees. A guarantee may be a guarantee of
payment or of collection. "Payment guaranteed" or
equivalent words added to a signature means that if the
instrument is not paid when due, the guarantor will pay it
according to its terms without resort by the holder to any
other party. "Collection guaranteed" or equivalent words
added to a signature means that if the instrument is not paid
when due, the guarantor will pay it, but only after the
holder has reduced to judgment a claim against the maker
and execution has been returned unsatisfied, or after the
maker has become insolvent or it is otherwise useless to
proceed against such a party.
Although a general resolution is perhaps satisfactory for
the short-term, unsecured borrowings of a corporation, a
specific resolution of the corporation's board of directors is
generally advisable to authorize such transactions as term
loans, loans secured by security interests in the
corporation's personal property, or mortgages on real
estate. Further, mortgaging or pledging substantially all of
the corporation's assets without prior approval of the
shareholders of the corporation is often prohibited,
therefore, a bank may need to seek advice of counsel to
determine if shareholder consent is required for certain
contemplated transactions.
Loans to corporations should indicate on their face that the
corporation is the borrower. The corporate name should
appear followed by the name, title and signature of the
appropriate officer.
If the writing is a negotiable
instrument, the UCC states the party signing is personally
liable as a general rule. To enforce payment against a
corporation, the note or other writing should clearly show
that the debtor is a corporation.
Contracts of guarantee are further divided into a limited
guarantee which relates to a specific note (often referred to
as an "endorsement") or for a fixed period of time, or a
continuing guarantee which, in contrast, is represented by a
separate instrument and enforceable for future (duration
depends upon State law) transactions between the bank and
the borrower or until revoked. A well drawn continuing
guarantee contains language substantially similar to the
following:
"This is an absolute and unconditional
guarantee of payment, is unconditionally delivered, and is
not subject to the procurement of a guarantee from any
person other than the undersigned, or to the performance or
happening of any other condition." The aforementioned
Bond and Stock Powers
As mentioned previously, a bank generally obtains a
security interest in stocks and bonds by possession. The
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unambiguous terms are necessary to the enforceability of
contracts of guarantee, as they are frequently entered into
solely as an accommodation for the borrower and without
the guarantor's participation in the benefits of the loan.
Thus, courts tend to construe contracts of guarantee strictly
against the party claiming under the contract. Unless the
guarantee is given prior to or at the time the initial loan is
made, the guarantee may not be enforceable because of the
difficulty of establishing that consideration was given.
Banks should not disburse funds on such loans until they
have the executed guarantee agreement in their possession.
Banks should also require the guarantee be signed in the
presence of the loan officer, or, alternatively, that the
guarantor's signature be notarized.
If the proposed
guarantor is a partnership, joint venture, or corporation, the
examiner should ensure the signing party has the legal
authority to enter into the guarantee agreement. Whenever
there is a question concerning a corporation's authority to
guarantee a loan, counsel should be consulted and a special
corporate resolution passed by the organization's board of
directors.
Regular Mortgages - The regular mortgage involves only
two parties, the borrower and the lender. The mortgage
document encountered in many states today is referred to
as the regular mortgage. It is, in form, a deed or
conveyance of realty by the borrower to the lender
followed or preceded by a description of the debt and the
property, and includes a provision to the effect that the
mortgage be released upon full payment of the debt.
Content of additional paragraphs and provisions varies
considerably.
Deeds of Trust - In the trust deed, also known as the deed
of trust, the borrower conveys the realty not to the lender
but to a third party, a trustee, in trust for the benefit of the
holder of the notes(s) that constitutes the mortgage debt.
The deed of trust form of mortgage has certain advantages,
the principle being that in a number of states it can be
foreclosed by trustee's sale under the power of sale clause
without court proceedings.
Equitable Mortgages - As a general rule, any instrument
in writing by which the parties show their intention that
realty be held as security for the payment of a debt,
constitutes an equitable mortgage capable of being
foreclosed in a court of equity.
Subordination Agreement
A bank extending credit to a closely held corporation may
want to have the company's officers and shareholders
subordinate to the bank's loan any indebtedness owed them
by the corporation. This is accomplished by execution of a
subordination agreement by the officers and shareholders.
Subordination agreements are also commonly referred to as
standby agreements. Their basic purpose is to prevent
diversion of funds from reduction of bank debt to reduction
of advances made by the firm's owners or officers.
Deeds Absolute Given as Security - Landowners who
borrow money may give as security an absolute deed to the
land. "Absolute deed" means a quitclaim or warranty deed
such as is used in an ordinary realty sale. On its face, the
transaction appears to be a sale of the realty; however, the
courts treat such a deed as a mortgage where the evidence
shows that the instrument was really intended only as
security for a debt. If such proof is available, the borrower
is entitled to pay the debt and demand reconveyance from
the lender, as in the case of an ordinary mortgage. If the
debt is not paid, the grantee must foreclose as if a regular
mortgage had been made.
Hypothecation Agreement
This is an agreement whereby the owner of property grants
a security interest in collateral to the bank to secure the
indebtedness of a third party. Banks often take possession
of the stock certificates, plus stock powers endorsed in
blank, in lieu of a hypothecation agreement. Caution,
however, dictates that the bank take a hypothecation
agreement setting forth the bank's rights in the event of
default.
The examiner should ensure the bank has performed a title
and lien search of the property prior to taking a mortgage
or advancing funds. Proper procedure calls for an
abstractor bringing the abstract up to date, and review of
the abstract by an attorney or title insurance company. If
an attorney performs the task, the abstract will be examined
and an opinion prepared indicating with whom title rests,
along with any defects and encumbrances disclosed by the
abstract. Like an abstractor, an attorney is liable only for
damages caused by negligence. If a title insurance
company performs the task of reviewing the abstract, it
does essentially the same thing; however, when title
insurance is obtained, it represents a contract to make
good, loss arising through defects in title to real estate or
liens or encumbrances thereon. Title insurance covers
various items not covered in an abstract and title opinion.
Real Estate Mortgage
A mortgage may be defined as a conveyance of realty
given with the intention of providing security for the
payment of debt. There are several different types of
mortgage instruments but those commonly encountered are
regular mortgages, deeds of trust, equitable mortgages, and
deeds absolute given as security.
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Some of the more common are errors by abstractors or
attorneys include unauthorized corporate action, mistaken
legal interpretations, and unintentional errors in public
records by public officials. Once the bank determines title
and lien status of the property, the mortgage can be
prepared and funds advanced. The bank should record the
mortgage immediately after closing the loan. Form,
execution, and recording of mortgages vary from state to
state and therefore must conform to the requirements of
State law.
Forms of Bankruptcy Relief
Liquidation and rehabilitation are the two basic types of
bankruptcy proceedings. Liquidation is pursued under
Chapter 7 of the law and involves the bankruptcy trustee
collecting all of the debtor's nonexempt property,
converting it into cash and distributing the proceeds among
the debtor's creditors. In return, the debtor obtains a
discharge of all debts outstanding at the time the petition
was filed which releases the debtor from all liability for
those pre-bankruptcy debts.
Collateral Assignment
Rehabilitation (sometimes known as reorganization) is
effected through Chapter 11 or Chapter 13 of the law and
in essence provides that creditors' claims are satisfied not
via liquidation of the obligor's assets but rather from future
earnings. That is, debtors are allowed to retain their assets
but their obligations are restructured and a plan is
implemented whereby creditors may be paid.
An assignment is generally considered as the transfer of a
legal right from one person to another. The rights acquired
under a contract may be assigned if they relate to money or
property, but personal services may not be assigned.
Collateral assignments are used to establish the bank's
rights as lender in the property or asset serving as
collateral. It is generally used for loans secured by savings
deposits, certificates of deposit or other cash accounts as
well as loans backed by cash surrender value of life
insurance. In some instances, it is used in financing
accounts receivable and contracts. If a third party holder
of the collateral is involved, such as life insurance
company or the payor of an assigned contract, an
acknowledgement should be obtained from that party as to
the bank's assigned interest in the asset for collateral
purposes.
Chapter 11 bankruptcy is available to all debtors, whether
individuals, corporations or partnerships. Chapter 13
(sometimes referred to as the "wage earner plan"), on the
other hand, may be used only by individuals with regular
incomes and when their unsecured debts are under
$100,000 and secured debts less than $350,000. The
aforementioned rehabilitation plan is essentially a contract
between the debtor and the creditors. Before the plan may
be confirmed, the bankruptcy court must find it has been
proposed in good faith and that creditors will receive an
amount at least equal to what would be received in a
Chapter 7 proceeding. In Chapter 11 reorganization, all
creditors are entitled to vote on whether or not to accept
the repayment plan. In Chapter 13 proceedings, only
secured creditors are so entitled. A majority vote binds the
minority to the plan, provided the latter will receive
pursuant to the plan at least the amount they would have
received in a straight liquidation. The plan is fashioned so
that it may be carried out in three years although the court
may extend this to five years.
CONSIDERATION OF BANKRUPTCY
LAW AS IT RELATES TO
COLLECTABILITY OF A DEBT
Introduction
Familiarity with the basic terms and concepts of the
Federal bankruptcy law (formally known as the Bankruptcy
Reform Act of 1978) is necessary in order for examiners to
make informed judgments concerning the likelihood of
collection of loans to bankrupt individuals or
organizations.
The following paragraphs present an
overview of the subject. Complex situations may arise
where more in-depth consideration of the bankruptcy
provisions may be necessary and warrant consultation with
the bank's attorney, Regional Counsel or other member of
the Regional Office staff. For the most part, however,
knowledge of the following information when coupled with
review of credit file data and discussion with bank
management should enable examiners to reach sound
conclusions as to the eventual repayment of the bank's
loans.
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Most cases in bankruptcy courts are Chapter 7
proceedings, but reorganization cases are increasingly
common. From the creditor's point of view, Chapter 11 or
13 filings generally result in greater debt recovery than do
liquidation situations under Chapter 7. Nonetheless, the
fact that reorganization plans are tailored to the facts and
circumstances applicable to each bankrupt situation means
that they vary considerably and the amount recovered by
the creditor may similarly vary from nominal to virtually
complete recovery.
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Trustees are selected by the borrower's creditors and are
responsible for administering the affairs of the bankrupt
debtor's estate. The bankrupt's property may be viewed as
a trust for the benefit of the creditors, consequently it
follows the latter should, through their elected
representatives, exercise substantial control over this
property.
When a borrower files a bankruptcy petition, an "estate" is
created and, under Chapter 7 of the law, the property of the
estate is passed to the trustee for distribution to the
creditors. Certain of the debtor's property is exempt from
distribution under all provisions of the law (not just
Chapter 7), as follows: homeowner's equity up to $7,500;
automobile equity and household items up to $1,200;
jewelry up to $500; cash surrender value of life insurance
up to $4,000; Social Security benefits (unlimited); and
miscellaneous items up to $400 plus any unused portion of
the homeowner's equity. The bankruptcy code recognizes
a greater amount of exemptions may be available under
State law and, if State law is silent or unless it provides to
the contrary, the debtor is given the option of electing
either the Federal or State exemptions. Examiners should
note that some liens on exempt property which would
otherwise be enforceable are rendered unenforceable by
the bankruptcy. A secured lender may thus become
unsecured with respect to the exempt property. The basic
rule in these situations is that the debtor can render
unenforceable judicial liens on any exempt property and
security interests that are both nonpurchase money and
nonpossessory on certain household goods, tools of the
trade and health aids.
Voluntary and Involuntary Bankruptcy
When a debtor files a bankruptcy petition with the court,
the case is described as a voluntary one. It is not necessary
the individual or organization be insolvent in order to file a
voluntary case. Creditors may also file a petition, in which
case the proceeding is know as an involuntary bankruptcy.
However, this alternative applies only to Chapter 7 cases
and the debtor generally must be insolvent, i.e., unable to
pay debts as they mature, in order for an involuntary
bankruptcy to be filed.
Automatic Stay
Filing of the bankruptcy petition requires (with limited
exceptions) creditors to stop or "stay" further action to
collect their claims or enforce their liens or judgements.
Actions to accelerate, set off or otherwise collect the debt
are prohibited once the petition is filed, as are postbankruptcy contacts with the obligor. The stay remains in
effect until the debtor's property is released from the estate,
the bankruptcy case is dismissed, the debtor obtains or is
denied a discharge, or the bankruptcy court approves a
creditor's request for termination of the stay. Two of the
more important grounds applicable to secured creditors
under which they may request termination are as follows:
(1) The debtor has no equity in the encumbered property,
and the property is not necessary to an effective
rehabilitation plan; or (2) The creditor's interest in the
secured property is not adequately protected. In the latter
case, the law provides three methods by which the
creditor's interests may be adequately protected: the
creditor may receive periodic payments equal to the
decrease in value of the creditor's interest in the collateral;
an additional or substitute lien on other property may be
obtained; or some other protection is arranged (e.g., a
guarantee by a third party) to adequately safeguard the
creditor's interests. If these alternatives result in the
secured creditor being adequately protected, relief from the
automatic stay will not be granted. If relief from the stay is
obtained, creditors may continue to press their claims upon
the bankrupt's property free from interference by the debtor
or the bankruptcy court.
Discharge and Objections to Discharge
The discharge, as mentioned previously, protects the
debtor from further liability on the debts discharged.
Sometimes, however, a debtor is not discharged at all (i.e.,
the creditor has successfully obtained an "objection to
discharge") or is discharged only as regards to a specific
creditor(s) and a specific debt(s) (an action known as
"exception to discharge").
The borrower obviously
remains liable for all obligations not discharged, and
creditors may pursue customary collection procedures with
respect thereto. Grounds for an "objection to discharge"
include the following actions or inactions by the bankrupt
debtor (this is not an all-inclusive list): fraudulent
conveyance within 12 months of filing the petition;
unjustifiable failure to keep or preserve financial records;
false oath or account or presentation of a false claim in the
bankruptcy case and estate, respectively; withholding of
books or records from the trustee; failure to satisfactorily
explain any loss or deficiency of assets; refusal to testify
when legally required to do so; and receiving a discharge
in bankruptcy within the last six full years. Some of the
bases upon which creditors may file "exceptions to
discharge" are: nonpayment of income taxes for the three
years preceding the bankruptcy; money, property or
services obtained through fraud, false pretenses or false
representation; debts not scheduled on the bankruptcy
petition and which the creditor had no notice; alimony or
child support payments (this exception may be asserted
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only by the debtor's spouse or children, property
settlements are dischargeable); and submission of false or
incomplete financial statements. If a bank attempts to seek
an exception on the basis of false financial information, it
must prove the written financial statement was materially
false, it reasonably relied on the statement, and the debtor
intended to deceive the bank. These assertions can be
difficult to prove.
Discharges are unavailable to
corporations or partnerships.
Therefore, after a
bankruptcy, corporations and partnerships often dissolve or
become defunct.
payment be returned and made the property of the bankrupt
estate. A transfer of security, such as the granting of a
mortgage, may also be invalidated by the trustee. Hence,
the trustee may require previously encumbered property be
made unencumbered, in which case the secured party
becomes an unsecured creditor.
This has obvious
implications as regards loan collectability.
Preferences are a potentially troublesome area for banks
and examiners should have an understanding of basic
principles applicable to them. Some of the more important
of these are listed here.
Reaffirmation
•
Debtors sometimes promise their creditors after a
bankruptcy discharge that they will repay a discharged
debt. An example wherein a debtor may be so motivated
involves the home mortgage. To keep the home and
discourage the mortgagee from foreclosing, a debtor may
reaffirm this obligation. This process of reaffirmation is an
agreement enforceable through the judicial system. The
law sets forth these basic limitations on reaffirmations: the
agreement must be signed before the discharge is granted;
a hearing is held and the bankruptcy judge informs the
borrower there is no requirement to reaffirm; and the
debtor has the right to rescind the reaffirmation if such
action is taken within 30 days.
•
Classes of Creditors
The first class of creditors is known as priority creditors.
As the name implies, these creditors are entitled to receive
payment prior to any others. Priority payments include
administrative expenses of the debtor's estate, unsecured
claims for wages and salaries up to $2,000 per person,
unsecured claims for employee benefit plans, unsecured
claims of individuals up to $900 each for deposits in
conjunction with rental or lease of property, unsecured
claims of governmental units and certain tax liabilities.
Secured creditors are only secured up to the extent of the
value of their collateral. They become unsecured in the
amount by which collateral is insufficient to satisfy the
claim. Unsecured creditors are of course the last class in
terms of priority.
•
•
A preference may be invalidated (also known as
"avoided") if it has all of these elements: the transfer
was to or for the benefit of a creditor; the transfer was
made for or on account of a debt already outstanding;
the transfer has the effect of increasing the amount a
creditor would receive in Chapter 7 proceedings; the
transfer was made within 90 days of the bankruptcy
filing, or within one year if the transfer was to an
insider who had reasonable cause to believe the debtor
was insolvent at the time of transfer; and the debtor
was insolvent at the time of the transfer. Under
bankruptcy law, borrowers are presumed insolvent for
90 days prior to filing the bankruptcy petition.
Payment to a fully secured creditor is not a preference
because such a transfer would not have the effect of
increasing the amount the creditor would otherwise
receive in a Chapter 7 proceeding. Payment to a
partially secured creditor does, however, have the
effect of increasing the creditor's share and is thus
deemed a preference which the trustee may avoid.
Preference rules also apply to a transfer of a lien to
secure past debts, if the transfer has all five elements
set forth under the first point.
There are certain situations wherein a debtor has given
a preference to a creditor but the trustee is not
permitted to invalidate it. A common example
concerns floating liens on inventory under the Uniform
Commercial Code. These matters are subject to
complex rules, however, and consultation with the
Regional Office may be advisable when this issue
arises.
Preferences
Setoffs
Certain actions taken by a creditor before or during
bankruptcy proceedings may be invalidated by the trustee
if they result in some creditors receiving more than their
share of the debtor's estate. These actions are called
"transfers" and fall into two categories. The first involves
absolute transfers, such as payments received by a creditor;
the trustee may invalidate this action and require the
Setoffs occur when a party is both a creditor and a debtor
of another; amounts which a party owes are netted against
amounts which are owed to that party. If a bank exercises
its right of setoff properly and before the bankruptcy filing,
the action is generally upheld in the bankruptcy
proceedings. Setoffs made after the bankruptcy may also
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be valid but certain requirements must be met of which the
following are especially important: First, the debts must be
between the same parties in the same right and capacity.
For example, it would be improper for the bank to setoff
the debtor's loan against a checking account of the estate of
the obligor's father, of which the debtor is executor.
Second, both the debt and the deposit must precede the
bankruptcy petition filing. Third, the setoff may be
disallowed if funds were deposited in the bank within 90
days of the bankruptcy filing and for the purpose of
creating or increasing the amount to be set off.
•
Transfers Not Timely Perfected or Recorded
In times of excess liquidity in the marketplace, spreads
typically are quite narrow for investment-grade facilities,
thus making it a borrower’s market. This may be
accompanied by an easing of the structuring and covenants.
In spite of tightening margins, commercial banks are
motivated to compete regarding pricing in order to retain
other business.
The syndicated loan market has grown steadily, and growth
in recent years has been extraordinary as greater market
discipline has lead to uniformity in pricing. In recent years
syndicated lending has come to resemble a capital market,
and this trend is expected to continue as secondary market
liquidity for these products continues to grow. The volume
of syndicated credits is currently measured in trillions of
dollars, and growth is expected to continue as pricing
structures continue to appeal to lenders or "investors.”
Under most circumstances, a bank which has not recorded
its mortgage or otherwise fails to perfect its security
interest in a proper timely manner runs great risk of losing
its security. This is a complex area of the law but prudence
clearly dictates that liens be properly obtained and
promptly filed so that the possibility of losing the
protection provided by collateral is eliminated.
Relaxing covenants and pricing may result in lenders
relying heavily on market valuations, or so-called
"enterprise values" in arriving at credit decisions. These
values are derived by applying a multiple to cash flow,
which differs, by industry and other factors, to historical or
projected cash flows of the borrower.
This value
represents the intangible business value of a company as a
going concern, which often exceeds its underlying assets.
SYNDICATED LENDING
Overview
Syndicated loans often represent a substantial portion of
the commercial and industrial loan portfolios of large
banks. A syndicated loan involves two or more banks
contracting with a borrower, typically a large or middle
market corporation, to provide funds at specified terms
under the same credit facility. The average commercial
syndicated credit is in excess of $100 million. Syndicated
credits differ from participation loans in that lenders in a
syndication participate jointly in the origination process, as
opposed to one originator selling undivided participation
interests to third parties. In a syndicated deal, each
financial institution receives a pro rata share of the income
based on the level of participation in the credit.
Additionally, one or more lenders take on the role of lead
or "agent" (co-agents in the case of more than one) of the
credit and assume responsibility of administering the loan
for the other lenders. The agent may retain varying
percentages of the credit, which is commonly referred to as
the "hold level."
Many deals involve merger and acquisition financing.
While the primary originators of the syndicated loans are
commercial banks, most of the volume is sold and held by
other investors.
A subset of syndicated lending is leveraged lending which
refers to borrowers with an excessive level of debt and debt
service compared with cash flow. By their very nature,
these instruments are of higher risk.
Syndication Process
There are four phases in a loan syndication: Pre-Launch,
Launch, Post-Launch, and Post-Closing.
The Pre-Launch Process - During this phase, the
syndicators identify the borrower’s needs and perform their
initial due diligence. Industry information is gathered and
analyzed, and background checks may be performed.
Potential pricing and structure of the transaction takes
shape. Formal credit write-ups are sent to credit officers
for review and to senior members of syndication group for
pricing approval. Competitive bids are sent to the
borrower. The group then prepares for the launch.
The syndicated market formed to meet basic needs of
lenders and borrowers, specifically:
•
•
•
•
•
raising large amounts of money,
enabling geographic diversification,
satisfying relationship banking,
obtaining working capital quickly and efficiently,
spreading risk for large credits amongst banks, and
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gaining attractive pricing advantages.
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An information memorandum is prepared by the agent.
This memorandum is a formal and confidential document
that should address all principal credit issues relating to the
borrower and to the project being financed. It should, at a
minimum, contain an overview of the transaction including
a term sheet, an overview of the borrower’s business, and
quarterly and annual certified financial statements. This
documents acts as both the marketing tool and as the
source of information for the syndication.
broadly be divided into financial and non-financial
categories.
The former refers to respecting certain
financial conditions that can be defined either in absolute
amounts or ratios. Some examples are:
The Launch Phase - The transaction is launched into the
market when banks are sent the information memoranda
mentioned above. Legal counsel commences to prepare
the documentation. Negotiations take place between the
banks and the borrower over pricing, collateral, covenants,
and other terms.
Often there is a bank meeting so
potential participants can discuss the company’s business
and industry both with the lead agent and with the
company.
Interest, Debt service or Fixed Charges Coverage test:
assure that some level of cash flow is generated by a
company above its operating expenses and other fixed
obligations.
Net worth test: restricts the total amount of debt a borrower
can incur, expressed as a percentage of net worth.
Current ratio/ Quick Ratio tests: measures liquidity.
Profitability test: Particularly important for the nonrated
company; some usual ratios include EBITDA (earnings
before interest, taxes, depreciation, and amortization)
divided by average capital, operating income as a
percentage of sales and earnings on business segment
assets.
Post-Launch Phase - Typically there is a two-week period
for potential participants to evaluate the transaction and to
decide whether or not to participate in the syndication.
During this period, banks do their due diligence and credit
approval. Often this entails running projection models,
including stress tests, doing business and industry research;
and presenting the transaction for the approval process
once the decision is made to commit to the transaction.
Capital expenditure limitations: Should be set according to
the company’s business plan and then measured
accordingly.
Borrowing Base Limitations: Ascertain that companies are
not borrowing to overinvest in inventory and provide a first
line of fallback for the lenders if a credit begins to
deteriorate.
After the commitment due date, participating banks receive
a draft credit agreement for their comments. Depending
upon the complexity of the agreement, they usually have
about a week to make comments. The final credit
agreement is then negotiated based on the comments and
the loan would then close two to five days after the credit
agreement is finalized.
Cash Flow volatility: Actual leverage covenant levels vary
by industry segment. Typical ratios that are used to
measure cash flow adequacy include EBITDA divided by
total debt and EBITDA divided by interest expense.
Non-financial covenants may include restrictions on other
matters such as management changes, provisions of
information, guarantees, disposal of assets, etc.
Post-Closing Phase - Post-Closing, there should be
ongoing
dialogue
with
the
borrower
about
financial/operating performance as well as quarterly credit
agreement covenant compliance checks. Annually, a full
credit analysis should be done as well as annual meetings
of the participants for updates on financial and operating
performance. Both the agent bank and the participants
need to assess the loan protection level by analyzing the
business risk as well as the financial risk. Each industry
has particular dominant risks that must be assessed.
Credit Ratings
Over the past several years, large credit rating agencies
have entered the syndicated loan market (Standard and
Poors, Moody, Fitch Investor Services). Loan ratings
differ from bond ratings in that bond ratings emphasize the
probability of default of the bond; whereas loan ratings
emphasize the probability of default as well as the
likelihood of collection upon default. Loan ratings
emphasize the loan’s structural characteristics (covenants,
cash flow, collateral, etc.) and the expected loss on the
loan.
Loan Covenants
Loan covenants are special or particular conditions that are
included in a loan agreement and that the borrower is
required to fulfill in order for the loan agreement to remain
valid. Typically, covenants cover several domains but can
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SNCs Do Not Include:
Overview of the Shared National Credit
(SNC) Program
•
The Shared National Credit (SNC) Program is an
interagency initiative administered jointly by the FDIC,
Federal Reserve Board, and the Office of the Comptroller
of the Currency. The program was established in the
1970's for the purpose of ensuring consistency among the
three Federal banking regulators in the classification of
large syndicated credits.
•
•
•
•
Each SNC is reviewed annually at its agent bank or a
designated review bank and the quality rating assigned by
examiners is reported to all participating banks. These
ratings are subsequently used during all examinations of
participating banks, thus avoiding duplicate reviews of the
same loan and ensuring consistent treatment with regard to
regulatory credit ratings. Examiners should not change
SNC ratings during risk management examinations. Any
material change in a SNC should be reported to the
appropriate regional SNC coordinator so that a
determination can be made as to the appropriate action,
including inclusion in the credit re-review process.
Definition of a SNC
•
For additional information regarding the SNC Program
examiners can contact the regional SNC coordinator.
Glossary of Syndicated Lending Terms
Agent – Entity that assumes the lead role in originating and
administering the credit facility.
Arranging Banks – The banks that arrange a financing on
behalf of a corporate borrower. Usually the banks commit
to underwriting the whole amount only if they are unable to
place the deal fully. Typically, however, they place the
bulk of the facility and retain a portion on their books. For
their efforts in arranging a deal, these banks collect an
arrangement fee.
Any loan and/or formal loan commitment, including any
asset such as other real estate, stocks, notes, bonds and
debentures taken for debts previously contracted, extended
to a borrower by a supervised institution, its subsidiaries,
and affiliates which in original amount aggregates $20
million or more and, which is shared by three or more
unaffiliated institutions under a formal lending agreement;
or, a portion of which is sold to two or more unaffiliated
institutions, with the purchasing institution(s) assuming its
pro rata share of the credit risk.
Front-end costs – Commissions, fees or other payments
that are taken at the outset of a loan. Some examples are:
lead management fees – paid in recognition of the lead
manager’s organization; management fees – usually
divided equally between the management group and is
payable regardless of drawdown; underwriting fees – a
percentage of the sum being underwritten; participation
fees – expressed as a percentage of each bank’s
participation in the loan; and agency fees – levied on most
loans and provide for the appointment of one or more agent
banks. The fee may be a percentage of the whole facility
or a pre-arranged fixed sum.
SNC's Include:
•
•
•
•
•
All international credits to borrowers in the private
sector, regardless of currency denomination, which are
administered by a domestic office.
Assets taken for debts previously contracted such as
other real estate, stocks, notes, bonds, and debentures.
Credits or credit commitments which have been
reduced to less than $20 million and were classified or
criticized during the previous SNC review, provided
they have not been reduced below $10 million.
Any other large credit(s) designated by the supervisory
agencies as meeting the general intent or purpose of
the SNC program.
Two or more credits to the same borrower that
aggregate $20 million and each credit has the same
participating lenders
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Credits shared solely between affiliated supervised
institutions.
Private sector credits that are 100 percent guaranteed
by a sovereign entity.
International credits or commitments administered in a
foreign office.
Direct credits to sovereign borrowers.
Credits known as "club credits", which include related
borrowings but are not extended under the same
lending agreement.
Credits with different maturity dates for different
lenders.
LIBOR – London Interbank Offered Rate – The interest
rate at which major international banks in London lend to
each other and the rate(s) frequently underlying loan
interest calculations. LIBOR will vary according to market
conditions and will of course depend upon the loan period
as well as the currency in question.
Participating Banks – a bank that has lent a portion of the
outstanding amount to the borrower.
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Reference Bank – A bank that sets the lending rate
(LIBOR) at the moment of each loan rollover period
Few, if any, institutions have an automated underwriting
system where the credit score is used exclusively to make
the credit decision. Some level of human review is usually
present to provide the flexibility needed to address
individual circumstances. Institutions typically establish a
minimum cut-off score below which applicants are denied
and a second cutoff score above which applicants are
approved. However, there is usually a range, or “gray
area,” in between the two cut-off scores where credits are
manually reviewed and credit decisions are judgmentally
determined.
Tranche – In a large syndicated loan, different portions of
the facility may be made available at different time periods,
and in different currencies. These separate components are
known as “tranches” of the facility.
Underwriter - A bank that guarantees the lending of the
funds to the borrower irrespective of successful syndication
or not.
Zeta score - There are models which predict bankruptcy
based on the analysis of certain financial ratios. Edward
Altman of New York University developed a model in
1968 which is used by the regulatory agencies called Zeta.
The Zeta score methodology is intended to forecast the
probability of a company entering bankruptcy within a
twelve month period. It uses five financial ratios from
reported accounting information to produce an objective
measure of financial strength of a company. The ratios
included in the measurement are: working capital/total
assets; retained earnings/total assets; earnings before
interest and taxes/total assets; market value of common and
preferred
equity/total
liabilities
(in
non-public
organizations, the book value of common and preferred
equity should be substituted); and sales/total assets (for
non-manufacturing companies, this variable is eliminated).
Most, if not all, systems also provide for overrides of
established cut-off scores. If the institution’s scoring
system effectively predicts loss rates and reflects
management’s risk parameters, excessive overrides will
negate the benefits of an automated scoring system.
Therefore, it is critical for management to monitor and
control overrides. Institutions should develop acceptable
override limits and prepare monthly override reports that
provide comparisons over time and against the institution’s
parameters. Override reports should also identify the
approving officer and include the reason for the override.
Although banks often use more than one type of credit
scoring methodology in their underwriting and account
management practices, many systems incorporate credit
bureau scores.
Credit bureau scores are updated
periodically and validated on an ongoing basis against
performance in credit bureau files. Scores are designed to
be comparable across the major credit bureaus; however,
the ability of any score to estimate performance outcome
probabilities depends on the quality, quantity, and timely
submission of lender data to the various credit bureaus.
Often, the depth and thoroughness of data available to each
credit bureau varies, and as a consequence, the quality of
scores varies.
CREDIT SCORING
Automated credit scoring systems allow institutions to
underwrite and price loans more quickly than was possible
in the past. This efficiency has enabled some banks to
expand their lending into national markets and originate
loan volumes once considered infeasible. Scoring also
reduces unit-underwriting costs, while yielding a more
consistent loan portfolio that is easily securitized. These
benefits have been the primary motivation for the
proliferation of credit scoring systems among both large
and small institutions.
As a precaution, institutions that rely on credit bureau
scores should sample and compare credit bureau reports to
determine which credit bureau most effectively captures
data for the market(s) in which the institution does
business. For institutions that acquire credit from multiple
regions, use of multiple scorecards may be appropriate,
depending on apparent regional credit bureau strength. In
some instances, it may be worthwhile for institutions to
pull scores from each of the major credit bureaus and
establish rules for selecting an average value. By tracking
credit bureau scores over time and capturing performance
data to differentiate which score seems to best indicate
probable performance outcome, institutions can select the
best score for any given market. Efforts to differentiate
and select the best credit bureau score should be
documented.
Credit scoring systems identify specific characteristics that
help define predictive variables for acceptable performance
(delinquency, amount owed on accounts, length of credit
history, home ownership, occupation, income, etc.) and
assign point values relative to their overall importance.
These values are then totaled to calculate a credit score,
which helps institutions to rank order risk for a given
population. Generally, an individual with a higher score
will perform better relative to an individual with a lower
credit score.
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Although some institutions develop their own scoring
models, most are built by outside vendors and subsequently
maintained by the institution. Vendors build scoring
models based upon specific information and parameters
provided by bank management. Therefore, management
must clearly communicate with the vendor and ensure that
the scorecard developer clearly understands the bank’s
objectives. Bank management should also adhere closely
to vendor manual specifications for system maintenance
and management, particularly those that provide guidance
for periodically assessing performance of the system.
Examiners should refer to the Credit Card Specialty Bank
Examination Guidelines and the Credit Card Activities
section of the Examination Modules for additional
guidance on credit scoring systems.
SUBPRIME LENDING
Introduction
There is not a universal definition of a subprime loan in the
industry, but subprime lending is generally characterized as
a lending program or strategy that targets borrowers who
pose a significantly higher risk of default than traditional
retail banking customers. Institutions often refer to
subprime lending by other names such as the nonprime,
nonconforming, high coupon, or alternative lending
market.
Scoring models generally become less predictive as time
passes. Certain characteristics about an applicant, such as
income, job stability, and age change over time, as do
overall demographics. One-by-one, these changes will
result in significant shifts in the profile of the population.
Once a fundamental change in the profile occurs, the model
is less able to identify potentially good and bad applicants.
As these changes continue, the model loses its ability to
rank order risk. Thus, institutions must periodically
validate the system’s predictability and refine scoring
characteristics when necessary. These efforts should be
documented.
Well-managed subprime lending can be a profitable
business line; however, it is a high-risk lending activity.
Successful subprime lenders carefully control the elevated
credit, operating, compliance, legal, market, and reputation
risks as well as the higher overhead costs associated with
more labor-intensive underwriting, servicing, and
collections. Subprime lending should only be conducted
by institutions that have a clear understanding of the
business and its inherent risks, and have determined these
risks to be acceptable and controllable given the
institution’s staff, financial condition, size, and level of
capital support. In addition, subprime lending should only
be conducted within a comprehensive lending program that
employs strong risk management practices to identify,
measure, monitor, and control the elevated risks that are
inherent in this activity. Finally, subprime lenders should
retain additional capital support consistent with the volume
and nature of the additional risks assumed. If the risks
associated with this activity are not properly controlled,
subprime lending may be considered an unsafe and
unsound banking practice.
Institutions initially used credit scoring for consumer
lending applications such as credit card, auto, and
mortgage lending. However, credit scoring eventually
gained acceptance in the small business sector. Depending
on the manner in which it is implemented, credit scoring
for small business lending may represent a fundamental
shift in underwriting philosophy if institutions view a small
business loan as more of a high-end consumer loan and,
thus, grant credit more on the strength of the principals’
personal credit history and less on the fundamental strength
of the business. While this may be appropriate in some
cases, it is important to remember that the income from
small business remains the primary source of repayment for
most loans. Banks that do not analyze business financial
statements or periodically review their lines of credit may
lose an opportunity for early detection of credit problems.
The term, subprime, refers to the credit characteristics of
the borrower at the loan’s origination, rather than the type
of credit or collateral considerations. Subprime borrowers
typically have weakened credit histories that may include a
combination of payment delinquencies, charge-offs,
judgments, and bankruptcies. They may also display
reduced repayment capacity as measured by credit scores,
debt-to-income ratios, or other criteria.
Generally,
subprime borrowers will display a range of credit risk
characteristics that may include one or more of the
following:
The effectiveness of any scoring system directly depends
on the policies and procedures established to guide and
enforce proper use. Policies should include an overview of
the institution’s scoring objectives and operations; the
establishment of authorities and responsibilities over
scoring systems; the use of a chronology log to track
internal and external events that affect the scoring system;
the establishment of bank officials responsible for
reporting, monitoring, and reviewing overrides; as well as
the provision of a scoring system maintenance program to
ensure that the system continues to rank risk and to predict
default and loss under the original parameters.
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Section 3.2
Two or more 30-day delinquencies in the last 12
months, or one or more 60-day delinquencies in the
last 24 months;
Judgment, foreclosure, repossession, or charge-off in
the prior 24 months;
Bankruptcy in the last 5 years;
Relatively high default probability as evidenced by,
for example, a Fair Isaac and Co. risk score (FICO) of
660 or below (depending on the product/collateral), or
other bureau or proprietary scores with an equivalent
default probability likelihood; and/or
Debt service-to-income ratio of 50 percent or greater,
or otherwise limited ability to cover family living
expenses after deducting total monthly debt-service
requirements from monthly income.
a common and relatively easily identifiable characteristic
of subprime lending. However, high interest rates and fees
by themselves do not constitute subprime lending.
This list is illustrative rather than exhaustive and is not
meant to define specific parameters for all subprime
borrowers. Additionally, this definition may not match all
market or institution-specific subprime definitions, but
should be viewed as a starting point from which examiners
should expand their review of the bank’s lending program.
For supervisory purposes, a subprime lender is defined as
an insured institution or institution subsidiary that has a
subprime lending program with an aggregate credit
exposure greater than or equal to 25 percent of Tier 1
capital. Aggregate exposure includes principal outstanding
and committed, accrued and unpaid interest, and any
retained residual assets relating to securitized subprime
loans.
•
•
•
•
Subprime lending does not include traditional consumer
lending that has historically been the mainstay of
community banking, nor does it include making loans to
subprime borrowers as discretionary exceptions to the
institution’s prime retail lending policy. In addition,
subprime lending does not refer to: prime loans that
develop credit problems after acquisition; loans initially
extended in subprime programs that are later upgraded, as
a result of their performance, to programs targeted to prime
borrowers; or community development loans as defined in
the CRA regulations.
Subprime lenders typically use the criteria above to
segment prospects into subcategories such as, for example,
A-, B, C, and D. However, subprime subcategories can
vary significantly among lenders based on the credit
grading criteria. What may be an “A” grade definition at
one institution may be a “B” grade at another bank, but
generally each grade represents a different level of credit
risk.
Capitalization
The FDIC’s minimum capital requirements generally apply
to portfolios that exhibit substantially lower risk profiles
than exist in subprime loan programs. Therefore, these
requirements may not be sufficient to reflect the risks
associated with subprime portfolios. Each subprime lender
is responsible for quantifying the amount of capital needed
to offset the additional risk in subprime lending activities,
and for fully documenting the methodology and analysis
supporting the amount specified.
While the industry often includes borrowers with limited or
no credit histories in the subprime category, these
borrowers can represent a substantially different risk
profile than those with a derogatory credit history and are
not inherently considered subprime. Rather, consideration
should be given to underwriting criteria and portfolio
performance when determining whether a portfolio of loans
to borrowers with limited credit histories should be treated
as subprime for examination purposes.
Examiners will evaluate the capital adequacy of subprime
lenders on a case-by-case basis, considering, among other
factors, the institution’s own documented analysis of the
capital needed to support its subprime lending activities.
Examiners should expect capital levels to be risk sensitive,
that is, allocated capital should reflect the level and
variability of loss estimates within reasonably conservative
parameters. Examiners should also expect institutions to
specify a direct link between the estimated loss rates used
to determine the required ALLL, and the unexpected loss
estimates used to determine capital.
Subprime lending typically refers to a lending program
that targets subprime borrowers. Institutions engaging in
subprime lending generally have knowingly and
purposefully focused on subprime lending through planned
business strategies, tailored products, and explicit borrower
targeting. An institution’s underwriting guidelines and
target markets should provide a basis for determining
whether it should be considered a subprime lender. The
average credit risk profile of subprime loan programs will
exhibit the credit risk characteristics listed above, and will
likely display significantly higher delinquency and/or loss
rates than prime portfolios. High interest rates and fees are
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The sophistication of this analysis should be commensurate
with the size, concentration level, and relative risk of the
institution’s subprime lending activities and should
consider the following elements:
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institution’s subprime capital evaluation in their comments
and conclusions regarding capital adequacy.
Portfolio growth rates;
Trends in the level and volatility of expected losses;
The level of subprime loan losses incurred over one or
more economic downturns, if such data/analyses are
available;
The impact of planned underwriting or marketing
changes on the credit characteristics of the portfolio,
including the relative levels of risk of default, loss in
the event of default, and the level of classified assets;
Any deterioration in the average credit quality over
time due to adverse selection or retention;
The amount, quality, and liquidity of collateral
securing the individual loans;
Any asset, income, or funding source concentrations;
The degree of concentration of subprime credits;
The extent to which current capitalization consists of
residual assets or other potentially volatile
components;
The degree of legal and/or reputation risk associated
with the subprime business line(s) pursued; and
The amount of capital necessary to support the
institution’s other risks and activities.
Stress Testing
An institution’s capital adequacy analysis should include
stress testing as a tool for estimating unexpected losses in
its subprime 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 deteriorating economic,
market, and business conditions. Portfolio stress testing
should include “shock” testing of basic assumptions such
as delinquency rates, loss rates, and recovery rates on
collateral. It should also consider other potentially adverse
scenarios, such as: changing attrition or prepayment rates;
changing utilization rates for revolving products; changes
in credit score distribution; and changes in the capital
markets demand for whole loans, or asset-backed securities
supported by subprime loans.
These are representative examples. Actual factors will
vary by product, market segment, and the size and
complexity of the portfolio relative to the institution’s
overall operations. Whether stress tests are performed
manually, or through automated modeling techniques, the
Regulatory Agencies will expect that:
Given the higher risk inherent in subprime lending
programs, examiners should reasonably expect, as a
starting point, that an institution would hold capital against
such portfolios in an amount that is one and one half to
three times greater than what is appropriate for nonsubprime assets of a similar type. Refinements should
depend on the factors analyzed above, with particular
emphasis on the trends in the level and volatility of loss
rates, and the amount, quality, and liquidity of collateral
securing the loans. Institutions with subprime programs
affected by this guidance should have capital ratios that are
well above the averages for their traditional peer groups or
other similarly situated institutions that are not engaged in
subprime lending.
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The results of the stress test exercises should be a
documented factor in the analysis and determination of
capital adequacy for the subprime portfolios.
Some subprime asset pools warrant increased supervisory
scrutiny and monitoring, but not necessarily additional
capital. For example, well-secured loans to borrowers who
are slightly below what is considered prime quality may
entail minimal additional risks compared to prime loans,
and may not require additional capital if adequate controls
are in place to address the additional risks. On the other
hand, institutions that underwrite higher-risk subprime
pools, such as unsecured loans or high loan-to-value
second mortgages, may need significantly higher levels of
capital, perhaps as high as 100% of the loans outstanding
depending on the level and volatility of risk. Because of
the higher inherent risk levels and the increased impact that
subprime portfolios may have on an institution’s overall
capital, examiners should document and reference each
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The process is clearly documented, rational, and easily
understood by the board and senior management;
The inputs are reliable and relate directly to the
subject portfolios;
Assumptions are well documented and conservative;
and
Any models are subject to a comprehensive validation
process.
Institutions that engage in subprime lending without
adequate procedures to estimate and document the level of
capital necessary to support their activities should be
criticized. Where capital is deemed inadequate to support
the risk in subprime lending activities, examiners should
consult with their Regional Office to determine the
appropriate course of action.
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institution will control portfolio quality and avoid
excessive exposure. Policies and procedures should be in
place before initiating the activity. Institutions may
originate subprime loans through a variety of channels,
including dealers, brokers, correspondents, and marketing
firms. Regardless of the source, it is critical that
underwriting policies and procedures incorporate the risk
tolerances established by the board and management and
explicitly define underwriting criteria and exception
processes. Subprime lending policies and procedures
should, at a minimum, address the items outlined in the
loan reference module of the Examination Documentation
Modules for subprime lending. If the institution elects to
use scoring systems for approvals or pricing, the model
should be tailored to address the behavioral and credit
characteristics of the subprime population targeted and the
products offered. It is not acceptable to rely on models
developed for standard risk borrowers or products.
Furthermore, the models should be reviewed frequently
and updated as necessary to ensure assumptions remain
valid.
The following items are essential components of a risk
management program for subprime lenders.
Planning and Strategy. Prior to engaging in subprime
lending, the board and management should ensure that
proposed activities are consistent with the institution's
overall business strategy and risk tolerances, and that all
involved parties have properly acknowledged and
addressed critical business risk issues. These issues include
the costs associated with attracting and retaining qualified
personnel, investments in the technology necessary to
manage a more complex portfolio, a clear solicitation and
origination strategy that allows for after-the-fact
assessment of underwriting performance, and the
establishment of appropriate feedback and control systems.
The risk assessment process should extend beyond credit
risk and appropriately incorporate operating, compliance,
market, liquidity, reputation and legal risks.
Institutions establishing a subprime lending program
should proceed slowly and cautiously into this activity to
minimize the impact of unforeseen personnel, technology,
or internal control problems and to determine if favorable
initial profitability estimates are realistic and sustainable.
Strategic plan performance analysis should be conducted
frequently in order to detect adverse trends or
circumstances and take appropriate action in a timely
manner.
Given the higher credit risk associated with the subprime
borrower, effective subprime lenders use mitigating
underwriting guidelines and risk-based pricing to reduce
the overall risk of the loan. These guidelines include lower
loan-to-value ratio requirements and lower maximum loan
amounts relative to each risk grade within the portfolio.
Given the high-risk nature of subprime lending, the need
for thorough analysis and documentation is heightened
relative to prime lending. Compromises in analysis or
documentation can substantially increase the risk and
severity of loss. In addition, subprime lenders should
develop criteria for limiting the risk profile of borrowers
selected, giving consideration to factors such as the
frequency, recency, and severity of delinquencies and
derogatory items; length of time with re-established credit;
and reason for the poor credit history.
Management and Staff. Prior to engaging in subprime
lending, the board should ensure that management and staff
possess sufficient expertise to appropriately manage the
risks in subprime lending and that staffing levels are
adequate for the planned volume of activity. Subprime
lending requires specialized knowledge and skills that
many financial institutions do not possess. Marketing,
account origination, and collections strategies and
techniques often differ from those employed for prime
credit; thus it is generally not sufficient to have the same
staff responsible for both subprime and prime loans.
Servicing and collecting subprime loans can be very labor
intensive and requires a greater volume of staff with
smaller caseloads. Lenders should monitor staffing levels,
staff experience, and the need for additional training as
performance is assessed over time. Compensation
programs should not depend primarily on volume or
growth targets. Any targets used should be weighted
towards factors such as portfolio quality and risk-adjusted
profitability.
While the past credit deficiencies of subprime borrowers
reflect a higher risk profile, subprime loan programs must
be based upon the borrowers’ current reasonable ability to
repay and a prudent debt amortization schedule. Loan
repayment should not be based upon foreclosure
proceedings or collateral repossession. Institutions must
recognize the additional default risks and determine if
these risks are acceptable and controllable without
resorting to foreclosure or repossession that could have
been predetermined by the loan structure at inception.
Profitability and Pricing.
A key consideration for
lenders in the subprime market is the ability to earn riskadjusted yields that appropriately compensate the
institution for the increased risk and costs assumed. The
institution must have a comprehensive framework for
Lending Policies and Procedures. Lenders should have
comprehensive written policies and procedures, specific to
each subprime lending product, that set limits on the
amount of risk that will be assumed and address how the
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pricing decisions and profitability analysis that considers
all costs associated with each subprime product, including
origination, administrative/servicing, expected charge-offs,
funding, and capital. In addition, the pricing framework
should allow for fluctuations in the economic cycle. Fees
often comprise a significant portion of revenue in subprime
lending. Consideration should be given to the portion of
revenues derived from fees and the extent to which the fees
are a recurring and viable source of revenue. Profitability
projections should be incorporated into the business plan.
Management should track actual performance against
projections regularly and have a process for addressing
variances.
counseling. Cure programs should be used only when the
institution has substantiated the customer’s renewed
willingness and ability to pay. Management should ensure
that its cure programs are neither masking poor initial
credit risk selection nor deferring losses. Effective
subprime lenders may use short-term loan restructure
programs to assist borrowers in bringing loans current
when warranted, but will often continue to report past due
status on a contractual basis. Cure programs that alter the
contractual past due status may mask actual portfolio
performance and inhibit the ability of management to
understand and monitor the true credit quality of the
portfolio.
Loan Review and Monitoring. Institutions must have
comprehensive analysis and information systems that
identify, measure, monitor and control the risks associated
with subprime lending. Analysis must promote
understanding of the portfolio and early identification of
adverse quality/performance trends. Systems employed
must posses the level of detail necessary to properly
evaluate subprime activity. Recommended portfolio
segmentation and trend analyses are fully discussed in the
subprime lending loan reference module of the
Examination Modules.
Repossession and resale programs are integral to the
subprime business model. Policies and procedures for
foreclosure and repossession activities should specifically
address the types of cost/benefit analysis to be performed
before pursuing collateral, including valuation methods
employed; timing of foreclosure or repossession; and
accounting and legal requirements. Policies should clearly
outline whether the bank will finance the sale of the
repossessed collateral, and if so, the limitations that apply.
Banks should track the performance of such loans to assess
the adequacy of these policies.
Analysis should take into consideration the effects of
portfolio growth and seasoning, which can mask true
performance by distorting delinquency and loss ratios.
Vintage, lagged delinquency, and lagged loss analysis
methods are sometimes used to account for growth,
seasoning, and changes in underwriting. Analysis should
also take into account the effect of cure programs on
portfolio performance. Refer to the glossary of the Credit
Card Specialty Bank Examination Guidelines for
definitions of vintage, roll rate, and migration analysis.
Compliance and Legal Risks.
Subprime lenders
generally run a greater risk of incurring legal action given
the higher fees, interest rates, and profits; targeting
customers who have little experience with credit or
damaged credit records; and aggressive collection efforts.
Because the risk is dependent, in part, upon the public
perception of a lender’s practices, the nature of these risks
is inherently unpredictable. Institutions that engage in
subprime lending must take special care to avoid violating
consumer protection laws. An adequate compliance
management program must identify, monitor and control
the consumer protection hazards associated with subprime
lending. The institution should have a process in place to
handle the potential for heightened legal action. In
addition, management should have a system in place to
monitor consumer complaints for recurring issues and
ensure appropriate action is taken to resolve legitimate
disputes.
Servicing and Collections. Defaults occur sooner and in
greater volume than in prime lending; thus a welldeveloped servicing and collections function is essential
for the effective management of subprime lending. Strong
procedures and controls are necessary throughout the
servicing process; however, particular attention is
warranted in the areas of new loan setup and collections to
ensure the early intervention necessary to properly manage
higher risk borrowers. Lenders should also have welldefined written collection policies and procedures that
address default management (e.g., cure programs and
repossessions), collateral disposition, and strategies to
minimize delinquencies and losses. This aspect of
subprime lending is very labor intensive but critical to the
program's success.
Audit. The institution’s audit scope should provide for
comprehensive independent reviews of subprime activities.
Audit procedures should ensure, among other things, that a
sufficient volume of accounts is sampled to verify the
integrity of the records, particularly with respect to
payments processing.
Third Parties. Subprime lenders may use third parties for
a number of functions from origination to collections. In
dealing with high credit-risk products, management must
Cure programs include practices such as loan restructuring,
re-aging, renewal, extension, or consumer credit
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take steps to ensure that exposures from third-party
practices or financial instability are minimized. Proper due
diligence should be performed prior to contracting with a
third party vendor and on an ongoing basis thereafter.
Contracts negotiated should provide the institution with the
ability to control and monitor third party activities (e.g.
growth restrictions, underwriting guidelines, outside audits,
etc.) and discontinue relationships that prove detrimental to
the institution.
erroneous assumptions can lead to the significant
overstatement of an institution's assets. Institutions should
take a conservative approach when accounting for these
transactions and ensure compliance with existing
regulatory guidance. Refer to outstanding memoranda and
examination instructions for further information regarding
securitizations.
Classification
Special care must be taken when purchasing loans from
third party originators.
Some originators who sell
subprime loans charge borrowers high up-front fees, which
may be financed into the loan. These fees provide
incentive for originators to produce a high volume of loans
with little emphasis on quality, to the detriment of a
potential purchaser. These fees also increase the likelihood
that the originator will attempt to refinance the loans.
Contracts should restrict the originator from the churning
of customers. Further, subprime loans, especially those
purchased from outside the institution's lending area, are at
special risk for fraud or misrepresentation. Management
must also ensure that third party conflicts of interest are
avoided. For example, if a loan originator provides
recourse for poorly performing loans purchased by the
institution, the originator or related interest thereof should
not also be responsible for processing and determining the
past due status of the loans.
The Uniform Retail Credit Classification and Account
Management Policy (Retail Classification Policy) governs
the evaluation of consumer loans. This policy establishes
general classification thresholds based on delinquency, but
also grants examiners the discretion to classify individual
retail loans that exhibit signs of credit weakness regardless
of delinquency status. An examiner may also classify retail
portfolios, or segments thereof, where underwriting
standards are weak and present unreasonable credit risk,
and may criticize account management practices that are
deficient. Given the high-risk nature of subprime portfolios
and their greater potential for loan losses, the delinquency
thresholds for classification set forth in the Retail
Classification Policy should be considered minimums.
Well-managed subprime lenders should recognize the
heightened risk-of-loss characteristics in their portfolios
and, if warranted, internally classify their delinquent
accounts well before the timeframes outlined in the
interagency policy. If examination classifications are more
severe than the Retail Classification Policy suggests, the
examination report should explain the weaknesses in the
portfolio and fully document the methodology used to
determine adverse classifications.
Securitizations.
Securitizing subprime loans carries
inherent risks, including interim credit, liquidity, interest
rate, and reputation risk, that are potentially greater than
those for securitizing prime loans. The subprime loan
secondary market can be volatile, resulting in significant
liquidity risk when originating a large volume of loans
intended for securitization and sale. Investors can quickly
lose their appetite for risk in an economic downturn or
when financial markets become volatile. As a result,
institutions may be forced to sell loan pools at deep
discounts. If an institution lacks adequate personnel, risk
management procedures, or capital support to hold
subprime loans originally intended for sale, these loans
may strain an institution's liquidity, asset quality, earnings,
and capital. Consequently, institutions actively involved in
the securitization and sale of subprime loans should
develop a contingency plan that addresses back-up
purchasers of the securities, whole loans, or the attendant
servicing functions, alternate funding sources, and
measures for raising additional capital. An institution’s
liquidity and funding structure should not be overly
dependent upon the sale of subprime loans.
ALLL Analysis
The institution’s documented ALLL analysis should
identify subprime loans as a specific risk exposure separate
from the prime portfolio. In addition, the analysis should
segment the subprime lending portfolios by risk exposure
such as specific product, vintage, origination channel, risk
grade, loan to value ratio, or other grouping deemed
relevant.
Pools of adversely classified subprime loans (to include, at
a minimum, all loans past due 90 days or more) should be
reviewed for impairment, and an adequate allowance
should be established consistent with existing interagency
policy.
For subprime loans that are not adversely
classified, the ALLL should be sufficient to absorb at least
all estimated credit losses on outstanding balances over the
current operating cycle, typically 12 months. To the extent
that the historical net charge-off rate is used to estimate
expected credit losses, it should be adjusted for changes in
Given some of the unique characteristics of subprime
lending, accounting for the securitization process requires
assumptions that can be difficult to quantify reliably, and
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trends, conditions, and other relevant factors, including
business volume, underwriting, risk selection, account
management practices, and current economic or business
conditions that may alter such experience.
takes on increased importance given the greater emphasis
on collateral. Prepayment penalties are sometimes used on
subprime real estate loans, where allowed by law, given
that prepayment rates are generally higher and more
volatile for subprime real estate loans. Government
Sponsored Agencies, Fannie Mae and Freddie Mac,
participate in the subprime mortgage market to a limited
degree through purchases of subprime loans and guarantees
of subprime securitizations.
Subprime Auto Lending
Underwriting. Subprime auto lenders use risk-based
pricing of loans in addition to more stringent advance rates,
discounting, and dealer reserves than those typically used
for prime auto loans to mitigate the increased credit risk.
As credit risk increases, advance rates on collateral
decrease while interest rates, dealer paper discounts, and
dealer reserves increase. In addition to lower advance
rates, collateral values are typically based on the wholesale
value of the car. Lenders will typically treat a new dealer
with greater caution, using higher discounts and/or
purchasing the dealer’s higher quality paper until a
database and working relationship is developed.
Servicing and Collections. Collection calls begin early,
generally within the first 10 days of delinquency, within the
framework of existing laws. Lenders generally send
written correspondence of intent to foreclosure or initiate
other legal action early, often as early as 31 days
delinquent. The foreclosure process is generally initiated
as soon as allowed by law. Updated collateral valuations
are typically obtained early in the collections process to
assist in determining appropriate collection efforts.
Frequent collateral inspections are often used by lenders to
monitor the condition of the collateral.
Servicing and Collections.
Repossession is quick,
generally ranging between 30 to 60 days past due and
sometimes earlier. The capacity of a repossession and
resale operation operated by a prime lender could easily be
overwhelmed if the lender begins targeting subprime
borrowers, leaving the lender unable to dispose of cars
quickly. Resale methods include wholesale auction, retail
lot sale, and/or maintaining a database of retail contacts.
While retail sale will command a greater price, subprime
lenders should consider limiting the time allocated to retail
sales before sending cars to auction in order to ensure
adequate cash flow and avoid excessive inventory build-up.
Refinancing resales should be limited and tightly
controlled, as this practice can mask losses. Lenders
typically implement a system for tracking the location of
the collateral.
Subprime Credit Card Lending
Underwriting. Subprime credit card lenders use riskbased pricing as well as tightly controlled credit limits to
mitigate the increased credit risk. In addition, lenders may
require full or partial collateral coverage, typically in the
form of a deposit account at the institution, for the higherrisk segments of the subprime market. Initial credit lines
are set at low levels, such as $300 to $1,000, and
subsequent line increases are typically smaller than for
prime credit card accounts. Increases in credit lines should
be subject to stringent underwriting criteria similar to that
required at origination.
Underwriting for subprime credit cards is typically based
upon credit scores generated by sophisticated scoring
models. These scoring models use a substantial number of
attributes, including the frequency, severity, and recency of
previous delinquencies and major derogatory items, to
determine the probability of loss for a potential borrower.
Subprime lenders typically target particular subprime
populations through prescreening models, such as
individuals who have recently emerged from bankruptcy.
Review of the attributes in these models often reveals the
nature of the institution’s target population.
Subprime Residential Real Estate Lending
Underwriting. To mitigate the increased risk, subprime
residential real estate lenders use risk-based pricing in
addition to more conservative LTV ratio requirements and
cash-out restrictions than those typically used for prime
mortgage loans. As the credit risk of the borrower
increases, the interest rate increases and the loan-to-value
ratio and cash-out limit decreases. Prudent loan-to-value
ratios are an essential risk mitigant in subprime real estate
lending and generally range anywhere from 85 percent to
90 percent for A- loans, to 65 percent for lower grades.
High loan-to-value (HLTV) loans are generally not
considered prudent in subprime lending. HLTV loans
should be targeted at individuals who warrant large
unsecured debt, and then only in accordance with
outstanding regulatory guidance. The appraisal process
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Servicing and Collections. Lenders continually monitor
customer behavior and credit quality and take proactive
measures to avert potential problems, such as decreasing or
freezing credit lines or providing consumer counseling,
before the problems become severe or in some instances
before the loans become delinquent. Lenders often use
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sophisticated scoring systems to assist in monitoring credit
quality and frequently re-score customers. Collection calls
on delinquent loans begin early, generally within the first
10 days delinquent, and sometimes as early as 1-day
delinquent, within the framework of existing laws. Lenders
generally send written correspondence within the first 30
days in addition to calling. Account suspensions occur
early, generally within the first 45 days of delinquency or
immediately upon a negative event such as refusal to pay.
Accounts over 90 days past due are generally subject to
account closure and charge-off. In addition, account
closures based upon a borrower’s action, such as repeated
refusal to pay or broken promises to bring the account
current within a specified time frame, may occur at any
time in the collection process. Account closure practices
are generally more aggressive for relatively new credit card
accounts, such as those originated in the last six months.
Credit Risk. Borrowers who obtain payday loans generally
have cash flow difficulties and few, if any, lower-cost
borrowing alternatives. In addition, some payday lenders
perform minimal analysis of the borrower’s ability to repay
either at the loan’s inception or upon refinancing; they may
merely require a current pay stub or proof of a regular
income source and evidence that the customer has a
checking account. Other payday lenders use scoring
models and consult nationwide databases that track
bounced checks and persons with outstanding payday
loans. However, payday lenders typically do not obtain or
analyze information regarding the borrower’s total level of
indebtedness or information from the major national credit
bureaus. The combination of the borrower’s limited
financial capacity, the unsecured nature of the credit, and
the limited underwriting analysis of the borrower’s ability
to repay pose substantial credit risk for insured depository
institutions.
Payday Lending
Legal and Reputation Risk. Federal law authorizes Federal
and state-chartered insured depository institutions making
loans to out-of-state borrowers to “export” favorable
interest rates provided under the laws of the State where
the bank is located. That is, a state-chartered bank is
allowed to charge interest on loans to out-of-state
borrowers at rates authorized by the State where the bank
is located, regardless of usury limitations imposed by the
State laws of the borrower’s residence. Nevertheless,
institutions face increased reputation risk when they enter
into certain arrangements with payday lenders, including
arrangements to originate loans on terms that could not be
offered directly by the payday lender.
Payday lending is a particular type of subprime lending.
Payday loans (also known as deferred deposit advances)
are small dollar, short-term, unsecured loans that borrowers
promise to repay out of their next paycheck or regular
income payment (such as social security check). Payday
loans are usually priced at a fixed dollar fee, which
represents the finance charge. Because these loans have
such short terms to maturity, the cost of borrowing,
expressed as an annual percentage rate is very high.
In return for the loan, the borrower usually provides the
lender with a check or debit authorization for the amount
of the loan plus the fee. The check is either post-dated to
the borrower’s next payday or the lender agrees to defer
presenting the check for payment until a future date,
usually two weeks or less. When the loan is due, the lender
expects to collect the loan by depositing the check or
debiting the borrower’s account or by having the borrower
redeem the check with a cash payment. If the borrower
informs the lender that he or she does not have the funds to
repay the loan, the loan is often refinanced (payday lenders
may use the terms “rollover,” “same day advance,” or
“consecutive advance”) through payment of an additional
finance charge. If the borrower does not redeem the check
in cash and the loan is not refinanced, the lender normally
puts the check or debit authorization through the payment
system. If the borrower’s deposit account has insufficient
funds, the borrower typically incurs a NSF charge on this
account. If the check or the debit is returned to the lender
unpaid, the lender also may impose a returned item fee plus
collection charges on the loan.
Transaction Risk. Payday loans are a form of specialized
lending not typically found in state nonmember institutions,
and are most frequently originated by specialized nonbank
firms subject to State regulation. Payday loans can be
subject to high levels of transaction risk given the large
volume of loans, the handling of documents, and the
movement of loan funds between the institution and any
third party originators. Because payday loans may be
underwritten off-site, there also is the risk that agents or
employees may misrepresent information about the loans
or increase credit risk by failing to adhere to established
underwriting guidelines.
Third-Party Risk. Insured depository institutions may have
payday lending programs that they administer directly,
using their own employees, or they may enter into
arrangements with third parties. In the latter arrangements,
the institution typically enters into an agreement in which
the institution funds payday loans originated through the
third party. These arrangements also may involve the sale
to the third party of the loans or servicing rights to the
loans. Institutions also may rely on the third party to
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provide additional services that the bank would normally
provide, including collections, advertising and soliciting
applications. The existence of third party arrangements
may, when not properly managed, significantly increase
institutions’ transaction, legal, and reputation risks.
address concentrations, including directing the institution
to reduce its loans to an appropriate level, raising
additional capital, or submitting a plan to achieve
compliance.
Capital Adequacy
Arrangements with third parties should be guided by
written contract and approved by the institution’s board.
At a minimum, the arrangement should:
•
•
•
•
•
•
•
Payday lending is among the highest risk subsets of
subprime lending, and significantly higher levels of capital
than the starting point for subprime loans - one and a half
to three times what is appropriate for nonsubprime assets
of a similar type - should be required. Institutions that
underwrite payday loans may be required to maintain as
high as one hundred percent of the loans outstanding
(dollar-for-dollar capital), depending on the level and
volatility of risk. Risks to consider when determining
capital requirements include the unsecured nature of the
credit, the relative levels of risk of default, loss in the event
of default, and the level of classified assets. The degree of
legal or reputation risk associated with payday lending
should also be considered, especially as it relates to third
party agreements.
Describe the duties and responsibilities of each party,
including the scope of the arrangement;
Specify that the third party will comply with all
applicable laws and regulations;
Specify which party will provide consumer
compliance related disclosures;
Authorize the institution to monitor the third party and
periodically review and verify that the third party and
its representatives are complying with its agreement
with the institution;
Authorize the institution and the appropriate banking
agency to have access to such records of the third
party and conduct onsite transaction testing and
operational reviews at the third party locations as
necessary or appropriate to evaluate such compliance;
Require the third party to indemnify the institution for
potential liability resulting from action of the third
party with regard to the payday lending program; and
Address customer complaints, including any
responsibility for third-party forwarding and
responding to such complaints.
Allowance for Loan and Lease Losses
Institutions should maintain an ALLL that is adequate to
absorb estimated credit losses with the payday portfolio.
Although the contractual term of each payday loan may be
short, institutions’ methodologies for estimating credit
losses on these loans should take into account the fact that
many payday loans remain continuously outstanding for
longer periods because of renewals and rollovers. In
addition, institutions should evaluate the collectibility of
accrued fees and finance charges on payday loans and
employ appropriate methods to ensure that income is
accurately measured.
Bank management should sufficiently monitor the third
party with respect to its activities and performance.
Management should dedicate sufficient staff with the
necessary expertise to oversee the third party. The bank’s
oversight program should monitor the third party’s
financial condition, its controls, and the quality of its
service and support, including its resolution of consumer
complaints if handled by the third party. Oversight
programs should be documented sufficiently to facilitate
the monitoring and management of the risks associated
with third-party relationships.
Classifications
The Retail Classification Policy establishes general
classification thresholds for consumer loans based on
delinquency, but also grants examiners the discretion to
classify individual retail loans that exhibit signs of credit
weakness regardless of delinquency status. Examiners also
may classify retail portfolios, or segments thereof, where
underwriting standards are weak and present unreasonable
credit risk, and may criticize account management
practices that are deficient.
Concentrations
Given the risk inherent in payday lending, concentrations
of credit in this line of business pose a significant safety
and soundness concern. In the context payday lending, a
concentration would be defined as a volume of payday
loans totaling 25 percent or more of a bank’s Tier 1 capital.
Where concentrations of payday lending are noted, bank
management should be criticized for a failure to diversify
risks. Appropriate supervisory action may be necessary to
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Most payday loans have well-defined weaknesses that
jeopardize the liquidation of the debt. Weaknesses include
limited or no analysis of repayment capacity and the
unsecured nature of the credit. In addition, payday loan
portfolios are characterized by a marked proportion of
obligors whose paying capacity is questionable. As a result
3.2-73
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LOANS
Section 3.2
of these weaknesses, payday loan portfolios should be
classified Substandard.
•
Furthermore, payday loans that have been outstanding for
extended periods of time evidence a high risk of loss.
While such loans may have some recovery value, it is not
practical or desirable to defer writing off these essentially
worthless assets. Payday loans that are outstanding for
greater than 60 days from origination generally meet the
definition of Loss. In certain circumstances, earlier
charge-off may be appropriate (i.e., the bank does not
renew beyond the first payday and the borrower is unable
to pay, the bank closes an account, etc.). The institution’s
policies regarding consecutive advances also should be
considered when determining Loss classifications. Where
the economic substance of consecutive advances is
substantially similar to “rollovers” – without appropriate
“cooling off” or waiting periods – examiners should treat
these loans as continuous advances and classify
accordingly.
•
•
Establish appropriate “cooling off” or waiting periods
between the time a payday loan is repaid and another
application is made:
Establish the maximum number of loans per customer
that are allowed within one calendar year or other
designated time period; and
Provide that no more than one payday loan is
outstanding with the bank at a time to any one
borrower.
Accrued Fees and Finance Charges
Institutions should evaluate the collectibility of accrued
fees and finance charges on payday loans because a portion
of accrued interest and fees is generally not collectible.
Although regulatory reporting instructions do not require
payday loans to be placed on nonaccrual based on
delinquency status, institutions should employ appropriate
methods to ensure that income is accurately measured.
Such methods may include providing loss allowances for
uncollectible fees and finance charges or placing
delinquent and impaired receivables on nonaccrual status.
After a loan is placed on nonaccrual status, subsequent fees
and finance charges imposed on the borrower would not be
recognized in income and accrued, but unpaid fees and
finance charges normally would be reversed from income.
When classifying payday loans, examiners should
reference the Retail Classification Policy as the source
document. Examiners would normally not classify loans
for which the institution has documented adequate paying
capacity of the obligors and/or sufficient collateral
protection or credit enhancement.
Renewals/Rewrites
The Retail Classification Policy establishes guidelines for
extensions, deferrals, renewals, or rewrites of closed-end
accounts. Despite the short-term nature of payday loans,
borrowers that request an extension, deferral, renewal, or
rewrite should exhibit a renewed willingness and ability to
repay the loan. Examiners should ensure that institutions
adopt and adhere to the Retail Classification Policy
standards that control the use of extensions, deferrals,
renewals, or rewrites of payday loans. Under the Retail
Classification Policy, institutions’ standards should:
•
•
•
Limit the number and frequency of extensions,
deferrals, renewals, and rewrites;
Prohibit additional advances to finance unpaid interest
and fees and simultaneous loans to the same customer;
and
Ensure that comprehensive and effective risk
management, reporting, and internal controls are
established and maintained.
In addition to the above items, institutions also should:
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Federal Deposit Insurance Corporation
SECURITIES AND DERIVATIVES
Section 3.3
System, Office of Thrift Supervision, and National Credit
Union Administration, effective May 26, 1998. The Policy
Statement provides guidance and sound principles to
bankers for managing investment securities and derivatives
risks. It makes clear the importance of board oversight and
management supervision, and focuses on risk management.
The Policy Statement covers all securities used for
investment purposes and all end-user derivative
instruments used for non-trading purposes. It applies to all
federally-insured commercial banks, savings banks, and
savings associations. Notably, the Policy Statement:
INTRODUCTION
Overview
Securities and end-user derivatives (investment) activities
can provide banks with earnings, liquidity, and capital
appreciation. Carefully constructed positions can also
reduce overall bank risk exposures. However, investment
activities can also create considerable risk exposures,
particularly:
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Market risk,
Credit risk,
Liquidity risk,
Operating risk,
Legal risk,
Settlement risk, and
Interconnection risk.
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•
This section provides guidance, policy, and sound practices
regarding:
•
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Policies, procedures and risk limits,
Internal controls,
Unsuitable investment activities,
Risk Identification, measurement, and reporting,
Board and senior management oversight,
Compliance,
Report of examination treatment, and
Other guidance (trading, accounting, and information
services).
The Policy Statement declares that banks should
implement programs to manage the market, credit,
liquidity, legal, operational, and other risks that result from
investment activities.
Adequate risk management
programs identify, measure, monitor, and control these
risks.
Failure to understand and adequately manage investment
activity risks is an unsafe and unsound practice.
Use this section to assess how effectively a bank’s board
and management identifies, measures, monitors, and
controls investment activity risks. Incorporate findings
into relevant examination assessments, including sensitivity
to market risk, liquidity, asset quality, and management.
Risk Management Process Summary
This subsection provides guidance for evaluating a risk
management program’s effectiveness at identifying,
measuring, monitoring, and controlling investment activity
risks. It also includes guidance for assessing those risks
relative to overall risk exposure.
Refer to the Capital Markets Examination Handbook for
reference information on a wide range of activities and
instruments, including fixed income instruments, mutual
funds, derivatives, sensitivity to market risk, portfolio
management, and specialized examination procedures.
That handbook’s information focuses more closely on
specific activities and instruments than this section’s
general guidance.
Management should establish a risk management program
that identifies, measures, monitors, and controls investment
activity risks.
Its intricacy and detail should be
commensurate with the bank’s size, complexity, and
investment activities. Thus, the program should be tailored
to the bank’s needs and circumstances. Regardless, an
effective risk management program will include the
following processes:
Policy Statement
•
The Supervisory Policy Statement on Investment Securities
and End-User Derivatives Activities (Policy Statement)
was adopted by the FDIC, Office of the Comptroller of the
Currency, Board of Governors of the Federal Reserve
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Underscores the importance of board oversight and
management supervision,
Emphasizes effective risk management,
Contains no specific constraints on holding “high risk”
mortgage derivative products,
Eliminates the requirement to obtain the former
regulatory volatility test for mortgage derivative
products, and
Applies to all permissible investment securities and
end-user derivatives.
•
3.3-1
The board should adopt policies that establish clear
goals and risk limits.
The board should review and act upon management’s
reports.
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
•
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•
•
•
•
•
Section 3.3
The board should establish an independent review
function and review its reports.
Management should develop investment strategies to
achieve the board’s goals.
Management should analyze and select investments
consistent with its strategies.
Management should maintain an effective internal
control program.
Management should regularly measure the portfolio’s
risk levels and performance.
Management should provide periodic reports to the
board.
The board and management should periodically
evaluate and, when warranted, modify the program.
POLICIES,
LIMITS
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•
•
•
The board’s investment goals,
Authorized activities and instruments,
Internal controls and independent review,
Selecting broker/dealers,
Risk limits,
Risk and performance measurement,
Reporting, and
Accounting and taxation.
At most banks, the investment portfolio serves as a
secondary source of both earnings and liquidity. At some
banks, the investment portfolio is a primary earnings
component. The policies should articulate the investment
portfolio’s purpose, risk limits, and return goals. Return
goals should express the board’s earnings objectives for the
investment portfolio. The board may also establish
portfolio performance targets.
Banks that engage in less complex activities may
effectively manage investment activity risk on an
individual instrument basis. That is, each instrument’s risk
and return is evaluated independently. An instrument’s
contribution to overall portfolio risk and return may only
be considered in general terms. This approach requires
rather specific individual instrument risk limits, but
typically does not involve aggregate portfolio analysis.
Policies should describe all authorized investment
activities and set guidelines for new products or activities.
Further, policies should delegate investment authority,
including naming specific personnel.
The board’s
approved policies should also provide management with
general guidelines for selecting securities broker/dealers
and limiting broker/dealer credit risk exposure.
Banks with complex or extensive investment activities
should strongly consider the portfolio approach for
managing investment activity risk. Under a portfolio
approach, management evaluates an instrument’s
contribution to overall portfolio risk and return. It requires
portfolio risk limits and a system for aggregating and
measuring overall portfolio risk and return. More complex
aggregate portfolio risk and return measurements should be
incorporated into overall interest rate risk or asset/liability
management programs.
The bank should have policies that ensure an
understanding of the market risks associated with
investment securities and derivative instruments before
purchase. Accordingly, banks should have policies that
define the characteristics of authorized instruments. The
policy should sufficiently detail the characteristics of
authorized instruments. For example, a policy that merely
authorizes the purchase of agency securities would not be
sufficiently detailed. The price sensitivities of agency
pass-throughs, step-up structured notes, agency callable
debt or leveraged inverse floaters are very different.
Therefore, the policy should delineate the authorized types
of agency securities that may be purchased. Management
should analyze the risks in an instrument that has not been
authorized and should seek the board’s permission to alter
the list of authorized instruments before purchase.
In recommending that all banks consider portfolio or
whole bank risk management, the Policy Statement notes
that such approaches generally provide certain advantages
over the individual instrument approach, including:
Integrated management of risk and return
Understanding of each instrument’s contribution to
overall risk and return
Increased flexibility when selecting instruments
Securities and Derivatives (12-04)
RISK
The board is responsible for adopting comprehensive,
written investment policies that clearly express the board’s
investment goals and risk tolerance. Policies should be
tailored to the bank’s needs and should address:
Management must determine, consistent with board policy,
how investment activity risks will be managed. The Policy
Statement provides considerable flexibility by permitting
banks to manage risk on an individual instrument basis, on
an aggregate portfolio basis, or on a whole bank basis.
•
AND
Policies
The following sections of the guidance cover each of the
above steps in greater detail.
•
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PROCEDURES,
3.3-2
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Federal Deposit Insurance Corporation
SECURITIES AND DERIVATIVES
Section 3.3
Banks should have policies that specify the analysis of the
risk of an investment that must be conducted prior to
purchase. The pre-purchase analysis is meant to discover
and quantify all relevant risks in the investment. Not all
investments will require pre-purchase analysis. Relatively
simple or standardized instruments, the risks of which are
well known to the bank, would likely require no or
significantly less analysis than would more complex or
volatile instruments. Policies should delineate which of the
authorized investments do not require pre-purchase
analysis.
Credit risk limits should generally restrict management to
investment grade instruments. The board may permit
management to acquire nonrated instruments; however,
these instruments should be consistent with investment
grade standards. For example, management may wish to
purchase a nonrated bond issued by a local municipality.
Regardless, the board should carefully monitor such
activity.
Liquidity risk limits should restrict positions in less
marketable instruments. These limits should apply to
securities that management would have difficulty selling at
or near fair value. Less marketable instruments may not
meet the board’s investment goals, and holdings should
generally be small. Obscure issues, complex instruments,
defaulted securities, and instruments with thin markets may
all have limited liquidity.
The list of authorized instruments may include instruments
of varying characteristics. Policies should divide the
spectrum of authorized investments into segments of
instruments of similar risk characteristics. Policies should
also require appropriate pre-purchase analysis for each
segment.
Asset type limits should limit concentrations in specific
issuers, market sectors, and instrument types. These limits
will require management to diversify the portfolio. When
properly diversified, a portfolio can have lower risk for a
given yield or can earn a higher yield for a given risk level.
For example, the board may limit total investment in a
particular instrument type to a specific percentage of
capital.
Risk Limits
To effectively oversee investment activities, the board must
approve the bank’s risk limits. Management should set
these risk limits, consistent with the board’s goals,
objectives, and risk appetite. The risk limits should be
formally approved and incorporated within the board’s
policies. Limits may be expressed in terms of bank-wide
risk, investment portfolio risk, portfolio segment risk, or
even individual instrument risk.
Maturity limits should place restrictions on the maximum
stated maturity, weighted average maturity, or duration of
instruments that management may purchase. Longer-term
securities have greater interest rate risk, price risk, and
cash flow uncertainty than shorter-term instruments
possess. Therefore, maturity limits should complement
market risk limits, liquidity risk limits, and the board’s
investment goals.
Risk limits should be consistent with the bank’s strategic
plans and overall asset/liability management objectives.
Limits should be placed on:
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Market risk,
Credit risk,
Liquidity risk,
Asset types, and
Maturities.
In addition, management should establish a standard risk
measurement methodology. The measurement system must
capture all material risks and accurately calculate risk
exposures. Management should provide the board with
consistent, accurate risk measurements in a format that
directly illustrates compliance with the board’s risk limits.
Refer to the Risk and Performance Measurement
subsection for additional guidance.
At a minimum, risk limits should be expressed relative to
meaningful standards, such as capital or earnings. More
complex investment activities may require more detailed
risk limits.
Market risk limits should at least quantify maximum
permissible portfolio or individual instrument price
sensitivity as percentage of capital or earnings. Capitalbased risk limits clearly illustrate the potential threat to the
bank’s viability, while earnings-based limits reflect
potential profitability effects. In addition, the board may
choose to establish limits relative to earnings, total assets,
total investment securities, or other standards.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
INTERNAL CONTROLS
Internal Control Program
Effective internal controls are the first line of defense in
supervising investment activity operating risks. Ineffective
controls can lead to bank failures.
Consequently,
examiners will carefully evaluate the internal control
3.3-3
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
•
•
program. Examiners will emphasize separation of duties
between the individuals who execute, settle, and account
for transactions.
Invoice review requirements should address standards for
all securities and derivatives sold or purchased. Invoices
and confirmations display each instrument’s original
purchase price, which provides a basis to establish book
value and to identify reporting errors. Invoice reviews can
also be used when determining if the bank is involved in
any of the following inappropriate activities:
The internal control program should be commensurate with
the volume and complexity of the investment activity
conducted, and should be as independent as practical from
related operations.
The board has responsibility for establishing general
internal control guidelines, which management should
translate into clear procedures that govern daily operations.
Management’s internal control program should include
procedures for the following:
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•
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Saving and safeguarding important documents, and
Invoice review.
•
•
•
Portfolio valuation,
Personnel,
Settlement,
Physical control and documentation,
Conflict of interest,
Accounting,
Reporting, and
Independent review.
•
Engaging one securities dealer or representative for
virtually all transactions.
Purchasing from or selling to the bank’s trading
department.
Unsuitable investment practices (refer to following
page.).
Inaccurate reporting.
Conflict of interest guidelines should govern all
employees authorized to purchase and sell securities for the
bank. These guidelines should ensure that all directors,
officers, and employees act in the bank’s best interest. The
board should adopt polices that address authorized
employees’ personal relationships, including securities
transactions, with the bank’s approved securities
broker/dealers. The board may also adopt policies that
address the circumstances under which directors, officers,
and employees may accept gifts, gratuities, or travel
expenses from securities broker/dealers and associated
personnel.
Internal controls should promote efficiency, reliable
internal and regulatory reporting, and compliance with
regulations and bank policies.
Portfolio
valuation
procedures
should
require
independent portfolio pricing.
The availability of
independent pricing provides an effective gauge of the
market depth for thinly traded instruments, allowing
management to assess the potential liquidity of specific
issues.
For these and other illiquid or complex
instruments, completely independent pricing may be
difficult to obtain. In such cases, estimated or modeled
values may be used. However, management should
understand and agree with the methods and assumptions
used to estimate value.
Accounting practices should be evaluated against the
standards, opinions, and interpretations listed in this
section.
Reporting procedures should be evaluated against the
guidelines discussed in the Risk Reporting subsection Risk
Identification, Assessment and Reporting.
Physical control and documentation requirements should
include:
Independent review of the risk management program
should be conducted at regular intervals to ensure the
integrity, accuracy, and reasonableness of the program.
Independent review may encompass external audits or an
internal audit program.
At many banks, however,
evaluation by personnel independent of the portfolio
management function will suffice. The independent review
program’s scope and formality should correspond to the
size and complexity of the bank’s investment activities.
Independent review of investment activity should be at
least commensurate with the independent review of other
primary bank activities. It should assess:
•
•
Personnel guidelines should require sufficient staffing
resources and expertise for the bank’s approved investment
activities.
Settlement practices should be evaluated against the
guidelines provided in the Settlement Practices,
Confirmation and Delivery Requirements, and Delivery
Documentation Addenda.
.
Possessing and controlling purchased instruments,
Securities and Derivatives (12-04)
3.3-4
Adherence to the board’s policies and risk limits,
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SECURITIES AND DERIVATIVES
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Section 3.3
trading may be intended to defer loss recognition, as
unrealized losses on debt securities in such categories do
not directly affect regulatory capital and generally are not
reported in income until the security is sold.
The risk measurement system’s adequacy and
accuracy,
The reporting system’s timeliness, accuracy, and
usefulness,
Personnel resources and capabilities,
Compliance with regulatory standards,
The internal control environment,
Accounting and documentation practices, and
Conflicts of interest.
Examiners should scrutinize institutions with a pattern of
reporting significant amounts of realized gains on sales of
non-trading securities (typically, AFS securities) after short
holding periods while continuing to hold other non-trading
securities with significant amounts of unrealized losses. If,
in the examiner’s judgment, such a practice has occurred,
the examiner should consult with the Regional Office for
additional guidance on whether some or all of the securities
reported outside of the trading category will be designated
as trading assets.
Banks with complex investment activities should consider
augmenting the independent review with internal or
external auditors, while banks with less complex
investment activities may rely on less formal review.
Sophisticated risk measurement systems, particularly those
developed in-house, should be independently tested and
validated.
When-issued securities trading is the buying and selling
of securities in the period between the announcement of an
offering and the issuance and payment date of the
securities. A purchaser of a when-issued security acquires
the risks and rewards of owning a security and may sell the
when-issued security at a profit before having to take
delivery and pay for it.
Independent review findings should be reported directly to
the board at least annually. The board should carefully
review the independent review reports and ensure that
material exceptions are corrected.
Examiners will evaluate the independent review’s scope
and veracity, and will rely on sound independent review
findings during examinations.
However, when the
independent review is unsatisfactory, examiners will
perform review procedures to reach independent
conclusions. When warranted, examiners will conduct a
detailed review of all investment activities.
Pair-offs are security purchase transactions that are closedout or sold at or before the settlement date. In a pair-off,
an institution commits to purchase a security. Then, before
the predetermined settlement date, the bank pairs-off the
purchase with a sale of the same security. Pair-offs are
settled net when one party to the transaction remits the
difference between the purchase and sale price to the
counterparty.
Pair-offs may also involve the same
sequence of events using swaps, options on swaps, forward
commitments, options on forward commitments, or other
off-balance sheet derivative contracts.
UNSUITABLE INVESTMENT ACTIVITIES
Trading activity within the held-to-maturity (HTM) or
available-for-sale (AFS) portfolio is an unsuitable
investment activity and may be considered unsafe and
unsound. Each of the following activities are unsuitable
within the HTM or AFS portfolio, and any resulting
securities acquisitions should be reported as trading assets.
The bank’s internal control program should be designed to
prevent the following unsuitable investment activities:
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•
Extended Settlement is the use of a securities trade
settlement period in excess of the regular-way settlement
period. Regular-way settlement for U.S. Government and
Federal agency securities (except mortgage-backed
securities and derivative contracts) is one business day
after the trade date. Regular-way settlement for corporate
and municipal securities is three business days after the
trade date, and for mortgage-backed securities it can be up
to 60 days or more after the trade date. The use of a
settlement period in excess of the regular-way settlement
period to facilitate speculation is considered a trading
activity.
Gains trading,
When-issued securities,
Pair-offs,
Extended settlement,
Repositioning repurchase agreement, and
Adjusted trading.
A repositioning repurchase agreement is offered by a
dealer to allow an institution that has entered into a whenissued trade or a pair-off (which may include an extended
settlement) that cannot be closed out at a profit on the
payment or settlement date to hold its speculative position
until the security can be sold at a gain. The institution
Gains trading is the purchase and subsequent sale of a
security at a profit after a short holding period, while
securities acquired for this purpose that cannot be sold at a
profit are retained in the AFS or HTM portfolio. Gains
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Federal Deposit Insurance Corporation
3.3-5
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
purchasing the security pays the dealer a small margin that
approximates the actual loss in the security. The dealer
then agrees to fund the purchase of the security by buying
it back from the purchaser under a resale agreement. Any
securities acquired through a dealer financing technique
such as a repositioning repurchase agreement that is used
to fund the speculative purchase of securities should be
reported as trading assets.
principal types of market risk are price risk, interest rate
risk and basis risk.
Price risk is the possibility that an instrument's price
fluctuation will unfavorably affect income, capital, or risk
reduction strategies. Price risk is usually influenced by
other risks. For example, a bond’s price risk could be a
function of rising interest rates, while a currency-linked
note’s price risk could be a function of devaluation in the
linked currency.
A short sale is the sale of a security that is not owned. The
purpose of a short sale generally is to speculate on a fall in
the price of the security. Short sales should be conducted
in the trading portfolio. A short sale that involves the
delivery of the security sold short by borrowing it from the
depository institution’s AFS or HTM portfolio should not
be reported as a short sale. Instead, it should be reported
as a sale of the underlying security with gain or loss
recognized in current earnings.
Interest rate risk is the possibility that an instrument’s value
will fluctuate in response to current or expected market
interest rate changes.
Yield curve risk is the possibility that an instrument’s value
will fluctuate in response to a nonparallel yield curve shift.
Yield curve risk is a form of interest rate risk.
Adjusted trading involves the sale of a security to a
broker or dealer at a price above the prevailing market
value and the simultaneous purchase and booking of a
different security, frequently a lower rated or quality issue
or one with a longer maturity, at a price above its market
value. Thus, the dealer is reimbursed for losses on the
purchase from the institution and ensured a profit. Such
transactions inappropriately defer the recognition of losses
on the security sold and establish an excessive cost basis
for the newly acquired security. Consequently, such
transactions are prohibited and may be in violation of 18
U.S.C. Sections 1001-False Statements or Entries and
1005-False Entries.
Basis risk is the possibility that an instrument’s value will
fluctuate at a rate that differs from the change in value of a
related instrument. For example, three-month Eurodollar
funding is not perfectly correlated with Treasury bill
yields. This imperfect correlation between funding cost
and asset yield creates basis risk.
RISK IDENTIFICATION,
MEASUREMENT, AND REPORTING
In addition, default exposes a bank to market risk. After
default, losses on a now unhedged position may occur
before the defaulted hedge instrument can be replaced.
Such losses would have been largely (or completely) offset
if the counterparty had not defaulted.
Credit risk is the possibility of loss due to a counterparty’s
or issuer’s default, or inability to meet contractual payment
terms. The amount of credit risk equals the replacement
cost (also referred to as current exposure) of an identical
instrument. The replacement cost is established by
assessing the instrument’s current market value rather than
its value at inception.
Risk Identification
All investment activities create risk exposures, but the risk
types and levels depend upon the activity conducted. The
following guidance summarizes the major risk exposures.
Refer to the Capital Markets Examination Handbook for
additional guidance on specific instruments, markets, and
strategies.
Exchange-traded derivatives (futures, options, and options
on futures) contain minimal credit risk. These instruments
are marked-to-market at the end of each trading day, or on
an intra-day basis, by the exchange clearinghouse. Position
value changes are settled on a cash basis at least daily. To
reduce credit risk, all exchange participants must post a
performance bond or maintain margin with the exchange.
Many over-the-counter (OTC) transactions use collateral
agreements. OTC transaction collateral agreements can be
one- or two-sided (only one party is required to post
collateral on out-of-the-money positions, or both are
required to post such collateral). Netting and collateral
agreements and their specific terms can materially reduce
credit risk exposure. For additional explanation of the
Market risk is the possibility that an instrument will lose
value due to a change in the price of an underlying
instrument, change in the value of an index of financial
instruments, changes in various interest rates, or other
factors. Frequently, an instrument will increase a bank’s
market risk due to price volatility, embedded options,
leverage factors, or other structural factors. The three
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3.3-6
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SECURITIES AND DERIVATIVES
Section 3.3
treatment of netting for capital calculations, refer to Part
325 of the FDIC Rules and Regulations.
should ensure that all agreements are enforceable and that
counterparties can legally enter into specific transactions.
In managing credit exposure, institutions should consider
settlement and pre-settlement credit risk. The selection of
dealers, investment bankers, and brokers is particularly
important in effectively managing these risks. When
selecting a dealer, investment banker, or broker,
management should, at a minimum:
Settlement risk is the possibility of loss from a
counterparty that does not perform after the investor has
delivered funds or assets (before receiving the contractual
proceeds).
Settlement risk may result from time
differences between foreign counterparties, delivery that is
not synchronized with payment, or method of payment
delays. Few transactions are settled on a real-time basis,
and any delay in receiving funds or assets after delivering
funds or assets will create settlement risk.
•
•
•
Review each firm’s most current financial statements,
such as annual reports and credit reports, and evaluate
its ability to honor its commitments.
Inquire into the general reputation of the firm by
contacting previous or current customers.
Review information from State or Federal securities
regulators and industry self-regulatory organizations
such as NASD Regulation, Inc., concerning any formal
enforcement actions against the dealer, its affiliates, or
associated personnel.
The most famous settlement risk example occurred in the
foreign exchange markets. German regulators closed
Bankhaus Herstatt after it had received deutschemarks on
its foreign exchange trades, but before it had sent out its
currency payments. Settlement risk is sometimes referred
to as Herstatt risk.
Interconnection risk is the possibility of loss due to
changes in interest rates, indices or other instrument values
that may or may not be held by the investor. Cash flows
associated with an instrument may be directly or indirectly
tied to a number of other rates, indices or instrument
values. These interconnections frequently involve crossborder and cross-market links and a wide range of
individual financial instruments.
Liquidity risk is the possibility that an instrument cannot
be obtained, closed out, or sold at (or very close to) its
economic value. As individual markets evolve, their
liquidity will gradually change, but market liquidity can
also fluctuate rapidly during stress periods. In some
markets, liquidity can vary materially during a single day.
Some markets are liquid for particular maturities or
volumes, but are illiquid for others. For example, the
Eurodollar futures market is liquid for contracts with
maturities up to four years, but liquidity decreases for
greater maturities (although maturities of up to 10 years are
listed).
For example, a U.S. dollar denominated structured note
may have a coupon formula linked to a currency exchange
rate. Structured notes with coupon payments linked to the
relationship between the Mexican peso and the U.S. dollar
fell substantially in value when the peso fluctuated in the
wake of the assassination of a Mexican presidential
candidate.
Many instruments trade in established secondary markets
with a large number of participating counterparties. This
ensures liquidity under normal market conditions.
However, uniquely tailored or more thinly traded products
may not have sufficient supply, demand, or willing
counterparties in periods of market stress.
Risk Measurement
Effective investment activity oversight requires accurate
risk measurement.
Without periodic assessments,
management can not determine the success of its
investment strategies. Further, the board can not determine
if management has achieved the board’s goals or complied
with its policies.
Operational risk is the possibility that inadequate internal
controls or procedures, human error, system failure or
fraud can cause losses. Operating risk can result in
unanticipated open positions or risk exposures that exceed
established limits.
Risk measurement should be tailored to the cash flow
characteristics of each particular instrument type. For
example, a mortgage derivative product should be given far
more sophisticated analysis than a U.S. Treasury bill.
Management’s analysis should focus on risk, return, and
compliance with risk limits.
Legal risk is the possibility that legal action will preclude
a counterparty’s contractual performance. Legal risk may
occur when a contract or instrument violates laws or
regulations. Legal risk may also occur when a law or
regulation prohibits a counterparty from entering into a
particular contract, or if an individual is not authorized to
execute transactions on behalf of the counterparty. Banks
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Federal Deposit Insurance Corporation
3.3-7
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
Authorized investment instruments should be segregated
into groups of like risk characteristics. There will likely be
a group of relatively simple or standardized instruments,
the risks of which are well known to the bank, which will
require no pre-purchase analysis. All other authorized
instruments will require pre-purchase analysis. It is
important that these groups be well defined and that the
pre-purchase analysis is tailored to capture the risks of the
instruments. For example, it would not be appropriate to
group dual-indexed structured notes with agency passthroughs. The characteristics of these two types of
instruments are different and each will require separate and
distinct pre-purchase analysis. It would also not be
appropriate to group simple agency pass-throughs with
inverse floater collateralized mortgage obligations
(CMOs). The inverse floaters are not only subject to
similar prepayment optionality as the pass-throughs but
also contain leverage and vastly different cash flow
characteristics.
•
In addition to pre-purchase analysis, management should
also periodically monitor investment portfolio risks. As
with pre-purchase analysis, this periodic analysis should
identify and measure the instrument’s or the portfolio’s risk
characteristics. Management can perform this periodic
analysis on an individual instrument basis or total portfolio
(or bank) basis.
To properly exercise its oversight responsibilities, the
board must review periodic investment activity reports.
The board should require management to periodically
provide a complete investment activity report. Report
frequency and substance should be commensurate with the
portfolio’s complexity and risk profile. Management’s
reports to the board should:
The market risk measurement system used to conduct prepurchase analysis and periodic monitoring should be
commensurate with the size and nature of the investment
portfolio. For detailed comments regarding the types of
risk measurement systems, refer to the Sensitivity to
Market Risk section of this Manual. The risk measurement
system should identify and measure all material risks.
Management should translate its measurements into results
that illustrate compliance with the board’s risk limits. For
example, to measure market risk the system should:
•
•
•
•
•
•
Subject instruments to nonparallel interest rate shocks
when those instruments are exposed to risk from
changes in the yield curve’s shape.
While management may measure risk and performance on
an individual instrument basis, broader risk management
should be considered.
Management may aggregate
individual instrument risk and return measurements to
produce risk and return results for the entire investment
portfolio. Portfolio results may then be aggregated into the
bank’s overall interest rate risk measurement system.
Aggregation does not necessarily require complex systems.
Management may simply combine individual instrument
results to calculate portfolio analysis, or use portfolio
results to compile whole bank analysis. Examiners should
coordinate risk aggregation review with the staff
completing the Sensitivity to Market Risk review.
Risk Reporting
•
Summarize all investment activity,
Clearly illustrate investment portfolio risk and return,
Evaluate management’s compliance with the
investment policy and all risk limits, and
List exceptions to internal policy and regulatory
requirements.
Management should receive reports that contain sufficient
detail to comprehensively and frequently assess the
portfolio.
Identify and measure the price sensitivity of embedded
options (modified and Macaulay duration measures do
not capture option risk).1
Use interest rate shocks large enough to measure
realistic potential market movements and risk (such as
100, 200, and 300 basis points).
Include adjustments (for example, convexity) to
accurately measure price changes when interest rate
movements exceed 100 basis points.2
Management should regularly ensure compliance with
internal policies and regulatory requirements. In addition,
management should periodically evaluate portfolio
performance. The board should review and consider each
policy exception. Management should present exceptions
for approval before engaging in an unauthorized activity.
Recurring exceptions should prompt close scrutiny from
the board. When warranted, the board may consider
changing its policies to permit an activity. The board
should take strong action when management fails to seek
prior approval for an unauthorized activity.
1
Macaulay duration is the weighted average term to maturity of a
security's cash flows. Modified duration is a measurement of the
change in the value of an instrument in response to a change in
interest rates. Refer to the Capital Markets Examination
Handbook for additional information.
Securities and Derivatives (12-04)
2
Convexity is a measure of the way duration and price change
when interest rates change. Refer to the Capital Markets
Examination Handbook for additional information.
3.3-8
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SECURITIES AND DERIVATIVES
Section 3.3
Investment Strategies
BOARD AND SENIOR MANAGEMENT
OVERSIGHT
Management should employ reasonable investment
strategies to achieve the board’s portfolio objectives. A
strategy is a set of plans that management uses to direct
daily portfolio operations. In order to develop sound
strategies, management must understand the board’s goals,
applicable risk limits, and related instruments and markets.
Investment strategies should also be consistent with the
following:
Board Oversight
Throughout this guidance, “board” references either the
board or directors or a designated board committee. Board
oversight is vital to effective investment risk management,
and the board has very specific investment activity
responsibilities. The board should adopt policies that
establish guidelines for management and periodically
review management’s performance. The board should:
•
•
•
•
•
•
•
•
•
•
•
•
Approve broad goals and risk limits,
Adopt major investment and risk management
policies,
Understand the approved investment activities,
Ensure competent investment management,
Periodically review management’s investment activity,
Require management to demonstrate compliance with
the board’s goals and risk limits, and
Mandate an independent review program and review
its findings.
Strategies will vary widely between banks, ranging from
simple to extremely complex. However, any strategy
should be documented, reasonable, and supportable.
Examiners will evaluate strategies to determine their effect
on risk levels, earnings, capital, liquidity, asset quality, and
overall safety and soundness. Additional guidance on
investment strategies and market risk modification
strategies is provided in this section under the headings
Investment Strategies and the Market Risk Modification
respectively.
Senior Management Oversight
Management is responsible for daily oversight of all
investment activity. Management should:
•
•
•
•
•
•
•
Delegation of Investment Authority
Investment authority may be delegated to a third party,
with specific board approval. Regardless of whether the
board’s policies permit management to delegate investment
authority to a third party, management must understand
every investment’s risk, return, and cash flow
characteristics. To conduct its independent analysis,
management may rely on information and industry standard
analysis tools provided by the broker/dealer, provided that:
Establish policies, procedures, and risk limits to
achieve the board’s goals,
Implement operational policies that establish a strong
internal control environment,
Understand all approved investment activities and the
related risks,
Identify, measure, monitor, and control investment
activity risks,
Report investment activity and risks to the board;,
Ensure that its staff is competent and adequately
trained, and
Adhere to securities broker/dealer selection policies.
•
•
•
Investment activity risk is not effectively managed if the
board and management do not fulfill their responsibilities.
Ineffective risk management can be an unsafe and unsound
practice. While the board or management may obtain
professional advice to supplement their understanding of
investment activities and risks, their responsibilities can not
be transferred to another party. The board and senior
management should also periodically evaluate and, when
warranted, modify the risk management process.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Overall strategic goals,
Capital position,
Asset/liability structure,
Earnings composition, and
Competitive market position.
The analysis uses reasonable calculation methods and
assumptions,
Management
understands
the
analysis
and
assumptions, and
Management’s
investment
decisions
remain
independent.
If management does not understand an investment’s risk
characteristics, then management should not engage in that
activity until it possesses the necessary knowledge. Failure
to adequately understand and manage investment activity
risks constitutes an unsafe and unsound practice.
3.3-9
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
Before delegating investment authority to a third party,
management should thoroughly evaluate the third party’s
reputation, performance, creditworthiness, and regulatory
background. Any third party arrangement should be
governed by a formal written agreement that specifies:
•
•
•
•
•
•
•
•
•
plan. When necessary, the board should adjust its portfolio
goals.
After evaluating its goals, the board should then affirm that
the existing risk limits accurately reflect the board’s risk
tolerance. When warranted, the board should consider
either relaxing or tightening the risk limits placed on
management. Before altering its risk limits, the board
should discuss the effects of accepting increased or
reduced risk. The board should consider if increased or
diminished risk would produce satisfactory returns.
Compensation,
Approved broker/dealers,
Investment goals,
Approved activities and investments,
Risk limits,
Risk and performance measurement,
Reporting requirements,
Settlement practices, and
Independent review.
In addition, the board should evaluate management’s
performance.
That review should encompass
management’s success at achieving the board’s goals,
adherence to policies and risk limits, and maintenance of
an effective control environment. The board should
determine the cause of any material deficiencies and obtain
management’s commitment to rectify those deficiencies.
In addition, written agreements should require that all trade
invoices, safekeeping receipts, and investment analyses are
readily available to the bank.
Finally, the board should determine if any changes to its
policies are warranted. For example, management may
request authority to engage in new investment activities.
The board should carefully consider such requests and
determine if the proposed activity comports with its
investment goals and risk tolerance.
Program Evaluation
Periodically, the board and management should evaluate
the risk management program to ensure that its investment
activities reasonably meet the board’s goals and the bank’s
strategic needs. Without such an assessment, the board and
management cannot prudently oversee investment
activities. The scope and detail of the evaluation should
correspond to the bank’s size, complexity, and investment
activities. At most banks, annual evaluations should be
sufficient. In larger or more complex banks, quarterly (or
more frequent) evaluation may be necessary.
Management should review the portfolio management
program in more detail to identify both broad and specific
weaknesses. Management’s responsibilities include:
•
•
The board should review management’s reports, including
an investment activity summary, portfolio risk and
performance measures, and independent review findings to
identify broad weaknesses and determine if:
•
•
•
•
•
•
•
•
•
•
Stated goals accurately represent the board’s
objectives,
Risk limits properly reflect the board’s risk tolerance,
Risk limits reasonably protect the bank’s safety and
soundness,
Management has appropriately pursued the board’s
goals,
Internal controls remain adequate,
Any new activities are warranted, and
Policies provide sufficient guidance for management.
At many banks, the periodic evaluation will result in few
program alterations. Less complex programs will naturally
require fewer modifications than more complex programs.
Successful programs will similarly need fewer changes
than unsuccessful programs. Examiners will assess the
periodic evaluations to determine if the board and
management effectively oversee the portfolio management
process.
The board should first consider the bank’s current and
expected condition, competitive environment, and strategic
plans. Then, the board should reassess its portfolio goals
to ensure that they do not conflict with the overall strategic
Securities and Derivatives (12-04)
Measuring portfolio risk and performance,
Validating risk measurement systems’ adequacy and
accuracy,
Reporting portfolio activity and performance to the
board,
Adjusting investment strategies to better achieve the
board’s goals, and
Correcting policy and regulatory exceptions.
COMPLIANCE
Permissible Activities
3.3-10
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SECURITIES AND DERIVATIVES
Section 3.3
Part 362 of the FDIC's Rules and Regulations, "Activities
and Investments of Insured State Banks," (Part 362)
implements Section 24 of the Federal Deposit Insurance
Act. Part 362 generally prohibits investment activities that
are not permissible for national banks, with certain
exceptions.
National bank investment activities are
governed by the National Bank Act (12 USC 21 et seq.)
and Office of the Comptroller of the Currency (OCC)
regulations (12 CFR Part 1). 12 CFR Part 1 outlines five
general types of investments that are permissible for
national banks. A copy of the updated rule may be found
at
the
OCC's
Internet
site,
http://www.occ.treas.gov/ftp/regs/part1a.txt.
Substandard assets are inadequately protected by the
current sound worth and paying capacity of the obligor or
of the collateral pledged, if any. Assets so classified must
have a well-defined weakness or weaknesses that
jeopardize liquidation of the debt. They are characterized
by the distinct possibility that the bank will sustain some
loss if the deficiencies are not corrected.
Doubtful assets have all the weaknesses found in
Substandard assets, with the added characteristic that the
weaknesses make collection or liquidation in full (on the
basis of currently existing facts, conditions, and values)
highly questionable and improbable.
In limited circumstances, the FDIC may grant an exception
to Part 362, on a case-by-case basis, if the FDIC
determines that:
•
•
Loss classifications are assigned to assets that are
considered uncollectible and of such little value that their
continuance as bankable assets is not warranted. This
classification does not mean that the asset has absolutely
no recovery or salvage value, but rather it is not practical
or desirable to defer writing off this basically worthless
asset even though partial recovery may be affected in the
future. Amounts classified Loss should be promptly
charged off.
The activity presents no significant risk to the deposit
insurance fund, and
The bank complies with the FDIC’s capital
regulations.
While Part 362 contains investment type restrictions, it
does not include the investment amount restrictions that
apply to national banks.
Investment quality debt securities are marketable
obligations in which the investment characteristics are not
distinctly or predominantly speculative.
This group
generally includes investment securities in the four highest
rating categories provided by nationally recognized
statistical rating organizations (NRSROs) and unrated debt
securities of equivalent quality. The Securities and
Exchange Commission (SEC) lists the following as
NRSROs:
REPORT OF EXAMINATION
TREATMENT
Adverse Classification
Examiners may adversely classify subinvestment quality
securities and off-balance sheet derivatives in the Report of
Examination. Any classifications should be consistent with
the Uniform Agreement on the Classification of Assets and
Appraisal of Securities Held by Banks and Thrifts. This
Agreement addresses the examination treatment for
adversely classified assets and:
•
•
•
•
•
•
•
•
(Check the SEC’s website to find the most current list of
NRSROs).
Provides definitions of the Substandard, Doubtful, and
Loss categories used for criticizing bank and thrift
assets,
Defines characteristics of investment quality and
subinvestment quality securities.,
Establishes specific guidance for the classification of
subinvestment quality debt securities and other-thantemporary impairment on investment quality debt
securities, and
Provides examiners discretion in classifying debt
securities beyond a ratings-based approach in certain
cases.
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Federal Deposit Insurance Corporation
Dominion Bond Rating Service Ltd.,
Fitch, Inc.,
Moody's Investors Service, and
Standard & Poor's Division of the McGraw Hill
Companies Inc.
When two or more NRSROs list different credit ratings for
the same instrument, examiners will generally base their
assessments on the more recently issued ratings.
Since investment quality debt securities do not exhibit
weaknesses that justify an adverse classification rating,
examiners generally will not classify them. However,
published credit ratings occasionally lag demonstrated
changes in credit quality and examiners may, in limited
3.3-11
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
Foreign debt securities are often assigned transfer risk
ratings for cross border exposures from the Interagency
Country Exposure Review Committee (ICERC). However,
examiners should use the guidelines in the Uniform
Agreement rather than ICERC transfer risk ratings in
assigning security classifications, except when the ICERC
ratings result in a more severe classification.
cases, classify a security notwithstanding an investment
grade rating.
Some debt securities may have investment quality ratings
by one (or more) rating agencies and sub-investment
quality ratings by others. Examiners will generally classify
such securities, particularly when the most recently
assigned rating is not investment quality. However, an
examiner has discretion to "pass" a debt security with both
investment and sub-investment quality ratings.
The
examiner may use that discretion if, for example, the
institution has demonstrated through its documented credit
analysis that the security is the credit equivalent of
investment grade.
Subinvestment quality debt securities are those in which
the investment characteristics are distinctly or
predominantly speculative. This group generally includes
debt securities, including hybrid equity instruments (i.e.
trust preferred securities), in grades below the four highest
rating categories, unrated debt securities of equivalent
quality, and defaulted debt securities.
Some individual debt securities have ratings for principal,
but not interest. The absence of a rating for interest
typically reflects uncertainty regarding the source and
amount of interest the investor will receive. Because of the
speculative nature of the interest component, examiners
will generally classify such securities, regardless of the
rating for the principal.
Other Types of Securities such as certain equity holdings
or securities with equity-like risk and return profiles, have
highly speculative performance characteristics. Examiners
should generally classify such holdings based upon an
assessment of the applicable facts and circumstances.
Treatment of Declines in Fair Value
Non-rated debt securities have no ratings from a NRSRO
and the FDIC expects institutions holding individually
large non-rated debt security exposures, or having
significant aggregate exposures from small individual
holdings, to demonstrate that they have made prudent preacquisition credit decisions and have effective, risk-based
standards for the ongoing assessment of credit risk.
Examiners will review the institution's program for
monitoring and measuring the credit risk of such holdings
and, if the assessment process is considered acceptable,
generally will rely upon those assessments during the
examination process. If an institution has not established
independent risk-based standards and a satisfactory process
to assess the quality of such exposures, examiners may
classify such securities, including those of a credit quality
deemed to be the equivalent of subinvestment grade, as
appropriate.
Under generally accepted accounting principles (GAAP),
an institution must assess whether a decline in fair value
below the amortized cost of a security – that is, the
depreciation on the security – is a "temporary" or "otherthan-temporary" impairment. When the decline in fair
value on an individual security represents other-thantemporary impairment, the cost basis of the security must
be written down to fair value, thereby establishing a new
cost basis for the security, and the amount of the writedown must be reflected in current period earnings. This
new cost basis should not be adjusted through earnings for
subsequent recoveries in fair value. If an institution's
process for assessing impairment is considered acceptable,
examiners may use those assessments in determining the
appropriate classification of declines in fair value below
amortized cost on individual debt securities.
Any decline in fair value below amortized cost on
defaulted debt securities will be classified as indicated in
the General Debt Security Classification Guidelines Table
following. Apart from classification, for impairment writedowns or charge-offs on adversely classified debt
securities, the existence of a payment default will generally
be considered a presumptive indicator of other-thantemporary impairment.
Some non-rated debt securities held in investment
portfolios represent small exposures relative to capital,
both individually and in aggregate. While institutions
generally have the same supervisory requirements (as
applicable to large holdings) to show that these holdings
are the credit equivalent of investment grade at purchase,
comprehensive credit analysis subsequent to purchase may
be impractical and not cost effective. For such small
individual exposures, institutions should continue to obtain
and review available financial information, and assign risk
ratings. Examiners may rely upon the bank's internal
ratings when evaluating such holdings.
Securities and Derivatives (12-04)
The following table outlines the uniform classification
approach the agencies will generally use when assessing
credit
quality
in
debt
securities
portfolios:
3.3-12
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SECURITIES AND DERIVATIVES
Section 3.3
General Debt Security Classification Guidelines Table
Security Type
Classification
Substandard
----
Investment quality debt securities with “temporary” impairment
Investment quality debt securities with “other than temporary”
---impairment
Subinvestment quality debt securities with “temporary” impairment
Amortized Cost
Subinvestment quality debt securities with “other than temporary”
Fair Value
impairment, including defaulted debt securities.
NOTE: Impairment is the amount by which amortized cost exceeds fair value.
Doubtful
----
Loss
----
----
Impairment
----
----
----
Impairment
The General Debt Security Classification Guidelines do
not apply to private debt and equity holdings in a small
business investment company or Edge Act Corporation.
The Uniform Agreement does not apply to securities held
in trading accounts, provided the institution demonstrates
through its trading activity a short term holding period or
holds the security as a hedge for a valid customer
derivative contract.
credit risk management framework entails appropriate preacquisition credit due diligence by qualified staff that
grades a security’s credit risk based upon an analysis of the
repayment capacity of the issuer and the structure and
features of the security. It also involves the continual
monitoring of holdings to ensure that risk ratings are
reviewed regularly and updated in a timely fashion when
significant new information is received.
Examiner Discretion in Classifying Securities
The credit analysis of securities should vary based on the
structural complexity of the security, the type of collateral
and external ratings.
The credit risk management
framework should reflect the size, complexity, quality, and
risk characteristics of the securities portfolio, the risk
appetite and policies of the institution, and the quality of its
credit risk management staff, and should reflect changes to
these factors over time. Policies and procedures should
identify the extent of credit analysis and documentation
required to satisfy sound credit risk management standards.
Examiners may assign a more or less severe classification
for an individual debt security than would otherwise apply
based on the security's rating depending upon a review of
applicable facts and circumstances. However, examiners
may not assign a Loss classification to the depreciation on
an individual debt security when this impairment is
determined to be temporary. Examiners have discretion to
“pass” a debt security with both investment and subinvestment quality ratings. For an investment quality debt,
examiners have the discretion to assign a more severe
classification when justified by credit information the
examiner believes is not reflected in the rating, to properly
reflect the security’s credit risk. As mentioned above,
published credit ratings occasionally lag demonstrated
changes in credit quality and examiners may, in limited
cases, classify a security notwithstanding an investment
grade rating.
Subinvestment Quality Available-for-Sale (AFS) Debt
Securities
Consistent with Statement of Financial Accounting
Standards (FAS) 115, AFS debt securities are "marked-tomarket" and carried at their fair value on the balance sheet
for regulatory reporting purposes. The unrealized holding
gains (losses) on these securities, net of tax effects, are
excluded from earnings and reported in a separate
component of equity capital on the balance sheet.
However, for purposes of determining a bank's regulatory
capital under Part 325 of the FDIC's regulations, any
unrealized holding gains (losses) on these AFS debt
securities that are included in the separate equity capital
component generally are ignored. As a result, any
amortized cost amount in excess of fair value on an AFS
debt security – that is, the amount of impairment or
depreciation – normally is not deducted in determining
regulatory capital.
Furthermore, examiners may in limited cases “pass” a debt
security that is rated below investment quality. For
example, when the institution has an accurate and robust
credit risk management framework and has demonstrated,
based on recent, materially positive, credit information,
and properly documented credit analysis, that the security
is the credit equivalent of investment grade, examiners
have the discretion to “pass” the security, irrespective of
the rating.
When an institution has developed an accurate, robust, and
documented credit risk management framework to analyze
its securities holdings, examiners can depart from the
General Guidelines in favor of individual asset review in
determining whether to classify those holdings. A robust
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
However, in order to appropriately reflect in regulatory
capital calculations the effect of any depreciation on a
subinvestment quality AFS debt security, when the
depreciation on such a security is deemed to be other than
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temporary and is therefore classified Loss, the depreciation
should be deducted in determining Tier 1 capital. In
addition, consistent with FAS 115 and Emerging Issues
Task Force (EITF) Issue No. 03-1, when the depreciation
represents an impairment that is other than temporary, the
bank should recognize an impairment loss in current period
earnings equal to the difference between the security's
amortized cost and its fair value. This fair value then
becomes the new cost basis for the AFS debt security and
the new cost basis should not be adjusted through earnings
for subsequent recoveries in value. Nevertheless, this AFS
debt security must continue to be "marked-to-market" with
the unrealized holding gains (losses) reported directly in
equity capital.
equity security must continue to be "marked-to-market"
with the unrealized holding gains (losses) reported directly
in equity capital.
Securities with Substantial Prepayment Risks FAS 115, as
amended by FAS 140, does not permit a debt security to be
designated as held-to-maturity (HTM) if it can be prepaid
or otherwise settled in such a way that the security holder
would not recover substantially all of its recorded
investment. Thus, those debt securities with a risk of
substantial investment loss in the event of early
prepayment, such as interest-only stripped mortgage
backed securities and principal-linked structured notes,
cannot be treated as HTM securities and carried at
amortized cost.
Rather, these securities should be
categorized as either trading or AFS securities and reported
at their fair value on the balance sheet for regulatory
reporting purposes.
The General Debt Security
Classification Guidelines shown above should be applied
to these securities when they have been categorized as AFS
securities.
For subinvestment quality AFS debt securities with
temporary impairment, amortized cost rather than the lower
amount at which these securities are carried on the balance
sheet, i.e., fair value, is classified Substandard. This
classification is consistent with the regulatory capital
treatment of AFS debt securities. As mentioned above,
under GAAP, unrealized holding gains (losses) on AFS
debt securities are excluded from earnings and reported in
a separate component of equity capital. In contrast, these
unrealized holding gains (losses) are excluded from
regulatory capital. Accordingly, the amount classified
Substandard on these subinvestment quality AFS debt
securities, i.e., amortized cost, also excludes the balance
sheet adjustment for unrealized losses.
Determining Fair Value
As currently defined under GAAP, the fair value of an
asset is the amount at which that asset could be bought or
sold in a current transaction between willing parties, that is,
other than in a forced or liquidation sale. Quoted market
prices are the best evidence of fair value and must be used
as the basis for measuring fair value, if available. If quoted
market prices are not available, the estimate of fair value
must be based on the best information available in the
circumstances. The estimate of fair value must consider
prices for similar assets and the results of valuation
techniques to the extent available in the circumstances.
Subinvestment Quality AFS Equity Securities Equity
securities may also be adversely classified if identified
weaknesses warrant such treatment. Some investment
advisory services issue rankings for equity instruments,
which generally indicate projected investment performance
rather than credit quality. Examiners should not rely on
equity rankings to adversely classify equity investments.
However, any AFS equity security whose cost is in excess
of its fair value – that is, an equity security that has
impairment or depreciation – must be evaluated to
determine whether the impairment is temporary or other
than temporary. When the impairment is determined to be
other than temporary, the amount of the impairment should
be classified Loss. In this situation, the equity security
itself may be considered subinvestment quality, in which
case examiners should also adversely classify the fair value
of the equity security Substandard. Consistent with the
treatment of AFS debt securities, when the impairment on
an AFS equity security is determined to be other than
temporary, the bank should recognize an impairment loss
in current period earnings equal to the difference between
the security's cost and its fair value. This fair value then
becomes the new cost basis for the AFS equity security and
the new cost basis should not be adjusted through earnings
for subsequent recoveries in value. Nevertheless, this AFS
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In order to properly classify a security or determine any
necessary regulatory capital adjustment, examiners must
determine its fair value.
Examiners will review
management's fair values for all adversely classified
securities. When management's valuation for an adversely
classified security appears reasonable, examiners will use
that value to determine classification amounts.
If
management's valuation does not appear reasonable,
examiners will discuss concerns with management and
request that management provide a more reasonable
valuation during the examination. When management
cannot provide a reasonable valuation during the
examination, examiners should use the information
services provided by the Capital Markets Branch of the
Division of Supervision and Consumer Protection in
Washington, D.C.
Qualitative Capital Adequacy Considerations for
Securities
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of statistical assumptions. Management’s assumptions
should be reasonable, supported, and consistent. Results
should be translated into terms that clearly illustrate
compliance with the board’s trading risk limits.
Although unrealized holding gains (losses) on HTM and
AFS debt securities normally are not recognized in
calculating a bank's regulatory capital ratios, examiners
should evaluate the extent of any unrealized appreciation
or depreciation on these debt securities in making an
overall qualitative assessment of the bank's capital
adequacy and in evaluating whether the bank has an
effective risk management system for securities. Such a
risk management system should include:
•
•
•
To measure the performance of the bank’s trading activity,
trading desks, or individual traders, management will
generally seek to compare their results to established
performance standards or to benchmarks. For example, a
benchmark’s return represents the return for simply
adopting a passive investment strategy in a similar class of
investments.
Performance evaluation benchmarks
commonly used are market indexes. Indexes frequently
used as equity portfolio benchmarks include the Standard
and Poor’s 500 Index and the Russell 2000 Index. An
index frequently used as a bond portfolio benchmark is the
Lehman Brothers Aggregate Bond Index. Management
should select benchmarks that provide realistic
comparative value. When the trading portfolio consistently
fails to achieve returns at least equivalent to reasonable
benchmarks, management should assess whether the
program achieves the board’s objectives.
Policies, procedures, and limits,
Risk identification, measurement, and reporting, and
Internal controls.
Examiners should discuss any concerns that result from
this assessment with management.
OTHER GUIDANCE
Trading
Whenever a bank reports or demonstrates trading activity,
examiners should refer to Part 325 of the FDIC’s Rules and
Regulations and determine if the bank adheres to all
trading-related requirements.
Trading activities involve strategies or transactions
designed to profit from short term price changes. Trading
activities almost always employ active strategies, which
assume that the bank can consistently outperform the
market.
Trading programs can generate significant
earnings, but also create unique risk exposures. The board
and management have the responsibility to identify,
measure, monitor, and control trading activity risks.
Accounting
Accurate accounting is essential to the evaluation of a
bank’s risk profile and the assessment of its financial
condition and capital adequacy. Reporting treatment for
securities and derivative holdings should be consistent with
the bank’s business objectives, generally accepted
accounting principles (GAAP), and regulatory reporting
standards. When necessary, examiners should consult
regional accounting specialists for additional guidance. A
listing of pertinent accounting guidance is included in the
Accounting Guidance portion of this section.
Failure to adequately understand and manage trading
activity risks is an unsafe and unsound practice.
This section’s investment activity guidance also applies to
all trading activity. In addition, trading programs should
include:
•
•
•
•
•
•
•
•
Specific board approval and periodic review,
Separate policies and procedures,
Management that possesses sufficient expertise,
Segregated accounting and reporting,
A risk measurement system that quantifies potential
trading loss,
Performance measurement relative to established
benchmarks,
Strong conflict of interest guidelines, and
Appropriately rigorous internal controls.
FAS 115, Accounting for Certain Investments in Debt and
Equity Securities, must be adopted for Call Report
purposes by all banks. It requires banks to divide their
securities holdings among three categories: held-tomaturity (HTM), available-for-sale (AFS), and trading.
Different accounting treatment applies to each category.
Only debt securities which management has the positive
intent and ability to hold to maturity may be designated as
HTM and carried at amortized cost. AFS securities are
those that management has not designated for trading or as
HTM. AFS securities are reported at fair value, with
unrealized gains and losses excluded from earnings and
reported in a separate capital component. Securities held
The trading program’s risk measurement system should
identify and measure all material risks, including potential
trading loss for defined periods. For example, the system
could measure potential one day trading loss for a given set
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Section 3.3
for trading must be reported at fair value, with unrealized
gains and losses recognized in current earnings and
regulatory capital. Proper categorization ensures that
trading gains and losses are promptly recognized in
earnings and regulatory capital. Refer to the Call Report
Instructions for additional information.
banks may defer the recognition in income of gains and
losses on derivative instruments used for hedging until they
recognize in income the effects of related changes on the
items hedged.
Market risk modification (including hedging) transactions
accounting should be consistent with the board’s risk
management and accounting policies. Consistent with
GAAP, derivatives and the hedged assets and liabilities
must be designated when the hedging transaction is
initiated.
Management should retain adequate
documentation to support deferrals of gains and losses,
including the market risk modifications strategy and
performance criteria.
Reporting trading assets as HTM or AFS is an unsafe and
unsound practice.
The substance of management’s
securities activities determines whether securities reported
as HTM or AFS are, in fact, held for trading. While there
are no standard benchmarks for identifying trading activity,
trading generally reflects active and frequent buying and
selling of securities for the purpose of generating profits on
short-term fluctuations in price.
Examiners having questions regarding the accounting for
derivatives should consult with their regional accounting
specialist.
Examiners should also evaluate the extent of any
unrealized gains and losses on both AFS and HTM
securities when evaluating capital adequacy.
Information Services
FAS 144, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, and its
predecessor amended FAS 115 and clarified that a debt
security may not be classified HTM if it can contractually
be prepaid or otherwise settled in such a way that the bank
would not recover substantially all of its recorded
investment. This provision is effective for financial assets
held on or acquired after January 1, 1997 (no grandfather
provision).
The Capital Markets Branch can help examiners identify a
security's characteristics and risks. Capital Markets can
provide a variety of security and derivative data to
examiners, including prices, credit ratings, historical
interest rates, mortgage prepayment forecasts, derivatives
market summaries, and other information.
Prices and ratings should be requested through the Capital
Markets Branch’s Security Information Request System
(SIRS). To use SIRS, examiners complete a computer data
entry form and transmit it via electronic mail to a dedicated
address. The Capital Markets Branch will enter all
available data in the form and transmit it to the examiner
within five business days of receipt. The data entry form is
an automated Excel file that may be downloaded from the
Capital Markets Branch’s FDIC website.
Premiums and discounts should be accounted for
according to the Call Report Instructions. Inadequately
amortized premium amounts should be adversely classified
as Loss.
Trade date accounting is preferred (to settlement date
accounting) for Call Report purposes to report HTM, AFS,
and trading assets (other than derivatives). However, if the
reported amounts under settlement date accounting would
not be materially different from those under trade date
accounting, settlement date accounting is acceptable.
Examiners should first submit a sample of a bank’s
securities and derivatives. When sampling results in
material, unresolvable discrepancies, examiners may
expand the sample and seek management’s commitment to
address any deficiencies. Prices provided by the Capital
Markets Branch should not be substituted for
management’s prices, unless significant deficiencies are
not resolved. Examiners should only submit requests to
price an entire portfolio when a material safety and
soundness concern exists.
Derivatives regulatory reporting instructions require that
derivatives be reported in accordance with GAAP, and in
particular FAS 133, Accounting for Derivative Instruments
and Hedging Activities; FAS 138, Accounting for Certain
Derivative Instruments and Certain Hedging Activities-an
amendment of FAS 133, and FAS 149, Amendment of
Statement 133 on Derivative Instruments and Hedging
Activities. In addition, the reporting should conform to the
interpretive reporting guidance provided in the regulatory
reporting instructions.
These instructions state that
derivatives generally should be marked to market, with
resulting market value gains and losses recognized in
current earnings. However, if certain criteria are met,
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The Capital Markets Branch obtains price and rating
information from several sources. Prices are indications of
value, but do not necessarily represent potential purchase
or sale values. Whenever available, prices are drawn from
market observations. However, many instruments do not
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Section 3.3
trade on organized exchanges. In such circumstances, the
Capital Markets Branch’s sources provide estimated prices
that have been derived from valuation models. These
estimated prices are indications of value, not precise
purchase or sale prices. Credit ratings are obtained from
several of the NRSROs.
and securities involved are transferred over the Fedwire
system. The Federal Reserve Bank of New York maintains
the book-entry custody system. All depository banks are
eligible to maintain book-entry accounts at their local
Reserve bank, provided that they also maintain a funds
account with their Reserve bank.
Historical interest rates are provided in the Market Index
and Rate Application (MIRA). MIRA contains a ten-year
database of rates, current forward rates, summary reports,
yield curves, and an index comparison analysis feature.
MIRA is an automated Excel template which examiners
may download from the Capital Markets Branch’s FDICnet
site.
Corporate and municipal bonds normally settle three full
business days after the date of the transaction. The
Municipal Securities Rulemaking Board Rule G-15
established guidelines for the settlement of municipal
securities transactions. Corporate and municipal debt
securities are available in book-entry and registered,
definitive form. Book-entry corporate and municipal
bonds settle through the Depository Trust Company
(DTC). Members effect securities deliveries through DTC
via computerized bookkeeping entries.
Mortgage prepayment forecasts and derivative market
summaries are provided in a simple spreadsheet format and
may be downloaded from the Capital Markets Branch’s
FDICnet site.
Mortgage securities settlement procedures are more
complex than those for government, corporate, and
municipal bonds.
The Bond Market Association
developed the "Uniform Practices for the Clearance and
Settlement of Mortgage-Backed Securities and Other
Related Securities" (Uniform Practices) to establish
industry standards for mortgage securities settlements.
Since the Uniform Practices are updated frequently, banks
engaged in mortgage and asset-backed securities
transactions should keep abreast of current settlement
standards. The current Uniform Practices are summarized
in the following paragraphs.
Other information, including detailed analytics and
financial information for debt and equity issuers, may be
requested on an individual basis. In addition, examiners
may contact the Capital Markets Branch for guidance on
examination procedures, supervisory policy, and Report of
Examination treatment. Examiners should coordinate
those requests with a Senior Capital Markets and Securities
Specialist in their assigned regional office before
contacting the Capital Markets Branch.
Settlement Practices, Confirmation and
Delivery Requirements, and Delivery
Documentation
Government National Mortgage Association (GNMA)
guaranteed mortgage pass-through securities are available
in book-entry and definitive form. While most GNMA
securities have been converted to book-entry, some
physical certificates still exist.
Book-entry GNMA
securities settle through the Participants Trust Company
(PTC) MBS Depository.
Settlement Practices
Inadequate understanding of standard settlement practices
coupled with poor internal controls can result in
unnecessary costs or losses.
The Federal National Mortgage Association (FNMA) and
Federal Home Loan Mortgage Corporation (FHLMC) both
issue Real Estate Mortgage Investment Conduits
(REMICs) and mortgage pass-through securities. Since
1985, these securities have been issued in book-entry form
only. Nearly all of the agency's securities that were issued
in definitive, registered form before 1985 have been
converted to book-entry. Book-entries are transferred,
delivered, and settled through the Fedwire system.
U.S. Treasury and Agency securities normally settle the
next full business day after the trade date. Transactions
involving U. S. Treasury and Agency obligations are
typically in book-entry form, rather than in physical
certificate form. Book-entry is an electronic registration,
transfer, and settlement system that enables the rapid and
accurate registration and transfer of securities with
concurrent cash settlement. Book-entry reduces handling
costs and quickens transaction completion. U. S. Treasury
and Agency book-entry securities are delivered and cleared
over the Federal Reserve Wire System (Fedwire) on a
delivery versus payment basis. Acceptance of the security
automatically debits the payment amount from the buyer's
account and credits it to the seller's account. The payment
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Private label CMOs/REMICs (those issued by an entity
other than FNMA and FHLMC) and asset backed
securities (ABSs) are available in book-entry and
registered, definitive form. Book-entry private label
CMOs/REMICs and ABSs settle through the DTC. Private
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label pass-through securities are only available in physical
form.
also be sent electronically. If the seller does not transmit
the required information before the 48-hour deadline, the
seller can not make delivery earlier than two business days
after such information is transmitted. The seller must then
promptly confirm in writing the following information:
Confirmation and Delivery Requirements
Within one business day following the trade date, each
party in a CMO/REMIC, stripped mortgage-backed
security (SMBS), or ABS transaction should send a written
confirmation of the transaction to the other party. Banks
should have procedures established to issue, receive, and
verify confirmations in a timely fashion. A bank is bound
to a particular trade if it does not object to the written
confirmation within 10 days of its receipt. Failure to
exercise appropriate controls over confirmation procedures
may result in the receipt or delivery of incorrect securities
and improper payment amounts. The confirmation must
contain the following information:
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
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Price,
Trade date,
Coupon rate,
Maturity date,
Settlement date,
CUSIP number,
Settlement amount,
Original face amount,
Security description,
Confirming party's name and address, and
Designation of "purchase from" and “sale to."
•
The delivery variance permitted on TBA trades is plus or
minus 2.50 percent of the dollar amount of the transaction
agreed to by the parties. There is no variance permitted on
transactions in which the seller provides the buyer with a
specific pool number and a specific original face amount at
the time of the trade. The 2.50 percent variance is
applicable to each $1,000,000 within a TBA trade larger
than $1,000,000. There are a maximum number of pools
that may be delivered to satisfy a TBA trade. For
securities with coupon rates below 12 percent, no more
than three pools per $1,000,000 may be delivered. Up to
four pools per $1,000,000 may be delivered for securities
with coupons of 12 percent and above. TBA transactions
that do not conform to these guidelines may result in
"failed" trades.
Confirmation procedures for mortgage pass-through
securities differ from those for CMOs/REMICs, SMBSs,
and ABSs, due to the manner in which mortgage passthrough securities typically trade. Most trades of mortgage
pools occur on a To Be Announced (TBA) basis. In TBA
transactions, information on the mortgage pools, such as
pool numbers, is not known at trade time. Instead, the
seller notifies the buyer of the pool numbers and original
face values of the underlying securities at least 48 hours
before delivery. No later than the second business day
before the settlement date of each TBA transaction, the
seller must transmit the following information to the buyer:
•
•
•
•
•
•
•
The settlement amount (sum of the principal amount and
accrued interest) is the amount payable by the buyer to the
seller on the settlement date. Refer to the Capital Markets
Examination Handbook for settlement amount formulas.
Price
Coupon rate and product
Trade date and settlement date
Pool, group, or other identification number
Issue date and maturity date for new pools
Identification of firm sending the information
Original face amount for each pool or group number
within the transaction
Delivery Documentation
Banks that purchase and sell mortgage-backed and other
related securities in physical form must be aware of the
documentation requirements contained in the Uniform
Practices. Physical securities must have assignments for
their registration in the name of the buyer on the books of
the issuer or transfer agent. Each certificate must be
accompanied by an assignment on the certificate or
separate assignment for each certificate containing a
signature that corresponds to the name written on the
This information may be transmitted to the buyer verbally
or by fax. If agreed to by both parties, the information may
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Price,
Settlement date,
Current face amount,
Proceeds to be paid,
Amount of accrued interest,
Identification of the "contra party,"
Designation of "purchase from" or "sale to,"
Pool, group, or other identification number,
Original face value for each pool or group number,
Confirming party's name, address, and telephone
number,
Securities' description, settlement month, coupon rate,
and product type, and
Additional information as agreed to by the parties of
the transaction.
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certificate. A detached assignment (standard corporate
bond power) must provide for the irrevocable appointment
of an attorney with power of substitution and must include
a full description of the security, maturity date, series
number, interest rate, and par amount. Each assignment,
endorsement, alteration, and erasure must bear a guarantee
acceptable to the issuer or transfer agent. A certificate
registered in the name of a party other than a natural person
will constitute good delivery only if it is accompanied by
evidence of the authority of the assignor to transfer the
securities.
The operations department should also be aware of the
Uniform Practices for reclamations. A reclamation is a
claim for the right to return or the right to demand the
return of a security that has been previously accepted as a
result of bad delivery or other irregularities in the
settlement process. Either party may make a reclamation if
information is discovered after delivery, which if known at
the time of delivery, would have caused the delivery not to
constitute good delivery. Reclamation must be made
within the stated time limits established by the Bond
Market Association.
If a trade has a settlement date between a record date and a
payable date, delivery of the securities must be
accompanied by a due bill. A due bill is a document
delivered by a seller of a security to a buyer evidencing
that any principal and interest received by the seller past
the record date will be paid to the buyer by the seller upon
submission of the due bill for redemption. The record date
is the date set by the trustee for determining who will be
paid principal and interest on a security. Book-entry
messages are considered acceptable due bill substitutes for
securities transferred over Fedwire, DTC, or PTC. Due
bills and book-entry messages cease to be valid after 60
days from their issue date. A bank may experience
considerable delays in attempting to recover payments
without the use of a due bill, which can result in the
accumulation of significant principal and interest
receivable accounts. If delivery and payment on a trade
occur after a record date and on or after a payable date,
delivery of the securities must be accompanied by a check
for the principal and interest due.
INVESTMENT STRATEGIES
Passive strategies generally do not require forecasting or
complex analysis. Rather, management seeks to mirror a
particular market segment’s performance or to retire
predetermined liabilities. Adopting a passive investment
strategy is a management decision to not attempt to
outperform the market. Passive strategies typically incur
lower expenses than do active strategies.
Indexing involves assembling a portfolio that closely
resembles the risk and return characteristics of a preferred
market index. For fixed-income portfolios, the portfolio
may possess the same maturity, duration, credit quality
characteristics, coupon, industrial classification, call or
sinking fund features as the index. Advantages of passive
bond portfolio management using indexing include low
management and advisory fees, performance that mirrors
the market, and low costs due to minimal turnover and no
research. Disadvantages include performance that is no
better than average, no immunization against interest rate
risk, no guarantee that a specific liability stream can be
funded from the portfolio, and the exclusion of many
different types of bonds in the market. For example, zerocoupon U. S. Treasuries and most asset-backed securities
are generally excluded from most conventional broad bond
market indexes.
Examiners may review the bank's procedures for good
delivery verification and interview bank personnel. The
bank's policies for mortgage-backed and other related
securities should conform to the Uniform Practices, and the
operations staff should be thoroughly familiar with these
standards. Failed trade frequency and costs will provide a
general quality indicator for the overall settlement
practices.
Immunization is a strategy that is employed to provide
protection against the interest rate risk of a liability stream.
The strategy requires that a bond portfolio be structured so
that its interest rate risk characteristics (Macaulay duration)
match those of the liability stream. The strategy, which is
often referred to as "duration matching," requires advanced
calculations and frequent re-balancing.
When a bank is on the sell side of a TBA trade, pools must
be delivered to the buyer within good delivery guidelines.
The process of assigning pools to a TBA transaction is
known as allocation. While allocation is a critical part of
the settlement process, relatively little effort is normally
expended on this function by traders and senior
management. Instead, the operations staff is usually
responsible for performing allocations. The independent
review should periodically confirm that the allocations
meet good delivery guidelines. Prudent allocation controls
will reduce the likelihood of costly "fails."
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Active strategies involve detailed analysis, such as
forecasting future events or interest rates, and selecting
investments that will perform best under those conditions.
Active strategies typically incur greater expenses than
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passive strategies, due to their higher transaction volume
and complex analysis.
barbell strategies will be disadvantageous if long-term
market interest rates rise while short-term rates remain
unchanged.
An interest-rate expectations strategy is an attempt to
maximize return based on a forecast of future interest rate
movements. An example of this strategy consists of
adjusting the duration of a bond portfolio to take advantage
of expected changes in interest rates. The success of this
strategy depends on the accurate forecasting of future
interest rates.
Yield spread3 strategies involve the positioning of fixedincome portfolios to profit on expected changes in yield
spreads between sectors of the bond market. These sectors
can vary by type of issuer (such as Treasury, agencies,
corporates, and mortgage-backed securities), quality or
credit (such as Treasuries, triple A, double A), coupon
(such
as
high-coupon/premium
bonds,
low
coupon/discount bonds), and maturity (such as short,
intermediate, or long term). Spreads can change for a
variety of reasons. For example, the spread between top
quality and lower quality bonds tends to narrow as business
conditions improve, and widen when business conditions
deteriorate. Making changes in the portfolio to take
advantage of changes in spreads will often result in
accepting additional credit risk or extension risk.
An individual security selection strategy is an attempt to
identify individual instruments that will outperform other
similarly rated instruments. The most common of this type
of strategy identifies an issue as undervalued because its
yield is higher that that of comparably rated issues or its
yield is expected to decline because credit analysis
indicates the issue’s rating will change. The success of this
strategy depends on superior skill in performing credit
analysis. An active strategy assumes that the investor will
attempt to outperform the market.
Cash flow matching strategies attempt to match the cash
flow requirements of a bank’s liabilities with the cash
flows provided by specific investments. This approach is
also known as dedicating a portfolio. Bonds are selected
with maturities, principal amounts and coupon payments
that match the bank’s liability payment stream.
Theoretically, this cash flow matching process can be
continued until all liabilities have been matched by the
cash flows from securities in the portfolio. Interest rate
risk reduction is the primary advantage of this strategy,
since a known amount of cash sufficient to fund the
required payment schedule will be generated with
certainty. The inability to reposition the securities being
used to match liabilities, the possibility of bonds being
called, and the possibility of bonds going into default are
the primary disadvantages of this strategy. Cash flow
matching strategies are becoming more popular in banks
that use FHLB borrowings.
Many other investment strategies may be employed without
measuring risk on a portfolio basis. Two commonly used
active strategies include yield curve strategies and yield
spread strategies.
Yield curve strategies involve the positioning of fixedincome portfolios to capitalize on or protect against
expected changes in the shape of the Treasury yield curve.
These strategies may be referred to as “riding the yield
curve.” Three common yield curve strategies are bullet
strategies, ladder strategies, and barbell strategies.
A bullet portfolio is constructed so that the maturity of the
securities is highly concentrated at one point on the yield
curve. A laddered portfolio spreads instruments (and
reinvestment risk) across the maturity spectrum and
provides regular cash flows. A typical laddered portfolio is
constructed with approximately equal percentages of the
portfolio maturing at different segments of the yield curve.
A barbell portfolio concentrates instruments at the short
term and long term extremes of the maturity spectrum.
Barbell strategies can be used to take advantage of, or
compensate for, non-parallel shifts in the yield curve.
These strategies are based on the theory that the value of
long-term bonds will appreciate more when long-term
market interest rates fall, than shorter-term bonds
depreciate even if short-term market interest rates
simultaneously rise (a non-parallel yield curve shift). The
ability to reinvest the proceeds from maturing short-term
bonds at higher short-term rates provides this value. The
actual performance of a barbell strategy will depend upon
both the type of non-parallel shift (e.g. steepening or
flattening) and the magnitude of the shift. For example,
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Using total return measurement in determining an
investment strategy better incorporates the investor’s
interest rate expectations over time than either a simple
yield to maturity or yield to call investment selection. The
total return for an individual bond consists of the change in
the market value over the measurement period; the coupon
received; and the reinvestment interest on the cash flows
received during the measurement period. For bond
portfolios, the total return is the weighted average of the
3
Yield spread is the yield premium of one bond over
another. Traditional analysis of the yield premium for a
non-U.S. Treasury bond involves calculating the difference
between the yield-to-maturity of the bond in question and
the yield-to-maturity of a U.S. Treasury security with a
comparable maturity.
3.3-20
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
returns of the bonds in the portfolio. Selecting investments
based solely on their yield to maturity assumes holding
those bonds to maturity and ignores the reinvestment return
on interim coupon payments.
effectively achieve the board’s goals. Refer to the Capital
Markets Handbook for additional information.
MARKET RISK MODIFICATION
STRATEGIES
Modern portfolio theory (MPT) refers to a variety of
portfolio construction, asset valuation, and risk
measurement concepts and models that rely on the
application of statistical and quantitative techniques. MPT
is an approach used for managing investment risk. The
theory states that by creating an efficient portfolio, an
investor can increase portfolio return without a
commensurate risk increase, or reduce portfolio risk
without a commensurate return reduction.
Market risk modification strategies involve using financial
instruments whose cash flow fluctuations partially or
completely offset the cash flow variability of an asset,
liability, or balance sheet segment.
Any financial
instrument with the desired cash flow characteristics may
be used to modify market risk, including off-balance sheet
derivatives, mortgage-backed securities, and structured
notes. For many banks, market risk modification is an
integral part of asset/liability management. This section
provides summary guidance for market risk modification
strategies. Refer to the Capital Markets Examination
Handbook for more detailed information.
First, an investor should determine the required portfolio
risk and return levels. By diversifying risk through prudent
investment choices, an investor can reduce portfolio risk.
Risk averse investors (such as most banks) require a
greater expected return in exchange for assuming increased
risk. Diversifying the portfolio among different asset
classes, maturities, and other characteristics can provide a
greater expected return without a commensurate risk
increase.
Bank earnings result primarily from the spread between
earning asset yields and funding costs. Market interest rate
changes can narrow the net interest margin and can reduce
the economic value of equity. In response, management
may attempt to modify the bank’s market risk profile to
reduce risk or improve performance.
The investor adds or removes assets from the portfolio in
order to maintain or alter overall portfolio risk and return
characteristics.
The investor focuses on the entire
portfolio’s cash flow characteristics, risk, and return. An
individual instrument may be extremely risky if evaluated
independently. However, its cash flow characteristics may
improve the overall portfolio’s risk and return
performance.
Risk Management Process
Management must evaluate many factors before
implementing a market risk modification strategy,
including:
•
•
•
•
•
•
•
For example, an interest-only strip may be very price
sensitive (market risk) under declining rate scenarios.
However, that instrument may offset some or all of a
portfolio’s price sensitivity under rising interest rate
scenarios.
Each instrument’s individual cash flow
characteristics are analyzed to determine the instrument’s
incremental effect on the overall portfolio’s cash flow
characteristics.
To devise a successful strategy (or simply determine if a
strategy is needed), management must first quantify the
bank’s market risk and identify the positions whose market
risk should be modified. Then, management must devise a
strategy to modify those positions’ market risk.
This approach also demands periodic performance
measurement. The investor must accurately measure both
risk and return for the overall portfolio and for major
portfolio segments. That is, the investor must determine if
the portfolio earned a return that adequately compensated
the investor for the risk level assumed.
Such
measurements require accurate pricing information,
detailed accounting systems, and a sophisticated risk
measurement system.
This process requires thorough understanding of the bank’s
market risk and cash flow characteristics for all on and offbalance sheet positions. For most banks, market risk
results primarily from repricing imbalances between
earning assets and funding. When developing strategy,
therefore, management should typically evaluate the
repricing and cash flow characteristics for all on and off-
No particular investment strategy is superior to any other.
Management must determine reasonable strategies that
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Market risk exposure,
The board’s risk tolerance,
Current and expected interest rate volatility,
Cash flow forecasts,
Strategy time horizon,
Specific instruments and cost, and
Potential effectiveness.
3.3-21
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
balance sheet positions. If management uses a market risk
modification strategy without assessing its effects on
overall bank market risk, then management may actually
worsen the bank’s market risk profile.
Failure to
understand and adequately manage those risks is an unsafe
and unsound practice.
instruments, which may include significant risk. In
addition, market risk modification strategies may require
enhanced management expertise and internal controls.
The board maintains oversight responsibility for all market
risk modification strategies. In that role, the board should
adopt policies that establish management’s responsibility
for developing, implementing, and monitoring the process.
Those policies should specify:
Next, management must determine the strategy’s intended
time horizon (the length of time the strategy must remain in
place) and number of periods needed. Horizon length is an
important factor, since many long-term derivatives and
some securities have limited liquidity. The number of
periods can be an equally important factor. For example, a
strategy that involves the value of a single cash position to
be liquidated or acquired on a single future date may be
described as a single-period strategy. However, a multiperiod strategy involves liquidation or acquisition of a cash
position over successive periods. Offsetting such positions
can involve a sequence of instruments that mature in
corresponding periods.
•
•
•
•
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•
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Risk limits,
Specific exposures needing modification,
Accounting treatment,
Reporting,
Monitoring,
Permissible strategies and instruments,
Counterparty credit risk guidelines,
Activity limits, and
Analysis and documentation standards.
Prior to implementing any market risk modification
strategy, management should evaluate all related costs,
including transaction costs, analysis and monitoring
expense, and foregone interest income on funds paid to
mark positions to market (for example, margin
maintenance).
Once a strategy has been implemented, management must
regularly monitor the strategy’s effectiveness. However,
careful development and monitoring can not guarantee a
strategy will achieve the intended market risk objectives.
Management should periodically evaluate instrument
performance to determine if the strategy remains
appropriate and effective. When warranted, management
should adjust the strategy.
The examination of this area should focus on evaluating
management's understanding and reporting of the
instruments used in any risk modification strategies. This
understanding will be reflected in a program for reviewing
and documenting financial contracts and counterparty
information.
Determining the effectiveness of risk
modification strategies should be conducted as part of the
rate sensitivity module. The interest rate risk review
should be able to rely on the individual investment findings
of the securities and derivatives review.
Board and Management Oversight
The board and management must understand and regularly
evaluate the risks and benefits from all market risk
modification strategies used. Market risk modification
strategies can involve complex transactions and
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Federal Deposit Insurance Corporation
3.3-22
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
Hedging Foreign Currency Risks with Purchased Options
ACCOUNTING GUIDANCE
EITF 89-4
Accounting for Purchased Investment in a Collateralized
Mortgage Obligation Instrument or in a Mortgage-Backed
Interest-Only Certificate
AICPA Audit and Accounting Guide: Banks and
Savings Institutions
Chapter 5 – Investments in Debt and Equity Securities
Chapter 8 – Mortgage Banking Activities and Loan Sales
Chapter 15 – Futures, Forwards, Options, Swaps, and
Similar Financial Instruments
EITF 89-18
Divestitures of Certain Investment Securities to an
Unregulated Common Controlled Entity Under FIRREA
APB - Accounting Principles Board Opinions
EITF - Consensus Positions of the Emerging Issues Task
Force
FAS - FASB Statements
FIN - FASB Interpretations
FTB - FASB Technical Bulletins
PB - AICPA Practices Bulletins
SOP - AICPA Statements of Position
EITF 88-9
Put Warrants
EITF 88-8
Mortgage Swaps
EITF 87-20
Offsetting Certificates of Deposit Against High-Coupon
Debt
APB 18
The Equity Method of Accounting for Investments in
Common Stock
EITF 87-1
Deferral Accounting for Cash Securities That Are Used to
Hedge Rate or Price Risk
EITF 00-9
Classification of a Gain or Loss from a Hedge of Debt That
is Extinguished
EITF 86-40
Investments in Open-End Mutual Funds That Invest in U.S.
Government Securities
EITF 98-15
Structured Notes Acquired for a Specified Investment
Strategy
EITF 86-28
Accounting Implications of Indexed Debt Instruments
EITF 96-12
Recognition of Interest Income and Balance Sheet
Classification of Structured Notes
EITF 86-25
Offsetting Foreign Currency Swaps
EITF 96-11
Accounting for Forward Contracts and Purchased Options
to Acquire Securities Covered by FAS No. 115
EITF 86-15
Increasing-Rate Debt
EITF 95-11
Accounting for Derivative Instruments Containing Both a
Written Option-Based Component and a Forward-Based
Component
EITF 85-29
Convertible Bonds with a “Premium Put”
EITF 85-20
Recognition of Fees for Guaranteeing a Loan
EITF 93-18
Recognition of Impairment for an Investment in a
Collateralized Mortgage Obligation Instrument or in a
Mortgage-Backed Interest-Only Certificate
EITF 85-17
Accrued Interest Upon Conversion of Convertible Debt
EITF 84-7
Termination of Interest Rate Swaps
EITF 90-19
Convertible Bonds with Issuer Option to Settle for Cash
Upon Conversion
FAS 149
Amendment of Statement 133 on Derivative Instruments
and Hedging Activities
EITF 90-17
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Federal Deposit Insurance Corporation
3.3-23
Securities and Derivatives (12-04)
SECURITIES AND DERIVATIVES
Section 3.3
Investor’s Accounting for Unrealized Losses on
Marketable Securities Owned by an Equity Method
Investee
FAS 140
Accounting for Transfers and Servicing of Financial Assets
and Extinguishment of Liabilities (Effective for transfers
and servicing of financial assets and extinguishments of
liabilities occurring after March 31, 2001)
PB 4
Accounting for Foreign Debt/Equity Swaps
FAS 138
Accounting for Certain Derivative Instruments and Certain
Hedging Activities-an amendment of FASB Statement No.
133
SOP 90-3
Definition of the Term “Substantially the Same” for
Holders of Debt Instruments, as Used in Certain Audit
Guides and a Statement of Position
FAS 134
Accounting for Mortgage-Backed Securities Retained after
the Securitization of Mortgage Loans Held for Sale by a
Mortgage Banking Enterprise
FAS 115
Accounting for Certain Investments in Debt and Equity
Securities
FAS 107
Disclosures About Fair Value of Financial Instruments
FAS 65
Accounting for Certain Mortgage Banking Activities
FAS 91
Accounting for Nonrefundable Fees and Costs Associated
with Originating or Acquiring Loans and Initial Direct
Costs of Leases
FAS 52
Foreign Currency Translation
FIN-41
Offsetting of Amounts Related to Certain Repurchase and
Reverse Repurchase Agreements
FIN-39
Offsetting of Amounts Related to Certain Contracts
FTB 94-1
Application of Statement 115 to Debt
Restructured in a Troubled Debt Restructuring
Securities
FTB 87-3
Accounting for Mortgage Servicing Fees and Rights
FTB 79-19
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3.3-24
Securities and Derivatives (12-04)
CASH AND DUE FROM BANKS
Section 3.4
OVERVIEW ......................................................................2
Cash................................................................................2
Clearings ........................................................................2
Cash Items......................................................................2
Due From Banks.............................................................3
Deposit Notes .....................................................................3
EXAMINATION OBJECTIVES .......................................4
Primary Reserves............................................................4
Interbank Liabilities .......................................................4
Compensating Balances .................................................4
Correspondent Concentration Risks ...............................4
Due Diligence.............................................................5
Identifying Credit Concentrations ..............................5
Identifying Funding Concentrations...........................5
Calculating Credit and Funding Concentrations.........5
Monitoring Correspondent Relationships...................5
Managing Correspondent Concentrations ..................5
EXAMINATION PROCEDURES.....................................6
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3.4-1
Cash and Due From Banks (3/12)
CASH AND DUE FROM BANKS
Section 3.4
that allowed them to read the bank and item number from
pre-encoded MICR information.
OVERVIEW
Financial institutions maintain cash on hand and at
correspondent banks to comply with statutory reserve
requirements and to meet customer demands. Cash accounts
include U.S. and foreign coin and currency on hand and
transit, clearing, and cash items. Demand and time deposits
maintained at correspondent banks are often known as due
from accounts, or correspondent balances. Banks maintain
correspondent accounts to facilitate the transfer of funds.
Legislative changes and advances in technology now allow
banks to process clearing items, or have items processed by a
servicer, on equipment that captures images of items, reads
the information, including MICR data, and stores images and
data in a computerized file. The file can then be transmitted
electronically for settlement. Similarly, institutions are now
able to use remote deposit capture systems. With remote
deposit capture, instead of physically transporting checks to a
banking facility, customers are able to scan checks on
devices maintained in their own offices and transmit
information electronically to a financial institution or its
service provider.
Cash
Every bank must maintain a certain amount of U.S. and/or
foreign coin and currency on hand. To avoid having excess
nonearning assets and to minimize exposure to
misappropriation and robbery, each bank should establish a
policy to maintain cash balances at the minimum levels
necessary to meet reserve requirements and customer
demands. Federal Reserve Regulation D governs the level of
required reserves. Part 326 of the FDIC Rules and
Regulations requires banks to adopt appropriate security
procedures to discourage robberies and to assist in
apprehending persons who commit such acts.
Although institutions can process clearing items such as
checks quickly and efficiently using modern technologies, in
many situations, checks are no longer the most convenient
payment instruments for consumers. Often consumers use
checks merely for person-to-person transactions that are not
conducive to electronic payments. Many consumers have
shifted to using fully electronic payments through Automated
Teller Machine, Point-of-Sale, and on-line bill payment
systems.
Clearings
No matter how transactions are initiated or processed, a
bank's objective remains the same: to forward items for
collection quickly so funds are available as soon as possible;
to distribute checks and deposits efficiently to their
destinations; to establish that deposit totals balance with the
totals shown on deposit tickets; to prove subsidiary and
general ledger entries and other transactions; to collect data
for computing customer's service charges and available
funds; and to accomplish the functions accurately, securely,
and efficiently.
The term clearing is used to describe the activities involved
with processing financial transactions from the time a
transaction is made until it is settled. Clearing items include
checks, drafts, notes, and other items that represent
instructions for processing financial transactions. Financial
institutions accept, collect, and process a variety of payment
instruments and can participate in a variety of clearing and
settlement systems.
For decades, many communities with two or more banks
organized local clearinghouse associations which adopted
rules governing the exchange of checks. Clearings were also
processed through regional associations, correspondent
banks, or the Federal Reserve. Physical items such as checks
(typically submitted in batches) were often processed on
proof and sorting machines that facilitated an institution's
ability to verify the accuracy of individual documents,
separate items by pre-identified categories, provide balance
verifications for transaction types (proof), and send cash
items drawn on other banks for collection (transit). Proof
machines had paper handling mechanisms that fed checks,
deposit slips, and other items into the system. As each item
went into the system, a proof operator read and entered the
courtesy amount of the check (the face value of the check).
The proof machine then printed the face value on the bottom
of the item in Magnetic Ink Character Recognition (MICR)
ink so the transaction information could be processed
electronically. Most proof machines also had a MICR reader
Cash and Due From Banks (3/12)
Cash Items
Cash items are checks or other items in process of collection
payable in cash upon presentation. A separate control
account of all such items is generally maintained on the
bank's general ledger and supported by a subsidiary record of
individual amounts and other pertinent data. Cash items and
related records usually are in the custody of one employee at
each banking office who is designated as the collection, or
exchange, teller.
In normal daily operations, all banks have items which are
charged to demand deposits but which cannot be charged to
individual accounts because of insufficient funds, a lack of
information, unknown accounts, etc. Such items include
return items, rejects, or unposted debits and may consist of
checks, loan payments, or other debit memos. In some
banks, such items are separated and an entry is made
3.4-2
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CASH AND DUE FROM BANKS
Section 3.4
reclassifying them to a separate asset account. Other banks
include the items in a subsidiary control account in the
individual demand deposit ledgers. In that case, the account
would have a debit balance that would be credited when the
bank returns the checks to their sources.
Some banks have purchased deposit notes as investments.
These instruments are a form of deposit liability somewhat
similar to negotiable time certificates of deposit (CD).
"Deposit notes" have been structured like corporate bonds by
having a five-day corporate settlement period for purchases
and semiannual interest payments calculated on a 30/360-day
basis. Although maturities vary from nine months to 15
years, most "deposit notes mature in four to seven years.
While the foregoing contract terms could be incorporated
into a CD, certain banks, for marketing purposes, prefer to
use the "deposit note" format.
Cash items not in process of collection should be carried in a
noncash account and reported as other assets. These include
items payable upon presentation that a bank has elected to
accumulate until forwarding to payers on a periodic basis.
Items not immediately payable in cash upon presentation, or
items that were not paid when presented and require further
collection efforts should also be included in an appropriate
account, such as suspense, and shown under other assets.
Many banks establish a three-day limit, after which all items
not collected must be automatically transferred from cash
items to a suspense account. Refer to the Other Assets
section of this Manual for additional comments on cash items
not in process of collection.
Bank purchases of such notes should be made in accordance
with established investment and asset/liability management
policies. While these note issues tend to be rated, banks
considering the purchase of a deposit note should nonetheless
obtain the offering circular or other similar information to
ensure that they understand the nature of such notes
(including possible deposit insurance coverage) before
investing. A bank's investment in a deposit note should
generally be included on the balance sheet in the
interest-bearing balances due from depository institutions
asset category. However, if the offering circular or note
instrument for a particular deposit note is available for review
and it does not contain a statement to the effect that the
liability represented by the note is a deposit liability of the
issuing bank, the bank's investment in the note should be
treated as a security or a loan based on the characteristics of
the note.
Due From Banks
As noted above, due from accounts enable the transfer of
funds between banks. The accounts are used to facilitate the
collection of cash items and cash letters, the transfer and
settlement of security transactions, the transfer of
participation-loan funds, the purchase or sale of Federal
funds, and for many other purposes.
Due from accounts may also exist when a bank utilizes the
services of another bank and maintains a minimum or
compensating balance in full or partial payment for the
services received. Such services may involve processing cash
letters, packaging loan agreements, performing information
technology or payroll services, collecting out-of-area items,
or exchanging foreign currency.
Structured CDs
Structured CDs are similar to structured note investment
securities in that they have customized features typically
containing embedded options or having cash flows linked to
various indices.
The uncertainty of the cash flows, caused by movements in
interest rates or other indices, may expose banks that invest
in the CDs to heightened market risk, liquidity risk, or other
such risks traditionally experienced in the context of
investment securities. As a result, investments in structured
CDs warrant heightened supervisory attention to ensure that
management understands, and has the ability to adequately
monitor and manage these risks.
Balances due from institutions cover all interest-bearing and
noninterest-bearing balances whether in the form of demand,
savings, or time balances, but excludes certificates of deposit
held for trading.
Reciprocal balances arise when two depository institutions
maintain deposit accounts with each other, i.e., when a
reporting bank has both a due from and a due to balance with
another depository institution. Reciprocal balances between
the reporting bank and other depository institutions may be
reported on a net basis when a right of set off exists. Net due
from balances should be reported as deposit assets. Net due
to balances should be reported as deposit liabilities.
The risk profile of structured CDs can be very similar to that
of structured notes. Certificates may include step-up features
with call options, inverse floating or dual indices, or other
such terms. These types of terms, in addition to severe early
withdrawal penalties and the lack of an established secondary
market, may result in cash flow behavior similar to that of
structured notes. Proper controls for these investments
include effective senior management supervision, board
oversight, periodic reporting, and appropriate policies and
DEPOSIT NOTES
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3.4-3
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CASH AND DUE FROM BANKS
Section 3.4
procedures. The degree and complexity of an institution's
monitoring and reporting systems should be commensurate
with the volume and complexity of their investment in
structured certificates.
Regulation F provides that when exposure limits are required,
banks should limit interday credit exposure to a
correspondent to 25 percent of a bank's capital, unless the
bank can demonstrate that its correspondent is at least
adequately capitalized. When a correspondent is not at least
adequately capitalized, banks should reduce their credit
exposure to the 25 percent level within 120 days after the
date when the current Call Report or other relevant report
would be available.
Classification of structured CDs should be consistent with the
adverse classification guidelines outline in the Securities and
Derivatives section of this Manual.
Compensating Balances
EXAMINATION OBJECTIVES
Banks may be exposed to insider abuse if their officers,
directors, or principal shareholders have loans at
correspondent banks. For example, a correspondent bank
may provide a bank insider a below-market rate loan if that
officer establishes a below-market rate deposit account at the
correspondent bank (in the name of their bank). In this
situation the officer would be abusing their position by
receiving personal gain (the below-market rate loan), and
harming the bank by establishing an account at the
correspondent that receives below-market returns. Therefore
examiners should be alert to potential abusive relationship
between executive officers, directors, and principal
shareholders of a bank and that bank's correspondent banks.
When reviewing activities related to cash and due from bank
accounts, examiners should consider the issues discussed
below.
Primary Reserves
Cash and balances due from other banks generally represent
an institution's primary liquidity reserves, except to the extent
they include required reserves. Excessive cash or due from
balances can have an adverse impact on earnings because
they generate little or no income, while insufficient balances
can contribute to a weak overall liquidity position.
Examiners should review the level of primary reserves as part
of the Earnings and Liquidity reviews. Some assistance in
making this assessment may be obtained by referring to the
UBPR. If a bank's level of cash and due from bank accounts
appears considerably out of line with those of the peer group
(after considering reserve requirements), or if the level
changed significantly from the previous examination, or over
a period of time, further investigation may be warranted.
Such arrangements may constitute a breach of a bank
official's fiduciary obligations to the depositing bank and thus
to its depositors, creditors and shareholders. In some cases,
the arrangements may also involve a criminal offense.
Accordingly, if the bank maintains a correspondent account
with another bank which has extended credit to any of the
above persons or anyone associated with them and where
there is evidence that the depositing bank may have suffered
a detriment because of the loan/deposit arrangement, the
situation should be thoroughly investigated. This is also the
case when the bank holds a deposit from another bank and
has outstanding extensions of credit to such persons in the
other bank or their associates. Refer to the Bank Fraud and
Insider Abuse section for further information.
Interbank Liabilities
All insured institutions are required to establish and maintain
written policies and procedures to prevent excessive
exposure to any individual correspondent, in accordance with
Federal Reserve Regulation F (12 CFR Part 206), Limitations
on Interbank Liabilities. This rule covers all exposure to a
correspondent, including credit and liquidity risks and
operational risks related to intraday and interday transactions.
The regulation requires banks to establish prudent standards
that consider credit, liquidity, and operational risks when
selecting correspondents and terminating relationships.
Where exposure is considered significant, banks must
periodically review their correspondents' financial condition.
Correspondent Concentration Risks
The FFIEC issued guidance (FIL-18-2010) detailing the
expectation that financial institutions take actions beyond the
minimum requirements established in Regulation F. The
guidance clarifies that risk management practices relating to
correspondent concentrations should encompasses all credit
and funding exposures. In addition, management should be
aware of its affiliates' exposures to individual correspondents
and their affiliated entities.
Policy standards should include exposure limits when a
correspondent's financial condition, or the general level of
exposure to a correspondent, creates a significant risk to a
bank. Exposure limits may be fixed by amount or flexible,
but should be based on the financial condition of the
correspondent and the type and level of identified exposure.
Cash and Due From Banks (3/12)
A financial institution’s relationship with a correspondent can
result in credit (asset) and funding (liability) concentrations.
Asset concentrations may be present when an institution
3.4-4
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CASH AND DUE FROM BANKS
Section 3.4
maintains significant due from balances; or advances, or
commits to advancing, significant funds to a correspondent or
their related entities. Liability concentrations may exist when
an institution maintains significant due to balances; or
depends on a correspondent or their related entities for a
disproportionate share of its total funding.
The primary risk relating to funding concentrations is that an
institution may need to replace the advances on short notice
or on unfavorable terms. The risks may be more pronounced
if funds are credit sensitive or the party advancing the funds
has a weakened financial condition. Additionally, the level
of risk relating to a funding concentration is likely to vary
depending on the type and maturity of the funds and the
structure of the recipient’s overall sources of funds. For
example, a concentration in overnight unsecured funding
would raise different concerns than a concentration in
secured long-term funding. Also, the risks of a concentration
from a particular correspondent would be more significant if
the level of funds constituted a high percentage of an
institution's overall funding sources.
Some correspondent concentrations may involve legitimate
business purposes, such as concentrations arising when an
institution maintains large due from accounts to facilitate
clearing activities. However, correspondent concentrations
represent diversification risks that management should
consider when formulating strategic plans and risk limits.
Examiners should ensure management performs appropriate
due diligence procedures and adequately identifies, monitors,
and manages all credit and funding concentrations.
Calculating Credit and Funding Concentrations
When identifying credit and funding concentrations,
institutions should calculate both gross and net exposures to
individual correspondents and to groups of affiliated
correspondents. Exposures are reduced to net positions to the
extent the transactions are secured by the net realizable
proceeds from readily marketable collateral or are covered by
valid and enforceable netting agreements.
Due Diligence
Financial institutions that maintain, or contemplate entering
into, credit or funding arrangements with other financial
institutions should establish correspondent risk management
programs. The programs should include written investment,
lending, and funding policies that incorporate appropriate
risk limits. In addition, the programs should ensure
institutions conduct analysis of credit transactions prior to
committing to, or engaging in, the transactions. The terms of
all credit and funding transactions should avoid conflicts of
interest and conform to sound investment, lending, and
funding practices.
Monitoring Correspondent Relationships
Management should maintain written policies and procedures
designed to prevent excessive exposure to correspondents in
relation to the correspondent’s financial condition. The depth
and frequency of monitoring procedures may be more or less
aggressive depending on the type and level of risk exposures.
Institutions should implement procedures that ensure
ongoing, timely reviews of correspondent relationships,
include documentation requirements, and specify when risks
that meet internal criteria are to be brought to the attention of
the board of directors.
Identifying Credit Concentrations
Credit concentrations involve a variety of assets and
activities. For example, an institution could have due from
bank accounts, Federal funds sold on a principal basis, and
direct or indirect loans to or investments in a correspondent
bank. When calculating credit concentration levels,
institutions should aggregate all exposures, including, but not
limited to:
In monitoring correspondent relationships, institutions should
specify internal parameters relative to information, ratios, or
trends that will be reviewed for each correspondent on an
ongoing basis such as:
Due from demand and time accounts,
Federal funds sold on a principal basis,
Over-collateralized amounts on repurchase agreements,
Under-collateralized portions of reverse repurchase
agreements,
Net credit exposures on derivatives contracts,
Unrealized gains on unsettled security transactions,
Direct or indirect loans to or for the benefit of the
correspondent, and
Investments in the correspondent, such as stocks,
subordinated debts, or trust preferred securities.
Managing Correspondent Concentrations
Institutions should establish prudent internal concentration
limits for each correspondent, as well as ranges or tolerances
for each factor being monitored. Institutions should also
Identifying Funding Concentrations
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
Deteriorating trends in capital, asset quality, or earnings,
Increasing levels of other real estate owned,
Significant use of volatile funding sources such as large
CDs or brokered deposits,
Downgrades in its credit ratings, if publicly traded, and
Public enforcement actions.
3.4-5
Cash and Due From Banks (3/12)
CASH AND DUE FROM BANKS
Section 3.4
develop contingency plans for managing risks when internal
limits, ranges, or tolerances are met, either on an individual
or collective basis. However, contingency plans should not
rely on temporary deposit insurance programs for mitigating
concentration risks.
Contingency plans should provide for the orderly reduction
of identified concentrations over reasonable timeframes.
Such actions may include, but are not limited to:
Reducing the volume of uncollateralized/uninsured
funds,
Transferring excess funds to other correspondents,
Requiring a correspondent to serve as an agent rather
than as principal for Federal funds sold,
Modifying credit and funding limits to a correspondent,
and
Specifying timeframes to meet targeted reductions for
different types of exposures.
EXAMINATION PROCEDURES
Examiners should review correspondent relationships to
ascertain whether an institution’s policies and procedures
appropriately manage correspondent concentrations.
Examiners should also review the adequacy and
reasonableness of an institution's contingency plans for
managing correspondent concentrations. The Examination
Documentation Modules include examination procedures
regarding the evaluation of the internal controls for cash,
cash items, and correspondent bank accounts. Refer to the
Other Assets and Liabilities and the Internal Routine and
Controls sections for additional details.
Cash and Due From Banks (3/12)
3.4-6
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PREMISES AND EQUIPMENT
Section 3.5
DEFINITIONS...................................................................2
FIXED ASSETS ACCOUNTING .....................................2
Fixed Assets - Owned ....................................................2
Fixed Assets - Leased ....................................................2
Sale-Leaseback Transactions .........................................3
ANALYSIS OF FIXED ASSETS......................................3
Depreciation Costs .........................................................3
Overinvestment ..............................................................4
Fixed Asset Investments ................................................4
FIXED ASSET INSURANCE...........................................4
EXAMINATION PROCEDURES ....................................4
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3.5-1
Premises and Equipment (3/12)
PREMISES AND EQUIPMENT
Section 3.5
when the construction funds are borrowed and the interest
costs imputed to internal financing of a construction
project. The rate used to capitalize interest on internally
financed projects in a reporting period shall be the rate(s)
applicable to the bank's borrowings outstanding during the
period. For this purpose, a bank's borrowings include
interest-bearing deposits and other interest-bearing
liabilities. The interest capitalized shall not exceed the
total amount of interest cost incurred by the bank during
the reporting period.
DEFINITIONS
Banks have historically relied on a reasonable investment
in premises and equipment to successfully conduct
business. A financial institution’s physical presence in a
community can bolster its public image and competitive
position, and enhance convenience for customers. Bank
offices can provide a platform for gathering deposits,
originating credit, and serving the financial needs of its
community. However, overinvestment in facilities may tie
up capital and hinder earnings. Therefore, similar to other
balance sheet assets, premises and equipment can pose
risks to the institution and present a range of accounting
issues that require appropriate oversight.
Fixed Assets - Leased
Premises and equipment are often leased.
Lease
obligations can represent commitments that have or will
have a significant effect on bank earnings. ASC 840,
Leases (formerly FAS 13, Accounting for Leases),
establishes generally accepted accounting principles
regarding lease transactions. Any lease entered into by a
Lessee bank, which at its inception meets one or more of
the four following criteria must be accounted for as a
property acquisition financed with a debt obligation (i.e.,
as a capitalized lease). The criteria are:
Premises include the cost, less accumulated depreciation,
of land and buildings actually owned and occupied (or to
be occupied) by the bank, its branches, and consolidated
subsidiaries. This includes vaults, fixed machinery,
equipment, parking lots, and real estate acquired for future
expansion. Interest costs associated with the construction
of a building should be capitalized as part of the cost of the
building. Bank premises also include leasehold
improvements. Leasehold improvements comprise two
types of accounts:
Buildings constructed on leased property, and
Capitalized disbursements directly related to leased
quarters such as vaults, renovations, or fixed
equipment.
Equipment includes all movable furniture, fixtures, and
equipment of the bank, its branches, and consolidated
subsidiaries, including automobiles and other vehicles, and
any liens on the above. The institution’s ownership
interest in premises or equipment of non-majority-owned
corporations is also included.
If none of the above criteria is met, the lease should be
accounted for as an operating lease. Normally, rental
payments should be charged to expense over the term of
the operating lease as they become payable.
FIXED ASSETS ACCOUNTING
Fixed Assets - Owned
Capitalized leases are to be reported in the Premises and
Fixed Assets category in the Call Report. The amount
capitalized equals the present value of the minimum
required payments over the noncancellable term as defined
by the lease plus the present value of the payment required
under the bargain purchase option, if any, less any portion
of the payments representing administrative expenses such
as insurance, maintenance, and taxes to be paid by the
lessor. The property shall be amortized according to the
bank's normal depreciation policy (except, if appropriate,
the amortization period shall be the lease term) unless the
lease involves land only.
Fixed assets are reported at original cost and are
depreciated over their estimated useful life, except for land
which is not a depreciable asset.
Interest may be capitalized as part of the historical cost of
acquiring assets that need a period of time to be brought to
the condition and location necessary for their intended use.
FASB Accounting Standards Codification (ASC) 835-20,
Capitalization of Interest (formerly Statement of Financial
Accounting Standards (FAS) 34, Capitalization of Interest
Cost), calls for capitalization of interest costs associated
with the construction of a building, if material. Such
interest costs include both the actual interest incurred
Premises and Equipment (3/12)
Ownership of the property is transferred to the lessee
at the end of the lease term.
The lease contains a bargain purchase option.
The lease term represents at least 75 percent of the
estimated economic life of the leased property.
The present value of the minimum lease payments at
the beginning of the lease term is 90 percent or more
of the fair value of the leased property to the lessor at
the inception date, less any related investment tax
credit retained by or expected to be realized by the
lessor.
3.5-2
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PREMISES AND EQUIPMENT
Section 3.5
If a lease is not being correctly reported, appropriate
comments should be included in the Report of
Examination. The comments should remind management
of the responsibility for accurate reporting and include the
recommendation that competent outside assistance be
obtained if the bank lacks satisfactory accounting
expertise. In addition, if the amount incorrectly reported is
significant, amended Call Reports may be necessary.
Decisions on how to report a lease should be fully
supported and documented.
ANALYSIS OF FIXED ASSETS
From an accounting standpoint, an investment in fixed
assets is an essential cost of doing business. Attention
should be focused on the adequacy of depreciation, the
reasonableness of the overall commitment, and the current
and prospective utilization of fixed assets in serving the
present and future anticipated banking needs. Only under
exceptional circumstances, such as the contemplated
abandonment of bank premises, gross under-utilization
due to obsolescence, closed bank situations, or other
extreme circumstances, do market value considerations
assume any significance in the analysis of fixed assets.
Sale-Leaseback Transactions
Sale-leaseback transactions involve the sale of property by
the owner and a lease of the property back to the seller. If
a bank sells premises or fixed assets and leases back the
property, the lease shall be treated as a capital lease if it
meets any one of the four criteria above for capitalization.
Otherwise, the lease shall be accounted for as an operating
lease. ASC 840-40, Leases – Sale-Leaseback Transactions
(formerly FAS 28, Accounting for Sales with Leasebacks)
provides guidance on the treatment of any gain or loss. A
loss must be recognized immediately for any excess of net
book value over fair value at the time of sale. In the event
a bank sells a property for an amount less than its fair
value, (for example, in order to obtain more favorable
lease terms), the difference between the sale proceeds and
fair value represents an additional loss that must be
deferred and amortized over the life of the lease. Any gain
resulting from a sale-leaseback transaction is generally
deferred and amortized over the life of the lease.
Accordingly, the general rule on deferral does not permit
the recognition of all or a part of the gain in income, at the
time of sale. Exceptions to the general rule do permit full
or partial recognition of a gain at the time of the sale if the
leaseback covers less than substantially all of the property
that was sold or if the total gain exceeds the minimum
lease payments.
Depreciation Costs
Depreciation is an overhead cost of doing business as the
item being depreciated will have to be replaced when it
ceases to have utility. An acceptable depreciation program
allocates the original cost of the fixed asset over its
estimated useful life. Failure to follow a realistic schedule
of fixed asset depreciation distorts both the balance sheet
and income statement.
Banks carry premises and equipment at cost less
accumulated depreciation, and adjust the carrying amount
for permanent impairments of value. Any method of
depreciation or amortization conforming to accounting
principles that are generally acceptable for financial
reporting purposes may be used. However, depreciation
for premises and fixed assets may be based on a method
used for federal income tax purposes if the results would
not be materially different from depreciation based on the
asset's estimated useful life. Under normal circumstances,
examiners should not need to prepare detailed depreciation
schedules in accordance with the generally accepted
accounting principles. In instances where tax depreciation
and book depreciation are the same, and depreciation is
accelerated for tax purposes only, detailed analysis of
book values may be necessary to determine whether fixed
assets are being appropriately depreciated.
Banks may provide seller-financing to the purchaser in
conjunction with a sale-leaseback transaction, ASC 36020, Property, Plant, and Equipment - Real Estate Sales
(formerly FAS 66, Accounting for Sales of Real Estate, as
amended by FAS 98, Accounting for Leases), applies to all
transactions in which the seller provides financing to the
buyer of the real estate.
Depreciation can result in a taxable temporary difference if
a bank uses the straight-line method to determine the
amount of depreciation expense to be reported for book
purposes but uses an accelerated method for tax purposes.
In the early years, tax depreciation under the accelerated
method will typically be larger than book depreciation
under the straight-line method. During this period, a
taxable temporary difference originates. Tax depreciation
will be less than book depreciation in the later years when
the temporary difference reverses. Therefore, in any given
year, the depreciation reported on the books will differ
from that reported in the bank's tax returns. However, total
The requirements of accounting for leases and sales of real
estate are complex and examiners who have questions on
lease capitalizations or sale-leaseback transactions should
refer to appropriate accounting resources or contact their
regional accounting specialist.
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3.5-3
Premises and Equipment (3/12)
PREMISES AND EQUIPMENT
Section 3.5
depreciation taken over the useful life of the asset will be
the same under either method.
Examiners should determine whether any arrangements or
transactions concerning fixed assets involve "insiders"
and, if so, that the transactions are made on substantially
the same terms as those prevailing at the time for
comparable transactions with non-insiders and do not
involve more than normal risk or present other unfavorable
features to the bank. In addition, examiners should
consider whether insiders’ use of bank owned/leased
facilities and equipment (including vehicles) is prudent
and in accordance with banking laws and employment
agreements.
Overinvestment
An overcommitment in equipment and facilities can
adversely impact earnings. A review of pertinent Uniform
Bank Performance Report (UBPR) schedules will reveal
how an institution compares to its peers in terms of total
assets invested in premises and equipment, and percent of
operating income absorbed by occupancy expense. This
information, though not in itself conclusive, can be a
useful starting point in the analysis. However, as long as
commitments conform to State banking regulations and
aggregate direct and indirect investments, including lease
obligations, appear reasonable in relation to the
institution's earnings performance and capacity, the
decision as to what constitutes an appropriate fixed asset
commitment should generally be left to management's
discretion.
FIXED ASSET INSURANCE
Historically, banks purchased property insurance to cover
damage caused by fire or lightning. Coverage to protect
against other risks, such as windstorms, hail, explosions,
riots or civil commotion, aircraft damage, vehicle damage,
etc., was obtained by purchasing extended coverage
policies or endorsements.
Modern property insurance is generally designated as
providing basic, broad, or special (a.k.a. all-risk) coverage.
The primary difference between these types of policies is
that basic and broad coverage policies only provide
coverage for items specifically included in a policy.
Special coverage policies provide coverage for other risks
not specifically excluded by a policy.
Fixed Asset Investments
A reasonable investment in premises and equipment is
essential to conducting bank business.
However,
overinvestment in facilities or equipment may weaken
depositor protection, encumber capital, and burden
earnings. Consequently, many states impose limits on
fixed asset investments. Reluctance on the part of banks to
keep their investments within statutory limits has resulted
in a variety of alternative arrangements, such as the
organization of subsidiary or affiliate realty corporations,
sale-leaseback transactions, and lease-purchase contracts.
These arrangements are most common in connection with
bank buildings, but in some instances are also used in
connection with equipment.
Basic policies typically provide coverage of risks caused
by fire, lightning, explosion, windstorm, hail, civil unrest,
aircraft or vehicle damage, etc. Broad form property
insurance includes coverage for the risks identified in
basic policies and adds additional coverage for falling
objects, weight of ice, sleet, or snow, and accidental water
damage.
The most common form of property insurance is special
coverage, or "all risk" insurance. As mentioned above,
special coverage policies provide protection against all
risks not specifically identified in a policy. Special
coverage policies normally provide the best overall risk
protection; however, the number and type of items
excluded from coverage can be numerous. Typical
exclusions include damage caused by government action,
nuclear hazard, wars, floods, fungus, and pollution.
The realty corporation arrangement typically calls for
investment in a subsidiary corporation and capitalization
by the bank of an amount within State limitations, with the
subsidiary corporation financing the additional cost of
banking facilities in the mortgage market. The facilities
are then leased to the bank by the subsidiary corporation at
a rent rate that usually coincides with the mortgage
payments. In one type of affiliate setup, a group of the
bank's directors may form a corporation to hold title to the
property and lease it to the bank.
Regardless of the type of property insurance policies a
bank carries, management must thoroughly understand,
periodically review, and document their analysis of the
adequacy of their institution's insurance coverage.
Lease-purchase contracts or sale-leaseback arrangements
should enable a bank, at its option, to acquire title to the
fixed assets either during, or at the expiration of, the lease
period.
EXAMINATION PROCEDURES
Premises and Equipment (3/12)
3.5-4
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PREMISES AND EQUIPMENT
Section 3.5
The Examination Documentation Modules include
examination procedures regarding the evaluation of the
reasonableness of investment in premises and equipment.
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3.5-5
Premises and Equipment (3/12)
OTHER REAL ESTATE
Section 3.6
OTHER REAL ESTATE ...................................................2
Maintaining Other Real Estate .......................................2
OTHER REAL ESTATE ACCOUNTING........................2
Carrying Value...............................................................2
FINANCED SALES OF ORE ...........................................3
Full Accrual Method ......................................................3
Installment Method ........................................................3
Cost Recovery Method...................................................3
Reduced-Profit Method..................................................3
Deposit Method..............................................................4
VALUATIONS AND CLASSIFICATION.......................4
ORE VALUATION ALLOWANCE.................................4
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3.6-1
Other Real Estate (3/12)
OTHER REAL ESTATE
Section 3.6
for the property, but also minimize liability and reputation
risks.
OTHER REAL ESTATE
Other real estate (ORE) consists of real property held for
reasons other than to conduct bank business. Banks
usually acquire ORE through foreclosure after a borrower
defaults on a loan secured by real estate. Most states have
laws governing the acquisition and retention of such
assets.
Real estate taxes on ORE should be paid in a timely
manner to avoid unnecessary penalties and interest.
Management should periodically review general insurance
policies to determine if adequate hazard and liability
coverage for ORE exists. If adequate general coverage is
not in place, management should consider obtaining
policies on each parcel of ORE. If an institution decides to
self-insure, the decision should be board approved and
appropriately documented.
Examiners should ensure management establishes
appropriate policies and procedures for acquiring, holding,
and disposing of ORE. Management should establish
policies and procedures that:
Management should implement reasonable procedures for
managing other miscellaneous expenses the institution
may incur during the ORE holding period. These expenses
could include, but are not limited to, sewer and water fees,
utility charges, property management fees, and interest on
prior liens.
Protect a bank's interests in ORE while mitigating the
impact on surrounding property values,
Ensure ORE is accounted for in conformance with
generally accepted accounting principles and Call
Report Instructions, and
Assure the institution's compliance with federal and
state laws pertaining to holding ORE.
For regulatory reporting purposes, ORE includes:
OTHER REAL ESTATE ACCOUNTING
The accounting and reporting standards for foreclosed real
estate are set forth in ASC 310-40, Receivables – Troubled
Debt Restructurings by Creditors (formerly FAS 15,
Accounting by Debtors and Creditors for Troubled Debt
Restructurings), and ASC 360, Property, Plant, and
Equipment (formerly FAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets). The
disposition of ORE is addressed in ASC 360-20, Property,
Plant, and Equipment – Real Estate Sales (formerly FAS
66, Accounting for Sales of Real Estate). For regulatory
reporting purposes, certain provisions of former AICPA
Statement of Position (SOP) No. 92-3, Accounting for
Foreclosed Assets, have been incorporated into the Call
Report Instructions even though SOP 92-3 was rescinded
subsequent to the issuance of FAS 144. Institutions must
follow these provisions of SOP 92-3 when preparing their
Call Reports.
All real estate, other than bank premises, actually
owned or controlled by the bank and its consolidated
subsidiaries, including real estate acquired through
foreclosure or deed in lieu of foreclosure, even if the
bank has not yet received title to the property;
Real estate collateral in a bank's possession, regardless
of whether formal foreclosure proceedings have been
initiated;
Property originally acquired for future expansion but
no longer intended for that purpose; and
Foreclosed real estate sold under contract and
accounted for under the deposit method of accounting.
Maintaining Other Real Estate
Part 364, Appendix A of the FDIC Rules and Regulations,
Interagency Guidelines Establishing Standards for Safety
and Soundness, requires institutions to identify problem
assets and prevent deterioration in those assets. Institutions
should maintain and protect ORE from deterioration to
maximize recovery values. Typical expenses incurred
during the ORE holding period relate to maintenance, tax,
insurance, and miscellaneous costs.
Carrying Value
Call Report Instructions provide that foreclosed real estate
received in full or partial satisfaction of a loan be recorded
at the fair value less cost to sell the property. This fair
value (less cost to sell) becomes the "cost" of the
foreclosed real estate. If the recorded amount of the loan
exceeds the "cost" of the property, the difference is a loss
which must be charged to the Allowance for Loan and
Lease Losses (ALLL) at the time of foreclosure or
repossession. However, if an asset is sold shortly after it is
received in a foreclosure or repossession, it may be
Management should maintain ORE in a manner that
complies with local property and fire codes. Other
requirements, such as homeowner association covenants,
may also require careful attention. Efforts to ensure an
ORE property is maintained in a marketable condition not
only improve an institution's ability to obtain the best price
Other Real Estate (3/12)
3.6-2
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OTHER REAL ESTATE
Section 3.6
appropriate to substitute the value received in the sale (net
of the cost to sell the property) for the fair value, with any
adjustments made to losses previously charged against the
ALLL.
The recorded amount of a loan at the time of foreclosure is
the loan balance adjusted for any unamortized premium or
discount and unamortized loan fees or costs, less any
amount previously charged off, plus recorded accrued
interest. An asset received in partial satisfaction of a loan
should be accounted for at its fair value less cost to sell,
and the recorded amount of the loan should be reduced by
the fair value (less cost to sell) of the asset at the time of
foreclosure. Legal fees and other direct costs incurred by
the bank in a foreclosure should be expensed as incurred.
Guidelines for meeting the minimum down payment are
set forth in Appendix A to ASC 360-20. These vary from
five to 25 percent of the property sales value. These
guideline percentages vary by type of property and are
primarily based on the inherent risk assumed for the type
and characteristics of the property. To meet the continuing
investment criteria, the contractual loan payments must be
sufficient to repay the loan over the customary loan term
for the type of property involved. For instance, the
customary repayment term for a loan secured by a singlefamily residential property could range up to 30 years.
After foreclosure, each foreclosed real estate parcel must
be carried at the lower of (1) the fair value of the real
estate minus the estimated costs to sell the real estate or (2)
the “cost” of the real estate. If the real estate’s fair value
minus the estimated costs to sell the real estate is less than
its “cost,” the deficiency must be recognized as a valuation
allowance against the real estate which is created through a
charge to expense. The valuation allowance should
thereafter be increased or decreased (but not below zero)
for changes in the real estate’s fair value or estimated
selling costs.
Installment Method
This method recognizes a sale and corresponding loan.
Profits are recognized as the bank receives payments.
Interest income is recognized on an accrual basis, when
appropriate.
The installment method is used when the down payment is
not adequate to allow for use of the full accrual method,
but recovery of the cost of the property is reasonably
assured in the event of buyer default. Reasonable
assurance of cost recovery may be achieved despite a
small down payment if there is recourse to borrowers who
have verifiable net worth, liquidity, and income levels, or
if there is additional collateral pledged.
FINANCED SALES OF ORE
ASC 360-20, which applies to all transactions in which the
seller provides financing to the buyer of real estate,
establishes five different methods of accounting for
dispositions of real estate. Failure to apply the correct
method may result in misstating ORE and earning assets
(i.e., loans). The deposit method is the only one of five
methods where disposition of ORE and financing by the
seller of real estate does not result in a sale and
corresponding recognition of a loan. Brief descriptions of
the five accounting methods for seller-financed
dispositions of ORE are listed below. Refer to ASC 36020 for more detailed definitions.
Cost Recovery Method
This method also recognizes a sale and corresponding loan
and may apply when dispositions do not qualify under the
full accrual or installment methods. No profit or interest
income is recognized until either the aggregate payments
exceed the recorded amount of the loan or a change to
another accounting method is appropriate. The loan is
maintained on nonaccrual status while this method is used.
Full Accrual Method
Reduced-Profit Method
Under this method, the disposition is recorded as a sale.
Any resulting profit is recognized in full and the sellerfinanced asset is reported as a loan. The following
conditions must be met in order to utilize this method.
This method is appropriate in those situations where the
bank receives an adequate down payment, but the loan
amortization schedule does not meet the requirements of
the full accrual method. Like the installment method, any
profit is recognized as payments are received. However,
profit recognition is based on the present value of the
lowest level of periodic payments required under the loan
A sale has been consummated,
The receivable is not subject to future subordination,
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The usual risks and rewards of ownership have been
transferred, and
The buyer's initial investment (down payment) and
continuing investment (periodic payments) are
adequate to demonstrate a commitment to pay for the
property.
3.6-3
Other Real Estate (3/12)
OTHER REAL ESTATE
Section 3.6
agreement. This method is seldom used in practice
because sales with adequate down payments are generally
not structured with inadequate loan amortization
requirements.
ORE VALUATION ALLOWANCE
As previously mentioned, a valuation allowance is
established for each parcel of ORE during the holding
period when the real estate’s fair value minus the
estimated costs to sell the real estate is less than the real
estate’s “cost.” Call Report Instructions clarify that
valuation allowances must be determined on an asset-byasset basis. As a result, the individual valuation allowance
should be subtracted from the related asset's "cost" to
determine the property’s carrying value, which is the
amount subject to classification.
Deposit Method
The deposit method is used in situations where a sale of
the real estate has not been consummated. It may also be
used for dispositions that could be accounted for under the
cost recovery method. Under this method a sale is not
recorded and the asset continues to be reported as ORE.
Furthermore, no profit or interest income is recognized.
Payments received from the borrower are reported as a
liability until sufficient payments or other events have
occurred which allow the use of one of the other methods.
Valuation allowances on foreclosed properties being held
for sale are not recognized as a component of regulatory
capital. The risk-based capital standards permit only the
"allowance for loan and lease losses" to be included in
Tier 2 capital up to a maximum of 1.25% of risk-weighted
assets.
VALUATIONS AND CLASSIFICATION
Many states require institutions to obtain ORE appraisals
or valuations when acquiring, holding, and/or disposing of
real estate. Management should obtain ORE appraisals or
valuations as required to ensure assets are reported at
appropriate values and any material change in market
conditions or physical property aspects is periodically
recognized. If an institution is selling and financing the
sale of an ORE parcel, Part 323 of the FDIC Rules and
Regulations, Appraisals, and some state laws require
updated appraisals or evaluations.
Examiners can test the general validity of appraised values
by comparing the sale prices and appraised values of
properties previously held. The fact of foreclosure is
presumptive, but not conclusive, evidence that takeover
value exceeds market or appraised value. Therefore, each
parcel of ORE is to be reviewed and classified on its own
merits.
Often a reliable appraisal may not be available or the
appraisal on file may be suspect for various reasons.
Nevertheless, a careful evaluation of all the relevant
factors should enable the examiner to make an accurate
and reliable judgment about a property’s fair value less
cost to sell with regard to classification. Any portion of
the carrying value in excess of fair value less cost to sell
should be classified Loss. The remaining carrying value
should then be evaluated and adversely classified, if
appropriate.
Regulatory definitions of Substandard,
Doubtful, and Loss (as discussed in the Loans section)
should be utilized in the analysis of ORE holdings.
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3.6-4
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OTHER ASSETS AND LIABILITIES
Section 3.7
INTRODUCTION .............................................................2
OTHER ASSETS...............................................................2
Accrued Income .............................................................2
Tax Assets ......................................................................2
Interest-Only Strips ........................................................3
Equities without Readily Determinable Fair Values ......3
Bank-Owned Life Insurance Policies.............................3
Miscellaneous Assets .........................................................4
Prepaid Expenses ...........................................................4
Repossessed Personal Property ......................................4
Suspense Accounts.........................................................5
Cash Items Not In Process Of Collection.......................5
Other Accrued Interest Receivables...............................5
Indemnification Assets...................................................5
INTANGIBLE ASSETS ....................................................5
Goodwill and Other Intangible Assets ...........................5
Accounting for Goodwill ...............................................6
Servicing Assets.............................................................6
Accounting .....................................................................6
Valuation........................................................................7
Regulatory Capital .........................................................8
Servicing Risk ................................................................8
Examination Procedures.................................................8
OTHER LIABILITIES ......................................................8
Other Borrowed Money .................................................9
Accrued Expenses ..........................................................9
Servicing Liabilities .......................................................9
Deferred Tax Liabilities .................................................9
Allowance for Off-Balance Sheet Exposures.................9
All Other Miscellaneous Liabilities ...............................9
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3.7-1
Other Assets and Other Liabilities (3/12)
OTHER ASSETS AND LIABILITIES
expected differences between items of income and expense
reflected on the Call Report and on the tax returns, and the
identification of expected tax credits.
INTRODUCTION
Assets and liabilities that are not reported in major balance
sheet categories are generally reported in other asset or
other liability categories. Although these items are listed
in "other" categories, it does not mean the accounts are of
less significance than items detailed in major categories.
Intangible assets lack physical substance and are also
reported separately on the balance sheet. The following
pages include descriptions of common other assets,
intangible assets, and other liabilities. Additional guidance
and information is included in the Call Report Instructions
and the Examination Documentation (ED) Module - Other
Assets and Liabilities.
Deferred tax assets and liabilities represent the amount by
which taxes receivable (or payable) are expected to
increase or decrease in the future as a result of temporary
differences and net operating losses or tax credit
carryforwards that exist at the reporting date. When
determining the current and deferred income tax assets and
liabilities to be reported in any period, a bank’s income tax
calculation will contain an inherent degree of uncertainty
surrounding the realizability of the tax positions included
in the calculation.
A net deferred tax asset is reported if a debit balance
results after offsetting deferred tax assets (net of valuation
allowance) and deferred tax liabilities measured at the
report date for a particular tax jurisdiction. If the result for
a particular tax jurisdiction is a net credit balance, then a
net deferred tax liability is reported. A bank may report a
net deferred tax debit, or asset, for one tax jurisdiction,
such as for federal income tax purposes, and also report at
the same time a net deferred tax credit, or liability, for
another tax jurisdiction, such as for state or local income
tax purposes.
OTHER ASSETS
Accrued Income
All banks, regardless of size, shall prepare the Call Report
on an accrual basis. Accrued income represents the
amount of interest earned or accrued on earning assets and
applicable to current or prior periods that has not yet been
collected. Examples include accrued interest receivable on
loans and investments. When income is accrued but not
yet collected, a bank debits a receivable account and
credits an applicable income account. When funds are
collected, cash or an equivalent is debited, and the
receivable account is credited.
Temporary differences arise when an institution
recognizes income or expense items on the books during
one period, but records them for tax purposes in another
period. For example a deductible temporary difference is
created when a provision for loan and lease losses is
expensed in one period for financial reporting purposes,
but deferred for tax purposes until the loans are charged
off in a subsequent period.
The degree to which accrual accounts and practices are
reviewed during an examination should be governed by
the examination scope.
When scoping examination
procedures, examiners should consider the adequacy of a
bank’s internal control structure and the extent to which
accrual accounting procedures are analyzed during audits.
A bank sustains an operating loss when deductions exceed
income for federal income tax purposes. An operating loss
in a year following periods when the bank had taxable
income may be carried back to recover income taxes
previously paid. Banks may carry back operating losses
for two years. Generally, an operating loss that occurs
when loss carrybacks are not available (e.g., when losses
occur in a year following periods of losses) becomes an
operating loss carryforward. Banks may carry operating
losses forward 20 years.
When reviewing accrual accounts and practices, examiners
should assess the general accuracy of the accrual
accounting system and determine if accruals relate to items
in default or to items where collection is doubtful. If
accrued income accounts are materially overstated,
examiners should consider the impact to overall
profitability levels, classify overstated amounts as Loss,
and recommend management amend Call Reports.
Tax credit carryforwards are tax credits that cannot be
used for tax purposes in the current year, but which can be
carried forward to reduce taxes payable in a future period.
Tax Assets
Banks must estimate the amount of the current income tax
liability (or receivable) to be reported on its tax returns.
Estimating this liability (or receivable) may involve
consultation with the bank's tax advisers, a review of the
previous year's tax returns, the identification of significant
Other Assets and Other Liabilities (3/12)
Section 3.7
Deferred tax assets are recognized for operating loss and
tax credit carryforwards just as they are for deductable
temporary differences.
However, a bank can only
recognize the benefit of a net operating loss, or a tax credit
3.7-2
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Federal Deposit Insurance Corporation
OTHER ASSETS AND LIABILITIES
carryforward, to the extent the bank determines that a
valuation allowance is not necessary.
A valuation
allowance must be recorded, if needed, to reduce the
amount of deferred tax assets to an amount that is more
likely than not to be realized. Examiners should obtain
management’s analysis and support for any deferred tax
asset and valuation allowance reported for financial
reporting purposes. Examiners should refer to the Call
Report Glossary for guidance on income taxes and may
contact the regional accounting specialist for further
guidance in cases involving significant amounts of net
deferred tax assets.
Section 3.7
currently available on a securities exchange registered with
the Securities and Exchange Commission and are not
publicly reported by the National Association of Securities
Dealers Automated Quotations or the National Quotation
Bureau. Equity securities that do not have readily
determinable fair values may have been purchased by a
bank or acquired for debts previously contracted, and may
include items such as paid-in stock of a Federal Reserve
Bank, stock of a Federal Home Loan Bank, and stock of a
bankers' bank. Refer to the Call Report Instructions for
additional details.
Bank-Owned Life Insurance Policies
Part 325 of the FDIC Rules and Regulations, Capital
Maintenance (Part 325), establishes limitations on the
amount of deferred tax assets that can be included in Tier
1 capital. The maximum allowable amount is limited to
the lesser of: the amount of deferred tax assets dependent
upon future taxable income expected to be realized within
one year of the calendar quarter-end date, based on
projected future taxable income for that year; or ten
percent of the amount of Tier 1 capital that exists before
certain deductions. Refer to Part 325 for more details.
The purchase of bank-owned life insurance (BOLI) can be
an effective way for institutions to manage exposures
arising from commitments to provide employee
compensation and pre- and post-retirement benefits, and to
protect against the loss of key persons.
Consistent with safe and sound banking practices,
institutions must understand the risks associated with
BOLI and implement a risk management process that
provides for the identification and control of such risks. A
sound pre-purchase analysis, meaningful ongoing
monitoring program, reliable accounting process and
accurate assessment of risk-based capital requirements are
all components of a comprehensive risk management
process.
The ability of state chartered banks to purchase life
insurance is governed by state law. The safe and sound
use of BOLI depends on effective senior management and
board oversight. An institution’s board of directors must
understand the complex risk characteristics of the
institution’s insurance holdings and the role this asset
plays in the institution’s overall business strategy.
Interest-Only Strips
Accounting standards for interest-only strips receivable are
set forth in ASC 860, Transfers and Servicing (formerly
FAS 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, as
amended by FAS 156, Accounting for Servicing of
Financial Assets, FAS 166, Accounting for Transfers of
Financial Assets, and certain other standards). ASC 860
defines interest-only strips receivable as the contractual
right to receive some or all of the interest due on a bond,
mortgage loan, collateralized mortgage obligation, or other
interest-bearing financial asset.
Each institution should establish internal policies and
procedures governing its BOLI holdings, including
guidelines that limit the aggregate cash surrender value
(CSV) of policies from, any one insurance company, as
well as the aggregate CSV of policies from all insurance
companies. In general, it is not prudent for an institution
to hold BOLI with an aggregate CSV that exceeds 25
percent of its Tier 1 capital. Therefore, an institution that
plans to acquire BOLI in an amount that results in an
aggregate CSV in excess of this concentration limit, or any
lower internal limit, should gain prior approval from its
board of directors or the appropriate board committee. In
this situation, management is expected to justify that any
increase in BOLI resulting in an aggregate CSV above 25
percent of Tier 1 capital does not constitute an imprudent
capital concentration.
Financial assets such as interest-only strips receivable, that
can contractually be prepaid or otherwise settled in such a
way that the holder of the financial asset would not
recover substantially all of its recorded investment do not
qualify to be accounted for at amortized cost. Interestonly strips subsequently measured at fair value like
available-for-sale securities are reported as other assets.
Alternatively, interest-only strips may be reported as
trading securities. Refer to the Call Report Instructions for
additional details.
Equities without Readily Determinable Fair
Values
An equity security does not have a readily determinable
fair value if sales or bid-and-asked quotations are not
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3.7-3
Other Assets and Other Liabilities (3/12)
OTHER ASSETS AND LIABILITIES
Management should conduct a thorough pre-purchase
analysis to help ensure that the institution understands the
risks, rewards, and unique characteristics of BOLI. The
nature and extent of this analysis should be commensurate
with the size and complexity of the potential BOLI
purchases and should take into account existing BOLI
holdings.
assets to determine the risk weight. Refer to Call Report
Instructions, the ED Module - Bank-Owned Life Insurance
(BOLI), and the Interagency Statement for further details.
MISCELLANEOUS ASSETS
Miscellaneous assets that are not reported in major
Balance Sheet or Other Asset categories should be
reported separately under all other assets in the Call
Report. Examples include derivative instruments held for
purposes other than trading that have a positive fair value,
computer software, and bullion. Some of the more
common miscellaneous assets are described below.
A comprehensive assessment of BOLI risks on an ongoing
basis is especially important for an institution whose
aggregate BOLI holdings represent a capital concentration.
Management should analyze the financial condition of
BOLI insurance carriers, review the performance of BOLI
products, and report their findings to the board at least
annually. More frequent reviews may be necessary if
management anticipates additional BOLI purchases, a
decline in an insurance carrier's financial condition, policy
surrenders, or changes in tax laws that could affect BOLI
products or performance.
Prepaid Expenses
Prepaid expenses are the costs that are paid for goods and
services prior to the periods in which the goods or services
are consumed or received. When the cost is prepaid, the
payment is recorded as an asset because it represents a
future benefit to the bank. In subsequent periods the asset
is reduced (expensed) as the goods or services are used or
rendered. At the end of each accounting period, the bank
makes adjusting entries to reflect the portion of the cost
that has expired during that period. The prepayment is
often for a service for which the benefit is spread evenly
throughout the year. As the service is provided, the
prepaid expense is amortized to match the cost to the
period it benefits. Examples of prepaid expenses include
premiums paid for insurance, advance payments for leases
or asset rentals, payments for stationery or other supplies
that will be used over several months, and retainer fees
paid for legal services to be provided over a specified
period.
Examiners should review the Interagency Statement on the
Purchase and Risk Management of Life Insurance
(Interagency Statement) when assessing an institution’s
BOLI program. Examiners should closely scrutinize risk
management policies and controls associated with BOLI
assets when an institution holds BOLI in an amount that
approaches or exceeds 25 percent of Tier 1 capital. An
institution holding life insurance in a manner inconsistent
with safe and sound banking practices is subject to
supervisory action. Where ineffective controls over BOLI
risks exist, or the exposure poses a safety and soundness
concern, supervisory action against the institution, may
include requiring the institution to divest affected policies,
irrespective of potential tax consequences.
ASC 325-30, Investments-Other – Investments in
Insurance Contracts (formerly FASB Technical Bulletin
No. 85-4, Accounting for Purchases of Life Insurance, and
Emerging Issues Task Force Issue No. 06-5, Accounting
for Purchases of Life Insurance – Determining the Amount
That Could Be Realized in Accordance with FASB
Technical Bulletin No. 85-4) addresses the accounting for
BOLI. Only the amount that could be realized under an
insurance contract as of the balance sheet date (that is, the
CSV reported by the carrier, less any applicable surrender
charges not reflected in the CSV) is reported as an asset.
If a bank records amounts in excess of the net CSV of the
policy, then the excess should be classified Loss.
Examiners should ensure management accurately adjusts
prepaid expenses to reflect exhausted purchased goods or
services.
Prepaid expenses that are recorded and
amortized in accordance with generally accepted
accounting principles should not be adversely classified.
However, any prepaid expense that is overstated should be
classified Loss.
Repossessed Personal Property
Repossessed personal property such as automobiles, boats,
equipment, and appliances, represents assets acquired for
debts previously contracted. A bank that receives assets
from a borrower in full satisfaction of a loan, such as a
receivable from a third party, an equity interest in the
borrower, or another type of asset (except a long-lived
asset that will be sold), will account for the asset at its fair
value. An asset received in partial satisfaction of a loan
should be accounted for as described above and the
For risk-based capital purposes, an institution that owns
general account permanent insurance should apply a 100
percent risk weight to its claim on the insurance company.
If an institution owns a separate account policy and can
demonstrate that it meets certain requirements, it may
choose to apply a look-through approach to the underlying
Other Assets and Other Liabilities (3/12)
Section 3.7
3.7-4
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OTHER ASSETS AND LIABILITIES
recorded amount of the loan should be reduced by the
asset’s fair value less the cost to sell. .Examiners should
assess repossessed assets individually for possible adverse
classification.
receivable amounts
classified Loss.
that are overstated should be
In a typical credit card securitization, an institution
transfers a pool of receivables and the right to receive the
future collections of principal (credit card purchases and
cash advances), finance charges, and fees on the
receivables to a trust. If a securitization transaction
qualifies as a sale, then the selling institution removes the
receivables that were sold from its reported assets and
continues to carry any retained interests in the transferred
receivables on its balance sheet. An institution should
treat this accrued interest receivable asset as a retained
(subordinated) beneficial interest. Accordingly, it should
be reported in all other assets in the Call Report and not as
a loan receivable.
Suspense Accounts
Suspense accounts, also known as interoffice or clearing
accounts, are temporary holding accounts in which items
are carried until they can be identified and their disposition
to the proper account is made. For example, items are
included in suspense accounts when a transaction is coded
incorrectly and cannot be processed immediately, when an
account number is missing on a loan or deposit
transaction, or when a check drawn on a deposit account at
the bank is not properly endorsed. Most suspense items
are researched and cleared the following day. The
balances of suspense accounts as of the report date should
not automatically be reported as Other Assets or Other
Liabilities. Rather, the items included in these accounts
should be reviewed and material amounts should be
reported appropriately in the Call Report. Moreover,
banks should regularly reconcile suspense accounts. Stale
suspense items should be charged off when it is
determined that they are uncollectible and should be
classified Loss in the report of examination.
For further guidance refer to the Interagency Advisory on
the Accounting Treatment of Accrued Interest Receivable
Related to Credit Card Securitizations and the Call Report
Instructions.
Indemnification Assets
Indemnification assets represent the carrying amount of
the right to receive payments from the FDIC for losses
incurred on specified assets acquired from failed insured
depository institutions or otherwise purchased from the
FDIC that are covered by loss-sharing agreements.
Despite the linkage between them, the acquired covered
assets and the indemnification asset, are treated as separate
units of account. Each covered asset is reported in the
appropriate category on the balance sheet.
The
indemnification asset is recorded at its acquisition-date fair
value and is reported in all other assets in the Call Report.
Cash Items Not In Process Of Collection
In contrast to those cash items that are in process of
collection, cash items that are not paid when presented are
referred to as cash items that are not in the process of
collection. In general, cash items that are not in the
process of collection occur when the paying bank has
refused payment after being presented with the cash item.
Once payment has been refused, the cash item immediately
becomes not in process of collection and is reclassified as
an Other Asset. Cash items not in the process of collection
are frequently kept in a suspense account. Although
collection efforts will continue, when it becomes clear that
the cash item will not be paid, the bank should promptly
charge off the cash item. It is common for the payee bank
to refuse payment if the customer’s deposit account had
insufficient funds, the check was improperly endorsed, the
checking account on which the check is drawn has been
closed, or for some other acceptable reason.
Examiners should ensure the acquiring institution’s
financial and regulatory reporting is appropriate for the
covered assets and the indemnification asset. Refer to the
Call Report Instructions for further details.
INTANGIBLE ASSETS
Goodwill and Other Intangible Assets
Goodwill is an intangible asset that is commonly
recognized as a result of a business combination. .Other
intangible assets resulting from a business combination,
such as core deposit intangibles, purchased credit card
relationships, servicing assets, favorable leasehold rights,
trademarks, trade names, internet domain names, and noncompete agreements, should be recognized as an asset
Other Accrued Interest Receivables
Accrued interest on securities purchased (if accounted for
separately from accrued interest receivable in the bank’s
records) and retained interests in accrued interest
receivable related to securitized credit cards is reported in
all other assets in the Call Report. Accrued interest
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Section 3.7
3.7-5
Other Assets and Other Liabilities (3/12)
OTHER ASSETS AND LIABILITIES
Section 3.7
separately from goodwill. This discussion will focus on
intangible assets acquired through business combinations.
portion of goodwill has been allocated to a business to be
disposed.
Goodwill represents the excess of the cost of a company
over the sum of the fair values of the tangible and
identifiable intangible assets acquired less the fair value of
liabilities assumed in a business combination accounted
for in accordance with ASC 805, Business Combinations
(formerly FAS 141 (revised 2007), Business
Combinations).
A bank may not remove goodwill from its balance sheet,
for example, by selling or upstreaming this asset to its
parent holding company or another affiliate.
Other intangible assets that have indefinite useful lives
should not be amortized but must be tested at least
annually for impairment. Intangible assets that have finite
useful lives must be amortized over their useful lives and
must be reviewed for impairment.
Push down accounting is the establishment of a new
accounting basis for a bank in its separate financial
statements as a result of it becoming substantially wholly
owned via a purchase transaction or a series of purchase
transactions. When push down accounting is applied, any
goodwill is reflected in the separate financial statements of
the acquired bank as well as in any consolidated financial
statements of the bank's parent.
Refer to the Call Report Instructions for further details.
Servicing Assets
The right to service assets is represented by the contractual
obligations undertaken by one party to provide servicing
for mortgage loans, credit card receivables, or other
financial assets for another. Servicing includes, but is not
limited to, processing principal and interest payments,
maintaining escrow accounts for the payment of taxes and
insurance, monitoring delinquencies, and accounting for
and remitting principal and interest payments to the
holders of beneficial interests in the financial assets.
Servicers typically receive certain benefits from the
servicing contract and incur the costs of servicing the
assets.
When measuring Tier 1 capital for regulatory capital
purposes, institutions generally must deduct goodwill and
other intangible assets (other than mortgage servicing
assets, nonmortgage servicing assets, and purchased credit
card relationships eligible for inclusion in core capital).
Refer to Part 325 for further information on the regulatory
capital treatment of goodwill and intangible assets.
Accounting for Goodwill
After initial recognition, goodwill must be accounted for
in accordance with ASC 350, Intangibles-Goodwill and
Other (formerly FAS 142, Goodwill and Other Intangible
Assets), which requires that goodwill be tested for
impairment at least annually.
Servicing is inherent in all financial assets; however, it
becomes a distinct asset or liability only when
contractually separated from the underlying financial
assets by sale or securitization with servicing retained or
by a separate purchase or assumption of the servicing
rights and responsibilities.
Whenever an institution
undertakes an obligation to service financial assets, a
servicing asset or liability must be recognized unless the
institution securitizes the assets, retains all of the resulting
securities, and classifies the securities as held-to-maturity.
Goodwill is considered impaired when the amount of
goodwill exceeds its implied fair value at the reporting unit
level. An impairment loss must be recognized in earnings.
After a goodwill impairment loss is recognized, the
adjusted carrying amount of goodwill shall be its new
accounting basis. Subsequent reversal of a previously
recognized goodwill impairment loss is prohibited once
the measurement of that loss is completed. Goodwill of a
reporting unit must be tested for impairment annually and
between annual tests if an event occurs or circumstances
change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount.
Examples of such events or circumstances include a
significant adverse change in the business climate,
unanticipated competition, a loss of key personnel, and an
expectation that a reporting unit or a significant portion of
a reporting unit will be sold or otherwise disposed. In
addition, goodwill must be tested for impairment after a
Other Assets and Other Liabilities (3/12)
Accounting
Accounting and reporting standards for asset and liability
servicing rights are set forth in ASC 860-50, Transfers and
Servicing – Servicing Assets and Liabilities (formerly FAS
140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, as amended by
FAS 156, Accounting for Servicing of Financial Assets,
and FAS 166, Accounting for Transfers of Financial
Assets), and ASC 948, Financial Services-Mortgage
Banking (formerly FAS 65, Accounting for Certain
Mortgage Banking Activities, as amended by FAS 140)..
Servicing assets result from contracts to service financial
3.7-6
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OTHER ASSETS AND LIABILITIES
assets for which the servicing benefits (revenues from
contractually specified servicing fees, late charges, and
other ancillary sources) are expected to more than
adequately compensate the servicer.
Contractually
specified servicing fees are all amounts that, per contract,
are due to a servicer in exchange for servicing the financial
assets and which would no longer be received by a
servicer if the contract for servicing were shifted to
another servicer.
value of the liability above the carrying amount of the
servicing liabilities, the bank should recognize the
increased obligation as a loss in current earnings.
Under the fair value measurement method, all servicing
assets or servicing liabilities in a class should be measured
at fair value at each quarter-end report date. Changes in
the fair value of these servicing assets and servicing
liabilities should be reported in earnings in the period in
which the changes occur.
A bank must recognize and initially measure at fair value a
servicing asset or a servicing liability each time it
undertakes an obligation to service a financial asset by
entering into a servicing contract in either of the following
situations:
Section 3.7
Institutions that sell only a limited number of financial
assets with servicing retained and do not otherwise
actively purchase or sell servicing rights may determine
that the servicing activity is immaterial. Typically, these
institutions will have a relatively low volume of financial
assets serviced for others and the value of any servicing
assets and liabilities would likewise be immaterial.
Management must provide a reasonable basis for not
reporting servicing activity. Refer to the Servicing
Liabilities section below and the Call Report Instructions
for further details.
The bank’s transfer of an entire financial asset, a
group of entire financial assets, or a participating
interest in an entire financial asset that meets the
requirements for sale accounting; or
An acquisition or assumption of a servicing obligation
that does not relate to financial assets of the bank or
its consolidated affiliates included in the Call Report.
Valuation
If a bank sells a participating interest in an entire financial
asset, it only recognizes a servicing asset or servicing
liability related to the participating interest sold.
The fair value of servicing assets and liabilities is
determined in accordance with ASC 820, Fair Value
Measurements and Disclosures (formerly FAS 157, Fair
Value Measurements) that defines fair value and
establishes a framework for measuring fair value. Fair
value is the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between
market participants in the asset’s or liability’s principal (or
most advantageous) market at the measurement date. This
value is often referred to as an exit price. ASC 820
establishes a three level fair value hierarchy that prioritizes
inputs used to measure fair value based on observability.
The highest priority is given to Level 1 (observable,
unadjusted) and the lowest priority to Level 3
(unobservable).
A bank should subsequently measure each class of
servicing assets and servicing liabilities using either the
amortization method or the fair value measurement
method. Once a bank elects the fair value measurement
method for a class of servicing, that election must not be
reversed.
Under the amortization method, all servicing assets or
servicing liabilities in the class should be amortized in
proportion to, and over the period of, estimated net
servicing income for assets (servicing revenues in excess
of servicing costs) or net servicing loss for liabilities
(servicing costs in excess of servicing revenues). The
servicing assets or servicing liabilities should be assessed
for impairment or increased obligation based on fair value
at each quarter-end Call Report date. The servicing assets
within a class should be stratified into groups based on one
or more of the predominant risk characteristics of the
underlying financial assets. If the carrying amount of a
stratum of servicing assets exceeds its fair value, the bank
should separately recognize impairment for that stratum by
reducing the carrying amount to fair value through a
valuation allowance for that stratum. The valuation
allowance should be adjusted to reflect changes in the
measurement of impairment subsequent to the initial
measurement of impairment. For the servicing liabilities
within a class, if subsequent events have increased the fair
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Federal Deposit Insurance Corporation
Valuation techniques consistent with the market approach,
income approach, and/or cost approach should be used to
measure fair value, as follows:
The market approach uses prices and other relevant
information generated by market transactions involving
identical or comparable assets or liabilities. Valuation
techniques consistent with the market approach include
matrix pricing and often use market multiples derived from
a set of comparables.
The income approach uses valuation techniques to convert
future amounts (for example, cash flows or earnings) to a
single present amount (discounted). The measurement is
3.7-7
Other Assets and Other Liabilities (3/12)
OTHER ASSETS AND LIABILITIES
based on the value indicated by current market
expectations about those future amounts. Valuation
techniques consistent with the income approach include
present value techniques, option-pricing models, and the
multi period excess earnings method.
The total amount of mortgage servicing assets,
nonmortgage servicing assets, along with purchased credit
card relationships recognized for regulatory purposes (i.e.,
not deducted from assets and capital) is limited to no more
than 100 percent of Tier 1 capital. In addition to the
aggregate limitation on such assets, the maximum
allowable amount of purchased credit card relationships
and nonmortgage servicing assets, when combined, is
limited to 25 percent of Tier 1 capital. These limitations
are calculated before the deduction of any disallowed
servicing assets, disallowed purchased credit card
relationships, disallowed credit-enhancing interest-only
strips, disallowed deferred tax assets, and any nonfinancial
equity investments. In addition, banks may elect to deduct
disallowed servicing assets on a basis that is net of any
associated deferred tax liability.
The cost approach is based on the amount that currently
would be required to replace the service capacity of an
asset (often referred to as current replacement cost). Fair
value is determined based on the cost to a market
participant (buyer) to acquire or construct a substitute asset
of comparable utility, adjusted for obsolescence.
When the discounted cash flow approach is used to
measure the fair value of servicing assets, a number of
factors and assumptions are considered when projecting
the potential income stream (net of servicing costs)
generated by the servicing rights. This income stream is
present valued using appropriate market discount rates to
determine the estimated fair value of the servicing rights.
These factors and assumptions, which should be
adequately documented, include:
Servicing Risk
Examiners should be aware of the risks that can affect an
institution from the failure to follow the servicing rules
related to securitized assets. While credit risk may appear
to be of little or no concern, the mishandling of procedures
in these transactions can affect a holder's ability to collect.
Financial institutions perform roles as sellers, buyers,
servicers, trustees, etc., in these types of transactions.
Examiners should evaluate the potential risks that might
arise from one or more of these roles. In most cases, the
government agency that provided the guarantee or
insurance against ultimate default will also impose
guidelines and regulations for the servicer to follow. If the
servicer or others involved in the servicing function fail to
follow these rules and guidelines, then the government
agency that is providing the guarantee or insurance may
refuse to honor its commitment to insure all parties against
loss due to default. It is necessary for the financial
institution to have adequate policies and procedures in
place to control and limit the institution's liability and
exposure in this regard.
Average loan balance and coupon rate,
Average portfolio age and remaining maturity,
Contractual servicing fees,
Estimated income from escrow balances,
Expected late charges and other possible ancillary
income,
Anticipated loan balance repayment rate (including
estimated prepayment speeds),
Direct servicing costs and appropriate allocations of
other costs, as well as the inflation rate effect, and
Delinquency rate and estimated out-of-pocket
foreclosure and collection costs that will not be
recovered.
Regulatory Capital
Part 325 provides information on the regulatory capital
treatment of mortgage servicing assets and nonmortgage
servicing assets.
Examination Procedures
When assessing asset quality during onsite examinations
and when reviewing merger applications, examiners and
supervisory personnel should review the valuation and
accounting treatment of servicing assets. The ED Module
- Mortgage Banking contains various examination
procedures and references for reviewing mortgage
servicing assets.
For purposes of calculating Tier 1 capital, the balance
sheet assets for mortgage servicing assets and
nonmortgage servicing assets will each be reduced to an
amount equal to the lesser of:
90 percent of the fair value of these assets; or
100 percent of the remaining unamortized book value
of these assets (net of any related valuation
allowances).
Other Assets and Other Liabilities (3/12)
Section 3.7
OTHER LIABILITIES
3.7-8
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Federal Deposit Insurance Corporation
OTHER ASSETS AND LIABILITIES
Section 3.7
Other Borrowed Money
Deferred Tax Liabilities
Mortgages, liens, and other encumbrances on premises and
other real estate owned, and obligations under capitalized
leases, which the bank is legally obligated to pay, are
reported as other borrowed money in the Call Report.
Regardless of the mortgage amount outstanding on bank
premises, the asset should be carried on the general ledger
at historical cost net of accumulated depreciation. ASC
840 establishes generally accepted accounting principles
regarding lease transactions that must be accounted for as
a property acquisition financed with a debt obligation
As noted under Tax Assets, a net deferred tax liability is
reported if a net credit balance results after offsetting
deferred tax assets (net of valuation allowance) and
deferred tax liabilities measured at the report date for a
particular tax jurisdiction. A bank may report a net
deferred tax debit, or asset, for one tax jurisdiction, and
also report at the same time a net deferred tax credit or
liability, for another tax jurisdiction.
Deferred tax liabilities are recognized for taxable
temporary differences. For example, depreciation can
result in a taxable temporary difference if a bank uses the
straight-line method to determine the amount of
depreciation expense to be reported in the Call Report but
uses an accelerated method for tax purposes. In the early
years, tax depreciation under the accelerated method will
typically be larger than book depreciation under the
straight-line method. During this period, a taxable
temporary difference originates. Tax depreciation will be
less than book depreciation in the later years when the
temporary difference reverses. Other taxable temporary
differences include the undistributed earnings of
unconsolidated subsidiaries and associated companies and
amounts funded to pension plans that exceed the recorded
expense.
Additional information on premises and leases is included
in the Premises and Equipment section of this Manual.
Accrued Expenses
Expenses are also reported in the Call Report on the
accrual basis of accounting that records revenues when
realized or realizable and earned, and expenses when
incurred. This attempt to match expenses incurred during
a period to the revenues that they helped generate is
known as the matching principle. At the end of each
reporting period, but no less frequently than quarterly,
bank management needs to make appropriate entries to
record accrued expenses. Interest on deposits accrued
through charges to expense during the current or prior
periods, but not yet paid or credited to a deposit account,
are reported as other liabilities in the Call Report.
Likewise, the amount of income taxes, interest on
nondeposit liabilities, and other expenses accrued through
charges to expense during the current or prior periods, but
not yet paid, are reported as other liabilities.
Allowance for Off-Balance Sheet Exposures
Each bank should maintain, as a separate liability account,
an allowance at a level that is appropriate to cover
estimated credit losses associated with off-balance sheet
credit instruments such as loan commitments, standby
letters of credit, and guarantees. This separate allowance
should be reported as an other liability, not as part of the
allowance for loan and lease losses. The allowance for
credit losses on off-balance sheet exposures should meet
the criteria for accrual of a loss contingency set forth in
generally accepted accounting principles.
Servicing Liabilities
As noted under Servicing Assets, servicers typically
receive certain benefits from a servicing contract and incur
costs of servicing the assets. The accounting and reporting
standards addressing servicing rights (i.e., assets and
liabilities) are set forth in ASC 860-50. Servicing
liabilities result from contracts to service financial assets
for which the benefits of servicing are not expected to
adequately compensate the servicer. Banks must initially
measure a servicing liability at fair value and subsequently
measure each class of servicing liabilities using either the
amortization method or the fair value measurement
method. The election of the subsequent measurement
method should be made separately for each class of
servicing liabilities. Refer to the Call Report Instructions
for further details.
RMS Manual of Examination Policies
Federal Deposit Insurance Corporation
All Other Miscellaneous Liabilities
Examiners will encounter other miscellaneous liabilities
not reported in major Balance Sheet or Other Liability
categories that should be reported separately in all other
liabilities in the Call Report. Examples include accounts
payable, deferred compensation payable, dividends
declared but not yet paid, and derivative instruments held
for purposes other than trading that have a negative fair
value.
3.7-9
Other Assets and Other Liabilities (3/12)
OFF-BALANCE SHEET ACTIVITIES
INTRODUCTION
OFF-BALANCE SHEET
LENDING ACTIVITIES
Off-balance sheet activities encompass a variety of items
including certain loan commitments, certain letters of
credit, and revolving underwriting facilities. Additionally,
swaps, futures, forwards, and option contracts are
derivative instruments whose notional values are carried
off-balance sheet, but whose fair values are recorded on the
balance sheet. Examiners reviewing off-balance sheet
derivative contracts will find resources such as the Capital
Markets Handbook, the Consolidated Reports of Condition
and Income (Call Report) Instructions, Senior Capital
Markets Specialists, and capital markets and accounting
subject matter experts helpful.
An evaluation of off-balance sheet lending activities should
apply the same general examination techniques that are
used in the evaluation of a direct loan portfolio. For
example, banks with a material level of contingent
liabilities should have written policies addressing such
activities adopted and approved by their board of directors.
The policies should cover credit underwriting standards,
documentation and file maintenance requirements,
collection and review procedures, officer and customer
borrowing and lending limits, exposures requiring
committee or board approval, and periodic reports to the
board of directors. Overall limits on these contingent
liabilities and specific sub-limits on the various types of
off-balance sheet lending activities, either as a dollar
amount or as a relative percentage (such as a percent of
total assets or capital), should also be considered.
Off-balance sheet fee producing activities can improve
earnings ratios, at a faster pace than on-balance sheet fee
producing activities. Earnings ratios typically use assets as
a component.
Since earnings generated from these
activities are included in income, while total asset balances
are not affected, ratios appear higher than they would if the
income was derived from on-balance sheet activities.
Because these types of activities remain off the balance
sheet, capital to asset ratios (with the exception of riskbased capital ratios) are not adversely affected regardless
of the volume of business conducted. But, the volume and
risk of the off-balance sheet activities needs to be
considered by the examiner in the evaluation of capital
adequacy. Regulatory concern with off-balance sheet
activities arises since they subject a bank to certain risks,
including credit risk. Many of the risks involved in these
off-balance sheet activities are indeterminable on an
offsite-monitoring basis.
In reviewing individual credit lines, all of a customer's
borrowing arrangements with the bank (e.g., direct loans,
letters of credit, and loan commitments) should be
considered. Additionally, many of the factors analyzed in
evaluating a direct loan (e.g., financial performance, ability
and willingness to pay, collateral protection, future
prospects) are also applicable to the review of such
contingent liabilities as letters of credit and loan
commitments. When analyzing these off-balance sheet
lending activities, examiners should evaluate the
probability of draws under the arrangements and whether
an allowance adequately reflects the risks inherent in offbalance sheet lending activities. (Such allowances should
not be included in the allowance for loan and lease losses
(ALLL) since off-balance sheet items are not included
within the scope of FAS 5 and 114.) Allowances for offbalance sheet items should be made to "Other liabilities."
Consideration should also be given to legal lending limits,
including the provision of Part 337 of the FDIC Rules and
Regulations, which generally requires standby letters of
credit to be included when determining any legal limitation
on loans to one borrower.
OFF-BALANCE SHEET ITEMS
AND DERIVATIVES
Accounting treatment for derivatives activities is largely
governed by Statement of Financial Accounting Standard
No. (FAS) 133, Accounting for Derivative Instruments and
Hedging Activities, and FAS 149, Amendment of
Statement 133. In general terms, FAS 133 provides that
derivative contracts must be reported at fair value on the
balance sheet. Prior to the issuance of FAS 133,
accounting standards generally allowed derivative
contracts to be carried off-balance sheet.
Letters of Credit
A letter of credit is a document issued by a bank on behalf
of its customer authorizing a third party to draw drafts on
the bank up to a stipulated amount and with specified terms
and conditions. The letter of credit is a conditional
commitment (except when prepaid by the account party) on
the bank’s part to provide payment on drafts drawn in
accordance with the document terms. There are four basic
types of letters of credit: travelers, those sold for cash,
commercial, and standby.
General guidance regarding the risks involved with
derivatives instruments and the proper recording and
accounting are outlined below. Expanded guidance is
delineated in the Capital Markets Handbook and the Call
Report Glossary and the instructions for RC-L –
Derivatives and Off-Balance Sheet Items.
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Section 3.8
3.8-1
Off-Balance Sheet Activities (12-04)
OFF-BALANCE SHEET ACTIVITIES
While no particular form is required for a SBLC, it should
contain certain descriptive information. First, there should
be a separate binding agreement wherein the account party
agrees to reimburse the bank for any payments made under
the SBLC. The actual letter should be labeled as a
"standby letter of credit," be limited in amount, cover a
specific time period, and indicate the relevant information
that must be presented to the bank before any draws will be
honored due to the account party's failure to perform.
Since the bank is not a party to the contract between the
account party and the beneficiary, the SBLC should not be
worded so as to involve the bank in making determinations
of fact or law at issue between the parties.
Travelers – A travelers letter of credit is addressed by the
bank to its correspondents authorizing drafts by the person
named in accordance with specified terms. These letters
are generally sold for cash.
Sold for Cash – When a letter of credit is sold for cash,
the bank receives funds from the account party at the time
of issuance. This letter is not reported as a contingent
liability, but rather as a demand deposit.
Commercial – A commercial letter of credit is issued
specifically to facilitate trade or commerce. Generally,
drafts will be drawn when the underlying transaction is
consummated as intended. Commercial letters of credit not
sold for cash do, however, represent contingent liabilities
and should be accorded examination treatment as such.
Refer to the International Banking section of this Manual
for further details on commercial letters of credit.
The two primary areas of risk relative to SBLCs are credit
risk (the possibility of default on the part of the account
party), and funding risk (the potential inability of the bank
to fund a large draw from normal sources). An SBLC is a
potential extension of credit and should be evaluated in a
manner similar to evaluating a direct loan. The risk could
be significant under an SBLC given its irrevocable nature,
especially if the SBLC is written for an extended time
period. Deterioration in the financial position of a
customer could allow for a direct loan commitment to be
rescinded if the commitment contained a "material adverse
change" clause; however, such would not be applicable
with an SBLC since it is an irrevocable agreement between
the bank and the beneficiary. Some SBLCs may have an
automatic renewal provision and will roll over until notice
of cancellation is given by either the bank or beneficiary
prior to a maturity date. However, notice given by the
bank usually allows the beneficiary to draw under the letter
irrespective of whether the account party is performing.
Standby – A standby letter of credit (SBLC) is an
irrevocable commitment on the part of the issuing bank to
make payment to a designated beneficiary. It obligates the
bank to guarantee or stand as surety for the benefit of a
third party. SBLCs can be either financial-oriented, where
the account party is to make payment to the beneficiary, or
performance-oriented, where a service is to be performed
by the account party. SBLCs are issued for a variety of
purposes, such as to improve the credit ratings for issuers
of industrial development revenue bonds and commercial
paper; to provide back-up facilities for loans granted by
third parties; to assure performance under construction and
employment contracts; and to ensure the account party
satisfies financial obligations payable to major suppliers or
under tax shelter programs.
SBLCs, like loans, can be participated and syndicated.
Unlike loans, however, the sale of SBLC participations
does not diminish the total contingent liability of the
originating bank. The name of the originating bank is on
the actual letter of credit, and it must therefore honor all
drafts whether or not the participants are willing or able to
disburse their pro rata share. Syndications, on the other
hand, represent legal apportionments of liability. If one of
the banks fails to fulfill its obligation under the SBLC, the
remaining banks are not liable for that bank's share.
FASB Interpretation No. (FIN) 45, Guarantor’s
Accounting and Disclosure Requirements of Guarantees,
Including Indirect Guarantees of Indebtedness of Others,
clarifies that a guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the
obligation undertaken in issuing the guarantee. FIN 45
applies to standby letters of credit, both financial and
performance.
Commercial letters of credit are not
considered guarantees, and therefore, are not subject to
FIN 45.
Section 337.2(d) of the FDIC Rules and Regulations
requires banks to maintain adequate controls and
subsidiary records of SBLCs comparable to records
maintained on direct loans so that a bank's total liability
may be determined at all times. Banks are also required to
adequately reflect all SBLCs on published financial
statements. Credit files should be kept current as to the
status of SBLCs, and reports should be provided on a
regular basis to the directors on the volume of standby
letters, with a breakdown by type, as well as by industry.
An SBLC differs from a commercial letter of credit in that
the latter facilitates the sale of goods and is expected to be
drawn upon by the beneficiary in the normal course of
business, whereas the SBLC is not, generally, expected to
be used unless the account party defaults in meeting an
obligation to the beneficiary.
Off-Balance Sheet Activities (12-04)
Section 3.8
3.8-2
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OFF-BALANCE SHEET ACTIVITIES
Section 3.8
This report will enable any concentrations to be monitored
so that steps can be taken to reduce any undue exposure
should economic or financial trends so dictate.
cancelable if the customer's financial condition
deteriorates, while others are simply subject to cancellation
at the bank’s option.
It may be appropriate to adversely classify or Special
Mention an SBLC if draws under the SBLC are probable
and credit weaknesses exist. For example, deterioration in
the account party’s financial standing could jeopardize
performance under the letter of credit and result in a draw
by the beneficiary. If a draw under an SBLC were to
occur, the offsetting loan to the account party could then
become a collection problem, especially if it was
unsecured.
Disagreements can arise as to what constitutes a legally
binding commitment on the part of the bank. Descriptive
terminology alone, as used by the bank, might not always
be the best guideline. For example, a credit arrangement
could be referred to as a revocable line of credit, but at the
same time may be a legally binding commitment to lend,
especially if consideration has been given by the customer
and if the terms of the agreement between the parties result
in a contract. It is important to identify the extent of the
bank’s legally binding and revocable commitments to
ensure that obligations are properly documented and
legally defensible should the bank contemplate canceling a
loan commitment.
Loan Commitments
A formal loan commitment is a written agreement, signed
by the borrower and lender, detailing terms and conditions
under which a loan of up to a specified amount will be
made. The commitment will have an expiration date and,
for agreeing to make the accommodation, the bank may
require a fee to be paid and/or require the maintenance of a
stipulated compensating balance by the customer. A
commitment can be irrevocable, like an SBLC facility,
operating as an unconditional guarantee by the bank to lend
when called upon to do so by the customer. In many
instances, however, commitments are conditioned on the
maintenance of a satisfactory financial standing by the
customer and the absence of default in other covenants. A
bank may also enter into an agreement to purchase loans
from another institution, which should be reflected as offbalance sheet items, until the sale is consummated. Loan
commitments intended for sale are covered under
Mortgage Banking later in this Section.
Credit documentation frequently contains a "material
adverse change" (MAC) clause, which is intended to allow
the bank to terminate the commitment or line of credit
arrangement if the customer's financial condition
deteriorates. The extent to which MAC clauses are
enforceable depends on whether a legally binding
relationship continues to exist when specific financial
covenants are violated. Although the enforceability of
MAC clauses may be subject to some uncertainty, such
clauses may provide the bank with leverage in negotiations
with the customer over such issues as requests for
additional collateral or personal endorsements.
Whether funding of a commitment or line of credit will be
required cannot always be determined in a routine manner
and careful analysis will frequently be necessary. A MAC
clause could allow the bank to refuse funding to a
financially troubled borrower, or a covenant default might
also be a means of canceling the commitment or line of
credit. Some banks might refuse funding if any covenant is
broken, whereas others might take a more accommodating
approach and make advances short of a bankruptcy
situation. The procedure followed by the bank in acceding
to or denying take down requests where adverse conditions
have arisen is an important consideration in the examiner's
overall evaluation of credit risk.
Some commitments are expected to be used, such as a
revolving working capital line for operating purposes or a
term loan facility wherein the proceeds will be used for
such purposes as equipment purchases, construction and
development of property, or acquisitions of other
companies. Other commitments serve as backup facilities,
such as for a commercial paper issue, whereby usage
would not be anticipated unless the customer was unable to
retire or roll over the issue at maturity.
In assessing the adequacy of a bank's asset/liability
management program, it is important to evaluate the
anticipated funding of loan commitments and lines of
credit relative to anticipated funding sources. At each
examination, the amount of funding that is anticipated for
unused commitments and disclosed lines of credit should
be estimated. If the amount is large relative to the bank's
liquidity position, completion of the Cash Flow Projection
workpaper may be useful to give an indication of cash
availability and whether borrowings will be needed to meet
Less detailed than a formal loan commitment, is a line of
credit, which expresses to the customer, usually by letter, a
willingness to lend up to a certain amount over a specified
time frame, frequently one-year in duration. These lines of
credit are disclosed to the customer and are referred to as
"advised" or "confirmed" lines, in contrast to "guidance"
lines, which are not made known to the customer, but are
merely used by the bank as lending guidelines for internal
control and operational purposes. Many lines of credit are
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Federal Deposit Insurance Corporation
3.8-3
Off-Balance Sheet Activities (12-04)
OFF-BALANCE SHEET ACTIVITIES
anticipated draws. For further information, refer to the
Liquidity and Funds Management section of this Manual.
repurchasing these assets in order to evaluate the degree of
risk involved. Contingent liabilities may result if the bank,
as seller of a loan participation without recourse, does not
comply with participation and/or loan agreement
provisions. Noncompliance may result from a number of
factors, including failure on the part of the selling
institution to receive collateral and/or security agreements,
obtain required guarantees, or notify the purchasing party
of default or adverse financial performance on the part of
the borrower. The purchaser of the participation may also
assert claims against the bank on the basis that the financial
information relied upon when acquiring the loan was
inaccurate, misleading, or fraudulent and that the bank as a
seller was aware of this fact. Therefore, a certain degree of
risk may in fact be evident in participation loans sold
without recourse. Examiners need to be mindful of this
possibility and the financial consequences it may have on
the bank. Further discussion of loan participations is
contained in the Loans section of this Manual.
OFF-BALANCE SHEET ASSET
TRANSFERS
Mortgage Banking
Under FAS 149, Amendment of Statement 133, loan
commitments that relate to the origination or purchase of
mortgage loans that will be held for sale, commonly
referred to as interest rate lock commitments, must be
accounted for as derivatives by the issuers of the
commitment. Interest rate lock commitments include
floating and fixed rate commitments to fund loans intended
for sale. Since they are derivatives, interest rate lock
commitments must be fair valued and accounted for on the
general ledger. Mortgage loan commitments (both floating
and fixed rate) that must be accounted for as derivative
instruments are considered over-the-counter written
interest rate options. The total notional amount of loan
commitments held for sale is typically reported in RC-L
Derivatives and Off-Balance Sheet Items within the
category for Gross Amounts of Derivatives.
Assets Sold With Recourse
Assets transferred in transactions that do not qualify as
sales under GAAP remain as balance sheet assets. For
example, loan transfers that do not qualify for sale
treatment would remain on the balance sheet and the
proceeds raised from transfer are reflected as a secured
borrowing with pledge of collateral.
Many times the bank will originate a forward contract to
sell loans (which could be mandatory delivery, best efforts,
or private-label securitization) with investors. In addition
to the held for sale loan commitment that is accounted for
as a derivative, the bank must account for the forward
contract to sell loans. Institutions cannot offset derivatives
with negative fair values against those with positive fair
values, unless the criteria for “netting” under generally
accepted accounting procedures (GAAP) have been
satisfied.
Assets (including loans) sold with recourse may qualify
for sale treatment under FAS 140, Accounting for
Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, if certain criteria are met.
Under FAS 140, a transfer of financial assets is accounted
for as a sale if the transferor surrenders control over those
assets and receives consideration other than an interest in
the transferred assets. Control is evaluated using three
criteria: legal isolation of the financial assets from the
transferor (purported seller); the ability of the transferee
(investor) to pledge or sell the assets; and the absence of a
right or obligation of the transferor to repurchase the
financial assets.
Commitments to originate mortgage loans that will be held
for investment purposes and commitments to originate
other types of loans are not considered derivatives.
Unused portions of loan commitments that are not
considered derivatives should continue to be reported as
off-balance sheet items.
If the asset transfer (e.g., a loan sale) qualifies as a sale
under FAS 140, the asset may be removed from the general
ledger. However, if an asset transfer, which qualifies for
sale treatment under GAAP, contains certain recourse
provisions, the transaction would be treated as an asset sale
with recourse for purposes of reporting risk-based capital
information in Schedules RC-R and RC-S within the Call
Report.
In those circumstances, examiners need to
consider the recourse attributes when calculating riskbased capital. When reviewing assets sold with recourse,
examiners should refer to the Call Report Glossary under
Assets Sold Without Recourse
Assets (including loans) sold without recourse are
generally not a contingent liability. In the case of
participations, the bank should reflect on the general ledger
only that portion of participated loans it retained.
However, some banks may follow the practice of
repurchasing loan participations and absorbing any loss on
such loans even when no legal responsibility exists. It is
necessary to determine management's attitude toward
Off-Balance Sheet Activities (12-04)
Section 3.8
3.8-4
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OFF-BALANCE SHEET ACTIVITIES
Section 3.8
Sales of Assets for Risk-Based Capital Purposes, FAS 140,
and Part 325 of the FDIC Rules and Regulations.
is contained in the International Banking section of this
Manual under the heading Forms of International Lending.
Recourse and Direct Credit Substitutes
Revolving Underwriting Facilities
A recourse obligation or direct credit substitute typically
arises when an institution transfers assets in a sale and
retains an obligation to repurchase the assets or absorb
losses due to a default of principal or interest or any other
deficiency in the performance of the underlying obligor or
some other party. Recourse may also exist implicitly
where a bank provides credit enhancement beyond any
contractual obligation to support assets it sold.
A revolving underwriting facility (RUF) (also referred to as
a note issuance facility) is a commitment by a group of
banks to purchase at a fixed spread over some interest rate
index, the short-term notes that the issuer/borrower is
unable to sell in the Euromarket at or below this
predetermined rate. In effect, the borrower anticipates
selling the notes as funds are needed at money market
rates, but if unable to do so, has the assurance that credit
will be available under the RUF at a maximum spread over
the stipulated index. A lead bank generally arranges the
facility and receives a one-time fee, and the RUF banks
receive an annual commitment or underwriting fee. When
the borrower elects to draw down funds, placement agents
arrange for a sale of the notes and normally receive
compensation based on the amount of notes placed. The
notes usually have a maturity range of 90 days to one-year
and the purchasers bear the risk of any default on the part
of the borrower. There are also standby RUFs, which are
commitments under which Euronotes are not expected to
be sold in the normal course of the borrower's business.
When an examiner encounters recourse arrangements or
direct credit substitutes (commonly found in securitization
and mortgage banking operations), they should refer to the
outstanding Financial Institution Letters, Call Report
guidance, Part 325 of the FDIC Rules and Regulations, and
FAS 133 and 140.
OFF-BALANCE SHEET
CONTINGENT LIABILITIES
Asset-Backed Commercial Paper Programs
Inability to sell notes in the Euromarket could be the result
of a financial deterioration on the part of the borrower, but
it could also be due to volatile short-term market
conditions, which precipitate a call by the borrower on the
participating banks for funding under the RUF
arrangement. The evaluation of RUFs by the examiner will
follow the same procedures used for the review of loan
commitments.
An adverse classification should be
accorded if it is determined that a loan of inferior quality
will have to be funded under a RUF.
Asset-backed commercial paper programs are usually
carried out through a bankruptcy-remote, special-purpose
entity, which generally is sponsored and administered by a
bank to provide funding to its corporate customers. Some
programs will qualify for consolidation onto a bank’s
general ledger. For programs that are not consolidated, a
bank should report the credit enhancements and liquidity
facilities it provides to the programs as off-balance sheet
liabilities.
Bankers Acceptances
ADVERSELY CLASSIFIED
CONTINGENT LIABILITIES
The following discussion refers to the roles of accepting
and endorsing banks in bankers acceptances. It does not
apply to banks purchasing other banks' acceptances for
investment purposes, which is described in the Other
Assets and Liabilities section of this Manual. Bankers
acceptances may represent either a direct or contingent
liability of the bank. If the bank creates the acceptance, it
constitutes a direct liability that must be paid on a specified
future date. If a bank participates in the funding risk of an
acceptance created by another bank, the liability resulting
from such endorsement is only contingent in nature. In
analyzing the degree of risk associated with these
contingent liabilities, the financial strength and repayment
ability of the accepting bank should be taken into
consideration. Further discussion of bankers acceptances
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
For examination purposes, Category I contingent liabilities
are defined as those which will give rise to a concomitant
increase in bank assets if the contingencies convert into
actual liabilities. Such contingencies should be evaluated
for credit risk and if appropriate, listed for Special Mention
or subjected to adverse classification. This examination
treatment does not apply to Category II contingent
liabilities where there will be no equivalent increase in
assets if a contingency becomes a direct liability.
Examination treatment of Category II contingencies is
covered under Contingent Liabilities in the Capital section
of this Manual.
3.8-5
Off-Balance Sheet Activities (12-04)
OFF-BALANCE SHEET ACTIVITIES
Section 3.8
Classification of Category I contingencies is dependent
upon two factors: the likelihood of the liability becoming
direct and the credit risk of the potential acquired asset.
Examiners should refer to the Report of Examination
Instructions and the Bank of Anytown contained in this
Manual for Report of Examination treatment when
adversely classifying or special mentioning contingent
liabilities.
Adverse classification and Special Mention definitions for
direct loans are set forth in the Loans section of this
Manual. The following adverse classification and Special
Mention criteria should be viewed as a supplement to those
definitions and considered when evaluating contingent
liability credit risk.
Special Mention – The chance of the contingency
becoming an actual liability is at least reasonably possible,
and the potentially acquired assets are considered worthy
of Special Mention. An example would be the undrawn
portion of a poorly supervised accounts receivable line
where the drawn portion is listed for Special Mention.
Substandard – The chance of the contingency becoming
an actual liability is at least reasonably possible, and the
potentially acquired assets are considered no better than
Substandard quality.
Undisbursed loan funds in a
speculative real estate venture in which the disbursed
portion is classified Substandard and the probability of the
bank acquiring the underlying property is high, would be
an example of a Substandard contingency.
Doubtful – The chance of the contingency becoming an
actual liability is probable, and the potentially acquired
assets are considered of Doubtful quality. Undisbursed
loan funds on an incomplete construction project wherein
cost overruns or diversion of funds will likely result in the
bank sustaining significant loss from disposing the
underlying property could be an example of a Doubtful
contingency.
Loss – The chance of the contingency becoming an actual
liability is probable, and the potentially acquired assets are
not considered of bankable quality. A letter of credit on
which the bank will probably be forced to honor draws that
are considered uncollectible is an example of a Loss
contingency. A Loss classification normally indicates that
a balance sheet liability (specific reserve) should be
established to cover the estimated loss. For further
information as to when a contingency should be reflected
as a direct liability on the balance sheet, refer to FAS 5,
Accounting for Contingencies.
Off-Balance Sheet Activities (12-04)
3.8-6
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confidence. It is this latter attribute and the public
accountability implicit therein that distinguishes the office
of bank director from directorships in most other corporate
enterprises. Bank directors are not only responsible to the
stockholders who elected them, but must also be concerned
with the safety of depositors' funds and the influence the
bank exercises on the community it serves.
INTRODUCTION
The quality of management is probably the single most
important element in the successful operation of a bank.
For purposes of this section, management includes both the
board of directors, which is elected by the shareholders,
and executive officers, who are appointed to their positions
by the board. In the complex, competitive, and rapidly
changing environment of financial institutions, it is
extremely important for all members of bank management
to be aware of their responsibilities and to discharge those
responsibilities in a manner which will ensure stability and
soundness of the institution, so that it may continue to
provide to the community the financial services for which
it was created.
Various laws governing the election of board members
emphasize the importance of a director’s position.
Statutory or regulatory qualifications usually include taking
an oath of office, unencumbered ownership of a specific
amount of the bank's capital stock, and residential and
citizenship requirements. Other laws also pertain to the
qualification and selection of directors. There are, for
example, certain restrictions, prohibitions, and penalties
relating to: interlocking directorates; purchases of assets
from or sales of assets to directors; commissions and gifts
for procuring loans; and criminal activities such as
embezzlement, abstraction, willful misapplication, making
false entries, and improper political contributions. These
qualifications and restrictions have no counterpart in
general corporate law and both illustrate and emphasize the
quasi-public nature of banking, the unique role of the bank
director, and the grave responsibilities of that office. The
position of bank director is one, therefore, not to be offered
or entered into lightly.
The extreme importance of a bank director's position is
clearly emphasized by the fact that bank directors can, in
certain instances, be held personally liable. Also, Congress
has placed great emphasis on the role of bank management
by passing legislation which allows regulatory authorities
to utilize "cease and desist" actions against individuals
(instead of solely against the institution) to assess civil
money penalties (CMPs), and even remove an officer,
director, or other person participating in the affairs of the
bank when their gross negligence or disregard for safety
and soundness considerations threatens the financial safety
of the bank.
Aside from the legal qualifications, each director should
bring to the position particular skills and experience which
will contribute to the composite judgment of the group.
Directors should have ideas of their own and the courage to
express them, sufficient time available to fulfill their
responsibilities, and be free of financial difficulties which
might tend to embarrass the bank. The one fundamental
and essential attribute, which all bank directors must
possess without exception, is personal integrity. Its
presence usually gives assurance of a well-intentioned,
interested and responsible director capable of assuming the
important fiduciary responsibilities of the office and
representing fairly and equitably the diverse interests of
stockholders, depositors and the general public. The
Statement Concerning the Responsibilities of Bank
Directors and Officers states that the duties of loyalty (to
administer the affairs of the bank with candor, personal
honesty and integrity) and care (to act as prudent and
diligent business persons in conducting the affairs of the
bank) are among the most important responsibilities of
bank directors. Other desirable personal characteristics
include: knowledge of the duties and responsibilities of the
office; genuine interest in performing those duties and
responsibilities to the best of their ability; capability to
recognize and avoid potential conflicts of interest, or the
appearance of same, which might impair their objectivity;
sound business judgment and experience to facilitate
The board of directors is the source of all authority and
responsibility.
In the broadest sense, the board is
responsible for formulation of sound policies and
objectives of the bank, effective supervision of its affairs,
and promotion of its welfare. On the other hand, the
primary responsibility of executive management is
implementation of the board's policies and objectives in the
bank's day-to-day operations.
While selection of
competent executive management is critical to the
successful operation of any bank, the continuing health,
viability, and vigor of the bank are dependent upon an
interested, informed and vigilant board of directors.
Therefore, the main thrust of this section is devoted to the
powers, responsibilities, and duties vested in bank
directors.
MANAGEMENT/DIRECTORS
Selection and Qualifications of Directors
Being selected to serve as a bank director is generally
regarded as an honor, for it often denotes an individual's
reputation as being successful in business or professional
endeavors, public spirited, and entitled to public trust and
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MANAGEMENT
Section 4.1
understanding of banking and banking problems;
familiarity with the community and trade area the bank
serves and general economic conditions; and an
independence in their approach to problem solving and
decision making.
scope and complexity of their operations. Therefore, it
remains the FDIC's strongly held belief that all banks
should have written policies which are readily understood
by all affected parties, kept up-to-date, and relevant to the
institution's needs and circumstances.
While it is
acceptable for a bank to obtain written policies from an
outside source, it is the responsibility of management to
ensure that the policies are suited to their bank and that the
policies accurately describe the bank's practices. The
board of directors should give final approval of the
substantial content of policies.
Powers, Duties and
Responsibilities of Directors
The powers, duties and responsibilities of the board of
directors are usually set forth in the applicable banking
statutes and the bank's charter and bylaws. Generally
speaking, the powers and responsibilities of bank directors
include but are not limited to those discussed below.
The policies and objectives of the directorate should
include provisions for adherence to the Interagency
Guidelines Establishing Standards for Safety and
Soundness set forth in Part 364, Appendix A, of the FDIC
Rules and Regulations. These standards set specific
guidelines for the safe operation of banks in the following
areas: internal controls and information systems; internal
audit system; loan documentation; credit underwriting;
interest rate exposure; asset growth; asset quality; earnings;
and compensation, fees, and benefits. The specific
provisions for each area are discussed in further detail
within the appropriate sections of this DSC Risk
Management Manual of Examination Policies (Manual).
Conformance to these standards may help identify
emerging problems and correct deficiencies before capital
becomes impaired. The standards, which should be viewed
as minimum requirements, establish the objectives of
proper operations and management, but leave specific
methods of achieving these objectives to each institution.
Regulating the Manner in Which
All Business of the Bank is Conducted
Directors must provide a clear framework of objectives and
policies within which executive officers operate and
administer the bank's affairs. These objectives and policies
should, at a minimum, cover investments, loans,
asset/liability and funds management, profit planning and
budgeting, capital planning, internal routine and controls,
audit programs, conflicts of interest, code of ethics, and
personnel. Specialty areas, such as the Bank Secrecy Act
(BSA), Information Technology (IT), Trust Department
activities, and consumer compliance should also be subject
to similar appropriate oversight and internal guidelines.
Objectives and policies in most instances should be written
and reviewed periodically to determine that they remain
applicable. Examiners may encounter situations (often in
smaller banks with control vested in one or a few
individuals) where written policies have not been
developed for these operational functions, and management
is reluctant to do so on the grounds that such written
guidelines are unnecessary. To a considerable degree, the
necessity for written policies may be inferred from the
results achieved by management. That is, if the examiner's
assessment of the bank reflects that it is sound and healthy
in virtually every important respect, it may be difficult to
convince management of the need for formalized written
policies. However, when deficiencies are noted in one or
more aspects of a bank's operations, it is nearly always the
case that absence of written and clearly defined objectives,
goals, performance standards, and limits of authority is an
important contributing factor. There are few better means
of ensuring that directors are properly supervising the
bank's affairs than by their direct participation in devising,
enforcing, and modifying the institution's written
guidelines on such matters as investments, loans,
marketing, capital and profit planning. Moreover, it is
recognized that the depth and detail of written policies may
properly vary among banks, depending on the nature,
Management (12-04)
Examiners should review the bank’s conformance to the
safety and soundness standards at each examination. The
nature, scope and risk of the institution’s activities should
be considered when evaluating the adequacy of controls in
each of the respective areas. Material deficiencies should
be documented in appropriate sections of the Report of
Examination.
Corporate Planning
A vital part of the responsibilities of directors is to set the
future direction of the bank. Planning, organizing, and
controlling are three fundamental dimensions of
management. Planning, however, had not been a priority
concern for a large part of the banking industry. This may
have been due in part to the fact that the industry has
historically been highly regulated and somewhat insulated
from competitive pressures and sudden change. Dramatic
changes in the structure, volatility and technology
associated with the financial services market altered this
situation and led to an emphasis on deregulating financial
institutions.
Increased competition and innovation
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Section 4.1
consequently produced an environment characterized by
uncertainty.
Personnel Administration
Sound planning is indispensable in dealing with this
uncertainty and rapid change. In order to be effective,
planning must be dynamic, carefully attended to, and well
supported. Projections must be revised periodically as
circumstances change and new strategies devised to meet
stated objectives. An increasingly competitive marketplace
suggests that an inadequate or ill-conceived planning
process may be as much the cause of bank failure as poor
loans.
Recruiting, training, and personnel activities are vital to the
development and continuity of a quality staff. Some
features of good personnel administration are a designated
organization structure, detailed position descriptions,
carefully planned recruiting, appropriate training and
developmental activities, a performance appraisal system,
quality salary administration, and an effective
communications network.
Honestly and Diligently Administering
the Affairs of the Bank
The adequacy of a bank's planning process may be judged
by considering questions such as:
•
•
•
•
•
The board of directors is charged with the responsibility of
conducting the affairs of the bank. It is not expected to
directly carry out details of the bank's business; these may
be delegated to senior officers. But they may not be
delegated and forgotten. The power to manage and
administer carries with it the duty to supervise; therefore,
directors must periodically examine the system of
administration they have established to see that it functions
properly. Should it become obsolete, it should be
modernized, or should the bank's officers fail to function as
intended, the cause(s) should be determined and
corrections made.
How formal is the bank's planning process?
Who is involved? The board? Middle management?
Is the plan based on realistic assumptions regarding
the bank's present and future market area(s) and
nontraditional competitive factors?
Does the bank monitor actual performance against its
plan?
Does the bank consider alternative plans in response to
changing conditions?
Although the focus must be on an evaluation of the
process, the plan itself cannot be ignored if, in the
examiner's judgment, the plan is predicated on assumptions
which are inappropriate or unrealistic. This assessment
must take into account the personnel and financial
resources and operating circumstances and conditions
unique to the bank being examined. It is emphasized that
plotting the future direction of the institution is, properly,
the responsibility of the board of directors and not
examiners. However, when the goals and objectives
chosen by directors are likely to result in significant
financial harm to the bank, examiners must identify the
deficiencies in the plan and attempt to effect necessary
changes.
Observance of Applicable Laws
It is important for directors to ensure that executive
management is cognizant of applicable laws and
regulations; develop a system to effect and monitor
compliance, which will likely include provisions for
training and retraining personnel in these matters; and,
when violations do occur, make correction as quickly as
possible. Board members cannot be expected to be
personally knowledgeable of all laws and regulations, but
they should make certain that compliance with all laws and
regulations receives high priority and violations are not
knowingly committed by themselves or anyone the bank
employs.
Absence of a satisfactory planning process or glaring
weaknesses in the plan itself must be considered in the
appraisal of bank management.
Avoiding Self-Serving Practices
Appointing, Dismissing at Pleasure,
and Defining the Duties of Officers
Although somewhat independent from the responsibility to
provide effective direction and supervision, the need for
directors to avoid self-serving practices and conflicts of
interest is of no less importance. Bank directors must
place performance of their duties above personal concerns.
Wherever there is a personal interest of a director that is
adverse to that of the bank, the situation clearly calls for
the utmost fairness and good faith in guarding the interests
of the bank. Accordingly, directors must never abuse their
It is a primary duty of a board of directors to select and
appoint executive officers who are qualified to administer
the bank's affairs effectively and soundly. It is also the
responsibility of the board to dispense with the services of
officers who prove unable to meet reasonable standards of
executive ability and efficiency.
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Management (12-04)
MANAGEMENT
Section 4.1
influence with bank management for personal advantage,
nor wrongfully employ confidential information
concerning the bank's clients. The same principles with
respect to self-serving practices and conflicts of interest
apply to the executive management of the bank.
sources regarding economic conditions, characteristics of
the marketplace and competition, technology, and legal
regulatory requirements. Quality, quantity and timeliness
are factors that determine the effectiveness of management
information systems.
Paying Such Dividends as
May Properly Be Paid
Supervision by Directors
Supervision by directors does not necessarily indicate a
board should be performing management tasks, but rather
ensuring that its policies are being implemented and
adhered to and its objectives achieved. It is the failure to
discharge these supervisory duties, which has led to bank
failures and personal liability of directors for losses
incurred.
The board of directors has the responsibility of maintaining
an adequately capitalized bank, and once this responsibility
has been satisfied, the payment of dividends can and
should receive consideration. Dividends represent the
distribution of bank earnings to owners. Establishing the
medium, rate, and date of payment must be based on the
directors' overall assessment of the bank's financial
condition.
Directors' supervisory responsibilities can best be
discharged by establishing procedures calculated to bring
to their attention relevant and accurate information about
the bank in a consistent format and at regular intervals.
From this critical point, the remainder of a director's job
unfolds. Directors who keep abreast of basic facts and
statistics such as resource growth, capital growth,
loan-to-deposit ratios, deposit mix, liquidity position,
general portfolio composition, loan limits, loan losses and
recoveries, delinquencies, etc., have taken a first,
indispensable step in discharging their responsibilities. It
is essential, therefore, that directors insist on receiving
pertinent information about the bank in concise,
meaningful and written form, and it is one of executive
management's most important responsibilities to make
certain directors are kept fully informed on all important
matters and that the record clearly reflects this.
Appropriate Internal Control System and
Adequate Auditing Program
A sound framework of internal controls and a reliable and
objective audit function are essential tools for bank
directors. The existence of such enable directors to remain
well informed of the adequacy, effectiveness, and
efficiency of accounting, operating, and administrative
controls and provide an assessment of the quality of
ongoing operations. Establishment and oversight of such
controls is the responsibility of the board of directors.
Refer to the Internal Routines and Controls section for a
complete discussion of these vital areas.
Management Information System (MIS)
Directors' meetings that are conducted in a businesslike
and orderly manner are a significant aid to fulfillment of
the board's supervisory responsibilities. This requires,
among other things, regular attendance (whether by actual
or audio, video or other remote access). Absence without
just cause is, like ignorance, not a valid defense.
Moreover, a director's attendance should be an informed
and intelligent one, and the record should reflect this. If
directors dissent from the majority, they should, for their
own protection, insist upon their negative vote being
recorded along with reasons for their action.
The critical need for and dependence on information
involves a concern and responsibility for the integrity of
not only the specific information furnished, but the system
that supplies it as well. Advances in technology have
helped banks improve both information availability and
models for analysis and decision making. Regardless of
the technology employed, management is responsible for
developing and implementing an information system that
facilitates managerial activities. Review of these reports
should be undertaken during onsite examinations to
ascertain the accuracy of the information being provided.
Careful and consistent preparation of an agenda for each
board meeting not only assists in the conduct of such
meetings, but also provides board members reasonable
assurance that all important matters are brought to their
attention. Agenda items will vary from bank to bank
depending on asset size, type of business conducted, loan
volume, trust activities and so forth. In general, the agenda
should include reports on income and expense; new,
An effective MIS is comprised of information from a
number of sources, and the information must serve a
number of users, each having various needs. The MIS
must selectively update information and coordinate it into
meaningful and clear formats. One possible approach
would be to combine information from the bank's
accounting system with other internal sources, such as
personnel records, and include information from external
Management (12-04)
4.1-4
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overdue, renewed, insider, charged-off and recovered
loans; investment activity; personnel; and individual
committee actions.
involving negligence (or breach of duty) which fall short of
breach of trust or fraud.
Directors' liability for negligent acts is premised on
common law for failure to exercise the degree of care
prudent individuals would exercise under similar
circumstances, and/or noncompliance with applicable
statutory law, either or both of which cause loss or injury to
the bank. Statutory liability is reasonably well defined and
precise. Common law liability is somewhat imprecise
since failure to exercise due care on the part of a director
depends on the facts and circumstances of the particular
case.
To carry out its functions, the board of directors may
appoint and authorize committees to perform specific tasks
and supervise certain phases of operations. In most
instances, the name of the committee, such as loan,
investment, examination, and, if applicable, trust, identifies
its duties. Of course, utilization of the committee process
does not relieve the board of its fundamental
responsibilities for actions taken by those groups. Review
of the minutes of these committees' meetings should be a
standard part of the board meeting agenda.
A director's duty to exercise due care and diligence extends
to the management, administration and supervision of the
affairs of the bank and to the use and preservation of its
assets. Perhaps the most common dereliction of duty by
bank directors is the failure to maintain reasonable
supervision over the activities and affairs of the bank, its
officers and employees. The actions and inactions listed
below have been found to constitute negligence on the part
of directors.
Communication of facts to a board of directors is essential
to sound and effective supervision. However, with the
ever-broadening scope of modern banking and the
increased complexity of banking operations, the ability of a
board of directors to effectively supervise is becoming
more difficult. Because of this, the use of outside
personnel to provide management supervision is relatively
common. While this does not release the board from its
legal and implied responsibilities, it does provide an
opportunity for management improvement through the use
of these external sources. The bank holding company can
play a very large role in the supervision of its individual
banks. Bank holding companies which control a number of
banks may be able to provide individual banks' boards with
lending and investment counseling, audit and internal
control programs or services, profit planning and
forecasting, personnel efficiency reports, electronic data
processing services, marketing strategy and asset appraisal
reports. Banks that do not operate within a holding
company organization are also able to obtain management
assistance from various firms offering the above services.
In the interest of quality supervision by a bank's board of
directors, the use of outside advisors, while not releasing
the board from its responsibilities, can be a valuable
management tool.
•
•
•
•
•
•
Legal Liabilities of Directors
•
In general, directors and other corporate officers of a bank
may be held personally liable for: a breach of trust;
negligence which is the proximate cause of loss to the
bank; ultra vires acts, or acts in excess of their powers;
fraud; and misappropriation or conversion of the bank's
assets. From the standpoint of imposing directors' liability
where the facts evidence that fraud, misappropriation,
conversion, breach of trust or commission of ultra vires
acts is clearly shown, a relatively simple situation presents
itself.
Difficulties usually arise, however, in cases
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
•
An attitude of general indifference to the affairs of the
bank, such as failing to hold meetings as required by
the bylaws, obtain a statement of the financial
condition of the bank, or examine and audit the books
and records of the bank to determine its condition.
Failure to heed warnings of mismanagement or
defalcations by officers and employees and take
appropriate action.
Failure to adopt practices and follow procedures
generally expected of bank directors.
Turning over virtually unsupervised control of the
bank to officers and employees relying upon their
supposed fidelity and skill.
Failure to acquaint themselves with examination
reports showing the financial condition of a company
to which excessive loans had been made.
Assenting to loans in excess of applicable statutory
limitations.
Permitting large overdrafts in violation of the bank’s
internal policies or permitting overdrafts to insiders in
violation of law.
Representing certain assets as good in a Report of
Condition when such assets were called to the
directors' attention as Loss by the primary regulator
and directions were given for their immediate
collection or removal from the bank.
In the final analysis, liability of bank directors for acts of
negligence rests upon their betrayal of those who placed
trust and confidence in them to perform the duties of their
4.1-5
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MANAGEMENT
Section 4.1
office honestly, diligently and carefully. While applicable
principles involving directors' negligence (or breach of
duty) are easy enough to state, their application to factual
situations presents difficulties. In essence, the courts have
judged the conduct of directors "not by the event, but by
the circumstance under which they acted" (Briggs v.
Spaulding, 141 U.S. 132, 155(1890), 35L. Ed. 662, 672).
Courts also have generally followed what may be called the
rule of reason in imposing liability on bank directors, "lest
they should, by severity in their rulings, make directorships
repulsive to the class of men whose services are most
needed; or, by laxity in dealing with glaring negligences,
render worthless the supervision of director's over...banks
and leave these institutions a prey to dishonest executive
officers” (Robinson v. Hall, 63 Fed. 222, 225-226 (4th Cir.
1894)).
incumbent upon bank directors in the exercise of
ordinary prudence, and as a part of their duty of
general supervision, to cause an examination of the
condition and resource of the bank to be made with
reasonable frequency."
FEDERAL BANKING LAWS
AND REGULATIONS PRIMARILY
PERTAINING TO BANK DIRECTORS
Section 18(k) of the Federal Deposit Insurance Act
(FDI Act) - Authority to Regulate or Prohibit Certain
Forms of Benefits to Institution Affiliated Parties
Part 359 of the FDIC Rules and Regulations - Golden
Parachutes and Indemnification Payments
The following quotation represents a brief recapitulation of
the law on the subject (Rankin v. Cooper, 149 Fed. 1010,
1013 (C.C.W.D. Ark. 1907) :
Part 359, pursuant to Section 18(k), permits the FDIC to
prohibit or limit, by regulation or order, golden parachute
payments or indemnification payments. Refer to “Other
Issues” within this section for additional information.
"(1) Directors are charged with the duty of reasonable
supervision over the affairs of the bank. It is their duty
to use ordinary diligence in ascertaining the condition
of its business, and to exercise reasonable control and
supervision over its affairs. (2) They are not insurers
or guarantors of the fidelity and proper conduct of the
executive officers of the bank, and they are not
responsible for lossses resulting from their wrongful
acts or omissions, provided they have exercised
ordinary care in the discharge of their own duties as
directors. (3) Ordinary care in this matter as in other
departments of the law, means that degree of care
which ordinarily prudent and diligent men would
exercise under similar circumstances. (4) The degree
of care required further depends upon the subject to
which it is to be applied and in each case must be
determined in view of all circumstances. (5) If nothing
has come to their knowledge to awaken suspicion that
something is going wrong, ordinary attention to the
affairs of the institution is sufficient. If, upon the other
hand, directors know, or by the exercise of ordinary
care should have known, any facts which would
awaken suspicion and put a prudent man on his guard,
then a degree of care commensurate with the evil to be
avoided is required, and a want of that care makes
them responsible. Directors cannot, in justice to those
who deal with the bank, shut their eyes to what is
going on around them. (6) Directors are not expected
to watch the routine of every day's business, but they
ought to have a general knowledge of the manner in
which the bank's business is conducted, and upon what
securities its larger lines of credit are given, and
generally to know of and give direction to the
important and general affairs of the bank. (7) It is
Management (12-04)
Section 39(c) of the FDI Act - Compensation Standards
This statute requires the FDIC to prohibit excessive
compensation to executive officers, employees, directors,
and principal shareholders as an unsafe and unsound
practice. The definition of excessive compensation, as
well as the specific prohibition required by Section 39(c),
is found in Section III of Appendix A to Part 364,
Standards for Safety and Soundness. Refer to “Other
Issues” within this section for further information.
Section 32 of the FDI Act - Agency Disapproval of
Directors and Senior Executive Officers of Insured
Depository Institutions or Depository Institution
Holding Companies
A troubled insured depository institution or troubled
depository institution holding company may not add any
individual to the board of directors or employ any
individual as a senior executive officer if the appropriate
Federal banking agency issues a notice of disapproval of
such addition or employment before the end of the 90-day
period beginning on the date the agency receives the
required notice.
Section 19 of the FDI Act - Penalty for Unauthorized
Participation by Convicted Individual
Section 19 of the FDI Act prohibits, without the prior
written consent of the FDIC, a person convicted of any
criminal offenses involving dishonesty or breach of trust or
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money laundering, or who has entered into a pretrial
diversion or similar program in connection with a
prosecution for such offense, from becoming or continuing
as an institution-affiliated party (IAP), owning or
controlling, directly or indirectly, an insured institution, or
otherwise participating, directly or indirectly, in the
conduct of the affairs of an insured institution.
their related interests. Section 18(j)(2) does not apply to
any foreign bank in the United States but does apply to the
insured branch itself. It is a very important statute in the
examination and supervisory process because it is aimed at
prevention and detection of insider abuse, a common
characteristic of failed or failing banks.
Part 215 of the Federal Reserve Board’s Regulation O was
issued pursuant to Sections 22(g) and 22(h) of the Federal
Reserve Act. It requires that extensions of credit to
executive officers, directors, principal shareholders or their
related interests be made on substantially the same terms
and follow credit underwriting procedures that are not less
stringent than those prevailing at the time for comparable
transactions with persons not covered by the regulation.
Aggregate lending limits and prior approval requirements
are also imposed by Regulation O. Moreover, payment of
overdrafts of directors or executive officers is generally
prohibited unless part of a written, preauthorized interest
bearing, extension of credit plan or by transfer of funds
from another account at the bank. The requirements,
prohibitions and restrictions of Regulation O are important
and examiners should be fully familiar with them. The
complete text of the regulation is contained in the FDIC
Rules and Regulations.
The intent of Section 19 is not punitive. Rather, the
purpose is to provide the applicant an opportunity to
demonstrate that a person is fit to participate in the conduct
of the affairs of an institution without posing a risk to its
safety and soundness or impairing public confidence in that
institution. The FDIC’s policy is to approve applications
in which this risk is absent. For additional guidance, refer
to the FDIC Statement of Policy for Section 19 of the FDI
Act.
Part 349 of the FDIC Rules and Regulations - Reports
and Public Disclosure of Indebtedness of Executive
Officers and Principal Shareholders to a State
Nonmember Bank and its Correspondent Banks
This regulation implements Section 7(k) if the FDI Act and
Section 106(b)(2)(G)(ii) of Bank Holding Company Act
Amendments of 1970 (BHCA Amendments). The BHCA
Amendments prohibit (1) preferential lending by a bank to
executive officers, directors, or principal shareholders of
another bank, when there is a correspondent account
relationship between the banks; or (2) the opening of a
correspondent account relationship between banks when
there is a preferential extension of credit by one of the
banks to an executive officer, director or principal
shareholders of the other bank. The BHCA Amendments
also impose reporting and disclosure requirements with
respect to certain insiders.
Section 337.3 of the FDIC Rules and Regulations makes
Regulation O applicable to state nonmember banks and
sets forth requirements for approval of extensions of credit
to insiders. Specifically, prior approval of the bank's board
of directors is necessary if an extension of credit or line of
credit to any of the bank's executive officers, directors,
principal shareholders, or to any related interest of any
such person, exceeds the amount specified in the regulation
when aggregated with the amount of all other extensions of
credit or lines of credit to that person. This approval must
be granted by a majority of the bank's directors and the
interested party(ies) must abstain from participating
directly or indirectly in the voting.
Section 22(g) and 22(h) of the Federal Reserve Act Loans to Executive Officers of Banks and Extensions of
Credit to Executive Officers, Directors and Principal
Shareholders of Member Banks
Any nonmember insured bank which violates or any
officer, director, employee, agent or other person
participating in the conduct of the affairs of a nonmember
insured bank who violates any provision of Section 22(g)
or 22(h) of the Federal Reserve Act may be subject to a
CMP. In determining the amount of the penalty, the FDIC
takes into account the financial resources and good faith of
the bank or person charged, gravity of the violation, history
if any of previous violations, and such other matters as
justice may require. Examiners are reminded violations of
Regulation O must be evaluated in accordance with the 13
factors specified in the Interagency Policy Regarding the
Assessment of Civil Money Penalties by the Federal
Financial Institutions Regulatory Agencies.
The Federal Reserve Board’s Regulation O – Loans to
Executive
Officers,
Directors
and
Principal
Shareholders of Member Banks
Section 337.3 of the FDIC Rules and Regulations –
Limits on Extensions of Credit to Executive Officers,
Directors and Principal Shareholders of Insured
Nonmember Banks
Sections 22(g) and 22(h) are incorporated into the FDI Act
via Section 18(j)(2) and pertain to loans and extensions of
credit by both member and nonmember banks to their
executive officers, directors, principal shareholders and
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MANAGEMENT
Section 4.1
except in certain circumstances.
Dual service is
permissible when the individual does not participate in any
deliberations involved in choosing a bank to underwrite or
market the securities of the utility, when the bank is chosen
by competitive procedures, or when the issuance of
securities by the public utility have been approved by all
appropriate regulatory agencies.
Part 348 of the FDIC Rules and Regulations Management Official Interlocks
This act is contained in 12 U.S.C. 1823(k) and its general
purpose is to foster competition.
It prohibits a
management official of one depository institution or
depository holding company from also serving in a similar
function in another depository institution or depository
holding company if the two organizations are not affiliated
and are located in the same area or if the two organizations
are not affiliated and are very large, as defined in the
regulation.
Section 8 of the FDI Act
A number of exceptions allowing interlocking relationships
for certain organizations and their affiliates are detailed in
Part 348 of the Rules and Regulations. Under Section 8(e)
of the FDI Act, the FDIC may serve written notice of
intention to remove a director or officer from office
whenever, in its opinion, such director or officer of an
insured bank has violated the Depository Institution
Management Interlocks Act.
Among other things, Section 8 of the FDI Act provides the
Federal banking agencies with the authority to take action
to remove from office or prohibit an IAP from any further
participation in the conduct of the affairs of any depository
institution. Specifically, Section 8(e) and Section 8(g) are
utilized in such proceedings. Actions taken under this
authority represent serious charges with significant
potential consequences. Therefore, outstanding guidelines
should be closely followed during the examination process.
For additional guidance, refer to Section 8 the FDI Act and
the Formal Administrative Actions section of this Manual.
Section 7(j) of the FDI Act and the Change in Bank
Control Act of 1978
OTHER ISSUES
Section 7(j) of the FDI Act prohibits any person, acting
directly or indirectly or through or in concert with one or
more other persons, from acquiring control of any insured
depository institution through a purchase, assignment,
transfer, pledge, or other disposition of voting stock of the
insured bank unless the appropriate Federal banking
agency has been given 60-days prior written notice of the
proposed acquisition. An acquisition may be made prior to
the expiration of the disapproval period if the agency
issues written notice of its intent not to disapprove the
action. The term "insured depository institution" includes
any bank holding company or any other company which
has control of any insured bank. The term "control" is
defined as the power, directly or indirectly, to direct the
management or policies of an insured bank or to vote 25%
or more of any class of voting securities of an insured
bank. Willful violations of this statute are subject to civil
money penalties of up to $1 million per day. This statute
gives the FDIC important supervisory powers to prevent or
minimize the adverse consequences that almost invariably
occur when incompetent or dishonest individuals obtain
positions of authority and influence in banks.
Indebtedness of Directors, Officers and
Their Interests
The position of director or officer gives no license to
special credit advantages or increased borrowing
privileges. Loans to directors, officers and their interests
must be made on substantially the same terms as those
prevailing at the time for comparable transactions with
regular bank customers. Therefore, management loans
should be evaluated on their own merits. Their business
operations will, in many instances, necessitate bank loans,
and these will ordinarily be among a bank's better assets.
Since directors usually maintain a deposit relationship with
their bank, this carries with it an obligation to meet their
reasonable and prudent credit requirements.
On the other hand, there have been many instances where
improper loans to officers, directors, and their interests
resulted in serious losses. Unfortunately, when the
soundness of a management loan becomes questionable, an
embarrassing situation usually results.
That is,
management loans frequently may not be subject to the
same frank discussion accorded other loans.
Bank
directors may assent to such loans, despite knowledge that
they are unwarranted, rather than oppose a personal or
business friend or associate. Moreover, directors who
serve on the board in order to increase their opportunities
for obtaining bank credit are reluctant to object to credit
extensions to their colleagues. Problems that occur with
Section 737 of the Gramm-Leach-Bliley Act – Bank
Officers and Directors as Officers and Directors of
Public Utilities
This section of the Gramm-Leach-Bliley Act amends the
Federal Power Act to preclude persons from serving both
as an officer or director of a public utility and a bank
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MANAGEMENT
Section 4.1
management loans have received considerable legislative
attention and laws have been passed to curb abuses
associated with the position of director or officer (i.e.
Regulation O). However, while steps have been taken to
reduce the potential for problems in this area, a review of
the board's policies and actual practices regarding insider
loans remains an important part of the examination
process.
directors and principal stockholders, as necessary, to obtain
it.
Examiners are also reminded to inquire into bank policies
and procedures designed to bring conflicts of interest to the
attention of the board of directors when they are asked to
approve loans or other transactions in which an officer,
director or principal stockholder may be involved. Where
such policies and procedures are lacking or insufficient to
reveal insider involvement before action is taken by the
board, the bank should be strongly encouraged to remedy
the deficiency. The board should also be encouraged to act
specifically on any loan or other transaction in which
insiders or their associates may be involved, either directly
or indirectly, or because of business associations outside
the loan or transaction in question. Moreover, the results
of board deliberations on any matter involving a potential
conflict of interest should be noted clearly in the minutes.
Conflicts of Interest
Examiners should be especially alert to any insider
involvement in real estate projects, loans or other business
activities that pose or could pose a conflict of interest with
their fiduciary duties of care and loyalty to the bank. On
occasion, loans are advanced to business associates
involved in apparently unrelated projects where an insider
nevertheless benefited. The involvement of bank insiders
in these projects is sometimes not apparent since
ownership is held in the form of "business trusts" or other
entities without disclosure of the identity or personal
guarantees of the principals. In order to help uncover these
types of situations, examiners should routinely inquire of
senior management, through incorporation in the "first
day" letter or request, whether any of the following
situations exist:
•
•
•
•
•
Examiners are also reminded to carefully scrutinize any
loan or other transaction in which an officer, director or
principal stockholder is involved. Such loans or other
transactions should be sound in every respect and be in full
compliance with applicable laws and regulations and the
bank's own policies. Any deficiencies in credit quality or
other aspects of the transaction should receive critical
comment not only from an asset quality perspective but
from a management perspective as well. More specifically,
if a director has a personal financial interest in a loan or
other transaction subject to adverse classification, the
board should be urged to require that director to strengthen
the credit sufficiently to remove the adverse classification
within a reasonable time frame or resign from the board.
In the event a principal stockholder or an officer who is not
a director is involved in an adversely classified loan or
other transaction, the board should be urged to assume
special oversight over the loan or activity, either directly or
through a committee of outside directors, with a view
towards limiting any further exposure and moving
aggressively to secure or collect any exposed balances as
the circumstances may permit. There should be concern
that these types of situations not only tend to compromise
the credit standards of the lending institution and
eventually may lead to losses, but that they can also lead to
violations of civil and criminal laws.
Loans or other transactions existing at the bank in
which an officer, director or principal stockholder (or
immediate family member of each) of the bank holds a
beneficial interest.
Loans or other transactions in which an officer,
director or principal stockholder (or immediate family
member of each) of another depository institution
holds a beneficial interest.
Loans or other transactions at any other depository
institution in which a bank officer, director, or
principal stockholder (or immediate family member of
each) holds a beneficial interest, either direct or
indirect.
Loans or other transactions in which an officer,
director or principal stockholder (or immediate family
member of each) has no direct interest but which
involve parties with whom an insider has other
partnership or business associations.
Loans extended personally by officers, directors or
principal stockholders (or immediate family member
of each) to parties who are also borrowers from the
bank or loans extended personally by any borrowing
customers to an officer, director or principal
stockholder of the bank.
Nonbanking Activities Conducted on
Bank Premises
Many banks conduct nonbanking activities on bank
premises by selling insurance (e.g. credit life, accident and
health) in conjunction with loan transactions of the bank.
When these nontraditional banking activities take the form
of establishment of a new department or subsidiary of the
If any of this information is not readily available,
management should be requested to survey their officers,
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Section 4.1
bank, the benefit and profit is directly realized by the bank
and its shareholders. However, when these activities are
conducted on bank premises for the benefit of others, a
bank may be deprived of corporate opportunity and profit.
The FDIC has long taken the position that when
nonbanking activities are conducted on bank premises
either by bank personnel or others and when the benefit
and profit do not flow directly to the bank, certain
disclosures, approvals, and reimbursements must be made.
control, and it is usually abetted by an apathetic board of
directors. Many bank directors when first elected have
little or no technical knowledge of banking and feel
dependent upon others more knowledgeable in banking
matters. When this feeling becomes deep-seated and
widespread, a managerial vacuum is created which an
overly aggressive officer may fill and thus achieve a
position of dominance. This development is facilitated by
the fact that directors are very often nominated by bank
officers to whom they feel indebted for the honor, even
though stockholders elect them. Over the years, an officer
can influence the election of a sufficient number of
directors so that the officer is ultimately able to dominate
the board and the affairs of the bank.
In all cases, the bank's directors and shareholders should be
fully informed regarding the nonbanking activity
conducted on bank premises. The operation should be
approved by the bank's shareholders, and expenses
incurred by the bank in connection with these operations
formally approved by the board of directors annually. The
bank should be adequately compensated for any expenses
it incurs in furnishing personnel, equipment, space, etc. to
this activity. It is recommended that bank management
disclose completely to its bonding company any such
nonbanking activity conducted on its premises.
Management would also be well advised to obtain
acknowledgement from the bonding company that such
activities do not impair coverage under the fidelity bond.
Finally, the conduct of nonbanking activity must be in
conformance with applicable State statutes and regulations.
There are at least two potential dangers inherent in a "One
Man Bank" situation. First, incapacitation of the dominant
officer may deprive the bank of competent management,
and because of the immediate need to fill the managerial
void, may render the bank vulnerable to dishonest or
incompetent replacement leadership. Second, problem
situations resulting from mismanagement are more difficult
to solve through normal supervisory efforts because the
bank’s problems are often attributed to the one individual
that dominates the bank.
In “One Man Bank” situations, it is extremely important
that examiners assess the bank’s control environment and,
when applicable, recommend necessary changes to the
control structure. When examiners review the risk profile
and control environment of a bank that is controlled by a
dominant official, examiners should consider and assess
whether:
Situations where the bank is being deprived of corporate
opportunity through the diversion of opportunity or profit,
or inadequately compensated for the utilization of its
resources should be discussed with bank management and
commented upon in the Risk Management Assessment and
the Examination Conclusions and Comments pages, if
appropriate. Additionally, the absence of disclosure and
approval to the bank's directors, shareholders, and bonding
company should be discussed with management and
covered in the aforementioned schedule(s). Finally, in
those instances where the examiner believes, based on
known facts, that a violation of applicable statutes or
regulations has occurred, or where there is no question that
a criminal violation has been committed, the matter should
be handled in accordance with guidelines prescribed in
other sections of this Manual.
•
•
•
•
Directors of "One Man Banks" and
Advisory Directors
•
Directors of “One Man Banks”
Supervisory authorities are properly concerned about the
"One Man Bank" wherein the institution's principal officer
and stockholder dominates virtually all phases of the bank's
policies and operations. Often this situation stems from the
personality make-up of the principal officer or ownership
Management (12-04)
•
4.1-10
An appropriate segregation of duties and
responsibilities is achieved or alternative actions are
taken to mitigate the level of control exercised by the
one individual.
Director involvement in the oversight of policies and
objectives of the bank is at an appropriate level.
A diverse board membership provides the bank with
an assortment of knowledge and expertise, including,
but not limited to, banking, accounting, and the major
lending areas of the bank’s target markets.
There are a sufficient number of outside and
independent directors.
Committees of major risk areas exert a proper level of
function, responsibility, and influence, and the value
of the committees is exhibited in the decision-making
process.
A proper level of independence has been achieved for
board committees of major risk areas, including, but
not limited to, audit committees.
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MANAGEMENT
•
•
•
•
•
•
•
•
•
Section 4.1
responsibilities or liabilities of the office, except where
there may be a continuing connection with a previous
breach of duty as an official director.
An adequate audit committee has been established
with only, or at least a majority of, outside directors.
A need exists for the performance of annual financial
audits by an independent certified public accounting
firm.
A qualified, experienced, and independent internal
auditor is in place at the bank.
A proper segregation of the internal audit function is
achieved from operational activities.
An appropriate rationale was established regarding
changing a bank’s external auditors, independent of
oral discussions with bank management, including, but
not limited to, a review of the audit committee minutes
or a review of auditor notifications.
An adequate written code of conduct and ethics and
conflicts of interest policies have been established.
A need exists for the bank’s board to perform and
report on an annual conflicts of interest and ethics
review.
A need exists for a bank to engage outside consultants
to conduct an external loan review.
A proper segregation of the internal loan review
process is established.
Restrictions on Golden Parachute Payments
and Indemnification Payments
Golden Parachute Payments
•
•
•
The above serve as potential controls to mitigate the risk
posed by a dominant official.
In situations where
appropriate segregation of duties, director independence
and
involvement,
audit
functions,
code
of
conduct/ethics/conflict of interest policies and practices,
and internal loan review function are lacking, deficiencies
should be emphasized in the Report of Examination.
When such weaknesses are evident, internal policies and
practices should be sufficiently strengthened in order to
mitigate the level of risk presented by the existence of such
a dominant official.
Recommendations, including
provisions for supervisory action, when warranted, should
be considered.
Refer to the Formal Administrative
Actions section for a discussion of possible supervisory
actions in dealing with an overly dominant management
official.
•
•
•
•
•
•
Bona-fide deferred compensation plans.
Nondiscriminatory severance payment
plans (for personnel reductions in force).
Qualified pension or retirement plans.
Payments pursuant to employee welfare
benefit plans.
Payments made by reason of termination
caused by death or disability.
Payments required by State statute or
foreign law.
The final three listed exceptions require the
approval of both the appropriate Federal banking
agency and the FDIC.
• A troubled institution hiring new
management (“White Knight”).
• Severance payment in the event of an
unassisted change in control.
• Any others on a case-by-case basis with the
regulators’ approval.
Advisory Directors
A naturally sensitive situation develops where the value of
a director diminishes due to extensive outside
commitments, illness, etc. Often such individuals do not
wish to relinquish their position and the bank may be
hesitant to request they do so. Some banks have met this
situation by establishing a position of honorary director (or
similar title) for persons who are no longer able to
effectively fulfill the demanding duties of bank director.
Generally, the honorary director attends board meetings as
desired and offers advice on a limited participation basis,
but has no formal voice or vote in proceedings, nor the
DSC Risk Management Manual of Examination Policies
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The rule (Part 359) limits and/or prohibits, in certain
circumstances, insured depository institutions, their
subsidiaries, and their affiliated depository institution
holding companies from agreeing to make or making
golden parachute payments when the entity making the
payment is "troubled," as defined in Section 303.101
of the FDIC Rules and Regulations.
The rule does not restrict the payment of golden
parachutes by healthy institutions, except that
depository institution holding companies (including
healthy ones) are prohibited from making golden
parachute payments to IAPs of troubled subsidiary
banks and savings associations.
Several exceptions to the prohibition are included in
the regulation; some are required by statute, others
have been added by the FDIC. These exceptions are
as follows:
Indemnification Payments
•
4.1-11
With regard to indemnification payments, Part 359
limits the circumstances under which an insured
depository institution, its subsidiary, or affiliated
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MANAGEMENT
Section 4.1
depository institution holding company may indemnify
institution affiliated parties IAPs for expenses incurred
in administrative or civil enforcement actions brought
by bank regulators.
The circumstances where
indemnification may be permitted are as follows:
1.
The institution’s board of directors determines in
writing that these four criteria are satisfied:
•
•
•
•
2.
•
and their IAPs on notice in the proposed rule (March
29, 1995) that the FDIC will look unfavorably upon
any golden parachute agreement which was entered
into after the proposal, but before the date of the final
rule, that attempts to circumvent the regulation.
Appropriate orders should be pursued in such cases.
•
The IAP acted in good faith and in a manner
believed to be in the best interests of the
institution.
The payment will not materially adversely
affect the safety and soundness of the
institution.
The payment is limited to expenses incurred
in an administrative proceeding or civil
action instituted by a Federal financial
institution's regulator.
The IAP agrees to reimburse the institution
if he/she is found to have violated a law,
regulation, or other fiduciary duty.
However, there are situations when an individual has
been charged with several significant items of
misconduct, etc., and then during the process a
settlement is reached where only some of the
infractions are admitted. The rule permits partial
indemnification in those cases. There is a special
case-by-case exception to allocate costs to the sets of
charges with indemnification permitted for those that
are dropped.
An insurance policy or fidelity bond may pay the
cost of defending an administrative proceeding or
civil action. It may not pay a penalty or
judgement.
Partial indemnification is not permitted in cases where
an IAP is removed from office and/or prohibited from
participating in the affairs of the institution.
It is recognized that in many cases the appropriate
amount of any partial indemnification will be difficult
to ascertain with certainty.
Although no prior
regulatory consent is required, obviously the
regulators are part of the settlement process. The
process provides the opportunity for the regulators to
give “non-objections” at the time of settlement, prior
to the indemnification being made. As part of the
settlement process, the bank should be required to
provide from the attorney a statement containing a
description of specifically attributable expenses.
Concern should focus on the reasonableness of the
allocations.
Under no circumstances may an institution or an
insurance policy of the institution indemnify an IAP
for any judgment or civil money penalty imposed in an
action where the IAP is assessed a civil money
penalty, is removed from office or prohibited from
participating in the affairs of the institution, or is
required to cease and desist from or take any
affirmative action pursuant to section 8(b) of the FDI
Act. However, partial indemnification is allowed for
charges that are found in the IAP’s favor as explained
below under “Issues.”
Issues
•
Generally speaking, the essence of Part 359 lies in its
definitions of terms such as: golden parachute payment,
bona fide deferred compensation plan, and prohibited
indemnification payment, as well as certain significant
exceptions to the general prohibitions.
The following are additional discussions on several issues
encompassed in the regulation.
•
The rule does not apply to contracts and agreements
entered into prior to the effective date of the rule
(April 1, 1996). However, the FDIC put institutions
Management (12-04)
With regard to indemnification payments, the majority
of administrative or civil enforcement cases end in a
settlement and no indemnification payment will be
permitted unless charges are dropped. The parties
concerned will have to factor in this cost of no
indemnification in their decisions to settle or not.
4.1-12
If a golden parachute is prohibited to an individual
leaving the institution, it is prohibited forever, even if
the institution returns to health (after the individual has
left the institution). There are ample exceptions and
procedures for an individual who is leaving a troubled
institution to avoid the prohibition if that individual
has not contributed significantly to the demise of the
institution. If an individual does not qualify for one of
these exceptions, that individual should not benefit due
to the institution reversing its course and returning to
health after that individual has left the institution.
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MANAGEMENT
•
•
Section 4.1
Troubled institutions cannot apply for an exception to
offer "white knight" parachutes to their current officers
to not leave the institution. Rather it is to entice new
management to join the institution by compensating
for the uncertainty of joining a troubled institution. It
is considered illogical for the FDIC to provide an
exception to permit a troubled institution to offer a
buyout to current management to get them to stay.
The regulation does not prohibit an institution from
offering golden parachutes to their current officers. It
only prohibits the payment of a golden parachute if the
individual leaves while the institution is troubled. On
the contrary, it is believed to be of greater incentive
that the only way the current officers' golden
parachutes will be of value is if they stay and work to
return the institution to health.
•
•
•
•
•
•
•
The FDIC does not seek to dictate specific salary levels or
ranges for directors, officers, or employees. In fact,
Section 39 of the FDI Act prohibits establishing guidelines
that set a specific level or range of compensation for bank
insiders. The criteria listed above are designed to be
qualitative rather than quantitative in order to grant an
institution’s directors reasonable discretion when
structuring a compensation program.
Approval is required for a severance payment in the
event of an unassisted change in control. A maximum
payment of 12 months salary is permitted under this
exception. Any requests for payments in excess of this
amount (12 months salary) would have to be
considered for approval under the general case-bycase exception.
This exception is provided in recognition of the need
for current management to be motivated to seek out
acquirers. This exception is believed appropriate for
cases where the IAP may not clearly demonstrate that
all the factors for the general exception are evident,
yet an acquisition of the troubled institution has been
arranged and the acquirer is willing to make the
otherwise prohibited golden parachute payment. On
the other hand, if after consideration of the factors for
the general case-by-case exception, the appropriate
Federal banking agency and/or the FDIC determines it
inappropriate to make the severance payment, an
exception should not be approved.
Examiners should review the information used by the
board to establish the compensation structure of the
institution. The information should adequately explain the
rationale for the system in place and should enable the
board to consider the above items that determine whether
compensation is excessive.
Gaining Access to Bank Records
and Employees
Section 10(b)(6) of the FDI Act provides authority for
examiners to make a thorough examination of any insured
depository institution and to complete a full and detailed
report of the institution’s condition. In most instances, the
executive officers of insured depository institutions
cooperate with the requests of examiners. However, there
are rare occasions when executive officers are extremely
uncooperative, or refuse to provide access to bank records
and employees that are essential to the evaluation of the
condition of the institution. In such cases, this pattern of
behavior by executive officers may be indicative of serious
problems in the bank, including fraud, mismanagement, or
insolvency.
The Regional Office should be consulted
when executive officers restrict access to bank records or
employees.
Excessive Compensation
Section III of Part 364, Appendix A, prohibits the payment
of excessive compensation, as well as compensation that
could lead to material financial loss to an institution, as an
unsafe and unsound practice. Furthermore, Section II of
Part 364, Appendix A, urges institutions to maintain
safeguards that prevent excessive compensation or
compensation that could subject the institution to material
financial loss. Excessive compensation is defined as when
amounts paid are unreasonable or disproportionate to the
services performed by an executive officer, employee,
director, or principal shareholder. The following items
should be considered when determining whether
compensation is excessive:
DSC Risk Management Manual of Examination Policies
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The combined value of all cash and noncash benefits
provided to an individual;
The compensation history of the individual and other
individuals with comparable expertise;
The financial condition of the institution;
Compensation practices at comparable institutions,
based on such factors as asset size, location, and the
complexity of the loan portfolio or other assets;
For post-employment benefits, the projected total cost
and benefit to the institution;
Any connection between the individual and any
instance of fraud or insider abuse occurring at the
institution; and
Any other factors determined to be relevant.
Bank Owned Life Insurance (BOLI)
4.1-13
Management (12-04)
MANAGEMENT
Section 4.1
A number of banks use BOLI as a means of protecting
against the loss of key employees or hedging employee
compensation and benefit plans. However, the purchase of
life insurance is subject to supervisory considerations and
life insurance holdings must be consistent with safe and
sound banking practices. Bankers should complete a
thorough analysis before purchasing BOLI. Associated
risks, minimum standards for pre-purchase analysis and
basic guidelines are detailed in the Other Assets and
Liabilities section of this Manual.
minimum, the assessment of management should include
the following considerations:
•
•
•
•
•
EVALUATION OF MANAGEMENT
Whether or not insider abuse is in evidence;
Existing management's past record of performance in
guiding the bank;
Whether loan losses and other weaknesses are
recognized in a timely manner;
Past compliance with supervisory agreements,
commitments, orders, etc.; and
Capability of management to develop and implement
acceptable plans for problem resolution.
A bank's performance with respect to asset quality and
diversification, capital adequacy, earnings performance and
trends, liquidity and funds management, and sensitivity to
fluctuations in market interest rates is, to a very significant
extent, a result of decisions made by the bank's directors
and officers. Consequently, findings and conclusions in
regard to the other five elements of the CAMELS rating
system are often major determinants of the management
rating. More specific considerations are detailed in the
Basic Examination Concepts and Guidelines section of this
Manual. However, while a bank's overall present condition
can be an indicator of management's past effectiveness, it
should not be the sole factor relied upon in rating
management. This is particularly true when there is new
management or when the bank's condition has been
significantly affected by external factors versus internal
decisions.
Assessment of new management, especially in a problem
situation, is difficult. Performance by individuals at their
former employment, if known to the examiner, may be
helpful, but the examiner should assess each situation
based on its particular circumstances. The management
rating should generally be consistent with any
recommended supervisory actions. A narrative statement
supporting the management rating and reconciling any
apparent discrepancies between the assigned rating and any
recommended supervisory actions (or lack of
recommended actions) should be included on the
confidential pages of the examination report.
When significant problems exist in a bank's overall
condition, consideration must be given to management's
degree of responsibility. However, appropriate recognition
should also be given to the extent to which weaknesses are
caused by external problems (such as a severely depressed
local economy). A distinction should be made between
problems caused by bank management and those largely
due to outside influences. Management of a bank whose
problems are related to the economy would warrant a
higher rating than management believed substantially
responsible for a bank's problems, provided that prudent
planning and policies are in place and management is
pursuing realistic resolution of the problems.
Management's ability becomes more critical in problem
situations, and it is important to note management's
policies and acts of omission or commission in addressing
problems.
RATING THE MANAGEMENT FACTOR
Examination procedures regarding the evaluation of
management are included in the Examination
Documentation Modules.
Uniform Financial Institutions Rating System
The Federal Deposit Insurance Corporation and the other
Federal Financial Institutions Examination Council
(FFIEC) member agencies adopted a uniform interagency
system for rating the condition and soundness of the
nation's banks. The Uniform Financial Institutions Rating
System involves an assessment of six critical aspects of a
bank's condition and operations.
Management and
administration is one of those critical dimensions.
The capability of the board of directors and management,
in their respective roles, to identify, measure, monitor, and
control the risks of an institution’s activities and to ensure
a financial institution’s safe, sound, and efficient operation
in compliance with applicable laws and regulations is
reflected in this rating. Generally, directors need not be
actively involved in day-to-day operations; however, they
must provide clear guidance regarding acceptable risk
exposure levels and ensure that appropriate policies,
procedures, and practices have been established. Senior
The extent to which mismanagement has contributed to
areas of weakness is particularly relevant to the
management evaluation. Similarly, positive economic
conditions may serve to enhance a bank's condition despite
weak or undocumented policies and practices. At a
Management (12-04)
4.1-14
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MANAGEMENT
Section 4.1
management is responsible for developing and
implementing policies, procedures, and practices that
translate the board’s goals, objectives, and risk limits into
prudent operating standards.
•
Depending on the nature and scope of an institution’s
activities, management practices may need to address some
or all of the following risks: credit, market, operating or
transaction, reputation, strategic, compliance, legal,
liquidity, and other risks. Sound management practices are
demonstrated by active oversight by the board of directors
and management; competent personnel; adequate policies,
processes, and controls taking into consideration the size
and sophistication of the institution; maintenance of an
appropriate audit program and internal control
environment; and effective risk monitoring and
management information systems. This rating should
reflect the board’s and management’s ability as it applies to
all aspects of banking operations as well as other financial
service activities in which the institution is involved.
Ratings
A rating of 1 indicates strong performance by
management and the board of directors and strong risk
management practices relative to the institution’s size,
complexity, and risk profile. All significant risks are
consistently and effectively identified, measured,
monitored, and controlled. Management and the board
have demonstrated the ability to promptly and
successfully address existing and potential problems and
risks.
•
A rating of 2 indicates satisfactory management and
board performance and risk management practices
relative to the institution’s size, complexity, and risk
profile. Minor weaknesses may exist, but are not
material to the safety and soundness of the institution and
are being addressed. In general, significant risks and
problems are effectively identified, measured, monitored,
and controlled.
The capability and performance of management and the
board of directors is rated based upon, but not limited to,
an assessment of the following evaluation factors:
•
•
•
•
•
•
•
•
•
•
The level and quality of oversight and support of all
institution activities by the board of directors and
management.
The ability of the board of directors and management,
in their respective roles, to plan for, and respond to,
risks that may arise from changing business conditions
or the initiation of new activities or products.
The adequacies of, and conformance with, appropriate
internal policies and controls addressing the operations
and risks of significant activities.
The accuracy, timeliness, and effectiveness of
management information and risk monitoring systems
appropriate for the institution’s size, complexity, and
risk profile.
The adequacy of audits and internal controls to:
promote effective operations and reliable financial and
regulatory reporting; safeguard assets; and ensure
compliance with laws, regulations, and internal
policies.
Compliance with laws and regulations.
Responsiveness to recommendations from auditors and
supervisory authorities.
Management depth and succession.
The extent that the board of directors and management
is affected by, or susceptible to, dominant influence or
concentration of authority.
Reasonableness of compensation policies and
avoidance of self-dealing.
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Demonstrated willingness to serve the legitimate
banking needs of the community.
The overall performance and risk profile of the
institution.
A rating of 3 indicates management and board
performance that need improvement or risk management
practices that are less than satisfactory given the nature of
the institution’s activities.
The capabilities of
management or the board of directors may be insufficient
for the type, size, or condition of the institution.
Problems and significant risks may be inadequately
identified, measured, monitored, or controlled.
A rating of 4 indicates deficient management and board
performance or risk management practices that are
inadequate considering the nature of an institution’s
activities. The level of problems and risk exposure is
excessive.
Problems and significant risks are
inadequately identified, measured, monitored, or
controlled and require immediate action by the board and
management to preserve the soundness of the institution.
Replacing or strengthening management or the board may
be necessary.
A rating of 5 indicates critically deficient management
and board performance or risk management practices.
Management and the board of directors have not
demonstrated the ability to correct problems and
implement appropriate risk management practices.
Problems and significant risks are inadequately
identified, measured, monitored, or controlled and now
threaten the continued viability of the institution.
Replacing or strengthening management or the board of
directors is necessary.
4.1-15
Management (12-04)
INTERNAL ROUTINE AND CONTROLS
or lack thereof, must be viewed in the context of other
control procedures that are in place. Every bank is unique,
and one set of internal procedures, or for that matter, even
a few sets of alternative procedures, cannot be prescribed
for all cases. There are, however, certain basic principles
and procedures that must be present in any bank to ensure
the adequacy of internal controls.
These include:
development of an effective organizational structure;
establishment of appropriate accounting procedures;
provisions for the protection of assets; and development
and use of an effective audit program.
INTRODUCTION
The board of directors is responsible for ensuring the
proper and profitable conduct of banking activities; the
safety of the bank's assets; and the accuracy and adequacy
of periodic reports to shareholders, regulatory bodies, and
in some instances, the general public. As a result, the
primary responsibility for creating, implementing, and
monitoring a system of internal control rests with the
directorate. Rarely, if ever, can the board personally
discharge the many duties stemming from these
responsibilities. The workload usually demands delegation
to the management team and other employees. Increases in
asset size and complexity and business lines result in the
need for a continually growing and changing series of
interrelated operating procedures intended to establish and
maintain control over delegated duties. These continual
changes require that the internal control system be
periodically reviewed and updated in order for it to be
effective.
Organizational Structure
The control environment begins with the bank's board of
directors, which is responsible for the development of
objectives and policies and for monitoring adherence to
such. The policies established should ensure that decisionmaking authority is vested at the proper management level
and that management decisions and policies are properly
implemented throughout the organization. An effective
directors’ audit committee, made up of or including outside
directors, is desirable to accomplish that responsibility.
Internal control is a process designed to provide reasonable
assurance that the institution will achieve the following
internal control objectives: efficient and effective
operations, including safeguarding of assets; reliable
financial reporting; and, compliance with applicable laws
and regulations.
Internal control consists of five
components that are a part of the management process:
control environment, risk assessment, control activities,
information and communication, and monitoring activities.
The effective functioning of these components, which is
brought about by an institution's board of directors,
management, and other personnel, is essential to achieving
the internal control objectives. This description of internal
control is consistent with the Committee of Sponsoring
Organizations of the Treadway Commission (COSO)
report entitled Internal Control-Integrated Framework.
Institutions are encouraged to evaluate their internal
control against the COSO internal control framework if
they are not already doing so.
The organization plan must have the complete support of
the board of directors and must establish clear lines of
authority and responsibility. The plan must segregate the
operating and recording functions and provide for
employees who are qualified to perform their assignments.
From an organizational viewpoint, an internal control
system, at a minimum, should provide for the items listed
below.
Directors' Approvals
Limitations imposed by the board of directors with regard
to authority levels, such as lending and investment
authority and responsibilities, should be clearly detailed in
(preferably) written job descriptions and policies. Actions
taken by officers should be subject to periodic review by
the board or a committee thereof. This control feature
should provide for a reporting system that keeps the
directors informed of such items as new loans, overdue
loans, overdrafts, securities transactions, the statements of
condition and income, and expense and audit reports.
BASIC ELEMENTS OF AN INTERNAL
CONTROL SYSTEM
Internal accounting controls are the techniques employed
to prevent and detect errors in the processing of data and to
safeguard assets and the reliability of financial records.
Many internal control techniques are built into the
operating system so that they appear to be part of the
normal processing of a given task. Any attempt to identify
and evaluate the overall system of controls requires that
individual activities be considered in concert with other
activities. The relative importance of an individual control,
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Federal Deposit Insurance Corporation
Section 4.2
Segregation of Duties
The participation of two or more persons or departments in
a transaction causes the work of one to serve as proof for
the accuracy of another. Additionally, when two or more
persons are involved in a transaction, the possibility of
fraud diminishes considerably. Ideally, duties should be
arranged so that no one person dominates any transaction
4.2-1
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
from inception to termination. For example, a loan officer
should not be allowed to disburse loan proceeds; those
having authority to sign checks should not be assigned to
reconcile correspondent bank accounts; records should be
reconciled to the general ledger by someone other than the
one originating the entries; and IT service center personnel
should not initiate transactions or correct data except when
such activity may be required to complete processing in a
reasonable period of time (if this unusual situation arises,
transactions should be approved by appropriate levels of
management at the data center and at the serviced
institution).
Section 4.2
and recommendations on the supplemental Internal Routine
and Controls schedule may be appropriate.
Accounting Procedures
The adoption of an accounting system that is flexible in
capacity and rigid in controls and standards promotes
accuracy and efficiency and holds costs to a minimum.
Such a system is considered basic to any system of internal
controls.
An efficient banking operation cannot be conducted
without a recordkeeping system capable of generating a
wide variety of internal information and reports. Such a
system is necessary if the board of directors is to be kept
well-informed and maximum managerial effectiveness is to
be achieved. Furthermore, the needs of customers,
supervisory agencies, and tax authorities must be met.
Banks are often called upon to produce certain records in
court.
Rotation of Personnel
Planned and unannounced rotation of duties is an important
principle of internal control. The rotation should be of
sufficient duration to be effective. Rotation of personnel,
besides being an effective internal check, can be a valuable
aid in the overall training program.
Sound Personnel Policies
Sound personnel policies are conducive to establishing an
effective control environment. Such policies should
include hiring employees for positions commensurate with
their skills, effective training before assignment to more
responsible positions, and evaluating and reviewing job
performance with each employee.
While it is expected that forms, records, and systems will
differ from bank to bank in varying degrees, the books of
every bank should be kept in accordance with wellestablished accounting and banking principles. In each
instance, a bank's records and accounts should reflect the
actual financial condition and accurate results of
operations. The following characteristics should be found
in a bank's accounting procedures.
Vacation Policies
Operating Responsibilities
All banks should have a vacation policy, which provides
that officers and employees be absent from their duties for
an uninterrupted period of not less than two consecutive
weeks. Such a policy is considered an important internal
safeguard largely because perpetration of an embezzlement
of any substantial size usually requires the constant
presence of the embezzler in order to manipulate records,
respond to inquiries from customers or other employees,
and otherwise prevent detection. Examiners and bank
management should recognize that the benefits of this
policy may be substantially, if not totally, eroded if the
duties performed by an absent individual are not assumed
by someone else. Where the bank's policy does not
conform to the two-week recommended absence period,
examiners should encourage the board of directors to
annually review and approve the policy actually followed
and the exceptions allowed. In such cases it is important
that adequate compensating controls be devised and strictly
enforced. If after consideration of all relevant facts and
circumstances it is determined that the vacation policies are
deficient, the matter should be discussed with the chief
executive officer and the board of directors. Comments
The accounting system should be designed to facilitate
preparation of internal reports that correspond with the
responsibilities of individual supervisors and key
employees.
Internal Routine and Controls (12-04)
Current Records
Records should be updated daily, reflecting each day's
activities separately and distinctly from that of another day.
The records should show the bank's financial condition as
of the given date.
Subsidiary Control Accounts
Subsidiary records, such as those pertaining to deposits,
loans, and securities should be kept in balance with general
ledger control figures.
Audit Trail
The records and systems should be designed to enable
tracing any given item as it passes through the books. The
4.2-2
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INTERNAL ROUTINE AND CONTROLS
following recordkeeping deficiencies are some of the more
prevalent encountered during examinations:
•
•
•
•
•
•
•
•
•
•
documents and certain practices pertaining to control over
the movement of documents from the user to the servicer
and their return, the daily reconcilement of subsystem
totals to the general ledger, and changes to master files.
General ledger entries fail to contain an adequate
transaction description,
Customer loan records are incorrect, inadequate, or
nonexistent,
Permanent and satisfactory records pertaining to cash
items, overdrafts, and other types of suspense or
holding items are lacking,
Tellers' cash records do not contain adequate details,
Securities registers, whether processed electronically
or manually, fail to list all necessary information,
Reconcilement records of correspondent bank
accounts are not kept current and/or fail to reflect the
description and disposition of outstanding items,
Details concerning debits and credits to the over and
short accounts are inadequate,
Accounts and records are not posted on a current
basis,
Control and subsidiary records of outstanding letters
of credit or other contingent liabilities are inadequate,
and
Interbranch or interoffice accounts are not properly
controlled and monitored.
Protection of Physical Assets
A principal method of safeguarding assets is to limit access
by authorized personnel. Protection of assets can be
accomplished by various procedures, including those listed
below.
Cash Control
Tellers should be provided with their own funds to which
they have sole access. Common cash funds should not be
utilized. Inability to fix responsibility in the event of a
difference could be embarrassing and is unfair to all
concerned.
Joint Custody or Dual Control
These two terms are not synonymous, but are often
discussed in tandem. Joint custody refers to a procedure
whereby two or more persons are equally accountable for
the physical protection of certain items or records. An
example consists of two keys or combinations, under the
separate control of two individuals, which must be used in
order to obtain access to vaults, files or other storage
devices. These custodial responsibilities should be clearly
assigned and communicated to all employees. For this
system to be effective, persons exercising control must
guard their key or combination carefully. If this is done,
only collusion can bypass the important control feature.
Reserve cash, negotiable collateral, investment securities,
trust assets, safekeeping items, reserve supply of official
checks, unissued electronic debit or credit cards, unissued
traveler's checks, unissued Series E Bonds, the night
depository, electronic banking terminals, dormant deposit
accounts, safe deposit spare locks and keys, and spare keys
to tellers' cash boxes are examples of items that should be
under effective joint custody.
Prenumbered Documents
Sequentially numbered instruments should be used
wherever possible.
Prenumbered documents aid in
proving, reconciling, and controlling used and unused
items. Number controls, including printer's confirmation,
should be monitored by a person who is detached from that
particular operation. Unissued, prenumbered instruments
that could be used to obtain funds should be maintained
under dual control or joint custody.
Accounting Manual
The uniform handling of like transactions is essential to the
production of reliable reports. Accordingly, it is essential
that instructions be established for processing routine
transactions. In smaller banks where some or all records
are manually produced, it may be advisable to reduce
instructions to writing, possibly in the form of an
accounting manual.
Dual control is a related, but slightly different concept in
which the work of one person is verified or approved by
another. The purposes of involving the second individual
are to ensure that proper authority for the transaction or
activity is given, that the transaction or activity is properly
recorded, and that proper settlement is made. Dual control
in automated systems should be used in the same manner as
in manual systems. Supervisory holds should be placed on
customer accounts requiring special attention.
For
example, dormant accounts, collateral accounts, and
accounts with large uncollected funds normally have holds
In banks where some or all records are computer
generated, there should be an understandable user's guide
for each application readily available for reference by user
departments and personnel. Manuals for each application
normally consist of a guide provided by the servicer and
supplemented by procedures written by the user. Manuals
normally delineate preparation and control source
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 4.2
4.2-3
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
that require the action of two people to remove. In
addition, certain types of transactions (e.g., master file
changes) should require special codes or terminal keys
from two people before they can be completed. When a
hold on an account is added/removed or when a transaction
requiring supervisory approval is completed on an
automated system, exception reports will be printed and
should be reviewed by a designated person not involved
with the transaction. Used conscientiously, automated dual
control methods are superior to the manual procedures.
The board of directors and senior management of an
institution are responsible for ensuring that the system of
internal control operates effectively. Their responsibility
cannot be delegated to others within the institution or to
outside parties. An important element in assessing the
effectiveness of the internal control system is an internal
audit function. When properly structured and conducted,
internal audit provides directors and senior management
with vital information about weaknesses in the system of
internal control so that management can take prompt,
remedial action. Examiners should review an institution's
internal audit function and recommend improvements, if
needed.
Employee Hiring Procedures
The credit and previous employment references of
prospective employees should be checked by management.
The facilities of the FBI are available to check the
fingerprints of employees and prospective employees of
banks and to supply such institutions with criminal records,
if any, of those whose fingerprints are submitted. Pursuant
to Section 19 of the FDI Act, written consent of the FDIC
is needed in order for persons to serve in an insured bank
as a director, officer, or employee if they have been
convicted of a criminal offense involving dishonesty,
breach of trust, or money laundering. Some insurance
companies that write bankers' blanket bonds also offer
assistance to banks in screening officers and employees.
The FDIC adopted minimum standards for an internal audit
program, which can be found in Part 364, Standards for
Safety and Soundness, of the FDIC Rules and Regulations.
The regulation requires each institution to provide the
following elements within the internal audit program:
•
•
•
•
•
Emergency Preparedness Plans
•
Written emergency preparedness plans and off-premise
storage of backup files for all critical records should be
maintained in the event of natural disaster or physical
damage to premises.
•
Adequate monitoring of the institution’s internal
control system,
Independence and objectivity,
Qualified personnel,
Adequate testing and review of information systems,
Adequate documentation of tests and findings of any
corrective actions,
Verification and review of management’s actions to
address material weaknesses, and
Review by the audit committee or board of directors of
the internal audit systems’ effectiveness.
Each institution should have an internal audit function that
is appropriate to its size and the nature and scope of its
activities. The Interagency Policy Statement on the
Internal Audit Function and Its Outsourcing sets forth the
internal audit function’s key characteristics, sound vendor
outsourcing practices, and outsourcing arrangements effect
on external auditor independence. Although the board of
directors and senior management cannot delegate the
responsibility for having an effective system of internal
control and an effective internal audit function, they may
delegate the design, implementation, and monitoring of
specific internal controls to lower-level management and
the testing and assessment of internal controls to others.
Directors and senior management should have reasonable
assurance that the system of internal control prevents or
detects significant inaccurate, incomplete, or unauthorized
transactions; deficiencies in the safeguarding of assets;
unreliable financial reporting (which includes regulatory
reporting); and deviations from laws, regulations, and the
institution's policies. In order to be confident that the
internal audit function addresses the risks and meets the
Reporting Shortages
Procedures should be developed for the prompt reporting
and investigation of shortages when they become known.
The results of an investigation should be reported to
supervisory personnel within the bank and to fidelity
insurers, regulators, and law enforcement agencies, when
appropriate.
AUDIT
All banks should adopt an adequate audit program.
Ideally, such a program would consist of a full-time,
continuous program of internal audit coupled with a wellplanned external auditing program. Such a system would
substantially lessen the risk that a bank would not detect
potentially serious problems.
Internal Audit
Internal Routine and Controls (12-04)
Section 4.2
4.2-4
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INTERNAL ROUTINE AND CONTROLS
demands posed by the institution's current and planned
activities, directors should consider whether their
institution's internal audit activities are conducted in
accordance with professional standards, such as the
Institute of Internal Auditors' (IIA) Standards for the
Professional Practice of Internal Auditing.
These
standards address independence, professional proficiency,
scope of work, performance of audit work, management of
internal audit, and quality assurance reviews. Furthermore,
directors and senior management should ensure that the
following key characteristics regarding structure,
management, staffing and audit quality, scope,
communications, and contingency planning are reflected in
the internal audit function.
Ideally, the internal audit function's only role should be to
independently and objectively evaluate and report on the
effectiveness of an institution's risk management, control,
and governance processes. The role should not include a
business-line management role over control activities, such
as approving or implementing operating policies or
procedures. The audit committee should ensure that any
consulting work performed (e.g. mergers, acquisitions,
advice on new products or services, etc.) by the internal
auditor(s) does not interfere or conflict with the objectivity
of monitoring the internal control system.
The internal audit function should be competently
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. Internal audit policies and procedures should
be consistent with the size and complexity of the
department and the institution.
Structure - The internal audit function should be
positioned so that the board has confidence that internal
audit will perform its duties with impartiality and not be
unduly influenced by managers of day-to-day operations.
The audit committee should oversee the internal audit
function, evaluate performance, and assign responsibility
for the internal audit function to a member of management
or the internal audit manager. The internal audit manager
should understand the internal audit function and have no
responsibility for operating the system of internal control.
Ideally, the internal audit manager should report directly
and solely to the audit committee regarding both audit
issues and administrative matters, e.g., resources, budget,
appraisals, and compensation.
If the internal audit
manager is placed under a dual reporting structure, the
board should weigh the risk of diminished independence
against the benefit of reduced administrative burden, and
the audit committee should document its consideration of
this risk and mitigating controls.
Scope - An effective system of internal control and an
independent internal audit function form the foundation for
safe and sound operations, regardless of an institution’s
size. The frequency and extent of internal audit review and
testing should be consistent with the nature, complexity,
and risk of the institution's on- and off-balance-sheet
activities.
It is the responsibility of the audit committee and
management to carefully consider the extent of auditing
that will effectively monitor the internal control system
after taking into account the internal audit function’s cost
and benefits. For institutions that are large or have
complex operations, the benefits derived from a full-time
manager of internal audit or an auditing staff likely
outweighs the cost. For small institutions with few
employees and less complex operations, however, these
costs may outweigh the benefits. Nevertheless, a small
institution without an internal auditor can ensure that it
maintains an objective internal audit function by
implementing a comprehensive set of independent reviews
of significant internal controls. The key characteristic of
such reviews is that the person(s) directing and or
performing the review of internal controls is not also
responsible for managing or operating those controls. A
person who is competent in evaluating a system of internal
control should design the review procedures and arrange
for their implementation. The person for reviewing the
system of internal control should report findings directly to
the audit committee. The audit committee should evaluate
the findings and ensure that senior management has or will
take appropriate action to correct the control deficiencies.
Management, staffing, and audit quality - The internal
audit manager is responsible for control risk assessments,
audit plans, audit programs, and audit reports. Control risk
assessments document the internal auditor's understanding
of significant business activities and associated risks.
These assessments typically analyze the risks inherent in a
given business line, the mitigating control processes, and
the resulting residual risk exposure of the institution. An
internal audit plan is based on the control risk assessments
and typically includes the key internal controls summaries
within each significant business activity, the timing and
frequency of planned internal audit work, and the resource
budget. An internal audit program describes the audit
objectives and lists the procedures that will be performed
during each internal audit review. An audit report
generally presents the purpose, scope, and results of the
audit
including
findings,
conclusions,
and
recommendations. Workpapers that document the work
performed and support the audit report should be
maintained.
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Federal Deposit Insurance Corporation
Section 4.2
4.2-5
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
At least annually, the audit committee should review and
approve internal audit's control risk assessment and the
audit plan scope, including how much the manager relies
on the work of an outsourcing vendor. The audit
committee should also periodically review the internal
audit's adherence to the audit plan and should consider
requests for expansion of basic internal audit work when
significant issues arise or when significant changes occur in
the institution's environment, structure, activities, risk
exposures, or systems.
effective system of internal control and for overseeing the
internal audit function.
Even when outsourcing vendors provide internal audit
services, the board of directors and senior management of
an institution are responsible for ensuring that both the
system of internal control and the internal audit function
operate effectively and must maintain ownership of the
internal audit function and provide active oversight of
outsourced activities. When negotiating the outsourcing
arrangement with an outsourcing vendor, an institution
should carefully consider its current and anticipated
business risks in setting each party's internal audit
responsibilities. The outsourcing arrangement should not
increase the risk that a breakdown of internal control will
go undetected.
Communication - Directors and senior management
should foster forthright communications including critical
issues to better understand the importance and severity of
internal control weaknesses identified by the internal
auditor and operating management's solutions to these
weaknesses. Internal auditors should immediately report
internal control deficiencies to the appropriate level of
management and significant matters should be promptly
reported directly to the board of directors (or its audit
committee) and senior management. Moreover, the audit
committee should give the manager of internal audit the
opportunity to discuss his or her findings without
management being present. Furthermore, each audit
committee should establish and maintain procedures for
employees of their institution to submit (confidentially and
anonymously) concerns to the committee about
questionable accounting, internal accounting control, or
auditing matters.
To clearly distinguish its duties from those of the
outsourcing vendor, the institution should have a written
contract that typically includes: a definition of both parties
expectations and responsibilities; the scope, frequency,
fees for the vendor’s work; the responsibilities for
providing and receiving information about the contract
work status; the process for changing service contract
terms; the internal audit reports are the institution’s
property and specified employees will have reasonable and
timely access to the vendor prepared workpapers; the
locations of internal audit reports and the related
workpapers; the time period that vendors must maintain the
workpapers; the vendor audits are subject to regulatory
review and examiners will be granted full and timely
access to the internal audit reports and related workpapers;
a process (arbitration, mediation, or other means) for
resolving disputes and for determining who bears the cost
of consequential damages arising from errors, omissions,
and negligence; and the vendor will not perform
management functions, make management decisions, or act
or appear to act in a capacity equivalent to that of a
member of management or an employee and, if applicable,
will comply with AICPA, U.S. Securities and Exchange
Commission (SEC), Public Company Accounting
Oversight Board (PCAOB), or regulatory independence
guidance.
Contingency Planning – Whether using an internal audit
staff and/or outsourcing arrangement, the institution should
have a contingency plan to mitigate any significant
discontinuity in audit coverage, particularly for high-risk
areas. Operational risk may increase when an institution
enters into an outsourcing arrangement because the
arrangement may be terminated suddenly.
Internal Audit Outsourcing Arrangements
An outsourcing arrangement is a contract between an
institution and an outsourcing vendor to provide internal
audit services. Some institutions consider entering into
these arrangements to enhance the quality of their control
environment by obtaining the services of a vendor with the
knowledge and skills to critically assess, and recommend
improvements to, their internal control systems.
Outsourcing may be beneficial to an institution if it is
properly structured, carefully conducted, and prudently
managed. The structure, scope, and management of some
internal audit outsourcing arrangements should contribute
to the institution's safety and soundness as directors and
senior management are still responsible for maintaining an
Internal Routine and Controls (12-04)
Section 4.2
Before entering an outsourcing arrangement, the institution
should perform due diligence to satisfy itself that the
outsourcing vendor has sufficient staff qualified to perform
the contracted work.
Throughout the outsourcing
arrangement, management should ensure that the
outsourcing vendor maintains sufficient expertise to
effectively perform its contractual obligations. Directors
and senior management should ensure that the outsourced
internal audit function is competently managed with proper
vendor oversight. Communication between the internal
audit function and the audit committee and senior
4.2-6
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management should not diminish because the institution
engages an outsourcing vendor. Rather, the entire vendor’s
work should be well-documented and all findings of
control weaknesses should be promptly reported to the
institution's manager of internal audit. Decisions not to
report the outsourcing vendor's findings to directors and
senior management should be the mutual decision of the
internal audit manager and the outsourcing vendor. In
deciding what issues should be brought to the board's
attention, the concept of "materiality," as the term is used
in financial statement audits, is generally not a good
indicator of which control weakness to report. For
example, when evaluating an institution's compliance with
laws and regulations, any exception may be important.
All banks are strongly encouraged to establish an audit
committee consisting, if possible, entirely of outside
directors and, in appropriate circumstances, should be
criticized for not doing so. Although a committee of
outside directors may not appear possible in a small closely
held bank where there are, in effect, no outside directors on
the board, all banks should be encouraged to add outside
directors to their board and to appoint them to the audit
committee. The audit committee or board should annually
analyze the extent of external auditing coverage needed by
the bank.
The board or audit committee, when evaluating the
institution’s external auditing needs should consider the
size of the institution and the nature, scope, and complexity
of its operations. It should also consider the potential
benefits of an audit of the institution’s financial statements
or an examination of the institution’s internal control
structure over financial reporting, or both. In addition, the
board or audit committee may determine that additional or
specific external auditing procedures are warranted for a
particular year or several years to cover areas of
particularly high risk or special concern. The reasons
supporting these decisions should be recorded in the
committee’s or board’s minutes. If, in the judgment of the
examiner, unique risks of the bank need additional external
audit procedures, specific recommendations for addressing
these areas should be made for audit committee and/or
board consideration.
Independence of the Independent Public
Accountant
When one accounting firm performs both the external audit
and the outsourced internal audit function, the firm risks
compromising its independence. While the SarbanesOxley Act of 2002 prohibits an accounting firm from
acting as the external auditor of a public company during
the same period that the firm provides internal audit
outsourcing services, non-publicly traded institutions are
also encouraged to consider the risks associated with
compromising independence versus potential audit cost
savings. Refer to the Corporate Governance portion of this
section for further details on applicability.
External Audit of the Financial Statements
External Audit
Each bank is strongly encouraged to adopt an external
auditing program that includes an annual audit of its
financial statements by an independent public accountant
(unless its financial statements are included in the audit of
its holding company's consolidated financial statements).
A bank that does so would generally be considered to have
satisfied the objectives of the Interagency Policy
Statement. An external audit of the financial statements
benefits management by assisting in the establishment of
the accounting and operating policies, internal controls,
internal auditing programs, and management information
systems necessary to ensure the fair presentation of these
statements. An audit also assists the board of directors in
fulfilling its fiduciary responsibilities and provides greater
assurances that financial reports are accurate and provide
adequate disclosure.
An external auditing program is designed to determine
whether a bank’s financial statements have been properly
prepared in accordance with GAAP and to alert
management to any significant deficiencies in internal
controls over financial reporting.
Part 363 of the FDIC Rules and Regulations establishes
specific audit and reporting requirements for insured
depository institutions with total assets of $500 million or
more which are discussed later in this section. In addition,
the FDIC adopted the Interagency Policy Statement on
External Auditing Programs of Banks and Savings
Associations which is applicable to all institutions. The
examination reports for banks that are not in general
compliance with the policy statement regarding external
audits should indicate the status of implementation efforts.
When warranted, the examiner's comments and
recommendations with respect to the adequacy of a bank's
external auditing program should also be presented.
Nevertheless, examiners should not automatically comment
negatively on a bank with an otherwise satisfactory
external auditing program merely because an independent
public accountant is not engaged to perform an audit of its
financial statements.
Audit Committees
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Section 4.2
4.2-7
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
Alternative External Auditing Programs
control. When choosing this type of external auditing
program, the board or audit committee is responsible
for determining whether these procedures meet the
external auditing needs of the institution, considering
its size and the nature, scope, and complexity of its
business activities.
Alternatives to a financial statement audit by an
independent public accountant include:
•
•
•
Reporting by an Independent Public Accountant on
an Institution's Internal Control Structure Over
Financial Reporting – This is an independent public
accountant's examination and report on management's
assertion on the effectiveness of the institution's
internal control over financial reporting. For a smaller
institution with less complex operations, this type of
engagement is likely to be less costly than a financial
statement or balance sheet audit. It would specifically
provide recommendations for improving internal
control, including suggestions for compensating
controls, to mitigate the risks due to staffing and
resource limitations. Since the lending and investment
securities activities generally present the most
significant risks that affect an institution's financial
reporting, management's assertion and the accountant's
attestation generally should cover those regulatory
report schedules.
If the audit committee or board, after due consideration,
determines not to engage an independent public accountant
to conduct an annual audit of the financial statements, the
reason(s) for the conclusion to use one of the acceptable
alternatives or to have no external auditing program should
be documented in the written meeting minutes. Generally,
the board or audit committee should consider not only the
cost of an annual audit, but also the potential benefits. The
examiner should determine whether the alternative selected
by the bank adequately covers the bank’s high-risk areas
and is performed by a qualified auditor who is independent
of the bank. As with deficiencies in an internal auditing
program, any scope weaknesses in the bank's external
auditing program should be commented on in the
examination report.
If a bank chooses not to have a financial statement external
audit by an independent public accountant, the examiner
should strongly encourage the bank, at a minimum, to
engage an independent auditor to perform an external
auditing program for the bank. However, if high-risk areas
are not adequately covered, the examiner should
recommend that the additional procedures be performed in
the future and that any other deficiencies in the auditing
program be corrected to ensure that there is adequate
independent external auditing coverage of operational risk
areas.
Balance Sheet Audit Performed by an Independent
Public Accountant – This is where the institution
engages an independent public accountant to examine
and report only on the balance sheet. As with the
financial statement audit, this audit is performed in
accordance with Generally Accepted Auditing
Standards (GAAS). The cost of a balance sheet audit
is likely to be less than a financial statement audit.
However, under this type of program, the accountant
does not examine or report on the fairness of the
presentation of the institution's income statement,
statement of changes in equity capital, or statement of
cash flows.
If a bank has no external auditing program, the examiner
should review the minutes to determine the reasons for this
choice. A strong internal audit program is fundamental to
the safety and soundness of a bank, but it is usually not a
sufficient reason for the lack of an external auditing
program. One should complement the other, and typically
the external program tests and proves (or disproves) the
strength of the internal audit program. In such situations,
the bank should be strongly urged to reconsider its
decision.
Agreed-Upon
Procedures
State-Required
Examinations - Some state-chartered depository
institutions are required by State statute or regulation
to have specified procedures performed annually by
their directors or independent persons. Depending
upon the engagement’s scope, the cost of agreed-upon
procedures or a State-required examination may be
less than the cost of an audit. However, under this
type of program, the independent auditor does not
report on the fairness of the institution's financial
statements or attest to the effectiveness of the internal
control structure over financial reporting.
The
procedures’ findings or results are usually presented to
the board or the audit committee so that they may
draw their own conclusions about the quality of the
financial reporting or the sufficiency of internal
Internal Routine and Controls (12-04)
Section 4.2
External Auditors' Reports
Each state nonmember bank that undergoes any external
auditing work, regardless of the scope, is requested to
furnish a copy of any reports by the public accountant or
other external auditor, including any management letters,
to the appropriate FDIC Regional Office, as soon as
possible after receipt by the bank. A bank whose external
auditing program combines State-mandated requirements
4.2-8
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with additional procedures may submit a copy of the
auditors' report on its State-mandated procedures that is
supplemented by a report on the additional procedures. In
addition, the FDIC requests each bank to notify promptly
the appropriate Regional Office when any public
accountant or other external auditor is initially engaged to
perform external audit procedures and when a change in its
accountant or auditor occurs.
bank and its auditors at which audit findings are to be
presented.
FDIC Rules and Regulations for Institutions
over $500 Million
Although the described audit programs are recommended
for all depository institutions in accordance with general
prudent banking practices, certain institutions are
specifically required by law to have external audit
programs. Part 363 of the FDIC Rules and Regulations
establishes audit and report requirements for insured
depository institutions with total assets of $500 million or
more and their independent public accountants.
The auditors' reports submitted to the FDIC by a financial
institution that chooses an alternative external auditing
program rather than an annual audit of the financial
statements should include a description of the procedures
performed.
If the auditor's report states that the
"procedures agreed upon with management" have been
performed, the bank should be requested to supply a copy
of the engagement letter or other document that outlines
the agreed-upon procedures so that the FDIC can
determine the scope of the external auditing program.
Management of each institution covered by this regulation
must:
•
•
Troubled Banks
•
When examining banks that have not had audits performed
by an independent public accountant and at which any of
the following conditions exist:
•
•
•
•
•
•
•
•
Engage an independent public accountant,
Prepare annual financial statements in accordance with
GAAP, and
Produce annual reports.
The annual management reports must contain a statement
of management's responsibilities for preparing the financial
statements, for establishing and maintaining an adequate
internal control structure and procedures for financial
reporting, and for complying with laws and regulations
relating to loans to insiders and dividend restrictions. The
reports must also contain an evaluation by management of
the effectiveness of the internal control structure and
procedures for financial reporting and an assessment of the
institution's compliance with designated laws and
regulations.
Internal controls and internal auditing procedures are
inadequate;
The directorate is generally uninformed in the area of
internal controls;
There is evidence of insider abuse;
There are known or suspected defalcations;
There is known or suspected criminal activity;
It is probable that director liability for losses exists;
Direct verification is warranted; and/or
Questionable transactions with affiliates have
occurred.
The independent public accountant engaged by the
institution is responsible for:
•
The examiner and Regional Office staff should consider
adding to any contemplated administrative order a
condition directing the bank to obtain an audit or, if more
appropriate, to have specified audit procedures performed
by a public accountant or other independent party. Since
each situation differs, the examiner and Regional Office
must evaluate the type of external audit program that would
be most suitable for each troubled bank and, in conjunction
with the Regional Counsel, ascertain that the inclusion of
such an external audit program as a condition in the order
is appropriate. Whenever a condition requiring an audit or
specified audit procedures is included in an order, it should
include requirements that the bank promptly submit copies
of the auditor's reports to the Regional Office and notify
the Regional Office in advance of any meeting between the
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 4.2
•
Auditing and reporting on the institution's annual
financial statements in accordance with GAAS; and
Examining, attesting to, and reporting separately on
the assertions of management concerning the
institution's internal control structure and procedures
for financial reporting.
Reporting Requirements
Part 363 requires that insured depository institutions
submit the following reports and notifications to the FDIC,
the appropriate Federal banking agency, and the
appropriate State bank supervisor.
•
4.2-9
Within 90 days after fiscal year end, an annual report
must be filed. The annual report must contain audited
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
•
•
annual financial statements, the independent public
accountant's audit report, management's statements
and assessments, and the independent public
accountant's attestation concerning the institution's
internal control structure and procedures for financial
reporting.
Within 15 days after receipt, the institution must
submit any management letter; the audit report and any
qualification to the audit report; and any other report,
including attestation reports, from the independent
public accountant.
Within 15 days of occurrence, the institution must
provide written notice of the engagement of an
independent public accountant, the resignation or
dismissal of a previously engaged accountant, and the
reasons for such an event.
Section 4.2
Part 363 at the holding company level, provided that the
holding company performs services and functions
comparable to those required of the institution. If the
holding company performs comparable functions and
services, the institution may elect to rely on the holding
company's audit committee and may file a management
report and accountant's attestations that have been prepared
for the holding company. Subsidiary institutions with $5
billion or more in total assets may elect to comply with
these other requirements of Part 363 at the holding
company level only if the holding company performs
services and functions comparable to those required by the
institution, and the institution has a composite CAMELS
rating of 1 or 2.
The institution's audit committee may be composed of the
same persons as the holding company's audit committee
only if such persons are outside directors of both the
holding company and the subsidiary and are independent
of management of both. A separate set of minutes must be
maintained.
Part 363 requires certain filings from independent public
accountants. The accountants must notify the FDIC and
the appropriate Federal banking supervisor when it ceases
to be the accountant for an insured depository institution.
The notification must be in writing, must be filed within 15
days after the relationship is terminated, and must contain
the reasons for the termination. The accountant must also
file a peer review report with the FDIC within 15 days of
receiving the report or before commencing any audit under
Part 363.
If the institution being examined is not the lead bank in the
holding company, the examiner need only confirm that the
institution qualified for, and has invoked the holding
company exemption and review the holding company
reports to determine if any pertinent information about the
institution is disclosed.
Audit Committee
Mergers
Each insured depository institution subject to Part 363
must establish an independent audit committee of its board
of directors. The members of this committee must be
outside directors who are independent of management.
Their duties include overseeing the internal audit function,
selecting the accountant, and reviewing with management
and the accountant the audit’s scope and conclusions, and
the various management assertions and accountant
attestations. Part 363 establishes the following additional
requirements for audit committees of insured depository
institutions with total assets of more than $3 billion: two
members of the audit committee must have banking or
related financial management expertise; large customers of
the institution are excluded from the audit committee; and
the audit committee must have access to its own outside
counsel.
Institutions subject to Part 363 that cease to exist at fiscal
year-end have no responsibility under this rule. If a
covered institution no longer exists as a separate entity as a
result of its merger into another institution after the end of
the fiscal year, but before its annual and other reports must
be filed under this rule, reports should still be submitted to
the FDIC and appropriate Federal and State banking
agencies. An institution should consult with the DSC
Accounting and Securities Disclosure Section in
Washington, DC, and its primary Federal regulator, if other
than the FDIC, concerning the statements and reports that
would be appropriate to submit under the circumstances.
Review of Part 363
Examination procedures regarding the review of the bank’s
audit program and Part 363 are included in the
Examination Documentation (ED) Modules under the
Management and Internal Control Evaluation section.
Holding Company Subsidiary Institutions
Subsidiaries of holding companies, regardless of asset size,
may file the audited, consolidated financial statements of
the holding company in lieu of separate audited financial
statements covering only the institution. In addition,
subsidiary institutions with less than $5 billion in total
assets may elect to comply with the other requirements of
Internal Routine and Controls (12-04)
When reviewing the audit report, particular note should be
taken of any qualifications in the independent accountant's
opinion and any unusual transactions. In reviewing
management's report and the accountant's attestation,
4.2-10
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INTERNAL ROUTINE AND CONTROLS
The Interagency Policy Statement on Coordination and
Communication Between External Auditors and Examiners
includes guidelines regarding meetings between external
auditors and examiners.
special attention should be given to any assessment that
indicates less than reasonable assurance that internal
controls over financial reporting are effective or less than
material compliance with the designated laws and
regulations exists.
Notices referencing a change in
accountants should be reviewed for possible "opinion
shopping" and any other issues that may be related to
safety and soundness.
The FDIC encourages communication between its
examiners and external auditors with the permission of
institution management. Permission has been given once
an institution notifies the FDIC of the accountant’s name or
the accounting firm that it engaged as external auditor (by
letter or by submitting a copy of the auditor’s report to an
FDIC Regional Office). Permission continues until the
institution notifies the FDIC that its relationship with the
external auditor has been terminated or that another auditor
has been engaged.
The board's annual determination that all members of the
committee are "independent of the management of the
institution" should also be reviewed. For institutions
exceeding $3 billion in total assets, the examiner should
review board determinations and minutes documenting that
at least two members of the audit committee have banking
or related financial management expertise and that no
member is a large customer of the institution. Appropriate
recommendations should be made in the examination
report if any determination is judged as unreasonable.
The FDIC encourages external auditors to attend exit
conferences and other meetings at which examination
findings are discussed between an institution's management
and its examiners. In addition, auditors may request a
meeting to discuss relevant supervisory matters with any of
the regulatory agencies involved in the institution's
supervision.
An auditor who determines that
communication with the FDIC is warranted concerning a
recent examination should contact the appropriate Regional
Office. A Regional Office staff member, the examiner, or
the field supervisor may discuss any of the examiner's
findings with the external auditor. The regulatory agencies
will usually request that institution management be
represented at the meeting. However, an external auditor
may request a meeting without the representation of the
institution's management.
At the first examination of each institution subject to Part
363, examiners should describe and discuss any apparent
violations, but based on their judgment of the institution's
situation, should focus on education and making
recommendations about compliance. The examination
report should indicate the status of the institution's
implementation efforts if not yet in full compliance with
the rule.
Problems or concerns with the accountant's or firm’s
auditing, attestation, or accounting policies and procedures
that may represent a basis for a suggested review of its peer
review workpapers should be referred to the Regional
Accountant. If the Regional Accountant considers a peer
review workpaper review warranted, the Regional
Accountant will confer with the DSC Accounting and
Securities Disclosure Section about conducting the review.
This referral does not preclude the Regional Office from
filing a complaint, or taking any other enforcement action,
against the accountant. Peer review workpaper reviews
would generally be appropriate only in unusual or
egregious circumstances; therefore, they are expected to be
relatively rare.
Requests for meetings and information can also originate
with the regulatory agencies. If questions arise concerning
matters pertaining to the institution on which the external
auditor is knowledgeable, examiners may request meetings,
including confidential meetings, with an institution's
external auditor. FDIC staff may also inquire of the
external auditor whether any problems were encountered
during the audit of which the FDIC should be aware.
Furthermore, copies of workpapers relating to services
performed by the external auditor may be solicited. In
some instances, an FDIC examiner, field supervisor, or
Regional Office staff member may determine that attending
the meeting between an institution's auditors and its
management or board of directors (or an appropriate
committee) at which the audit report is discussed would be
useful. The institution should be advised and asked to
present the request to the auditor.
Examiners, if requested, are not to provide any written
representations concerning Part 363 to institutions or their
independent outside auditors. Examination staff should
continue to respond orally to inquiries of external auditors
in accordance with outstanding guidelines on these
communications.
The Policy Statement suggests that the institution provide
its external auditor a copy of certain regulatory reports and
supervisory documents including, but not limited to,
reports of condition, examination reports and
Communication with External Auditors
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 4.2
4.2-11
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
correspondence from regulators, any memorandum of
understanding or written agreement, and a report on any
actions initiated under Section 8 of the FDI Act or similar
action taken by a State banking supervisor. Similarly, the
AICPA’s Audit and Accounting Guide for Depository and
Lending Institutions: Banks and Savings Institutions,
Credit Unions, Finance Companies and Mortgage
Companies (Guide) provides auditors with guidance
regarding communicating with examiners during audits of
financial institutions. Chapter 5 of the Guide stresses
communication between auditors and examiners. For
example, the Guide recommends that auditors endeavor to
be responsive to any requests from examiners to attend
meetings with an institution's management at which audit
reports are reviewed. According to the Guide, a refusal by
bank management to allow the auditor to review such
material or to communicate with the examiner would
ordinarily be an audit scope limitation sufficient to prevent
the auditor from rendering an opinion.
aggressive accounting practices, mortgage
activities, or large deferred tax assets.
servicing
Requests by the Regional Director to independent public
accountants for access to workpapers should be in writing
and specify the institution to be reviewed, indicate that the
accountant's related policies and procedures should be
available for review, and request that a staff member
knowledgeable about the institution be available for any
questions.
Since workpapers are often voluminous,
examiners are expected to view them where they are
located. Since these workpapers are highly confidential,
examiners are encouraged to take notes of needed
information, and should request copies of only those
workpapers that are needed for their records. No requests
for copies of all workpapers should be made.
Complaints Against Accountants
An examiner encountering evidence of possible violations
of professional standards by a CPA or licensed public
accountant should, if practicable, initially discuss the
matter with the accountant in an attempt to resolve the
concern. If the concern is not resolved in this manner, the
examiner should send a memorandum to the Regional
Director, with a copy to the Regional Accountant,
summarizing the evidence of possible violations of
professional standards and the inability to resolve the
matter with the accountant. As part of the discussion, the
accountant should be made aware that a complaint to the
AICPA and/or the State board of accountancy is under
consideration. Documentary evidence should be attached
to support comments. Where notification of apparent
violation of professional standards appears appropriate,
letters should be concurrently forwarded by the Regional
Director to the State board of accountancy in the
institution's home state, the Professional Ethics Division of
the AICPA (in the case of certified public accountants), the
subject accountant or firm, and the DSC Accounting and
Securities Disclosure Section.
Workpaper Review Procedures
Examiners, in consultation with the Regional Accountant,
may review the workpapers of the independent public
accountant. Workpapers of the holding company audit
may be examined with regard to the examination of a
subsidiary institution. However, before any workpaper
review is undertaken, the primary Federal regulator, if
other than the FDIC, and any State bank supervisors of the
institution or other holding company subsidiaries should be
contacted to arrange a coordinated review. No set of
workpapers should be reviewed more than once by all
concerned agencies combined.
A workpaper review is not expected to be performed for
every institution; however, examiners should review
workpapers before or during an examination, (unless the
workpapers of the institution for that fiscal year have been
previously reviewed) in the following instances: each
insured institution subject to Part 363 that has been or is
expected to be assigned a CAMELS rating of 4 or 5; each
state nonmember bank not subject to Part 363 that has been
or is expected to be a assigned a CAMELS rating of 4 or 5;
and where an institution, regardless of size, is not expected
to be assigned a rating of 4 or 5, but significant concerns
exist regarding other matters that would have been covered
in the audit. A workpaper review may assist with the
examination scope by identifying those areas where
sufficient audit work was performed by the independent
public accountant so examination procedures could be
limited and by identifying those higher-risk areas where
examination procedures should be expanded. A workpaper
review may be especially useful before or during an
examination if the institution has asset quality problems,
Internal Routine and Controls (12-04)
Section 4.2
In addition to violations of professional standards,
complaints should also include substandard auditing work
or lack of independence.
Institutions Contracting With A Third
Party To Perform Specific Work at
the FDIC’s Request
Examiners sometimes find that an institution is involved in
unique activities or complex transactions that are not
within management’s range of expertise. For example, the
institution may carry certain complex financial instruments
or other unusual assets on its financial statements at values
4.2-12
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INTERNAL ROUTINE AND CONTROLS
that management cannot adequately support and that the
examiner cannot confirm. Additionally, the institution may
have certain internal control problems that require the
expertise of an independent consultant to properly resolve.
•
•
In situations such as these, after receiving appropriate
approval, examiners may request that an institution
contract with an independent public accountant or other
professional to perform specific work to address the
identified concern. Such an assignment normally would
not be included in the scope of the work performed in the
usual external auditing programs, i.e., an audit, balance
sheet audit, or attestation on internal control over financial
reporting. This additional work, when performed by an
independent public accountant, may be considered an
engagement to perform “agreed-upon procedures,” to issue
a “special report,” or “to report on the application of
accounting principles” under applicable professional
standards. These latter two engagements are performed by
an independent public accountant under GAAS, while
“agreed-upon procedures,” are performed under Generally
Accepted Standards for Attestation Engagements
(GASAE). If another type of professional is contracted to
perform services for an institution, the professional may be
subject to a different set of professional standards.
Nevertheless, the important elements for the examiner to
consider when evaluating the adequacy of the institution’s
contract with the professional are similar in all cases.
•
•
•
•
•
•
The workpapers for this (specify type of
engagement, e.g., agreed-upon procedures, special
report) are the property of (name of firm) and
constitute confidential information. However,
(name of firm) agrees to make the workpapers
supporting this engagement available to the FDIC
and other Federal and State banking regulators.
In addition to the workpapers, (name of firm)
agrees to make any or all of the following
available to the FDIC and other Federal and State
banking regulators:
•
•
•
the work plan, or similar planning document
relating to this engagement,
the process used for the selection of samples
used in the specific work, if applicable, and
other pertinent information on the firm's
policies and procedures that may affect this
work plan..
Access to the workpapers will be provided at
(name of firm) local office under the supervision
of our personnel. Furthermore, upon the request
of the FDIC or other Federal and State banking
regulators, we agree to provide photocopies of
selected workpapers to them.
A description of the work to be performed,
The responsibilities of the accountant or other
professional,
An identification of, or a reference to, the specific
financial statement elements, accounts, or items on
which the work is to be performed, if applicable; the
party responsible for recording them in the financial
statements; and the basis of accounting of the specific
elements, accounts, or items on which the work is to
be performed,
A reference to the applicable professional standards
covering the work, if any. Examples include, auditing
DSC Risk Management Manual of Examination Policies
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standards, attestation standards, and appraisal
standards,
An enumeration of, or a reference to, the specific
procedures to be performed,
The types of sources to be used to obtain the relevant
information, if applicable,
The qualifications of the employees who are to
perform the work,
The time frame for completing the work,
Any restrictions on the use of the reported findings,
and
A provision for examiner access to workpapers.
The contract or engagement letter covering the specific work
should include language assuring examiner access to the
accountant’s or other professional’s workpapers.
An
example of the type of language that should be included in
the engagement letter or other contract between the
institution and the independent public accountant or other
professional is:
When requiring or recommending that an institution
contract with an independent public accountant or other
outside professional for specific additional work, the
examiner should advise the institution to provide the FDIC
with a copy of the contract for review before the contract is
signed. The contract should be reviewed to ascertain
whether it describes the work that needs to be performed in
sufficient detail so that the outside professional
understands exactly what the FDIC's expectations are and
can be responsive to any requirements established by the
FDIC concerning the work to be performed. The contract
or engagement letter should, at a minimum, include:
•
•
Section 4.2
CORPORATE GOVERNANCE
The provisions of the Sarbanes-Oxley Act of 2002 are
primarily directed toward those companies, including
depository institutions, that have a class of securities
4.2-13
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
registered with the Securities and Exchange Commission
(SEC) or the appropriate Federal banking agency under
Section 12 of the Securities Exchange Act of 1934, i.e.,
public companies. Applicability of the Sarbanes-Oxley
Act to insured depository institutions depends, in large
part, on an institution’s size and whether it is a public
company or a subsidiary of a public company.
internal controls and accountant’s attestation on this
assessment are applicable for FDIC-supervised banks with
$500 million or more in total assets.
When performing a review of the Act and its applicability
to the institution being examined, examiners should refer to
outstanding guidance and, when necessary, should consult
with the Regional Accountant.
FDIC- Supervised Banks That Are
Public Companies or
Subsidiaries of Public Companies
THE EXAMINER'S RESPONSIBILITIES
Examinations are not undertaken for the detection of fraud,
nor are their sole or primary purpose to assure the
complete correctness or appropriateness of records. The
overall assessment of a bank's system of internal control is,
however, an important examination function. In most
cases, such an appraisal can be accomplished by an overall
evaluation of the internal control system, a specific review
of audit systems and reports, performance of standard
examination procedures, and recommendations to
management. In some instances, all or a portion of a
bank's system of internal control may be deficient, or
management or the condition of a particular institution may
be such that more intensive audit tests, suited to the
particular circumstances and needs of the bank under
examination, should be undertaken. These matters are
discussed in a following section on possible audit
techniques.
Some FDIC-supervised banks have registered their
securities pursuant to Part 335 of the FDIC’s regulations
and are, therefore, public companies. Other FDICsupervised banks are subsidiaries of bank holding
companies that are public companies. These public
companies and their independent public accountants must
comply with the Sarbanes-Oxley Act – including those
provisions governing auditor independence, corporate
responsibility and enhanced financial disclosures.
Non-public FDIC-Supervised Banks With
Less Than $500 Million in Total Assets
Non-public, FDIC-supervised banks that have less than
$500 million generally do not fall within the scope of the
Act. Nevertheless, certain provisions of the Act mirror
existing policy guidance related to corporate governance
issued by the FDIC and other banking agencies. Other
provisions of the Act represent sound corporate
governance practices; and although such practices are not
mandatory for smaller, non-public institutions, the FDIC
recommends that each institution consider implementation
to the extent possible, given the institution’s size,
complexity and risk profile.
These techniques may lead to an indication of possible
fraud or insider abuse.
Such situations should be
thoroughly investigated by the examiner. Please refer to
the Bank Fraud and Insider Abuse section of this Manual
for further information.
Overall Evaluation of Internal Controls
Insured Depository Institutions With
$500 Million or More in Total Assets
The examiner's principal efforts should be focused on the
detection, exposure and correction of important
weaknesses in the bank's records, operating systems, and
auditing procedures. Information should be developed
through discussions with management and employees and
examiner observation of performance and procedures.
Each bank presents specific situations to which common
sense and technical knowledge must be applied. The
institution’s size, the number of employees, and the
character of the bank's operations must be considered in
any meaningful evaluation.
Institutions that have $500 million or more in total assets
as of the beginning of their fiscal year are subject to the
annual audit and reporting requirements of Section 36 of
the FDI Act as implemented by Part 363 of the FDIC’s
Rules and Regulations. Some large institutions are also
public companies or subsidiaries of public companies, and
some institutions subject to Part 363 satisfy the
requirements of the Act on a holding company basis.
There are selected provisions of the Act that are applicable
to FDIC-supervised banks with $500 million or more in
total assets. For example, the auditor independence
requirements, management’s responsibility for financial
reporting and controls, and management’s assessment of
Internal Routine and Controls (12-04)
Section 4.2
Specific Review of Audit Systems and Reports
The examiner's evaluation of internal/external audit
procedures and reports plays a key role in the overall
4.2-14
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INTERNAL ROUTINE AND CONTROLS
assessment of a bank's internal controls system. The
following is a listing of functions and procedures that
should be encompassed by the audit program. The list is
not all-inclusive and performance lacking in any one area
should not necessarily be viewed as a major deficiency.
The list may, however, serve as a framework to assist in the
evaluation of a bank's audit program.
Section 4.2
Verify loan balances for loans charged-off since the
previous audit and the debit entries to the ALLL account;
check supporting documentation for loans charged-off; and
review loan recoveries and check the credit entries in the
allowance account; and review ALLL methodology to
determine compliance with GAAP.
Bank Premises and Equipment
Cash Accounts
Examine entries and documentation relative to purchases
and sales since the previous audit; check computation of
depreciation expense; and check computation of gain or
loss on property sold and trace sales proceeds.
Verify cash on hand; review cash items, cutbacks, or any
other assets or liabilities held in suspense accounts to
determine proper and timely disposition; and verify
clearings.
Other Assets
Due From Banks
Verify the appropriateness of all other asset categories.
Test and review bank prepared reconcilements with
particular emphasis on old or recurring outstanding items;
obtain cut-off bank statements as of audit date and an
appropriate date subsequent thereto for use in testing bank
reconcilements; review all return items for an appropriate
period subsequent to the audit date; and confirm balances
due from banks to include time accounts with the banks
holding the deposits.
Deposits
Reconcile subsidiary records to general ledger accounts;
verify account balances on a test basis; review closed
accounts and determine they were properly closed; review
account activity in dormant accounts and in the accounts of
bank insiders; review overdrafts; check computation of
service charges and trace postings to appropriate income
accounts; review accrued interest accounts and check
computation of interest expense; account for numerical
sequence of prenumbered certificates of deposit and
official checks; reconcile outstanding official checks;
determine the validity of outstanding official checks;
examine documentation supporting paid official checks;
and test certified checks to customers' collected funds
balances.
Investments
Prove subsidiary records to the general ledger; verify
securities on hand or held by others for safekeeping; check
the gain and loss entries on securities sold or matured since
the previous audit; review accrued interest accounts and
test check computations and disposition of interest income.
Review premium amortization procedures, especially for
securities that have principal reductions to determine that
premiums are being amortized appropriately.
Borrowed Funds
Verify borrowed fund balances; verify changes in capital
notes outstanding; and review the accrued interest accounts
and check interest expense computation.
Loans
Prove subsidiary records to general ledger; verify a
sampling of loan balances on a positive or negative basis;
verify the existence of negotiable collateral; review
accrued interest accounts and test the computation and
disposition of interest income; verify leases and related
balance sheet accounts; verify unearned discount account;
and test rebate amounts for loans that have been prepaid.
Verify that Rules of 78 loans and loans with unearned
discounts have decreased and that only those loans booked
prior to January 1, 1999, remain on the books. Installment
loans booked thereafter should be booked using the simple
interest method for accounting.
Other Liabilities
Check the appropriateness of all other liabilities.
Capital Accounts and Dividends
Account for all unissued stock certificates; review capital
account changes since the previous audit; check
computations for dividends paid or accrued; and review
minutes to determine propriety of dividend payments and
accruals.
Allowance For Loan and Lease Losses (ALLL)
Consigned Items and Other Non-Ledger
Control Accounts
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4.2-15
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
The Examination Documentation (ED) Modules include
examination procedures regarding control activities and
monitoring. Procedures are provided both for institutions
with formal internal audit departments and for institutions
with either no audit functions or limited audit activity.
Refer to the Management and Internal Control Evaluation
ED Module for details.
Test rental income for safe deposit boxes; examine and
confirm safekeeping items; and reconcile consigned items
on hand.
Income and Expenses
Test income and expenses by examining supporting
documentation for authenticity and proper approval; and
test accruals by either recomputing amounts or examining
documents supporting such accruals.
Recommendations to Management or the
Board of Directors
Serious or numerous internal routine and controls
deficiencies detected during an examination should be
brought to management's and the board's attention and
appropriate action urged. In making recommendations and
criticisms, examiners should consider the following points.
Direct Verification
Direct verification is universally recognized as one of the
most effective methods of confirming the correctness and
validity of certain accounts, primarily loan and deposit
balances and collateral. Direct verification should be an
important part of any internal and/or external audit
program, and may be employed alone as an internal control
separate from regularly scheduled audits.
•
•
There are two well-recognized types of direct verification,
positive and negative. When the positive method is used,
the customer is asked to confirm whether or not the
balance, as shown, is correct. When the negative method is
used, a reply is not requested unless an exception is noted.
•
The positive method has obvious advantages from an audit
standpoint as it provides considerable assurance the
customer has carefully checked the confirmation form.
The negative method is less costly and provides a measure
of protection in those institutions having a strong program
of internal control. The positive method is recommended
for loan accounts and preferred for deposit accounts, but
because of the high volume and cost factor in the latter, the
negative method is often employed. It is suggested that at
least large accounts, public accounts, dormant accounts
and accounts with high and usual volumes of activity be
positively verified.
•
•
•
Direct verification may be conducted in whole or in part.
The necessity for a complete verification of loans and
deposits is rare. A partial verification of representative
accounts is usually satisfactory. Overdue loans should be
included in the verification as well as charged-off loans. It
should be noted that direct verification may be
accomplished internally, as well as externally. To be
effective, the verification procedure (including follow-ups)
must be completely controlled by someone not having
responsibility for the accounts or records being verified.
The advantage and profitability of the suggestion to
the bank should be stressed, not the advantage to the
examiner.
The suggestion or criticism must have substance and
merit; criticisms that might be regarded as petty or
reflect personal preference of the examiner will not be
well-received.
The recommendation or criticism should be discussed
with operating management prior to bringing it to the
attention of the board of directors. The record or
procedure being criticized may have been devised by
the banker who may have considerable pride in it and,
conceivably, can offer a persuasive reason for its
continuance.
Recommending records or accounting forms supplied
by a particular vendor is to be avoided. These
decisions are within the purview of bank management,
not examiners.
It is possible to overdo criticisms. The goal of
obtaining correction of major deficiencies, as opposed
to listing a volume of relatively minor criticisms, is
more desirable.
The best results are achieved when criticisms are
based on specific negative findings, rather than
generalities, and accompanied by recommended
remedial action consistent with the seriousness of the
deficiencies and the bank's capacity and needs.
However, the relative importance of an individual
control or lack thereof must be viewed in the context
of the other offsetting control procedures that may be
in place. When deficiencies are considered to be of
sufficient importance, appropriate comments should be
set forth in the examination report.
Fraud and Insider Abuse
Examination Procedures
Internal Routine and Controls (12-04)
Section 4.2
4.2-16
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INTERNAL ROUTINE AND CONTROLS
Section 4.2
As noted previously, while examinations are not
undertaken for the purpose of uncovering fraud, the
examiner must be alert to its possible existence. Bank
personnel at every level have committed fraud and
experienced officers and employees have perpetrated large
defalcations over a period of years. The following
represent some of the most frequently used methods of
manipulation, as applied to those accounts that normally
offer the greatest risk and vulnerability. In addition, the
Fraud section of this Manual contains a surveillance
module for detecting bank fraud and insider abuse.
Lapping deposits; theft of cash; excessive over and short
activity; fraudulent checks drawn on customers' accounts;
fictitious cash items; manipulation of cash items; and
intentional failure to report large currency transactions or
suspicious activity.
Loans
Bond Trading
Forged or fictitious notes; accommodation loans; loans to
insider-related shell companies; embezzlement of principal
and interest payments; failure to cancel paid notes; use of
blank, signed notes; embezzlement of escrow and
collection accounts; commissions and kickbacks on loans;
fraudulent loans to cover cash items and overdrafts; and
diverted recoveries of charged-off loans.
Adjusted trading, which usually involves collusion between
a bank employee and a securities dealer to trade securities
at inflated prices; concealing trading losses from bank
management and examiners; and unauthorized purchases
and sales of securities, futures, or GNMA forward
contracts with benefit accruing to a bank employee.
Improper securities trading practices include:
Loan Collateral
•
Income and Expense
Embezzlement of income; fraudulent rebates on loan
interest; fictitious expense charges; overstated expense;
and misapplication of credit life insurance premiums.
Loans secured by phony collateral such as altered, stolen,
or counterfeit securities; or certificates of deposit issued by
illegitimate offshore banks; and brokered loans and linkfinancing arrangements where underlying collateral is not
properly pledged or is prematurely released.
•
•
Deposits
Unauthorized withdrawals from dormant accounts;
fictitious charges to customer accounts; unauthorized
overdrafts; payment of bank personnel checks against
customer accounts or against fictitious accounts,
manipulation of bookkeepers' throw-out items, computer
rejects or other items needed to reconcile deposit trial
balances; unauthorized withdrawals from accounts where
the employee is acting as an agent or in some other
fiduciary capacity; withholding and destroying deposit
tickets and checks; misappropriation of service charges;
kiting; and manipulation of certificates of deposit, official
checks, and money orders.
•
The different types of manipulations employed in
defalcations appear to be limited only by human ingenuity
and inventiveness. The schemes and methods devised to
cheat banks are virtually unlimited and pose a continuing
problem to banks and examiners alike. While no bank is
exempt from the threat of defalcations by management,
employees or outsiders, certain institutions are more
vulnerable than others. Any one or more of the following
conditions or situations may be indicative of the need to
utilize more comprehensive and intensive audit techniques:
Correspondent Bank Accounts
Lapping of cash letters; delayed remittance of cash letters;
fictitious credits and debits; issuing of drafts without
corresponding recordation on the bank's books or credit to
the account; overstatement of cash letters and return items;
and false collection items.
•
Tellers and Cash
DSC Risk Management Manual of Examination Policies
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Placing personal trades through bank accounts,
thereby obtaining the advantage of the bank's volume
discounts on commissions,
Purchasing or selling an issue of securities prior to
executing bank or trust account trades which could be
expected to change the price of the security, thereby
obtaining a personal price advantage ("frontrunning"),
Purchasing and selling the same securities issue on the
same day, with the trader pocketing any price
increases and assigning transactions to trust accounts
in the event of any price decreases, and
Buying or selling based on nonpublic material inside
information, which might affect the price of securities,
thereby enabling the trader to benefit personally from
the transaction.
•
4.2-17
The one-person dominated or operated institution
wherein one officer has complete control over a bank's
operations;
Lack of audit program;
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
•
•
•
•
•
•
•
Director’s approval, conduct a direct verification of loans
and/or deposits. The following basic procedures or
guidelines are utilized in direct verification.
Weak internal controls such as deficient vacation
policies or lack of separation of duties;
Records are poorly maintained and carelessly handled;
Close supervision by the board of directors and/or
senior management is lacking, especially where rapid
growth has occurred with concomitant accession of
inexperienced management;
Banks that recorded substantial growth in a short time
period. This may reflect the employment of "hot"
money or brokered funds, combined with fraudulent or
poor quality loans, resulting in dishonest acts to
conceal the bank's true condition;
Banks that recorded little growth or a steady decline in
deposits despite general economic prosperity in their
operating area and continued growth by competing
institutions;
Earnings and yields are below average and expenses
are high in comparison with past operating periods
with no apparent explanation for the change; and
Abnormal fluctuations in individual revenue or
expense accounts either in terms of dollar amounts or
in relation to all other operating accounts.
•
•
•
•
•
•
•
•
Possible Audit Techniques
Because of the virtually limitless opportunities for
perpetrating and concealing bank fraud, even a complete
and comprehensive audit may not expose the commission
of deceptive practices. Time constraints and optimum
resource utilization do not permit a complete audit during
bank examinations, nor would the benefits derived from
such efforts generally be warranted. Nevertheless, in those
cases where the examiner perceives the need, the
examination may be expanded to include the use of more
audit techniques and procedures. The following is a listing
of certain audit techniques available to examiners. The list
is not all-inclusive, nor is it intended that any or all of these
procedures be utilized at every examination.
•
Addressing, stuffing, sealing, and mailing of envelopes
should be done by examination personnel only.
Franked envelopes furnished for reply should be
preaddressed to a post office box rented for that
purpose, the Field Office, or the Regional Office.
A duplicate record of all items verified should be
maintained for control purposes.
Watch for borrowers with common addresses or post
office box numbers and for accounts having the same
addresses as bank officers and employees.
Loan verification should include charged-off notes;
separate notices should be sent to primary obligors,
comakers, endorsers, or guarantors.
Third party guarantees on lines of credit or individual
notes should be verified directly with guarantors and
not through primary obligors.
Deposit verification of recently closed dormant
accounts, overdrawn accounts, and pledged accounts
should be included.
All replies should be compared against retained
duplicate records. Exceptions should be further
investigated against bank records or through follow-up
correspondence with customers until discrepancies are
satisfactorily resolved.
Undelivered and returned tracers, unacknowledged
verifications, and unexplained differences should be
discussed with the entire board, not just with officers.
Loans
The techniques suggested below may be valuable when
examiners have cause to suspect possible irregularities
involving the loan portfolio.
•
General
•
Examiner-prepared reconcilements of all asset and liability
items can ensure that individual subsidiary records balance
to general ledger controls. Performance of any or all of the
checks, tests, and reviews listed in this section of the
Manual under Specific Review of Audit System and
Reports may also be helpful.
•
•
Direct Verification
Except for securities, correspondent bank accounts and
loan participations, direct verification is an audit procedure
not often employed by examiners. However, the examiner
may in certain circumstances, after obtaining the Regional
Internal Routine and Controls (12-04)
Section 4.2
•
4.2-18
Compare the signature on a note with other notes or
documents signed by the maker.
Determine by review of bank records who actually
pays the interest and principal on large lines of
continuous credit, and the sources of funds.
Regarding weak lines of a continuous nature,
investigate the possibility that directors or
management are actually the interested party although
the bank's records may fail to indicate such
information.
If a large number and amount of out-of-territory loans
are carried, spot check a cross-section of these items
as to disbursement of loan proceeds and sources of
payment of principal and interest.
Audit the interest collected on a sampling of loans.
Test check the loan interest account for several days
DSC Risk Management Manual of Examination Policies
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INTERNAL ROUTINE AND CONTROLS
•
•
•
and compare the total with journal figures and amount
credited to the general ledger.
Compare collateral records to loans secured by such
collateral, and compare the collateral receipt date with
the date the loan was granted.
In banks having large or numerous loan charge-offs,
compare actual charge-offs to those approved by the
appropriate authority; confirm that the amount
charged-off was the actual balance due on the loan;
determine who prepares the list of charge-offs, who
collects recoveries, and the accuracy of the reporting
of these items; and compare the actual instrument with
the bank's records to confirm balances and signatures.
Tracing the proceeds of loans charged off should also
be considered. Where sizeable loan losses have
occurred, it may be advisable to analyze the lines of
credit involved by tracing disbursement of loan
proceeds and reviewing the borrower's deposit account
for possible payments of commissions or fees to a
bank officer.
In investigating installment and account receivable
(A/R) financing departments, the following possible
activities should be considered: the "lapping" of
payments (use of prior payments which have been
withheld to-make current payments on a specific
loan(s)) is sometimes encountered. Check installment
A/R records for an unusually large number of advance
payments and/or a sizeable number of overdue loans.
In suspect cases, spot check payments made or due to
borrowers' checking accounts. Also, where the
volume of total outstanding installment loans has
increased substantially between examinations for no
apparent reason and overdue loans are unusually low
or high, spot check a cross-section of loans as to
disposition of proceeds, signatures, collateral and
sources of payment. In cases of fraudulent credits,
loan payments may be traced directly to proceeds of
other loans. Be watchful for multiple payments made
on the same date on a particular note and compare the
total of these payments with new loans granted on the
same date. In addition, poorly handled indirect dealer
paper lines should be investigated. Test checks should
be made for possible lapping of payments, creation of
fraudulent notes to cover delinquent payments, and
unauthorized use of the dealer reserve accounts.
•
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•
•
•
•
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•
Deposits
The following suggestions may be useful in the
investigation of improper activities in the bank's deposit
accounts.
•
In those banks manually posting deposit records, scan
ledgers for perfect alignment of figures and similar ink
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 4.2
density. This may indicate the sheet was prepared in
one operation to conceal a shortage. Check any
changes made in handwriting or by typewriter.
Comparison of the balances of transferred sheets with
end-of-month statements and pick-up balances on
carry forward sheets may prove helpful in suspect
situations.
Be alert for possible kiting in accounts.
The
characteristics of this type of account usually include
large, even checks, deposits of a like or similar
amount, and small average balances. The important
facts to determine in such cases are the amount of
"float", sources of funds, other banks involved and to
what extent, and how, when, and under what
circumstances the activity began. Computer generated
kiting suspect reports or uncollected funds reports can
be helpful and should be reviewed. Examiners should
determine who reviews the printouts and how often
they are reviewed. The printouts should be marked up
by whoever is reviewing them.
Note any unusual withdrawals from inactive or
dormant accounts.
Take note of packages of unposted checks and
undelivered or returned customer statements.
In connection with savings accounts, various methods
are available to determine the presence or disposition
of accounts to which interest was credited on the last
interest payment date.
Particularly in small banks that lack adequate
separation and rotation of duties, the transferring of a
shortage between individual deposit accounts is
always a possibility. In a bank where deposit
transactions are computer posted, such a situation may
be reflected in a machine reject of a continuous and
constant amount. In banks with a manual posting
system, a comparison of ledger sheets to customer
statements for consistency of entries may prove
helpful.
Cash items, machine rejects and cutbacks should be
compared to individual account records to determine if
the accounts have been closed, do not exist, or
balances are insufficient.
Interest paid on certificates of deposit can be crosschecked to the interest expense account as to date,
amount due, and amount actually paid.
Gain control of incoming cash letters and local
clearings. Sight-post items to demand account records
to determine if there is an account for each item. If the
cash letter has been opened prior to taking control,
compare the number of items listed on the tape
accompanying the letter with actual items to ascertain
whether any items have been removed.
Correspondent Bank Accounts
4.2-19
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
Determine the reason for any unusual or abnormal
variations between the various general ledger accounts.
Check the validity of any reversing or correcting entries,
particularly for a few days immediately following the
previous examination. Trace all income closing entries to
the undivided profits account.
The following audit steps are available relative to these
accounts:
•
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•
•
•
A comparison of the daily total for several days of
paid and cancelled drafts drawn on correspondent
banks with the general ledger entries for the same days
may reveal discrepancies. In particular, this test
should be made for the date of the last examination
and for the following several days.
Review of past reconcilements should emphasize large
outstanding items, unusual activity, forced balancing,
and continuous unreasonable delays in crediting
correspondents for their charges.
Cross entries on the same day between correspondent
accounts may indicate possible "kiting" or shortages
between correspondent accounts.
Delays in remitting for cash letters can be used to
cover defalcations.
Coin and currency transactions reflected on
correspondent accounts should be compared to a
bank's increase or decrease in the cash account on
those particular days.
Other
Be watchful for any major change, particularly growth, in
assets or liabilities. In cases of rapid loan expansion,
check for the possibility of out-of-territory loans to
insiders. If both loans and certificates of deposit have
increased beyond normal expectations check the source of
certificates of deposit; check for tie-ins between new notes
and new certificates of deposit as to common names,
common amounts and/or common dates; trace the proceeds
of new loans; and determine the source of principal and
interest payments on new loans.
Secretary of State Websites
Many states have websites that can provide valuable
information on an entity’s corporate structure, principal
shareholders, or officers and directors. In addition, a
search can usually be completed to ascertain the principals
other business relationships.
Tellers and Cash
Tellers' daily cash records can be inspected for possible
discrepancies such as forced balancing, unusual charges or
an excessive total and number of cash items. Items drawn
on or by bank personnel should always be verified as to
final payment or disposition. All work can be checked for
prior endorsements and dates that may indicate a teller has
been carrying these items for a long period.
OTHER RELATED MATTERS
Information Technology
With respect to internal controls in information systems,
Part 364 of the FDIC Rules and Regulations requires
institutions to have systems that provide for the following
elements commensurate with the size of the institution and
the nature, scope and risk of its activities:
Suspense Accounts
In many banks, asset and/or liability suspense accounts are
used as "catch-alls." These accounts should be reviewed
for large or unusual items. In some instances, suspense
accounts have been used for concealment of shortages,
worthless assets, and deposit diversions.
•
•
•
Income and Expense Accounts
Test check interest computations on a sampling of loans
and securities. Large, regular or unusual debits to income
accounts should be verified and interest rebates on loans
and monthly service charges on demand deposits may be
tested. Finally, interest paid on time and savings deposits
can be compared to the amount credited to the respective
controls.
•
•
An organizational structure that establishes clear lines
of authority and responsibility for monitoring
adherence to established policies;
Effective risk assessment;
Timely and accurate financial, operational, and
regulatory reports;
Adequate procedures to safeguard and manage assets;
and
Compliance with applicable laws and regulations.
If an institution’s internal control systems do not meet the
above standards, the deficiencies should be described in
the Report of Examination or Information Technology
Report of Examination, as appropriate.
General Ledger Accounts
Internal Routine and Controls (12-04)
Section 4.2
4.2-20
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Federal Deposit Insurance Corporation
INTERNAL ROUTINE AND CONTROLS
Rapid changes in information technology have vastly
altered the methods by which financial institutions process
data. There may be any number of mediums incorporated
within the institution to accomplish data processing needs.
Networks are increasingly prevalent in the present multilocation banking environment. As with any other function
in banking, operation of information systems presents
certain risks and may ultimately impact safety and
soundness of the institution. For this reason, the operation
and control over information technology should be
identified and reviewed at every examination.
desired information is usable as a performance
measurement. There are five essential elements that must
be addressed before any MIS can be considered usable.
They are timeliness; accuracy; consistency; completeness,
and relevance. Management decisions and strategies may
be rendered invalid or, in fact, detrimental should any one
of these components be compromised.
In order to evaluate MISs, and ultimately the foundation
upon which management's decisions are based, examiners
must scrutinize each of the five essential components.
First, information must be current and available to all
appropriate users to facilitate timely decisions. This
necessitates prompt collection and editing of data.
Secondly, a sound system of internal controls must be in
place to ensure the accuracy of data. Information should
be properly edited and reconciled, with the appropriate
control mechanisms in place. A comprehensive internal
and external audit program would greatly facilitate this
endeavor. Strategies and decisions can not be adequately
monitored or measured unless information provided is
consistent. Variations in how data is collected or reported
can distort trend analysis. Any change in collection or
reporting procedures should be clearly defined,
documented, and communicated to all users. Information
provided by MIS mechanisms must be complete. Lastly,
information provided must be relevant. Details that are
inappropriate, unnecessary, or unsuitable are of no value in
effective decision-making. Decision-makers can not fulfill
their responsibilities unless all pertinent information is
provided in a comprehensive, yet concise format. Care
should be taken to ensure that senior management and the
board of directors receive relevant information in order to
identify and measure potential risks to the institution.
Sound MIS is a key component of management
effectiveness and should be evaluated in relation to the
size, structure and decision-making process of each
individual institution.
Protecting or securing information and facilities that
process and maintain information is vital to the continuity
of operations. It is essential that information be accurate,
safeguarded and provided without interruption. In order to
maintain continuity and reliability of information,
institutions should, at a minimum, formulate a
comprehensive security plan to ensure that operations and
data are not vulnerable to undue risks and exposures. The
plan should, at a minimum, address: physical security; data
security; and backup and contingency planning.
The FFIEC Information Technology Systems Examination
Handbook is comprised of several booklets, each on a
different topic, serves as a reference for the examination of
these systems.
The Handbook contains information
technology examination procedures, examination report
format, workprograms and related laws, regulations and
examination policies. It also provides the examiner with
fundamental principles of internal controls in all
information processing environments.
The FFIEC
procedures, workprograms, and examination report format
are the primary tools for the examination of large, complex
data centers in financial institutions and independent
technology service providers.
Information Technology Maximum Efficiency, RiskFocused, Institution Targeted (IT-MERIT) procedures and
the IT General Workprogram are the primary tools for
evaluating information technology in financial institutions
with non-complex information technology functions.
Electronic Funds Transfer Services
Electronic fund transfer services can be grouped broadly
into wholesale and retail systems. Wholesale systems
generally are thought of as large dollar systems. Whereas,
retail systems might include automated clearing houses,
automated teller machines, point-of-sale systems, telephone
bill paying, home banking systems and debit cards.
Procedures for review of retail systems are comprehensive
and are covered in the FFIEC Information Technology
Examination Handbooks on Retail Payment Systems and
Wholesale Payment Systems.
Information systems
procedures do not cover wholesale wire transfer systems.
Management Information Systems
A management information system (MIS) is a system or
process that provides the information necessary to
effectively manage an organization. MIS is essential in all
institutions, but becomes increasingly important in larger
more departmentalized organizations. MIS is considered a
feedback device and as such is a method for managing
risks. The board of directors and management determine
what information is needed for them to make informed
decisions and monitor activities of the institution. Staff
correspondingly develops the systems to ensure that the
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
Section 4.2
Access to wholesale or large dollar transfers is most often
provided through the FEDWIRE and CHIPS (Clearing
4.2-21
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
House Interbank Payment System). The latter of which is
an international payments clearing system for transactions
between domestic and foreign banks. Services available
through FEDWIRE include transfers of funds between
member institutions; transfers of U.S. Government and
Federal agency securities; data transfers such as Automated
Clearing House payment files; and administrative and
research information. Member institutions may access
FEDWIRE by three methods: off-line via telephone with
Federal Reserve Bank; dial up access via a PC based
system; or direct computer interface.
•
•
Although there is no settlement risk in the FEDWIRE
system, there may be exposure due to errors and omissions
and fraud. Because of these risks, a review of credit risks
and control systems for wholesale wire transfer systems
should be conducted at each safety and soundness
examination. A separate examination procedures module
on electronic funds transfer risk assessment is included in
the ED Modules.
Securities are defined as corporate securities (those
with a CUSIP number), municipal securities, and
bearer U.S. Government and Agency securities that
have actual certificates (not book-entry securities).
Missing is defined as any certificate that cannot be
located, but which is not believed to be lost or stolen,
or that the transfer agent believes was destroyed, but
was not destroyed according to the certificate
destruction procedures required by SEC Rule 17AD19.
For the purposes of this rule, the following types of
securities are not subject to the inquiry and reporting
requirements: registered securities of the U.S. Government,
any agency or instrumentality of the U.S. Government, the
International Bank for Reconstruction and Development,
the InterAmerican Development Bank, or the Asian
Development Bank, and counterfeit securities of such
entities; security issues not assigned CUSIP numbers; and
bond coupons. In addition, the SEC commented that the
rule does not include bond coupons, or escheated, called,
or restricted securities, issues in litigation, and bankrupt
issues.
Lost and Stolen Securities Program
(SEC Rule 17f-1)
Banks may receive securities certificates through
transactions for their own investment, as collateral for
loans, as trust assets, or through transfer agent activities.
In each situation, a bank may possess a securities
certificate that has been reported as lost, stolen, counterfeit,
or missing.
In 1979, the Securities and Exchange
Commission (SEC) implemented Rule 17f-1 to require
reporting and recordkeeping of such securities, so that the
certificates are not later used erroneously or fraudulently.
The regulation authorized the SEC to delegate the
recordkeeping function and named Securities Information
Center (SIC) as the central repository. SIC may be
contacted at the Securities Information Center, Inc., P.O.
Box 55151, Boston, MA 02205-5151 or via the Internet at
www.secic.com.
Banks must make an inquiry to the SIC by the end of the
fifth business day after a certificate comes into its
possession, unless the security is received directly from the
issuer or issuing agent at the time of issue; received from
another reporting institution or Federal Reserve bank or
branch, or a securities drop that is affiliated with a
reporting institution; received from a customer of the bank,
and the security is registered in the name of the customer
or its nominee or was previously sold to the customer, as
verified by the internal records of the bank; or part of a
transaction involving bonds of less than $10,000 face value
and stocks of less that $10,000 market value. The limit
applies to the aggregate transaction amount, not to the
individual security. However, the recent amendment to the
rule also provides that inquiries shall be made before the
certificate is sold, used as collateral, or sent to another
institution, if occurring sooner than the fifth business day.
Registration
All banks that possess or plan to possess securities
certificates should be registered as either a direct or
indirect inquirer. For direct inquirers, the bank has direct
access to the SIC. For indirect inquirers, the bank submits
information through another bank, most likely a
correspondent bank, to inquire on the bank’s behalf. In
either event, institutions may inquire of the SIC whether a
certificate has been reported as lost, stolen, counterfeit, or
missing.
All securities certificates identified as lost, stolen,
counterfeit or missing, which are or were in the bank’s
possession or control must be reported to the SIC on Form
X17FIA. The transfer agent for the certificate should
receive a copy of the report, also. For each report
submitted, the bank shall maintain and preserve copies of
the forms for three years, along with other information
received from the SIC as a result of the inquiry. Banks that
are registered as indirect inquirers should maintain
evidence of the inquiries made via the direct inquirer to the
same extent required of the direct inquirers.
For the purposes of the rule, the following definitions are
applicable:
Internal Routine and Controls (12-04)
Section 4.2
4.2-22
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INTERNAL ROUTINE AND CONTROLS
Counterfeit securities certificates and stolen certificates
involving suspected criminal activity must also be
promptly reported to the FBI if there is a “substantial
basis” for believing that criminal activity was involved.
All counterfeit securities must also be reported to the FBI.
If a report has been filed with the SIC or the FBI has been
notified, a report to the FDIC is not required. Refer to
FDIC Rules and Regulations Part 353 regarding suspicious
activity reports. A Suspicious Activity Report (SAR) is
required for:
•
•
•
Section 4.2
excessive fees or salaries paid to officers, and low to zero
interest rate loans. In addition, political contributions have
been made by providing equipment and services without
charge to candidates for office. Many of these devices
involve clear departures from acceptable accounting
practices. Consequent lack of corporate accountability
raises serious questions regarding the effectiveness of an
organization’s own internal audit procedures. For banking
organizations to engage in illegal or unethical activities and
to attempt to conceal those activities by the use of irregular
accounting practices only serves to undermine public
confidence in the banking system.
Insider abuse involving any amount;
Transactions aggregating $5,000 or more where a
suspect can be identified;
Transactions aggregating $25,000 or more regardless
of potential suspects..
The following items may be considered to detect violations
of these two laws, and to evaluate the effectiveness of an
individual institution’s control in detecting such violations.
A Suspicious Activity Report must be filed within 30 days
of discovery with the Financial Crimes Enforcement
Network.
1.
Determine whether the bank has a policy prohibiting
improper or illegal payments, bribes, kickbacks,
loans, and the like covered by statutes. If the bank
has a policy, review and analyze it for adequacy.
2.
Determine how the policy, if any, has been
communicated to officers, employees or agents of the
bank.
3.
Review any investigative study performed by or on
behalf of the board of directors evaluating the bank's
policies and operations concerning the advance of
funds in possible violation of the statutes. In
addition, ascertain whether the bank was investigated
by any other government agency with respect to a
possible violation of the statutes and, if so and
available, review the materials generated by such an
investigation.
4.
Review and analyze any internal and external audit
program employed by the bank to determine whether
the internal and external auditors have established
appropriate routines to discover improper and illegal
payments under the statutes. To determine the
adequacy of any audit programs, the examiner should
complete the following procedures:
Examination Considerations
Examiners should consider reviewing the requirements of
Rule 17f-1 with bank personnel to ascertain their
knowledge and understanding of the rule. Bank procedures
may be reviewed to determine adherence to the provisions
of the rule. The examiner should consider the bank's audit
procedures covering the lost and stolen securities program
and ascertain whether documentation is adequate to
determine compliance with the rule.
Test checks of the bank's inquiry procedures can be
effectively integrated into the examination process.
Inquiry will most likely be required for securities coming
into the bank's possession as collateral for loans or as
assets received by the bank's trust department.
A
subsequent check of the bank's inquiry records can
determine compliance with Rule 17f-1. Noncompliance
should be reported as an apparent violation of SEC Rule
240.17f-1 on the violations page of either the commercial
or trust report of examination. Various aspects of SEC
Rule 17f-1 are also discussed in the Trust Manual.
Improper and Illegal Payments by Banks and
Bank Holding Companies
•
During the review of audit programs, determine
whether the programs remind the auditors to be
alert to any unusual entries or charges which
might be improper or illegal payments to persons
or organizations covered by the aforementioned
statutes;
•
Determine whether the auditor is aware of the
provisions of the Foreign Corrupt Practices Act
and the Federal Election Law and whether audit
The Foreign Corrupt Practices Act and the Federal
Election Campaign Act cover improper and illegal
payments by banks and bank holding companies.
The devices used by banking organizations to make
political payments include compensatory bonuses to
employees, improperly designated expense accounts,
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Federal Deposit Insurance Corporation
4.2-23
Internal Routine and Controls (12-04)
INTERNAL ROUTINE AND CONTROLS
programs have been developed to check
compliance with those laws; and
•
Review such programs and the results of any
audits.
5.
Analyze the general level of internal control to
determine whether there is sufficient protection
against improper or illegal payments under the
aforementioned statutes being inaccurately recorded
on the bank's books.
6.
If the review and analysis under paragraphs 4 and 5
indicate that either the audit program or the internal
controls or both are inadequate, then the examiner
should perform the following verification techniques:
Section 4.2
•
Activity in overdrafts and accounts of directors,
officers, and employees; and
•
Reconcilement of bank controlled accounts such
as official checks and escrow accounts.
• Randomly select charged off loan files and
determine whether any charged off loans are to
foreign government officials or other persons or
organizations covered by the Foreign Corrupt
Practices Act or are to persons covered by the
Federal Election Law;
7.
•
Review bank controlled accounts on a random
sample basis, such as dealer reserves and
cash/collateral accounts, to determine the validity
of entries and notification procedures to the
customer of activity. With respect to official bank
checks, review copies of the checks and
supporting documentation on a random sample
basis for unusual items or any checks to persons
or organizations which may be in violation; and
•
For those significant income and expense
accounts on which verification procedures have
not been performed elsewhere, analyze such
accounts for the period since the last examination
and obtain by discussion with bank personnel and
the review of supporting documents explanations
for the significant fluctuations and unusual items
noted.
Examiners should be alert in the course of usual
examination procedures for any transactions, or the
use of any bank services or equipment, which might
represent violations. Examiners should be especially
alert with respect to:
•
Commercial and other loans, including
participations, which may have been made in
connection with any political campaigns;
•
Income and expense ledger accounts for unusual
entries and significant entries from an unusual
source;
Internal Routine and Controls (12-04)
4.2-24
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Federal Deposit Insurance Corporation
RELATED ORGANIZATIONS
Section 4.3
also discusses the major provisions of the GLBA as
affecting such transactions and the statutory implications
for the FDIC examination process.
DEFINITIONS AND AUTHORITIES
Sections 23A and 23B of the Federal Reserve Act (FR
Act), as applied by the Federal banking agencies under
various Federal banking statutes, govern transactions
between banks and affiliated business organizations. The
Gramm-Leach-Bliley Act (GLBA) amended many laws
governing the affiliation of banks and other financial
service providers. Among other laws, the GLBA amended
the Banking Act of 1933, the Bank Holding Company Act
of 1956, (BHC Act), the Interstate Banking and Branching
Efficiency Act of 1994, the Investment Company Act of
1940, the Investment Advisers Act of 1940, the Securities
Exchange Act of 1934, the International Banking Act of
1978, the FR Act, the Federal Deposit Insurance Act (FDI
Act), and the Home Owners’ Loan Act.
GRAMM-LEACH-BLILEY ACT (GLBA)
The passage of the GLBA significantly expanded the
powers of bank subsidiaries of bank holding companies to
engage in “financial activities,” including offering
insurance and securities products. The GLBA added
Section 46 of the FDI Act that prescribes the circumstances
in which an insured state bank may engage in financial
activities as principal that may be conducted by a national
bank only through a financial subsidiary. The GLBA also
repealed the restrictions on banks affiliating with securities
firms which were contained in Section 20 of the GlassSteagall Act and repealed the prohibition on interlocking
directors between banks and securities firms contained in
Section 32.
Section 18(j) of the FDI Act extends the provisions of
Sections 23A and 23B of the FR Act to state nonmember
banks. Section 23A regulates transactions between a bank
and its "affiliates,” as that term is specifically defined in
Section 23A. Section 23B of the FR Act was enacted as
part of the Competitive Equality Banking Act of 1987 to
expand the range of restrictions on transactions with
affiliates. Section 10(b)(4) of the FDI Act authorizes
FDIC examiners in the course of examining insured banks
“to make such examinations of the affairs of any affiliate of
any depository institution as may be necessary to disclose
fully --- (i) the relationship between such depository
institution and any such affiliate; and (ii) the effect of such
relationship on the depository institution.” “Affiliate” is
defined in Section 3(w)(6) of the FDI Act as having the
same meaning as the definition of that term in Section 2(k)
of the BHC Act.
Financial Holding Company
The GLBA authorizes the organization of a “financial
holding company” (FHC) under Section 4 of the BHC Act.
A FHC can engage in any activity, and may acquire shares
of any company engaged in any activity, that the Board of
Governors of the Federal Reserve System (the FRB)
determines to be either financial in nature or incidental to
such financial activity, or complementary to a financial
activity and does not pose a substantial risk to the safety or
soundness of depository institutions or the financial system
generally.
The GLBA identifies some specific activities which are
determined to meet this test and prescribes a consultative
process involving the shared input of both the FRB and the
Secretary of the Treasury for future definition of activities
determined to meet the test.
FDIC’s enforcement authority also extends to certain
parents and affiliates which are not bank holding
companies.
Section 3(u) of the FDI Act defines
“institution affiliated parties” to include the controlling
stockholder of an insured depository institution, or any
shareholder or person who participates in the conduct of
the affairs of an insured depository institution, or any
independent contractor who participates in certain acts
which cause significant adverse affect on an insured
depository institution. This would include the parent
companies of Industrial Loan Companies and other “nonbank” charters. Under Section 8(b) of the FDI Act, the
FDIC can issue Orders against institution affiliated parties.
Section 4(k)(4) of the BHC Act identifies a list of specific
activities deemed “financial in nature” for these purposes.
Qualifying FHCs may engage in such activities without
regulatory approval provided notice is given to the FRB
within 30 days after the activity is commenced. The listed
activities include:
•
This section of the Manual discusses affiliates and
subsidiaries, including the restrictions on transactions
between affiliates and insured banks, exceptions to those
restrictions, and the examination authority of the FDIC
with respect to affiliates of nonmember insured banks. It
DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation
•
4.3-1
Lending, exchanging, transferring, investing for
others, or safeguarding money or securities,
Insuring, guaranteeing or indemnifying against loss or
illness, or issuing or providing annuities, as principal,
agent or broker,
Related Organizations (12-04)
RELATED ORGANIZATIONS
•
•
•
•
•
•
•
Section 4.3
activities that were identified in the GLBA as being
financial in nature are already permissible for a national
bank to conduct directly.
Providing various forms of financial, investment or
economic advisory services, including advising
investment companies,
Issuing and selling instruments representing interests
in pools of assets permissible for a bank to hold
directly,
Securities underwriting, dealing and market making,
Engaging in activities that have been determined to
meet the “closely related” and “proper incident” tests
under Section 4(c)(8) of the BHC Act,
Engaging in activities in the United States that the
FRB has previously authorized bank holding
companies and their subsidiaries to conduct abroad
under Section 4(c)(13) of the BHC Act,
Certain merchant banking activities, and
Certain “insurance company portfolio investment”
activities.
The statutory criteria that must be satisfied in order to
engage in activities through a financial subsidiary are:
•
•
•
Conditions Precedent to New Activities:
•
The following guidelines exist relative to a bank holding
company entering into new activities:
•
•
•
•
All depository institution subsidiaries of the bank
holding company must be “well capitalized” and “well
managed.”
A “satisfactory” or better CRA rating must have been
received by all of the depository institution
subsidiaries at their most recent examination.
The bank holding company must file with the FRB an
election to become a financial holding company.
There is a grandfather provision for certain nonconforming activities of a company that is not now a
bank holding company but then becomes one to
continue to engage in commercial activities in an
amount not to exceed 15 percent of its consolidated
annual gross revenues, excluding bank subsidiaries.
The grandfather provision will expire ten years after
the date of enactment, unless extended by the FRB for
an additional five years.
•
Functional Regulation
The GLBA also provides for the functional regulation of
securities and insurance activities. This means that similar
activities should be regulated by the same regulator so as to
promote regulatory efficiencies and eliminate burden and
duplication. Accordingly, banking activities are to be
regulated by bank regulators, securities activities by
securities regulators and insurance activities by State
insurance departments. In order for functional regulation to
be effective, certain consultation and information-sharing
requirements are also contained in the statute.
The FRB is the umbrella supervisor for FHC’s. As such,
the FRB assesses the FHC’s overall financial condition and
the systems for monitoring risks for the entity as a whole.
The BHC Act was amended to restrict the authority of the
FRB to require reports, conduct examinations, impose
capital requirements or take any other direct or indirect
action with respect to any functionally regulated affiliate of
a depository institution. Section 45 was added to the FDI
Act, which made these restrictions applicable to the FDIC.
Financial Subsidiaries
Implementing Section 121 of the GLBA as it pertains to
state nonmember banks, the FDIC added Subpart E to Part
362 of its regulations. For purposes of Subpart E, a
“financial subsidiary” is defined as a subsidiary that is
controlled by a state nonmember bank and engages as
principal in activities which may be conducted by a
national bank only through a financial subsidiary. Most
Related Organizations (12-04)
The state nonmember bank and each insured
depository institution affiliate of the state nonmember
bank must be and continue to be well capitalized after
deducting the bank’s investment, including retained
earnings, in all financial subsidiaries.
The state nonmember bank must disclose the capital
deduction and the separate assets and liabilities of the
subsidiary in any published financial statement.
The state nonmember bank must comply with the
ongoing financial and operational safeguards required
by Section 5136A(d) of the Revised Statures of the
United States, which requires operational safeguards
to separate the bank from the risks of the subsidiary.
The state nonmember bank must comply with the
amendments to Sections 23A and 23B of the FR Act
made applicable by Section 121(b) of the GLBA that
require certain ongoing transactional restrictions.
The state nonmember bank and all of its insured
depository affiliates must have received a CRA rating
of not less than a “satisfactory record of meeting
community credit needs” in its most recent CRA
examination.
It is still necessary to determine the significance of the
activities conducted by the functionally regulated
subsidiaries and determine whether the level of such
activities could pose a material risk to the insured
4.3-2
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Federal Deposit Insurance Corporation
RELATED ORGANIZATIONS
Section 4.3
depository institution. This functional regulation concept
does not, however, alter the Corporation’s authority under
Section 10(b)(4) of the FDI Act to examine affiliates “as
may be necessary to disclose fully (i) the relationship
between the depository institution and the affiliate; and (ii)
the effect of such relationship on the depository
institution.”
any matter in respect to the affairs or ownership of any
such institution or affiliate. Accordingly, individuals,
corporations, partnerships, or other entities which in any
way affect the bank's affairs or ownership may be
subpoenaed and required to produce documents under the
FDIC's Section 10(c) powers.
Proper use of Section 10(c) powers can be a valuable aid to
the FDIC in carrying out its supervisory responsibilities.
However, the reasons why examinations of affiliates are
considered advisable or necessary by the examiner should
be documented, and the extent of any such examination
should have prior clearance from the Regional Office. The
exercise of Section 10(c) powers will require extensive
legal documentation and should only be initiated following
authorization from the Director, DSC.
A functionally regulated entity under the GLBA means a
company:
•
•
•
•
Engaged in insurance activities (as agent or principal)
supervised by State insurance commissioners;
Registered with the Securities and Exchange
Commission (SEC) as an investment company under
the Investment Company Act of 1940;
Registered as an investment adviser either with the
SEC or any State; or
Engaged in commodity activities regulated by the
Commodities Futures Trading Commission.
BANK HOLDING COMPANIES
Under Section 2 of the BHC Act a "bank holding
company" is defined to include any corporation,
partnership, business trust, association, or similar
organizations, or any long-term trust (one which extends
beyond 25 years or 21 years and 10 months after the death
of individuals living on the effective date of the trust)
which has control over any bank or over any bank holding
company. A bank, of course, is a company and, therefore,
may be a bank holding company if it controls another bank
or bank holding company. By virtue of amendments to the
BHC Act, one-bank holding companies, partnerships, an
