Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Syndicated loan wikipedia , lookup
Systemic risk wikipedia , lookup
History of the Federal Reserve System wikipedia , lookup
Securitization wikipedia , lookup
Financialization wikipedia , lookup
Investment management wikipedia , lookup
Interbank lending market wikipedia , lookup
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 1.1-11 Basic Examination Concepts and Guidelines (10/12) BASIC EXAMINATION CONCEPTS AND GUIDELINES 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 1.1-12 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation Section 1.1 1.1-13 Basic Examination Concepts and Guidelines (10/12) BASIC EXAMINATION CONCEPTS AND GUIDELINES 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 1.1-14 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation Section 1.1 1.1-15 Basic Examination Concepts and Guidelines (10/12) 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) 1.1-16 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 Basic Examination Concepts and Guidelines (10/12) BASIC EXAMINATION CONCEPTS AND GUIDELINES 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 Basic Examination Concepts and Guidelines (3/12) Section 1.1 1.1-18 RMS Manual of Examination Policies Federal Deposit Insurance Corporation BASIC EXAMINATION CONCEPTS AND GUIDELINES 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. RMS Manual of Examination Policies Federal Deposit Insurance Corporation 1.1-19 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies 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 Basic Examination Concepts and Guidelines (10/12) 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, RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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. RMS Manual of Examination Policies Federal Deposit Insurance Corporation 1.1-25 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies 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 2.1-8 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation CAPITAL 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 2.1-9 Capital (12-04) CAPITAL Section 2.1 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 Capital (12-04) Policies 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. 2.1-10 DSC Risk Management Manual of Examination Federal Deposit Insurance Corporation CAPITAL Section 2.1 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 2.1-11 Capital (12-04) CAPITAL 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) Policies 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 DSC Risk Management Manual of Examination Federal Deposit Insurance Corporation CAPITAL Section 2.1 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation It is important to note that what is adequate capital for safety and soundness purposes may differ significantly 2.1-13 Capital (12-04) 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 Capital (12-04) Policies 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 DSC Risk Management Manual of Examination Federal Deposit Insurance Corporation CAPITAL 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Federal Deposit Insurance Corporation ASSET QUALITY Section 3.1 INTRODUCTION..............................................................2 EVALUATION OF ASSET QUALITY ............................2 RATING THE ASSET QUALITY FACTOR....................2 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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. RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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, DSC Risk Management Manual of Examination Policies 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 Loans (12-04) 3.2-2 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies 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; DSC Risk Management Manual of Examination Policies 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: • • • • 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-9 Loans (12-04) 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. • • • • 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 Loans (12-04) LOANS • • • • • • 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-13 Loans (12-04) 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; Loans (12-04) Loan administration procedures; Documentation, approval and reporting requirements; and Procedures for monitoring real estate markets within the institution's lending area. 3.2-14 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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: DSC Risk Management Manual of Examination Policies 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 3.2-15 Loans (12-04) LOANS 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. Loans (12-04) 3.2-16 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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. 3.2-17 Loans (12-04) LOANS 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 Loans (12-04) 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, 3.2-18 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-19 Loans (12-04) LOANS 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 Loans (12-04) 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. DSC Risk Management Manual of Examination Policies 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 3.2-21 Loans (12-04) LOANS 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 3.2-22 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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 Loans (12-04) LOANS 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. Loans (12-04) 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS • • 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 3.2-25 Loans (12-04) LOANS 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. Loans (12-04) 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 3.2-26 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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: • • • • • • • 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation • 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; Loans (12-04) LOANS • 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. • • • 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 Loans (12-04) Appraisal and Evaluation Program - An institution's board of directors is responsible for reviewing and adopting 3.2-28 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 policies and procedures that establish an effective real estate appraisal and evaluation program. The program should: • • • • • • • • 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: • • • • 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation Minimum Appraisal Standards - The agencies' appraisal regulations include five minimum standards for the preparation of an appraisal. The appraisal must: • 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 Loans (12-04) LOANS • • • • 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 Loans (12-04) 3.2-30 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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: • • • • • • 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, DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation Renewals, Refinancings, and Other Subsequent Transactions - The agencies' appraisal regulations 3.2-31 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 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 3.2-32 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 • 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: DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-33 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) During the life of the participation, the participant should monitor the servicing and the status of the loan. In order to 3.2-34 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-35 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-36 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation Technical incompetence usually is manifested in management's inability to obtain and evaluate credit information or put together a well-conceived loan package. 3.2-37 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS • 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; DSC Risk Management Manual of Examination Policies 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. 3.2-39 Loans (12-04) 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. 3.2-40 DSC Risk Management Manual of Examination Policies 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. DSC Risk Management Manual of Examination Policies 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. 3.2-41 Loans (12-04) LOANS 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 Loans (12-04) 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. 3.2-42 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 Loans (12-04) 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 DSC Risk Management Manual of Examination Policies 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. Loans (12-04) LOANS • • 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. Loans (12-04) 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 3.2-46 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-47 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-48 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 Federal Deposit Insurance Corporation 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 3.2-49 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) • 3.2-50 The examination indicates that the bank maintains and applies loan loss classification standards that are DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS • 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] DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-51 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 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 3.2-52 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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. 3.2-53 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 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. 3.2-54 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-55 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-56 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-57 Loans (12-04) LOANS Section 3.2 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. Loans (12-04) 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. Functions of Bankruptcy Trustees 3.2-58 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 Property of the Estate DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-59 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-60 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation gaining attractive pricing advantages. 3.2-61 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-62 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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. 3.2-63 Loans (12-04) LOANS Section 3.2 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. Loans (12-04) 3.2-64 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-65 Loans (12-04) LOANS • 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 Loans (12-04) 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: 3.2-66 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS • • • • • • • • • • • Section 3.2 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. • • • • 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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. Risk Management 3.2-67 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-68 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.2-69 Loans (12-04) LOANS Section 3.2 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 Loans (12-04) 3.2-70 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 3.2-71 Loans (12-04) LOANS Section 3.2 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 Significant Risks Loans (12-04) 3.2-72 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation LOANS Section 3.2 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 Loans (12-04) 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: Loans (12-04) 3.2-74 DSC Risk Management Manual of Examination Policies 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: • • • • • • • Market risk, Credit risk, Liquidity risk, Operating risk, Legal risk, Settlement risk, and Interconnection risk. • • • • This section provides guidance, policy, and sound practices regarding: • • • • • • • • • 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 • • • • • • • 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 • • • • • • • • 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. • • PROCEDURES, 3.3-2 DSC Risk Management Manual of Examination Policies 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: • • • • • 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: • • • • • • • • 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, DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation SECURITIES AND DERIVATIVES • • • • • • • 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: • • • • • • 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 DSC Risk Management Manual of Examination Policies 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 Securities and Derivatives (12-04) 3.3-6 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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. DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 3.3-13 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES Section 3.3 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 3.3-14 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES Section 3.3 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 3.3-15 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES 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, DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 3.3-16 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 3.3-17 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES Section 3.3 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: • • • • • • • • • • • • • • • • • • • • • • 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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. 3.3-18 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES Section 3.3 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." DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 3.3-19 Securities and Derivatives (12-04) SECURITIES AND DERIVATIVES Section 3.3 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. • • • • • • • • • 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 3.4-3 Cash and Due From Banks (3/12) 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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. RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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. RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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, RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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. Other Real Estate (3/12) 3.6-4 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies Federal Deposit Insurance Corporation 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 RMS Manual of Examination Policies 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 RMS Manual of Examination Policies 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation MANAGEMENT Section 4.1 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 4.1-1 Management (12-04) 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 4.1-2 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation MANAGEMENT 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 4.1-3 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation MANAGEMENT Section 4.1 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 Management (12-04) 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 4.1-6 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation MANAGEMENT Section 4.1 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 4.1-7 Management (12-04) 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 Management (12-04) 4.1-8 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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, DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 4.1-9 Management (12-04) MANAGEMENT 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 Federal Deposit Insurance Corporation 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 Management (12-04) 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. DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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, DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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. DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation INTERNAL ROUTINE AND CONTROLS 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation INTERNAL ROUTINE AND CONTROLS 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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 Federal Deposit Insurance Corporation 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 Federal Deposit Insurance Corporation 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. • • • • • • • • 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: • • • • • 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation 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, DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies 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 DSC Risk Management Manual of Examination Policies 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